Armstrong Flooring, Inc.
Q1 2019 Earnings Call Transcript

Published: 8 May 2019

[Operator:]

Greetings, and welcome to the Armstrong Flooring, Inc. First Quarter 2019 Earnings Call. [Operator Instructions]. As a reminder, this conference is being recorded. I would now like to turn the conference over to your host, Doug Bingham, Senior Vice President, Chief Financial Officer. Please go ahead.

[Douglas Bingham:]

Thank you for joining us today for Armstrong Flooring's First Quarter 2019 Earnings Conference Call. I am joined by our Chairman and Interim CEO, Larry McWilliams; and our Chief Product Officer and Senior Vice President of Global Operations, Dominic Rice. We trust you've seen our press release on Friday. Additionally, a copy of the slide presentation to accompany this call is available on the Investors section of our website at armstrongflooring.com. I refer you to Slide 2 of that presentation and advise you that during this call, we will make certain 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 are made, and we undertake no obligation to update any forward-looking statement beyond what is required by applicable securities laws. 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 and in the appendix of this presentation. With that, I will now turn the call over to Larry.

[Larry McWilliams:]

Thank you, Doug. Good morning, everyone, and thank you for participating in our first quarter 2019 earnings call. On the call today, I will be discussing our operating highlights and business activity. Doug will then cover additional details regarding our financial results before I offer some closing remarks and open the call for questions. I first want to discuss the recent announcement of our leadership transition. On Friday, we announced that Don Maier has stepped down as CEO and from his position on the Board. I want to thank Don for his many years of service and dedication to our company. We wish him the very best. I have served as Chairman of Armstrong Flooring since 2016, working closely with Doug and the entire management team since that time. As interim CEO, I view my mandate is focusing on the company's strategic priorities and our valued consumers, driving profitable growth and innovation in every facet of our operations. As Chair of Armstrong Flooring, a role that I will continue to hold and as Chair of Armstrong World Industries, I'm aware of the industry dynamics and the challenges the business and our teams must address. I have every confidence that we can do so. I am focusing on improving our execution and our financial performance. I will also be working with the Board to seek permanent CEO and ultimately helping facilitate that transition. I look forward to working with the talented teams across our business along with our distributors, customers and suppliers as we enter the next chapter for Armstrong Flooring. Now on to the results for the quarter. Our team has been focused on executing key growth initiatives during 2019. That said, the first quarter results were challenged by several dynamics. Demand pull forward into 2018 has kept distributor inventory at elevated levels since year-end. This was in part due to the timing of customer purchases in response to the uncertainty in U.S. tariff policy. We expected this dynamic to impact the first quarter performance and it did. Results were further negatively affected by softer end market demand along with wet weather conditions in many parts of the United States. Our residential categories were affected the most by these adverse impacts. The effect on commercial sales was less severe, partly attributable to the emphasis of our strategy on that end market. While we are not pleased with our first quarter results, we made encouraging progress on several fronts. During the quarter, we continued to drive innovation and bring new products to the market. We also realized higher selling prices and productivity gains, which help partly offset input cost increases. While input cost increases are likely to remain higher on a year-on-year basis, we are seeing cost pressures moderate on a sequential basis, and we look - and we took additional price actions in April. Following the sale of our Wood business in the fourth quarter, we have achieved a number of planned reductions in overhead to right size our operation as a purely Resilient company. We have worked closely with our customers to maintain strong relationships and exceptional levels of service with transition to a purely Resilient company. All of these factors support our confidence in a more favorable operating environment as we move into the back half of 2019. We have a strong portfolio of award-winning products and our team is committed to expanding its leadership positions in the Resilient Flooring industry. We are working to improve our growth trajectory and augment our margin profile. Our actions are primarily focused on LVT leadership, differentiated innovation, strengthened distribution partnerships and leveraging our strong position in commercial channels. In LVT, we continue to energize our market presence through a steady stream of new products, including a comprehensive set of cutting edge LVT products. We have also refreshed our Alterna, Elements, Rigid Core, Vantage and other product lines. Overall, we remain excited by our growth prospects in this attractive category. Looking at innovation across our broader set of categories, advances in design, durability, installation, maintenance and material composition remain key to our success. Our proprietary, award-winning Diamond 10 Technology continues to have good traction with customers in all of our key categories. Our innovation pipelines remain strong, and we plan to continue to invest in our broad portfolio of compelling high-demand products. In distribution, as I mentioned earlier, we have experienced a seamless transition to a purely resilient relationship. Additionally, our 2018 go-to-market pivot to focus on commercial and national accounts is progressing well and aligned with the weighting of our portfolio towards the commercial end market. Through all of these efforts, our team is dedicated to improving our operational performance in all categories through innovation and cost efficiencies to more effectively grow our market presence. We have a strong balance sheet to invest in growing our Resilient categories to take advantage of significant opportunities ahead. Combined with our focus on rationalizing costs and streamlining processes, we believe that we are making progress to strengthen our position as a leader in Resilient Flooring. I'll now turn the call over to Doug to walk through the details of our financial performance.

