mentary suggests weakness should linger into the first half, and the office furniture space as a whole looks reasonably troubled.But I still think KNL is best-in-breed, and yet it's lagged those peers over the past year.There's an argument that there's no need to rush in at the moment, given a "falling knife" stock and the lack of a first-half catalyst.But after selling at $28, I'd be happy to get back in around $22.I sold my shares in Knoll (NYSE:KNL) last month, reluctantly. I like Knoll as a company quite a bit, and Knoll management has done a solid job in terms of both execution and strategy. But all-time highs around $28 at the New Year looked a bit stretched, given what seemed like increasing difficulty to drive margin expansion going forward. And with a portfolio bulging with cyclical names, something had to go. That turned out to be a fortunate move: KNL shares plunged after the company's Q4 report last week, in which the company posted a surprising decline in revenue. Office segment sales were down 8.4%, a stunning reversal against a 12.5% increase through the first three quarters of 2016.
Commentary on the Q4 conference call implies a tough 2017, with margin expansion likely paused and office pressure unlikely to abate until the second half, at the earliest. And from a long-term standpoint, the margin expansion concerns still linger, with steel prices normalizing and the Office segment, in particular, having reached Knoll's double-digit operating margin target. All that said, I still like KNL below $23, and I think the argument at the moment revolves mostly around whether it's worth stepping in now, or waiting. The decline knocks KNL's earnings multiple back below 14x - implying basically zero growth. I still think there's a "wonderful company at a fair price" argument for Knoll in general, and recent reports from peers show that the Office weakness in North America was not confined to Knoll. Essentially, I see two questions with KNL shares back in the low $20s. First, whether there's any need to catch the falling knife at the moment. And second, whether there's any need to have exposure to the office furniture market at all.
Among the four publicly traded majors, I still think KNL is far and away the best choice. But timing seems important - both relative to KNL itself and to its space. Near-Term Worries And A Struggling Market Knoll CEO Andrew Cogan said on the Q4 call that the sales weakness was primarily limited to the Office segment, and specifically to energy and financial services customers in the Northeast and South/Southwest regions. The numbers back up that assessment. Revenue in the Studio (+3.3%) and Coverings segments both increased year over year, with Coverings rebounding nicely after several quarters of declines. In addition, Cogan's argument jibes well with commentary from peers. Steelcase (NYSE:SCS) called out energy industry weakness after its November quarter report. Herman Miller (NASDAQ:MLHR) shares plunged after its North America sales and orders declined in the same period. And HNI Corporation (NYSE:HNI) disclosed a 2.3% decline in its Office business for calendar Q4. Whether the weakness was related to the U.S. presidential election is unclear, but it's not as if Knoll had significant execution problems in the quarter, or lost some of the share it has taken from larger peers over the past few years.
It does appear, however, that the recent weakness will persist. Office absorption showed a "precipitous decline" even in New York City, per the Q4 call. Knoll's opportunity 'funnel' remains solid, but decisions are being stretched out. In energy and financial services, in particular, the upheaval surrounding the election and tax and regulatory changes may be delaying decisions. With Knoll already having an often significant lag between orders and revenue recognition, that means any acceleration in demand won't show up on the P&L until Q3 - at the earliest. But, again, at the moment this appears to be an industry-wide problem, and Knoll at the least is controlling well what it can control. The company added another tuck-in acquisition of DatesWeiser after adding Vladimir Kagan for ~$9 million earlier in the year. In both cases, Knoll plans to leverage its larger size to ramp up growth. The Rockwell Unscripted collection looks well-received, and performance outside of the Office segment was solid.
