Armstrong Flooring, Inc.
Q3 2018 Earnings Call Transcript

Published: 10 Nov 2018

[Operator:]

Greetings, and welcome to the Armstrong Flooring, Inc. Third Quarter 2018 Earnings Conference 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. I would now like to turn the conference over to your host, Doug Bingham, Vice President of Treasury and Investor Relations.

[Doug Bingham:]

Thank you for joining us today for Armstrong Flooring's Third Quarter 2018 Earnings Conference Call. Today's call is hosted by Chief Executive Officer, Don Maier; and Chief Financial Officer, Ron Ford. 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 Investor Relations section of our website at www.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 statements 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 Don.

[Don Maier:]

Thank you, Doug. Good morning, everyone, and thank you for participating on our third quarter 2018 earnings call. Today, I will discuss our operating highlights and business activity. Ron will then cover additional details on our financial results and outlook before I offer closing comments. After our prepared remarks, we will open the call to answer your questions. Like to ask you to turn to Page 3, which provides some key highlights and updates. Third quarter net sales improved for the second straight quarter, with 7% growth in the Resilient segment, more than offsetting lower Wood segment sales consistent with our performance year-to-date. I am pleased with the ongoing progress that we are making in our Resilient business, largely driven by significant volume growth in Luxury Vinyl Tile, or LVT, and our unrelenting focus on innovation across the portfolio. Adjusted EBITDA grew 17.1% to 29.9 million, generating 140 basis point improvement in adjusted EBITDA margin to 9.7%. We are achieving productivity gains, cost savings and SG&A reductions through our strategic priorities, along with higher selling price across most product categories, reflecting a number of 2018 pricing actions. Taken together, these combined actions have effectively mitigated the intense inflationary pressures evident across the entire flooring industry. We believe we are taking the right steps to build value in our company through all avenues. We are committed to investing in our business to generate solid returns. The return on our investments has been most evident in Resilient where our LTM margins have steadily improved since 2015. I'll now move on to strategic priorities on Page 4. Our five strategic priorities include LVT leadership, innovation, share of wallet with distributors, enhancing Wood profitability and revitalization of our legacy categories. We are actively working to improve our competitive position and drive transformative growth as we have demonstrated in our Resilient segment year-to-date. I will now share some updates with you. In LVT, our new product introductions and expanded supply capabilities are driving sustained double-digit volume gains. We continue to expand our existing portfolio, especially domestically produced LVT, where we believe there are meaningful opportunities following recent tariff developments. We have seen renewed interest in our domestically produced LVT offering, including such new products as American Personalities made in Oklahoma and design-leading Alterna, produced in Illinois. In Pennsylvania, we produce Vivero and Natural Creations featuring our Diamond 10 Technology. Beyond these products, we have an exciting pipeline in the next generation of LVT, and we plan to continue to invest in our broad and compelling portfolio of high-demand products. In all of our flooring categories, innovations in durability and design is central to our strategy. Our proprietary award-winning Diamond 10 Technology is generating results in 5 key categories, which collectively represent over 80% of our sales. In May, we announced our most recent launch of Diamond 10 Technology on Vinyl Composition Tile, or VCT, which offers lower installation costs and enhanced scratch and stain resistance, leading to a lower total cost of ownership. To date, the market response has been strong and our distributors continue to be excited about the potential of this innovation to revitalize the category. We have completed test installations with key commercial customers which should provide further evidence to the industry of its value. In distribution, we are focused on gaining additional share of wallet in aligning ourselves with partners who are best positioned to support our growth strategy. As previously announced, in the third quarter, we began to allocate more of our marketing spend to commercial and national accounts, where we believe we can better leverage our scale. Our commercial exposure is almost entirely in Resilient, so the benefits of that shift will be more pronounced in that segment. In turn, in residential, we have empowered our distributor partners to directly market and merchandise our residential products to better serve local customers at a lower cost and higher margin. The shift is underway with distributors working on merchandising to support sales of our residential products, and we continue to expect the full transition to be completed by year-end 2018. In our Wood segment, we have been pleased with the expansion of our margins, but recognize that there is still more work to do. We have slowed down the rollout of the licensing program discussed on our last call given the uncertainty around tariffs imposed on Chinese imports. However, we expect that the tariffs will also have a favorable impact on the overall engineered wood category, where low-value imports have been problematic and our domestic operations position us well. In addition, we continue to work to make our manufacturing more efficient and creating new on-trend product offerings. In all of our legacy categories, we're actively revitalizing our portfolio, improving capacity utilization and driving productivity at our plants to more effectively compete in our markets. We will continue to pursue more product innovation and productive selling efforts, which is helping us to move closer to our medium-term margin goals. Armstrong Flooring is poised to strengthen its position as a leader in hard surface flooring. We are driving improvements across our products, channels and operations. We are better situated than ever to drive sales by providing an even more competitive lineup of winning products. I'll now turn of the call over to Ron to walk through the details of our financial performance.

