Interface, Inc. (TILE) Q3 2016 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen, and welcome to the Interface, Inc. Third Quarter 2016 Earnings Conference Call. At this time all participants are in a listen-only mode. And later we will conduct the question-and-answer session, and instructions will follow at that time. [Operator Instructions] As a reminder, this conference is being recorded. I would like to now introduce to you Mr. [David Fischer] (ph) VP. Sir, you may begin.

Thank you, operator. Good morning. And welcome to Interface’s conference call regarding third 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 An archived version of this conference call will also be available through that website.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 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 may 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 filed 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 that may not be re-recorded or rebroadcasted without Interface’s express permission. Your participation on the call confirms your consent to the Company’s taping and broadcasting of it. Now I would like to turn the call over to Dan Hendrix. Please go ahead, Dan.

Thank you, David. Good morning, everyone. Really quickly I would like to run through the highlights of the quarter before turning the call over to Jay, who will outline our high-level plans for going forward. Our sales numbers and regional ups and downs are in the earnings release, but the most encouraging signs where the positive trends that developed throughout the quarter. Our orders turned positive year-over-year for the first time since first-quarter 2015, with a steady, building trend from July through September. And even though sales were down slightly for the quarter, the year-over-year comps improved from July through the month of September, when we recorded positive sales growth. After six straight quarters of triple-digit gross margin expansion, we saw a contraction in the third quarter to 37.4%, down 105 basis points versus last year. The decline was driven by an important strategic transition to a centralized warehouse and distribution center to support our Troup County, Georgia, operations. This is the first step in our Troup County optimization project, which Jay will talk more about in a few minutes. It’s on track to deliver significant savings in our operations. We held SG&A even with the second quarter, but it was slightly up versus prior-year due to our rollout of modular resilient flooring products, along with enhanced marketing of our core carpet tile products. As we mentioned in the earnings release, we are tightly controlling and targeting reductions in SG&A, with the goal of achieving 25% of sales. I am encouraged about our prospects as we close out this year and head into 2017. As our initiatives to grow sales gain further traction, we continue to improve our operational efficiencies. For more details on our plans for growing earnings and shareholder value, I will turn the call over to our President, Jay Gould.

Thank you, Dan. Obviously relative to our record-setting 2015 financial results, our 2016 performance has been a bit disappointing. However, in the third quarter we saw our orders turn positive for the first time in 18 months, and that does provide some encouragement as we head into Q4. Dan also mentioned that we’ve made progress on our strategic initiatives to accelerate value creation, and we are focused on four activities to yield significant earnings growth. Our first priority is to grow our core carpet tile business with improved branding, expanded sales reach, and more productive innovation. Our second initiative is to optimize our flagship manufacturing and distribution assets in Troup County, Georgia. Ultimately, when completed, we project annualized savings of $30 million. Thirdly, we are entering the modular resilient flooring market with a unique product that allows customers to integrate hard and soft flooring in a truly modular installation. And lastly, but significantly, we are deploying a zero-growth planning discipline in our SG&A. That means we are redeploying resources to fund our growth initiatives, and we do anticipate achieving our 25% target by 2018. So allow me to elaborate on each one of these a bit more. First, growing the core business has obviously been a challenge this year. That said, looking back over the past decade, we have delivered 4% compound average growth rate, and I am confident that we can do that again. To accomplish this, we are really focused on three things. First, we are creating brand love and brand loyalty by keeping our customers at the center of our thinking, and by leading the flooring industry in a bold, new sustainability movement that we call Climate Take Back. This focuses us on driving positive impacts in the world to create a climate fit for life, and it provides more brand differentiation to our key customers. Secondly, we are strengthening our selling system to expand our reach and our penetration through improved sales productivity and enhanced dealer channel in a reactivation of our market segmentation efforts to help penetrate non-office segments. And thirdly, we are accelerating innovation across our product portfolio with enhanced product management and design leadership. This includes the introduction of margin-accretive products at lower price points to open up market opportunities where we previously had not been competing. The second initiative for our Troup County plant -- we plan to invest a little over $40 million in CapEx over the next few years in new systems, technologies, and factory layout to optimize operations and align with global best practices. The benefits of this transformational project will phase in over the next four years, but we anticipate achieving a total annualized savings of $30 million by the year 2020. The first major step in this Troup County optimization process is the transition from multiple local warehouses to one centralized warehouse and distribution center, which is operated by a third-party logistics partner. This transition accounted for most of the drag on gross margins in the third quarter, but we expect to have the warehouse move completed by the end of the year. And we are still on track to hit our 38.5% to 39% gross margins for the full year. Thirdly, with regard to modular resilient flooring -- and we are really talking about luxury vinyl tile in this first phase, and that is the fastest-growing segment of commercial flooring. Importantly, more than half of our customer projects include a combination of soft and hard surfaces. And our end-users, architects, and designers are requesting these products from us. Importantly, they are modular, and they integrate perfectly with our carpet tile, so modular resilient flooring is a very natural fit with our existing business and with our existing route-to-market system. We launched the four-city test market in the third quarter, and we are seeing strong interest from our customers. Our goal with modular resilient flooring is aggressive, but we plan to grow it to a $100 million business by the year 2020. In the fourth initiative, for SG&A we are planning zero growth in 2017, which means we plan to make cuts in our existing SG&A to offset inflation effects while also redeploying existing spending to support the priorities that I have laid out. Overall, we believe this plan will result in SG&A of around 26.5% in 2017 and 25% in 2018. But we will also continue to invest in our branding and our key growth opportunities. With these drivers, our goal is to become the world’s most valuable interior products and services company; essentially doubling our shareowner value over the next four years. I look forward to keeping you updated on our progress, and I hope you will continue to support us on this journey. With that, Patrick, I will turn it over to you for the details of the third quarter.

