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Rick Konrad on Legg Mason and HNI Corporation

(Guest Commentary by Rick Konrad – September 20, 2007)

Dear Subscribers and Readers,

For those who had wanted to learn more about picking stocks, evaluating companies, and other issues related to the stock market, we have again brought in one of our regular guest commentators, Mr. Rick Konrad for a guest commentary.  Rick is one of our two regular guest commentators (besides Bill Rempel) and usually writes for us every third Wednesday of the month.

In this commentary, Rick will be sharing his thoughts on one of the top money managers in the world – and then follow up with a company that he likes, but in a relatively obscure industry (note that these are the industries where bargains can usually be found.  Without further ado, following is a biography of Rick:

Rick is author of the excellent investment blog “Value Discipline,” founder of “Value Architects Asset Management”, and is a regular guest commentator of MarketThoughts (please see “Credit Crunch” for his last guest commentary).  Prior to his current role, Rick has been a professional portfolio manager for institutional investors for over 25 years.  You can view a more complete profile of Rick on his blog and should you have any questions or thoughts for Rick after reading his commentary, you can also email him at the following address.  Rick is a very genuine teacher of the financial markets and treats it very seriously.  Case in point: Rick has also been responsible for running the education program for the CFA Society in Toronto (which is the third largest CFA society in the world besides the New York and London Societies) and had also been responsible for grading CFA papers.

Disclaimer: This commentary is solely meant for education purposes and is not intended as investment advice.  Please note that the opinions expressed in this commentary are those of the individual author and do not necessarily represent the opinion of MarketThoughts LLC or its management.


“Helicopter” Ben Bernanke flew to rescue Wall Street with a very aggressive and bold cut to contain the rot of the spreading credit crunch.  Clearly, the Fed is willing to err on the side of higher inflation in order to lean against house price deflation or recession. What are the implications for the value investor?

I think for most of us who practice this discipline, the fact of the matter is that a rate cut per se, should not affect investment strategy. In a CNBC interview with Warren Buffett  completed just prior to the Fed announcement, Buffett observed, “today's decision by the Federal Reserve on interest rates won't make any difference whatsoever to his investment decisions.” As he further commented, "The Fed has nothing to do with investing in good companies."

That seems like a rather cavalier and bold statement. Many years ago, I made a similar bold statement to the Investment Committee of the life insurance company where I was employed, “The economy has very little to do with the stock market.” Peter Lynch is also known for his views of the economy ("If you spend more than 13 minutes analyzing economic and market forecasts, you've wasted 10 minutes.") In fact, his philosophy can be encapsulated in a few brief bullet points:

  • Know what you own.
  • It's futile to predict the economy and interest rates.
  • You have plenty of time to identify and recognize exceptional companies.
  • Avoid long shots.
  • Good management is very important - buy good businesses.
  • Be flexible and humble, and learn from mistakes.
  • Before you make a purchase, you should be able to explain why you're buying.
  • There's always something to worry about.

Despite yesterday's energizing rally, in my view, there's still a lot of money to be made from current levels in well-selected stocks. Prices may have moved up a little from where they were, but in my view there's still a lot of upside left. Here are a couple of suggestions:

Legg Mason (LM)

Sure I sound like a broken record on this one. But I continue to like and to accumulate more at admittedly lower prices than we started.

LM is a global asset manager, no longer a broker. Back in December 2005, LM acquired the Citigroup subsidiaries that constituted substantially all of Citigroup's worldwide asset management business, which they refer to as the “CAM” business. Through last year and this, LM has worked hard to attempt to integrate this business into its various divisions.

To quote the 10-K, “Substantially all of CAM's U.S. and international fixed income asset management business, including providing advisory services to the fixed income funds that had been sponsored by CAM, has been integrated into Western Asset Management Company. Most of the U.S. equity asset management business of CAM has been combined to create ClearBridge Advisors. ClearBridge Advisors also provides advisory services to a majority of the equity mutual funds that had been sponsored by CAM. CAM's portfolio implementation and client servicing team for retail separately managed account programs has been moved to a new subsidiary, Legg Mason Private Portfolio Group. Together with our asset managers, who determine the securities to be purchased and sold for client accounts, Legg Mason Private Portfolio Group provides equity and fixed income asset management services to retail separately managed account programs. Most of CAM's non-U.S. equity asset management business has been combined with a legacy equity asset management business to create our Legg Mason International Equities business.”

Asset management is a brand business. Portfolio management is a lucrative business that requires little capital. Consequently, though LM owns all of its brands' as wholly owned subsidiaries, there is a portion of revenue that is used to pay managers' incentives and bonuses. I have spoken to a number of LM managers who are quite happy with having monetized their experience through the sale of their brand, yet remain in the business because of the attractive revenue sharing incentives.  Consequently, LM operates 14 different brands including, Western Asset Management Company; Brandywine Global Investment Management; Batterymarch Financial Management; Private Capital Management; Barrett Associates; Bartlett & Co.; and Permal Group (a fund of hedge funds manager.)

At current levels, the valuation is quite compelling in my view. The company has $992 billion in assets and trades at just 1.1% of assets under administration. What do you pay for in an investment manager?

Team and bench strength…with names such as Bill Miller, Chuck Royce, Whitney George, Bruce Sherman, Mike Mauboussin etc there is terrific intellectual capital with some of the best-in-class long term track records in the business.

You pay for distribution…LM has one of the most global and far reaching distribution platforms of any management firm. There is strong retail as well as institutional presence so there is great balance in the firm. The internationally sourced distribution represents more than 30% of assets under management though it is mostly fixed income and money market at this point. An announcement yesterday also highlights expanded distribution opportunities for the firm.