[Douglas Bingham:]

Thank you, Larry. I'll begin with a review of our first quarter results on Slide 5. For the first quarter 2019, net sales were down 13.8% to $142 million as compared to $164 million in the prior year quarter. The decrease in net sales was largely due to unfavorable mix and lower volumes in almost all product categories, including residential LVT. Our first quarter volumes were affected by distributor destocking and soft end market conditions along with wet weather in many regions of the U.S. These dynamics were particularly acute in our residential categories. This was partially offset by overall higher selling prices in response to inflationary pressure. Changes in currency exchange rates had an unfavorable impact of 120 basis points year-over-year. In the distributor channel, which represents 3 quarters of our sales, customers continued to work down inventory levels from unusually high levels at year-end. As we explained last quarter, many distributor stocked up inventory in the third quarter 2018 ahead of U.S. tariffs on Chinese imports implemented on October 1. The subsequent delay and general uncertainty around further tariffs have created a temporary departure from normal seasonal buying pattern since that time. While inflation in reported results is likely to continue to be higher year-over-year, we have experienced a moderation in input cost increases on a sequential basis compared to the fourth quarter, which is encouraging. Our price increases that went into effect on October 1 have allowed us to partly blunt the impact of inflation due to tariffs and other input costs. We've implemented additional price increases of 4% to 6% based on inflation in freight in select commercial and residential products effective on April 1. Our first quarter 2019 adjusted EBITDA was breakeven as compared to $10.6 million in the first quarter of 2018. The decline in adjusted EBITDA was primarily due to input cost inflation pressure, lower net sales and higher SG&A spend, partly offset by improved productivity. Higher reported SG&A spending was primarily driven by the timing of a benefit of $4.3 million related to customer reimbursements in the prior year quarter, which did not recur in the first quarter of 2019. During the first quarter, we experienced an operating cash outflow of approximately $63 million compared to an outflow of approximately $5 million in the same period last year. As we mentioned on our last call, in the first quarter of 2019, we rebuilt working capital off year-end lows and also experienced normal seasonality of first quarter cash usage. For the quarter, we invested $9 million in CapEx, which remained below our run rate depreciation. In our financing activities, we paid down the $25 million of outstanding borrowings on our revolving credit facility. We ended the quarter with a strong balance sheet and net cash position. We have announced that our current unused share repurchase authorization has been set at $50 million. This is in addition to the $41 million that we have already deployed. This will allow us to return excess capital to shareholders, while still preserving flexibility to invest in initiatives and growth avenues that makes sense for our business. Our capital allocation objectives remain unchanged with our focus on maintaining the business, funding internal growth initiatives and pursuing M&A opportunities to support our growth strategy. Moving to our full year outlook. Based on our first quarter performance and a likely challenging remainder of the first half, we are moderating our full year expectations. For the full year 2019, we now anticipate adjusted EBITDA to be in the range of $50 million to $58 million. We expect energy, transportation, raw materials, operating costs and tariffs to be a headwind on our P&L in 2019 despite some moderation in costs on a sequential basis. We expect that the impact of pricing actions, productivity gains and other cost savings will help to offset these continuing inflationary pressures. Additionally, activity in our end markets, particularly in residential have improved in recent months, which is encouraging. With this in mind, we continue to expect full year EBITDA to be heavily weighted towards the second half of 2019 as the market strengthens and elevated inventory levels in the channel are worked down. On the P&L, our effective tax rate could change significantly quarter-to-quarter. We continue to expect our tax rate to be approximately 25% in 2019. In regards to cash flow, we expect capital expenditures of approximately $30 million for the year. Maintenance CapEx should continue to approximate 2% to 3% of sales with the balance of the spending budgeted for high return investments. While we are not providing a full year 2019 free cash flow outlook, the majority of our 2019 working capital investments were planned for the first quarter, and we expect to build cash as we progress through the year. With that, I will now hand the call back to Larry for closing comments.

[Larry McWilliams:]

Thanks, Doug. As we have discussed today, while the year is off to a challenging start, we believe we will experience a better operating environment in the second half. I along with the entire Armstrong Flooring team are committed to improving our business through our efforts to grow share in LVT, enhance innovation across our award-winning portfolio, strengthen our distribution partnerships and leverage our leadership position in traditional commercial categories. We believe these priorities will help accelerate positive momentum in our business over the long term. We look forward to executing on our objectives as we build upon our strong brand and market leadership to drive returns for our shareholders. Operator, we are now ready to take questions.

[Operator:]

Our first question comes from the line of Alvaro Lacayo with G. Research.

