Armstrong Flooring, Inc.
Q3 2016 Earnings Call Transcript

Published: 11 Nov 2016

[Operator:]

Greetings, and welcome to the Armstrong Flooring Third Quarter 2016 Earnings Call. At this time, all participants are in a listen-only mode. A brief 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, Mr. Doug Bingham, Vice President of Treasury and Investor Relations. Thank you Mr. Bingham, you may begin.

[Douglas Bingham:]

Thank you for joining us today for Armstrong Flooring’s third quarter 2016 earnings conference call. Today’s call is hosted by Chief Executive Officer, Don Maier; and Chief Financial Officer, Jay Thompson. We trust you have seen our third quarter 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 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 prior 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 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 presentation. Both are available on our website. Slide 3 explains our basis of presentation. Please note that we primarily measure our operating performance on a constant currency basis. We apply 2016 budgeted foreign exchange rates for the 2016 period and prior comparable year periods to exclude the impact of FX from our results. In addition to FX, adjusted EBITDA adds back non-core items such as restructuring charges, non-cash pension expense, and other large unusual items. A reconciliation of all non-GAAP adjusted metrics is included in the appendix of this presentation. With that, I will now turn the call over to Don.

[Donald Maier:]

Thank you, Doug. Good morning, everyone, and thank you for joining us today on our third quarter 2016 earnings call. In honor of Veterans Day, I’d like to take this opportunity to thank all the American men and women, who have served or are currently serving in our country’s military. The courage and strength that you all exude are qualities which deserve only our highest gratitude. Thank you to all of you. Today, I will discuss our operating highlights and business activities. Jay will then cover additional details on our financial results and outlook. After our prepared remarks, we will open up the call to answer your questions. Page 4 provides some key highlights for the quarter and year-to-date. Our focus on improving profitability is an integral part of achieving our medium-term goals. We are making significant progress internally to execute on this portion of our strategic plan. These operational enhancements were evident during the third quarter, in which we grew adjusted EBITDA by 25% to $30.4 million. This resulted in a 220 basis point improvement in adjusted EBITDA margin to 9.7%, which was helped by increased productivity and lower input costs. We are especially encouraged by our team’s ability to deliver another quarter of adjusted EBITDA gains, despite softer end markets and competitive price pressures in the quarter. In fact looking year-to-date, adjusted EBITDA is up $15 million or 27%, while our sales are up $19 million or 2%. Building on this operational momentum, we have more than doubled free cash flow to $28 million year-to-date. This is $18 million better than prior year. As a result we are steadily strengthening our balance sheet and making great progress on our goal to improve our free cash profile in 2016. I am proud of the fact that we delivered bottom line improvements, but we are also very focused on restoring our sales momentum. Although our third quarter sales were impacted by varying dynamics, we grew in target segments with above market growth in Luxury Vinyl Tile or LVT. This market category continues to represent an increasing mix of net sales with another quarter of double-digit growth, with particular strength in residential end markets, where we have gained share in the retail channel. Our strong LVT growth mostly offsets softer trends in traditional resilient categories, which continue to be challenged by slower commercial demand and shifting consumer preferences. In Wood, we are carefully balancing volume and price to maintain our share. During the quarter industry price pressures continued, but we held Wood price essentially flat. Volumes were adversely impacted by inventory reductions at two large customers. Year-to-date, our Wood sales were up 3.6%, with increases across all of our core selling channels and key customers. Overall, we have a lot more work to do to grow our revenue base, which has fallen short year-to-date compared to our initial full-year expectations. To that end, we believe the steps we were taking today, are getting us in the right position longer term to recapture share in our hard surface flooring categories. Restoring the positive momentum in our business beyond 2016 requires continuous innovation across all major wood and resilient categories. This is a key focus for us along with our other strategic priorities, which I’ll now discuss on Slide 5. As we mentioned on our last call, our team is dedicated to building value through our strategic priorities. To achieve our medium-term goals, I’ll walk you through some highlights of the steps we are taking to accomplish our objectives. We are investing in innovative products across our portfolio and are actively engaging with customers to stay ahead of trends. Residential LVT with Diamond 10 technology continues to enjoy good sell-through at retail. In the quarter we have also begun selling commercial LVT with Diamond 10 technology into select projects, and in the past month launched commercial sheet with Diamond 10 technology. These products will help us to win new specifications and new end-users in our targeted commercial end markets. As we move forward, our plan is to apply this technology to other categories in the portfolio, such as residential sheet where this innovation will give us a significant competitive advantage. In a category