Is Leggett & Platt a growth trap? (Part 2 of 2)

Value Investing Case Study 15-2. In my Seeking Alpha article that was published in Feb 2021, I had valued Leggett & Platt at USD 50 per share. The current price has exceeded this. In this second part of my fundamental analysis of the Group, I will show that it is a growth trap.

Leggett & Platt (LEG or the Group) is an S&P 500 diversified manufacturer that is trading at USD 54.65 per share as of 7 June 2021.

Its Book Value as of 31 Mac 2021 was USD 10.70 per share. The Price to Earnings based on the average 2010 to 2020 earnings was 29.3.

By convention, a stock with a high Price to Book and Price to Earnings multiples would be considered a growth stock.

I have shown in Part 1 that because of the acquisition of the Specialty Foam division in 2019, there is a new growth path for LEG.

But is this growth sustainable? If it is not, then LEG would be a growth trap.

A growth trap is a stock that appears to have a strong growth runway. But after you have invested, you found out that the growth is not sustainable. The market has overpriced the stock.

To identify growth traps, you have to compare the stock price with the intrinsic value. This intrinsic value is determined based on fundamental analyses of the underlying businesses.

Join me in Part 2 of this series as I continue my analysis and valuation of LEG to show that it is a growth trap.

Should you go and short it? Well, read my Disclaimer.

Did Top Management Seize Opportunities?

Is there an Awesome Buying Opportunity?

Will there be Spectacular Growth in Shareholders’ Value?

How to Secure Your Investment by Minimizing Risk

Pulling it all together

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Did Top Management Seize Opportunities?

In 2020

The directors and executives of LEG collectively held a 1.3 % share of the company.

3 institutions (Vanguard, State Street, and BlackRock) held 26.3 % of the company. There was no representative from these 3 institutions on the Board of Directors.

I would not classify LEG as an owner-managed group given the low ownership by the directors and executives.

However, LEG has an executive compensation programme. It is meant to drive performance and shareholders value and fosters sustained excellence. It is also to motivate the executives to take appropriate business risks.

Over the past 3 years, the incentive components in the form of stock-based compensation averaged 3.9 % of LEG’s EBIT.

In its 2020 SEC filings, LEG reported 7 executive officers with an average age of 57 years and 26 years average tenure with the Group.

With such an incentive scheme and long tenure, how did senior management perform? I looked at this from operations and capital allocation perspective.

Operations

LEG compensation committee identified 17 peer companies to benchmark LEG performance. (Note that I could only find the data for 16 of them and hence the comparison excluded USG Corp’s data.)

In terms of Return on Assets, LEG appeared to the somewhere in the middle of the annual ROA for the past 10 years as can be seen in the chart below.

LEG averaged 8.0 % ROA from 2010 to 2019 (to exclude the impact of Covid-19).

Over the 10 years period, the peers' average ROA ranged from 4.1 % to 12.1% with a mean of 7.2 %.

Chart 1: Peer ROA Source: TIKR.com

In terms of revenue, I thought that it was more appropriate to split the peer comparisons into the following.

LEG Bedding and Furniture, Flooring and Textile segments with a selected number of bedding and furniture companies. Note that some of these bedding companies were not on the LEG compensation committee’s list.

LEG Specialty Products segment with a number of companies in the automotive, and construction companies from the LEG compensation committee’s list.

The results of the comparisons are shown in the 2 charts.

LEG Bedding, Furniture, Flooring and Textile Peer Revenue Index

Chart 2: Bedding, Furniture, Flooring & Textile Peer Revenue Index

LEG Speciality Products Peer Revenue Index

Chart 3: Specialty Products Peer Revenue Index

The analysis showed that:

For the Bedding and Furniture, Flooring & Textile segments, LEG was outperformed by its peers. Over the past 10 years, LEG segment revenue grew at 3.1 % CAGR while the peer revenue CAGR ranged from 3.7 % to 12.2 %.

I would rate LEG Speciality Products segment revenue growth as average. LEG segment revenue grew at a CAGR of 7.4 % over the past 10 years whereas the peer revenue CAGR ranged from 2.8 % to 12.7 %.

