Armstrong Flooring, Inc.
Q3 2020 Earnings Call Transcript

Published: 21 Oct 2020

[Operator:]

Greetings. Welcome to Armstrong Flooring Incorporated Third Quarter 2020 Earnings Call. [Operator Instructions] Please note this conference is being recorded. I will now turn the conference over to your host, Greg Waina, Interim Chief Financial Officer. You may begin.

[Gregory Waina:]

Thank you for joining us today for Armstrong Flooring's third quarter 2020 earnings conference call. I'm joined by our President and CEO, Michel Vermette. In addition to the earnings press release issued today, a copy of the slide presentation to accompany this call is available on the Investors section of our website at www.armstrongflooring.com. During this call, we will be making forward-looking statements that involve risks and uncertainties. Actual outcomes may differ materially from those expected or implied. For a more detailed discussion of the risks and uncertainties that may affect Armstrong Flooring, please review our SEC filings. Forward-looking statements speak only as of the date they were made, and we undertake no obligation to update any forward-looking statement beyond what is required by applicable security law. In addition, our discussion of operating performance will include non-GAAP financial measures within the meaning of SEC Regulation G. A reconciliation of these measures to the most directly comparable GAAP measures is included in the press release. I'll now turn the call over to Michel, beginning on Slide 3.

[Michel Vermette:]