that has lacked meaningful innovation in the recent past. Applying Diamond 10 technology across our portfolio represents our first step to further leverage our innovation platforms, and extend our leadership position across the entire product portfolio. We’re also making progress in growing our share of wallet with distributors. Last quarter we took significant steps toward cleaning up our basis of sale, and leveraging our best-in-class distribution network to more efficiently serve the independent retail channel with local sales, service and logistics support. In turn, this will allow us to refocus our efforts on product and program innovations to help these customers grow their sales and profits. So far we have been pleased with the results as both distributors and retailers have responded positively. Retailers have seen improved support and distributor service at the store-level. Retail buying groups and other large retail partners has seen a renewed program commitment and our fall promotions are under way to support incremental demand through the channel. Most importantly, distribution sell-through rates are above market in the majority of our segments. These actions are just an example of the broader strategic steps we are taking to enable Armstrong Flooring to deepen customer engagement, and become the preferred choice for our distributors, and the retailers and other channel partners that we serve through this network. In our fourth priority, LVT, we are rapidly gaining share in this attractive category. Our new Lux LVT product with Rigid Core Technology is gaining significant traction. Customers like it, because it’s durable, and for its leading style and design. Retailers recommend it, because it’s easier to install compared to traditional LVT products, and because of the confidence that comes from knowing it’s backed by Armstrong Flooring, the leading brand in hard surface flooring. We continue to scale our production at our new state-of-the-art LVT facility, where we are producing premium LVT, while continuing to source traditional LVT from Asia. About third of our LVT growth this quarter came from products produced in our new operation. We are improving throughput, reducing scrap, and improving line speeds, all while adhering to our strict product quality standards. As a result, we remain confident that our LVT ramp-up efforts will positively contribute to the bottom line beginning in 2017, as we optimize our production processes. Looking at Wood probability and our fifth priority, there are quite a few moving pieces in our third quarter results, but our strategic initiatives continue to pay off. We are expanding our product portfolio to improve margins in price competitive segments, and adding offerings in premium segments to improve our mix of margins. And our ongoing productivity initiatives essentially offset the impact of softer sales in the third quarter. We have established a culture of continuous improvement and this is driving much of our productivity benefits. I would like to give you a couple of examples. In our solid wood plants, we have driven significant improvements in our drying processes. These gains have not only improved the finished product quality, but also have driven improvements in yields, scrap rates and cost. Similarly, we are using our lean principles in our engineered wood plants to achieve significant improvements in key processes such as our plywood press operation, which has resulted in flatter boards, which reduces scrap improves yield and increases throughput all while giving the customer a better product. That said, raw material lumber cost have been steadily rising for most of the year, and we are now higher than last year’s second-half lows. So we remain committed to improving our price commodity relationship over time. Our mid-June price increase, in both solid and engineered wood, was marginally successful and helped us hold Q3 price flat year over year. On the heels of rising lumber cost, we will continue to assess opportunities to implement additional pricing initiatives, amid a persistently competitive environment. With these strategic priorities, we continue to make meaningful strides to deliver on our medium-term goals. We may experience quarter-to-quarter volatility, but with our positive EBITDA margin trend, we are excited about the prospects for our business going forward. I’ll now turn the call over to Jay to walk through the details of our third quarter performance.

[John Thompson:]

Thank you, Don. Good morning to those participating on the call today. Beginning with overall operating results on Page 6 of the presentation, our third quarter and year-to-date results are consistent with our goal to improve adjusted EBITDA margin to 10% over the next three to five years. Third quarter highlights include

[Donald Maier:]

Thanks, Jay. I’ll summarize our call today on Slide 11. We are committed to profitably growing our Resilient and Wood net sales in target categories. As the North American leader in these hard surface flooring categories, we are excited to continue implementing our strategy to build value through driving our strategic priorities. Our operational, financial and organizational transformation is fully underway. We are making great progress on our EBITDA and cash flow expectations for 2016. We are capitalizing our brands, new customer relationships, and widening portfolio of innovative products. We are poised to achieve our medium term objectives. In the interim, we will continue to carefully balance volume and price to maintain our share and tightly manage our operations to deliver additional adjusted EBITDA improvements and cash flow. Operator, we’re now 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 Keith Hughes with SunTrust Robinson Humphrey. Please proceed with your question.

