Interface, Inc. (TILE) Q2 2017 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen. And welcome to Q2 2017 Interface Earnings Conference Call. At this time, all participants are in a listen-only mode. Later we will conduct the question-and-answer session and instructions will follow at that time [Operator Instructions]. I would now like to introduce your host for today's conference, Ms. Christine Needles, Global Corporate Communications. You may begin.

Thank you, Catharine. Good morning, and welcome to Interface's conference call regarding second 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 An archived version of this conference call will also be available through that Web site.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 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 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. Please go ahead, Jay.

Good morning. Well, I would like to start by thanking the Interface associates around the world. We delivered a solid Q2 and built good momentum heading into the back half. We have a clear value creation strategy. We are executing that strategy, and it's beginning to work in the marketplace. Our solid Q2 provides confidence that we will deliver our full year outlook of 3% to 4% organic growth, gross margins of 38% to 38.5% and holding SG&A to $260 million to $265 million. Additionally, in Q2, we completed a $25 million share repurchase on our $100 million authorization. So looking at the details of Q2, net sales grew 1.4% on a GAAP basis. Importantly, however, organic sales were up 4%. Organic sales adjust for foreign currency fluctuations and exit of FLOR specialty retail stores. Also encouraging, organic order growth was up 6%. Order momentum for our core commercial carpet tile business is promising going into the back half of the year. We also expect to see continued LVT growth as the products are now available globally, and we are on track to achieve our $20 million to $25 million in sales for 2017 and also well position to reach our $50 million goal for next year. In the second quarter, we delivered gross margins of 38.9%, which were down 100 basis points year-over-year. But that number was in line with our expectations due to delayed input cost inflation that didn't fully materialize in the second quarter. Globally, we continue to manage SG&A effectively coming in at $64.9 million or 25.8% of sales. We focused on key efficiency opportunities, while also ensuring that we invest in our growth areas, like our LVT business. As planned, we were able to repurpose dollars and fund growth initiatives out of SG&A savings gained by exiting the FLOR specialty retail business. Now, it's worth pointing out that SG&A is down year-over-year by 140 basis points as a percentage of sales. And again, we're on track to deliver our targeted annual SG&A of $260 million to $265 million. Solid sales growth, solid gross margin, coupled with SG&A management, resulted in operating income of $33 million or 13.1% of sales. This is an increase of 30 basis points over last year second quarter. Now, regarding our capital allocation strategy, we did complete the $25 million stock repurchase program. We also increased our quarterly dividend to $0.065. Looking ahead to the third and fourth quarters; our full year targets and our full year targets [technical difficulty] back half organic sales growth in the 4% to 6%; now that will be offset by approximately 200 basis points of negative impact from exiting the FLOR specialty retail business. This puts us in the range to achieve our full year organic sales growth of 3% to 4%. We do anticipate lower back half gross margin, because of expected input cost inflation, lower production volumes versus year ago and costs associated with exiting the specialty retail business. We continue to remain on target for our gross margin for the full year at 38% to 38.5%, likely finishing at the higher end of that range. In summary, the team continues to be focused on the execution of our strategic agenda to become the world's most valuable interior products and services Company. And with that, I'll turn the call over to Bruce.

