Kimball International, Inc.
Q3 2013 Earnings Call Transcript

Published: 3 May 2013

[Operator:]

Good morning ladies and gentlemen. My name Charlene and I will be your conference allocator today. At this time, I would like to welcome everyone to the Kimball International Third Quarter Fiscal 2013 Financial Results Conference Call. All lines have been placed on listen-only mode to prevent any background noise. After the Kimball speakers’ opening remarks, there will a question-and-answer period where Kimball will respond to questions from analysts. (Operator Instructions) As with prior conference calls, today’s call May 2, 2013 will be recorded and may contain forward-looking statements as defined under the Private Securities Litigation Reform Act of 1995. Risk factors that may influence the outcome of forward-looking statements can be seen in the Kimball Form 10-K and today’s release. The panel for today’s call is Jim Thyen, President and Chief Executive Officer of Kimball International, and Bob Schneider, Executive Vice President and Chief Financial Officer. I would like now to turn today’s call over to Jim Thyen. Mr. Thyen you may begin.

[Jim Thyen:]

Thank you, Charlene. Welcome everyone to our third quarter conference call. Our earnings release was issued this morning on the results of our third quarter ended March 31, 2013. We have posted a financial summary presentation to our website to accompany this conference call. Presentation can be found on our Investor Relations website, alongside the webcast link. I will start with an overview comments followed by Bob’s financial review. We will then open the call to your questions. Overall, Kimball International results for the third quarter improved nicely over last year, led by strong performance during the quarter in our EMS segment. This is an exciting time for our EMS segment. The overall EMS market is healthy and growing. Manufacturing Market Insider or MMI is predicting approximately 6% growth for the EMS market in calendar year 2013. MMI also recently reported the top 50 EMS providers for 2012 and Kimball Electronics was ranked 18th largest in the world. We were ranked 20th last year. We are delighted with the sales growth we have been experiencing that allowed us to move up two spots in the ranking. If you remember from past discussions, we had a contract expire at the end of fiscal year 2011, which impacted our sales by approximately $41 million per quarter. In the two years since that contract expired, our business development team has been working diligently to diversify and replace that lost revenue. This quarter we are happy to say we have been successful in that effort. Sales in our EMS segment in the third quarter are back to where they were prior to the expiration in that contract with significantly more diversification and balance in the book of business. Along with that revenue growth, we are very pleased with the much improved margins we have seen within this segment over the past five quarters. Back in fiscal year 2008, we set a long-term operating income goal of 4% for this segment. Unfortunately, the recession delayed our progress in meeting this goal until now. Our EMS segment operating income has as a percent of sales is 4.9% in the third quarter. I am very proud of the accomplishments this team has achieved over the last two years. We will work hard to sustain these gains and continue to focus on our growth and diversification strategies as well as continued operational excellence. Looking overall at the furniture industry forecast, BIFMA’s most recent outlook for office furniture growth in calendar year 2013 is growth of approximately 3% with weaker growth in the first half of the year and stronger growth towards the end of the calendar year. Industry orders were soft during the quarter, although forecasted order activity remained strong. On an industry-wide basis, customers have continued to defer the purchase of new furniture particularly with larger projects. Market projections for one of the key leading indicators in the hospitality industry, RevPAR or revenue per available room are to increase approximately 6% for the calendar year 2013. This is a positive sign for this market. A majority of the market growth in hospitality is now existing in hotel renovations. New hotel construction remain slow. Also the luxury segment of the market is recovering while there is continuing price sensitivity and discounting in the lower portions of the market. Orders received during the third quarter within the furniture segment increased approximately 4% over the prior year on increased orders for hospitality furniture. We spoke at our last conference call about the reduced government spending. That continued in our third quarter. The reduction in federal and state government office furniture orders are being partially offset with increases in the other market verticals. While overall office furniture orders slowed during the third quarter, the order pace has picked up in the early part of the fourth quarter. As you saw in the press release, our furniture segment incurred a loss of $2.5 million for the third quarter. Tighter margins coupled with seasonal low sales of office furniture drove the loss. We were disappointed with the furniture segment results and have identified and are implementing corrective actions to address the challenges within this segment to increase our topline growth and improve margins. Now Bob will discuss our third quarter results in more detail. Bob?