[Keith Hughes:]

Thank you. A couple questions, first within Resilient, you highlighted in the slide about $10 million from the manufacturing and input cost gains. Can you give us sort of the feel between those two, which was the larger driver?

[John Thompson:]

Good morning, Keith. Thanks for the question. It was a good amount of both productivity at the plants and input cost gains. I’d say they were both significant drivers of that year-over-year benefit.

[Keith Hughes:]

And if we look at those two, plus SG&A and other positive, how will those look into the fourth, will you continue to get benefits from those in the same rate?

[John Thompson:]

I think about the fourth quarter consistent with our revised guidance on sales and EBITDA. I think about general trends being fairly consistent. So on the Resilient business, we see some continued benefit year-over-year from an input cost basis. And in terms of spending specific to G&A, we’re going to continue to be prudent in the way that we’re spending G&A dollars in the business.

[Keith Hughes:]

And you highlighted the - I think, you said a third of your LVT growth was from your internal production. Was it the growth or the total LVT sales? I guess this is my question, I wasn’t clear.

[Donald Maier:]

Yes, Keith. This is Don. Good morning. The statement that I made in the opening comments refers to our growth for the quarter. So we’re excited to see the positive lift it’s giving us. But the predominant amount of our volume still is coming from our source product lines.

[Keith Hughes:]

And do you have a feel for the end of the year, what that mix will look like internal versus external?

[Donald Maier:]

Well, I don’t think we’re going to provide information to that level. What I can tell you is that the ramping up of the plant and the subsequent volumes that we’re selling are exceeding the expectations that we set out to achieve at the beginning of the year.

[Keith Hughes:]

Okay, thank you.

[Operator:]

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

[John Baugh:]

Thank you. Good morning, Don. Good morning, Jay. Congrats on a very nice margin in the quarter.

[Donald Maier:]

Thank you.

[John Baugh:]

I was wondering if you could dissect a little. So I guess the - you’re over indexed to commercial. And you mentioned some pressures there. So I’d love some color on what you’re seeing there. And then, how do we think about the pressure you’re seeing on the VCT line versus the - I think you mentioned that Diamond 10 is going into the commercial markets. I guess this is really a 2017 question. How do we see the yin and the yang from those two divergent trends?

[Donald Maier:]

Yes, John, I’ll take that question. Thank you for it. First of all, as we’ve been very proud of our history, we have at the number one position in all of our categories in our commercial business with the exception of LVT, which is an area that we are focused very heavily on. Because of the overweighting of the portfolio in the traditional segments, clearly those are muting the gains and growth that we’re seeing in the LVT part of the business. You’re right. Our strategy to really accelerate our growth there and to as well, I think, give a lift to our traditional categories centers around innovation. And so then I - that’s why I think it’s important that you understand we’ve now launched our commercial products in LVT with Diamond 10 technology, as well as in our sheet categories. So - and that will be a continuation you will see not only across our commercial portfolio, but also our residential portfolio products as well.

[John Baugh:]

So is there any thought, Don, on how that plays out next year in terms of a plus versus a minus? What are you seeing in commercial marketplace?

[Donald Maier:]

We’re seeing the overall commercial market actually softer than what we had anticipated. We’re not providing a view yet as what we were anticipating in 2017. But obviously, we’re excited about the investments that we’ve made on technology such as Diamond 10 to be able to grow meaningfully in those segments.

[John Baugh:]

And then maybe if you could comment on the vinyl sheet market and talk about trends within felt versus trends within fiberglass. I think you mentioned seeing price pressure there. Are you seeing price pressure on the fiberglass? And is vinyl sheet as a whole category growing, shrinking? I assume felt shrinking and fiberglass is growing, but I’m curious as to the net. Thank you.

[Donald Maier:]

Yes, you are correct in your assumption on the migration from felt to fiberglass. And we’re proud to be able to have capabilities in both of those categories. There are certain parts of the end markets, property management probably being one of the more prevalent ones, where there is a preference for the felt products, because of its performance characteristics. Having said that, as we indicated there’s been quite a bit of capacity brought on recently in this part of the product portfolio, and that’s creating very aggressive pricing dynamics out there, it’s a very competitive market. That’s why I’m excited, as we indicated in the last call that the next part of our portfolio that we’ll be bringing the Diamond 10 technology to - as our residential sheet products. And as a result we think that that is going to bring some real meaningful differentiation for us, frankly in a category that hasn’t seen much innovation in the recent past.