Thank you, Jay and good morning, everyone. As Jay mentioned, net sales in the second quarter were $251.7 million, up 1.4% over the prior year period with solid gains in the Americas and Asia Pacific. When we adjust for the impact of foreign currency fluctuations and exiting the FLOR specialty retail stores, we experienced an organic growth rate of 4%. Organic orders also grew and were up 6%. This growth was evenly balanced between the core carpet tile business and the recently launched modular resilient flooring LVT business. Sales in the Americas were up 4% in the second quarter compared with prior year period with broad base growth across the region, particularly in Canada and interface services. In local currency, sales in Europe were down 4% year-over-year and in U.S. dollars they were down 6% year-over-year. Most markets experienced single digit declines with the exception of Germany. And I do want to point out in the UK in local currency we had strong orders in the quarter with double digit increases over the second quarter of last year. Asia Pacific sales were also up compared to the prior year period. They were up 6% in fact. Looking at our market segmentation, globally, core office was down slightly over the same period last year but this was offset by increases in our non-office segments, including government, retail and multifamily residential. Sales were also down in our residential segment due to the exit of FLOR specialty retail. Gross margin was 38.9% for the second quarter, which was an anticipated reduction compared to the second quarter of last year due to higher raw material input costs and the previously announced FLOR restructuring in which the Company exit the FLOR specialty retail stores. For the full year, we continued to target gross margin in the 38% to 38.5% range. As Jay mentioned, we’re pleased with our efforts to manage SG&A expenses, coming in at $64.9 million or 25.8% of sales in the quarter compared to $67.3 million or 27.1% of sales last year. This improvement in both absolute dollars and as a percentage of sales is due to effective cost management, as well as repurposing SG&A from the exited FLOR specialty retail stores to the core carpet and LVT business. And as you know, managing SG&A continues to be a key priority. As mentioned in the press release, we remain focused on our full year SG&A expense target in the $260 million to $265 million range. This resulted in second quarter operating income improvement over the prior year. Second quarter operating income was $33 million or 13.1% of sales, up versus prior year of $31.8 million or 12.8% of sales last year. Net income during the second quarter of 2017 was $20.9 million or $0.33 per share, which was an increase over prior year net income of $20.7 million or $0.32 per share. Moving over to the balance sheet. We ended the period with total cash on hand of $67 million. As Jay noted, we completed the $25 million stock repurchases in the second quarter, and we’re executing on the previously announced $100 million share repurchase program. Looking ahead, we continue to be on track to execute on the remaining $75 million of repurchases over the next year. Debt was $230 million at the end of the quarter or $164 million net of cash on hand. Interest expense was $1.7 million for the second quarter compared with $1.6 million for the second quarter last year. And depreciation and amortization was $7.4 million this quarter versus $7.4 million last year in the same quarter. Capital expenditures for the second quarter were on plan at $6.9 million compared to $8.3 million in the comparable period last year. We do expect capital expenditure spending to increase in the back half of the year, as we continue to invest in the business, invest in manufacturing operations and we expect total capital expenditures to be in the $50 million to $55 million range for the total year. With that, I'll open up the call for questions. Operator?

Thank you [Operator Instructions]. And our first question comes from Mike Wood with Nomura. Your line is open.

First question, you mentioned that you didn't fully realize the higher input costs. It does look like benzene has come down significantly. Curious if you still expect the $10 million to $30 million input cost inflation, or would these lower benzene prices help you more towards the end of the year, or possibly 2018?

We're still anticipating inflation closer to $10 million range, so our estimates have come down the year, Mike. But because of our pricing mechanisms with our suppliers, we haven't felt it in the first half of the year as much as we will in the second half of the year.

And you guys are doing a good job staying true to SG&A guidance. Curious if you're feeling pressures now as the growth is remerging? And how are you balancing that desire to stay in that SG&A range versus more growth opportunities for investments as that growth restarts?

Mike, I'm pleased with your observation. We just think its discipline and we're staying disciplined to how much we reinvest in the business. We feel like we've got plenty of SG&A to deliver our strategic plan.

Just one final quick question on the balance sheet, looking at, it does look a bit under-leveraged with maybe just one-time net debt to EBITDA this year. And you've got the CapEx in the buybacks out there. I'm just curious, are you now ready to look at bolt-ons or M&A? Or do you want [technical difficulty] base from more proof that that core business growth is here to stay?

We are not ready to venture out into the M&A conversations yet. We want to continue to deliver on this existing plan, shore up the confidence and maybe next year, we'll enter into that conversation. But it is not definitely not on the near term horizon.

Thank you. And our next question comes from Matt McCall with Seaport Global. Your line is open.

So first I’m concerned about maybe some overcapacity in the LVT space. Maybe, Jay, can you address that and is it a concern, maybe talk about pricing trends for your business, margin trends, just are they on plan, ahead of plan, or on plan. What are you seeing there? I mean clearly the growth seems to be working. But is pricing and are margins holding up?

Matt, before we went into the LVT business, we were aware of the added capacity that was going to be coming on in '16, '17 and the beginning of '18. Those were previously announced. And we did study what we thought the impact would be in the commercial market. Most of that capacity is coming on for residential purposes. So what we've seen, thus far, is pricing on the commercial side has held and our margins on LVT are running ahead of what we had originally modeled, which was 35%. So we're feeling pretty optimistic, right now, about the continued, the ongoing the sustainable margin structure in LVT.

So on the growth margin front, you showed 35% faster growing part of the business, you’ve pulled out FLOR. So I know you talked about the full year view on gross margin. But may be just give me a little bit a longer term view on where you can see things going as you see LVT grow into a bigger piece of the pie?