All right, Jay. Thank you, and good morning, everyone. I will take a few minutes to walk through the financial highlights for the third quarter. Sales for the quarter were down 2.5% to $248.3 million versus $254.7 million in the third-quarter 2015. Currency did not have a significant impact on the consolidated comparison versus the third quarter of last year. As Dan already mentioned, we took a step back in gross margin for the quarter, down 105 basis points to 37.4% for the third quarter of 2016 compared to 38.5% in the same period in 2015. This is the first decline in some time for us on a year-over-year basis, but it is directly related to our investments in our manufacturing and distribution footprints in the Americas. As Jay noted, these investments will generate significant cost savings in the future. SG&A expenses were slightly up in absolute dollars as compared to the third quarter of 2015, but due to the lower sales, we saw an increase as a percentage of sales for the period to 27% for 2016 as compared to 26.2% in 2015. SG&A was essentially even sequentially versus the second quarter in absolute dollars and as a percentage of sales. And we’ll only increase our focus and scrutiny on these costs going forward. Due to the decline in sales, the margin compression, and elevated SG&A levels, we exited the quarter with operating income of $25.7 million or 10.4% of sales compared to $31.3 million or 12.3% of sales in the third-quarter 2015. In the Americas we saw a sales decline of 3.4%, which was a result of a softer corporate office market in the quarter. Corporate office sales were down 10% in total, but this was partially offset by an increase in our non-office segments, both hospitality and healthcare up double digits. After a slow first half of the year, our services business posted a 3% increase for the quarter, which is due to the project delays we discussed in our last call finally starting to come through. Canada continues to be down, but we are happy to see Latin and South America post small gains for the quarter. And our direct-to-consumer business floor also saw a small sales increase for the quarter. In Europe, the Brexit fears and other geopolitical issues continue to plague the macro business environment, and we experienced a sales decline of 5.7% in US dollars and nearly 6% on a local currency basis. Within Europe, the UK saw the most significant decline, but this was partially offset by a nice quarter for Germany and in the southern and central European regions. On a segment basis, we had a small 3% decline in the corporate office market segment, but nearly a 13% decline in non-office segments, with education and government market being the -- showing the largest declines. It’s important to note, however, that despite the lower sales, the region did post an increase in gross margin as a percentage of sales compared with the third quarter of 2015. It was a far more positive quarter for Asia-Pacific region, as the sales increased 7.4% for the period as compared for the third-quarter 2015. Leading the way in the region were China, Australia, both turning in substantial sales increases; India also grew sales by 5% for the quarter. Only Southeast Asia, Japan, Korea experienced the sales decline for the quarter. The corporate office market led the way with an 11% increase, offset somewhat by decline in the non-office segments of nearly 4%. The decline in the non-office segment was most significant in healthcare, which saw a reduction of over 20%. As in Europe, Asia-Pacific also expanded its gross margin for the quarter. Cash generation continued to be a bright spot for the quarter. Even after paying $7.5 million under our syndicated credit facility, we generated over $25 million of cash for the quarter. Our debt level, net of our $113 million in cash, now stands at just under $104 million. Our balance sheet position gives us tremendous flexibility to continue to make investments in the business, including our manufacturing upgrades in the Americas, as well as acting on our previously announced share repurchase program. Interest expense remained very manageable at $1.7 million for the quarter. Depreciation and amortization was $7.5 million in the third quarter versus $7.7 million in the third quarter of last year. CapEx in the third quarter were $8.2 million compared with $11.6 million in the third-quarter 2015. And for the full year, we expect our CapEx to be in the range of $30 million to $35 million. With that, I will open the call up for questions. Operator?

