Office Furniture

O'Sullivan Industries Holdings

St. Lamar, Missouri-based O'Sullivan Industries <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: OSU)") else Response.Write("(NYSE: OSU)") end if %> takes the number two spot in the ready-to-assemble (RTA) furniture market. The company is run by the O'Sullivan family, with Daniel, Tom, Mike, and Patrick all in significant management positions. The company has an interesting, if checkered history, as it was acquired by Tandy in 1983 and then spun off from the ailing retailer in 1994. O'Sullivan family and company personnel managed to purchase a significant but not a controlling interest.

O'Sullivan makes products targeted at home offices, furniture for electronics, and "home decor" offerings, which includes stuff like microwave carts, recreation room furniture and the like. The company has facilities in Missouri, Virginia, and a recently opened distribution facility in Utah to meet expanding demand in the West. O'Sullivan had roughly 2 million square feet of production facilities at the close of 1996.

Overall, the company's top five customers accounted for 51% of sales in fiscal 1996. O'Sullivan sells big to the office superstores, with Office Depot and OfficeMax accounting for 16% and 13% of sales in fiscal 1996, respectively. Anyone interested in O'Sullivan would probably do well to watch carefully for any sales info reported by either of these two companies. The company does not have a meaningful backlog, so this is as good as it gets as far as predicting sales trends. International sales were only 5.8% of total sales in fiscal 1996.

O'Sullivan presents an interesting analytical puzzle, which is why it is in our Spotlight this week. Based on the PEG and the price-to-sales ratio, the company is the cheapest of the group. However, the company also has the lowest return on equity (ROE) and the return on invested capital (ROIC) of the group, which helps explain why it also carries the lowest valuation. Although novice investors think every dollar of earnings is valued equally, the reality is that high ROE and ROIC without leverage generate tons of free cash flow, making them more valuable.

In O'Sullivan's defense, the company sports the lowest debt-to-equity of the group. With more debt, a company can generate a higher ROIC and a higher ROE depending on the interest rate at which it has financed its debt. Because ROIC uses after-tax operating earnings, the interest payments are not considered when you look at the company's returns. This is why the company's net profit margins are not much different than any of its peers, despite the fact that the operating margins, the ROICs, and the ROEs are much higher.

If O'Sullivan were to leverage its balance sheet, it could significantly jack up its ROE and ROIC. Despite the fact that these are so low, given the relatively debt free nature of its return, we can balance the two out and look a little deeper. The question becomes: Can O'Sullivan increase capacity utilization and maintain or increase pricing and therefore increase net profit margins? We look to the historical margins to see where the company is relative to past cycles. Profit margins over the last five years have gone as follows:

1993 - 6.7%
1994 - 4.8%
1995 - 3.1%
1996 - 1.2%
1997 - 5.1%

Clearly, O'Sullivan has turned margins around and it is heading in the right direction. Given the relative debt-free nature of the balance sheet and the room for operating margin improvement, O'Sullivan appears to be a middling business with a middling valuation. Although it seems reasonable to get a decent 15% to 25% return over the next year with downside risk in the 10% range, our preference would be to wait for a significant pullback that would put the valuation at the bargain basement level, i.e. a price in the $9 to $10 range.

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