We’re modeling that separately, quite honestly. We're modeling carpet tile and then we're going to add -in what our modeling is on LVT, and the combined Company output. We're still committed that as we exit 2019, there will be 40% gross margins on the carpet tile business. Now, we're going build -- which is going to built to a $100 million LVT business. We're looking at models that say, what if that business is at 35% gross margins, that’s obviously can slightly dilutive to the Company total at the gross margin line. But I've said before, it's still accretive at the operating margin line, I think that’s the way to think about. So we are still focused on achieving 40% gross margins. We set those targets because we were talking about carpet tile only. So if we are operating slightly below that and we combine carpet tile and LVT, I still think it’s a very healthy range for us to be in.

So is new way to think about it, may be the operating margin target, or where things want to go. I know you put some SG&A goes out there. Is that the better way to think about it, just given that mix shift?

Sure, ultimately, that the way to think about it. I mean, we were setting gross margin targets to allow us to hit particular operating margins. And we're still in that 14% to 15% target range, a year ago, I was talking 13% to 15%. I think we’ve elevated our expectations to the 14% to 15%.

As our long-term algorithm…

Yes, as our long-term algorithm.

So what's the basic -- what’s the main cause of the incretion from below in 13% or now 14%. What helped you there?

The LVT.

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

On the closure of the FLOR stores, it looks like they then by the revenue about $5 million and $4 million in the second. Would you expect that kind of number in the second half of the year?

Quarterly, it's about $4 million to $5 million impact, Keith.

And when you talk about organic growth, being 3% to 4% for the year. Does that include or excluded those loss of sales?

Those FLOR stores?

Yes.

Yes, it excludes that.

The way it works Keith is that organic growth excludes the FLOR specialty retail sales that we just spoke. So you adjust for that and you also adjust for foreign currency fluctuations.

And final question on the order growth, the organic order growth you discussed in the release. Can you talk about how that looks the geographies Europe versus North America versus Asia, and any commentary on why it started in the various regions?

Well, the first thing I would say is we saw order growth build through the quarter, and it's really continued into July to support our 4% to 6% back half organic growth forecast or outlook. We saw better order growth in the Americas and in Asia Pacific versus Europe.

Thank you. And our next question comes from Kathryn Thompson with Thompson Research. Your line is open.

Just first on gross margins. Could you parse out the difference -- there's 100 basis points difference year-over-year, roughly 70 basis points should be from FLOR. Could you confirm that that is an impact? And maybe help us understand the other puts and takes as we think about that gross margin bridge. Thank you.

So 100 basis point step back year-over-year, 70 basis points of that was from FLOR, the other 30 basis points were from input cost inflation, lower production volumes year-over-year. We produced 3% less volume in the quarter this year versus last year. Those are the two key drivers of that.

And as we think about rising raw material costs, which is still a big scene throughout this earnings season. How should we think about that headwind as we enter the remainder of year? The $2 million headwind still on track, and is it tracking in line or ahead, or a little bit better than your expectations? Thanks.

Let me answer that in two ways. I mean if you recall for the full year -- so last year we delivered 38.5% gross margins. From that, we said we’re going to have 70 basis points step back because of FLOR. And then added to that, we're going to have 50 basis point growth in our core business, which put us back in that 38.3% range which is why we gave the range for the year. We're still executing that plan. So we fully expect to be in line with the full year on gross margin. Last year, second half of the year was 37.5% gross margins and we expect a similar pattern for the back half of this year.

Now then moving to LVT business continuing to build very nice momentum there. Could you -- I know that you said that they counted for about half of the growth for your orders, the organic growth in orders, but as you look forward into back half of the year, do you expect that momentum to improve? And also, if you could give a little bit more color on what are you seeing the greatest amount of acceptance and traction of that product?

So it was about half of our order growth, and it represented about 3% of our orders, which is why we still feel good about delivering to $20 million to $25 million this year and building towards delivering $50 million next year. It continues to build, week-on-week, month-on-month as a percent of our overall orders. Traction we're getting really across the segments, I would say in particular in office and in living space. And Kathryn, this really builds off the trend that we're seeing globally, which is the integration of residential, commercial and hospitality, and how much commercial buildings are taking influence from the residential market.

Thank you. Our next question comes from David MacGregor with Longbow Research. Your line is open.

Jay, you were talking about orders in Europe being down compared to where you were in North America and Asia Pacific. But I think the comment was may be by Bruce, UK orders were up double digits. And so I just wonder if you could talk or open up the discussion around Europe a little bit. And give us a better sense of the patterns you're seeing in your order backlog within that region.

The two areas of growth strength are the UK and Germany. And when Bruce quoted the double digit growth in orders that’s accurate, but that is in local currency, that’s in British Pounds. As you translate that back into euro, we're up just a little bit. So we're still dealing with the currency issues in the UK. But the fundamental business, again, if you look at it on a constant currency basis, is very encouraging in the UK also, Germany, very high single digit growth in orders. So we're seeing the continuation of the trend from broadening the carpet tile in Germany. We’re seeing weaknesses in other markets, quite honestly. So Europe's a little week for us and Benelux area is a little week right now.

