Interface, Inc. (TILE) Q1 2016 Earnings Report, Transcript and Summary

Good afternoon, ladies and gentlemen, and welcome to the Q1 2016 Interface Inc earnings conference call. Participants are in a listen-only mode at this time. Later we will conduct a question-and-answer session and instructions will follow at that time. [Operator Instructions]. As a reminder, this call is being recorded. I would now like to turn the conference over to our host, Mr. David Foshee.

Thank you, operator. Good morning and welcome to Interface's conference call regarding first quarter 2016 results. Joining us from the Company are Dan Hendrix, Chairman and Chief Executive Officer, Jay Gould, President and Chief Operating Officer, and Patrick Lynch, Senior Vice President and Chief Financial Officer. Dan and Jay will review highlights from the quarter, as well as Interface's business outlook. Patrick will then review the Company's key performance metrics and financial results. We will then open the call for Q&A. A copy of the earnings release can be downloaded off the Investor Relations section of Interface's website. An archived version of this conference call will also be available through that website. Before we begin the formal remarks, please note that during today's conference call, management's comments regarding Interface's business, which are not historical information, are forward-looking statements. Forward-looking statements involve a number of risks and uncertainties that could cause actual results to differ materially from any such statements, including risks and uncertainties associated with the economic conditions in the commercial interiors industry, as well as the risks and uncertainties discussed under the heading Risk Factors in Item 1A of the Company's annual report on Form 10-K for the fiscal year ended January 3, 2016, which has been filed with the Securities and Exchange Commission. We direct all listeners to that document. Any such forward-looking statements are made pursuant to the Private Securities Litigation Reform Act of 1995. The Company assumes no responsibility to update or revise forward-looking statements made during this call and cautions listeners not to place undue reliance on any such forward-looking statements. Management's remarks during this call refer to certain non-GAAP measures. A reconciliation of these non-GAAP measures to the most comparable GAAP measures is contained in the Company's earnings release and Form 8-K filed with the SEC yesterday. These documents can be found on the Investor Relations portion of the Company's website, www.interfaceglobal.com. Lastly, please note that this call is being recorded and broadcasted for Interface. It contains copyrighted material and may not be re-recorded or re-broadcasted without Interface's express permission. Your participation on the call confirms your consent to the Company's taping and broadcasting of it. Now, I'd like to turn the call over to Dan Hendrix. Please go ahead, Dan.

Good morning, everyone. Once again, the lead story of the quarter was our continued streak of gross margin expansion, up 285 basis points compared with the first quarter of last year. This is our fifth straight quarter of posting year-over-year triple digit basis gains in gross margin. From an operational standpoint, I am very pleased with the progress we've made and I'd like to thank our management team and our employees for an incredible amount of attention and hard work that has gone into realizing these results. Obviously, I'm disappointed in our first quarter revenue being down 6% but there are a couple of points to keep in mind here. The first quarter is usually our seasonally lowest period of the year and last year's first quarter had 14 weeks versus 13 weeks this year. So it's not a direct apples-to-apples comparison. Also, we had a number of initiatives in place to accelerate our top line growth over the balance of the year and we'll talk about those in greater detail in a few minutes. Despite the decline in sales with the earnings power we've created in our business we were able to achieve year-over-year improvements in gross profit, operating margin, net income, and earnings per share. Looking ahead, I believe we have some additional headroom for further gross margin expansion, but our primary focus will be on increasing sales volume and controlling SG&A expenses. For a more in-depth review of the operational highlights of the quarter and discussion of these initiatives we have in place to accelerate our growth this year, I'd like to turn the call over to Jay Gould. You'll recall that Jay joined us in January 2015 as Executive Vice President and Chief Operating Officer. He came to Interface from American Standard Brands where he was the CEO of an iconic kitchen and bath fixtures company. Before that, Jay held executive level positions at Newell Rubbermaid, the Campbell Soup Company, and the Coca-Cola Company. Jay hit the ground running at Interface and has done a remarkable job of leading to his appointment as President and Chief Operating Officer earlier this year. Jay, please go ahead