[Alvaro Lacayo:]

Doug and Larry, I do want to start off talking about the revenue decline. And I realize you highlighted a lot of the drivers there, which were not unique to AFI. It seems like these were industry-related issues, but the magnitude in decline of the revenue was a little bit higher than what we've sort of normally seen across some of the competitive set. Maybe if you could talk to us a little bit more about what's going on specifically with AFI? And from a selling standpoint, what has been done right versus wrong in the past? And what kind of leverage you have to change that going forward?

[Douglas Bingham:]

This is Doug. Thanks for the question. I think one of the dynamics that we have is that we probably have a higher amount of sourced product than others. And so given the tariff uncertainty and noise and inventory build throughout the channel, I think the destocking impacted us more than a lot of other folks out there. It's also worth remembering that the market softness that we experienced probably disproportionately impacted a lot of the traditional categories that we have, which - those two factors combined made our results more challenged.

[Alvaro Lacayo:]

Okay. And you mentioned - I think the comment was around residential LVT volume is declining. Can you give us an idea of what the LVT category as a whole grew at during the quarter? And can you give us an update from a momentum standpoint of what happened in April, because you did make comments around an improving residential market, I was just wondering if that flowed through into what you're seeing in your business?

[Douglas Bingham:]

Sure. Yes. So the first question on kind of what we saw with LVT, I think the LVT - in general, there was a lot of noise in Q1 again because of the tariff situation, not just for us but throughout the industry. We still believe that in normal course of business, LVT is still growing at those kind of high rates that the we've seen from industry sources of 20% to 30%, but we believe that Q1 probably had a little bit of a pause, if you will, given the inventory overhang. And what was your second question?

[Alvaro Lacayo:]

It was just with regard of trends you've seen in April and you mentioned improving residential end market. And I'm wondering if that's flowing through in what you're seeing in your business?

[Douglas Bingham:]

Yes. We did see some pick up as we exited Q1 and came into Q2. It's a trend that we were encouraged by and hope that, that will continue.

[Alvaro Lacayo:]

Okay. And then just - I realize you're not going to provide free cash flow guide for the year. But can you give us what receivables, inventories, payables and incurred expenses were for just the Resilient business last year versus this year? And what you think your working capital levels are today versus what you expected going into the year?

[Douglas Bingham:]

Yes. So I'd say that our working capital levels are about where we expected them to be at this point. As we had indicated, we ended the year with a low working capital position and we expected that we would replenish that. In addition, normal seasonality is that we build net working capital in Q1. Q1 is usually our high watermark and then the working capital comes down throughout the balance of the year. So we're more or less where we expected to be.

[Alvaro Lacayo:]

Year-on-year, so are you up? And how much? And if you breakdown those categories for me, because we need a baseline on the changes in working capital year-on-year?

[Douglas Bingham:]

Yes. I don't have all the details that I can provide you right now. But typically, net working capital as a percent of sales for Resilient is in that kind of 10% to 11%.

[Operator:]

Our next question comes from the line of Mike Wood with Nomura Instinet.

[Mason Marion:]

This is Mason Marion on for Mike. Can you talk about the impact either positive or negative you're seeing from giving distributors more influence control over your advertising?

[Dominic Rice:]

It's Dominic Rice here. I'll take that question. Thank you for it. Yes. We pivoted last year and provided our distributor partners with greater responsibility for the merchandising and sale of our residential products, especially into the independent retail channel as they are best positioned on a local and regional basis to execute effectively with those individual retailers. That transition has gone very smoothly, and we're very satisfied with the progress we're making there.

[Mason Marion:]

Okay. And then what is LVT pricing environment has been like, given the substantial competition from overseas competitors and then the increased domestic product capacity from competitors like Shaw and Mohawk.

[Douglas Bingham:]

Yes. So Mason, in LVT, I think we've said this in the past that we've seen price pressure on LVT. It's been fairly stable. I'd say that the change in the dynamic more recently has been with the tariff increase. A lot of that got passed through in price to the consumer.

[Operator:]

Our next question comes from the line of Justin Speer with Zelman & Associates.

[Justin Speer:]

I wanted to just go back to the inventory levels. If you can help us understand how elevated inventories are in the channels relative to normal seasonality across your business? And maybe if you can unpack any product categories where this is more or less pronounced?

[Douglas Bingham:]

Sure. Yes. The main impact really is - at this point is LVT, which is an imported product and just given the uncertainty around tariffs has led to some unusual behavior. So we ended the year - normally, we end the year at a fairly low point of inventory and then build it back up during Q1. What we saw was that inventories were fairly high at year-end throughout the channel. And so we didn't see that normal change in inventories we have historically. I think at this point, we - our inventory position in the channel, it definitely came down. There's probably still a little bit more to go, but I think we expect that by the time we get to the first half, it will be flushed out and cleaned, assuming that there are no further tariff changes as - that may happen.