Thank you, [Operator Instructions] and our first question comes from the line of David MacGregor from Longbow Research. Your line is open.

Yes, good morning everyone. Question on the gross margins -- and you talk about the impact to the third-quarter numbers from the warehouse initiative. Can you talk about the extent to which that will carry into 4Q, and then potentially into 1Q as well, I guess? And is this really kind of an attempt to try and get as much of the costs into 2016 as possible, so that you clear the deck for 2017? And maybe just talk a little bit around that for us.

We expect this to kind of linger on into four. We’re kind of anticipating gross margins in Q4 similar to that of Q3, but should be largely behind us by the end of the year and should be in good shape going into 2017.

And I know this is kind of an ongoing, multiyear initiative, trying to set up a hybrid manufacturing model; can you just talk about where you see potential risks heading into 2017 around gross margins. This time it’s the warehouse. Is there going to be another kind of negative surprise around gross margins associated with some other aspect of the project? Just talk about the risks.

Well -- this is Jay. We been talking all year round delivering 38.5% to 39% gross margins for the year, and that’s about where we will end up this year. We are looking to a 50 to 100 basis point improvement in that as we go into next year, so that will be the target for next year, is to get back onto our margin expansion track.

Yes, David, I would say that the risk to that plan is really volume. I think everything else is within our control. So volume -- if we can get some lift in volume, those are very achievable without a lot of headwinds.

And the second question, just on the European business: it was interesting that you were able to improve your gross margins despite the revenue decline, and I guess there’s mix working there. But can you just kind of open that up for us a little bit and just talk about what was moving around within the business that allowed you to achieve the higher gross margin, despite the revenue declines?

Yes. It was pretty good manufacturing efficiencies that we had there on lower production volumes. And we are still seeing a slight tailwind from raw materials in Q3. So the combination of those two things -- good pricing control, led to gross margin expansion in Europe.

And was the corporate non-office mix helpful?

Well, it’s about the same. It still sits around 75% corporate,25% non-corporate there. So the corporate office market -- we’re actually pretty decent in Europe in Q3.

Thank you. [Operator Instructions] And your next question comes from the line of John Baugh with Stifel. Your line is open.

Wanted to focus on orders, and I was, I guess, first just going to ask -- we have some lumpy orders from large customers. Is there any way to back that out and look at order trends without that, number one? Number two, as we look at the office segment in the U.S., it was quite weak on a delivered basis in Q3. Has that trended much better on an order basis? And did that also trend better sequentially as you moved through the quarter, as you commented overall orders did?

Sure. John, I’m much are we had a whole lot of lumpiness that we would need to exclude from the order pattern this quarter. But the progression that we highlighted in our comments was that the progression improved throughout the quarter, July/August through September, down 5, up 2, and then up 7 in September. So the progression was pretty nice during the quarter. That is kind of where we sit today. And the momentum feels pretty good here in the early part of Q4.

John, I would also say that one of the things that is absent from that order pattern are the big orders. There’s fewer of them this year than last year. And so you’ve got the renovation business that is kicking in, but there has been a -- less big orders this year than last year.

Great. And maybe some specifics around, I don’t know, physically what you are going to do in terms of the CapEx plan. We know the number of CapEx; we know the eventual savings. My experience has been when you tackle things within plants and move them around, there are disruptions, startups -- you know, things that maybe you don’t expect to happen do happen. I was just curious what physically is going to take place during calendar ‘17 or here in the fourth quarter, kind of when the peak efforts occur? And then when that benefit really starts accruing on the backend? Thank you.

