Interface, Inc. (TILE) Q1 2017 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen, and welcome to Interface, Inc. First Quarter 2017 Earnings Conference Call. [Operator Instructions] I would now like to introduce your host for today's conference, Ms. Christine Needles, Senior Director of Global Corporate Communications. Ma'am, you may begin.

Thank you, Skylar. Good morning and welcome to Interface's conference call regarding first quarter 2017 results. Joining us from the company are Jay Gould, President and Chief Executive Officer; Bruce Hausmann, Vice President and Chief Financial Officer; and Greg Bauer, Vice President and Corporate Controller. Jay will review the highlights from the quarter as well as Interface's business outlook. Bruce 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 from the Investor Relations section of Interface's Web site. An archived version of this conference call will also be available through that Web site. Before we begin the formal remarks, please note that on 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 1, 2017, 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 Web site at www.interfaceglobal.com. Lastly, please note that this call is being recorded and broadcasted for Interface. It contains copyrighted material and may not be rerecorded 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'd like to turn the call over to Jay Gould. Jay, please go ahead.

Good morning. You are accustomed to hearing my voice on our investor calls. However, on this first earnings call as our CEO, I did want to take a moment to express how honored I am to serve as only the third CEO in our 43 year history. I'm confident that Interface has a bright future, one that builds on our past success, innovative product design, a passion for making great products every day, an entrepreneurial spirit directed at serving our customers, a commitment to teamwork and an unwavering zeal to make the world a better place. I also want to take a moment to introduce you to Bruce Hausmann, our new CFO, who joined us on April 10. Bruce brings nearly 25 years of corporate and operational finance experience to Interface. He has spent the last 8 years with Aramark Corporation, most recently as Senior Vice President and Chief Financial Officer for Aramark's uniform and refreshment services business units. Bruce will play an important role leading our global financial functions as we enter our next growth phase focused on building industry leading margins, optimizing our global manufacturing operations and driving growth at twice the industry rate. Bruce, welcome to the Interface team. Now on to our first quarter results. We had a solid first quarter of 2017 and I'm pleased to see our continued gross margin progress at 39.7%, up 80 basis points compared with the first quarter last year. We reached a new first quarter gross margin record, largely driven by improvements in the Americas and in Europe. Importantly, we saw the beginning of a shift in momentum of our business. Orders were up year-over-year compared to the first quarter of 2016. Constant currency orders in the first quarter were up 3.8%, slightly aided by a shift in the timing of Easter. So normalizing this shift, orders in constant currency were up 3% through the first 16 weeks of the year. As you know, we also officially launched our first modular resilient flooring offering, a luxury vinyl tile collection called Level Set. We launched this in the middle of the first quarter in the Americas region following a soft launch in selected U.S. cities back in 2016. We're seeing promising early signs of momentum with the initial LVT orders and sales flowing through the first quarter. We will continue to roll out our LVT collection globally over the next two quarters, and we expect to see more sales volume specific to LVT particularly accelerating in the back half of the year. In addition, our board approved a new $100 million stock repurchase program that demonstrates their support of our long term strategy and belief in our growth prospects. Stock repurchases are an important aspect of our capital allocation strategy, as we focus on delivering long term value for our share owners. Also in Q1, we completed our previously announced $50 million repurchase authorization. Our Q1 gross margin of 39.7% was exceptionally strong, driven by 50 basis points of pricing in selected markets around the world, input cost deflation and labor savings from our major productivity programs. We do, however, anticipate contraction of our gross margin in the coming quarters related to oil derived input cost inflation and the exit from our specialty retail business. We continue to advance our strategic agenda to become the world's most valuable interior products and services company. We also remain committed to the delivery of our full year plan. As you recall, that includes 3% to 4% top line growth, gross margin of 38% to 38.5%, and SG&A spending of $260 million to $265 million. Now I'd like to turn the call over to Bruce for a more in-depth review of the financial details of the first quarter. Bruce, welcome. Please go ahead.