Capital Allocation

From 2010 to 2020, LEG generated USD 5.0 billion in cash from operations. Of this,

LEG incurred USD 1.5 billion for its share buyback programme, equal to 30 % of the cash flow from operations.

It paid USD 2.0 billion for dividends. Given its USD 2.8 billion net income, this is equal to a 72% payout.

It spent USD 1.2 billion for its CAPEX (excluding acquisitions) and an additional USD 1.4 billion for acquisitions (net of disposal of business/assets)

From 2010 to 2020 LEG did not raise any additional capital from its shareholders. Instead, it funded the various capital programmes from internally generated funds and borrowings. Its borrowings increased by USD 1.1 billion during this period. Note that I have included the lease debt here.

The chart below shows how the cash from operations and loans was deployed.

Chart 4: Deployment of cash from ops

The Group did not provide any breakdown of how its funds were deployed by segments. However, based on the Total Assets you can see that the bulk has been deployed to the Bedding segment. This is in line with the proportion of revenue and EBIT contribution.

Chart 5: Total Assets by segments

Note

a) The majority of the unallocated assets are intangibles and cash.

Is there an Awesome Buying Opportunity?

In my Seeking Alpha article “Leggett & Platt: The Specialty Foam Potential” I valued LEG based on a sum of parts model as USD 50 per share with:

Classic LEG division valuation based on a single-stage low growth model.

Specialty Foam division valuation assuming a high-growth business. I use a 2-stage growth model for this.

That valuation is about 4 months old and I don’t think the intrinsic value would have changed much since then. I will treat that as one valuation point and for this post, I would value LEG following my standard Asset-based and Earning-based approaches.

For the Earning-based valuation, I had 3 scenarios:

An Earning Power Value ie zero growth.

A Conservative Earning Value based on LEG's historical long-term growth rate of 2.5 % per annum.

An Optimistic Earning Value with growth based on 4.1 % revenue growth per annum derived as follows:

Classic LEG division with 73 % of the Total Assets achieved historical revenue growth of 2.2 % CAGR (from 2011 to 2019).

Specialty Foam division with 27 % of the Total Assets is assumed to have revenue growth of 9.1 % CAGR. This is the historical growth rate achieved by the US bedding industry. Refer to my article “Is Tempur Sealy a growth trap?”

The LEG growth rate is then the weighted average growth rate of 4.1 %.

For the base revenue, I assumed that it was the average of 2019 and 2020 ie post-ECS acquisition.

For the Earning Power Value and the Conservative Earning Value, I used the single-stage free cash flow to the firm model. For the Optimistic Earning Value, I used a 2-stage free cash flow to the firm model. This was because, with the 5.80 % WACC for LEG, the 4.1 % growth rate would skew any valuation based on the single-stage growth model.

Chart 6: Valuation

As can be seen from the chart:

The Earning Power Value is larger than the Asset Value. This reflects the situation that there have been significant share buybacks. As such the current Book Value does not reflect an “accurate” value of the assets of LEG.

The current market price is higher than the Earning Power Value.

Over the past 5 years, the market price has been greater than the Asset Value, but lower than the Optimistic Earning Value.

Table 1: Valuation table

The analyses suggest that the market is pricing LEG based on an optimistic view of the Speciality Foam division.

At the current market price, there is not a sufficient margin of safety even with the Optimistic EV.

In order to achieve a higher intrinsic value than that of the Optimistic EV,

The growth rate of the Classic LEG division must be significantly higher than its past decade average growth rate of 2.2 %.

The Speciality Foam division must grow faster than the 9. 1% achieved by the US bedding sector over the past decade.

I cannot find any evidence to support both the above growth scenarios. The conclusion then is that LEG at the current price is a growth trap.

Case Notes

According to Professor Bruce Greenwald, you can gain strategic insights by comparing the Asset Value with the Earning Value. Refer to “The Basics Of Valuation - Picking out Value Traps”

However, this relies on the Balance Sheet providing an “accurate” picture of the Asset Value. I generally compute Asset Value from the shareholders’ funds.