Thank you, Greg, and good morning to everyone on the line. Our team remains focused on executing our multiyear transformation to modernize our operations and become a leaner, faster-growing and more profitable company. During the quarter, we made great progress across many initiatives. Our results were largely in line with our expectation, in which we produced sequential topline improvement compared to the second quarter of 2020, primarily from stronger trends in residential end markets that have outpaced a slow recovery in commercial activity within the U.S. In addition, results from our international operations have improved sequentially, primarily in China. We were pleased that our residential business grew in the third quarter, led by strong demand at home centers and supported by the actions we have taken in our go-to-market approach and refined customer-centric operating model. Additionally, record low interest rates and deep urbanization trends have fueled growth in new residential construction, an area where we are working to deepen our presence through increased targeting of single and multifamily builders. Home centers have generally continued to operate at a robust pace, offsetting lower activity at some independent customer retail locations. As evidenced by recent data from the Architecture Billings Index, commercial activity is choppy in nearly every sector and geography. On the commercial retail side, some customers' projects have been postponed as they reassess demand or floor plans. This dynamic is also evident at larger institutions. For example, in the education sector, many operators are focused solely on reinventing their own operating model to adapt to evolving policy, with less time to spend on planning remodeling projects. We are noticing the same trend with hospitals. We are cautious on starting major renovation projects as they do not want to have any capacity limitations whatsoever in this environment. These are just a few example what has been an overall softer commercial demand environment as the pandemic has progressed. Looking ahead, we expect residential activity to continue its recovery at a strong pace, while commercial demand will likely be pushed out. I will also note that we experienced benefits from several commercial roll-outs in the fourth quarter of last year, which will not reoccur in the fourth quarter of 2020. Furthermore, inconsistent state and local government orders related to COVID-19 have resulted in and will continue to have varying impacts on Armstrong Flooring and some of our customers. Despite these complex market dynamics, I'm extremely proud of our team's progress and efforts to execute the projects as part of our business transformation. With greater access to capital, following our debt recapitalization in June, we've been able to ramp up more of our planned SG&A investments. We are focusing on the factors that are in our control and the disciplined execution of our strategy is already leading to some benefits that set the foundation for our long-term transformation. Armstrong Flooring is listening more intently to its customers and becoming more competitive, both in product quality, service and the overall presentation of our products in the marketplace. The positive feedback from customers is translating into a stronger desire to work with us. This is opening new doors for our company on many fronts. I will build on this as we turn to Slide 4 to discuss more details on our business transformation. As a reminder, our strategy encompasses three critical objectives that include expanding customer reach, simplifying products offering in operations and strengthening our core capabilities. We're expanding our reach with customers in the third quarter. We added resources to our commercial national account sales team and our residential sales team with an increased focus on starting home center business. In addition, we continue growing in the number of our sample displays and other sales initiatives with the National Flooring Alliance. To quantify that, at the end of September, we already have increased our displays over 85% compared to the end of the first quarter. On top of these sales efforts, we are pleased to have recently announced the appointment of our new Head of Hospitality Sales. This is a completely untapped vertical for AFI that we're pursuing from a long-term perspective in an area where we do not have a material presence historically. And most importantly, we already produce the rest and refuge line of flooring that will - we provide to that vertical. As more hospitality providers see early signs of demand, we expect them to start monetizing their properties, so they can be more competitive when demand returns to more normal levels. Expanding our presence into more verticals is a significant area of future upside. These collective actions represent major steps forward in our go-to-market capabilities that we expect to better utilize our capacity as time progresses. In regards to simplifying our business, we have undertaken several initiatives to simplify our product portfolio, optimize inventory and improve operational efficiency. Last quarter, we discussed the relocation of our corporate headquarters, which will become effective in the summer of 2021, with estimated annual lease savings of approximately 60%. In the third quarter, we started upgrading our plant lines in Kankakee, Illinois, to improve the throughput and scale to service new products from that line going forward. This moving part to management transition of production from our South Gate facility as we look to monetize that asset. In addition, we continue to reduce our mix of underperforming SKUs, and we have put several initiatives in place to optimize our inventory levels. We have also implemented various initiatives to remove certain bottlenecks out of our manufacturing processes, which are already leading to improved productivity across some of our plant lines. These simplification exercises are leading to strengthened service capabilities with customers, which is the third pillar of our business transformation. With improved organization and movement of our inventory comes greater opportunities to better service our customers. On this front, we have recently introduced a new Quick Ship program, which has allowed us to take advantage of some quick service opportunities for our distributor partners. Project timelines continue to contract, particularly on the commercial side, making agility and speed for manufacturers increasingly important. Our Quick Ship program is one more way we will be able to accommodate these accelerated timelines. Innovation remains an important part of our goal to strengthen our capabilities with customers. We continue to invest in innovative product offerings with the attention to manufacture more of our LVT in our facilities in the U.S. As we listen more intently to customers, our service is getting better and feedback from customers is improving. We're increasingly being perceived by the marketplace as a more customer-centric company, which is also helping us attract great new talent. We recently appointed our first VP of Logistics, who will help us enhance our interactions with customers by aligning our capabilities with their expectations. Working through a business transformation during a global pandemic is not an easy task. But we are pleased with our progress, considering the circumstances of these unique times. We're focusing on the factors we can control, and we will continue to manage through any changes in demand or in the marketplace. With all that said, I would like to reiterate the important point we have stated in prior calls, our operating results in the short term will continue to be pressured by incremental expenses necessary to execute our business transformation initiatives. We are making significant progress in executing our strategy in this complex environment, but we are still in the early stages. Having now been CEO of Armstrong Flooring for just over a year, I'm more confident than ever in the immense upside potential of our company. Earlier this week, we announced an important update to our leadership team with the hiring of Amy Trojanowski to the position of Chief Financial Officer. We are pleased to welcome Amy as a well-rounded financial expertise in our fresh perspective to our executive team. As we continue to execute on our business transformation, our proven record of building world-class finance organization makes her a great fit for Armstrong Flooring. I look forward to working closely with Amy as we further advance our company's transformation. Before I turn the call over to Greg, I would like to thank him for his service and dedication to help us build value during his tenure with us as Interim CFO. I equally appreciate his assistance with advising Amy and a consulting capacity to ensure a smooth transition. I will now turn the call to Greg to provide additional updates on our financial performance and liquidity.

[Gregory Waina:]