Yes, John, it’s Jay. First of all, I would start by saying there’s no new technology involved in this move. It’s really the application of our best practices from around the world. And it’s really coming in three big phases. The first phase was to get a centralized warehouse up and running so we could feed that in continue to serve our customers. The second phase is the deployment of a fixed creeling system in LaGrange to allow us to do long runs. And that actually has already started. We’ve got the first fixed creel up and running, and we’re getting the yields on that at slightly better than what we had planned. So that is encouraging. We have ordered three more creeling systems that will be installed by the end of the year. Ultimately, we will end up with seven fixed creeling systems in that facility. The next phase is to install a new backing line in our existing tufting plant in West Point. So that is where the -- you know, some of the more heavy lifting is, is when we put a new backing line in. But it’s a secondary line. We will continue to have our current backing line. So the phasing in of this is -- it’s really to get the long-run plant up and running next year. And then in 2018, we will be putting in that new backing line.

Okay, that’s very helpful.

John, that backing line that we are putting in his current technology. It’s not new technology. We don’t really have -- usually have big issues when we start up a new backing line.

And then my final wrap-up question around that fixed creel long runs -- are we still trying to, I don’t know, discourage custom orders and encourage in-stock orders in terms of salesmen and new product launches, etc.?

No, we’re not trying to discourage that. We are simply trying to batch better than what we had previously done. So instead of sending down a single order to the factory floor, we will be batching orders, putting multiple orders together -- same lead time. And actually, what we have modeled so far is slightly less working capital required to do that.

Thank you, and the next question comes from the line of Kathryn Thompson from Thompson Research. Your line is open.

Hi, thank you. With energy prices moving up, what are your expectations for raw material impact in the next 6 to 12 months? And to what degree did lower -- you previously had anticipated about a $2.5 million impact or tailwind from lower raw materials in the quarter. Is it still the case? And are there any other puts and takes as we think about the gross margin? Because I know you said the majority of the drag was the warehouse initiative, but what are the other puts and takes that impacted the gross margin line?

Well, I will cover the gross margin impacts in Q3. So the selling volume and selling prices were only down slightly in the quarter. That was offset by the positive tailwinds in raw materials. And that kind of washed there. So we did realize that raw material savings in the quarter. It was exclusively related to the transition costs, the redundant leasing costs, incremental moving costs associated with the move to the centralized warehousing operation, coupled with -- we were down about 9% in overall production. So the lower volumes and the increased fixed costs kind of had a double-whammy effect on us in Q3 related to gross margin contraction. Right now we’re seeing raw materials fairly flat. But we could see, as we enter into 2018, some slight increases on a year-over-year basis in terms of raw materials. But we are working hard to neutralize those.

And one thing, I just wanted to make sure that we are clear on the scaling back of manufacturing volume by 9%. Is this a physical scaling back of the -- your actual footprint? Is it more efficient? Or was that just more related to the volumes in the quarter?

It was a combination of both matching to demand. I think maybe we were a little heavy in 2015 in terms of our production levels, so it maybe looks artificially lower. But it was also coupled with the transition, and facilitating that move, and not overwhelming the centralized warehousing operation as well. So all of those factors contributed to the overall production levels.

Any color -- could you give a little more color on how floor is operating?

Sure. Floor had a nice quarter in terms of top line. They still posted right around $1 million operating income loss for the quarter. But a nice sales increase for the quarter.

And final question: just wanted to get your thoughts on capital allocation, given where your balance sheet currently stands and given some of the initiatives that you are going to be undertaking in the next few years.

Yes. Obviously the reinvestment back in our business has been our first priority. The CapEx earmarked for the Americas project will be first. Secondly, we will continue on with our share repurchase program. We have $50 million authorized. We still have $40 million available under that for repurchases. I think we intend to continue with a modest dividend here in the near term, and then we have selected deleveraging opportunities as well. So that would probably be the priority there, in order, for capital allocation.

Thank you. [Operator Instructions] Our next question comes from the line of Mike Wood from Macquarie. Your line is open.

One quick clarification, just on the plant investment: are these largely expenses, as you were talking about? Or are these production inefficiencies? Just to really have an understanding on your visibility on when they would go away.

