HNI Corporation: A Reasonable Deal At The Wrong Time

Investors in HNI Corporation (NYSE:HNI) have had to swallow some tough news as of recent. After shares peaked at $45 in 2021 they had fallen to the $30 mark in recent weeks as the company surprised the market by a big acquisition for Kimball International, Inc. (KBAL).

To judge the deal on its merits, let us first deep-dive into HNI itself.

The HNI Corporation Business

HNI Corporation is a manufacturer of commercial furnishing and building products. The business reports across two segments. Workplace furnishing focuses on the design and manufacturing of commercial furnishing, marketed under several brands.

The residential building product segment focuses on the manufacturing of health products such as gas, electric, wood fireplaces, and related product. As seen below, this is a less competitive and much higher margin business.

The company posted an 8% increase in 2022 sales to $2.36 billion and, while gross margins in the mid-fifties look reasonable, this inherently is a low-margin business (on a consolidated basis). The company posted operating profits of $155 million, for margins of 6.6%, but this includes a $50 million gain on the sale of a subsidiary. Adjusted for this and some items, the company posted adjusted operating profits of $128 million, for margins equal to 5.4%, translating into earnings of $2.20 per share.

The workplace furnishing business was responsible for $1.48 billion in sales in 2022, making it the largest segment, yet operating profits of $3 million translate into an essentially breakeven result. Even adjusted earnings of $23 billion only worked down to margins of 1% and change. The residential building products business is the bright spot, as it grew 2022 sales by as much as 17% to $875 million, reporting fat operating profits of 18% along the way.

HNI Corporation ended the year with $170 million in net debt, as the company posted a gross debt ratio of 0.7 times. With shares trading at $30 at the start of 2023, HNI Corporation trades at around 14 times earnings, but there is a reason for that.

Higher interest rates had a clear impact on the housing and construction sector, something likely to have a big impact in 2023. The company indicated that it sees volumes down in 2023, yet it has not quantified this, as it expects cost savings and productivity initiatives to offset many of these headwinds.

The 42 million shares awarded the company a $1.26 billion equity valuation at the start of the year (at $30 per share), and the business an enterprise valuation just in excess of $1.4 billion. This values the company at around 0.6 times sales, but that does not tell much, as the company basically operates a large breakeven unit (workplace) and very profitable building products business under a single roof.

A Big Deal

On the 8th of March, HNI Corporation announced its intention to acquire Kimball International in a deal valued at $486 million, or $531 million on an enterprise basis. This deal is substantial, valued at just over a third of the own enterprise value, but the timing of the deal is terrible as it took place in the midst of the regional banking crisis which arrived relatively out of the blue.

Deal terms call for a $9 per share cash component and 0.1301 shares of HNI offered to shareholders in Kimball. The deal implicitly values Kimball at $12.90 per share, indicating that the vast majority of the deal is paid in cash, yet Kimball owners combined will still own 10% of the shares of the new entity. With the deal, the company will move towards office furniture, with many investments made by the corporation into offices post the Covid-19 period.

Kimball generated $719 million in sales in 2022, indicating that it is valued at 0.7 times sales. The business generated $53 million in EBITDA, margins largely in line with the overall performance of HNI. The 70% cash component of the deal and assumed debt implies a $386 million increase in debt, increasing to about $556 million on a net basis.

The company has arranged a $440 million facility, which would increase net debt of $610 million. The company claims a 2.3 times leverage ratio, which suggests about $260 million in EBITDA being generated by the pro forma operations. This seems to add up if we take the EBITDA of both standalone businesses, as $25 million in anticipated synergies boost the pro forma EBITDA number to $290 million.

The Market Does Not Like It

Shares of HNI Corporation fell from about $30 to $27 in response to the deal announcement, shedding over $125 million in value in response to a deal valued at about half a billion dollars. That is hard to read into as the market was digesting worsening financing markets amidst the collapse of some regional banks, which hurt the deal financing, but certainly hurt the core business as well, as rates for mortgages will likely increase further.

The deal might make sense, although the increase in leverage is ill-timed as investors likely would have wanted to see a solution for the Workplace solutions, which has been struggling in good times for the economy. Instead, leverage is perhaps a small concern in a very uncertain economy nowadays.

On the other hand, if HNI Corporation can deliver on synergies and pay down debt, there likely is a roadmap for earnings of $3 per share, but real execution and deleveraging are needed before this is likely awarded a mid-teens or market multiple. Such an achievement could unleash value to the $50 mark again, but again, real performance has to be delivered upon in a very tough environment.

Under more normal market conditions I guess that the Kimball International deal would have made some sense, but given the volatility in the marketplace, I understand the caution of HNI Corporation investors, and I have to agree. This is certainly the case if I throw in the long-term performance, which is simply too mixed with HNI Corporation posting sales in the low $2 billion for the last decade, amidst stable margins and a rather flattish share count.

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