We view the Malaysian furniture industry as a potentially undervalued sector which is poised for re-rating, driven by: (i) their high proportion of export sales, (ii) margin expansion on strengthening USD, (iii) sector-wide capacity expansion, (iv) long-term growth riding on the TPPA, and (v) healthy balance sheets. We peg the sector valuation at an average of 10.6x Fwd. PER, which is at a premium to board makers' average Fwd. PER of 9.5x as the sector shares similar positives (consistent EPS growth, steady margin expansion) but enjoys better fundamentals (higher dividend yields, stronger balance sheet positions). Our valuation is applied to annualised latest quarters' EPS, with adjustments for growth and seasonality. The resulting fair values indicate strong return potential for furniture makers averaging +15%. Among the furniture players, we see above-average return potential for: LATITUD (Fair Value: RM9.55; Total Return: 20%), LIIHEN (FV: RM4.01; TR: 55%), POHUAT (FV: RM2.54, TR: 34%) and SHH (FV: RM3.09, TR: 35%).

Shopping for furniture stocks. We take a look at the Malaysian furniture industry which is an undervalued sector with potential for re-rating, in our opinion. We noticed that this sector shared many similarities with the board makers and timber companies that have seen strong share price appreciation due to the rising USD, which expanded margins and boosted export demand for wood-based products. Thus it follows that downstream segments, including furniture, should similarly benefit from the stronger dollar. We are reviewing Latitude Tree Holdings (LATITUD), Lii Hen Industries (LIIHEN), Homeritz Corporation (HOMERIZ), Poh Huat Resources Holdings (POHUAT), SYF Resources (SYF), Jaycorp (JAYCORP) and SHH Resources Holdings (SHH). Our review will compare these seven furniture companies against five board makers by key metrics (i.e. earnings growth, margin expansion, balance sheet position and dividend yield) to determine potential upside/downside. We present our preferred picks below.

Exports to drive sales growth. The Malaysian furniture industry is highly export driven, with an average of 58% of furniture players’ revenue coming from exports. The largest export market for wood-based furniture is USA which recorded USD580m of Malaysian furniture imports in 2014 (+7% YoY). We expect furniture exports to USA will continue rising as the 5-year’s CAGR for US housing starts is 12.7% while FY15-16E housing starts are expected to grow by 11.3-12.7% to 1.12-1.26m houses. We are positive that continued strong US housing growth should drive demand for Malaysian furniture companies.

Riding on dollar-driven margin expansion. With their high proportion of export sales, furniture companies are a beneficiary of the rising USD. As the USD appreciated 11% QoQ in 3Q15, QoQ average operating margins rose to 12.6% from 14.4%. In fact, average quarterly earnings growth has been on the rise for the last four quarters. We are short-term positive on stronger margins as the USD has continued to appreciate 2.8% as of quarter-to-date 1Q16 to MYR4.41 due to weak Crude oil prices dampening ringgit sentiment. Hence, we believe coming earnings reports should record similar-to-higher margins overall. Note that companies with net USD cash position have a slight advantage as they should see additional forex gains on continued USD appreciation. Capacity expansions an extra boost. We expect sector-wide capacity additions to continue to drive long-term growth for furniture companies. Notably, POHUAT will be adding equipment valued at RM20m in its Malaysian plant and RM16.3m in its Vietnam plant. Meanwhile, HOMERIZ has allocated RM10m for upgrades up to 2017, while there are rumours of new expansion at LIIHEN recently coming online. On the whole, we are positive on earnings-generating ability of new capex because the 3-year average capex spending by furniture companies was RM13.6m which resulted in 3-year revenue CAGR of 8% and net profit 3-year CAGR at 24%, historically. Hence we believe that continued capacity spending should ensure positive earnings growth moving forward.

TPPA opening up new markets. Another positive long-term catalyst is the Trans-Pacific Partnership Act (TPPA) which could lead to long-term demand growth as the TPPA opens up new markets for furniture companies to the 11 member countries, including the USA, which have a combined population of 800m. Although we gather that wooden furniture exports are not subject to US import duties currently, we think the agreement will still contribute to long-term sustainable demand by reducing duties in other member countries and reducing red tape due to fewer customs requirements.

Healthy balance sheet. We observe that 5 out of the 7 furniture stocks we are studying are in a net cash position with net cash per share averaging 8.8% of their respective share price. We are positive on furniture companies' overall net cash position as this should easily support future dividend payouts. Note that historical dividend yield averaged 2.5%, well below the average net cash/share level. Furthermore, LATITUD, LIIHEN and SYF are in net cash position for USD as well, hence an appreciating USD is net positive for these companies. In comparison with the benchmark board makers, only 1 of 5 board makers is in a net cash position. Notably, this explains the reason dividend yields of furniture companies seem to be better than average board makers 1.2%.

Doing better than board makers? We peg the furniture players’ valuation at an average of 10.6x Fwd PER, based on applying 0%-20% premium to Malaysian board maker companies’ average Fwd. PER of 9.6x. We think the benchmark is fair as board makers have enjoyed similar margin expansion driven by USD appreciation, and furniture makers’ raw materials are partially derived from board makers as well. However, our fundamental analysis of both segments indicates that the furniture makers are showing better performances than board makers (refer to table below). Hence, we apply a higher or lower premium to individual furniture manufacturers' valuation taking into account fundamental factors such as degree of earnings growth, margin expansion, dividend yield, balance sheet position and potential dilution from non-furniture segments. Our valuation method is applied to the annualised latest quarter EPS with additional growth adjustment for capacity expansion (equivalent to 0.5x historical ROA) as well as seasonality. The resulting fair values indicate strong return potential for furniture makers with average total return of +15%. 

Source: Kenanga Research - 13 Jan 2016