PSB Monthly Issue August 2011

Millions are still stuck in homes worth less than what they owe on their mortgage.  A seemingly never-ending stream of foreclosures and abandoned homes continues to pressure home prices lower.  And thanks to highly restrictive lending policies, it’s near impossible for anyone to get a mortgage.

As a result, the housing market continues to bump along what some analysts are calling “the bottom”.

It’s discouraging we haven’t seen clearer signs of a turnaround in housing.  But we just might be getting closer to it.  A new report by the Joint Center for Housing Studies of Harvard University suggests the housing market is poised to turn on a dime.

Sharp drops in home prices and interest rates have made many homes across the country more affordable than they’ve been in decades.  Only high unemployment and tightened lending standards are keeping many first time homebuyers on the sidelines.

However, we know this group is poised to go on a buying spree once the economy improves.  Remember, first-time homebuyers taking advantage of the 2010 homebuyer tax credit spurred strong growth in home sales and prices last year.

And, once this group gets going, it could spark a broader recovery in housing.

Of course, a housing market rebound would be great news for homebuilders, real estate developers, and realtors.  But it would also provide a big boost for other related industries like home furnishings… particularly the bedding industry.

It makes perfect sense.  One of the first things homeowners buy when furnishing a new home is a new bed.  Let’s face it, we spend a third of our lives in bed, so we might as well be comfortable, right?

And here’s the really interesting part of this story…

The bedding industry’s recovery is already under way.  After a dismal 2009, the industry made good progress on a turnaround last year.  The International Sleep Products Association (ISPA) reports industry sales increased 6.2% in 2010.

That ended four straight years of sales declines.

Now, a 6.2% increase may not sound like much, but it’s a big improvement over 2009’s figures.  That year saw sales plunge by nearly 9% year over year.

Even better, the ISPA’s forecasting strong growth in 2011 and 2012.  They’re expecting unit sales to increase 4% this year.  And they’re looking for a 3.5% increase next year.

Here’s the key…

Rising demand for mattresses and bedding products is great news for one penny-sized company in particular.  And that company is… Culp Inc. (NYSE: CFI).

Culp is the largest producer of mattress fabrics in North America.  And they’re one of the largest marketers of upholstery fabrics on the continent as well.

If the recovery in demand for bedding products continues gaining steam, this upstart little company should see revenues and profits explode to the upside.  And you know what that means… a significantly higher stock price down the road!

Let’s take a closer look at this hidden gem…

THE MATTRESS FABRICS AND UPHOLSTERY FABRICS BUSINESS

Culp’s business is divided into two distinct segments.  The Mattress Fabrics segment makes woven and knitted fabrics used for covering mattresses and box springs.  And the Upholstery Fabrics segment makes a variety of fabrics used in the production of residential and commercial upholstered furniture.

In fiscal year 2011 (ended in May), mattress fabrics accounted for 56% of revenue and upholstery fabrics made up the rest.

Don’t let Culp’s small market cap fool you. They’re truly a global company in every sense of the word.  They have production facilities in the US and Canada for making mattress fabric products.  And since 2004, the company’s been manufacturing upholstery fabrics at their plant in Shanghai, China.

What’s more, Culp recently established a new subsidiary called Culp Europe.  Based in Poland, this entity markets upholstery fabrics to furniture manufacturers in the European market.  A wise decision since the European market makes more than 40% of the world’s furniture.

But here’s what I really like about Culp…

The company has reinvented itself over the past decade.

In the Mattress Fabrics segment, Culp has made significant investments to increase their competitive position.  The company spent $33 million on faster, more efficient weaving machines and increased knit machine capacity.  And they also purchased high technology finishing equipment for woven and knitted fabrics.

Now, these capital expenditures have hampered Culp’s financial results over the years. But now the modernization and expansion effort is finally complete.  This means significantly lower capital expenditures going forward.

But that’s only part of the story…

Culp also invested $11.4 million in 2009 to acquire their supplier of knitted mattress fabric.  This was a very smart move as sales of knitted fabrics are growing much faster than other mattress fabric categories.

As for the Upholstery Fabrics segment, Culp essentially tore it down and rebuilt it.

Over the past decade, demand for US produced upholstery has declined significantly. Customers have increasingly purchased less expensive fabrics from China-based manufacturers.  As a result, Culp has aggressively reduced their US manufacturing costs.

The cost cutting effort involved shutting down all but one US based manufacturing plant and one upholstery distribution facility.  At the same time, Culp established operations in China, where labor’s much cheaper.

These moves have lowered the company’s operating costs dramatically.

The result… after ten years of declines in the upholstery fabrics business, Culp has produced back to back years of sales gains.  And the business has returned to profitability.

It certainly sounds like things are turning around at Culp.  Let’s take a look under the hood…

THE NUMBERS

As I mentioned earlier, the bedding industry is in the midst of a turnaround after the 2008 financial crisis and global economic recession.  And while demand is gradually returning to normal, Culp’s financials are still being impacted by slower than usual industry growth.

