Armstrong Flooring, Inc.
Q3 2019 Earnings Call Transcript

Published: 5 Nov 2019

[Operator:]

Greetings, and welcome to Armstrong Flooring Inc. Third Quarter 2019 Earnings Call. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. [Operator Instructions] As a reminder, this conference is being recorded.It is now my pleasure to introduce your host, Doug Bingham, Senior Vice President and Chief Financial Officer. Thank you, Mr. Bingham. You may begin.

[Doug Bingham:]

Thank you for joining us today for Armstrong Flooring's third quarter 2019 earnings conference call. I am joined by our new President and CEO, Michel Vermette.We trust you have seen our press release this morning. 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 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 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 Michel.

[Michel Vermette:]

Thank you, Doug. Good morning, everyone, and thank you for participating on our third quarter 2019 earnings call. I will discuss our business activity and Doug will then cover additional details regarding our financial results before we open the call for questions.I'm excited to be at Armstrong Flooring, since joining company in September, I spent time connecting with customers, visiting stories, reviewing our product portfolio and having an open dialogue with many members of our team.Having operated in the global flooring industry for over two decades, I can confidently say that there's tremendous value behind the Armstrong Flooring brand. The company has a strong history of innovation and great potential. And I'm pleased by the many untapped ideas the team has to help the company achieve that potential as the leading resilient flooring company.We are aware that our recent performance does not reflect the significant upside potential for our business. We are moving quickly and we're conducting a comprehensive review of our business and strategy so we can change the discipline trend of our results. We're deepening our review and expect to provide a more comprehensive plan in coming months.I see opportunities in many places. Some will take time; others, we have already begun to implement and will improve our competitiveness and maximize our penetration with all customers moving forward. This includes steps to expand our customers' reach and serve them in the way they desire.We also need to optimize our product portfolio so we can be cost competitive and have the most in-demand resilient products in the industry. Finally, we're looking to modernize our processes, so we could be more efficient and easier to do business with.Looking at our broader market opportunity, we are in the best categories with the highest growth in flooring. We should be growing. There are verticals such as hospitality, office, single family builders and multifamily, where there's significant room to grow. We're in the process of recruiting additional representatives to call on commercial national account, home centers and multifamily customers.We are exploring all options to maximize our reach within customers through the most cost effective combination distributors and direct sales. Within the distributor channel we will be working closely with them to ensure all end customers are receiving exceptional service so that Armstrong Flooring wins their trust. Given our innovation and brand presence, is much more than we can do the foster our reputation and the value chain.Look at our product portfolio, our award winning Diamond 10 Technology continues to appeal the wide range of customers and we are expanding it on to source products. The benefits to our commercial end users in particular are meaningful and deliver extra margin to us but we have done a good job promoting it.Across all categories, we have too many underperforming activities and need to sharpen our focus on products that are growing or have higher contribution margins to realize better returns on our cutting edge designs. Accordingly, we are conducting line reviews with our product managers to assess strategic direction and stocking profile so we can focus on resources on growth in value add categories such as Rigid Core, commercial sheet and non-PVC options. An example of this is our investment in our new and innovative restore sheet product that reduces healthcare workers' fatigue, and has a better long-term performance and rubber alternatives.In addition, we are working on some exciting options for non-PVC products, which is becoming increasingly important to commercial customers. Even within the broad LVT categories, we're taking a hard look at what product lines make the most sense for our business and aligning our product offering with customer demand.In addition, we made the decision to liquidate the remaining linoleum and laminate inventories and some older or less profitable product lines. So we could use our warehousing to improve our LVT service. Our goal is to have the right products available for each customer. In regards to our production, we're focused on optimizing our manufacturing footprint, where there may be excess capacity in evaluating ways to drive modernization to improve efficiency.In line with that, we recently reduced shifts at 2 of our domestic plants to consolidate production and improve our cost profile. We have also initiated a strategic assessment of our South Gate Plant portfolio in California, as the demographics of that region have changed. In terms of monetizing processes, the team has already started a review of needed changes to improve our productivity, accelerate our decision making and increase of responsiveness to customer needs.We have standardized procedures to align our business structure, increased transparency, and empowered frontline employees. In Q4, we will start designing processes and systems we need to reduce complexity and support our strategy. We have already initiated a redesign of our pricing system to simplify our execution and improve customer satisfaction.Furthermore, I made a change in my leadership team to streamline communication and decision making. Additionally, I'm aligning our leadership and incentive structure to be more customer-centric, and proactively to capture business improvements. As a tangible example, we're implementing system changes across our client network that will allow us to improve our operations more consistently and efficiently use scrapped driving down our operating costs.I recently walked the floor of one of our facilities and the production crews were pleased by the prospect of spending less time chasing materials and more time on productive efforts just as quality in service. Overall, these are just several areas where we can improve and reignite profitable growth in coming years. We're committed to improving our performance through a more modern and efficient platform that more effectively reaches and expand base of productive customers. I look forward to working with the talented teams across our business along with our customers and suppliers to get our business back on solid footing.I now turn the call over to Doug to walk through the details or a financial performance.

