BDO Seidman's Furniture Executive Outlook For 2005 & 2006

Furniture World Magazine

Furniture Executives 2004 Comparative Annual Summary And Outlook For 2005 and 2006 - by BDO Seidman. Overview We noted last year that 2001, 2002 and 2003 were not very good years for most residential furniture manufacturers but held out hope that 2004 would be a better year. We projected growth in shipments of about 7 percent. Based on our monthly surveys, the actual growth reported was a little shy of that projection coming in at 5.5 percent. While not as much growth as everyone hoped, it was much better than the previous three years, when decreases were reported in two of those years. This annual survey includes a slightly different group of participants. Growth reported for the annual survey was 5.87 percent. The results of our monthly survey indicated growth of 7 percent over the first half of 2004 compared to 4.06 percent in the second half. This comparison may be a little misleading due to the results of 2003 where shipments in the first half declined by 5.5 percent but increased in the second half by 2.9 percent. As we have noted in Furniture Insights, there has been a wide range of results for the participants. Some 56 percent of our participants reported an increase in shipments for the year. This compared with only 37 percent reporting increases in 2003. Many of the participants reported double-digit increases for the year, although there were those who also reported double-digit declines as well. For the first quarter of 2005, the results have been somewhat mixed. New orders were basically flat compared to the first quarter of 2004, while shipments were up 4 percent for the quarter. Based on recent conversations, business has not been all that great, but on the other hand, not that bad either. It seems to be sort of bumping along with a slower economy in general. Our latest projections indicate a growth in shipments of about 3 percent for 2005. These projections anticipate a growth rate in shipments of slightly over 4 percent in the first half of the year. The second half shipments are projected to be slightly less than 2 percent. We hope these projections are conservative. Consumers have continued to buy homes, second homes and vehicles due to the historically low interest rates coupled with deals and incentives offered by automakers. Interest rates are expected to continue to rise and housing prices are extremely high. We expect purchases of homes and vehicles to ease somewhat. This should divert some money to furniture assuming current payments are not locked in too high. Last year, we also pointed out that consumers are spending a great deal on things that were not available to them just a few years ago. We mentioned the money that most families are spending on cell phones, internet connections and enhanced cable or satellite connections. We said conservatively at least $75 to $250 per month is being spent by most families today that a few years ago was money available for furniture or other purchases. Most people we talked to afterwards noted that these amounts were low for most people. It was not unusual for people to tell us that many are spending $400 per month or more. This would mean that consumers are spending $900 to $5,000 a year today that before could have been spent on furniture. Again, these are monthly commitments, just like mortgages, car payments and utility bills. It is not like buying a TV and paying it off in six months, then having the ability to buy something else. Consumers are buying the most expensive homes they can afford due to the low interest rates, as well as their spending on vehicles. When you add the spending on the items mentioned above, along with higher property taxes and higher utilities on larger homes, it is no wonder that many of the new homes have empty rooms or that older furniture is not immediately replaced. With all that said, furniture continues to be sold. Due to lower prices for imported goods, more furniture is being sold in terms of pieces than is reflective in dollars. Unfortunately, as many retailers and manufacturers have found out, selling more pieces for less dollars does not always convert to more profits. We continue to believe consumer confidence is the key to furniture sales. Interest rates remain at historically low levels and housing results have been great. Consumers are still not confident due to slow gains in employment, the war in Iraq, plant closings and layoffs. They are quick to take advantage of deals on cars and low interest rates on homes, especially where they see the home as an “investment.” Furniture can wait, especially when they know another “deal” is just a “sale” away. Key Statistics Summary The good news for the year was the growth in shipments. Profitability percentages overall were relatively similar to 2003. Gross profit margins increased slightly from 20.90 percent in 2003 to 21.47 percent in 2004. Operating profits (gross profit less selling and administrative expenses) fell slightly from 5.29 percent to 5.26 percent. As with our surveys in the past, we have some changes in participants. In order to provide more meaningful comparisons from year-to-year, we break out some of the results for those who participated in both years (referred to as “both year participants”) in order to have better comparisons. For both year participants, the results were very similar. Gross margins improved from 20.48 percent to 20.89 percent. Operating margins declined from 5.21 percent to 4.68 percent. Case Goods For the case goods category, gross profits increased to 22.69 percent in 2004 from 21.19 percent in 2003. Both year participants’ gross profits increased to 21.40 percent from 21.07 percent. Operating income increased to 6.39 percent from 5.25 percent in 2003 reflecting the increase in gross margins, offset by slightly higher selling expenses. Both year case goods participants’ operating profits increased to 5.61 percent from 5.34 percent, reflecting the increase in gross