[Ron Ford:]

Thank you, Don, and good morning to those on the call today. I'll begin with a review of our financial results on Page 5. Total revenues were stronger year-over-year. Resilient had a good quarter with net sales increasing 7% to $208.1 million. This was primarily due to strong growth in LVT and better prices across many categories in response to inflationary pressure. In LVT, we generated double-digit volume growth resulting in a positive impact to sales mix. Additionally, as planned, and similar to the first half of 2018, the migration of a portion of our laminate sales to a licensing model generated lower reported sales, albeit at more attractive EBITDA margins for that category. This margin accretive laminate licensing transition will occur through the remainder of 2018. Wood segment net sales remain challenged with volume down in both solid and engineered wood, partially offset by higher pricing. Challenges in engineered reflect continued industry pressure at the low end from import competition similar to recent quarters. We anticipate that tariffs will alleviate some of this pressure in 2019. To that point, let me take a moment to discuss our updated thoughts on the potential impact on our business from the recently implemented tariffs on flooring. We are primarily a domestic manufacturer with 75% of our sales in 2017 coming from product that we produce. This model provides us with some natural insulation from trade disputes. LVT and engineered wood are the largest categories where we import a meaningful amount of product. We believe most peers source heavily from China. We've raised prices on imported product effective October 1 in response to the first round of tariff increases, and we proactively announced further increases effective January 1, with the expectation that tariffs will increase as announced by the administration from 10% to 25%. This may have a larger impact on customer buying behavior across the overall market. And we'll provide continued updates, as appropriate, as we monitor trade developments. Total adjusted EBITDA increased by double-digit percent for the fourth consecutive quarter, up 17.1% or $4.3 million to $29.9 million compared to the prior year quarter. The increase in adjusted EBITDA was driven by productivity gains, lower manufacturing and SG&A costs, stronger mix and better pricing, which combined to more than offset intense inflationary pressures. We continue to experience cost increases in energy, transportation, raw materials and operating costs, which we expect to continue rising into 2019. We've implemented additional price increases of 3% to 5% on many Resilient products effective in October. Lumber costs have begun to level off in the third quarter, although they're still significantly higher than last year. Our team has done a great job in anticipating and overcoming the challenges inflation. We expect the impact of these pricing actions in Q4, combined with additional productivity gains and other cost savings, will help to offset continuing inflationary pressures. Turning to our free cash flow and liquidity on Slide 6. During the first nine months of 2018, we experienced approximately $6 million outflow of cash. This is primarily related to the timing of planned inventory spend combined with higher receivables as distributors build inventory at quarter-end. CapEx remains below depreciation, which has an annual run rate of approximately $50 million. Based on the timing of working capital investments, we anticipate 2018 free cash flow will be in line with levels achieved in recent years. We ended the quarter with a strong balance sheet, consisting of $55 million of net debt. This gives us significant flexibility to invest in ongoing initiatives and pursue additional growth opportunities to invest in a range of value-enhancing opportunities. Now turning to our outlook on Slide 7. We're encouraged by our stronger results year-to-date, particularly in Resilient, which has helped offset challenges in Wood. With our increased visibility into year-end, we are narrowing our outlook for adjusted EBITDA, which we now expect to be in the range of $72 million to $78 million for the full year 2018. Our sales outlook is unchanged, although we expect some volatility in the quarter based on the higher-than-normal inventory levels at distributors and the potential for buy ahead of imported products in anticipation of the tariff increase in January. For the full year 2018, we continue to expect sales growth in the low-single digits, primarily driven by growth in Resilient. We expect capital expenditures to approximate $40 million for the year, which is at the low end of our prior range of $40 million to $45 million. Maintenance CapEx should be approximately 2% to 2.5% of sales, with the balance of the spending budgeted for high-return investments consisting of productivity projects with short paybacks or innovation projects where we expect a strong return. On the P&L, our effective tax rate could change significantly from quarter-to-quarter, but it's worth remembering that we expect our full year cash taxes to be zero as a result of federal NOLs. We anticipate that 2018 will be another year of positive free cash flow in line with recent years. With that, I'll now hand the call back to Don for closing comments.

