Integrated Company Analysis Herman Miller: MLHR

Nicholas Grant! Travis Campbell Brad Zoltak Marisol Serdiouk
December 14th, 2009

Executive Summary Herman Miller, Inc. is a mid to high-end furniture manufacturer primarily concentrated in the business and institutional market. The industry is experiencing significant declines in sales due to poor macroeconomic conditions. The Company is well positioned as one of the top-tier firms in the industry, but its business model is highly sensitive to the overall economic cycle. First and foremost, Herman Miller needs to continue to successfully execute its core office furniture business. To reduce its vulnerability to downturns in the overall economy, Herman Miller should work to raise its brand awareness and fully leverage its products in adjacent markets. Recommendations • To ensure that Herman Miller capitalizes on its near 30-year expansion into the healthcare sector, the Company should increase the resources it dedicates towards healthcare and implement the following initiatives: o o Develop a patient bed to enable Herman Miller to offer a complete patient room solution. Consolidate its healthcare distribution network by appointing the best dealers in a given territory and enabling them to offer the Company’s full healthcare product line. Ensure that these dealers are fully trained on the Brandrud and Nemschoff offerings. o Once the office furniture industry rebounds, Herman Miller should begin to consolidate its Brandrud and Nemschoff brands under Herman Miller Healthcare. • To increase brand awareness and sales among non-institutional customers, Herman Miller should enhance its distribution through Costco. o Sell a product through Costco that better represents the Herman Miller brand by offering the Mirra office chair in three prominent colors that grab the customers’ attention. o Capitalize on the Costco partnership by launching a test marketing campaign for the Mirra chairs. Program includes a six week trial period with an integrated Herman Miller message delivered through the pallet display, design engineered packaging, comprehensive product brochures and promotion through the Costco circular.

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Institutional Furniture Industry The institutional furniture industry is comprised of office, healthcare and home segments. Herman Miller holds a 15% share in an industry where the top six competitors control an estimated 83% of the market (see Appendix 1). Products are offered across segments and price ranges; Herman Miller and Knoll focuses on the mid to high-end products, Steelcase offers a broader range of price points and HNI targets the value segment (see Appendix 2). Key drivers of differentiation for Herman Miller include reputation, product breadth and quality, design, customization capability, compressed lead times and distribution channel strength. Since public and private spending tend to be counter-cyclical, both government and private buyers represent important revenue sources to help stabilize sales (see Appendix 3). Many institutional manufacturers also operate in related furniture industries and Herman Miller, in particular, competes in healthcare and high-end home and retail. Institutional Segment: The institutional segment includes office, government and education customers, and is further divided into contract and commercial buyers (see Appendix 4). A contract purchase represents a substantial investment for an institution and is characterized by large, customized projects, long buying cycles, extensive product warranties, distribution through independent dealer networks, all of which contribute to repeat purchases from the same manufacturer. Standard products include seating, office systems (cubicles/desks), storage and accessories (see Appendix 5). Contract buyers experience significant inertia because of high switching costs and a customer’s preference for a coordinated office environment. Herman Miller has a competitive advantage through its strength in office systems and seating products both of which experience high-inertia from a large institution’s desire for standardization. Manufacturers that are strong in the contract area are able to leverage their relationships and expand the product offering for each customer. In contrast to a contract buyer, the commercial purchaser represents smaller businesses that may be more cost conscious, choosing products that are often distributed through wholesalers and office superstores. Product selection and quality remain high in the commercial subgroup; however, there is a tendency