margins offset by slightly higher administrative expenses. The slight increase in operating income was mixed among the both year participants. Just less than one-half the both year case goods participants reported an increase in operating profits and gross profit margins. Again this year, there were several participants that reported negative operating margins. Upholstery In the upholstery category, results were also somewhat mixed. Overall, the gross profit margin increased to 20.65 percent from 20.45 percent in 2003, but operating profit margins fell from 5.39 percent to 4.56 percent. Similar results were reported with both year participants. Gross margins increased for both year participants to 20.55 percent from 20.07 percent. Operating margins declined, falling to 4.19 percent from 5.14 percent. The decline in operating margins was caused primarily by a rather large increase in selling expenses of 1.26 percent. Similar to last year, some 64 percent of both year participants’ gross profit and operating profit margins declined. This marked two years in a row that a majority of the participants reported declines in both categories. Gross Margins In case goods, the improvement in gross margins for both year participants, was attributable to a 2.3 percent increase in material costs offset by a 0.8 percent decline in labor costs and a 1.9 percent decline in overhead costs. We believe that most of the change in materials and labor is a result of higher levels of imports, which are treated as material costs. Since imports require less labor, labor costs would be expected to decline. The results by participants were mixed, but most of the participants who reported significant increase in material costs are involved in importing. The decline in overhead was mixed. Some of the decline seemed to be related to increased sales with relatively stable overhead. Some appeared to be the result of plant closings helping to reduce overhead. In upholstery, the improvement in gross margins for both year participants was primarily attributable to a decrease of 0.6 percent in overhead costs with very small changes in materials and labor. This decrease appeared to be related to higher volumes relating to fixed costs, as well as some cuts in overhead expenses even with increased sales. Other Factors Factory payrolls as a percent to sales increased slightly in 2004 to 17.91 percent from 17.53 percent. There was a decline of 1.3 percent in case goods where those payrolls declined from 18.63 percent to 17.35 percent. The decline was similar with the both year participants where factory payrolls declined 1.7 percent. Upholstery factory payrolls increased from 16.57 percent to 18.24 percent. Both year participants increased only about 0.4 percent from 17.74 percent in 2003 to 18.15 percent in 2004. We believe that the decline in factory payrolls in case goods as a percent of sales was primarily a result of the impact of imports, with sales of those products increasing, but not requiring the same amount of factory labor. The increase in upholstery was likely impacted by the mix of participants as the both year participants’ increase was very slight. Frankly, with more cut-and-sewn products coming in and more leather in the mix, we would have expected these percentages to decline instead of increase. Shipments per factory employee also increased. Both year participants increased in the case goods category to $136,000 from $116,000 last year. Shipments per factory employee in upholstery also increased with current year shipments per employee at $152,000 versus $143,000 last year. Overall, shipments per factory employee improved to $147,000 from $131,000 last year. Most of these increases likely relate to more imported product as well as better business conditions allowing more product to be made and shipped without adding employees. Operating profits per factory employee improved in 2004 from $6,921 last year to $7,751 in 2004. For both year participants, the results were almost equal with operating profits per employee at $6,842 in 2004 compared to $6,880 last year. The results between categories were quite different for both year participants. In case goods, operating profit per factory employee increased from $6,191 in 2003 to $7,632. In upholstery, operating profits fell to $6,386 from $7,375 in 2003. Net worth per employee increased to $54,602 from $43,557. Working capital increased 7.6 percent over 2003 with the ratio of current assets to current liabilities increasing slightly to 3.16 to 1 from 3.12 last year. Inventories increased 13.86 percent after a 2.49 percent decrease last year. As would be expected, inventory turns declined to 4.28 times in 2004 versus 4.87 in 2003. Case goods turns declined to 3.20 times from 3.82 in 2003 while upholstery turns were 5.41 times versus 6.16 last year. As would be expected with lower profits overall, the return on equity fell again this year. Returns on equity were 5.64 percent in 2004 versus 8.86 percent last year and 12.08 percent in 2002. Days sales in receivables remained in reasonable shape. Days sales (average daily sales divided into year-end receivables) were 46.29 in 2004 compared to 47.15 last year. National The overall economy continues to move along with reasonable growth in the GDP since the second quarter of 2003. The GDP grew 3.0 percent in 2003, 4.4 percent in 2004 and first quarter 2005 estimates indicate growth of 3.5 percent. Alan Greenspan’s testimony before the Joint Economic Committee included comments such as “Despite imbalances and uncertainties that were apparent a year ago, the U.S. economy has done well, on net, by most measures.” The Conference Board’s Index of Leading Economic Indicators has decreased 0.5 percent during the six months ended April 2005. Six of the ten components advanced during that period. Most have felt that this decline is consistent with the economy continuing to expand, but at a slower pace. After a strong rally in late 2003 and early 2004, the stock market bounced around