Thank you, Dan. Well, as mentioned the best news of the quarter was the gross margin expansion, rising from 38.9% up from 36.1% in the first quarter of last year. Importantly, each of our business units, Americas, Europe, Asia-Pacific, and Floor contributed triple digit basis point gross margin expansion. The drivers of the improvement were lower input costs, lower raw material costs, and lower usage at our manufacturing facilities along with increases in our average selling prices, which more than made up for the lower sales volume. We have a number of initiatives underway throughout our manufacturing supply chain to drive further improvement in gross margin. These include reductions in material usage and labor costs at our production facilities, continued declining raw material input costs, increases in our average selling prices, improved product mix, and the introduction of new margin accretive products such as additional skinny planks. As noted in the earnings release, sales were down 6.1% in the quarter or 4.5% on a currency neutral basis. And those figures include the extra week in the prior year period. It's somewhat hard to quantify the impact of the extra week, but I would estimate that sales were down about 3% on an apples-to-apples basis. The Americas region was down 6% with two primary drivers of the decrease. First, it's clear that sales in our regions that rely on the oil and gas industry are suffering. Those include Houston, Denver, Western Canada, Brazil, and Argentina. In addition, one of our accounts in the Interface Services business has delayed but not cancelled major refurbishing products. So they've moved it from the first half of the year and pushed all that refurbishment into the second half of the year. In Europe, we believe our 10% sales decline was caused mostly by geopolitical and economic issues. These are very well known, but to mention just a few, the potential exit of Britain from the EU, the slowdown and layoffs in the financial services sector, the terror attacks in Paris, Belgium, and Turkey, continued unmanageable refugee crisis, the conflicts with Russia, the potential exit for Greece from the EU, and also the downturn in the energy sector impacting the Nordics and the Middle East. Each of these issues carries sizable ramifications for the European governments, for the economies, and of course the corresponding business and consumer confidence levels. In Asia-Pacific, sales were up 3% due to improved confidence in commercial building in India and also a continued rebound in our Southeast Asia business. Our lower revenue figure in the quarter somewhat skewed our SG&A expenses as a percent of sales. We trimmed expenses where consistent with our strategic plans, but continued to invest where we see major growth opportunities. Consistent with our strategic plan, we're transforming from a decentralized regional structure to a more globally integrated structure for functions such as marketing, innovation, product management, human resources, and organizational development. As a result of that, we're experiencing a degree of elevated SG&A expenses as we migrate those functions and elevate them into this global structure. For the first quarter, almost all of the increased SG&A expenses were from marketing and innovation as we're making longer-term investments in our brand and our products. Apart from the slight increase in selling expenses, all other SG&A categories were down year-over-year. Looking ahead, although the order level in the first quarter was concerning, we have several initiatives in place to drive demand and increase revenue over the balance of the year. As you know, our competitors also listen to this call and we don't want to provide them a clear roadmap of our strategy, but at high level, let me point a few things out. First of all, we're accelerating our product development and introductions, including new margin accretive products at lower price points to meet competition in certain areas. Secondly, we're enhancing our dealer programs across all divisions. Next, we're increasing our focus on sales in non-office segments and specific geographies with continued large growth opportunities, geographies like Germany, India, and Southeast Asia. And lastly, we are moving into a modular hard surface, otherwise known as LVT, test in the four cities in the United States. These products are designed to integrate with our modular carpet tile and address the growing trend of hard and soft surfaces working together. We also believe the macroeconomic environment in the U.S. is healthy and there is a great deal of pent-up demand in the market, as real estate developers and users have been cautious about increased spending over the past six months. As they gain more confidence in the U.S. economy, we expect to see orders pick up. In Europe, our sales teams are optimistic about their markets and they see plenty of architect and design work in progress. Things could turn around quickly in Europe, like it did last year, if some of the challenging issues I mentioned earlier stabilize or turn positive. Certainly, the election or the vote in Britain on June 23rd will be important for that. In Asia-Pacific, demand has been solid and the project pipeline supports a good forecast for the balance of the year. We're going to be running up against some very tough prior year comparables over the next two quarters and it's shaping up like growth this year will be back half loaded. But overall, we're still looking at the full year with modest topline growth. With that, I'll turn it back over to Patrick for the financial details.