Yes, these are operational expenses that we incurred in Q3. That was the drag on margins. I think we expect to have most of this done by the end of the year -- and the start of 2017, this will be behind us.

Just to give you an idea, we went from six warehouses to a one centralized warehouse. So in that consolidation of six into one is where a lot of the inefficiencies in cost actually were created.

Okay, that’s good to hear. Then, on the orders, you had mentioned the steady building trend in orders. I just want to clarify a couple things on that. Did the orders include the CVS business that was pushed into the back half of the year? And then was the monthly order numbers from an absolute dollar level -- were they also going up, or is that primarily easier comparisons intra quarter?

Well, the CVS didn’t have a huge impact on that order trend. It did -- we did $76 million, $72 million, and then it’s a five-week month in September, where we did $95 million. So the easier comparisons did help the July/August comparisons.

Great. Then just my final question: you gave a little bit of an update on LVT. I’m curious if you’re going to give us thoughts in terms of impact or early success or challenges in the dealer channel and at store retail, where you are working on that program with the home centers?

Yes. So quickly, on all three of those: the LVT -- we will continue to give you updates. We have only been selling for three weeks. So it hasn’t impacted the orders, but if you look into our CRM system, we’ve got over $5 million of activity bid already. So we are encouraged by the initial response, particularly from the hospitality segment. It really seems to fit the direction where they are going with their room designs. And we’ve been pleasantly surprised with the margin structure of that LVT business so far. On floor, we have witnessed some weakness in store traffic so our same-store sales are down slightly versus year-ago, but we are seeing a lot of activity on the commercial side of that business. So what we call our synergy program, which is how we work with floor product into the commercial segment, actually showing attractive growth. Oh the dealer channel. We are gearing up product to be able to serve the dealer channel. We are in some strategic conversations with some of the bigger dealers to help develop our partnerships. So as we head into 2017, we are expecting a big uptick in that piece of the business.

And our next question comes from the line of Keith Hughes from SunTrust. Your line is open.

Thank you, couple of questions. You referred to, next year, some goals of moving up the gross margin 50 to 100 basis points. Are you going to need a -- some level of growth, revenue growth, in order to hit that kind of range in gross margin?

Well, we are expecting relatively modest growth, so we don’t need that -- we just don’t need production volumes to be down 9%. Honestly, Keith, that’s around 125 basis points of margin decline from softer production. So if we can get our production levels flat, I feel pretty confident we can get that 50 to 100 basis points expansion.

And the same thing on the 26.5% SG&A as a percentage of sales -- that would be in a flattish environment?

Yes.

And specific to the problems this quarter, Dan referred to the six warehouses to one warehouse -- is this just the extra cost of duplicate inventory and maybe some trucks running back and forth between buildings, and things of that nature causing the problem?

Yes, it’s duplicate labor, first of all; duplicate trucking expenses. We have to bring all that product back up to this new warehouse, which is about 30 miles north of our existing facilities. But we also had to truck it back down to LaGrange to actually ship it to customers. So it was just a lot of duplicate costs for the quarter.

Once you get this completed as part of the manufacturing restructuring program, what would be the next step as we go through 2017?

So the next step is the deployment of our fixed creel system for our long-run plant. So we’ve got the first of those installed, and we’ve got three more to do yet this year. Ultimately, we will end up by the end of next year with seven fixed creeling systems. So this is not a greenfield facility. We are taking an existing building and just putting new creeling systems into them.

Will you be -- while you’re setting those up, will you be running the duplicate systems, both the fixed as well as the portable creels? And I assume the tufting machine goes along with that as well, but will they be duplicate at -- while you are setting those up?

They will be, but it’s not incremental costs. We are moving seven tufting machines from one facility into another facility, but we’ve got plenty -- we were actually freeing up pretty significant capacity as we do this.

So you will be using the same tufting machines. It’s just the creels we are exchanging, correct?

Correct.

Thank you. And I’m showing no further questions at this time. I would now like to turn the call back over to Mr. Dan Hendrix, CEO.

Thank you. Well, thanks for listening to the call. I’m really excited about the journey that we are embarking on. We’ve got a lot of energy around how to grow the top line and how to realize these optimization savings. We will talk to you next quarter. Thanks.

Ladies and gentlemen, thank you for your participation in today’s conference. This concludes the program, you may now disconnect. Everyone have a great day.