Kimball International, Inc.
Q2 2018 Earnings Call Transcript

Published: 1 Feb 2018

[Operator:]

Good morning, ladies and gentlemen. My name is Tiffany, and I will be your conference call facilitator today. At this time, I would like to welcome everyone to the Kimball International Second Quarter 2018 Financial Results Conference Call. All lines have been placed on a listen-only mode to prevent any background noise. After the Kimball’s speakers opening remarks, there will be a question-and-answer period, where Kimball will respond to questions from analysts and investors. [Operator Instructions] As with prior conference calls, today’s call February 1, 2018 will be recorded and may contain forward-looking statements as defined under the Private Securities Litigation Reform Act of 1995. Actual results could differ materially from forward-looking statements. Risk factors that may influence the outcome or forward-looking statements can be seen in Kimball International Form 10-K and today’s release. The panel for today’s call is Bob Schneider, Chairman and CEO of Kimball International; and Michelle Schroeder, Vice President and Chief Financial Officer of Kimball International. I would now like to turn today’s call over to Bob Schneider. Mr. Schneider, you may begin.

[Bob Schneider:]

Thank you, Tiffany. And welcome everyone to our second quarter fiscal year 2018 conference call. We announced yesterday the financial results for our second quarter ended December 31, 2017. As in prior calls, we have an investor presentation slide deck that has been posted to the Investor Relations section of our website to accompany this conference call. As in the past, I suggest you pull up that slide deck as it includes important information on the quarter along with trending of our financial results. I will start today with a few comments regarding our second quarter sales and order trends, the recently completed acquisition and our outlook, before I turn the call over to Michelle who will provide us with the key financial highlights for the second quarter. We will then open the call to questions from analysts and investors. Revenue in the second quarter increased 2% over the prior year, led by record sales in the hospitality vertical and the acquisition of D’style, Inc. which was completed on November 6, 2017. Sales in four out of the six vertical markets we report in experienced growth in the quarter. The record sales in hospitality -- in the hospitality vertical was a record on an organic basis without the D’style acquisition. We were also encouraged by the pickup in orders in the second quarter, increased demand in five out of our six vertical markets resulted in an overall 8% increase in consolidated orders for the second quarter. If you recall, our orders were down in the first quarter, so it was nice to see the trend quickly turned around this quarter and as we look to our third quarter, we’re getting off to a good start with orders in January up over 20% from a year ago. Now that’s organic growth by the way, it excludes D’style, a very strong start. During the quarter, our National brand was awarded a three-year contract extension with Premier, which is a leading healthcare improvement company that utilizes an alliance of approximately 3,900 U.S. hospitals and health systems, and approximately 150,000 other providers and organizations. This contract extension allows Premier members to take advantage of special pricing and terms on National product pre-negotiated by Premier. Also during the quarter, National was awarded a blank purchasing agreement from the United States Navy that allows National to provide contract furniture to all Navy installations in the east region, west region and outside of the continental U.S. These contractors are just two examples of recent wins that will provide benefits over multiple periods going forward. Our margins during the quarter were challenged as sales in the second quarter were more heavily weighted towards project-based business that carried lower margins when compared to last year. We won more project-based business which includes more Open Plan Systems product and that product has higher discounting associated with it. As we win more of these projects we are working very diligently to offset the additional costs with automation, productivity improvements and other cost saving initiatives. There were some other factors that impacted profitability in the quarter as well, which Michelle will discuss in more detail. The macroeconomic environment is very positive and the overall sentiment in the furniture market remains very optimistic. We believe the passage of the Tax Reform Act in December will also drive investment, which will have a positive effect for our industry. And we are continuing to invest in product development, marketing initiatives, our distribution network and automation in our factories and back-office processes to achieve our long-term strategic goals, which will position us nicely as the economy improves. In our last call, I mentioned the pending acquisition of D’style and the Allan Copley Designs brand, which are well known in the hospitality industry for providing public space furnishings and guest room accent pieces. The acquisition was completed on November 6th, as I mentioned earlier, and our second quarter financial results include D’style activity since that date. D’style is a good fit strategically with our Kimball Hospitality brand. Their focus on providing furnishings for public spaces in a hotel complements nicely our strength of providing quality high design guest room furnishings. D’style exceptional capabilities with steel, glass and other mixed materials will further enhance the custom design capabilities we are already provide to our customers. D’style is a very respected brand in the hospitality marketplace, as we integrate the operations with Kimball Hospitality we will keep the D’style brand name alive and the previous owners will remain in charge of day-to-day operations in the California headquarters. I am very pleased with how smoothly the integration is proceeding and the acquisition was very well received by our customers and designers in this space. We look forward to growing our presence in the hospitality market even faster with this acquisition. As a reminder, our long-term financial targets are to grow organic sales on average mid-single digits. With this level of sales growth we set a target for achieving operating income margin of 9.5% to 10.5% in fiscal 2019, with return on capital exceeding 20%. We continue to believe we will be able to hit this operating income target in 2019. Please see page 12 in our investor slide deck that I referred to earlier for a trend of our recent operating margin improvement. Now I will turn the call over to Michelle for a brief overview of the financial results before we open the call to your questions. Michelle?