[Don Maier:]

Thanks, Ron. Turning to Slide 8. I am very proud of the Armstrong Flooring team for delivering improved bottom line results during the third quarter and year-to-date, especially in the face of rising cost inflation and tariffs. We are excited to enter 2019 with a more profitable operation and clear path for additional success. Investments in LVT, Diamond 10 Technology and other product innovations, along with strengthened distributor partnerships, operating efficiencies and cost reduction actions provide us with a very exciting catalyst to realize our goals. We believe we are on strong footing today to build upon our strong brand and market leadership to drive shareholder returns and achieve a 10% EBITDA margin by 2020. Operator, we are now ready to take questions.

[Operator:]

[Operator Instructions]. Our first question comes from Mike Wood, Nomura Instinet. Please proceed with your question.

[Mike Wood:]

First, I wanted to ask about how -- you mentioned the LVT demand impact from the price increases. How are you thinking about measuring that demand impact? And any thoughts in terms of whether that flows share gains in LVT against other flooring categories?

[Don Maier:]

Mike, thanks for your question. So first of all, on LVT, we're very pleased with the progress we continue to see there in the growth, driven largely, we believe, by not only the expansive product introductions that we've added to our portfolio, but also with some of the proprietary innovation that is included on the products. We do believe that as the announced tariffs came out at the end of Q3, that, that did drive some buying behavior towards the end of the quarter. Having said that, as you know, the announced tariffs increase to 25% January 1, and so it would be reasonable to anticipate a similar sort of surge in the fourth quarter. So having said that, we're pleased with the progress we've made on the gross side. We announced and have implemented the increases consistent with the tariff, and we've announced that we're going to do the same thing should the 25% tariffs be implemented January 1.

[Mike Wood:]

Can you give us a sense of how large effectively the prebuy was in LVT? Whether or not you stocked up inventories well in anticipation? And are you hearing of the China LVT supply chain adjusting to maybe moving to other countries in Asia in order to avoid tariff impact?

[Don Maier:]

So I prefer not to provide any quantification for competitive, sensitive reasons. We've been bringing in additional inventory because of the demand for our new products. And obviously, those orders had been placed months and months before the announced tariffs. So we do believe that our distributors appropriately took advantage of the fact that they could buy ahead of the 10% tariff, but would not want to quantify that further for you. As it relates to the supply chain, yes, there are other options external to China and a number of our suppliers and others in China have announced their plans to broaden their base beyond China to alleviate the impact of the tariffs. We've really been focused on two things in addition to taking the appropriate pricing actions which is leveraging the domestic capabilities that we have on LVT out of our three manufacturing facilities here in the U.S., and as well all of our other Resilient products, the relative value of those products has improved given the execution of the tariff and price increases associated with it. So we have a full blitz taking place on all of our sheet and tile products beyond our LVT offering that are all produced here domestically and not susceptible to the tariffs.

[Mike Wood:]

Just finally, any progress on the decision in terms of swapping some of the wood capacity out for LVT? And do you hold off maybe to see how demand is impacted by the tariffs before making that decision?

[Don Maier:]

Yes. We're obviously watching the impact of the 10% tariff on engineered wood, which is continued to be pressured by the Asian imports largely coming out of China. And we see an opportunity for us given that about 80% of our engineered products are produced here in the U.S. So we have a large amount of capacity here. And certainly, as the tariffs increase to 25%, we think that dynamic could create some opportunities for us.