Thanks, Jay and thank you, everyone and good morning. Sales for the first quarter of 2017 were $223.4 million on a constant currency basis, up 0.4% versus $222.6 million in Q1 of last year. As reported, net sales were down 0.7% for the period to $221.1 million. Europe was the source of negative currency impact, with the pound and euro both down versus the prior year period. We did see this offset somewhat by a stronger Australian dollar. As Jay noted, gross margin was a record for the first quarter for us, as we continued to see benefit from raw material prices and production efficiencies. However, we do expect some contraction to gross margin for the rest of the year as we continue to execute the FLOR business restructuring as well as anticipated increases in raw material pricing. For the full year, we continue to target gross margin in the 38% to 38.5% range. Sales in the Americas were up 1%, approximately 1%. Declines in the U.S. and Latin America were bolstered by gains in Canada. In addition, LVT sales are beginning to flow through and order volume is showing momentum, which gives us confidence in achieving the company's full year targets. Sales in Europe were up 3% in local currency, with strong growth in Germany as well as welcome uptick in the U.K., offset by declines in Southern Europe and Holland. As translated into U.S. dollars, sales in Europe were down 3% for the quarter. Turning to Asia Pacific. Sales were down 2.5% for the quarter principally due to a decline in Asia, which was partially offset by an increase in Australia. That said, I'm happy to report that we took our first LVT order in Asia Pacific during the quarter. Looking at global market segmentation. First quarter sales were up year-over-year across government, education and hospitality segments, balanced slightly by declines in corporate office and retail and larger declines in healthcare compared to the first quarter of last year. As you can see in our press release, we completed the previously announced restructuring and asset impairment charge for the FLOR business in the first quarter. With the exception of the design centers, two in New York and one in San Francisco, we've closed all of our retail locations. Going forward, we will continue to market the FLOR brand through our three design centers, our commercial sales organization and on the web. Turning to SG&A. First quarter was in line with expectation run rate with total SG&A expense of $65.2 million. As anticipated, we reinvested savings from our restructuring plans into market expansion activities as we progress toward achieving full year targets. Managing SG&A continues to be a key priority. As mentioned in the press release, we're continuing to target full year SG&A expense of $260 million to $265 million range. All of these pieces added up to a solid operating income improvement for the quarter. Excluding the previously announced restructuring and asset impairment charge, operating income was $22.6 million or 10.2% of sales compared to $21 million or 9.4% of sales in the first quarter of 2016. Including the restructuring and asset impairment charge, operating income was $15.3 million. Moving to the balance sheet. You'll notice a reduction in both cash and debt outstanding for the quarter. In the first quarter, we repaid a significant portion of the borrowings incurred in one of our foreign subsidiaries during the fourth quarter of 2016. As discussed in the 2016 Q4 call, the funds from this borrowing were distributed as a return on capital to the U.S. to fund current and projected U.S. cash needs, including capital expenditures associated with our LaGrange manufacturing optimization project and anticipated share repurchases. In total, we repaid $51 million of debt during the quarter. We used another $31 million of cash to repurchase and retire 1.6 million shares of outstanding common stock during the quarter, and that exhausted our previously approved $50 million share repurchase plan. Debt, net of cash on hand was $143 million at the end of the quarter. Interest expense was $1.6 million for the first quarter of 2017 compared to $1.5 million for the first quarter of 2016. Depreciation and amortization was $8.2 million in the first quarter of 2017 compared to $7.5 million in the first quarter of 2016 and capital expenditures for the first quarter of 2017 were on plan at $8.5 million compared with $4.5 million at the comparable period of 2016. With that, I'll open the call up for questions. Operator?

[Operator Instructions] Our first question comes from Mike Wood with Nomura Investments. Your line is now open.

This is [Mason] [ph] on for Mike. So your commentary is focused on LVT growth initiatives, but we know you're trying to penetrate lower price points, dealer channel and other growth markets. Are those other growth initiatives lower priority or can you comment on any traction there?

I'd say we are making traction on all of them. I mean the LVT is meeting our expectations, where we've said we'd deliver 200 to 250 basis points of growth out of LVT. The kind of balancing of our portfolio for the specification market to ensure that we're hitting the $16 to $18 price points, feel really good about the progress we're making in those category of products. The dealer channel development is a little bit slower, frankly, than we had anticipated. Still an important growth opportunity. As you know, I've talked about our market share and that piece of the market is only around 10%. So that's developing a little more slowly than we had anticipated.

And our next question comes from Keith Hughes with SunTrust. Your line is now open.

Just a few more questions on LVT. Can you give us some sort of indication where you are now in the number of SKUs you have? And ultimately, over 12, 18 months, just in terms of size, how big is your current view on how big this business could be?

Well, Keith, we launched with 30 SKUs globally and feel that's a pretty good portfolio to start with. Although I will tell you we're introducing some new product at NeoCon in June that are specifically targeted to go after polished concrete because it's one of the fastest growing flooring surfaces in commercial today. By getting into the category, we actually increased our served market by 50%. So carpet tile globally is about a $3.3 billion category. LVT is a $1.7 billion to $1.8 billion category. So you could argue that we should build a several hundred million dollar business. Our target that we've talked about previously is to build $100 million business by 2020, over the next three years. And if we put in the bank $25 million, which I expect to do this year, I think that'll be a big down payment on the way there.

