Armstrong Flooring, Inc.
Q4 2019 Earnings Call Transcript

Published: 3 Mar 2020

[Operator:]

Greetings. Welcome to Armstrong Flooring, Inc. Fourth Quarter 2019 and Business Update Earnings Call. [Operator Instructions].I would now like to turn the conference over to Doug Bingham, Chief Financial Officer. Thank you. You may begin.

[Douglas Bingham:]

Thank you for joining us today for our fourth quarter results and business strategy update conference call. I am joined by our 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, 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 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 and in the appendix of this presentation.On today's call, I will begin with a review of our quarter and full year performance. Michel and I will then discuss our new, long-term strategic road map, where we will provide a holistic update on our new operating model and our critical objectives underpinning the exciting path for our company moving forward.We have begun to make significant changes in our business. Our fourth quarter results on Slide 5 set the stage for what we view as the hurdles to overcome through a range of initiatives in coming years. During the quarter, we faced pressure on multiple fronts while managing to perform in line with our expectations. Net sales were down compared to the prior year quarter due to several factors. We experienced share loss in some categories, particularly in residential, where we have the most work to do to better serve our customers' needs. Mix was adversely impacted by lower relative LVT sales. We will discuss today the factors in our control to more effectively gain back share and some of the positive signs we are already seeing from customers who have wanted Armstrong Flooring to succeed that have not been served appropriately. The decline in adjusted EBITDA was primarily due to lower net sales as well as higher manufacturing costs and other operating inefficiencies. This was partially offset by benefits from improved raw material sourcing.Looking at our full year results on Page 6, we experienced unfavorable volumes and product mix throughout 2019. Roughly half of the decline in sales was attributable to increased channel stocking in 2018 as a result of anticipated tariff increases. This was further compounded by distributor challenges and share loss, particularly in residential. Full year adjusted EBITDA was impacted by lower net sales and higher input cost inflation pressure related to tariffs. These costs were partly offset by improved productivity and SG&A benefits. As a reminder, SG&A benefited from additional income associated with our transition service agreement from the sale of our Wood business as well as lower expense for incentive compensation.Turning to free cash flow and liquidity on Slide 7. During 2019, we invested $29 million in CapEx and operating cash flow was modestly negative. While we effectively drove down working capital according to plan as we move through the year, the unusually steep first quarter outflow was difficult to fully overcome. As a reminder, the timing of operating cash outflows over the past 2 years resulted in relatively strong free cash flow in 2018 compared to an outflow of free cash in 2019. In addition, we incurred roughly $13 million related to executive transitions and other nonrecurring cash costs. We ended the year with a strong balance sheet to support our strategy. In addition, in the fourth quarter, we completed the replacement of our prior credit facility with a new $100 million asset-based facility. This new credit structure provides us with better flexibility to invest in initiatives and growth opportunities that make sense for our business and align with our multiyear strategic road map. During the fourth quarter, we began to execute our plan to expand, simplify and strengthen our business to generate stronger performance and augment the trajectory of our long-term profitability.I will now turn the call over to Michel to walk through our strategic business update and provide context behind the decisive actions that we are taking to help our company achieve its full potential in coming years.

[Michel Vermette:]

Thank you, Doug, and good morning, everyone. Over the past 6 months, we have thoroughly reviewed our business and strategic direction. The plan we will detail today reflects both the areas of strength in the business that we believe we can build upon as well our diagnosis of the root causes of some of the most critical issues the business has faced that our plans seek to remedy.We have already begun to execute on the multiyear plan announced today, this includes expanding our customer reach and modernizing our processes as well as optimizing our product portfolio and production footprint to better serve our end markets. And to do so more profitably, some examples of actions we already taken are

[Douglas Bingham:]