Thank you, Michel. One of my key initiatives as Interim CFO was to help hire an exceptional operator for the permanent CFO position. I could not be more excited with Amy, and I look forward to assisting her during this transition period. Now I'll provide a review of our third quarter financial results on Slide 6. As Michel mentioned, our results were in line with our expectations, including a sequential increase in sales. On a year-on-year basis, revenues were $156.6 million compared to $165.6 million in the prior year quarter. Increased activity at home centers and other residential channels helped to partially offset COVID-19 related business disruptions, mainly the postponement of certain commercial projects and slower activity at many of our independent customer retail locations. Adjusted EBITDA was $2.8 million in the third quarter of 2020. Favorable product mix amounted to a roughly $3 million EBITDA benefit, which offset half of the $6 million impact from lower volume. Adjusted EBITDA was approximately $6 million of incremental SG&A, resulting primarily from transition service agreement income in the prior year quarter, which did not reoccur, as well as planned growth investments to support our business transformation. Improvements in manufacturing productivity and lower input costs contributed positive impacts of approximately $2 million and $1 million, respectively. As a reminder, we entered 2020 with SG&A headwinds totaling $20 million as a result of benefits incurred in 2019 from income related to the transition service agreements with the buyers of our wood flooring business, with approximately $4 million of that in the third quarter of 2019. We expect a similar SG&A impact of approximately $4 million in the fourth quarter of 2020. Looking at our cash flow on Slide 7, during the third quarter of 2020, we spent $4 million in CapEx with spending related to manufacturing consolidation, maintenance and safety, and other key initiatives to support long-term growth as part of our business transformation. Operating cash usage was $9 million during the third quarter of 2020. As we mentioned last quarter, we don't expect the remainder of the year to follow normal cash flow patterns, and we have implemented numerous measures to preserve cash as necessary. Cash flow will continue to reflect incremental CapEx to execute our business transformation. Additionally, we expect inventory levels to increase in the short term to support our new Quick Ship initiatives as well as the transfer of production from our South Gate facility. At September 30, 2020, we had total liquidity of approximately $110 million, including cash of $22 million, plus availability under our credit facilities. We have no significant debt maturities until the year 2023. Prior to the answer the pandemic, we began to assess monetization of noncore assets, namely our South Gate facility and land portfolio. As we indicated in our press release today, given our intention to sell South Gate, we've reclassified that property as an asset held-for-sale on our balance sheet. Under the terms of our credit agreements, $30 million of availability will be withheld under the credit facilities. The withholding will begin upon the filing of our third quarter Form 10-Q and continue until we close on the sale of South Gate. Factoring in the $30 million to be withheld, our available liquidity will be approximately $80 million. We believe that we have ample financial resources to effectively execute our near- and long-term objectives. Looking ahead, we will remain focused on additional actions to optimize our liquidity and cash as necessary. I will now turn the call back to Michel for closing remarks.

[Michel Vermette:]

Thank you, Greg. In conclusion, I'm extremely proud of the Armstrong Flooring team for their unwavering commitment to transform our business, while providing the best possible service to our customers. Positive feedback from customers in regard to our service enhancement leaves us confident that we are on the right path to improve our market positioning and sets the stage to ignite growth in the coming years. Through our customer-centric operating model, we will continue to approach opportunities with a returns oriented mindset, while keeping our focus on the three core areas that include expanding our reach within our addressable flooring market, simplifying our processes and strengthening our competitive positioning for long-term success. We look forward to updating you in the coming quarters as we make further progress on our business transformation. Thank you, again, for joining us today. Operator, please open the lines for question.

[Operator:]

[Operator Instructions] And our first question is from Brian Biros from Thompson Research Group. Please proceed with your question.

[Brian Biros:]

Thank you for taking my questions. I wanted to start and see if you could talk about the cadence of sales throughout the quarter? And I guess, really going back thinking April was down 20% and Q2 was down, I believe, 18%. So some better trends there, but not super meaningfully and then it seems like things really picked up at the end of Q2 and into Q3. So I guess just how did sales trend throughout Q3 and maybe into October, if you have any insight?

[Michel Vermette:]

Well, I think the positive - and thank you for joining the call. I appreciate you being here. So I won't give comments for per month, but I think overall, we're definitely - the trends in Q3 were more bullish than Q2, and we expect that to continue. In particular, on the residential side, the home center, new construction and I would say even in remodel, commercial remains challenged as we saw with the ABI and the number of projects being listed. So we expect continued improvement in residential, overall, and with some challenges in commercial. But I think the - if the trend is positive overall, and we expect continuous improvement in that area.

[Brian Biros:]

Okay. And if you could segment out the big box and home centers and just focusing on them for a minute, some of our context had mentioned that their sales into the big box stores were up even more than what the big box stores were reporting overall, so really robust sales there. Your commentary seen consistent with that theme, but I wanted to see if there was anything more to add on that? And if you think those trends will continue into Q4 or if that might return to a more normal cadence going into the end of the year?