Nevertheless, signs of a turnaround are clearly evident.

Just take a look at the numbers for fiscal year 2011, which ended in May…

Revenues increased by a solid 5% year over year to nearly $217 million.  While the growth is nothing stellar, it marks the company’s second consecutive annual sales increase since the recession began in 2008.

What’s more, Culp’s making nice strides in boosting profitability.  Net income surged 23% in FY 2011 to an impressive $16.2 million.  And earnings jumped 21% to $1.22 per share.

Clearly, Culp’s capital investments and cost-cutting efforts are starting to pay off.  And I think the payoff will continue for many quarters to come.

But despite the company’s obvious financial recovery, analysts remain very conservative with forward earnings estimates.  They’re forecasting an 11% decline in earnings for fiscal year 2012 and just an 8% increase for fiscal year 2013.

And I couldn’t be happier…

By low-balling their estimates, analysts have set the stage for upside earnings surprises.  Remember, nothing gets a stock moving like better than expected earnings.

Why do I think Culp will perform better than analysts expect?

It’s simple. A recent consumer survey by Furniture/Today and HGTV Mattress shows the bedding industry’s turnaround is about to accelerate.

The survey asked consumers about their mattress buying plans for 2011.  And the results were just what the industry was looking for.  A hefty 46% of respondents said they plan on buying a mattress this year.

That’s a solid increase over the 31% who said they planned to buy a mattress in 2010.

No question about it, many consumers put off buying a mattress in 2010 due to the fragility of the economic recovery.  And the delay has created a situation which economists describe as pent-up demand.

This is great news for the bedding industry and for Culp.

Pent-up demand is very powerful. When the dam bursts and consumers finally begin to buy, it often accelerates into a buying frenzy.  And nothing could be better for Culp than legions of consumers itching to buy mattresses and upholstered furniture.

But you don’t have to take my word for it…

Let management’s actions speak for themselves.

Culp’s board of directors just authorized a $5 million share repurchase program.  In other words, management is going to buy Culp stock through open market purchases.  Nothing says “I have confidence in my company” like a stock buyback program.

Clearly, the future’s looking bright for Culp.

And strong growth potential isn’t the only reason I’m excited about the company. They also boast a solid balance sheet.

As of the most recent quarter, Culp’s sitting on a veritable cash hoard of $30 million. That works out to about $2.33 per share.  And debt is clearly manageable at just under $12 million.

But the best part is the company’s surging cash flows… Over the past 12 months, Culp has generated operating cash flows of $14.8 million.  Strong positive cash flows are a great sign of a healthy, growing company.

INVESTMENT RISKS

Of course, an investment in Culp is not without risk.

The company’s positive outlook depends on the global economic recovery continuing. If the recovery fizzles, it could impact spending for Culp’s mattress and upholstery fabrics.

Another risk is the potential for surging commodity prices.  High commodity prices drive up Culp’s raw material costs and could eat into profits.

A third risk is the potential for higher tariffs on imported bedding products.  Domestic manufacturers are lobbying hard for tariffs on drastically cheaper imports.  If they’re successful, it could hurt demand for Culp’s products.

POTENTIAL RETURNS OF 100% OR MORE

No question about it, Culp shares are ready to make a substantial upward move.

Pent-up consumer demand is poised to ignite a flurry of mattress sales in the months ahead.  The bedding industry’s turnaround is gathering steam.  And the housing market’s emerging recovery could spur robust demand for new mattresses and upholstered furniture.

Bottom line…

Stronger demand for mattresses and upholstered furniture means higher sales of Culp’s mattress and upholstery fabrics.  And thanks to the company’s comprehensive restructuring, higher sales should translate into significantly higher earnings going forward.

Nevertheless, CFI is trading at a nice discount.

At a recent price of $8.92, the stock’s trading at just 9x analysts’ 2012 estimate of $1.05 per share.  That’s a low P/E for a company projected to grow earnings 23% annually over the next five years.  And it’s well below the industry average P/E of 12x earnings.

If CFI were to trade up just to the industry average, the shares would have to jump by 35%.  Nothing wrong with that.

But I think the stock is poised for even bigger gains.  As the company continues to impress with their financials, investors will likely drive the share price up to a level consistent with the company’s projected earnings growth.

In other words, we’re likely to see Culp’s P/E expand from 9x to something closer to 23x.  If we use a conservative P/E of 17x, you get a potential price target of $17.85.

That’s upside potential of 100%!

And don’t forget, analysts’ earnings estimates are probably overly conservative.  If Culp consistently delivers better than expected earnings, we should see an even bigger P/E and of course… an even greater profit on our position.

Based on our analysis, we see CFI trading up to at least $17.85.  Buy shares now for potential gains of 100% or more.

ACTION RECOMMENDATION

BUY Culp (NYSE: CFI) up to $9.81 per share.