[Justin Speer:]

And so in terms of this LVT, is it all types of LVT because I know there's different types of it, both Rigid and legacy non-Rigid product. You're saying elevated inventories across all product types of - in terms of LVT.

[Douglas Bingham:]

Yes. It's probably more pronounced in the Rigid where we've got more sourced product, but we do source some flexible as well. And so there is a fair amount of our product as well as other suppliers that have a lot of flexible product out in the channel.

[Justin Speer:]

So when you look at your - overall your LVT-related sales, how much did those fall in the quarter? And I know you were painting that picture last quarter, but in terms of your expectations, obviously, a little worse. Was it just LVT that was below expectations? What meaningfully drove it downside?

[Douglas Bingham:]

Yes. I think the inventory correction was more or less in line with what we expected. I think the market softness was really the bigger news.

[Justin Speer:]

In terms of the price mix for the business, in light of the inventory situation, it sounds like you're going to get further price increases. Is - in terms of the implication to your business of getting price through, are you successfully realizing price? And when I say successful, you're realizing it through your channels and is it affecting - is there an elastic response that's taking place within the portfolio that's harder to identify at least from our standpoint, but you see under the hood.

[Douglas Bingham:]

Yes. We've announced price increases effective April 1. We had a price increase that was more commodity driven, and October 1, really meant to recover those costs. It really comes down to the market though and what price the market is going to set. If we see that we're out of line with the competition, then we certainly adjust our price appropriately.

[Justin Speer:]

And last question for me. Just in terms of the tariff and the recent news on that front, what are you guys hearing from your supplier partners about this tariff perspectively going in Friday. Maybe give us a little bit of context on how things are trending if, in fact, there is a 25% tariff put in place, maybe not on Friday but let's assume, a bad case scenario of 25% tariff, how do you guys respond and how do you think that domino falls within your portfolio?

[Dominic Rice:]

Thank you for the question, Justin. It's Dominic here. I'll take that one. So from an overall portfolio point perspective, source products represents about 35% of our revenue. So not as great an exposure in that respect. And then within LVT, we do have domestic manufacturing. We're well positioned with 3 plants that manufacture LVT in North America. Certainly, we work very closely with our vendors in Asia around any implications or impact that would be from tariffs. They have plans in place. But as we have communicated previously, if necessary, we would anticipate taking some price action to minimize or offset the impact - the flow through impact of any tariffs.

[Operator:]

Our next question comes from the line of Dillard Watt with Stifel.

[Dillard Watt:]

I wanted to talk a little bit about gross margin. Doug, I believe you quantified something. I apologize I missed it. But if you could maybe help us a little bit understanding how much of the gross margin decline year-over-year was related to inflation versus the lower volume than you anticipated? And then assuming the volume kind of comes back throughout the year and raw materials hold sort of steady, I know that's a big assumption, but where you'll point to the year where we'd start to see maybe a balance of pricing versus inflation.

[Douglas Bingham:]

Yes. That's a good question. So if you think of how the inflation panned out last year, it started fairly early in the year and continued through into Q4. So really on a year-on-year basis, we'll have a headwind through most of the year, but it will diminish each quarter. For this quarter, we've highlighted that we had about $8 million of input cost impact, which we were able to offset in part with some pricing and productivity, assuming that we get some of this price realization from the increase we just did and that should help somewhat and then we also expect that the year-on-year input cost inflation should be less, given that we're not seeing the same sequential headwinds on inflation.

[Dillard Watt:]

Okay. And then moving down a little bit. SG&A, is that - first quarter sort of $38 million, is that a decent run rate to use or was there some lower spending due to maybe some incentive compensation or anything like that?

[Douglas Bingham:]

Yes. I'd say Q1 was a pretty normal SG&A quarter other than the adjustments that we called out in the recon tables. I think what we're going to try to do today is also get posted on our website some supplemental financial information that will kind of give you some - a better understanding of the company after the Wood exit and kind of show some historical SG&A figures.

[Dillard Watt:]

Okay. Great. And then are there any more sort of cost reduction initiatives, charges that you're going to expect to - expect to take through the rest of the year?

[Douglas Bingham:]

Yes. There may be some that kind of dribbling, nothing of large magnitude other than the costs that were in the 8-K that we filed on Friday related to the separation of the CEO.

[Operator:]

Ladies and gentlemen, we have reached the end of the question-and-answer session. And I would like to turn the call back to management for closing remarks.

[Larry McWilliams:]

Thank you, everyone, for joining us today. We appreciate your interest in Armstrong Flooring, and we look forward to updating you on future calls.

[Operator:]

This concludes today's conference. You may disconnect your lines at this time. Thank you for your participation.