Kimball International, Inc.
Q3 2018 Earnings Call Transcript

Published: 3 May 2018

[Operator:]

Good morning, ladies and gentlemen. My name is Mark, and I will be your conference call facilitator today. At this time, I would like to welcome everyone to the Kimball International Third Quarter 2018 Financial Results Conference Call. [Operator Instructions] As with prior conference calls, today's call, May 2, 2018, will be recorded, and may be - may contain forward-looking statements as defined under the Private Securities Litigation Reform Act of 1995. Actual results could differ materially from the forward-looking statements. Risk factors that may include the outcome of forward-looking statements can be seen in the 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.

[Robert Schneider:]

Thank you, Mark, and welcome, everyone, to our third quarter fiscal year 2018 conference call. We announced yesterday the financial results for our third quarter ending March 31. 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 call. I will start today with a few comments regarding the third quarter ending March 31, and our outlook going forward before I turn the call over to Michelle, who will provide us with the key financial highlights for the third quarter. We will then open the call to questions from analysts and investors. I'll start with a few important highlights for the quarter that we were very pleased with. First, activity in the hospitality vertical market has been robust. Sales in this vertical increased 7% excluding the D’style acquisition and 20% including the acquisition. As I've mentioned in prior calls, the market is often very choppy in its order flow. While our hospitality orders were down during the third quarter, we saw a significant uptick in orders in April. As a matter of fact, organic orders in April were the highest month since November of 2014, almost four years ago. So we continue to see strength in this market, along with our other markets, Michelle will be sharing with you shortly the incredible overall order level we experienced in April. Another important highlight was the 21% increase in orders in the finance vertical market this quarter as we continue to strengthen relationships and existing accounts and build relationships with new customers. Additionally, we wrapped up our first full quarter with D’style, the company we acquired in November that focuses on public spaces within the hospitality market. We're making nice progress with the integration, and it is good to see a company operating at a profit this early in the acquisition given all the intangibles that often get amortized in these type deals. So while I am encouraged about so many activities at Kimball International the past quarter, one area that is getting a lot of focus is the apparent headwinds we are seeing in the commercial furniture market in general. In the last two quarters, we've experienced a pause in the market so to speak. Quoting activity though remains high but orders are coming in slower than we expected, in part due to the construction delays, caused by labor shortages and unfavorable weather conditions that we often hear from dealers and designers. And recently, we noted that growth expectations by BIFMA, the organization that publishes market statistics for our market verticals excluding hospitality, have been reduced for calendar year 2018 for the overall U.S. commercial furniture market. As a backdrop, in November, BIFMA was forecasting growth of 4.8% for the U.S. commercial furniture market for calendar year of 2018. A couple of weeks ago, they revised that forecast to 1.9% growth for 2018. That there are so many positive economic statistics occurring along with the effects of the tax reform beginning to be felt across the U.S., and so we are watching this very closely how our markets respond. Given the current market, we've been increasing our continuous improvement and cost management efforts while at the same time working on aggressive product development to bring new products to market quicker. We have launched several significant new products earlier this fiscal year within both our Kimball and National brands. And we look forward to showcasing these products along with new introductions and enhancements during the upcoming June office furniture trade show in Chicago. One product I'm really excited about is the recently introduced Alterna product within the Kimball brand, which is a caseworks product that can be integrated into any environment but is especially conducive to the health care environment with ADA-compliant heights, sink cabinets, wall-mounted cabinets and sloped top options to meet specific needs unique to spaces often seen in the health care environment. The health care market is beginning to rebound since discussion of changes to the Affordable Care Act have settled down some, and this new product will help us take advantage of the opportunity. We're quoting several projects, but note the selling cycle for health care is longer than the typical office environment selling cycle. So the results of our efforts are not yet showing up in our revenue. We are also seeing a lot of activity in the education market vertical as we are presently in the usual buying season, which means installation in late summer and early fall. We're making many investments in marketing and selling efforts to take advantage of this peak time in the education market. Let me now briefly touch on our quarterly results and financial targets. Third quarter results fell short of our expectations with organic sales ending flat with the prior year and operating margin declining. The cost challenges that we faced last quarter with the significant increase in freight continued into the third quarter. We expect that cost pressure to continue due to the demand outpacing supply in the transportation industry. We're also seeing commodity cost pressures, and there is still uncertainty on how much of an impact the aluminum and steel tariffs will have on us. We're working diligently to offset these costs through growth, lean initiatives, productivity improvements and other cost changes. We are targeting $7 million of cost savings from these efforts in 2019, which Michelle will be going into more specifics shortly. We believe these cost reductions coupled with recent and planned price increases will offset much of the cost increases before us. That said, the lower commercial furniture market revenue forecast for 2018 and 2019 as well as the increasing transportation cost, steel, aluminum and other commodity cost pressures, we reassess the timing of our financial targets. If you recall, in 2014, at the time of the spin-off of electronics, we set a goal to achieve 8% operating income margin, and we did that quickly, improving our adjusted pro forma operating income from 1.6% in fiscal year 2014 to 8.2% in fiscal year 2017, our last fiscal year. Our view at the time was that about 8% operating margin reflected the market for our U.S. commercial furniture, and that's why we set that as a goal. When we hit 8%, we then readjusted our outlook to mid-single digits organic sales growth in operating income margin of 9.5% to 10.5% in fiscal year '19. Given the headwinds we are seeing in the market and cost challenges, we think it's appropriate to revise our financial targets to the following with a view of 3 to 5 years. Our new projections for the next 3 to 5 years are

