HNI Corporation
Q3 2017 Earnings Call Transcript

Published: 24 Oct 2017

[Operator:]

Good morning. My name is Amy and I will be your conference operator today. I would like to welcome everyone to the HNI Corporation Third Quarter 2017 Fiscal Results Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. [Operator Instructions] As a reminder, today's conference call is being recorded. Thank you. Mr. Herring, you may begin your conference.

[Jack Herring:]

Thank you. Good morning. I am Jack Herring, Treasurer and Director of Investor Relations for HNI Corporation. Thank you for joining us to discuss our third quarter fiscal 2017 results. Here with me are Stan Askren, Chairman, President and CEO; and Marshall Bridges, Vice President and Chief Financial Officer. Copies of our financial news release, earnings presentation and non-GAAP reconciliations are posted on our Web-site. Statements made during this call that are not strictly historical facts are forward-looking statements which are subject to known and unknown risks. Actual results could differ materially. The earnings presentation posted on our Web-site includes additional factors that could affect actual results. The Corporation assumes no obligation to update any forward-looking statements made during the call. I am pleased to turn the call over to Mr. Stan Askren.

[Stan Askren:]

Thank you, Jack. Good morning, everyone. Marshall and I will share our assessment of the third quarter 2017, provide some thoughts on our outlook for the fourth quarter of 2017 and then give a brief outlook for 2018, and then as usual, we'll open the call up for questions. In the third quarter, we drove strong top line growth and delivered earnings as expected. Our top line results were better than anticipated. We generated more than 20% growth in our North American Contract and International office furniture businesses. We also drove solid growth in our supplies-driven office furniture and hearth businesses. Our strong sales results combined with SG&A cost management offset disruption related to operational transformations and unfavorable business mix to deliver earnings as we expected. As we look to the fourth quarter, we are expecting a profit decline as we work through two major challenges. The first, the supplies-driven marketplace continues to experience rapid transition resulting in increased investment on our part and lower near-term sales. We now expect to see lower sales as wholesale shipments, which were relatively stable in the third quarter, decline significantly as the wholesalers forgo their year-end program buys. Second, our operational transformation projects have been more difficult than we anticipated and will negatively impact our fourth quarter profitability. In retrospect, we took on too many strategic initiatives and we underestimated the resources required to successfully execute them. One of our big initiatives, BST, has required significant resources which otherwise would have been focused on these operational execution initiatives. Though successful to date, we've made a proactive decision during the fourth quarter to defer the next phase of our BST implementation to February 2018. Our decision to delay allows us to focus on customer needs, strengthen our operational network, and align the implementation with historically slow seasonal demand period. We understand the challenges in front of us, we know where we want to go and we know how to get there. Our supplies-driven business is a strong platform for growth with market access, brands and scale unmatched by competition, even in the new environment. We are taking actions to increase our competitiveness, building out our direct service capabilities and leveraging our industry-leading platform to generate economic advantage for us and our resellers. We have a long proven track record of successfully managing through operational challenges. We are realigning people, structure and processes to address these issues. I'm confident we are making progress and I'm confident in our ability to drive profit improvement for the future. I'll now turn the call over to Marshall Bridges to review some financial details and then I'll return to discuss our views on 2018. Marshall?

[Marshall Bridges:]

Thanks, Stan. Okay, let's look at some of the details of the third quarter first. Consolidated organic net sales grew 10.6% versus the prior year. Including the impacts of acquisitions and divestitures, sales increased 2.5%. In the office furniture segment, sales increased 12.9% organically and increased 2.3% in total. Within the office furniture segment, sales in our supplies-driven business increased 5% organically, or minus 6% including the impacts of divestitures. Sales in our North American contract businesses increased 23% organically, or up 11% in total. Sales in our international businesses increased 21%. In our hearth segment, sales increased 3.4%. New construction sales increased 5% and sales of retail products including wood, gas and pellet increased 2%. Non-GAAP net income per diluted share was $0.82, compared to $0.80 in the third quarter of 2016. Versus the prior year, our improved earnings were driven by volume, which was mostly offset by input cost inflation, strategic investments and unfavorable business and product mix. Okay, let's shift gears and look at the fourth quarter. For the fourth quarter, we expect consolidated organic sales to be flat to up 3%, or flat to down 3% when including the effects of acquisitions and divestitures. Office furniture sales are expected to be down 1% to up 2% organically, or down 2% to 5% in total. Organic sales in our supplies-driven business are projected to decline 2% to 5%, or be down 6% to 9% when including divestitures. We do expect to see continued growth in our contract business but not at the high third quarter levels. We are forecasting sales in our contract office furniture businesses to be up 3% to 6% organically, or down 1% to up 2% when including the impacts of acquisitions and divestitures. We expect hearth sales to be up 3% to 6%. Within the hearth segment, new construction sales are forecasted to be up 5% to 8% and we are projecting retail hearth sales to be up 2% to 5%. Non-GAAP gross profit margin is expected to be approximately 38%. Non-GAAP SG&A, which includes freight and distribution expense, is expected to be 31.5% to 32% of net sales. In the fourth quarter, our tax rate will be negatively impacted by a one-time adjustment related to the estimated future benefit of foreign tax items. As a result, we estimate our full-year tax rate will be approximately 36%. Our estimate of non-GAAP earnings per diluted share for the fourth quarter is in the range of $0.38 to $0.45. Our resulting estimate of non-GAAP earnings per diluted share for the full-year 2017 is now in the range of $1.88 to $1.95. Stan?

