Flexsteel Industries, Inc. (FLXS) Q2 2022 Earnings Report, Transcript and Summary

Good morning, and welcome to the Flexsteel Industries Second Quarter Fiscal Year 2022 Earnings Conference Call. All participants will be in a listen-only mode. [Operator Instructions]. After today’s presentation, there will be an opportunity to ask questions. [Operator Instructions]. Please note this event is being recorded. I would now like to turn the conference over to Derek Schmidt, Chief Financial Officer and Chief Operating Officer for Flexsteel Industries. Please go ahead.

Thank you, and welcome to today's call to discuss Flexsteel Industries' second quarter fiscal year 2022 financial results. Our earnings release, which we issued after market close yesterday, Monday, January 24, is available on the Investor Relations section of our Web site, www.flexsteel.com, under News & Events. I am here today with Jerry Dittmer, President and Chief Executive Officer. On today's call, we will provide prepared remarks, and then we will open the call to your questions. Before we begin, I would like to remind you that the comments on today's call will include forward-looking statements, which can be identified using words such as estimate, anticipate, expect and similar phrases. Forward-looking statements by their nature involve estimates, projections, goals, forecasts, and assumptions and are subject to risks and uncertainties that could cause actual results or outcomes to differ materially from those expressed in the forward-looking statements. Such risks and uncertainties include, but are not limited to, those that are described in our most recent annual report on Form 10-K as updated by our subsequent quarterly reports on Form 10-Q and other SEC filings, as applicable. These forward-looking statements speak only as of the date of this conference call and should not be relied upon as predictions of future events. Additionally, we may refer to non-GAAP measures, which are intended to supplement but not substitute for the most directly comparable GAAP measures. The press release available on the Web site contains the financial and other quantitative information to be discussed today as well as the reconciliation of the GAAP to non-GAAP measures. And with that, I will turn the call over to Jerry Dittmer. Jerry?

Good morning and thank you for joining us today. I'm encouraged by our continued strong sales performance. We delivered growth of 18.9% during the quarter despite the ongoing supply chain challenges, and it was our sixth consecutive quarter of double digit sales year-over-year growth. I feel we're well positioned to continue growing and gaining market share longer term. While our top line performance has been solid, we're contending with several global supply chain challenges, which are putting intense pressure on near-term profits. Most noteworthy are ancillary costs associated with ocean container logistics, such as demurrage, detention and chassis charges. As a reminder, almost 70% of our sales are supported by globally sourced products, which require us to import thousands of containers each quarter. Given our strong growth combined with concerns about ongoing global supply chain disruptions from COVID and other issues, we imported a record number of containers in the past seven months to support our growth trajectory and strategically build inventory to protect our service levels. Unfortunately, the ramp up in imports coincided with worsening supply chain conditions as severe congestion at ports and railroads left our containers stranded for days or weeks, incurring ancillary fees. At the same time, the trucking industry is in crisis given the widening gap between demand and supply of truck drivers. For us, the lack of truck drivers to pick up and return containers has further compounded the number of days our containers are waiting and incurring ancillary fees. All this disruption has also emboldened logistics firms to increase per diem rates, in some cases by 3x to 4x pre-COVID rates while also tightening other terms. The result, ancillary charges which used to be a negligible item on our P&L unexpectedly ballooned to over 15 million in the recent quarter. The magnitude of these costs is not acceptable going forward, and we have deployed a variety of strategies to aggressively manage these expenses, which Derek will expound on in his comments shortly. The other significant issue we're navigating is cost inflation. As I noted, global imports are a large portion of our business and we are exposed to ocean container freight rates, which continue to climb to new highs due to supply and demand imbalances. We are also seeing inflationary cost pressures from other areas of our supply chain, including materials and domestic transportation, where we've recently experienced double digit increases in wages, notably in Mexico, which recently increased by 22%. We are implementing price increases to pass along these higher costs to the market where we can, but the lag in price realization will negatively impact gross margins near term. Though much uncertainty remains in a global supply chain and cost conditions could worsen, we are taking actions to assertively manage cost and address margin pressures, where possible, to return the company to a profitable level for the remainder of fiscal 2022. Now I'll turn the call over to Derek to discuss our financial and operational results. And I'll be back with some closing comments on what we see ahead.