[Operator:]

Our next question comes from Keith Hughes, SunTrust Robinson Humphrey.

[Keith Hughes:]

Can you tell us on LVT, how much are your LVT is produced domestically now versus how much is imported? And where those imports are coming from?

[Don Maier:]

Yes, Keith, so we -- what we've disclosed are 2 things. In 2017, our total sales of 75% of them were produced domestically. On LVT, we certainly supply -- depend more heavily upon our suppliers. And what we've disclosed there is that we purchase about 2/3 from sourced parties and produce about 1/3 ourselves.

[Keith Hughes:]

And are the -- is the 2/3 sourced, is that primarily from China?

[Don Maier:]

It includes China, but -- yes, primarily is China.

[Keith Hughes:]

And can you give us any sense for how big LVT now as a percentage of Resilient or rough dollar figure or something like that for the company?

[Doug Bingham:]

Yes, Keith, we've said in the past that for 2017, LVT represented 25% of our Resilient segment. We've continued to see strong growth in LVT. We haven't provided an updated number, but you can probably make some assumptions and get to your own conclusion on that.

[Keith Hughes:]

Okay. If you look at the other categories within Resilient in the quarter, and I think specifically of VCT, but in general, were any of the categories up in volume? Or was LVT the only one?

[Don Maier:]

Yes. We saw growth in all -- almost all the categories, Keith, but the most significant growth, as has been consistent for the past several years, has come out of LVT, where we once again saw significant double-digit growth in that category, really being driven largely on the rigid-type structures. Although still seeing nice growth on the traditional flexible LVT as well. So I'd say in ranking of order, the Rigid Core products explosive growth, very impressive growth on the flexible LVTs and then kind of consistent market growth rates on our other categories.

[Keith Hughes:]

Okay. The volume for Resilient was reported as effectively flat, negative 0.24% year-over-year. So if LVT is up, something has got to be down to get to that number.

[Don Maier:]

No. Resilient, Keith, was up 7%.

[Keith Hughes:]

Just on the volume.

[Don Maier:]

Just on the volume, just -- got you. Okay.

[Keith Hughes:]

So in terms of volume, I assume LVT volume was up really big too, sounds like pricing is okay in that. What categories are struggling on volume right now?

[Don Maier:]

I'm looking to Doug to...

[Doug Bingham:]

The main one, Keith, has been red sheet.

[Keith Hughes:]

Red sheet.

[Doug Bingham:]

It's getting to be a smaller piece of the business, but it still continues to decline.

[Keith Hughes:]

And then switching to Wood Flooring here quickly. If we do get the 25% tariff, are there other large sources of engineered hardwood supply that would easily supplement Chinese or is it that not quite as easy to do?

[Don Maier:]

So there is certainly within our plant capacity, we have the capability to add additional crewing. So we see an ability to satisfy the demand on our side and there is a significant domestic supply chain within North America on the engineered side as well. In addition, we have seen a continuation of the supply chain expanding beyond China into Southeast Asia.

[Operator:]

[Operator Instructions]. Our next question comes from Alvaro Lacayo, Gabelli & Company.

[Alvaro Lacayo:]

All right, so just 2 quick questions. One, I wanted to get an update on the plans for licensing in the engineered wood. Maybe you can comment -- with the tariffs that are projected to come on, does that change the math a little bit or the timing of when you decide to do that? And then secondly, the amount of losses, the magnitude of losses in the business that you're looking to transition over to that licensing business, if you can remind me what that number is in terms of magnitude?

[Don Maier:]

Yes. So your first question, we have slowed down what we were planning to do as far as rolling out the license program. And frankly, I think, we need to get to the other side of January before distributors and retailers understand what is going on with tariffs and what the implications are there. Frankly, while that's a slowdown of our licensing program, it could be a significant benefit to our domestically produced products given a rather significant swing in the economics with the 25% tariff. So realistically, I think we're going to be -- we'll let the dust settle out in Q1 and understand where we're at. We have the licensing plans, the agreement, everything is done, we just need to understand what is going to be the playing field here as it relates to the tariffs. And no, we haven't provided any guidance on the size or impact of that. And given my prior comment around this, it would have probably not be valid any longer given the change in the macro environment here with tariffs.