[Stan Askren:]

So, looking forward to 2018, I like our opportunities and I'm confident we will return to profit growth. We will conclude our operational transformations, stabilize our network and deliver benefits from core productivity improvement and structural cost reductions in 2018. I anticipate the supplies-driven market will continue to be dynamic. We will effectively navigate those market transitions. We hold a unique competitive advantage through brand, product and capabilities, allowing us to directly serve the market, which no other manufacturer can match. I remain confident our investments will deliver growth, solidify our position as the best total cost producer, and drive long-term profit improvement for our shareholders. We continue to believe we owe shareholders our best current outlook for the business. For that reason, we are providing initial forecast estimates for next year. Our current estimate of non-GAAP earnings per diluted share for the full-year 2018 is in the range of $2.15 to $2.65. This is based on the assumption of 2% to 5% consolidated organic sales growth and we are expecting 1% to 4% growth in office furniture and 3% to 6% in our hearth business. We are confident in our strategies and in our ability to deliver profitable growth and create long-term value for our shareholders. With those comments complete, we'll now open it up to questions.

[Operator:]

[Operator Instructions] Your first question comes from the line of Matt McCall with Seaport Global. Matt, your line is open.

[Matthew McCall:]

So, Stan, maybe expand on the last comments, you gave some kind of view of 2018, can you walk through some of the components of your margin outlook? I don't think you gave the specifics around margin specifically, but maybe some of the components that we should think about as we look out in the next year trying to gauge kind of the visibility that you have in the margins next year, your cost saves or the elimination of pressures that are hurting you in 2017.

[Marshall Bridges:]

Sure, Matt. As you look into what the big assumptions there are behind that $2.15 to $2.65 non-GAAP EPS estimate, there is really three big assumptions. The first is around market growth, and so we are assuming slow market growth, kind of low single digits in office furniture and mid-single-digit growth in hearth. Second big assumption is around net productivity. We have obviously not [indiscernible] the productivity we expected this year and we are expecting to get back on track next year, get the operational transformations behind us and return to driving cost savings, and we are assuming that we can drive favorable net productivity and structural cost reduction in the range of $25 million to $35 million next year. The third big assumption has to do with pricing and input cost inflation. So we are assuming that we can offset inflation, which we do expect to be lower in this year, with price. So we should have zero price-cost gap. There are some other things we have to deal with as well, which I will note. We have kicked off the amortization of our BST asset in the third quarter, and so as we enter next year, we'll have some wrap-around that amortization. That will be about $8 million of additional expense, all else equal. And we've also had some favorable adjustments from a P&L perspective to the variable comp programs which should reset next year and be another $8 million of headwind we have to overcome.

[Matthew McCall:]

Okay, all right. That's helpful. Thank you, Marshall. So, maybe on the supplies side, can you talk about the anticipated pressure, maybe quantify some of the buckets of cost that kind of caught you off-guard that was impacting that supplies segment? And then how long is this going to persist? You've given the guidance for or the outlook for next year, but is it, we have to continue to face this pressure for another quarter or another two quarters and then it starts to get better, how do we model out the next year as it pertains to the supplies issues and the moves that you are making to address these issues?