Thank you, Jerry, and good morning, everyone. Second quarter net sales were $141.7 million, up $22.6 million, or 18.9%, compared to $119.1 million in the prior year period. Our sales results were at the high end of our revised $137 million to $143 million guidance range, despite the ongoing supply chain issues faced in the quarter, which Jerry highlighted earlier. Sales performance in our retail channel continues to be strong as sales increased $22.5 million, or 22.3% versus prior year. We continue to benefit from the gains in retail product placements made over the past year as well as our healthy inventory position in service levels of in-stock products. As we ramp up North American manufacturing capacity, we expect our lead times on custom manufactured products to become even more competitive, which should be a source of growth for the remainder of the fiscal year. On the e-commerce side of our business, sales performance was solid at $18 million. Although growth was flat in comparison to a strong prior year quarter, sales improved by $5 million, or 38%, compared to first quarter results. We are regaining growth momentum in this channel and feel bullish on our growth outlook for the remainder of the fiscal year. In addition to share gains with existing customers, we expect e-commerce growth to be driven by new customers, new product launches and improved content and advertising effectiveness. From a profit perspective, we provided a business update in December that we expected an operating loss in the quarter due to significantly higher ancillary costs. Consistent with that guidance, we reported a fiscal second quarter net loss of $7.5 million or a negative $1.13 per diluted share that compared to net income of $8.5 million or $1.13 per diluted share in the prior year quarter. The reported net loss included a $600,000 pre-tax restructuring expense. Please see the non-GAAP disclosure included in the earnings release for a detailed reconciliation of GAAP to non-GAAP adjusted net income and adjusted earnings per share. Gross margin as a percent of net sales in the second quarter was 6.7%, which was 1,380 basis points lower than the prior year quarter. The primary driver of the year-over-year decline in both net income and gross margin percentage is higher ancillary costs associated with ocean containers, which as Jerry explained, exceeded $15 million in the quarter. As outlined in the earnings press release. There are other factors influencing profit margins, but they largely offset each other as the year-over-year reduction in SG&A of 350 basis points more than offset the reduction in gross margins related to cost inflation and capacity growth investments. Moving to the balance sheet, the company ended the quarter with a cash balance of $4 million and working capital of $171.1 million and a $60 million balance on our secured line of credit. Compared to the end of fiscal 2021, working capital increased by $42.4 million. The increase in working capital was primarily related to a $17.9 million increase in inventory and a $29.7 million decrease in accounts payable, which largely related to payment for inventory purchased at the end of fiscal 2021. As Jerry noted earlier, we made a strategic investment in inventory to support higher sales and improve service levels to customers. We anticipate gradually reducing inventory over the balance of fiscal 2022, while still maintaining an advantaged position with our customer service levels. Looking forward, guidance for the third quarter sales is between $135 million and $145 million, which translates to sales growth between 14% and 22% year-over-year. For the full fiscal year 2022, we are still targeting sales growth between 15% to 20%, but achievement of that growth will be dependent on global supply chain conditions and the impact of rising cost inflation in the second half of the fiscal year. Given uncertainty on cost inflation and supply chain conditions, we are not providing detailed profit guidance for the third quarter at this time. But as Jerry alluded to earlier, we are taking aggressive actions to increase the likelihood of returning the company to profitable levels in the third and fourth quarters. Three key initiatives include; first, lowering ancillary charges to less than $5 million in the third quarter by reducing inbound containers. Given our strong inventory position, we intend on gradually reducing inventories without compromising service levels. Next, we are realigning with a select group of freight forwarders who can perform more effectively and managing the physical flow of our containers and reducing ancillary fees. And finally, we are dedicating additional internal and external resources to track and minimize fees by container on a daily basis. For our second profit improvement initiative, we are implementing pricing increases across most of our products to offset cost inflation from ocean freight, materials, wages and domestic transportation costs. Revised pricing will be effective with new February orders. Due to the lag in price realization, we expect cost inflation to run higher than price by roughly $1 million to $2 million in the third quarter compared to the second quarter. Lastly, we will tightly manage SG&A expenses at or below $17.5 million in the third quarter while still funding critical long-term growth investments. If supply chain conditions worsen or inflationary pressures escalate higher, we'll adjust our plan and take additional actions as necessary. Regarding our cash flow outlook, working capital is expected to be a source of cash flow in the second half of the year as we reduce inventory levels. Near-term priorities for cash include funding capital expenditures and reducing debt. For fiscal 2022, the company anticipates spending $10.5 million to $12.5 million for capital expenditures, of which a large portion will be spent in the fourth quarter related to equipment for our new production facility in Mexicali, Mexico. The effective tax rate for fiscal 2022 is still expected to be in the range of 26% to 27% and restructuring expenses are estimated at $1 million for the full year. I'll turn the call back over to Jerry to share his perspective on our outlook.