In the case of LEG, a large part of the shareholders’ funds has been reduced by the share buyback programme. Thus the computed Asset Value does not present an “accurate” picture of the assets of the company.

A more appropriate picture of the Asset Value would be to add back all the money spent on the share buyback. If I add back the money spent on share buybacks from 2010 to 2020, the Asset Value would increase to USD 21.80 per share.

Instead of just adding back the money spent on the past decade of buyback, I could go as far back to when the share buyback first started. Since I did not do this for LEG, I would not try to look for any strategic insights by comparing the Asset Value and Earning Value for LEG.

As you can see, fundamental analysis is more than just using some formula. There are choices to be made in terms of which approach to use and what to assume.

So, if you are just starting out to analyze and value companies, it may be helpful to supplement it with third-party analyses and valuation.

There are several financial advisers who provide such analyses.

Those who do this well include people like Seeking Alpha.* Click the link for some free stock advice. If you subscribe to their services, you can tap into their business analysis and valuation.

Will there be Spectacular Growth in Shareholders’ Value?

There are several perspectives to gauge whether LEG has been able to grow shareholders' value. Based on these metrics, LEG has grown shareholders' value.

For the period 2010 to 2020, LEG had an average after-tax return on total capital employed of 13.6 %. Note that this is return is based on EBIT(1-t) / TCE where t = tax rate and TCE = total capital employed comprising shareholders’ funds plus total debt. Comparing this to its WACC of 5.8 %, I would conclude that any growth will create shareholders' value.

From the end of 2010 to 2020, if there was no share buyback and dividends, the shareholders’ funds of LEG would have grown by 10.5 % CAGR. Compare this to its cost of equity of 7.0 %. As there was no new infusion of capital, this growth has been due to retained earnings. Note that I excluded those due to stock compensation and/or options.

A long-term investor of LEG who bought LEG shares at the end of 2010 would have achieved a total return as shown in the following table. This is equal to a CAGR of about 9.7 %. Considering the cost of equity of 7.0 %, the returns look good.

Table 2: Shareholder's gain

What are other points to consider?

The average dividend from 2010 to 2020 is equivalent to a 3.1 % dividend yield at the current market price of LEG shares.

The share buyback exercises in the early part of the decade added to shareholders' value. This was because they were purchased at prices lower than intrinsic values. But, those carried out over the past few years are unlikely to have added value to the shareholders. On a volume-weighted basis, I would conclude that the share buybacks from 2010 to 2020 have added value to the shareholders.

Share purchases

The table below summarized the average cost for purchasing the treasury shares for the various years.

Table 3: Share repurchases

What should we do to assess whether the share buyback would have added value to the shareholders? We should compare the respective years’ purchased price with the respective years’ intrinsic value.

I used the back-of-envelope method to estimate the intrinsic value of each year.

I noticed that currently, the Earning Power Value is 3.2 times the Book Value while the Conservative Earning Value is 5.1 times the Book Value.

Assuming that this ratio is “stable”, I now have a simple way to estimate the intrinsic value for the various years. I can refer to the respective Book Values.

The intrinsic value for each year is either the Book Value multiplied by 3 or 5 (rounding it off). This is based on whether you are looking at Earning Power Value or Earning with growth bases. Any share buyback at price to Book Value multiple of less than these multiples would be considered as adding value to shareholders.

The table shows that the share buyback in the early part of the decade added value to shareholders even on an Earning Power Value basis. On a volume-weighted basis, the share buybacks were carried out at an average price to Book of 3.9. In other words, there was value-added to shareholders from an Earning with growth basis.

Case Notes

Intrinsic values are derived based on assumptions about the free cash flow and discount rates. As such you would expect the computed intrinsic values to be different for the various years. This is because the prospects and the Debt Equity ratio (affecting the discount rates) changes.

My assumption about the “stable” ratio between Book Value and Earnings Value should be interpreted with these changes in mind.