[Doug Bingham:]

Thank you, Michel. I'll begin with the review of our third quarter results on Slide 4. For the third quarter of 2019 net sales were down 20.7% to $166 million, as compared to $209 million in the prior year quarter including an unfavorable impact of 90 basis points from changes in currency exchange rates. This disappointing sales performance was largely due to lower volumes and unfavorable mix.We believe that volumes were affected by several factors including an unfavorable comparison against third quarter 2018. A period that saw significant customer purchases in the distribution channel in anticipation of U.S. tariffs, combined with additional destocking this year. Additionally, performance of several of our key distributors was much weaker than the market. We also experienced share loss in some categories, particularly in residential where we need to better serve our customers' needs. Mix was adversely impacted by lower relative LVT sales as a result of distributor loading activity in the prior year quarter.Over the past year, we have implemented several rounds of price increases to partly offset the impact of tariffs. While we largely held firm on price in the third quarter, we believe intense competition resulted in modest overall price pressure on results. Many small to mid-sized competitors have not an active price increases in response to tariffs. We continue to work closely with our distributors to effectively implement price increases, but remain committed to pricing in line with market conditions.Our third quarter 2019 adjusted EBITDA was $9 million as compared to $24 million in the prior year quarter. This decline in adjusted EBITDA was primarily due to lower net sales and increased input costs inflation pressure, including U.S. tariffs. This was partially offset by improved productivity and lower SG&A spending. Adjustments to EBITDA in the third quarter 2019 totaled $23.3 million.Michel discussed several actions we have taken during the quarter in connection with our efforts to shift our focus from less profitable products and improve our operating efficiency. This includes write down of certain finished goods inventory to rationalize obsolete products, such as our discontinued linoleum and laminate product lines. We also dispose of merchandising displays and samples that are no longer required following a shift in our marketing strategy.Separately during the quarter, we overhauled our procedures across plants to standardize how we handle raw materials and scrap. We also incurred other business transformation costs to modernize additional processes and systems. Finally, we had executive transition costs largely associated with realignments within our senior leadership team.During the third quarter, we generated operating cash flow of approximately $32 million. This was in line with our plan to drive down working capital as we move through the year. For the quarter we invested $7 million in CapEx, which remained below our run rate depreciation. We ended the quarter with a strong cash position and modest levels of debt. We are in process of replacing our existing credit facility with a new asset based facility.We expect to have new credit structure in place by year end, providing us with even more flexibility to invest in initiatives and growth avenues that makes sense for our business. In the interim, our current facility has been reduced from $150 million to $100 million to better align with our anticipated asset based facility size and provide some modest savings on unused funds.Moving to our full year outlook, we are taking many steps to improve our business for the long term. But the persistent top-line challenges have impacted our year-to-date results and will continue into the fourth quarter. In the fourth quarter we anticipate that lower net sales and investments for future improvements will more than offset the benefits of productivity gains.Factoring in results for the third quarter, we are moderating our adjusted EBITDA outlook for the full year, which we now expect to be in the range of $20 million to $25 million. We will also incur $1 million to $3 million of onetime cash charges in connection with our manufacturing changes and small residual management transition costs. On the P&L are effective tax rate could change significantly quarter-to-quarter, but we do not expect to pay any cash taxes for the full year 2019.In regards to cash flow, we continue to 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 higher return on investments. We expect to end the year with a strong and flexible balance sheet to execute on our unchanged capital allocation objectives. We are focused on modernizing the business and funding growth initiatives while preserving balance sheet strength.Before I turn the call back to Michel, I'd like to mention that in 2019, we benefited from roughly $15 million of favorable impacts to SG&A, such as income from our transition service agreements with the purchaser of our wood flooring business, rental income, lower incentive compensation and deferrals of IT upgrades among other items. We anticipated these SG&A benefits will represent headwinds of a similar amount in 2020. We acknowledged it will take time to improve results. But we started taking decisive actions and are committed to continue to do so to achieve the company's full potential.With that, I will now hand the call back to Michel for closing comments.