Thank you and good morning everyone. I'll now take a few minutes to walk through the financial highlights for the first quarter. Sales in the quarter were down 6.1% to $222.6 million versus $236.9 million in the first quarter of 2015. We're not seeing a significant currency impact in 2016 as currency volatility has settled in the first quarter. On constant currency basis, our sales were down 4.5% for the quarter and as Dan mentioned earlier, the first quarter of 2015 was a 14-week period versus the first quarter of 2016 was a 13-week period, which is a factor in these comparisons. Our gross margin performance with the engine power in the quarter's performance, up 285 basis points over a very good first quarter 2015, improvement was across all business units and was driven by higher average selling prices, lower raw material costs, and better material usage. While we're thinking gross margins will stabilize over the course of the year as we right size production levels, we're on track to realize the additional $7 million to $8 million of additional lower raw material cost savings as we've discussed in our fourth quarter call. In the Americas, in particular, we experienced a sales decline of 6.4% for the quarter, which occurred across both the commercial and the non-commercial market segments. The decline was most acute in the corporate office segment and government sectors, as well as weakness in our floor residential business due to the disappointing results of their spring sale. The aforementioned delay in some of our services business was also a factor in the decline. These declines in sales were mitigated significantly by the gross margin enhancement discussed above and as a result, the operating margin in the Americas business was essentially flat year-over-year. And our European business was down 9% in local currency and 10% in U.S. dollars, which was expected given the turmoil in the region during the first three months of 2016, which led to a very unstable market and deferrals of discretionary purchases. The decline was primarily seen in the corporate office market, which was down 10%. Only the retail and hospitality market segments grew in Europe during the quarter. Asia-Pacific turned in a nice quarter with a 3% increase in sales driven primarily by India and Southeast Asia. Australia was up in local currency but was flat when converted to US dollars, and China experienced a slight decline for the quarter. The sales increase was most significant in the office market, which improved by 11% over the first quarter of 2015. Increases in the government and healthcare market segments were negated by other non-corporate market segments with hospitality showing a large decline in the quarter. Currency exchange had approximately $1.4 million negative impact for the quarter in the Asia-Pacific region. SG&A expense was an issue in the quarter as sales declined coupled with our planned initiative spending, led to SG&A to increase to 29.5% of sales for the quarter, versus 27% of the first quarter of 2015. Again, the increases were primarily due to investments in our marketing and growth initiatives to accelerate the top-line growth. As the rest of the year continues, we'll keep a close watch on discretionary spending and only invest in areas of greatest return. Despite the increase in SG&A expense, we did see an increase in operating income margin for the quarter. Operating income for the first quarter 2016 was $21 million or 9.4% of sales compared with operating income of $21.4 million or 9% of sales in the first quarter of 2015. We did temporarily increase our borrowings for the quarter with the largest portion of this increase was to lock in some favorable exchange rates in Australia for our raw material purchases, and it was not a result of working capital or liquidity issues. Our cash position increased as a result of this and now sits at $83.2 million. Our debt level net of cash remains at a very manageable $149.4 million. Our interest expense was $1.5 million in the quarter versus $1.9 million for the first quarter of 2015. Depreciation and amortization was $7.5 million in the first quarter of 2016 compared with $7.9 million in the first quarter of 2015. CapEx was $4.5 million in the first quarter versus $4.6 million in the comparable period of 2015. For the full year, we expect our capital expenditures to be in the $40 million to $45 million range. And as we announced in our earnings release, our Board also approved an amendment to our current share repurchase plan that now authorizes us to repurchase up to $50 million of shares. With that, I will open the call up for questions. Operator?

[Operator Instructions] Your first question comes from Stephen Kim from Barclays. Your line is open.

Hey guys, it's actually Tray [ph] on for Steve. Thanks for taking my questions. So first, one of your competitors we hear is opening up a large carpet tile plant some time mid this year. With that in mind, can you talk about where the domestic industry capacity utilization rates are currently and how you think they're going to trend going forward?

Well, I would say that our biggest competitor is opening up a carpet tile plant, but they've had a lot of capacity and been in the carpet tile business a long time. So I'd say the capacity levels in this industry are probably running in the 75% kind of range. But there's always been excess capacity in this industry since I can remember and I've been here 30 years.

