Friday, July 21, 2017

Latitud nails the wicked economics of furniture industry


A value chain describes the process by which businesses receive raw materials, add value to the raw materials through various processes to create a finished product, and then sell that end product to customers.

In a typical industry, downstream of the value chain is more lucrative than the upstream. Downstream operations are where margins are the widest.

Although that is still the case for furniture industry, retail prices of furniture get cheaper year after year. Retailers (i.e. Ikea and Nebraska Furniture Marts) make their quality pieces more and more affordable than before.






















In some cases, products (designs) disappear entirely. That is a result of survival-of-the-fittest catalog that wields an enormous amount of influence over residential interiors.

The industry has clearly evolved to democratizing design for affordable prices.

Any retail price drop is reflected on upstream players. They are unlikely to survive unless they are cost effective and able to meet/surpass the minimum standard of quality.

In this letter, we examine how Latitud has positioned itself in such a wicked economics.

Building blocks of Latitud

Latitud seems to understand that wicked economics of furniture industry well.

The Managing Director of Latitud - Mr. Lin acknowledged that (1) efficiency and (2) quality must be joined at the hip in order to save profits from low production costs.

In its low-cost business model, Latitud's strategies bode well with furniture retailers' value preposition - a complex interaction between prices, product quality (e.g., aesthetic designs and materials), and service quality (e.g., delivery and warranty). 

These factors, however, are not equal.

Quality is a precondition in price setting. Products must be designed and delivered to satisfy per-determined criteria in order to fetch a reasonable profit margin.

To what extent that Latitud can meet and maintain the quality of its products and services becomes the primer. As reported in Annual Report 2016:







At the same time, Latitud also strives to produce more outputs using less inputs through cost control.



How were they materialized?

In order to improve both quality (of raw materials, which have a direct impact on recovery rate) and efficiency, Mr. Lin has shaped Latitud into a vertically integrated furniture manufacturer.

In 2015, Latitud acquired a (ply)wood lamination factory near Port Klang.

Then, Latitud built a saw mill in Kuala Terengganu in 2016.

These upstream integration reinforced strategic value preposition (quality + efficiency) of Latitud. 

Since Mr. Lin became the Managing Director in 2012, Latitud has experienced significant rise in:
  • Revenue, registering CAGR 13.36% ;
  • Net profit, registering CAGR 49.19%;
  • Gross margin from 10.3% to 17.7%;
  • Operating margin from 4.1% to 12.2%; and
  • Net margin from 1.9% to 9.4%
















Unboxing Latitud's margins

However, it is noted from the figure above that operating and net margins of FY16 were lower than that of the previous year.

To explain this, we have to acknowledge that upstream operations are where margins are the narrowest. 

The (ply)wood lamination factory that previously owned by KPSCB (KLSE 9121) consistently returned less than 3% operating margin and 2% profit margin. Similarly, margins of saw mill business are also slim.

It is, therefore, logical to observe lower margins of Latitud in general.

To help us further, we prove this mathematically using net margin as a demonstration. Although Latitud did not provide any segmental information, we can achieve that by applying reasonable assumptions.

Assumption 1: Both upstream businesses on average generate 3% net margin (underpinned by Latitud's strategic commitment to boost their efficiency from a weak base) on RM100 revenue; and
Assumption 2: The furniture manufacturing division returns 10% net margin on RM970 revenue. 

  






As a result of their integration, the overall net profit becomes 9.35% (total net profit/total revenue). 

In fact, Latitud has reported improved both operating and net margins as at the end of 3 quarters of FY17.














Takeaway

Through this letter, we learn that retailers in general reduce prices of quality furniture year after year. To what extent furniture manufacturers can respond to this wicked economics is key to their survival.

Latitud has had its operation in sync with that wicked economics. Its furniture manufacturing division is integrated with a saw mill and a (ply)wood lamination factory. 

Given that the margin of the upstream division is narrow, Latitud has devoted physical efforts to boost its efficiency. 

Signs of improvement are visible and, most importantly, there are plenty of room for improvement.

Acknowledgement

I wish to thank Uncle David (a former top man at IKEA Malaysia) and a respected anonymous (who received his hands-on education through saw mill and furniture manufacturing businesses) for their unselfish sharing.

"The ultimate winners in furniture business are those know how to (produce) sell $1 quality furniture for 90c next year," said Uncle David.