[Michel Vermette:]

Thank you, Doug. As I mentioned earlier, we're updating our strategy in crafting a comprehensive path to improve our operating performance and results, which we expect to share in the coming months. While we have a long road ahead, to get our business back on track, we're setting the foundation to target numerous areas of improvement in the short and long term to better capitalize on the strong market opportunities in the resilient flooring industry.I look forward to working closely with our dedicated team to strengthen our growth trajectory and augment the margin profiles of our award winning portfolio. We are all committed to realizing the significant value underpinning Armstrong Flooring brand to generate meaningful returns for shareholders.Operator, we're ready to take questions.

[Operator:]

Thank you. We will now be conducting a question-and-answer session. [Operator instructions] Our first question comes from the line of Michael Wood with Nomura Instinet. Please proceed with your question.

[Michael Wood:]

Hi, good morning.

[Michel Vermette:]

Hey, Mike.

[Michael Wood:]

You talked about some actions that you're taking, reduced shifts and some optimization actions. I'm curious why there aren't some more dramatic plant closures. Clearly there's some businesses that are in secular declines not likely to get better. And curious why you are - how you're evaluating some of those businesses, which I imagine are running at fairly low levels, capacity utilization?

[Michel Vermette:]

Hey, Michael, this is Michel. So we're going through this category by category. As you know, not every product can be made in every plant and directly. So we're going through that process one by one. We basically took actions with things that made sense to move immediately. And we're evaluating every components of each facility in that regard. There are certain capabilities that make sense to keep in these facilities. So we will be looking at those, but I think everything's on the table and we're looking at that across the portfolio.

[Michael Wood:]

Okay. And on guidance. Can you just bridge for us what specifically caused the reduction since 2Q?

[Doug Bingham:]

Sure. Yeah, Mike. This is Doug. The biggest piece has been the continued decline that we've had in sales. And I point to the further reductions in inventory in the channel, some of our distributors we mentioned has shown weaker performance than what we expected. And then we've also had some share loss in some categories which have combined to make a tougher sales environment than what we anticipated.

[Michael Wood:]

Okay, and on the distributor performance that you called out, is this share loss that the distributors are experiencing in the market, is it that you're losing share with them. And I guess now that we're kind of getting beyond the changes you made in terms of that advertising structure, have you evaluated whether or not that was a good decision at this point?

[Michel Vermette:]

Michael, this is, Michel. Let's face it, not every distributor is made equal. So there's different performance for different distributors. So some are performing better some performing worse. But it’s obviously based on results that what we’re doing right now is not the way we meant to operate for the long term, so we need a combination. So we will be looking at every aspect to make sure we reach our customers.We need to get closer to our end customer. And so, we’re looking at that we’ll have the right conversation with our distributors and also make sure that we have the right access and serve the customers the way they need to be. So there are definitely opportunities there to augment our reach.