[Michel Vermette:]

Well, the feedback we're getting from the home centers is they remain bullish on their outlook and let's face it, they have a competitive advantage in this setting with their operations their ability to go through. We expect continued good results in the home centers in that area, and we expect that to be a bright spot definitely for the business. So I think there will be continued momentum there as people want to remodel their home in an attempt to projects that they've been waiting for, but yeah, we're bullish on the home center channel for sure.

[Brian Biros:]

Okay, that's good to hear. And if we could switch to maybe the independent retail segment. Through your comments slower activity, I would have thought maybe you would have seen a little stronger demand once this reopens. I guess, could you talk about - more about that slower activity? And if that was due to maybe COVID restrictions and maybe still some shutdowns on the actual independent retailers or if that was more of a lack of demand from buyers walking into those retail stores?

[Michel Vermette:]

I think it's a very regional specific. As you know, there is very different protocol - safety protocols in different parts of the country. So definitely, where states that are more open are definitely having good results. Actually, some retailers are coming that their business with the pickup in Q3, they expect actually some of them to be up for the year. So I think its geography based, but from a national perspective, when you have some big states, like New York, California and others that represent a large demand, the remodel piece, in particular, that have restrictions, that definitely impacts the national average overall. So I think that the retail - independent retail is better in Q3 than Q2 and depending on what happens with this stimulus and new activity and depending what government position will be on COVID-19 in the coming quarters, I'm sure that will impact, but overall I think the trend should be bullish in there, just maybe take a little longer based on the different state restrictions for retailers.

[Brian Biros:]

Okay. But you are seeing some pockets of strong demand. But when you said when you go to the national level, and you have some of those larger restrictions, it does drag down the overall?

[Michel Vermette:]

That's right, that's kind of - to put in context, that's well said.

[Brian Biros:]

At least we're seeing some regional strength. And then I guess still on the - kind of the resi R&R and the specialty independent retailers, I think on one of the previous calls, it was mentioned that the true test for activity in that segment might really be in this October-November timeframe, kind of once those backlogs from before start to roll off. Are there any early indications on that thought now that we're kind of almost through October and if there's any update to that thought?

[Michel Vermette:]

I'm bullish on the independent retailer as they improve and stabilize. I think, to your point, right now, everybody is trying to work through their backlog. It's hard to get qualified labor. Labor is probably the biggest limitation the industry talking to residential remodel contractors. So they are working hard to execute, and also with builder being so strong in certain areas, everybody is competing for some of the same resources depending on the marketplace. So I think residential, I said, both in new construction or remodel should be a bright spot for the rest of this year and next year.

[Brian Biros:]

I do have a few more questions, but I'll jump back in the queue for anyone else on the call.

[Michel Vermette:]

All right. I appreciate that. Thank you. Operator?

[Operator:]

And our next question is from Keith Hughes from Truist. Please proceed with your question.

[Keith Hughes:]

A question on product availability, have you had issues or have any of your distributors have issues with just not having the right products due to the surge in demand we've seen in residential and any demand push to the fourth quarter? Initial comments on what you're seeing there would be helpful.

[Michel Vermette:]

We've been pretty lucky, Keith. And thank you for joining. We have put a lot of effort improving our service and our metrics. So we actually had our best service in Q3, then probably had some time, and that's the effort of us modernizing our processes and being in touch with our customers. So we've had actually pretty limited disruptions. There is some transportation challenges right now, trucking is a little more difficult to get the base as demand picking up across the country. But in case - for product availability, we are definitely move in the ball in the right way, and I'm pretty bullish that's how we are also changing our relation with our customers. So we've done a really nice job there with the team to stay ahead of our customers and making product available, and we've also increased our U.S. offering, so probably allows us to be more nimble and more responsive than some others that depend on long supply chain so.

[Keith Hughes:]

Second question, within your residential product offering, going to see LVT to your best growth product. But have you seen in the last six months, as the all the changes have gone LVT with the tariffs coming and the hot and cold demand we've seen for consumers has it changed the trajectory of LVT growth at all?

