MillerKnoll Shares (NASDAQ: MLKN) have nearly returned to their COVID lows despite a booming business posting strong revenue numbers and a so far successful integration with its large acquisition of Knoll. The main reason stocks are down so much is that inflation has eroded profitability, but the company is struggling to get the business back on track with price increases and seeking supply chain improvements.
To better appreciate this discrepancy between revenue and earnings, we compare trailing 12-month revenue to normalized diluted earnings per share. Most of the revenue growth can be attributed to the Knoll acquisition, but there was also organic revenue growth. Despite booming business, profits have all but collapsed, and the main reason is shrinking gross profit margins due to inflation headwinds.
So far, MillerKnoll has made good progress towards its goal of generating $120 million in cost synergies, having captured $66 million in operating cost synergies at the end of its 2022 fiscal year. supply chain have brought lead times and reliability back to near normal levels for nearly all products and geographies.
Consolidated net sales in the last quarter (Q4) were $1.1 billion, an increase of 77% on a reported basis and 23% on an organic basis compared to the prior year. The international business delivered a superb performance with record sales of $136 million in the quarter, an increase of 28% over last year on a reported basis and an organic increase of 37%. Demand continued to exceed prior year levels with orders of $1 billion, up 47% from last year and an organic increase of 4%.
Inflation has continued to weigh on profit margins, but there is a clear trend of improvement from the low of around 33% gross profit margin in the prior quarter (Q3). For the fourth quarter, the gross margin was 34.8%, 160 basis points lower than a year earlier. This was mainly due to inflation in the form of higher commodity costs. Fortunately, on a sequential basis, gross margin improved by 180 basis points as the company begins to feel the impact of price increases. The company expects further improvement as these price increases will continue to drive margin expansion in the coming quarters.
For the first quarter of 2023, the company expects revenue of between $1.08 billion and $1.12 billion and adjusted earnings per share of between $0.32 and $0.38.
The best indication we have seen so far from management that they are confident that profit margins will continue to improve as price increases materialize is the response they gave to an analyst on the last earnings conference call (emphasis added):
Alex Fuhrman – Analyst
It looks like now, with the first quarter guidance, several quarters of pretty solid improvement over the 33% gross margin rate approximately that we saw in the third quarter, I know it is difficult to have visibility over several quarters and you only guide yourself on one quarter. But just as you think about what you know today given labor costs, material costs, what you have in terms of price increases already announced that may or may not have been fully realized in your business.
I mean should we think about this kind of, call it, around 35% gross margin that you’re looking at in Q1 as a base you would hope to grow on in future quarters? It seems like there are so many dynamics that push and pull back and forth. Just a little curious based on what we know right now, what would you expect the gross margin base case to be in the second and third quarters of the year?
Andrea Owen – CEO
I mean, Alex, we certainly expect that to be a base from which we will grow. And I’m going to caution that by saying provided nothing else happens in the world that might impact that from a macro perspective. But if you look at the price lag, especially in the contract business, we have not yet realized all the price increases that we have put in place. We have budgeted for more if needed, to offset cost increases. So I think it’s fair to say that’s a good base to build on.
Jeff Stutz – Chief Financial Officer
Yeah. No. I think that’s true, Andi. The only thing I would add is that we would be disappointed – very disappointed if this did not happen. I said last quarter and I’ll say it again, I think we think we have enough pricing that’s been made. And again, we consider the need for additional potential. We can bring this activity back to levels that were equal to or better than pre-COVID and we are nowhere near that right now. And so, we should see continued margin improvement over the rest of the year.
We therefore expect that as profit margins return to or exceed pre-COVID levels, earnings per share should recover near previous highs, given that sales have not been an issue so far. .
The balance sheet is much weaker than it was before the Knoll acquisition, which had a large cash component. Debt now stands at about $1.4 billion, while cash and short-term investments total about $230 million.
We expect the company to put a lot of effort into deleveraging once profitability improves. This should definitely be a priority for the company.
On the latest earnings call, management said it had released its 2030 sustainability goals during the quarter. These goals are shared by all their brands. They aim to reduce their carbon footprint by 50%, eliminate waste and stop the use of single-use plastics. They also plan to source better materials by using 50% or more recycled content and purchasing responsibly and sustainably produced materials.
Given the current profitability issues due to inflation, it is difficult to value the company using the results. Using EV/Revenue, stocks are trading below their ten-year average, and the forward multiple looks very cheap at ~0.75x.
When measured using price/pound, the stock looks even cheaper, at less than half the ten-year average. Using this metric, stocks weren’t this cheap since the COVID crisis.
Based on estimated forward earnings, stocks also look cheap. For example, stocks are trading at only ~5 times analyst estimates of earnings for fiscal year 2025.
While stocks certainly look cheap, there are a few risks to consider. The first is that profitability has been badly affected by inflation, although management seems confident that it should improve going forward. Another risk is that the balance sheet will be much weaker after the acquisition of Knoll, and that the management will have to make a lot of effort to deleverage. We do not expect any significant increase in dividends or share buybacks until the company is deleveraged. The Altman Z score has dropped significantly due to the amount of debt added to the balance sheet and declining profitability.
We think MillerKnoll shares are extremely cheap, but they come with significant risk. Our thesis is that management will be successful in restoring profitability levels through supply chain efficiencies and price increases. If inflation were to moderate, that would certainly also help restore profit margins to pre-COVID levels. Analysts seem to agree, assigning relatively high revenue estimates for the coming years. At around 5x earnings estimates for FY2025, we think stocks are a good deal, just be aware of the risks. If profit margins return to where they were before the impact of inflation, stocks should be able to rise significantly or even double in no time. We therefore rate “Strong Buy” stocks at these levels.