Thank you, Michel. I'll begin with the revenue drivers to support our road map on Slide 27. And as we look to reengage with our customers to drive top line growth, there are several factors that we have taken into account. First, we have established relationships in key commercial verticals, where we will continue to invest. In addition, we will partner with major customers such as the builder multifamily channel to deliver the consistent services they need to run their businesses. Finally, all of these customers already know and trust Armstrong Flooring, so it is important that we stay current in our product offering and time to market. It all comes down to providing the best products and services that our customers want and we believe this will enable us to grow sales.Looking at Slide 28, our incremental direct sales model will come with higher margins but there are other initiatives we will execute on to improve our gross profit. First, as Michel mentioned earlier, we have taken action at 2 plants to consolidate production and increase our utilization. We also began a strategic assessment of our South Gate facility to explore monetizing that asset. In addition, as we discussed on our last earnings call, we are working to update our pricing approach. This is a sensitive topic for competitive reasons but at a high level, we are reducing complexity for both our customers and ourselves. We are simplifying our product offering in declining categories, particularly residential sheet and VCT, which will allow us to run our plants more efficiently and raise customer satisfaction. Finally, we are developing new logistics capabilities to better serve our customers. In many cases, our current logistics approach is based on capabilities that are outdated and the technological developments in that space provide us with the opportunity to simultaneously improve our service levels, reliability, feed and grow margins. When we benchmark ourselves with the competition, we believe that AFI has a long way from the gross margin that a business with our brand recognition and commercial mix should have. Our improvement plan focuses on realizing that significant potential.Turning to SG&A on Slide 29, to facilitate the various improvements we have discussed, we are looking to make several key investments. First, we need to put the right sales team in place that can serve our existing customers as well as direct accounts that we don't currently do business with. We also need to invest wisely in marketing our brand, especially with younger generations, where there is a significant market opportunity. Our business transformation will be helped by 2 important factors. First, we are looking to reduce the lease expense for our corporate headquarters. Second, we have aligned our incentive structure to focus on profitable growth, so that we can set the foundation for enhanced margins.Furthermore, as we mentioned previously, many of our processes and systems are old and inefficient, which not only increases costs but also adds complexity. One implication is that our control environment is very complex. And as you will see in our 10-K filing, we identified and reported a material weakness in internal controls related to information technology general controls around a specific type of customer rebate program that we use. I can tell you that there have been no misstatements identified in the financial statements as a result of these internal control deficiencies. Remediation efforts have begun but the material weakness will not be considered remediated until the applicable controls operate for a sufficient period of time and we conclude through testing that the controls are operating effectively. We expect the remediation to be completed by the end of fiscal 2020. As we modernize our systems and processes, we expect this will further improve our control environment and allow us to capture operating efficiencies, helping us to more effectively manage costs.In regard to working capital and CapEx on Slide 30, there are a few key areas we are focused on. First, as we discussed earlier on the call, we are looking to reduce inventory in declining categories and build inventory in growing categories. We also expect to increase our receivables as we sell more product directly to retailers and contractors, in some cases, with longer terms than our current average. We are also looking to initiate targeted capital investments in areas such as recycling capabilities to meet customer needs and reduce cost as well as back-end systems to enable greater operating efficiencies.We expect to facilitate these key investments in 2 ways. First, we are looking to monetize noncore assets such as the South Gate facility we mentioned earlier. Also, we have closed on a new $100 million ABL facility, which will provide us with improved operating flexibility to invest where we need to in order to grow our business.Looking at our financial path forward on Slide 31, the challenges we are facing have been building over time and we know that it will require a lot of hard work to improve our results. We have already begun to take action in some areas, like improving the reach and capabilities of our sales team. The reaction of large residential and commercial customers have been very positive. Accordingly, in 2020, we expect to see improvements in our top line for both volume and price mix as well as improvements in gross profit margin. These improvements will be offset in 2020 by the investments required to create a long-term growth engine. In addition, certain 2019 SG&A benefits that we discussed on our previous call will not repeat in 2020. Therefore, we expect a significant percentage decline in our adjusted EBITDA dollars and margin in 2020 compared to 2019.As we continue to make meaningful progress on our initiatives, the benefits will grow and we expect our EBITDA dollars to be higher in 2021 than 2019, driven by top line growth and productivity generated by our actions. We also expect that our EBITDA margin will improve in 2021 compared to 2019 and each year thereafter as accretive initiatives and investments drive meaningful benefits to results. Given our current low valuation, it will be important that we improve the fundamental health and trajectory of the company. And this will be reflected in top line and gross profit improvements. We will be judicious in our pace of investments and pay particular attention to cash usage. We expect to consume cash over the next 2 years. However, we believe that we can monetize noncore assets to help fund our growth initiatives. As we move into 2022 and beyond, we expect to once again generate positive free cash flow as we restore EBITDA to healthy levels.I'll highlight some factors to keep in mind for the first quarter. The 2019 SG&A benefits that I referenced earlier, totaled around $20 million, with roughly 2/3 of that in the first half of 2019 and 1/3 in the second half of 2019. Separately, we directly serve the China market and also have portions of our supply chain in Asia. The coronavirus epidemic is truly tragic and we are doing all we can to keep our regional employees safe. Based on what we know so far in the first quarter of 2020, we expect to see a $6 million to $8 million unfavorable impact to sales and a $2 million to $3 million adverse EBITDA impact due to lower sales in China. Beyond the first quarter, we are likely to experience some supply chain disruptions for our U.S. operations, with some but not all of our suppliers, having started production again. Transportation is improving and our own plant is running but not yet at full capacity since all our employees have not yet returned. We are working to find alternative products in the U.S. market, which should help to offset part of the impact. That said, the full coronavirus impact to our 2020 performance will depend on the magnitude and duration of this epidemic, which remains unclear.Like any business transformation, we expect that there will be challenges along the way. And it is important for us to stay focused on creating long-term shareholder value rather than managing to the quarter. Accordingly, beginning in 2020, we will no longer provide annual guide ranges as we have in the past. Instead, we will provide an update on the key metrics that are important to delivering our strategic plan. In closing, we believe the steps we are taking should create enhancements that will allow us to drive value for our shareholders in coming years.With that, I'll now turn the call back over to Michel for closing remarks on Slide 32.