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toward less customization. Since Herman Miller is not as strong with commercial buyers, it is at risk that in a declining economy, buyers may trade down to value-oriented competitors in the commercial sector to save on costs. Healthcare Segment: The healthcare furniture customer segment includes hospitals and clinics within the medical industry. Manufacturers distribute through a combination of dedicated healthcare dealers and traditional independent institutional dealers. Products sold to this segment typically include lobby furniture, patient room furniture and seating and hospital trays and carts (see Appendix 5). It is estimated that healthcare accounts for 10% to 15% of Herman Miller’s overall revenue (see Appendix 6). The acquisition of healthcare manufacturers, Brandrud and Nemschoff, contributed approximately $110M in revenue annually. Competition in the healthcare segment arises from both medical equipment suppliers that offer furniture as well as institutional furniture manufacturers that service the healthcare market. For example, Knoll and Steelcase have broad healthcare furniture offerings. This segment is particularly attractive because its growth rates have and are expected to continue to exceed GDP (see Appendix 7). Home and Retail Segment: Herman Miller also sells its high-end furniture in the retail segment, targeting small businesses and affluent consumers. These products, such as the Eames Lounge Chair in the Classics Collection, are more expensive than typical consumer furniture and are primarily distributed through high end niche retail shops in metropolitan areas, such as Design Within Reach (see Appendix 5). The Company is also experimenting with club store sales on select lower priced seating furniture. Home retail accounts for approximately 3% of Herman’s Miller overall revenue. Retail furniture offers contract manufacturers an opportunity to create brand awareness and to educate future decision makers about Herman Miller’s products.

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Institutional Furniture Industry Trends The institutional furniture industry is strongly correlated to the strength of the overall economy and is currently undergoing significant stress due to the recent poor economic conditions. Major indicators of U.S. institutional furniture production include new building construction, primarily in the area of office space, changes in service sector payrolls, and the Architectural Billings Index. • Service Sector Payrolls: New Office Construction: Represents changes in white-collar unemployment which is indicator of office furniture sales (see Appendix 8). • New office construction values serves as an indicator as new buildings will need to be equipped with institutional furniture (see Appendix 9). • Architectural Billings Index: The ABI serves as a leading economic indicator that precedes nonresidential construction activity by approximately 9-12 months (see Appendix 10). Growth in office construction, service sector payrolls and architectural billings are correlated metrics and are appropriately utilized by the industry to forecast growth. As anticipated, Herman Miller’s sales correlate strongly to the Business and Institutional Furniture Manufacturer’s Association (BIFMA) aggregate industry production values (see Appendix 11). BIFMA forecasts U.S. production to decrease 30.2% in 2009 and an additional 4.6% decrease in 2010 (see Appendix 12). Diversification Trends The mature institutional furniture market has driven many manufacturers to diversify into segments with varying economic cycles. For example, HNI operates in the home and hearth market (electric fireplaces), and Kimball International has a large electronics operation producing products for the automotive, industrial, medical and public safety markets. Many major office furniture manufacturers including Herman Miller, Knoll and Steelcase, have also moved into healthcare furniture. Position, Brand and Customer Analysis Herman Miller has traditionally sold mid to high-end products through the institutional market and holds a leading position within the industry. The Company has made further inroads with health, education and retail customers.

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Herman Miller’s target customers include: • • • • • • Corporations Government Architect & design firms Real estate developers Higher education institutions Healthcare providers

Over the years the Company earned a reputation as a manufacturer of high quality, innovative products that continue to be relevant over time. Further, the Company executes with strong customer service provided through their dealer network, high customization of products and reliable on-time delivery. The Herman Miller name, however, is not well known outside the institutional buyer segment. The established dealer network is effective in specifically targeting large customers but misses the broader end-user customer base. The benefits of improved awareness are evident from Herman Miller’s performance and high market share in the institutional contract segment. The lack of awareness outside of the industry limits Herman Miller’s ability to grow because potential customers are unaware of the company’s reputation and product portfolio. Financial Performance and Analysis Herman Miller’s market position as a provider of mid to high-end institutional furniture, enhanced by the Company’s restructuring and acquisition initiatives, has enabled it to generate strong financial performance relative to its industry (see Appendix 13). Comparing Herman Miller’s performance over the past four years to its competitors, the Company is among the leaders in generating return on sales. In fact, Herman Miller experienced increases in return on sales each year between 2006 and 2008, while many of its competitors experienced declines in return on sales. We believe this metric is more appropriate than return on equity given Herman Miller has repurchased stock over the past year, which has reduced equity to a level that is not meaningful.