[Marshall Bridges:]

Matt, so for the fourth quarter, I'll answer that question first, roughly speaking three-fourths of our decline or expected decline versus the prior year is really driven by the supplies-driven business, and so there's really three big factors there. First is sales and that's primarily driven by weakness with the wholesalers. The other is, we are continuing to invest in that business and the biggest investment there is our quick ship fulfillment model, which we are building out. And then we are also experiencing some input cost inflation, which we partially offset with price, but similar to earlier in the year where we had a negative price-cost gap in the fourth quarter. As we look to next year, Matt, the sales side of that will still be in transition. But as I said earlier, we are not expecting to see that price-cost gap and some of these investments will anniversary and not be incremental next year.

[Matthew McCall:]

Okay. And then I guess that leads me to my final question. So the investments that you've had to make, can you remind me what the total is going to be in 2017 and what you will anniversary, and is that included in that $25 million to $35 million number or is that $25 million to $35 million number more tied to the facility moves?

[Marshall Bridges:]

The $25 million to $35 million number is tied to the facilities and just driving core operational productivity. As it relates to the investments we are making in the kind of quick ship fulfillment model, that will be $7 million to $10 million in 2017.

[Matthew McCall:]

And that should not recur? Will the spending largely be behind us by the time you get through Q4?

[Marshall Bridges:]

Yes, that's a fair assumption. As we ramp volume up there, there will be incremental investment, but it won't be nearly at the same level.

[Matthew McCall:]

Okay, all right. Thank you, guys.

[Operator:]

Your next question comes from the line of Kathryn Thompson with Thomson Research. Kathryn, your line is open.

[Kathryn Thompson:]

Working backwards and tagging on to the cost reduction initiatives, you had focused on $35 million to $40 million annual cost reduction by fiscal 2018. This is just something that you have outlined in the past. You previously have targeted $24 million to $30 million in 2017 and $10 million to $15 million in 2018. Obviously a lot of this has changed. One thing just to help us better understand why – help us understand why the shortfall in 2017 in those cost saves? And then I just want to be clear, you did outline in your prepared commentary what the saves would be for 2018, but I just want to make sure that we are on the same page with that. Thank you.

[Stan Askren:]

Good questions, Kathryn. I will start with why the shortfall and let Marshall fill in sort of the specific details. So, what happened in 2017, it did not develop as we thought. First off, the year started off a little slower and some of it had to do with the transition of wholesalers, and then we got hit with really kind of inordinate amount of demand, which put us in a pretty intensive sort of production environment. When we got to that situation, we basically pulled resources from some of our cost reduction transformations, we arrested, we stopped some of the moves simply to take care of existing customers that had placed existing orders to make sure that we didn't disappoint them. And so, we kind of had a multiple series of factors there happening at one time. The result of that is we simply didn't get done the things that we wanted to get done. And then, in addition, as this wholesaler transition became more dynamic and began to develop, they went through periods where we didn't get the orders that we thought we might, and so then that impacted cost as well. So, basically what we are saying is, we believe in 2018 we are going to stabilize and get those moves done, number one. Number two, let me comment on this BST while I have the platform. This BST has actually gone well. We think of it very, very serious and it's on track. We chose when things were a little bit rocky to delay that. And more the implications are that quite frankly I underestimated is we had the A-team on making sure that the BST transition, transformation, changeover would go well and we did not get the A-team on these major cost reduction initiatives, and so they didn't get done as fast and get done as well. The good news is, BST is on track. The good news is, I think as we've deferred going live on that whole new system until February when our production environment would be more stable and it's historically a period where there is few orders so there is sort of less stress and tension on the overall system, and I think that puts us in a good spot. Marshall, you want to comment on some of the specific questions?

[Marshall Bridges:]

Kathryn, as it relates to that $35 million to $40 million of structural cost, we are now expecting to hit about $11 million to $12 million in 2017, and about $15 million in 2018. So part of that $25 million to $30 million sort of net productivity and structural cost reduction that I mentioned to Matt includes this $15 million of additional structural cost reduction. And then the balance of the $35 million to $40 million will hit 2019, early 2019.

[Kathryn Thompson:]

Okay, all right, helpful. And you've a mentioned in your prepared comments there wasn't as much year-end buy from wholesalers. What percentage of supplies sales are year-end buys of wholesalers that typically hit in the Q4? Really what we're trying to do is get a better sense of the magnitude of that year-end buying impacting the shortfall versus other fundamental weakness.

[Marshall Bridges:]

That's a good question. The wholesalers typically pursue these program buys in the fourth quarter, in which they increase their inventories. I guess the way to answer your question is to say that we are expecting our year ending inventory that the wholesalers hold to be down about $20 million. It's a pretty significant impact on the quarter.