Meanwhile, Knoll managed to keep margins intact; while revenue missed consensus by almost seven points, EPS was in-line. Opex actually declined even adjusting year-prior figures, and leveraged 80 bps despite the drop in revenue. Gross margin rose 30 bps as well. For the full year, Knoll grew adjusted operating margin 140 bps, reaching 11.7%, including a long-targeted 10% margin in the Office business, even with the Q4 results. All told, from my perspective, Q4 was a market problem, not a Knoll problem. That's probably a good thing for a company - but it's not necessarily a good thing for Knoll stock, at least not yet. Two Key Questions It's getting relatively clear that the market simply isn't sure what to do with the office furniture industry: KNL data by YCharts There are secular concerns about telecommuting and "open office" plans creating a steady pressure on overall market size. Like in so many other industries, smaller competitors continue to gain share. The usually macro-sensitive space as a whole now is down about 14% on average year to date, a notable divergence from a 5% increase in the S&P 500.
Of course, as seen in the chart above, the industry still did rather well bouncing off 2016 lows, even if there has been quite a bit of volatility along the way. So there is a case that there may have been a bit of a "too far, too fast" feel toward the space, particularly at the beginning of the year. So there's a real question as to whether the space as a whole is worth investing in at the moment. I'd still rather have KNL at under 14x trailing EPS against MLHR at the same multiple, and HNI and SCS at 15-16x. But investors don't have to own any of them, and the intense correlation among the stocks means a pair trade is unlikely to offer much in the way of return. One short-term concern has to be that the space is going the wrong way at a time when broad markets are at all-time highs. That, in turn, raises the question of what happens to KNL and peers should those broad markets correct at all. Meanwhile, reports from MLHR and SCS are due in March, and HNI and KNL's fourth quarters suggest similar weakness there.
There's a real question as to whether there's any need to jump into KNL now, given that a) the stock remains a bit of a falling knife and b) the company itself is clearly preparing investors for a tough first half. Knoll said expenses would be first half-weighted (including spend for the launch of Rockwell Unlimited) and recent order activity doesn't appear to suggest a quick rebound, particularly against tough comparisons. 14x is a nice earnings multiple - but it still implies modest growth, something Knoll may not be able to drive in the first half. From my perspective, there's enough to stay a bit patient here. KNL dipped below $21 as recently as October; I'm not quite sure $22-23 represents a floor. Put-selling is one option (no pun intended), though liquidity is rather light. (The June 22.5, which probably can be sold for $1.50+, is worth considering.) But there's still a chance KNL can get to $20 or so - and I think there it becomes a more aggressive buying opportunity. The Long-Term Case The irony of KNL's plunge is that it should, in theory, be close to a perfect "Trump stock".
The company doesn't import much. It has a high tax rate, and would benefit from lower corporate taxes both directly and indirectly (assuming other corporations would loosen their purse strings after a corporate tax reduction). Knoll even could bring back overseas cash with a repatriation holiday, which could lower debt and/or boost a dividend currently yielding 2.6%. It was that argument that drove a post-election run in KNL, a run that has been almost totally wiped out by the Q4 decline. But I don't think that argument is dead, by any means. There's still a path for KNL to get EPS above $2 by 2018, and then some, assuming lower corporate taxes, a rebound in Office demand, and only modest margin expansion. That figure suggests a price near $30, if not better, and ~30% upside from current levels. Such a scenario likely implies gains at peers too, but I still think Knoll is best positioned. So does Cogan, who took a subtle swipe at peers on the Q4 call (bold text mine): North American office furniture represents a smaller part of our overall sales and profit (unlike Herman Miller).
Our European business is highly profitable (Steelcase's is a mess). Our residential strategy does not involve building out an extensive direct-to-consumer retail network (a la Herman Miller's struggling Design Within Reach) and we don't have any exposure to mass supply-driven channels (like HNI). I think Cogan is right. And I think Knoll will rebound - eventually. But that rebound likely is not coming soon - while volatility in both the market and KNL may be. And I think that might provide a better opportunity. Long story short, I am relatively sure I'll be a shareholder in KNL again in 2017 - but I'm not at all sure when that will be. Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in KNL over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.