Got you. Thanks for that. And then we understand that Interface plans to implement a new order taking system that should allow for it to have a more efficient management of its products and schedule and reduce the amount of down time from SKU changes. Can you talk a little bit more about this initiative, where it stands now and what impact, if any, it can have on your inventory levels?

Yes, Tray [ph], this is Patrick. It's very, very early stages in that initiative, that, you referenced the order taking system is just a small component of the broader overall program of an opportunity to take out some significant costs in the product. We're in very early stages of this product. We did not see any impact from this project in the first quarter and it will be a very minimal impact for the fully year this year as we get the systems and processes in place then to implement both the technology and the CapEx associated with that in 2017 going forward. So right now, we're in very early stages but longer term we see this as a very meaningful opportunity to take cost out of the product, but we won't realize that until 2017 and 2018.

Got it. Thanks very much, guys.

Your next question comes from Mike Wood from Macquarie Capital. Your line is open.

Hi, good morning. Maybe a first question on that LVT comment that you had made. Is this going to be third-party manufacturing? And I'm guessing its margin dilutive and just if there's any broader move into the hard surfaces category?

Well, we are going into it in an asset lightweight. So we will be manufacturing the product in Asia, have the product manufactured for us in Asia. We believe that the LVT market is an attractive place to play given the studies we've done on it. Our customers are asking more and more for the integration of hard and soft surfaces and we think that the margins will be consistent with our plan to deliver 40% gross margins in the midterm. So again, I think on LVT we'll be in the 35% to 40% range.

Great. And your comments on the SG&A initiative that you're doing to make it more global, can you give us an order of magnitude of how much duplicative costs there are in there now?

During the quarter, it was probably an incremental million dollars related to the transition to this new organizational structure. That was the impact in the P&L in Q1.

Great. And then finally, are orders still down in April?

Yes, orders through the first three weeks of April are running down 12%.

Okay. Thank you.

I will say that the second quarter was our toughest comp. It was our best quarter since 2007 in orders in that quarter and that's a good stuff.

Dan mentions a good point. The first three weeks of the second quarter last year was a tough comparison. We were up 17% versus those three weeks. That's the comp the 12% compares against.

Your next question comes from Sam Darkatsh from Raymond James. Your line is open.

Good morning. This is Josh Wilson filling in for Sam. Thanks for taking my questions. First more on the LVT, can you tell us who you're sourcing it from?

No, we haven't made that decision yet.

Okay. And are you seeing encroachment within the carpet tile industry from LVT?

Well, we're seeing the growth of LVT. We don't think it's coming from carpet tile. We think it's coming from other flooring surfaces, including broadloom. So it's impinged on the growth of carpet tile taking share from broadloom, but we're not really seeing it take directly from carpet tile. So I think both of those categories can be growth categories as we look forward.

If you looked at where the biggest impact LVT is having, it's really in hospitality of which carpet tile has a pretty low penetration of hospitality, and in healthcare where carpet tile has a pretty low penetration because of the whole issues around carpet tile and having a floor that you can't have seepage in.

Got it. And then on the price point initiative you talked about, can you talk a little bit about you see a mixed shift in the industry towards lower price points and what's driving it, and how long have those sorts of shifts lasted in the past?

Yes, we are. In fact, I would say we're not losing market share in our core market where we focus, which is above $20. But we are seeing a shift towards more value priced products, so say less than $18, which is exactly what we're ramping up to be able to deliver to the market is sub $18 priced products with acceptable gross margin structures.

Yes, this is Dan. If you look at our profile, we really have not played in what I call tenant improvement space, three-year lease space that typically used to be broadloom. It's now going to very value engineered carpet tile products. We don't play in that market but I think we should play in that market and that's sort of what we're looking at trying to get into that market as well.

And the driver of that shift?

I think the driver of that shift is carpet tile is being priced where it's pretty competitive with broadloom and there's an upgrade from broadloom into carpet tile in the tenant improvement space.

And just one last on that topic if I might squeeze it in. How do you go after those price points without causing any dilution or jeopardy to your brand?

Well, I think our brand adds that value in that category. We're not talking about creating a total commodity product, but I think Interface adds a lot of value there from a design standpoint.

Yes, we'll maintain the performance integrity of the product, which is if you really go and talk to flooring installers, what they say is Interface is best known for having the best backing, our PVC backing. So we'll maintain the strength of that backing as we go into these better value products.