Thanks, Derek. While the short-term profit impact of continued supply chain difficulties is frustrating, I'm encouraged by our growth momentum and confident that our team is adjusting to manage external cost pressures, while remaining steadfast to executing our long-term growth strategies. Our recent investments to expand capacity will both support future growth and build supply chain resiliency. Production at our third and newest manufacturing plant in Juarez, Mexico is ramping up as expected, and construction of our new facility in Mexicali, Mexico is still on target to be completed by June and will start production in August. Our new distribution center in Greencastle, Pennsylvania will begin shipping to East Coast customers next month, and will improve service levels and support future growth in that region. In addition, we continue to strategically invest in our talent, brands, product innovation, and digital capabilities to advance our growth ambitions. In summary, I remain enthusiastic about our prospects for long-term profitable growth. With that, we'll open up the call to your questions. Operator?

We will now begin the question-and-answer session. [Operator Instructions]. And our first question comes from Anthony Perala of Punch & Associates. Please go ahead.

Hi, guys. Good morning. Thanks for taking my questions.

Good morning.

If you could -- it would be helpful on the top line sales growth, how much of that 18.9% is from -- what's the breakdown between volume and pricing there in the most recent quarter?

Yes, the price component is in the low teens and the remainder is unit volume growth.

Okay, that's great. And then going forward, could you give just some more color on how those price increase conversations are going with customers as we head into fiscal Q3 and into February orders?

Yes, from an industry perspective, everybody who competes in the industry is broadly impacted by inflation. So we are seeing competitors at this time take similar pricing actions. So we feel that the pricing that we're pushing forward that's effective February 1st is in line with the competitive set. No one in the industry likes it, but everyone understands the inflationary factors behind it. So we don't believe that we are going to be disadvantaged or adversely impacted by our pricing actions compared to our competitors.

And then just one last one, the difference with the business update in December, I think you quoted ancillary charges at around 10 million. And I think in the release, it's around 15 million. Is there anything that pops up in the last couple of months that led to that change, or is that just a realization of the higher ancillary costs that you had mentioned?

Yes. Unfortunately, Anthony, really over at least the last six months, there's been so much disruption in the global supply chain, specifically logistics, and there are so many different parties involved in moving container; that's the freight forwarder, the shipping lines, ports, the railroads, domestic trucking companies, and all of them, to varying extents, have, I'll say, probably taken advantage of the current environment and started implementing either new charges or raising prices on existing charges. And so when you have that many parties passing along ancillary charges, we just had limited visibility I think at the end of last quarter in terms of what we knew and understood to be the total ramifications of the supply chain disruption on ancillary charges. As I noted in my comments, what we are doing specifically to get control over these charges in the near term is we are slowing inbound containers. I'll give you perspective that in the first quarter of fiscal year '22, on average, we received 880 containers per month. We anticipate for the third quarter of the year in receiving somewhere between 250 and 300 containers per month, so significantly lower than our peak period. We are also aligning ourselves, like I said, with what we believe are the strongest, most capable freight forwarders who can effectively manage this, and we're putting internal resources. Those are the things -- those are the steps that give us confidence that we can substantially reduce these ancillary charges in the coming quarter.