[Michel Vermette:]

Well, I think I believe LVT will still be a growth category for this. We were fortunate to grow our LVT in Q3, which is definitely a positive. And I expect that to continue to get better in Q4. I think for the next three years, Keith, I think we can see definitely high-single digit, low-double digit growth in LVT for the next two or three years. You just see it taking share from the other categories. You see builder offerings changing in LVT just has a competitive advantage due to maintenance in sound now. So it's still taking share from the other categories, and I expect that to be a bright spot for us in the industry.

[Keith Hughes:]

That would be a deceleration in the last several years, but I guess our large numbers coming into play to a certain extent.

[Michel Vermette:]

Right. That's the math, but it's still, as you know, 10% to 12% of that category of a bigger base is still large numbers and opportunities for all of us. Right?

[Keith Hughes:]

Good point. Yeah. I guess final question, TSA you referred to, how long this - how long will that be in the numbers?

[Michel Vermette:]

Greg, do you want to take that one? No, let me just go through. You will see another $4 million, I believe, Keith, in the fourth quarter, and then it's really turned off. So that'll be the last quarter that we'll have to compare to that, so.

[Operator:]

And our next question is from Ken Zener with KeyBanc Capital Markets. Please proceed with your question.

[Ken Zener:]

I just - I wanted to take a step back, if we could, given obviously COVID is impacting the business, but there are structural issues, and I just want to get kind of an update on the reference point. Starting with how the industry, the tariff factor, I believe, about 30% of your business is LVT kind of split commercial res. Can you just talk about how tariffs - what impact it is having in the U.S. market by category? And how much of that market is actually being impacted that's being imported versus your domestic capacity? Just help me understanding of how pricing is affecting things?

[Michel Vermette:]

So on overall spread, for the industry, I believe, the latest number I saw was about 85% is sourced and 15% is made in the U.S. even though there is capacity being added, it's definitely not keeping up with the growth that we talked earlier there, so source is still the largest part by far. But I would say the sources of supply are expanding, so to your point, China has - China's supply chains have been impacted by tariffs, but our sales and many others have basically diversified, the supply chain in other countries such as Vietnam, Korea and others and so there is more supply from other locations, and I would say many of the North American providers are now sourcing a large part, if not all from these other countries to avoid any unknowns tariffs. So definitely there has been some pricing actions to recognize those impacts. So it has impacted certain product lines, different manufacturers differently depending where they are in that change in the supply chain and probably dampened some demand in the short term, but I think there is a reset there and as we all diversify that supply chain down only be better and that's also why we augmented our U.S. offering to be more competitive and not have to deal with that complexity for everybody, so.

[Ken Zener:]

Appreciate that. Would you say because of the deemphasis of sourcing from China where the tariffs were being impacted. Has that taken away some of the pricing powers? What has been, I assume, the tailwind from price asks has diminished? Or how is the industry responding to that in terms of the end market?

[Michel Vermette:]

Well, as you know, the market is competitive, right, so there's definitely been a lot of, I think you got to keep the different products competitive with each other and when you're gaining multiple sources of supply, you have to be relevant to the marketplace. So I think pricing is going to be remaining competitive, and I think it will be the source of supply going to be less relevant. There is just some price points for key products that you just have to meet if you're going to compete. So and I would say it's fairly stable right now, and we just got to stay relevant and bring up the right innovation to make it there. The other thing that's going to by LVT you see longer, wider you see some trends also this year, products that are actually helping the price point that were not as prevalent maybe 24 months ago and so that's also offsetting some of the overall category. So and there's just some bare looking higher end products that are out there, versus just the tuna have ml - tuna have 12ml product or 6ml product.

[Ken Zener:]

Understood. Thank you. And if I could switch gears a little bit, just for business transformation obviously can be very powerful for a company. As you - given your time so far at the company when you think about what the future will look like, and you talk about SKU rationalization, which has got to be a big part of margin expansion in the categories that aren't growing. How do you approach that? I mean there's many different ways, right, rationalization could be 80-20 to reduce your fixed cost basis, to reduce your channel concentration or how does it work? I think about 75% of your sales are to distribution in the U.S., but how do you maximize? What's your approach essentially to get these SKU cost down, yet having a more effective in the end market just given you've been there for a year. I appreciate it. Thank you for your time.