Okay. And one follow up to that. Do you have currently or do you have any plans to introduce any rigid core LVT as part of your offering?

We do not, but I will tell you that we have an active innovation pipeline against hard surface right now.

Our next question comes from Kathryn Thompson with Thompson Research. Your line is now open.

In terms of gross margins, I appreciated your commentary in the prepared comments just on the impact and for the remainder of this year, but could you quantify the impact of FLOR store closings to gross margins and then balance that against the potential impact of higher inflation cost for the year. Thank you.

Yes. Thanks, Kathryn. So FLOR impact will be a step back of 70 basis points globally. So that was a business that was running gross margins north of 65%, so that's why that big step back in how it impacts our business in that way. Full year numbers, we have anticipation of input cost inflation between $10 million and $13 million. Now we do have productivity to offset that of roughly $20 million. So we are anticipating an improvement in the core business gross margins of about 50 basis points as a result of that math.

Okay, helpful. And then moving to SG&A. FLOR also was a higher SG&A business. Could you just help us understand some of the puts and takes as we walk through 2017 and really beyond? So in other words, what would be the benefit of lower FLOR SG&A cost versus higher costs related to LVT ramp and other initiatives that are being worked through Interface right now? So if you could just help us understand kind of the landscape for the puts and takes for SG&A. Thank you.

Yes. I want to make sure that I say this appropriately because I think I created some confusion on the last call, Kathryn. Our run rate last year on SG&A was $275 million. That's not what ultimately flow into the P&L, as you know. We did $264 million of SG&A but we reduced incentives. So our real run rate was $275 million. We're taking out $13 million to $15 million of SG&A associated with FLOR with the intention to get our annualized run rate down to about $260 million. We're not going to get all the way there this year because we obviously had FLOR as part of the first quarter, which is why I've been giving this range of $260 million to $265 million. But I think, longer term, we're trying to manage it closer to the $260 million number. We did repurpose. So you saw us take a restructuring charge in the fourth quarter of last year and that was to get some of our existing SG&A more focused on our growth initiatives. So investing in the launch of LVT and investing in the building of a better innovation pipeline for the company. So we're in the midst of kind of re-crafting how we spend our SG&A.

Okay, great. Thank you. And then finally, just one clean up question with LVT. Could you put into perspective, for those listening, what traction you're getting right now with your LVT sales initiatives and what end markets or what areas are you're seeing the greatest acceptance?

Well, a data point which underscores my enthusiasm for our product launch is that in the month of March, LVT represented 1% of our orders globally. And obviously, to achieve a 200 basis point business size this year, it needs to be 2%, but we're well on our way. That was our first month of selling really only in North America. So the market reaction has been driven by the approach that we took in designing the product which allows seamless integration from hard surface to soft surface. That's the first thing that the customers react to. The second thing that they positively respond to is that we recommend glue free installation, which allows for a truly modular selective replacement flooring system like our carpet tile. And then thirdly, we've gotten great response to our acoustic management system. We have an acoustic layer on the bottom of our LVT, which has proven to be particularly positive in living spaces. So hospitality, dorms, multifamily living. The business response has been really positive to that. So I think that there's -- on 75% of the jobs on which we quote, there are hard surface applications. So I think we'll see an uptick in corporate but I think some of the bigger opportunities are actually outside of the office market.

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

First, I want to start over in Asia Pacific. Could you remind us again roughly of the breakout between Australia and the rest of Asia, and then update us what's going on in China specifically.

Yes. So Australia is about 60% of our Asia Pac business. It's a little over AUD100 million. And our business in Australia is very hot right now. I mean we've been able to capture some really big jobs in Australia in the first quarter of the year, so I'm very bullish about what's going on there. China, on the other hand is pretty weak. China is roughly a $30 million business for us, John. And we've started off the year with orders and revenue down year-over-year. I will say that we've gone through a management change there. So we actually now have a Chinese national running our business and I think we're just going through some leadership transitions. I think the market is still there, so I'd say we slightly lost market share in the first quarter.

Okay. Was curious and pleased to see the U.K. ticking up, and I recall that was about 7% or so of your consolidated revenues. Is that right, number one? And number two, what do you think is behind that and what's the prospects in the U.K.? How do you see that business going forward?