most of 2004 with a strong finish late in the year. Since the first of the year though, the market has seemed somewhat unstable. It seems that every time the price of oil moves, the market moves the opposite way. Even the hint of almost any news, the market seems to respond even though it may only be one company’s earnings forecast. The unstable markets continue to have a negative impact on consumer spending. Consumers are not seeing their retirement accounts growing as they did before. That tends to make consumers think twice about spending or adding to their debt loads. Housing The housing market continues at a record or near record pace. The year 2004 was another record breaking year for housing sales. Most expected a cooling down period in 2004, but it did not materialize. Most expect to see 2005 reflect slower sales but the first few months of the year have remained at historically high levels. With the fear of interest rates going up, as well as the growing second home market, consumers have continued their spending on housing. The National Association of Realtors continues to report that they believe the housing market will cool down this year. Even with some slower sales, housing sales are still expected to remain at very strong levels. Consumer Confidence Consumer confidence, as measured by the Conference Board’s Consumer Confidence Index, improved in May after a decline in April. The Index at the end of May was 102.2, up from 97.5 in April. The Present Situation Index increased to 116.7 from 113.8. The Expectations Index improved to 92.5 from 86.7 in April. At this time last year, the overall index was in the 90’s, up from the low 80’s in 2003. For comparison, prior to 9-11, the index was in the 115 range. The Conference Board’s report indicated that while the Expectations index was slightly below last year’s levels, the current levels seem to signal economic growth in the months ahead. The report noted that consumers concerns about the economy and jobs have eased somewhat. The University of Michigan’s Consumer Survey was not as positive as it registered a small decline in May – the fifth straight monthly decline. That report indicated that increases in gas prices were a major concern for most. Even with oil prices declining somewhat, the uncertainty remains bothersome to consumers. Unemployment The unemployment rate in May 2005 stood at 5.1 percent. This compared to a 5.6 percent range at this time last year and the mid 6 percent range in 2003. There have been gains in non farm employment for 2004 and to-date in 2005. In May 2005, there were 7.6 million unemployed persons. There continue to be major plant closings – in and out of the furniture industry. As plants continue to close, most reports have been concerned that much of the job growth has been in lower paying jobs. Still, the good news is that we are continuing to create jobs. Inflation Most of the inflation pressures so far this year have related to oil prices. Unfortunately, oil goes into many products other than gasoline for vehicles. In addition, rising gasoline prices affect freight costs as well. Alan Greenspan continues to worry about inflation and has begun raising interest rates again. Most expect him to increase rates in late June and again in August, probably a quarter point at a time. Overall inflation does not appear to be a significant issue, at least not fears of high levels of inflation. Unfortunately, the prices at the pumps take money out of consumers’ pockets and reduce dollars available for other consumption. Other Thoughts on Furniture Furniture continues to be sold at retail. One of the tough issues relates to what impact that is having on residential furniture manufacturers. As more and more manufacturers import product and attempt to balance production versus importing, it becomes much more difficult to really gauge how U.S. companies are performing. We expect that balancing to continue. As it does, profitability is hurt as decisions are made as to how much domestic production a company will eventually have. As those decisions are being made, plants are likely to be run at less than capacity. Until plants are shuttered to allow more capacity to be used, or until more business is obtained to fill up the factories, profitability will be negatively affected. In addition, the cost of closing plants is not cheap. Retailer Profits We believe many retailers have been hurt from time to time by direct importing. We continue to hear more and more stories of being stuck with too much merchandise or quality and delivery problems. In addition, many retailers have noted lower profits due to selling more and more lower priced goods. Since the fixed costs are the same and margin dollars are down, profits have been squeezed. Manufacturers’ Profitability Many companies have shifted to at least some importing, whether parts, cut-and-sewn covers or finished products. Most have indicated that they believe margins on these goods have improved. We know in our discussions that many importers have tried to increase these margins from the early days when it was believed that, if one did not have to worry about manufacturing inefficiencies, you could sell on a smaller margin. With that in mind, we wonder why we do not see more improvement in operating results. Our survey does not get into enough detail to understand exactly why profits are down. We know that some is attributable to getting production facilities right sized for current volumes. Also raw material prices have gone up with little ability to increase selling prices until recently. We suspect that part of the problem is also attributable to many of the hidden costs associated with importing. Quality issues, overstocks, travel and costs associated with customer issues are very hard to measure. We find that most companies have not fully determined how much these costs really are. As we stated earlier, most companies we talk to are trying to get better margins on these products. So far, the proof is not in the numbers. So