[Michel Vermette:]

Thank you, Doug. We have provided you with a clear road map for our company in coming years. It begins with repositioning our culture for constant improvement and empowerment. To reiterate the core enhancement of our new operating model, we are putting the customer first by aligning our services to meet their needs in the ways they want. We are realigning our go-to-market model to operate in every channel, to better reach underserved areas such as builder, multifamily and some key national and global accounts. Becoming an industry leader in product innovation to differentiate the Armstrong Flooring brand while carefully evaluating our participation in unbranded or private label opportunities. Simplifying our processes to fit the size of our company to become more competitive and efficient. Implementing system changes across our plant network that allow us to improve our operations, drive down costs and reignite organic growth. And finally, in investing thoughtfully with a return-focused mindset supported by an improved incentive structure.We are confident these actions will bring stronger performance to our organization in the coming years and should allow to generate greater value for our shareholders in the future. In conclusion, and to reinforce the key points we want you to take away from today's call, we believe we are laying a sturdy foundation to build on our growth pillars of expanding, simplifying and strengthening our business in the years ahead. We have a large and addressable market opportunity in the commercial and residential flooring spaces, combined with solid positioning in attractive geographies and product categories and a market-leading brand. I'm confident that our company will become leaner, more agile and more profitable through our multiyear road map to transform and modernize the way we do business. With the full support of the Board, our team is highly aligned with our long-term plan and incentives to get it done. Thank you, again, for joining us today, and we look forward to updating you on our progress during our next quarterly call.Operator, please open the lines for questions.

[Operator:]

[Operator Instructions]. Our first question is from Michael Wood with Nomura Instinet.

[Michael Wood:]

Thanks for outlining the strategic plan. On that topic, can you talk about the CapEx and SG investment that's needed as well as just management capacity in general? It sounds like you're doing a lot and I've seen companies in the past move too quickly and suffering some short-term disruption. So just if you can talk about how you're going to manage all these changes to ensure the relationships remain steady.

[Michel Vermette:]

So Mike, thank you for the question. This is Michel. I'll take the management bandwidth one. I think we have a key set of priorities listed, to your point. I think we're going through a process of triage, what makes sense and what does not make sense and we're going off priorities. Obviously, engaging with customers is right on top of that. And I think that's to correct our top line growth and our gross margin growth. So those are, first and foremost, I would say there's a lot of -- we're doing a lot of things, but also -- and everything also ties together to support the go-to-market. So we're hopeful and we like also the early feedback we're getting on those activities. But we're very conscious of that and watching that carefully to make sure we put our energies on the areas that have the most impact, so -- and we'll adjust accordingly. So we're very much on top of that all the way through. And we brought in some new talent also that helps us execute in these areas. So we're complementing the team with the right skill set to execute these activities.So I'll turn it over to Doug for the SG&A and capital component.

[Douglas Bingham:]

Yes, Mike, as we think about where we're going to invest, clearly, the top line has been the challenge historically and that's what we want to focus on in driving some improvement there in the gross profit, which is why the SG&A increases that we've been talking about have really been focused in the go-to-market space, places where we can get a quick payback. We're cognizant of the constraints that we have, both for time and money on these investments, and so we're being judicious in the way that we pace them. The same goes for CapEx. Michel and I look at each capital project as it comes up and make that decision of, "Is this something that is going to have a quick payback for us? Or is this something that we need to delay until a future date?"

[Michael Wood:]

Okay. And as you've reached out, like you talked about in prior calls to distributors to help shape your plan, can you just share with us some of the top feedback that you received in terms of what they were asking for to help stabilize or improve wallet distribution?

[Michel Vermette:]

We've had very candid conversation with our distributors. I must say, I'm very happy with their support of some of the decisions. They do realize in some areas, we -- they were not participating and we were not participating in our prior go-to-market strategy. So they've been -- as we've been very open with them, they've been very supportive in this area.Also, I'm happy to say that as we're introducing new products, they have been supportive and making commitments to stock in this area. So I think -- and the other piece is we made some key investments in people, in products that they recognize and know, and they're encouraged by what we're doing product-wise. I think, let's face it, for them and us, overall, having a great product line helps cures a lot of challenges. So they're very happy in the direction we're taking on the product side, in particular.But we keep evolving. We keep discussing with them things we can help each other. And I think we're both mutually really important to each other, so we need to be accretive and supportive of that and I look forward to what we can accomplish this year and the years to come.