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Driving the relatively higher return on sales figure for Herman Miller compared to its peers is its higher operating margins, which primarily reflects the Company’s ability to maintain lower SG&A expenses. This is a direct result of the efficiencies Herman Miller has extracted out of its business. With the recent downturn in the economy, especially in the office and commercial sector, the entire institutional furniture industry has experienced deterioration in performance metrics over the past several quarters. Despite the negative headwinds, Herman Miller has outperformed most of its competitors in terms of profitability, illustrated through strong operating margins and return on sales. Restructuring Initiatives Herman Miller has been proactive in driving efficiencies in its operating model over the past decade. For example, the Company generated $2.2 billion in 2001 with nearly 10,000 employees compared to revenue of $2.0 billion in 2007 with approximately 6,000 employees. The Company took further actions to address the current downturn in the market, first through a 2008 restructuring then through a more extensive 2009 restructuring. These initiatives altered Herman Miller’s operations through workforce reductions, a shortened workweek, plant closings, and a reduction in certain employee benefits such as the 401-k match. The restructurings have enabled the Company to remain profitable in a challenging environment, and will provide additional operating leverage once the economy rebounds. While some of the initiatives are likely temporary, the actions should provide additional flexibility and cash flow. Given the backdrop of a challenging employment situation, especially in Michigan, the temporary reduction in certain employee benefits is not expected to lead to higher turnover and loss of talent. Acquisitions – Healthcare Herman Miller is attempting to reduce the sensitivity of its operations to the volatility of business cycles. Like several of its competitors it is seeking diversification strategies by targeting the healthcare segment, which tends to exhibit less volatility in sales and profitability. The Company’s most recent acquisitions of Nemschoff and Brandrud are evidence of the Company’s commitment to further penetrating the healthcare segment. These acquisitions appear to be a good fit with Herman Miller’s core furniture business and represent an effective use of cash.

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Stock Repurchase with Debt In early 2008, Herman Miller issued $200 million of senior unsecured private placement notes in order to repurchase common stock under an accelerated stock repurchase program. This action was in part a defensive strategy to reduce the probability of a takeover attempt by private equity firms attracted to Herman Miller’s strong balance sheet and cash flows. This action, however, significantly altered the firm’s capital structure, with the debt to capital ratio increasing to .90 in 2009, the highest among competitors, from .50 in 2007 (see Appendix 13). Additionally, the Company’s coverage ratio declined to 3x EBIT in 2009 from around 17x EBIT in 2007, which reflected a combination of reduced earnings and higher interest costs from the additional debt. While this action is not expected to cause significant pressure on the Company, it does reduce its flexibility to take advantage of strategic initiatives, especially larger acquisitions. In hindsight, the decision to buy back shares at an average price of $26 was not the most efficient use of cash as the Company could have repurchased shares at a much cheaper price later in the year. Valuation Herman Miller’s value of $23 per share was derived through a discounted cash flow (DCF) analysis (see Appendix 14). The DCF model assumes a 10-year forecast period with an estimated 5% revenue growth per year. The current estimates are in part based on the prior two business cycles from the 1991/1992 trough to the 2003/2004 trough where Herman Miller’s revenue expanded over 9-year (12% annual growth) and 5-year periods (9% annual growth), respectively. Each of these expansions was followed by two to three years of decline and a subsequent period of stabilization. If the previous cycle is indicative of future sales, then revenues should continue to decline in 2010, stabilize in 2011, and begin to grow in 2012. The model assumes a similar pattern of growth as in past cycles, but incorporates a slower reacceleration considering the commercial market is in worse condition than in the past two downturns. The derived weighted average cost of capital (WACC) for Herman Miller is 9.0%, which was utilized to discount cash flows. To determine return on equity, several betas were calculated using monthly and weekly periods over a 3 and 5 year time horizon referencing the S&P 500 index as the market proxy. This