[Michael Wood:]

Okay, thank you for the comment.

[Operator:]

Our next question comes from the line of Alvaro Lacayo with G. Research. Please proceed with your question.

[Alvaro Lacayo:]

Good morning, this is Alvaro. Thank you for taking my questions. I wanted to start with cash flow and working capital and just your expectations for the fourth quarter, just because over the years, over the last several quarters there’s been a lot of volatility there. But would you expect working capital to continue to be reduced sequentially from the third quarter or what kind of an impact are you going to see in the fourth quarter from a cash perspective from working capital?

[Michel Vermette:]

Yeah, so we’ve made some good progress this year in bringing down inventory levels and improving our working capital. As we go into the fourth quarter, we’ll continue to look at opportunities to reduce inventory to rationalize skews, to do the things that get our business in track, understanding that in some cases we may need to build inventory positions to better serve customers or to meet their needs.So, I would expect that we’ll follow, for Q4 specifically we’ll probably follow fairly normal improvement in working capital as we went through the month.

[Alvaro Lacayo:]

Can you just describe what normal is, just because there’s been so many moving pieces? And if you can just - is working capital expected to be down in the fourth quarter versus the third quarter, just yes or no, do you have any view into that?

[Michel Vermette:]

Certainly, it should be down in the fourth quarter.

[Alvaro Lacayo:]

Okay, thank you. And then with regards to the guidance, I mean, the last time you gave guidance you were five weeks into the quarter. I realize things obviously didn’t work out as expected. But the magnitude is fairly large so I want to go into how - what kind of assumptions do you make when you provide forward guidance, given that you had been through the second quarter, you were five weeks through the third quarter and you’re cutting guidance by a significant amount.So, maybe just walk us through what your assumptions were going in. And what happened in the remaining of the quarter, given you’d already seen what was going on in the first five weeks?

[Michel Vermette:]

Yeah, so as we - the time that we gave the guidance or the sales we’ve seen so far were in line with our expectations, they were a little bit soft, but we really saw some degradation later in the quarter, which has caused us to reevaluate where we’re at in terms of sales and the outlook.I think, what we’ve seen is that there were larger distributor movements on inventory. So we were expecting that with the tough comp, with the buy head activity that happened last year. But we weren’t necessarily expecting a kind of sequential reduction in inventory and the distribution channel and we get to see that in the third quarter.In addition, the performance of our distributors, we believe that they were doing fairly well in the first part of the year. And as we have had further conversations and then we will work, it’s clear that there are some challenges with some of our distributors that have caused us to revisit our outlook.

[Alvaro Lacayo:]

So, during the first five weeks of the third quarter they were not reducing inventory or what changed just because, you’d think five weeks and then you have some color into those trends?

[Michel Vermette:]

Yeah, we saw more of the movements as we got into September.

[Alvaro Lacayo:]

All right, thank you.

[Operator:]

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

[Justin Speer:]

Hi, good morning guys, thank you and Michel thanks for the color. I know you’re coming into a pretty - obviously a pretty turbulent environment flooring in general, and just appreciate your perspective. Number one, I just wanted to talk through LVT and non-LVT volume trends or revenue trends in the quarter. A lot of moving parts, but can you give us maybe characterize if it’s below or above fleet in terms of the percentage down 20% organic? If LVT was above or below that and you're non LVT volumes and the quarter?

[Doug Bingham:]

Yes, so I'll take that one, Justin, this is Doug. The volumes in LVT were below the overall company's. And again, a big part of that was the inventory bill last year compared to the production this year. But even so, we believe that LVT sales adjusting for that were soft.