[Michelle Schroeder:]

Thank you, Bob. Before I get into the second quarter financial results, I am going to provide a little bit of information on the acquisition of D’style that was completed during the quarter. The acquisition price was $20 million and that includes a $2.2 million earn-out, which is contingent upon further operating income results, so in the quarter cash out the door with $17.8 million. The final purchase price is also subject to certain post-closing purchase price adjustments, which will be finalize soon. This was an all-cash deal. The $20 million purchase price equates to approximately a six times EBITDA multiple. Our second quarter reported results included about $2.8 million in sales for D’style. That represented not quite two months of sales under our ownership because of the November 6th closing date. Operating income and net income for D’style were positive, but do not have a material impact to our consolidated results. Now moving to our financial results, Kimball International recorded sales of $173.7 million in the second quarter, that was an increase of 2%, excluding the acquisition organic sales increased 1%, while not a significant increase, it was nice to see an increase given the lower order activity that we experienced in the first quarter. And as Bob mentioned, we are very pleased with the pace of orders of the second quarter. Overall our consolidated orders increased 8%, or 6% excluding the acquisition. It was encouraging to see this level of growth and the trend reversed following the decline in orders in the previous quarter. And as Bob mentioned, the organic orders were strong in January as well, up over 20% from a year ago. Our backlog ended at $131.6 million at the end of December, which was an 8% increase over December of last year including the acquisition. Looking at the various vertical markets, the hospitality, education and government vertical markets experienced solid double-digit percentage growth over the prior year for both sales and orders. The hospitality vertical hit a sales record level in the second quarter even when you exclude the acquisition, sales were up 11% and orders increased 23%. The overall hospitality market finished stronger than many anticipated in calendar year 2017 and optimism still exist for calendar year 2018. Sales in the education vertical market increased 14% and orders increased 20% in the second quarter. We put a lot of focus on this vertical the last couple of years by introducing new products geared towards the market and creating concentrated marketing efforts to grow this market, and that’s really paid off as we continue to see significant growth quarter-after-quarter in this area. We continue to see steady growth in the government vertical market as well, with sales increasing 20% and orders increasing 11%. Most of that increase was coming from the state and local government entities. The only vertical market where we experienced a decline in both sales and orders during the quarter was the healthcare market. Sales declined 15% and orders declined 3%. This market has been down for us the last couple of quarters, but we are starting to see some improvement, we have recently been awarded a couple of larger projects within our Kimball Health brand. The efforts of the new leadership within the Kimball Health brand are really beginning to pay off. This market has a notoriously long sales cycle, so it’s taken a few quarters for this new team to make meaningful progress. We expect third quarter sales in Healthcare to remain sluggish, but expect to see some larger project awards begin shipping in the fourth quarter. The Healthcare pipeline for fiscal year ‘19 looks strong. As I mentioned last quarter, we are focused on our strategic initiatives around further developing our distribution network and building upon delivery of high design and innovative products to gain market share in all of our vertical markets. Sales of new products were 18% of our total sales during the second quarter. This metric fluctuates depending on the timing of when product hit the three-year mark and fallout the new product category, and when new products ramp up fully. Last quarter some products that are selling extremely well hit the three-year mark and fell out of that new product category, those products are still selling well, they are just no longer included in the new product metric any longer. And we are seeing recently introduced products starting to ramp up to help fill the gap. And as a reminder, we do exclude sales from the hospitality vertical in this metric as hospitality products are primarily hotel brand specific. Now moving to operating income, we were disappointed with the 8% decline in operating income for the quarter. Operating income margins ended at 6.9% compared to 7.7% in the prior year. There were quite a few items this quarter that impacted