Got it. Good luck with the next quarter, guys.

Thank you.

Your next question comes from Keith Hughes from SunTrust. Your line is open.

Thank you. I guess the question is more directed at Europe. I know it was weak in the quarter. What kinds of trends have you been seeing in the last month or two in Europe? Any different than the United States?

Yes, Keith ,our European business through the first three weeks in euro terms is up 10% versus a flat comparison versus the first three weeks of the second quarter last year. So off to a good start here in our European business in Q2.

And Patrick, in your part of the prepared statement you said margin – I think you said EBIT margins in North America were flat. You're saying just flat year-over-year and no basis point gain, is that correct?

Correct.

And so was Europe up during that period?

Last year, I believe they were about flat as well.

Got it. So they were flat in the first quarter versus prior year as well?

Yes. That's right.

And so has all the margin gain changed from Asia in this quarter; is that correct?

For the most part.

Okay. And then, on the raw materials, you've outlined the number for the year. Given where prices are moving sequentially is that going to be about all we're going to see based on where we are right now and will that be more first half versus back half focused for the gains you're going to get?

Yes, I would say that the – I think we'll get a little bit of down tick in the second quarter on pricing related to benzene and capital item [ph], but I don't foresee it decreasing anymore in the second half of the year based on what we see today.

Okay. Thank you.

Your next question comes from John Baugh from Stifel. Your line is open.

Thank you. Good morning, Dan, Jay, and Patrick. A couple things, education and government, I think it was down, was it, 9% in the first quarter. I think though seasonally those businesses are fairly week in the first quarter. Obviously, education kicks in, in the summer, and then I think government is more skewed to the back half. Could you kind of discuss the outlook of what you see and hear in that sector that would perhaps reverse that numbers which run through the year?

Yes, I think that for the first time and sort of the last year that the K through 12 that actually have – they're getting funding, particularly the public K through 12s. And we're anticipating a really good education business this year related to the fact I think the market is going to be better in that category, and obviously higher is always really good. They have really good budgets and continue to invest in the schools. So education is our second biggest market and I really anticipate to have growth business in education in the United States.

Okay. And government, any comment on how that will track, Dan?

I think, yes, I think government, we typically see a pretty good government in the second half of the year, right. Their budgets end in October and they try and spend their budgets by the end of the year. So typically, the government business starts picking up in the second and third quarter, and we'll get our fair share of the government business.

Okay. And then are you still seeing a shift, I think it was a strategic focus to drive more of a make to stock versus make to order business model. Maybe if you could update us on that mix and then where that's trending. Is that a driver of gross margin? And then, also on the gross margin, very impressive results in light of lower production, I guess you commented that the gross margin percentage, if I heard it right, would be relatively flat year-over-year for the next nine months? I'm just kind of curious first of all is that right. And then secondly, what are the kind of plusses and minuses are that drive that flattish performance? Thank you.

John, it's Jay. Well, first of all, thank you. We've been pleased with the progress we've made on gross margin expansion. We do get a slight lift on products that we do produce the inventory because we use our plant more efficiently. We plan and produce more efficiently. The balance hasn't shifted dramatically over the last year and we continue to run 30% to 35% of our business on custom and we think that's part of our magic or our distinctiveness as we compete in the marketplace, being very efficient on some products but still being able to maintain our custom orders. And frankly, we still think there's up side as we look out over the next couple of years as we get our manufacturing facilities, particularly in La Grange, better prepared to run these longer runs. We did run up inventory more than what we expected in the first quarter. Our inventory was up $12 million globally. That had a roughly 100 basis point impact on gross margins. So the key to the business is to make sure that we bring those inventory levels down. So I think we can operate at 38% to 39% gross margins for the balance of the year. That's certainly our target.

Great. Thank you for that color and good luck.

Thank you.

[Operator Instructions]. Your next question comes from Matt McCall from BB&T Capital Market. Your line is open.

Thanks. Good morning, guys. So, Jay, I think you said – I think it was you, you said that the growth this year to be back half loaded. If I look at the comps that you had from a year ago and kind of strip out the FX benefit, it looks like Q2 is up 10%, Q3 was up 10%, Q4 was actually down a little bit. So I understand the Q4 commentary with that easy comp. But what gives you the confidence that the two-year trend, if you will look that much better in Q3 versus Q2?