[Justin Speer:]

Okay. In terms of the inventories and the channel, as it stands today, I guess maybe characterize what your visibility is, how good it is? And what your sense is as it stands today, based on your guidance, I'm guessing it's still big, still elevated, but in terms of what you're seeing how long decline the system?

[Michel Vermette:]

At this point, the inventories are actually low. They're at the lowest point they've been in about three years in the channel. So we feel like it's - the channel is where it needs to be and maybe even a little bit under.

[Justin Speer:]

So as you think about. And I wanted to unpack your statement there at the end of the prepared remarks on the $15 million of benefits SG&A in 2019. And that those will become, I guess, headwinds in 2020. When were those benefits? Are those benefits spread across the first three quarters or is that the first half of the year or four quarters? And how should we think about the -within your guidance for the fourth quarter the actual SG&A spend for the fourth quarter?

[Doug Bingham:]

We saw some of those benefits in the first half. So you think of the rental income we talked about last quarter. That was all in the first and second quarter. Some of them the income that we received has been more evenly spread and then the adjustments on the incentive comp tends to be more back half loaded based on the timing of when we make the changes before.

[Justin Speer:]

Okay. So you know, Michel, if you thinking about just walking through and seeing areas of opportunity on the margin front on the efficiency front, on the process front, how much in terms of savings potential, do you see high level as you think about process improvements on an annualized basis?

[Michel Vermette:]

Well, we are in deep review of that, but I'll just give you like the two adjustments we did to our plans, that's a little about $4 million of improvement. So there's improvements in many areas. So we're building that list and we'll share that list at that plan in the coming months. But we believe there's significant opportunities across the business. And one thing I would add also as we are having conversation with our customers and discussing how we want to serve them, they're very open to different models. A lot of people want to help us and support us.So we're actually finding opportunities in the marketplace as we speak, to help reverse the trend. Let's face it. Our biggest priority is reversing the sales trend. And that's our first and foremost focus as we speak. So - and we're seeing people want to support us in that regard. So that's definitely a positive.

[Justin Speer:]

In terms of the distributor partners that may be, I don't know if they're distressed or just underperforming in terms of the receivables that you have opted those particular customers. Are those you think in good standing or do you think we maybe need a risk adjust for potential risk to outstanding receivables?

[Michel Vermette:]

Well, the good thing is many of these receivables are paid very quickly. And so they have incentive to take early payment discounts. So they're very efficient in their nature. So we feel pretty good about that process. So and as we work through our strategy and sit down with them actually having seen them with them tomorrow. So we will go through, but I would say we feel pretty good where we're at right now.

[Justin Speer:]

Okay, and last question for me is tied. It's a twofold question. But we know that in costs input should be a good guy for your manufactured components of your business manufacturer, the components of your business that you do in house or perform in-house. But tariffs mud [ph] that water because of the source nature of a portion of your business, particularly LVT. Could you maybe help us characterize how cost inputs graduate into your model, if at all?And to in terms of tariffs, let's assume tariffs stay in motion or perhaps maybe we say tariffs are removed altogether. Let's say we come to some kind of good terms. Is that good or bad for your business? Just trying to get a sense for how tariffs manifest themselves and your cost structure, how you plan around both cost inputs and tariffs?

[Michel Vermette:]

The tariffs have really been a headwind for us this year. We've been able to offset some of that through negotiating better terms with our suppliers as well as an acting price increases out in the marketplace. But net-net, there has been a slight headwind there. I think more broadly speaking, we do produce a significant portion of our product in the US. And so that part is really insulated from tariffs. I think as we look at our manufacturing footprint and ways that we can take advantage of that, as the tariff dynamic evolved, I think that's an opportunity for us.

[Justin Speer:]

So in terms of the - so tariffs are mixed, maybe for your business, but it's been a headwind. Inventories are in better shape now and now you've got cost inputs that are probably favorable to you in terms of, separately the cost inputs, raw materials? How does that factor into the quarter and what are the expectations going forward with oil prices where they are?