[Michelle Schroeder:]

Thanks, Bob. Kimball International recorded sales of $157.9 million in the third quarter, which was an increase of 3%. Organic sales were flat for the quarter. As Bob mentioned earlier, sales in our hospitality vertical increased 20%, or 7% on an organic basis. This put a lot of focus on increasing both our custom business and our seating business in this vertical, and we're seeing results from that. Sales to the commercial vertical increased 6% due to some nice project wins we had that shipped in the quarter. Sales in the health care, education and government vertical markets declined while sales in the finance vertical market were flat. Consolidated orders decreased to 6% in the third quarter. As a reminder, in the prior year third quarter, one of our furniture brands had a price increase that was effective on April 1, and that caused customers to pull orders forward into March to beat that price increase. We estimated that, that had approximately $6 million to $8 million favorable impact on our orders last year, but this is now having a negative impact on our year-over-year comparison this year. Partially offsetting this is the impact of the D’style acquisitions this year. So when you exclude both of those items our consolidated orders declined 5%. And that's up against a strong order quarter of last year when orders were up 7% excluding the price increase impact, so we have a little bit of a tough comparison. We've seen a nice rebound in April, though. Bob mentioned earlier that orders in the hospitality vertical market were the best since November of 2014. And overall, on a consolidated basis, April organic orders increased approximately 30% compared to April of 2017. And this does exclude the impact of the price increase last year that I mentioned. So it is a clean comparison, so a nice increase in our orders in April. We did have a couple larger projects that booked in April, but even without those orders, the increase was significant. Sales of new products were 22% of our total sales during the third quarter. This metric fluctuates depending on the timing of when products hit that 3 year mark and fall out of the new product category and then when new products ramp up fully. In the first quarter, some of the products that are really still selling extremely well hit the three year mark and fell out of the new product category so we did see a dip in new product sales to below 20% in the first two quarters of this fiscal year. We're now seeing recently introduced products starting to ramp up in volume, and so we're pleased with the uptick in this metric to 22% this quarter. And just as a reminder, we do exclude sales from the hospitality vertical in this metric as hospitality products are primarily hotel brand specific. Our operating income margin ended at 5.4% in the third quarter compared to 7.2% in the prior year. The decline was primarily due to lower gross profit margin, which ended 320 basis points below last year. The two biggest items impacting gross profit were shift in sales mix and the increased freight and commodity cost that Bob mentioned earlier. So the sales mix had an unfavorable impact on our margins primarily due to a higher mix of open plan systems product that carries a lower margin. This lowered our gross profit percent by approximately 130 basis points in the quarter. Generally, when we have larger products that includes systems product and that hits in the third quarter, that tends to have a magnified effect on our margins because of the seasonally lower volumes in the third quarter. We do expect the unfavorable sales mix issue to lessen somewhat in the fourth quarter. In addition, the higher transportation cost and increased commodity cost continued this quarter, which negatively impacted our gross profit percent by approximately 120 basis points. We don't see those costs declining anytime soon. Other various cost increases and a LIFO inventory valuation adjustment combined to negatively impact our gross profit by approximately 160 basis points. Now partially offsetting this, the realization of price increases during the quarter favorably impacted gross profit margins by approximately 90 basis points. Selling and administrative expenses decreased 2% in the third quarter compared to last year, and that was primarily due to