I have to tell you, the biggest confidence booster is the conversations in the sales organization right now. We're seeing the architectural community extraordinarily busy. The workloads are high. The amount of sales samples that we're sending out are up year-over-year. So I think there's a lot of work in the pipeline. We just need to get it released.

Okay. All right, that's helpful. So, what's tied into the SG&A commentary you talked about the strategic plan going decentralized to more globally integrated. I think you called a $1 million of – or Patrick might have – the duplicative costs, but when I think about the – so there's $1 million of maybe temporary costs. You said more was related to marketing and innovation. I'm just trying to make sure I understand what part of the increase was, quote, temporary. Was it just the million bucks? I think you said other parts were actually down. Could you just go through that SG&A commentary and how you look at it through the balance of the year should that back half-loaded situation not play out?

Let me start and then I'll let Patrick talk. The temporary portion is we're committed to the structural investments that we're making. The reason it's enhanced in the short-term is we haven't taken the regional expenses out yet. So we've put in some more global expenses. As an example, we just hired a head of – a new head of innovation, formerly the Chief Innovation Officer from Coca-Cola. So we're putting some expenses in there. I would say the number one driver of increased expense year-over-year is in marketing in general, but the majority of that marketing money is related to innovation and getting our innovation system cranked up to be able to deliver LVT and lower cost margin accretive products. And I think its right. I think our growth game plan will create the right value out of these increased investments. So Patrick, I'll turn that over to you.

Yes, I mean, the color is helpful. Yes, we made some investments across the marketing category. As you know, Matt, we had lower incentive based and restricted stock compensation in Q1 and we had an opportunity and have invested into our strategic plan, and primarily into the marketing areas. And right now, we're in a transition phase with the organizational structure and temporarily have about a million dollars of additional cost that has yet to come out of the business at the business unit level.

Okay. That's helpful. Jay, you may have just answered this. You called it lower cost margin accretive products. I noticed when you talked about moving into that lower end, at lower pried, those lower priced products, you said it was accretive to margins. I guess is the dematerialization effort a part of that? Is the fact that you'll be running longer runs a part of that? How is it that you're going to sell lower priced products at better margins?

I have to say yes and yes to your questions. I mean yes to dematerialization. So, lower face weight products. Yes to more efficient runs. Yes to better planning. We're implementing a new SNOP process to better integrate our selling and manufacturing organization. And then thirdly, we continue to look at yarn suppliers to make sure that we find the right balance between cost and sustainability.

Okay. All right. And it sounds like I was last so I'll sneak one more in. Patrick, you mentioned that the comps were tough in the first three weeks of the quarter so you're down 12 but up against difficult comps. Can you remind us what the comps are through the next – I guess through the remainder of this quarter?

I know Q2 last year was a very significant quarter. We had $272 million in orders. Hang on a second. I think I have Q2 2015.

272 in orders, 275 in…

I don't recall what the comp is. I don't have that handy.

Okay. All right, that's fine. All right. Thank you guys.

Your next question comes from Keith Hughes from SunTrust. Your line is open.

You had referred in an earlier question to the inventory and gross margin running in the 38% to 39% range. Does that assume you run production very similar to what we saw in the first quarter or there'll be a point where you'll have to pull back production to let inventory catch up with sales?

Well, the latter. I mean we're going to pull back production to bring down that inventory by year end. So we're going to run the plants sub what orders are coming in because we want to run that inventory down. I will say there's a lot of seasonality in that, though. The first quarter, from a revenue perspective, is our lowest quarter. So they'll probably run at about the same levels that we did in the first quarter.

Will that bring the inventory down in as well?

Yes. It will.

Okay. And you'll still be able to hit a 38 and change gross margin?

I feel pretty good about that.

Okay. Thank you.

I am showing no further questions at this time. I would now like to turn the conference back to Dan Hendrix.

Well, thank you for joining us for our first quarter call and hopefully we'll have good news in the second quarter. Thank you.

Ladies and gentlemen, this concludes today's conference. Thank you for your participation and have a wonderful day. You may all disconnect.