[Michel Vermette:]

Sequentially our raw material prices have been fairly stable. We are showing you a little bit of a benefit relative to last year when they were increasing throughout the year. Our - the feedstock that gets into a lot of our product is actually propane rather than oil. So it moves similar to oil but not exactly the same.

[Justin Speer:]

Thank you, guys. Appreciate it.

[Michel Vermette:]

Thank you.

[Operator:]

Our next question comes from the line of John Baugh with Stifel. Please proceed with your question.

[John Baugh:]

Thank you and good morning. I guess my first question is, have you lost any distributors and/or lost any shelf space with distributors over say the past year or is their business just down with you?

[Michel Vermette:]

John, this is Michel. I think they have introduced other products within their base. We have not lost any distributors. But distributors have had other products as in their offerings.

[John Baugh:]

Okay. And Michel, what would be I mean, there's probably a different situation with each distributor. But if you try to ring fence, the reason why they went somewhere else it would be well?

[Michel Vermette:]

I can't. I won't speculate, John. I mean, so I'll sit down with them and have that conversation. I've talked to a few of them. I need to talk some more of them. But let's face it, us not having an incumbent that in my job, so insurance didn't help that discussion where we're going. So we'll have that discussion with them. And we're - what's happening with that, so.

[John Baugh:]

Good. And what percentage of your revenue is currently sourced versus manufactured? And what might that look like a year from now? I would assume there's immense pressure with your revenue down on the fixed manufacturing footprint. And you may look at sourcing more and making less if that's an error correctly? Thank you.

[Doug Bingham:]

So we're about 35% sourced and 65% manufactured. It really is product line by product line. So you look at something like VCT, and the change that we made on the production line there, we're not going to change how much VCT we're manufacturing, we're just able to consolidate some of the operations. So the plant changes that we talked about don't necessarily have an impact on using on that source versus manufacturer next.

[Michel Vermette:]

And the one thing, John, just looking at where we participate and how we are set up to compete in individual channels, we believe there're significant opportunities to do more. So we're actually hiring some representatives so we can participate. We talked about some changes in business. We definitely have pulled back from representations in certain areas. And we need to add back representation. So we have the right conversation to get closer to our customers.So I think both - I think there's opportunities both on the manufactured side and on the source side. I think we - just based on the reach I received from multiple customers and relations I have, I think having more feet on the street will help us significantly in that area.

[John Baugh:]

And can you remind me, Michel, how much right now run rate is commercial versus residential. I believe got a lot of commercial.

[Michel Vermette:]

I think we're 60 40. Doug, is that right? So 60% commercial, 40% residential.

[Doug Bingham:]

You're correct.

[John Baugh:]

And then lastly, there was an LVT comment in there. Your intelligence is better than mine. Is your sense that LVT whether it's flexible or Rigid or WPC or whatever it is and maybe you could parse it, is it slowing in terms of rate of growth? I assume it is all, because it’s got much larger in the log numbers, but is it decelerated a lot in your view or what could you sort of describe as the interplay between laminate and LVT and maybe even engineered wood flooring. And I know you’re not in that anymore but you were.

[Michel Vermette:]

Baugh, I think just based on the feedback I mean from our sales to customers recently I think, LVT is definitely growing. It, to your point maybe slightly off from what it has been in recent years, but it’s definitely very strong still. So, overall the outlook it’s definitely taking a significant piece of the growth in the market place overall, so it’s a place to be.

[John Baugh:]

Okay, great, good luck. Thank you.

[Michel Vermette:]

Thank you.

[Operator:]

There are no further questions in the queue. I’d like to hand the call back to management for closing comments.

[Michel Vermette:]

Well, thank you everyone for joining us today. We appreciate your interest in Armstrong Flooring and look forward to updating you with the next chapter of Armstrong Flooring on future calls.

[Operator:]

Ladies and gentlemen, this does conclude today’s teleconference. Thank you for your participation. You may disconnect your lines at this time and have a wonderful day.