Seeking Small-Cap Moats: Culp

This article is part of Todd's monthly series "Seeking Small Caps With Moats." The introductory article can be found here. New articles in the series are published on the fourth Wednesday of every month. Due to the December holiday calendar, we are featuring this article Jan. 1.

As the head of Morningstar's stewardship methodology, I'm always on the lookout for companies led by management teams with strong capital-allocation practices. Though management itself isn't a moat source, we do believe that management's capital-allocation decisions can enhance, establish, or in some cases erode a company's economic moat.

Indeed, the combination of an economic moat and outstanding management can be extremely valuable for investors. Warren Buffett recently said as much during a meeting with some business school students at the University of Maryland: "You need two things--a moat around the castle, and you need a knight in the castle who is trying to widen the moat around the castle."  

Unfortunately, this combination of moat and knight is also quite rare. Across Morningstar analysts' coverage universe, we've awarded Exemplary stewardship ratings (our highest rating) to just under 10% of companies. Among firms with either wide or narrow economic moat ratings, the percentage with Exemplary stewardship ratings is only a bit higher, around 13%. Conversely, about 7% of our coverage universe and 4% of firms with economic moats carry Poor stewardship ratings.

Given the rarity of Exemplary stewardship and its importance in the small-cap world, I was intrigued not only by one company's potential economic moat, but also by its outstanding track record of smart capital-allocation decisions. The company is $240 million Culp Inc. (CFI)--the largest marketer and manufacturer of fabrics for mattresses and furniture in North America, with global operations in Canada, Poland, and China as well. 

As I noted in last month's article, my favorite small caps are those that operate in decidedly sleepy industries, and it doesn't get much sleepier than a company that produces mattress fabric. Yet it's precisely the slow-but-steady and predictable nature of mattress (and by extension, mattress fabric) demand that makes it an intriguing business. 

Culp was founded by (you might have guessed) the Culp family in 1972 and remains somewhat of a "family-owned" business, with one of the founders, Robert Culp III, having served as the chairman since 1990 and owning about 13% of shares outstanding. His son, Robert Culp IV, serves as president of Culp Home Fashions. CEO Franklin Saxon has been with the company since 1983 and has also served as COO and CFO during his time with Culp.  

Culp's stock was a particularly strong performer in the 1990s, and the company increased its dividend at almost a 19% annualized clip between 1990 and 1997. The company invested quite aggressively over this period and borrowed more than it could afford. When the recession began in early 2001, Culp found itself in a tight spot financially and ended up cutting its dividend and focusing all available cash flow on deleveraging the balance sheet. 

Over the last 10 years, Culp management has done a fantastic job of putting the company on much sounder financial footing, shifting from a $136 million net debt position in fiscal year 2000 to a $22 million net cash position in fiscal year 2013, as shown in Exhibit 1 below.

Source: Culp

With its deleveraging period nearing completion, Culp reinstated its dividend program in June 2012 and proceeded to increase its nascent payout by 33% in fiscal 2013 and another 25% in fiscal 2014. Management also made very smart use of shareholder cash by repurchasing 8.5% of its shares outstanding in fiscal years 2012 and 2013 at an average price of $9.23 per share (less than half the current share price). 

Finally, I'm encouraged by the company's decision in fiscal year 2011 to base annual bonuses on the economic value added, or EVA, metric, which provides a financial incentive for management to invest in projects that generate returns above the company's cost of capital. In my experience, boards and management teams that use EVA as an incentive metric are confident that they'll be able to outearn their cost of capital on a regular basis--otherwise they'd be unwilling to accept the terms--and it is generally a good sign that a moat is present.

To confirm that the company possesses an economic moat, let's examine the quantitative evidence.

Results over the last four years have been particularly good and seem to indicate some level of competitive advantage, but whether these advantages are durable remains to be seen. If we can identify an economic moat source for Culp, I'd feel a lot more comfortable arguing that Culp possesses a narrow economic moat.

It's important to note that while Culp was repairing its balance sheet, it was also transforming its business from one that was primarily dependent on U.S.-based upholstery fabric production toward one that primarily produces mattress fabrics and China-based upholstery fabric. 

Source: Culp

 

This business mix shift matters quite a bit because domestic mattress fabric production is significantly more advantaged than the more capital- and labor-intensive U.S. upholstery fabric market. First, shipping costs are fairly high, and the industry's "just-in-time" development cycle makes it difficult for mattress fabric imports to compete with local fabric producers on cost and quality. Second, labor costs are a small percentage of total mattress fabric production costs, providing less advantage to foreign producers that may have lower labor costs relative to domestic producers. As the U.S. market's largest mattress fabric producer, Culp may possess a low-cost-production economic moat source, derived from economies of scale and transportation cost advantages.

At this point you may be rightly asking, "What's stopping another company from entering this market?" The simple answer might be that the domestic mattress fabric market is niche enough that it doesn't fit nicely into another firm's strategy, particularly if the new entrant needs to learn the fabric production business from the ground up. 

I'm less clear on what sustainable advantages, if any, Culp has in the upholstery fabric industry. To its credit, Culp has dramatically reduced its capital and labor costs in upholstery fabric production, going from 14 U.S.-based plants with 3,500 employees and $92 million in fixed assets in 2000 to one U.S. plant and four China-based plants staffed by 564 total employees and $5.8 million in total fixed assets in 2013. As a result, returns on capital in this segment are actually pretty good. Perhaps its China-based operations have some scale or product-design advantages over smaller regional competitors, and China's shift from an investment-driven economy to a more consumer-driven economy should be a tailwind for regional upholstery fabric demand, but I would expect this phenomenon to lead to more intense competition over time, and I'm not sure this business has a moat.  

Morningstar doesn't have full analyst coverage on Culp, and the company hasn't been vetted by our moat committee to produce an official Morningstar Economic Moat Rating. Still, given that mattress fabric production accounts for the majority of Culp's sales and operating profit and that the company is focusing its capital spending on the advantaged mattress fabric business, I'm comfortable in my opinion that Culp possesses a narrow economic moat.  

In terms of valuation, Culp doesn't look exactly cheap these days, but then again not much does in the U.S. small-cap market.

Exhibit 3: Culp Free Cash Flow and Earnings Yield (TTM)

Source: CFI Free Cash Flow Yield (TTM) data by YCharts

At about $20 per share, Culp trades with a free cash flow yield just below 6%, which doesn't strike me as ridiculously expensive given my thesis that the company is on a decent growth trajectory and led by a skilled team of capital allocators. That said, I'd be much more inclined to invest in Culp closer to $17 per share and will do so in my personal portfolio if the stock falls closer to that level. 

Do you have any questions about Culp? Please add your questions, comments, and feedback in the comments section below.