[Michael Wood:]

Great. Just if I can sneak one more in, when -- I know it's early but when your strategy is complete, do you have any sense, at this point, in terms of what you'd be targeting for a longer-term EBIT margin goal?

[Michel Vermette:]

I think there's been this question on the company of when we reach a 10%-plus EBITDA, and I think I mentioned earlier in the previous call, I'm totally convinced that can be done. That better. We have some issues we need to fix now. We're addressing those. But there's nothing limiting us from doing that. But unfortunately, that hasn't been the path of the company in the past. And we're addressing that, and that can definitely be done or better.

[Operator:]

Our next question is from Justin Speer with Zelman & Associates.

[Justin Speer:]

I just wanted to make sure I understood the answer to the previous question. In terms of the SG&A investment growth versus 2019 required in your strategic plan for 2020, can you give us some kind of a baseline to think about for the initiatives? Because recognizing that I know there's a lot of moving parts, but the headcount initiatives that you have, what kind of SG&A investment growth are you expecting year-over-year?

[Douglas Bingham:]

We're not providing specific details on the magnitude. What I will tell you is that the SG&A investments that we make will be self-funding this year. So as we add additional sales folks or other roles like that, we expect that we'll have gross margin improvement to offset the cost.

[Justin Speer:]

Okay. And then in terms of the drive towards LVT and your mix of business, just what will be required from a sourcing standpoint to drive towards that improved mix there, recognizing that you do produce flexible LVT internally?

[Michel Vermette:]

We do. So we produce flex, and that's definitely with the current circumstances in the marketplace. That's a big plus. We also have key relationships outside of China that we're leveraging to bring product in also. So I think it's going to be a combination of rigid and loose line to go through. So we have the opportunity to do some of that here soon. So we're working through that. And I think that's making sure we're using our assets for the most profitable type products.And I think the other thing we're doing, we're also investing in working capital. When we started this process, we adjusted some inventory levels of areas we were not participating in the way we should. And so we have made some net working capital investment starting in the fourth quarter, and that will help us for the rest of this year also. So we started adjusting that mix in the fourth quarter, which will benefit us for 2020.

[Justin Speer:]

Okay, okay. And then in terms of, I guess, in terms of the cash generation expectations, and I know you're looking for outlays in the next couple of years possibly. But what are the leverage requirements of your refinance credit facility? Just give us a sense for any risks there that we need to be aware of?

[Douglas Bingham:]

The ABL structure is really tied more to availability -- remaining availability on the facility. So it's a $100 million facility. And as is standard with a lot of these asset based loans, if you get to the point where you've used all but 15% or somewhere in that range, that's where it becomes problematic.

[Justin Speer:]

Right. And then last question for me, just the near- and intermediate-term impact to your portfolio from the removal of Click LVT tariffs. And separately, maybe help us understand what went to your math on the coronavirus impact?

[Douglas Bingham:]

Sure. So the impact of the exclusion on the Click products, it's got kind of a 2-pronged effect. One is that we've been able to recognize lower import costs but then we've also turned around to our customers and provided that benefit back to them. So we're still working through the exact details, and this program is scheduled according to the administration to end in August. So we'll kind of have to see how that dynamic plays out.So on the coronavirus, what we've seen is that our China operations were down for an extended period, given government restrictions on travel, our plant is now up and running, not at full capacity, but up and running. And so the overall Chinese economy, there's not a lot of construction activity going on right now, obviously. And so that's where we've seen the main impact. As I mentioned earlier, we do expect that there will be some impact to sourcing product into the U.S. from China. We're still working with our suppliers to understand where they're at and their ramp-ups and when we can start getting product. And in the meantime, we're looking at domestic alternatives that we can sell in the marketplace to help our customers meet the needs and deadlines that they have.

[Michel Vermette:]

And I would add that transportation is a key issue. We've been fortunate that our team have secured sailings, and we are getting product from both our vendors and our facility, so that's definitely a positive. The team has done a great job dealing with that challenge. So we're staying on top of it daily and focused on it. And -- but the team has responded very, very well under difficult circumstances.

[Operator:]

[Operator Instructions]. We have no further questions at this time. I would like to turn the conference back over to Michel for closing remarks.

[Michel Vermette:]

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

[Operator:]

Thank you. This does conclude today's conference. You may disconnect your lines at this time, and thank you for your participation.