[Kathryn Thompson:]

Okay, all right. Following and just pulling the string a little bit more on the whole supplies transition, some of the larger wholesalers, as we discussed in the past, are struggling or are developing private-label options that potentially could be a direct competition to your product. To what extent do you think that these competitive label products in supplies business versus just that acceleration of the model shift could impact either the current quarter trends or future trends?

[Stan Askren:]

That's a complex question. The answer is, their private-label initiatives are significant. They are real. I mean it's real competition for us. I think it's not the big story. I think the bigger story is simply large customers wanting to go direct, looking for better connection with us, more direct connection. And so I think that's the big story. And I think the secondary story is then just private-label competition. We're seeing private-label competition amongst all of these sort of private-label, and this private-label has been there for some time and we've been dealing with them for some time and we're actually responding aggressively to that coming out with products that are value profile down, that match up directly and providing those same solutions directly to our resellers versus having them buy them through really an intermediary or somebody who is sourcing those from someplace else and package them and then deliver. We think we have a better model to produce them domestically. Most of the time, often we can source them better, and then we can add more value and give them better experience overall. So, I think we can meet that challenge. It is a challenge, but it's not too me the big story.

[Kathryn Thompson:]

Okay. The bigger story is more structural versus private-label, because we are just trying to make sure that we understand that sometimes it's not the direct but there can be some indirect factors impacting.

[Stan Askren:]

Yes, I think you've got it. I think you can just characterize it, while the big story is this transition from intermediary to direct and then throughout the market is this competition from private-label, low-branded, unbranded sort of product and business models.

[Kathryn Thompson:]

We talked about higher cost. One area I want to just focus on, just as you get to that more direct model, to what extent is higher freight cost impacting higher cost in Q4 and 2018 expectations, because still you are paying for freight ahead of selling to customers with this new, more direct model? Just help us understand how that freight layers into your cost expectations.

[Marshall Bridges:]

When I mentioned earlier about that $7 million to $10 million we are investing in the quick ship fulfillment, Kathryn, most of that is going to be in the freight expense line. There is some expense related to setting those distribution centers up, et cetera, but most of it is in freight. In the fourth quarter, it's about $3 million.

[Kathryn Thompson:]

Okay. All right, that's all I have for now. Thank you.

[Operator:]

Your next question comes from the line of Greg Burns with Sidoti & Company. Greg, your line is open.

[Gregory Burns:]

What percent of your office segment is supplies and what percent of that is wholesale at this point?

[Marshall Bridges:]

Greg, about half of office furniture is the supplies-driven business and we are down to about 20% of that supplies-driven business through wholesalers at this point.

[Gregory Burns:]

Okay. And if the bigger trend here is the transition of demand to move more direct, do you feel like you are missing out on some sales opportunities in the near-term as you build your direct ship infrastructure that maybe you'll be able to pick up over time or is that not a dynamic that's happening?

[Stan Askren:]

It's a good question, Greg. Certainly the transitions are never linear and smooth. And so, I would guess we probably are missing out on some short-term sale just as this goes through the convulsion of change. But putting our finger on that is very, very difficult. I would expect – our intent is to make this transition as fast and smooth as possible, and when we get to the other side, then we should be advantaged in that we are able to more efficiently and effectively supply our largest customers, our largest resellers with furniture, and we should be more effective in helping them sell through or we should be more efficient as we run all the way from manufacturing to logistics network to solve that. Short term, I have no doubt that these transitions will lose some things through the cracks, and we are working that intensely but I can't put my finger exactly on what's happening there.

[Gregory Burns:]

Okay. And given the significant decline in wholesale channel inventory, do you feel that that level of inventory is sufficient to support your demand outlook through that channel or do you think it's kind of lean where they may have to – you might have some stronger quarters as they fill that inventory maybe over the next couple of quarters?

[Stan Askren:]

I can't speculate on that, Greg, because I don't know what their demand horizon looks like and I don't know what their intent is to order. But you are tapping into a dynamic that we are going to need to watch and track as we go forward. I mean, certainly we value these wholesalers and we want to help them as they go through the transition. How it all plays out is yet to be determined.

[Gregory Burns:]

Okay. Thank you.

[Operator:]

This concludes our question-and-answer session. I would now like to turn the call back over to Stan Askren for closing remarks.

[Stan Askren:]

Thank you very much. We appreciate your interest in tuning into our third quarter call. We look forward to talking to you all in the future. Have a good day. Bye-bye.

[Operator:]

This concludes today's conference call. You may now disconnect.