[Alvaro Lacayo:]

And then maybe if you'd make comments year-to-date on price realization, maybe talk about, across the portfolio and -- or on a consolidated basis. And then with the tariffs, assuming the tariffs do move up to 25% in January, what kind of -- what's the magnitude of price increases that you're thinking about? Or in terms of dollar amount, what's the impact to your costs from a dollar amount assuming tariffs go up to 25%?

[Don Maier:]

Well, this is an area that I'm particularly proud of our team. As you know, we took decisive pricing actions back at the end of the first quarter as we saw the inflation ramping up. And quite candidly have not seen the same level of support for the pricing actions that we've continued to take through the summer and then most recently here with a 3% to 5% increase on Resilient at the end of Q3. Having said that, we have not only been able to see and enjoy nice price realization, but we've also seen nice mix improvement and volume coming along with that. And I think it's a testament of, frankly, to the strength of the innovation and the differentiation that we've been driving in the portfolio, but as much as well a testament to the strength of our distribution network and their efforts to go make sure that we didn't have margin declines in face of the significant input cost inflation and freight inflation, notwithstanding now the tariff inflation that's coming through as well. So I think it's been a combination, an all-out team effort here with our distribution partners and their retailers as well as with our sales team and the product differentiation in our portfolio.

[Alvaro Lacayo:]

So from a number's perspective, what's been the pricing realization year-to-date? And what's the incremental cost if the tariffs go to 25% that you'd have to sort of offset via the tools that you have in your toolbox?

[Ron Ford:]

This is Ron. I'll take that one. Well, without disclosing a specific number, let's just say that we've been -- we went into the year anticipating some inflation in our guidance for the year. We saw more inflation than that, we've been able to still stay within our guidance after having taken the actions that we've taken that Doug -- that Don described. And so as Don mentioned, we're pleased with our ability to get -- to anticipate and get on top of the incremental inflation for this year. Of course, relative to next year and the -- I'll also say relative to this year, it's my sense that across-the-board, the entire supply chain absorbs some piece of all of that tariff and inflation during the course of this year. I expect that to a lesser extent next year. And so it remains to be seen if those tariffs will stay in place, but if they do, as we've announced, we intend to recover those costs.

[Operator:]

Our next question comes from Dillard Watt, Stifel.

[Dillard Watt:]

Wondering if maybe we could talk a little bit about where your expectations might be for incremental margins next year, particularly, if you do get a fair bit of pickup in volume on the engineered wood side, which, as we've gone through the last couple of years, I think, embedded in your guidance is some assumption that volume is sort of been flat or slightly down there due to all the imports. But if there is a significant change that goes the other way, how would that shakeout in the incremental margin next year?

[DonMaier:]

Well, margin expansion's an important part of our overall strategic plan and the actions that we have lying behind that. While we were disappointed in third quarter Wood revenue, we had very nice expansion with adjusted EBITDA going up over 25% in the quarter and 150 basis points improvement in the EBITDA margin. So continuing to make progress there, and it's all of the product introductions, mix improvements and other actions that we've taken on the innovation side of the equation that are allowing us to transition not only the wood category but the entire portfolio.

[Dillard Watt:]

And then maybe I'll be the one to ask the macro question. Are you seeing or hearing anything that's indicating we may be closer to moving towards a pause in the macro growth environment?

[Don Maier:]

So short answer is nothing on the radar right now. We saw really no change and fairly robust growth in new housing starts and remodeling. So on the residential side, that looks good, pretty consistent with where we've been. On the commercial side, we actually saw that tick up slightly better. So nothing on our forward-looking horizon other than maybe a little bit of encouragement on the commercial side of the equation.

[Operator:]

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

[Don Maier:]

Well, great, thank you, everyone, for joining us today. We continue to appreciate your interest in Armstrong Flooring, and we look forward to updating you on future calls on our progress. Have a great day. Thanks.

[Operator:]

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