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Changes in business are sometimes measured in small increments; at other times, they come quickly and are highly disruptive to entire industries. The risks associated with lending into an industry which is undergoing significant change are well documented. These situations are marked by restructurings, mergers and, often, business failure and bankruptcy. However, these situations are also opportunities. Lenders who have the ability to think through the changes and understand them are the ones who ultimately will be able to lend safely as they mitigate the risks that arise.
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If a lender does lend into a rapidly changing sector, one of the problems to anticipate is the impact on collateral values that these changes to the business can have; both short- and longer-term. Those businesses which can evolve their model faster and better than their competitors will ultimately be the survivors in these situations. A good case in point is in the furniture sector.
There have been and continue to be dramatic changes occurring in the furniture industry. In 1996, imports of wooden bedroom furniture made in China was about $29 million. In 2004, within that same category, Chinese imports represented $1.2 billion in revenue. Today, Furniture Brands International, the largest residential furniture manufacturer with almost $2.5 billion in sales and owning household names such as Broyhill, Thomasville and Lane, generates a third of their sales from imported goods. The reason for this is that, even when accounting for the significant freight costs associated with importing bulky products such as furniture, the net costs are some 30 percent lower when these goods are sourced from Far East factories. This change in sourcing has contributed to the loss of around 40,000 US furniture manufacturing jobs since 1995.
The first valuation impact occurs at the wholesale level as those companies either attempt to restructure their US operations to compete with the lower cost of product from Asia or move their own sourcing there to take advantage of the lower costs. Collateral values of high cost US-made goods (those which cannot be differentiated from lower cost Asian goods and are not price competitive in the marketplace) will suffer. Until that company gets its costs in line, the collateral values will be lower. Over time, assuming the company can get its sourcing correct and demand levels in the marketplace are consistent, collateral values will stabilize, though perhaps not to prior levels, given fixed expenses.
The next impact is farther down the supply chain at retail. Furniture retailers have significant fixed costs within their stores and warehouses. As the retail price compression caused by the influx of inexpensive Asian goods has flowed through the marketplace, a retailer must sell many more units (bedroom and dining room sets, occasional tables, etc.) just to maintain their dollar sales year over year. For instance, a dining room set that a consumer bought at $999 last year can now be purchased for $699 as retailers have passed on much of the savings from the cheaper Asian sourcing. It is also important to note that the quality of these goods is now often better than goods manufactured domestically. The consumer gets the same quality for much less. Unlike other types of retail where a consumer may purchase an additional shirt or pair of shoes when they get a savings, furniture purchases do not get this same benefit. For many furniture retailers, sales and margin dollars are not being generated at a level which can justify the fixed expense structure of the company. This sales compression has a direct negative impact on the liquidation value of the inventory.
Recently, Gordon Brothers has been involved in a number of furniture retail liquidations in the marketplace. Even beyond the price compression issues mentioned above, we have found the consumers are not responding to our sales events in the same positive manner as they have in the past. Whether it is the impact of lagging new home sales (forecasted in July by the National Association of Realtors to be down some 13 percent for 2006), rising interest rates or some other unknown variable, the consumers have become much more value-oriented in buying furniture. These poor sales results have resulted in a much lower recovery on the assets than we have historically achieved.
After extensive review of these events and an examination of the retail furniture landscape, we have come to the conclusion that, in the short- to medium-term, recoveries of furniture goods in a retail liquidation are lower than in the past, and therefore, we have downgraded all our values in our retail furniture appraisals.
Furniture is only the most recent sector to be impacted by massive change. In this instance, change has been brought about through changes in sourcing, lowering significantly the cost of goods. These same dynamics have impacted consumer electronics, textiles, footwear and other high labor-content goods where the vastly different wage rates between the US and low-wage countries such as China make a material difference in the cost of goods. Those industries went through wrenching change in much the same way as the furniture sector is going through now. As stated previously, whenever there is change, there is opportunity. The secret is to stay ahead of the changes and manage your risk accordingly.
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