Natuzzi S.p.A. (NYSE:NTZ) is an Italian company that sells furniture all over the world.

Between its initial public offering (IPO) and the Great Recession (GFC), the company grew quickly, but after the GFC, it lost markets because it didn’t have a brand name.

In 2016, the business started focusing on branded stores, most of which were run through franchises or joint ventures. With this change in strategy, the costs of commercialization have gone down while sales and gross profits have gone up.

Even though the company is doing well enough that its earnings multiples aren’t too high, it faces a big risk of operating leverage. A global recession could hurt the company’s sales, which would hurt the bottom line a lot.

The company’s idea seems reasonable, but there is too much chance of a recession for it to work, and Natuzzi is not strong enough yet.

Unless otherwise said, all of the information came from NTZ’s SEC filings.

Natuzzi started out in the 1970s as a company that sold furniture made in Italy. For 40 years, the business had stores all over Italy and also sold to wholesalers in other countries. Italy already had a good name for itself. NTZ went public in the US in 1993, and at its peak, it was worth $1.6 billion. Before the Great Recession, it was making more money.

After that, sales dropped by a lot. I think the only thing that made people aware of the problems was the GFC.

The two biggest problems with NTZ were that it only had one brand, “made in Italy,” and that it was less competitive because it was made there.

The company didn’t do anything to spread its name outside of the U.S., and it didn’t have any stores with its name on them. The company’s cake was eaten by competitors who were cheaper and just as good.

Change in strategy: In the “Markets” section of its 10-K, the company called itself a wholesale business until 2015. In 2016, the company changed its focus to opening branded stores overseas, mostly through franchise operators.

In 2016, the company had 377 stores with its own brand, and one out of every two products had its own label. In 2019, the company had 555 stores all over the world, and 36% of its products did not have a brand name on them. By 2021, when the company will have 651 stores, only 25% of its products will be sold under its own brand names.

Also, the company stopped making things in Italy. In 2005, when the company was at its busiest, most of its products were made in Italy, where 3,000 people worked. In 2015, there were about 2,000 people working there, but they only brought in about 35% of the money. In 2021, the Italian plants employed 1,500 people and brought in 40% of the money. The rest of the production is done in China, Romania, and Brazil.

The problem with making things in Italy is that replacing workers is hard and expensive. For example, in 2021 or 2020, the company will have to pay either €5 million or €3 million in labor claims. The manufacturer will then be able to use the “made in Italy” label, which has some meaning outside of Italy.

To increase gross profit margins, the company moved production overseas and opened stores with its own name (trending up since FY17 end). Most importantly, the business started making more money because the ratios of SG&A to revenue did not go up.

The company’s joint ventures that did business outside of the country also did more business. A joint venture with the store KukaHome in China (49% ownership) has been very successful. The JV started making money in 2018, and it made €1,000,000 in 2019, €1.5,000,000 in 2020, €3.5,000,000 in 2021, and €2,000,000 in 9M22 (in a bad year for China).

Even though KukaHome has 340 locations, none of them sell only Natuzzi products, which is a problem. This means that the collaboration doesn’t help a brand grow, which is what was supposed to happen. Even though this partnership may bring in money right now, it will hurt the business in the long run. When KukaHome figures out that the category is successful over time without putting a lot of money at risk, it may just copy Natuzzi’s strategy.

Natuzzi announced a new partnership in May 2022 to help it grow in the APAC region. Singapore is the center of administration for the partnership. The Vietnamese furniture company TTF is one of the partners. It bought a 20% share of the partnership for €5 million. The partnership will lead to more sales.

As of December 2021, the company owed €17 million in long-term securities with interest rates of Euribor + 2.5% and €36 million on a credit facility with 5.5% interest rates. In the 9M22 time frame, the company paid back €6 million of these loans. Even though the company has €53 million in cash on hand, there aren’t many worries about when it will run out.

But the company has other problems, like a pension deficit of €15 million and a legal provision of €10 million for labor disputes. It has an even amount of working capital. By the end of December 2021, it will have assets worth about €150 million and debts worth about €150 million.

Pasquale Natuzzi, who started the company, owns 56% of the shares, or 60% if family shares are included. The founder of the business is the chairman and CEO until May 2021. Managers are paid a lot: €3 million for the executive team and directors.

Valuation

I like that NTZ’s SG&A costs (as a percentage of sales) stay the same while its gross margins grow. Future financial success depends on it. I also like that the business is making more money again after a 15-year slump (chart below). Also, the company’s joint venture in China brings in profits that aren’t used to pay for operations, but they do help pay interest.

Since at least 2005, there have been limits on margins. This is the problem. Even in the recent past, from 2019 to 2022, SG&A costs have often been higher than gross income.

In 9M22, NTZ made a profit of €6.9 million from its operations. In the end, it cost €5 million net to finance it. As the exchange rate went up by €5 million, the Chinese JV made €2 million more money. Because of this, the company made a net profit of €6.6 million ($6.5 million in September 2022) The company is worth $56 million, which makes it look like a great chance.

Yet, these results are very random: operating margins for the period are only 2%, operating earnings barely cover finance costs and gains in exchange rates can suddenly turn into losses (the company will probably record FX losses and lower revenues from the U.S. for the Sept22-Mar23 period, given that the dollar devalued).

The most important thing is for the company to understand operational leverage, especially in its factories. Even though shipping and commissions make up 60% of SG&A expenses, which are mostly variable, the business’ gross margins and operational profitability would be hurt by a drop in volume.

Since I think the company’s plan is good, a drop in volume doesn’t usually bother me as much. But the current macroeconomic data seems to point to a recession, and the situation is getting worse by the hour.

If I thought NTZ was a solid, long-term business that could keep making money even after two years of losing money, I wouldn’t be worried. I think NTZ will do well in the long run, but it has a lot of debt and fixed costs, so even a short period of falling sales could cause it to lose money. Still, the situation is dangerous.

Don’t be fooled by cash flows. Many investors will notice that the FCO and FCF numbers for the company are much bigger than its net income. This is done so that capital lease payments can be recorded as financing payments under IFRS and subtracted from FCF. Since capital lease payments are related to activities, they should be reported as a negative FCF cash flow. This also makes it easy to compare with companies that use US GAAP. Taking into account this difference, NTZ’s net income and FCF seem to be very similar.

The change that NTZ is going through seems exciting, hopeful, and successful so far. The company is also making more money and trading at a low multiple of its current net income.

Even so, running the business is still risky and can be affected by even small drops in sales. I think the business is too risky because most economic signs point to a worldwide recession coming soon.

Still, I think NTZ stock will become more popular in the future. This could happen, for example, if people stop worrying about a recession or if the business shows it can survive lower sales. I’ll keep it on my list, but right now is not the best time to invest.

Featured Image: Unsplash @ Nathan Fertig

Please See Disclaimer