Office Furniture Is a Must-Avoid Business in this Market

Check out our deep value picks (click here). If the economy is weak, why would businesses buy more furniture? Well, they wouldn't. With unemployment near three decade highs and economic growth expected to be modest over the interim, one of the stocks that should continue to suffer is Knoll (NYSE:KNL), one of the nation's leading designers and manufacturers of branded office furniture products. Steelcase  (NYSE: SCS) and Herman Miller  (NASDAQ:MLHR)  are two of the other major office furniture stocks on the market. As businesses keep their purse strings tight, these stocks should see downward pressure. 

Knoll is down 25% from its 2007 highs, a time when the company was generating some $1 billion in revenue. Analysts project that sales will remain below the $1 billion mark for both 2013 and 2014, so it's easy to see why Knoll's stock might remain below $20 for the interim. 

Top line pressures and margin compression Knoll has significant exposure to the weak European market and local governments, where budgets are strained, which limits its top line growth. For the third quarter, Knoll saw revenue from government sales decline 24% quarter over quarter. Now government sales make up 12% of the company's total revenue, versus the 22% it made up just a couple years ago.

The weakness in government sales should continue as local and state governments see budget cuts. Knoll's entire office furniture segment saw a near 6% decline in year over year sales last quarter, driven by the fact that the company can't seem to find enough commercial business to offset the weakness in government.

We're also seeing higher raw material costs, which should put some pressure on operating margins. Most notably, there is the ever-rising price of lumber. As a result, operating margin at Knoll has gone from 10.5% in 2011 to 8.4% over the trailing twelve months. Currently, the random length lumber price is around $350 per thousand board feet, but this is expected to change in the near future. The International Wood Markets Group believes that the price of lumber will set record highs in 2014. 

Assuming the economy remains weak, it's common sense that office furniture sales will remain weak. Hence all three of the major furniture stocks listed above will ultimately underperform the market.

Steelcase gets about 3% of revenues from the U.S. federal government, so it should see some continued weakness there. The company looks to be in somewhat of a transition period as well--it just announced a new CEO who will take over in March of next year. Steelcase is also closing a production facility in Germany to open a new plant in the Czech Republic, which is all part of its multi-year restructuring plan in Europe. 

Meanwhile, Herman Miller appears to be having some success overseas. Sales for the third quarter came in 17% higher year-over-year thanks to the success of its high margin products that are selling well in Asia. Longer-term, Herman Miller appears to be in the worst shape. Analysts expect the company to grow earnings per share at a mere 2% per annum over the next five years. 

Foolish bottom line Knoll trades at less than 20 times earnings, less than both Steelcase and Herman Miller, which trade above 25 times earnings. Although Knoll's cheaper than its major peers, the entire industry should remain under pressure thanks to continued weakness in the economic recovery and high unemployment, not to mention rising raw material input costs. Knoll should also face other headwinds related to weakness in Europe. It's a safe bet to avoid the office furniture industry entirely for now.