profitability and I’ll start with gross profit, which ended 170 basis points below last year. The biggest piece impacting the gross profit margin was the shift in sales mix that Bob mentioned earlier. We had a higher percentage of our sales from Open Plan Systems product, which normally has higher discounting and lower margins. This lowered our gross profit percent by approximately 160 basis points. In addition, similar to what’s been reported in the news recently, we experienced a significant increase in our freight costs this quarter, this higher cost negatively impacted our gross profit percent by approximately 90 basis points, and we are closely monitoring that as we look for alternatives to lower these costs or offset them with reductions elsewhere. Then to a smaller degree higher discounting on select product and the higher LIFO inventory valuation adjustments that was mentioned in the press release combined to negatively impact gross profit by approximately 80 basis points. Now partially offsetting these negative impacts, realization of price increases during the quarter favorably impacted gross margins by approximately 120 basis points. Selling and administrative expenses decreased 2% in the second quarter, compared to last year. We have some unusual items here as well but they mostly offset each other. The current year second quarter included a $1.7 million gain on the sale of that administration building that was offset by costs related to completing the acquisition during the quarter and then the additional selling and administrative costs for D’style that we did not have in the prior year. So if you exclude all of these unusual items which gets us a more comparable comparison, selling and administrative costs were down 1%. A decline in incentive compensation costs resulting from the lower profitability during the quarter was almost offset by higher salary expense. So, not a significant change in selling and admin expenses from last year when you pull out all the noise. As Bob mentioned, we are working on automation and productivity improvements, as well as other cost savings initiative. So we still believe will hit our 9.5% to 10.5% operating income margin target in fiscal year 2019. The effective tax rate for the second quarter of 40.6% is not indicative of a normal quarter with the passage of the Tax Reform Act in December we had some unusual adjustment during the quarter. First was an adjustment to the deferred tax assets that we have on our balance sheet. These are future tax benefits that will now turn in the future at a lower tax rate due to the reduction in the federal statutory rate from 35% to 21% effective January 1st. As a result, these deferred tax assets have a lower value at lower tax rate. This adjustment resulted in one-time tax expense of $2 million during the quarter. The second adjustment related to adjusting our year-to-date tax rate to 28.1%, because we are a fiscal year company with the June 30 year end, the reduction in the federal tax rate to 21% is effective for only half of our fiscal year, and as a result, we will have a blended statutory federal tax rate of 28.1% for fiscal year 2018. So we reported the December year-to-date adjustment to decrease the statutory federal rate from 35% to 28.1% and this resulted in a tax benefit of $1.6 million. So the net of these two adjustments was about $468,000 of additional tax expense during the quarter, which caused the higher effective rate. The changes in the tax law were numerous and complex and we are still analyzing the overall impact for Kimball International on a go forward basis. For the remainder of fiscal year 2018, we will have the benefit of the lower full federal blended rate of 28.1% versus 35% and that will be offset somewhat by a reduction in credits and the reduction of certain tax deductions. So we do not expect a significant impact for fiscal year [ph] 2018 (18

[Operator:]

[Operator Instructions] The first question comes from Kathryn Thompson of Thompson Research Group. Please go ahead with your question.

[Steven Ramsey:]

Hi, guys. This is Steven on for Kathryn.

[Bob Schneider:]

Good morning, Steven.

[Steven Ramsey:]

I want to ask a couple questions, I guess, relating to the environment and you had some of this out during your comments. But, first, competition, are there more -- are you saying more smaller competitors in the space, just wondering if this is a factor for you or for the industry if competitors -- smaller competitors are pushing into more project-type business that you called out?

[Bob Schneider:]

Steven, we are not seeing much change in terms of the competitive set. The small players that we compete against, the large players, a year ago there was a saying that we are working against today. It is a very competitive and intense environment, but in terms of new entries, nothing of significance.