much of the industry issue relates to the competitiveness created by a fragmented industry. As we discuss in our monthly newsletter, Furniture Insights, business has been reasonably good over the last year and going into 2005. Unfortunately, business has not been good for all companies. We continue to see wide spreads in the monthly numbers. In some cases, shipments for some participants are up as much as twenty plus percent. There are also participants that are down over twenty percent as well. We expect we have not seen the last of plant or company closings. Several were hurt by a few major bankruptcies of retailers this year, especially Rhodes and Breuners. On the other hand, several companies are doing quite well. With overall growth expected to be in the 3 to 4 percent range this year, gaining market share will need to be the key for 2005 and 2006. Our econometric model forecasts growth for the residential furniture industry through 2006. The model is based on actual results through the first quarter of 2005 and may be adjusted based on future results. Household furniture shipments in 2004 increased approximately 5.5 percent according to our monthly survey. Total manufacturing costs as a percent of sales decreased from 79.10 to 78.53. The decrease resulted from an increase in material costs of .32 percent and an increase in labor of .11 percent offset by a decrease in overhead of 1.02 percent. Comparing only companies who participated in both years’ surveys (in later comments referred to as “both year participants”), material costs increased .83 percent, direct labor decreased .16 percent and overhead decreased 1.07 percent. Within the categories, case goods material costs increased 2.29 percent for both year participants. Direct labor was down .76 percent while overhead declined 1.88 percent. We believe most of this change was due to increases in imported products, increasing material costs with related reductions in direct labor as a percent to sales. We did see some increases in base material costs during the year. We believe most of the reduction in overhead resulted from some plant closings that took place in 2003 or early 2004 as well as general belt tightening. For upholstery, material costs were basically flat for both year participants while labor costs increased slightly. Overhead declined .62 percent. Overall, 60 percent of the both year participants experienced a decline in gross profit margins. While some were very slight declines, 35 percent of the participants recorded a decline of 1 percent or more. The declines were fairly consistent in all categories. The mix of all of the categories resulted in improved gross profit percentages of .57 percent for the industry. Both year participants reported a .41 percent increase. Selling and administrative costs as a percentage of sales increased to 16.21 percent from 15.61 last year. Selling and expenses increased .61 percent and administrative expenses were basically flat. Case goods participants selling expenses increased .33 percent while upholstery participant’s selling expenses increased .99 percent. Administrative costs were down slightly for both case goods companies and upholstery companies. For both year participants, case goods selling expenses were about the same as last year and upholstery expenses were up 1.26 percent. Administrative expenses for both year participants were up .15 percent. The industry slight decrease in operating profits made 2004 the lowest year for income from operations since 1995. For both year participants, operating income fell even further to 4.68 percent from 5.21 percent last year. For case goods both year participants, operating income increased to 5.61 percent from 5.34 percent. Upholstery both year participants declined from 5.14 percent to 4.19 percent. Approximately 47 percent of the case goods both year participants experienced an increase in operating profits. Over 60 percent of the upholstery participants recorded a decline in operating profits. Several participants in all categories moved from positive operating incomes to the negative. Inventory turns (computed by dividing total cost of sales by the average of beginning and end of the year inventories) decreased to 4.28 turns in 2004 from 4.87 in 2003. The case goods category recorded a decrease in turns from 3.82 to 3.20 while upholstery turns decreased from 6.16 to 5.41. In the case goods category, direct import shipments to customers will improve the turnover calculation, but we believe that more participants are also carrying more inventories in an effort to better service customers. Shipments per factory employee in 2004 increased to $147,422. The increase in shipments per factory employee was 12.7 percent following a 6.4 percent increase last year. The case goods category increased 18.0 percent and upholstery increased 6.6 percent. The results for both year participants were very similar. Again, the effect of more imported goods and direct shipments to retailers has a positive impact on these results. Number of days Year outstanding 2004 46.29 2003 47.15 2002 46.71 2001 45.58 2000 47.04 Days sales in receivables decreased slightly to 46.29 from 47.15 but this factor remained at reasonable levels compared to recent history. As we reported last year, the demise of some of the larger retailers who demanded longer terms, is likely the reason for the decline from the 1998 and 1999 levels of over 50 days. About BDO Seidman: BDO Seidman, LLP is a national professional services firm providing assurance, tax, financial advisory and consulting services to private and publicly traded businesses. For more than 90 years, the company has provided quality service and leadership through the active involvement of our most experienced and committed professionals. BDO Seidman serves clients through more than 35 offices and 250 independent alliance firm locations nationwide. Their Furniture Industry Services practice publishes Furniture Insights®. For more information go to http://www.bdo.com.