[John Baugh:]

And then my last question would be on - I think there was a reference in Wood to inventories being reset with a couple of large retailers. Was that due to slow sales in that category or a change from your side, where you working to support a certain product line. It looks to me like strategy in Wood is to - which I applaud - is to try to improve mix and keep price and not play in the base grade. And yet, you mentioned I think base grade with the home centers going up. So I’m a little confused.

[Donald Maier:]

Yes, I’ll address the inventory situation to large retailers. They were different drivers. One of them was a retailer where we had been enjoying special placement in the promotional area of their stores. And those promotional areas are now being turned over to the holiday season, and different products in that space. So as a result, it was a one-time adjustment as inventory that was sitting in those spaces was pulled out of the entire chain. It’s a one-time thing that we see when we get those promotional placements. The other was more of a strategic move by one of our customers to realign their inventory strategy, and again I see it as a one-time adjustment from them, and we’ve seen our sell through at both of the retailers to remain constant.

[John Baugh:]

Great, thanks for all of - answering all my questions. I appreciate it. Good luck.

[Donald Maier:]

Thanks, John.

[Operator:]

Thank you. Our next question comes from the line of Scott Rednor with Zelman & Associates. Please proceed with your question.

[Scott Rednor:]

Hi, good morning. A question on the 4Q guidance, Jay, it sounds like you guys feel pretty confident with the productivity and mix gains. But the EBITDA guidance for 4Q could imply you’re up or down versus the really nice growth you’ve seen year-to-date. So is there something unusual or unsustainable that shouldn’t occur in 4Q?

[John Thompson:]

Good morning, Scott, so 4Q about the sales and the EBITDA guidance is informed by the recent trends in the business that - particularly we saw in the third quarter. And based on top line performance in the third quarter, we’ve reduced our expectations for what the top line could contribute in the fourth quarter. That said, we’ve seen good gains in productivity. We’ve been frugal and spending specifically on G&A. Those are things that we plan to continue into the fourth quarter. But we’re not planning on a lot of help from the top line. Obviously going forward, our goal is to invest in the business to grow it. And that’s as we think about selling and innovation, those are areas that we’re continuing to spend in to grow the business over the medium term.

[Scott Rednor:]

And on that point can you may be split out the SG&A, the year-over-year leverage benefit, I mean, because on one hand you guys continue to talk about reinvesting behind the brands, but that’s obviously been a leverage area. So how do you guys think about that going forward?

[Donald Maier:]

So we think about our spending as really separating the S from the G&A. And so where we see attractive opportunities to invest in the brands, to invest in innovation new product launches, we’re investing in those things. But we’re driving as much productivity in G&A as we can. And the idea is to in the short-term really funnel those efficiencies into selling and innovation over time. As we grow the business, we expect that we will see some leverage in SG&A as a percentage of sales.

[Scott Rednor:]

And then just finally, maybe for you, Don, years ago the Wood business was a double-digit EBITDA margin business. I understand there is additional corporate allocation that doesn’t make that comparable. But realizing you now being running this business for an extended period of time and there continues to be competitive pressures, what’s the right margin profile that this business can get back to whenever things clicking on all cylinders?

[Donald Maier:]

Yes. I mean, well it’s a key part of our overall strategy, obviously, one of the five strategic priorities and tied in largely to as well our winning with distribution initiative as well. I’ve been very pleased with the progress that we’ve seen over the past several quarters. I would say, third quarter is one that was not at my expectations. However, having said that I believe the fundamental changes and investments we’re making in this business allow us to achieve the midterm guidance that we provided and we’re not going to do that without improving the Wood business.

[Scott Rednor:]

Thank you.

[Operator:]

Thank you. Our next question comes from the line of Alvaro Lacayo with Gabelli & Company. Please proceed with your question.

[Alvaro Lacayo:]

Good morning and nice quarter, guys.

[Donald Maier:]

Thank you.

[John Thompson:]

Thanks, Alvaro.