[Steven Ramsey:]

Okay. And then on the elevated discounting, would you say your commentary on elevated discounting was due more to the project nature of business that you guys had in the quarter or is it more of an environment assessment that there’s more discounting going on?

[Bob Schneider:]

It is more relative to the mix that we had in the quarter, where we had more of those types of projects that we won that typically come with less margin and that really was the driver. I don’t mean to downplay the intensity of discounting in the market right now. We do have a lot of pressure on pricing, but that happens quite often and this was more matter of the distribution of orders that we won. We had some good size orders that that had Open Plan System product that that comes with a tighter margin typically.

[Steven Ramsey:]

Right. And then do you see as far as the factor of an intense competitive environment, which as you and others have stated is somewhat steady state way the industry works, but if the discounting -- if you would describe it as elevated above normal and if so are there signs that that will persist or pass away in the near to medium-term?

[Bob Schneider:]

We are planning for the discount environment that we’ve been seeing really for quite some time and what we experience this past quarter to continue, and what that drives is from our internal aspects to look at everything in terms of process improvement, leaning out our facilities, our administrative processes. So we are going under the pretense that what we’ve been experiencing for a long time and what we just saw will continue.

[Steven Ramsey:]

Excellent. Then that kind of leads to my answer part of the next question I had on the shift to lower margin products. Did some of that, you talked about part of the way you can adapt this better operations, is there anything you need to do to have different sorts of products that will carry better margins in this kind of environment?

[Bob Schneider:]

Well, recognize the quarter we just had and the choppy nature of our business is big projects come and get filled and as you go to the next quarter it doesn’t necessarily imply that, that exact same event is going to occur. Keep that in mind, Steven. And also if you look back in terms of prior calls going, boy, almost three years, you see a tone of new product introductions that we have done. That has continued and we are putting a lot of money in the new products. They generally have higher margins than what we have had in the past and so the -- we are very, very focused, I have said in the past, hitting the gas pedal on new products and trying to make sure that we have got every type of offering that can satisfy our dealers and dealer distribution and designers that we are working with and that will continue. But at the same time all that’s happening and we are driving some really creative business with seating and other areas, you do run in the time where you win a number of big orders that are mostly system based and you end up with a pretty tough discounting situation.

[Steven Ramsey:]

Right. And then if -- let’s say this, sort of environment stays steady-state to the next 18 months or so, would -- is your mid-term guidance still achievable?

[Bob Schneider:]

The mid-term, what I had indicated in my prepared comments Steven is we fully believe that that is obtainable at this point and I think as we look at all of the different things we’re doing with new products, we are doing with distribution and incentives, that we are going to be able to achieve that.

[Steven Ramsey:]

Excellent. And then last question, there’s been some M&A activity on the office manufacturer side announced in the past few months in response to this new office format that has been a theme for the past few years. Do you think with recent acquisitions and the new tax code coming into effect, does this change your outlook for M&A in the industry both as an acquirer or even as a seller?

[Bob Schneider:]

As we have said in the past, we are very, very focused on looking at acquisition that makes sense to fill out our product line that might be perhaps one lean over that can enhance what we share with our distribution with the design community. So we’ve already been looking for good fit. We found one in D’style recently in the hospitality vertical. We are constantly looking at deals that come across our desk with respect to the office furniture industry. So that is going to continue. As I look at what the tax code does as we go forward. I think the primary aspect is it’s going to drive a bullish economy and it’s going to certainly drive us to continue that what we have been doing in terms of looking at potential companies that could fill out our product offering and help us drive sales even faster.

[Steven Ramsey:]

Excellent. Thank you.

[Bob Schneider:]

Thanks, Steven.

[Operator:]

Thank you. [Operator Instructions] Okay, there are no further questions. I will turn the call back over to Bob Schneider for any closing remarks.

[Bob Schneider:]

Thank you, Tiffany. Thanks everyone for joining us today. It was a challenging second quarter, but I am encouraged by the strong start for Q3 orders and we are very optimistic about the overall economic environment heading into the second half of our fiscal year. We appreciate your interest in Kimball International and look forward to speaking with you on our next call. Thank you and have a great day.

[Operator:]

At this time, listeners, you may simply hang up or disconnect from the call. Thank you and have a nice day.