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analysis provided a beta range of 1.06 – 1.40. Additionally, a risk-free interest rate of 3.5% was used in the analysis which reflects the 10-year treasury bond yield. The 6% risk premium incorporated into the WACC is consistent with current estimated equity returns and treasury bond returns. (see Appendix 15) Recommendation: Costco Retail Expansion Herman Miller should expand its distribution in the retail market place to increase brand awareness and expand sales. Costco represents a strong partner as it targets both small business owners and the mid to upper middle income home and office customers (see Appendix 16). The Costco market represents a major opportunity to increase brand awareness through 56.0 million cardholders including 9.1 million business cardholders (see Appendix 17). Costco provides an avenue for Herman Miller to increase its mindshare among non-institutional customers, the potential customer who is currently the least aware of the brand. In 2009, Herman Miller launched two different office chairs through Costco at a price point of $289 and $320 dollars. This particular product offering could be improved upon as these chairs are standard, black office chairs and are Herman Miller’s lower end goods that do not exemplify all that the brand has to offer (see Appendix 18). The recommendation is to continue to partner with Costco and offer the Mirra office chair in three prominent colors that grab the customers’ attention and to stand out among other products in the warehouse store environment. The launch of the adjusted product line at Costco should include a major announcement that informs all Costco members of the new additions. The Mirra chair clearly differentiates Herman Miller’s products from the typical chairs sold at office supply stores (see Appendix 18). The pallet display should showcase the Herman Miller name and insignia (see Appendix 19). In addition, the product packaging should be stylish and ergonomically engineered to present an image consistent with Herman Miller. To signal the additional offerings available, the chair should be bundled with a comprehensive Herman Miller brochure, a home office and small business version of the Company’s “Idea Book” (see Appendix 20). This brochure will direct the consumer to independent dealers or home retailers to purchase additional products. In conjunction with the Mirra product launch,

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Herman Miller should advertise in Costco’s circular and measure the effectiveness of this promotion and product launch by comparing sales to the previous chair offering (see Appendix 21). Recommendation: Healthcare Expansion and New Product Development The Company should increase resources dedicated towards its 30-year expansion into the healthcare sector. This additional emphasis will improve Herman Miller’s diversification so that it is better positioned for future down cycles in the institutional market segment (see Appendix 22). The healthcare industry has demonstrated steady growth over the prior two decades and is expected to continue (see Appendix 7). Currently, there is political will in the United States to expand health coverage. If the legislation is approved, industry expenditures would increase over the already strong growth by an estimated $150 billion annually totaling $1.5 trillion over the decade (“Cost of Health Care Reform”, New York Times, June 12th, 2009). Herman Miller is well known for quality furniture, so continued expansion into healthcare complements the Company’s core strength. The acquisition of healthcare furniture manufacturers Brandrud and Nemschoff provide Herman Miller with and expanded product set, a larger dealer network and the opportunity to take advantage of the health industry’s growth. Even with the addition of these companies, healthcare is a low share of Herman Miller’s revenue, representing a major growth opportunity (see Appendix 6). Consolidate Healthcare Brands While Herman Miller should maintain and leverage the Nemschoff and Brandrud names during the down economy, when the Company’s core revenue from office and institutional market turns around, Herman Miller should consolidate into a single brand. The Company should maintain its Foxxman brand to enable it to offer value-oriented solutions without devaluing the Herman Miller brand. This transition process can occur over a long period but will ultimately strengthen the Herman Miller reputation within healthcare.

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Consolidate Dealer Network To maximize the market opportunity in healthcare, Herman Miller must review their distribution network to ensure all dealers are educated about and have access to the full suite of products. Not all dealers currently offer both Nemschoff and Brandrud products and Herman Miller should select and appoint its best dealers in a given territory to offer the Company’s entire healthcare product line. The ability to sell the entire portfolio of Herman Miller healthcare products will enable dealers to provide a total customer solution, increase the average sale size and accommodate a greater range of customer aesthetic preferences. New Product Development – Patient Bed Herman Miller should expand its healthcare product offering to include patient beds. While patient beds often incorporate sophisticated technology that deviates from Herman Miller’s traditional products, it rounds out the Company’s healthcare offering to include a full patient room solution. A full solution will improve Herman Miller’s attractiveness to strong healthcare dealers that will be able to supply healthcare providers with the opportunity to utilize one manufacturer to furnish an entire patient room. Since the bid cycle is long due to the extended product lives, companies should seek to maximize the average sale size. The Company should utilize its free cash flow to invest in new product development. Additional penetration into the healthcare market will enable the Company to diversify its revenue to a more stable and higher growth industry. Conclusion Herman Miller is a well run organization and serves as a leader within its industry. However, we believe the Company has several opportunities to improve its position. During the challenging economic climate, Herman Miller must leverage its core strengths and continue to invest in research and development. The recommendations to adjust its healthcare strategy and to increase its consumer brand awareness will enable Herman Miller to further expand into growth markets and improve its overall position.

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Appendix 1

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