[Alvaro Lacayo:]

Just a question on the Wood side and the inventory drawdown, so for the quarter, volume was down about 3%. Can you give us a sort of order magnitude of how much of that sort of 3% was made up by the inventory drawdown? And if you exclude that, what might the volumes look like?

[Donald Maier:]

Yes, great question. So I think, probably the best way to answer that is if you were to exclude the volume drawdown as related to those two inventory adjustments, we saw a low-single-digit growth in both our engineered, as well as in our solid business in the quarter.

[Alvaro Lacayo:]

And I guess, through the year that volume number in Wood has been moving around a lot. Can you just remind me on, I guess, for your midterm goals, what you think the correct sort of midterm growth is for volume within wood?

[Donald Maier:]

So we are indexed very heavily on the solid side, which is growing a little slower although growing well versus the engineered side of the business. And so our blend there - our attentions are to grow at market with some gains, in particular with our investments into the upper ends of the - upper parts of the segments of that category. So really, it’s a combination of market growth volume coming through. But the real focus of our initiatives are increasing both the mix of products within each of the channels that we serve, as well as change in the index of channels towards the independent retailer.

[Alvaro Lacayo:]

Got it, okay. And then, the midterm goal just on a more consolidated basis of that 5% to 6%, given sort of the competitive pressures you see, can you sort of maybe provide a little bit more color? I know you talked about Diamond 10 and your channel initiatives, but what are some of the things that you’re driving to sort of make sure you hit on those midterm goals, given that this year might be a little bit lower than what you might have originally expected?

[Donald Maier:]

Yes. So well, so first of all to get grounded, our assumption is that the market grows at about 3%. We’ve stated aspirations to be at the 5% to 6%, and it really is the strategic priorities that I mentioned that are going to deliver that. And they apply pretty much broadly across both the Wood as well as the Resilient categories, and certainly transcend our commercial and residential businesses.

[Alvaro Lacayo:]

Okay. Thank you very much.

[Operator:]

Thank you. Our next question is a follow-up from Keith Hughes with SunTrust Robinson Humphrey. Please proceed with your question.

[Keith Hughes:]

Thank you. After the quarter, you basically have no balance sheet debt $10 million on ABL. As you generate more cash, has the - internally or with the Board have you talked about beyond the obvious internal investments, what you will be looking to do with that in any more detail?

[John Thompson:]

Hey, Keith, it’s Jay. I’ll take that one. So we have been talking internally and with our Board. And as we think about the cash flow in the business, first of all, we’re very pleased with the cash flow generation year-to-date. And it’s our intention to continue to grow cash flow. As we think about allocating capital, we’re really focused on four things. And the first is to make sure that we’ve got adequate financial flexibility to meet growth objectives. Second is to maintain a strong balance sheet with the ability to reinvest in the business, as we create value through innovation, customer relationships and productivity. As we as we move forward, we do think that there’s a long-term debt-to-EBITDA target for the business that makes sense for capital efficiency reasons somewhere in the 1.5 to 2 times range. And we think about getting there over time in addition to investing in internal projects thinking about value added acquisition opportunities. And then finally, to the extent that we’ve got excess capital, we would look to return that to shareholders as appropriate.

[Keith Hughes:]

Okay, okay, along those lines the new push in LVT is this WPC LVT. I believe you sell some of that your source. Are there any plans about adding production or converting production to be able to produce that internally?

[Donald Maier:]

Yes, Keith, this is Don. And you’re right, we’re seeing, frankly, a very, very significant growth in that end of our LVT product line. And we’ve got a really successful category with what we go to market with called Rigid Core. This is an area that we have continued to spend quite a bit of our R&D work on. And while I’m not at a point where I can share anything, it’s a category we’re very focused on. And I think that you’ll see the commensurate investments both in the product as well as in the manufacturing of this product line.

[Keith Hughes:]

All right. Thank you.

[Operator:]

Thank you. There are no further questions at this time. I would like to turn the call back over to Mr. Don Maier for closing remarks.

[Donald Maier:]

Well, thank you. I want to express my thanks for everybody joining us today. We truly do appreciate your interest in Armstrong Flooring. And we really do look forward to updating you as we make progress on our long-term growth strategies in the future calls. Thanks and have a great day.

[Operator:]

Thank you. This concludes today’s teleconference. You may disconnect your lines at this time. Thank you for your participation. And have a wonderful day.