That's great. That's all for me. That's fine. Keep up the good work, guys.

Okay. Thanks, Anthony.

The next question comes from Jeff Geygan of Global Value Investment Corp. Please go ahead.

Thank you. Good morning, guys. I appreciate you taking my questions here.

Good morning, Jeff.

With respect to your logistics cost of 15 million during the quarter, maybe more broadly discussing ancillary, did you suggest that that number was going to 5 million in Q3? So I understand that there may have been a $10 million increase that you think can be mitigated?

Well, part of that to just sort of Derek's comments, Jeff, we're bringing close to 900 containers in. Now we're going to bring that down closer to 250 or 300. Our inventories are in a good place right now. And even though we're continuing to see escalations that we have not seen these charges minimize at all. In fact, we're still seeing ocean container rates rise. We are hoping with the Chinese New Year's coming that we would see a little bit of a decrease, we have not. So overall averages are still where they’ve been or higher. But the big decrease there is until this starts to stabilize, we'll be bringing in a lot less containers. Plus, as Derek also mentioned, we've gone down to just six to eight main folks who were using and hopefully we'll be able to get some better terms and conditions going forward using less folks that can help us estimate these costs better. Because these cost as we've set are costs that it used to be negligible and now they've become a big part of our business. So we're going to just continue to monitor them, and have put a lot of resources in place to monitor this.

Yes, sure. I appreciate the color. Just to be certain on this. So is the roughly 900 versus 250 a normal seasonal event, or is this truly an inventory replenishment one-time event?

Yes, it's lower than what our normal run rate would be. Because we have such a strong inventory position, we feel that we can slow things up and still maintain really, really good service levels.

Great, I appreciate it. Next question, your SG&A improved by 350 basis points to 12.4% of sales. Is this a good percent run rate on a forward basis?

No. Jeff, I would say it's an appropriate, I think, percentage for the near term. Given the gross margin pressures and the uncertainty that we're facing, we're going to control cost in a very disciplined fashion. As we think prospectively about a multiyear period, I'm still of the mindset that we are going to target gross margins longer term, about 22% and then SG&A in the 14% to 15%.

Got it, all right. Well, good job on your cost management. I know it's been a tricky time for everybody. Last question with respect to capital allocation, your Board approved a $30 million buyback. You have a dividend that you're paying on a current basis. You've talked about CapEx net 10 million, 12 million. How should we think or how are you thinking and the Board potentially about capital allocation, particularly in light of your drawn and your revolving credit facility and this recently announced potential share buyback?

Yes, I think, Jeff, I'll reiterate the cash priorities that I mentioned earlier. Really for the remainder of calendar 2022 are going to be funding our CapEx, which is primarily related to the build out of our new Mexicali facility, and then debt reduction. What I am directionally targeting for calendar 2022 is a reduction in inventory of at least 30 million and a corresponding decrease in debt. The additional share repurchase authorization was due to two factors. One, as of today, we have only about $1 million left on our existing authorization. And then we still want the flexibility and the optionality to repurchase shares when our cash priorities change, and one we believe the stock is trading at a price below our view of intrinsic value. So what I wouldn't do, Jeff, is interpret that the $30 million additional authorization constitutes a near-term priority of cash to do more share repurchases. But it is an option that we have in the future to continue share repurchases where we believe it's appropriate.

Thank you for the clarification and your time again. Good luck.

Thanks, Jeff.

Thanks, Jeff.

This concludes our question-and-answer session. I would like to turn the conference back over to Jerry Dittmer for any closing remarks.

Thank you. In closing, I'd like to thank all our Flexsteel employees for their outstanding performance and service during the second quarter. I would also like to thank you for participating in today's call. Thank you for your questions today. And please reach out if you have any additional ones. And we look forward to updating you on our next call. Everyone have a great day. Thanks.

The conference has now concluded. Thank you for attending today's presentation. And you may now disconnect.