[Michel Vermette:]

I appreciate. Good, very good question. So it's - we go product by category. We start by simplification. So the company has a broad portfolio for many years. Some of that was dated and some we need to revamp. So to give you an idea, so far, we discontinued about a third of the SKUs we have the same time last year. Some categories, the mature categories as we see team in residential sheet vinyl have had a lot more than others. We've actually invested in LVT and you see that our gross margin is trending up year-over-year and improving in that regard. So and we have reset our footprint. We consolidated our residential sheet activities into the Lancaster. We consolidated our ECT operation from South Gate to both Jackson and Kankakee, and will do now the same thing for peeled fix, so we reset the footprint to get higher utilization, more simplified runs, higher margin product, to your point, to go through it. So it's really done in a very surgical way category, category. Some of this, we're just gaining the early benefits as of now to go through and also I would say the feedback of the different products has been very, very good across the business. So it's a journey to turn around the whole portfolio. But just like look at overall business for the quarter, every product category is up, other than our VCT category that is dealing with challenges both in mass retailers that don't want to disrupt or hospitals or education as I mentioned. So it's definitely we're doing this and still growing the business in the other categories as we're changing our offering. So I think that's only going to get better in the near future.

[Operator:]

And our next question is from Brian Biros with Thompson Research Group. Please proceed with your question.

[Brian Biros:]

Can we just touch on the commercial market a little bit? It sounds like healthcare and education have kind of hit a wall now based on your comments, after previously being bright spots. Is any more color there? And then any comments on other end markets and commercial and whether things maybe are expected to bounce back in the first half of 2021 or maybe it's still too uncertain to call, any thoughts on those?

[Michel Vermette:]

Well, as you saw, the ABI, so a lot of people are looking at projects, but a lot of people are postponing. So you think of commercial, the areas - some of the areas where we have significant presence, such as retail or education or hospital, right, they are probably retailers that are open, don't want to disrupt their operation. We still have the same specs. They're just making sure that they can operate freely. They only want the disruption of contractors or work, so that demand is still there, it will pick back up when there is some better outlook on the pandemic. No one thought this pandemic would be this lengthy when we went down that road or got impacted in that March, April timeframe. And you look at schools, I mean, they're reinventing their whole model with technology and processes and many of them don't have students in their buildings. So their priorities are somewhere else, right. And naturally hospitals, they want to keep their capacity open for any changes. So there's realities out there. As we know, hospitality, it's - if we really don't have any presence, but have worked in that market for many years, many operators are impacted and their demand is significantly down in the whole tourism industry. And corporate, in many corporate offices, particularly in major cities, are still very limited in capacity. So everybody is kind of thinking through that. I think the commercial market will be the more challenging market for the coming 12 months. And we've adjusted to that and - but within that, for a couple of like ours, there's a lot of opportunities across that. But I think for the industry, I think that's probably the biggest question forward to 2021 demand.

[Brian Biros:]

And then last one from me kind of related to Keith's question about product availability. Did you hear some other flooring manufacturers have kind of had to play catch-up once things were reopened in terms of restocking the retailer inventory? I got to do that across multiple SKUs required shorter more frequent production runs, so that comes at the detriment of margins? Did that come into play at all for AFI in the quarter?

[Michel Vermette:]

I would say we probably took some actions to increase our inventory in the right areas early based on the feedback we got from customers. There is always opportunities there and also - that's also based on the feedback we're getting in the industry, that's why we introduced our Quick Ship program and that's been a nice success in that regard to get more demand. So to your point, the supply chains are more challenging and the patterns are a little bit different, but we were fortunate to have been focusing on service since I started. And it's - we took some bets, and we're happy that - and we were able to service our customers at a high level, and we'll continue to do so.

[Operator:]

And then we have reached the end of the question-and-answer session. And I will now turn the call over to Michel Vermette for closing remarks.

[Michel Vermette:]

Well, thank you very much. I appreciate everybody joining the call and look forward to talking to you next quarter, as we continue progressing and improving our operations, so. Thank you very much.

[Operator:]

And this concludes today's conference, and you may disconnect your lines at this time. Thank you for your participation.