Well, John, this has been one of the pleasant, positive surprises in the first quarter. I mean the U.K. represents roughly 9% of our global sales ad we saw order growth in the first quarter in the U.K. of about 3% or 4%, and that's been great. I don't know how the France election now will impact the U.K. ,there are people that believe because the France outcome was positive for the EU, it may reflect poorly on the opportunities in the U.K., but we haven't seen that play out right now. I was in the U.K. recently and there are so many cranes still in the air that business activity seems very positive there.

Okay. Switching gears back to the U.S., Troup County and the integration and all of the efforts there. Give us an update on, I don't know, CapEx. Where are we in that sort of $60 million number? Where are we with expenses versus benefits? And I guess that question is more framed around what do you expect in 2017 in total.

Yes. I'm very excited about the transformation efforts that are going on in Troup County. I look forward to walking you through the new facility down there, John. The distribution center is now up and running, fully running. It's running as planned at kind of world class service levels. So that $6 million or $7 million that we experienced in the back half of last year of transition costs are behind us. So that's working. We have 5 tufters as of this week, running in that new fixed creel system that we put in place that really is the basis to drive the labor savings. So we're expecting to get $7 million of labor savings out of Troup County this year, and we are on track to do that. I think that the rollout of that $30 million of savings, John, is $7 million this year, an additional $11 million next year and $12 million the following year. So that's kind of the road map for the $30 million.

And I think you'd commented, Jay, that you expected productivity initiatives to be $20 million this year. Did I hear that right? And I guess, so you get the $7 million you think from labor this year, but there are other things that you get a benefit from as well.

Yes. I mean we've got a whole host of productivity drivers, from labor savings to input cost management, material savings. So it's a pretty robust pipeline. Not all of it's in the U.S. We've got roughly $12 million or $13 million of the $20 million in the U.S.

Great. And my last question is, I'm curious, and it might be too early to really know. But when you're talking to customers and talking about LVT and mixing it, say, with carpet tile, any insights as to have we only sold carpet tile the project we would have gotten would have been X and now it's going to be X plus Y. And I'm curious if there's any cannibalization of that still probably in that positive of lost carpet tile to the total project mix because now we have hard surface.

What we're learning so far is that it's pretty highly incremental, potentially synergistic. I think we misread the market a couple of years ago and didn't fully understand how popular this particular type of hard surface is. So we would not have been invited into some jobs, frankly John, that we're now being invited in on. So I'm actually encouraged that it's going to help grow the carpet business.

Our next question comes from Matt McCall with Seaport Global. Your line is now open.

So, Jay, going back to the comment you made about the longer term SG&A target. I think you said $260 million. I mean, if I just run that through like what we have for '18, it gets you around 25% of sales now. I guess the question is, when would you want to achieve that target? And I guess the bigger question is, how do you get there, especially giving what I hear to be a lot or numerous growth initiatives that you would have out there? So how do you keep that number so low without sacrificing the growth opportunities that you have in front of you?

Well, look, Matt, I'm not trying to hold the number to $260 million over the long term. That's not the objective. I think getting SG&A between 25% and 26% of sales is the target, really with the outcome, the objective of driving 13% to 15% operating margins. I mean that's really what we're trying to get to. And to the extent that we see upside on LVT margins, that could help that. I mean don't forget we've modeled the LVT at a 35% gross margin business right now and we're early days seeing upside to that. So I think to model it at 25% to 26% SG&A is the right way to think about it.

Okay, all right. And you talked about your expectations for inflation of about $10 million to $13 million in '17, but you saw some deflation in the first quarter. First, can you quantify the deflationary benefit in Q1? And is the $10 million to $13 million net of that number?

Yes. So the $10 million to $13 million is net of that number. It was around $1.5 million. It's not a big number of deflation. I pointed that out, though, in particular Matt, because I think you heard some of our primary competitors talking about input cost inflation in the first quarter and we did not expedience inflation. We had the opposite.

Okay, all right. It sounds like that's just a timing difference.

It is. I think I've talked previously, I think I've mentioned this to you that a couple of years ago, back in 2015, we put some contracts in place so that we would actually have a delayed impact of oil price changes so that we have a chance to take pricing, if required, to the market. So we're just trying to align our input cost changes with our ability to price in the market.

Okay. And that actually leads to my final question. So pricing in Q1, did you break that out and what your expectation is for the rest of the year?

Well, we got about 50 basis points of margin expansion from pricing and we've done very selective and targeted pricing around the world. The big drivers were Australia and the U.K., the U.K. in particular as we were dealing with the impact of the pound decline last year. And we think that's permanent, so we've decided to take slightly more aggressive pricing in the U.K.