Performance…everyone knows about Bill Miller's long term out performance and short-term under performance. But consider that the very prominent LM Value Trust represents about $10 billion of $992 billion in assets. Measured against equity alone, the Value Trust represents only about 3% of equities.

Strong growth has come from a number of brands. Permal is managing $35 billion versus only about $18 billion just a year and a half ago. Western, the large institutional fixed income manager has also shown great growth as have Batterymarch and Brandywine Global. Permal has not been subject to hedge funds that have been hurt by the sub-prime debacle.

Legg announced a 5 million share buyback recently. With $1.4 billion in cash and some $1 billion per year in free cash flow (of which 20% is allocated to revenue sharing so 80% is available to the parent) there is lots of dough to fund dividends, buybacks, a contingent acquisition payment for Permal and paying down of debt.

I think it is unusual to get an opportunity to buy a firm of this caliber with some of the best long term investment managers, with this much distribution at a price that translates into about a 12% free cash flow yield.

Here is a Reuters ratio analysis of LM.

Disclaimer: I, my family or clients own a position in Legg Mason.

Here's another high quality company that I think represents decent value:

HNI Corporation (HNI)

Office furniture as an industry doesn't seem to get a lot of investors' attention. HNI, formerly known as Hon Industries was incorporated in 1944. The Corporation is a provider of office furniture and hearth products. A broad office furniture product offering is sold to dealers, wholesalers, retail superstores, end−user customers, and federal, state, and local governments. Dealer, wholesaler, and retail superstores are the major channels based on sales. Hearth products include a full array of gas, electric, and wood burning fireplaces, inserts, stoves, facings, and accessories. These products are sold through a national system of dealers, wholesalers, large regional contractors, as well as Corporation−owned distribution and retail outlets.  Unlike Knoll, which focused on the higher end of the office furniture market, HNI is focused on small to mid-size businesses.  Also, unlike Knoll, the Company sells fireplaces and that makes up just over 20% of sales.

Unlike consumer furniture markets which have been weak, the office furniture market has been quite strong. Prior to Helicopter Ben's actions of yesterday, some would argue that the chances of a recession threatened this industry due to collateral damage from housing, and sub-prime weakness, yet the primary macro drivers of office furniture consumption, namely corporate profits, office vacancy rates, white collar employment, and non-residential construction seem to support continued strength in this market. In the period of 1980-2000, there were only two years where the industry experienced down sales year-over-year. The industry did see weakness in 2001-2002 as a result of the bursting of the tech bubble, but demand has remained quite strong since.

In fact, industry stats are quite easily tracked for about three quarters of the industry's sales. The Business and Institutional Furniture Manufacturers Association (BIFMA)

released its market statistics for July 2007 showing July orders up 9% YOY following 13% growth in June. Shipments accelerated to 12% in July versus 5% for June.

The Corporation distributes its products through an extensive network of independent office furniture dealers, office products dealers, wholesalers, and retailers. The Corporation is a supplier of office furniture to the largest nationwide distributors of office products, including Corporate Express Inc., A Buhrmann Company; Office Depot, Inc.; Office Max Incorporated; and Staples, Inc. This differentiates it from Knoll which uses a direct sales force. Also, while Knoll's international exposure was focused on Europe, HNI has a broader focus (50 countries) and there are many opportunities via Asia especially with its 2006 acquisition of Lamex, a privately held Chinese manufacturer and marketer of office furniture.

HNI has been active in returning capital to shareholders, both through dividends which have been paid through 1955 and share buybacks. As per the 10-K:

"During 2006, the Corporation repurchased 4,336,987 shares of its common stock at a cost of approximately $203.6 million, or an average price of $46.96. The Board of Directors authorized $100 million on May 4, 2004, an additional $150 million on November 12, 2004, an additional $200 million on November 11, 2005, and an additional $200 million on August 8, 2006, for repurchases of the Corporation's common stock. As of December 30, 2006, approximately $139.8 million of this authorized amount remained unspent.  During 2005, the Corporation repurchased 4,059,068 shares of its common stock at a cost of approximately $202.2 million, or an average price of $49.82. During 2004, the Corporation repurchased 3,641,400 shares of its common stock at a cost of approximately $145.6 million, or an average price of $39.99"

The stock has come down from its 52 week high of $52 and is down 16% YTD. The street is obviously spooked by the hearth business which is 70% dependent on new construction. The company has an excellent record of cost control and cutting back on operations that are uneconomic. Again, from the 10-K

“Management believes its growth in the office furniture segment will be consistent with the industry and anticipates increasing profit momentum as the full benefit of price increases and cost reduction initiatives are realized. Declining industry trends in the hearth product segment will make 2007 very challenging. Management believes that profitability will be challenged through the first half of 2007 as its hearth product business continues to adjust to lower demand levels and cost reduction initiatives become effective.  The Corporation will continue to implement structural and operating cost reduction initiatives to ensure that its cost structure is appropriately aligned with market conditions.  The Corporation remains focused on creating long−term shareholder value by growing its business through investment in building brands, product solutions, and selling models, enhancing its strong member−owner culture, and remaining focused on its long−standing rapid continuous improvement programs to build best total cost and a lean enterprise."

HNI is very conservatively capitalized resulting in a fairly low WACC and is not overlevered on an interest coverage basis (7.0x coverage) nor a debt to EBITDA basis (only 1.0x).  The Company has shown a phenomenal ability to generate a Return on Invested Capital consistently above 15% and it has done an exemplary job returning capital to shareholders.

Here are the Reuters ratios for HNI

Here is a DCF model for HNI.

Disclaimer: I, my family or clients own a position in HNI Corp.

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