a decline in incentive compensation costs resulting from the lower profitability during the quarter. To address the cost challenges, we have several productivity and lean initiatives that we're working on throughout the company, which as Bob mentioned will save us approximately $7 million in fiscal year 2019. This includes making investments in equipment and automation at our production facilities to improve production flow and increase efficiency. And as we're making these changes to our facilities, we do take great care to ensure that we do not disrupt lead times. We also dedicated resources towards the lean initiative around our transportation and warehousing processes where again we believe there is some opportunity to reduce costs there. And we have many other smaller lean initiatives continually occurring throughout the company, and these initiatives are in different stages of completion. Some have been in the works for a while, some will start seeing the benefit soon. Others are not as far along in the benefits are going to be a little further out. But over the course of fiscal 2019, we expect to realize approximately the $7 million in savings. Also, our National brand implemented a price increase that was effective on April 6, 2018, and our Kimball brand announced a price increase this week that will be effective in July of 2018 to help offset the increased cost. Our effective tax rate for the third quarter was 31.2% compared to 36.8% in the prior year. The lower rate is primarily due to the benefit from tax reform. Recall because we're a fiscal year reporting company, we have a blended federal statutory tax rate for fiscal year 2018 of 28.1%. We'll see the reduction to the 21% federal rate beginning in July. The changes in the tax law were numerous and complex, and there's still a lot of issues where further guidance is needed from the IRS. Based on our analysis so far, we expect the benefit of the lower tax rate to be approximately $5 million annually beginning in fiscal year '19, and we're already seeing a small benefit here in fiscal 2018 because of the blended rate but we'll see the full $5 million in savings next fiscal year. And of course, this estimate will fluctuate with changes in pretax income. Net income for the third quarter was $5.9 million compared to $7.2 million in the prior year, and earnings per share equaled $0.16 compared to $0.19 last year. Now moving to the balance sheet, our cash, cash equivalents and short term investments balance was $77.7 million at the end of March. We had operating cash flow in the third quarter of $11 million compared to $17.6 million in the third quarter of last year. The decrease was primarily driven by a change in our working capital balances and lower income. We paid $2.6 million in dividends and repurchased 397,000 shares totaling approximately $6.6 million during the third quarter. We have 1.3 million shares remaining under our current share repurchase program, and we will continue to monitor the market and repurchase shares opportunistically. Our capital expenditures totaled $3.6 million for the quarter, primarily related to investments in manufacturing equipment and automation. We had some renovation of our corporate headquarters and also showroom renovations. We estimate our total capital spend for fiscal year 2018 will be approximately $20 million, which is higher than normal, as we continue these investments. Our balance sheet remains strong, with very little debt as of March 31. We have a $30 million credit facility and are in compliance with all covenants. So with that, I'd like to open today's call to questions. Mark, do we have anyone with questions?

[Robert Schneider:]

Thank you, Mark. And thanks, everyone, for joining us today. I'm very, very excited about the new products we have introduced this past year and very optimistic for those new products that we are working on presently that will be introduced this summer. We're confident that the investments we are making in growth initiatives and the focus on lean activities that Michelle talked about will drive long-term shareholder value. We appreciate your interest in Kimball International and look forward to speaking with you on our next call. Thank you very much, and have a great day.

[Operator:]

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