Okay. And maybe one more question. You gave some details about your end markets. Can you maybe talk about the outlook for some of your end markets, just maybe from a pure cyclical perspective this year? I know office was one of the areas you called out as being weaker. How do you expect office to progress this year? What could be some of the drivers of some acceleration and then any other segments that should lead or lag?

No. I mean I'm still anticipating having a very solid year, 2% or 3% growth in office. And if the conversations in Washington get resolved, I mean the CEO confidence level are at all time record highs. Small business confidence levels are at record highs. So we believe that, that will impact the office investment and therefore carpet tile and those remodeling opportunities. I love hospitality. We continue to grow double digits in hospitality. We were just put on the specification for hotel rooms with one of the major brands in the U.S. with our LVT. So that should help propel our hospitality business, particularly in the U.S. K-12 looks pretty interesting this year. It appears as if state coffers are rebuilt and that helps fuel our education business. So those are a few ones I'm particularly excited about.

Our next question come from David MacGregor with Longbow Research. Your line is now open.

Welcome, Bruce. Wanted to, just maybe to start off with, to pick up on John's questions on the U.K. What kind of growth do you expect to see there in terms of orders in the business after the anniversary of Brexit?

Well, I think this growth rate of 3% or 4% could hold for the year. Our teams there are pretty bullish. And David, one of the things that we did not do last year was pullback on our sales organization after the exit. We had made a pretty significant investment, particularly in London, at the beginning of last year. And we think that's a good investment. So I still believe that 3% to 5% growth is appropriate for the U.K. for the year.

Okay. Thanks for that. And then I guess I noticed from the balance sheet your inventories are up. Obviously, you've got some LVT there but can you just talk about production levels in the quarter?

Yes. I think, if you look at it versus year end, they are up pretty significantly but if you look at it versus the first quarter of last year, it's only up about $4 million, the majority of which is LVT. We have a typical seasonal build as we head into the second quarter and we beef that up in Europe this year because we have an ERP deployment in May. So I feel pretty confident that inventories are in control.

Okay. And can you just talk about within the order numbers? Is there any way to give us some granularity around the cadence within the quarter?

It was choppy. I wish I didn't have to say that, but January was up. February was down. March was up. Last time we did a quarterly call, we were up about 5% in the first few weeks of January. So feeling very good about that. February was actually negative almost 4%. So net-net, it ended up at about 3%. That's good. It's not great. So we're still pushing hard.

Okay. The last question. Just given all the moving parts you've got around your cash, what's your expectation for free cash flow this year?

Well, let me say this as a headline, and then I'm going to turn it over maybe to Greg to answer that question. But with our $100 million stock repurchase, we are anticipating borrowing money to be able to do that and that's going to be in the $50 million to $60 million range ultimately when we get through with this, with the full $100 million. Greg, you want to talk about cash for the year?

Sure. I mean I think the high points are CapEx [indiscernible] on plan. We discussed earlier it will be a use of cash near to prior year's in the $60 million range, and any share repurchase activity we do under the $100 million plan. From a working capital perspective, we don't see any significant changes versus our sort of previous run rate, this CapEx will be the only significant difference you'll see due to TCO and other initiatives.

Yes. So we're targeting -- I think you remember, David, we're targeting to spend $55 million to $60 million on capital this year, which is elevated from a typical run rate closer to $35 million to $40 million.

And our next question comes from Sam Darkatsh with Raymond James. Your line is now open.

This is Josh filling in for Sam, and Bruce, congratulations. Wanted to get a little more detail on the U.K. business. What was the prior year comparison like in the first quarter?

Gone of memory now, but we had a pretty good first quarter last year. Things slowed down in the second quarter as we neared the vote. So the first quarter was solid.

Got it. And then switching to the U.S. business. You've got some pressure on the comp from rising raw materials and some peers have raised price. So why would you not do the same?

Well, we're always getting that strategic dial put perfectly right and trying to find the right balance between margin, pricing and volume. I would say our competitors are catching up to the actions that we took over the previous two years. We took pricing actually when input costs were declining because we like to look at it from a market perspective. So we'll always reevaluate what our prices are in the marketplace. We can actually turn that dial pretty quickly but at this point we don't feel like we need to take pricing in the market.

At this time, I'm showing no further questions. I'd like to turn the call back over to Mr. Jay Gould, CEO, for closing remarks.

Okay, well, thank you once again for participating in the call, for following our stock. We appreciate all the recommendations we have out there. Again, solid, solid start to the year. I'm very optimistic that we'll be able to achieve our full year commitments that we've made. Thanks, again. We'll talk to you next quarter.

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