My recollection is that you guys have ramped up pretty significantly in terms of your sales presence in the UK markets, specifically London. And at one point, it was slow within the Company, let's take London. And I'm wondering if that level of investment on year-over-year basis is now leveling out as you wait to get paid for that prior level investment? Or whether you continue to build there?

Well, I think we're starting to see the return on that investment by the order growth that we're getting and again in local currency in UK. So yes, I feel actually very optimistic about the investments that we made on London.

Are you still growing the London and the team lower if you level that out?

No, that’s flat toed off now. So SG&A is flat. And we went through our restructuring late last year. We did not touch that team. We felt bullish about the opportunities there.

And then just second question. Is there any update you can give us on the whole initiatives of trying to venture up with a large retailer on FLOR and see where that would go? Is there anything there that we should be thinking about, going forward?

No, unfortunately. I would still model no value creation out of the FLOR business, right now. I mean, honestly, I’m encouraged by the work that we're doing on the Internet. But we don’t currently have a retailer lined up yet.

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

I was wondering if you could comment on the next stage of the manufacturing plan, the three year plan where you're, what the next phase is. And then maybe talk about influence on gross margin next phase may have as we look at the '18 versus '17?

Well, we're about half a way through a five year transformation of those manufacturing assets in Southern Georgia. This year, we should capture about $10 million of the $30 million three year plan. So we have another $20 million to harvest, which we think will come pretty uniformly over the next two years. We're moving into a heavy capital investment phase over the next year. We're getting ready to break ground on an expansion. But the proof of concept of how we're going to run the plants have been fully done, so we have, right now, six cufters running in our long run plant shortly to be seven. Ultimately, we'll have 12 cufters in that long run plant. And the economies of that are very encouraging, John. So I'm just -- honestly, I'm thrilled with the results that the team down there is driving.

And this is a North American question. Could you comment on carpet tile only, I guess, not that LVT is big yet. But was there a channel mix drag on margin with office being weak and some of the other categories strong? Was there any change within the mix high priced, lower price through your line? Just trying to get any color if there’s any movement on gross margins relate to North American and carpet tile?

We had a really strong quarter in North American margins, honestly John. And I love the balance of the team's finding between pricing and volume. So I just think that they've hit that dial turn exactly right here in the second and third quarter.

And then are you seeing -- someone earlier asked the question about the European investment and sales. As I recall, you also made some investments in the North American sales force that of course initially dragged. Is that starting to pay benefits? And are your sales personnel numbers in North America still growing, or what kind of -- where you want it and you'll get more leverage, because of increases you took in prior periods?

I mean we are getting a return on the investments that we made there, feel good. I mean based on the order growth here that we’re seeing as we head into the back half of the year. But I think we're done making investments in the sales organization, no. Gnerally, we're outgunned in the major metropolitan markets by our primary competitors. So as you look out over the next few years, while staying within our SG&A targets, we're going to invest more in sales people.

Thank you. And we have a follow-up from David MacGregor with Longbow Research. Your line is open.

Jay, I just wanted to ask about NeoCon this year and what your takeaways were, what you were hearing in terms of customer preferences and how those were evolving. I guess I’d be interested in the year-over-year comparisons and your observations? Thanks.

Well, the traffic was up 7% year-over-year. So NeoCon was high energy this year. We got great feedback from our design. We had two major global launches that we previewed at NeoCon, one from our internal design team and one from David Oakey studios. And I thought it was a really strong showing for us. The other thing that really took our customers, held our customers, and just pretty high was our LVT. And so we preview some LVT product that we're going to be launching in the back half of this year. So I think our first round of LVT was a little utilitarian. Meaning, we covered all the basis, but the next round is really led by design and how it integrates with our carpet. So LVT is very prevalent amongst all the competitors, I think the customers really appreciated our approach to the integration of carpet and LVT design. So I'm pretty excited actually as we go into the back half of the year as we start selling those new products.

Thank you. And I'm showing no further questions, at this time. I'd like to turn the call back to Mr. Jay Gould for any closing remarks.

Okay. Well, first of all, thanks for your continued support, really encouraged as we going to the back half of the year that we're going to execute on our commitments. And I look forward to our next question call. Thanks very much.

Ladies and gentlemen, thank you for participating in today's conference. This concludes today's program. You may all disconnect. Everyone, have a great day.