But while I agree that computed intrinsic values do vary, I do not expect the estimates of free cash flow or discount rates to double or half. This is especially if you have a stable business such as LEG (pre-ECS acquisition).

Yes, you can have large variations for start-up and IPO situations where there are not many historical data to base the estimates. But for LEG where there is considerable history, I think that my assumption of “stable” Earning Value to Book Value multiple can be justified.

The other point is that I am using the ratio as a back-of-envelope assessment. It was a quick look at whether the share buyback over the years has added value to the shareholders. It was a “yes or no” comparison. I did not need precise estimates of the intrinsic value.

How to Secure Your Investment by Minimizing Risk

In Part 1, I have postulated that LEG can be considered as comprising 2 divisions:

The Specialty Foam division employing about USD 1.3 billion of total assets.

The rest of the LEG business units (Classic LEG division) employing about USD 3.5 billion of total assets.

The Classic LEG division is a “stable” business in that it has been around for decades. There is a continuous process of “re-inventing” itself with disposals and acquisitions. The risks are the normal operating and business risks associated with any business.

On the other hand, the Specialty Foam division arose from the acquisition of ECS for its product and manufacturing know-how. There is a large element of intangibles associated with the USD 1.2 billion spent on the acquisition.

The key risks for any LEG investor are then the risks associated with the Specialty Foam division.

Would LEG be able to recoup the USD 1.2 billion spent on the acquisition? Note that before the acquisition (in 2018), ECS only generated about USD 27 million in PAT. There are several aspects to this question:

Would the Specialty Foam division deliver the double digits growth?

Would the synergy with the Classic LEG division materialize?

In the press release on the acquisition of ECS, LEG stated that

“…with the acquisition, Leggett & Platt gain critical capabilities in proprietary foam technology, along with scale in the production of private label mattresses…the combined expertise of the two companies in spring and foam technology makes us the leading provider of differentiated products for the global bedding industry..."

LEG is entering the foam industry via the bedding sector. But the global polyurethane foam market is highly competitive. There are major global vendors such as BASF SE, Covestro AG, DowDuPont, Huntsman International LLC, and Recticel NV. They all compete based on price, quality, and product/service offerings. How would the competitor react?

Valuation risk

In my Seeking Alpha article, I have mentioned the valuation risk associated with assuming a high growth rate for the Specialty Foam division. I reproduce it below as this risk remains.

“It is clear that the margin of safety comes from modelling the Specialty Foam division as a high-growth business. Over the 10 years' high revenue growth period, the cumulative EBIT for the Specialty Foam division amounted to USD 1.2 billion. Assuming a 25 % tax rate, this is equivalent to an after-tax payback period of about 13 years based on the USD 1.24 billion acquisition price. There may be those who would argue that the payback period is too long and that my assumptions were "conservative".

While LEG has not shared the financial projections for the acquisition, I would think that LEG would have assumed that it was a high-growth business for the acquisition to make financial sense. Therein lies the risk. If the Specialty Foam division does not deliver double-digit growth over the coming decade, it would have been an expensive acquisition. And of course, the sum of part valuation would not make sense.”

Pulling it all together

What is my investment thesis? There is currently no margin of safety even if you viewed the Specialty Foam Division as a growth segment. At the current price, LEG is a growth trap.

As shown in Part 1, the Classic LEG division is a “stable” business that has been able to grow its revenue by 2.5 % CAGR from 2010 to 2019. This division has very low reinvestment rates and generated about USD 288 million of free cash flow per year.

While the operating results have not been industry-leading, LEG has a good capital allocation track record. If not for the loan taken to fund the acquisition of the Specialty Foam business, the debt-equity ratio would have been below 1.0.

LEG has a good track record in growing shareholders' value.

The key investment risk comes from the Specialty Foam division. To recoup its investments, LEG has to achieve double digits growth for this division.

The current market price does not provide a sufficient margin of safety. This is comparing it with the intrinsic value based on an optimistic growth scenario. I can only conclude that at the current price, LEG is a growth trap.

End of Part 2 of 2

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