[Bob Schneider:]

Thanks Jim. Our third quarter consolidated net sales were $301.5 million which is an increase of 6% from the third quarter of last year. We were very pleased with a 13% increase in net sales in our EMS segment compared to the third quarter of last year. Sales increased in all four of our vertical markets that is, automotive, medical, industrial and public safety. Jim already mentioned this, but I think it is important enough to repeat that we have successfully backfilled the revenue void that was left when the Bayer contract went end of life two years ago. That was a big hole to fill and it feels good to see that success. In the furniture segment, sales declined 3% in the third quarter compared to last year as a reduction in sales of hospitality furniture more than offset an increase in sales of office furniture products. We had a very difficult prior year comparison this quarter due to the two unusually large hospitality projects that completed shipping during the third quarter of last year which we discussed in our last conference call. As a reminder, the $14.3 million of revenue related to these two projects was recognized in the third quarter of last year. While office furniture sales increased in the third quarter compared to last year, the softness in sales of office furniture to the federal government that we discussed in our last call continued. Our open order backlog in this segment as of March 31, 2013, is up 3.3% compared to March 31, 2012 due to increases in hospitality. Open orders declined in office furniture due to slower orders Jim mentioned previously. Third quarter consolidated gross profit as a percent of net sales remained flat with the prior year. Improved margins in the EMS segment were partially offset by a reduction in margins in the furniture segment. Also in packing margins was our sales mix between the segments. As a reminder, our EMS segment margins are lower than our furniture segment margins. In the third quarter, we had a greater mix of sales from the EMS segment compared to last year which had the natural effect of lowering our consolidated gross profit percentage. In our EMS segment, gross profit as a percent of sales increased 1.4 percentage points compared to third quarter of last year. More specifically, when comparing to third quarter of this year to the third quarter of last year, a majority of the improvement is related to the 13% increase in sales as we were better able to leverage our fixed costs. Our focus on diversification of our customer base has also had a positive impact on our margins. Our furniture segment gross profit as a percent of net sales declined 0.6 percentage points in the third quarter compared to last year. We continue to experience competitive pricing pressures in this segment which caused some increase price discounting and lower margins on projects shift during the quarter. In addition in the third quarter of last year, we had a recovery of some previously paid import duties related to a retroactive change in the hospitality related tariff rates which hurts the current third quarter comparison to last year and we discussed that in our conference call last year at this time. Consolidated selling and administrative expenses declined slightly as a percent of sales from last year, but increased 6% in absolute dollars in the third quarter compared to the prior year. Incentive compensation costs were higher related to our improved earnings in the EMS segment, and we also had one of our office furniture dealers file for bankruptcy in the quarter requiring us to record an allowance for open receivables. Fortunately, over the last couple of years we have had very little bad debt, this one amounted to slightly over one penny per share. Our third quarter effective tax rate ended at a negative 6%, which means we recorded a net tax benefit during the quarter even though we had a pre-tax operating income. The unusual relationship is due to the combination of couple of factors, first the mix of earnings between our US and foreign locations. We had income from our foreign locations that have lower statutory tax rates coupled with a third quarter loss in the US, which has higher tax rates. And secondly we recorded approximately $500,000 for a tax benefit related to the extension of the research and development credit that was signed into law in early January. The extension of the tax credit was retroactive for the entire calendar year 2012, so we had a catch up entry to record during the third quarter. The credit was extended through calendar year 2013. Net income in the third quarter was $3.7 million compared to $2.5 million in the third quarter of last year an increase of 47%. We had very little restructuring cost this year compared to 539,000 of after tax restructuring cost in the prior year. Excluding this restructuring cost, net income in the prior year was $3 million. You will find this non-GAAP reconciliation in the tables at the end of the press release. On a segment basis our EMS segment recorded net income of $6.5 million in the third quarter which was a significant improvement compared to the net income of $3.3 million last year. We had a net loss of $2.5 million in the furniture segment for the third quarter compared to a loss of $842,000 last year. Our net cash position which includes cash and cash equivalents less our short term borrowing at March 31, 2013 ended at $89 million and that compares to $75.2 million at June 30. Operating cash flow in the third quarter was a positive $11.4 million compared to $28.8 million in the third quarter of last year. We continue to work on improving our working capital metrics. Day sales outstanding otherwise known as DSO improved from 46.8 days for the third quarter of last year to 44.3 days for the third quarter of this year. The improvement is primarily due to improved collections within the furniture segment and most of that due to lower government sales which tend to pay slow. Our production day supply on hand of inventory or PDSOH improved from 57.1 days for the third quarter of last year to 56.4 days for the third quarter of this year. The improved PDSOH resulted from ongoing successful inventory majority initiatives in our EMS segment. Capital investments for the third quarter totaled 8.1 million mostly for new machinery and equipment in both of our segments. We continue to have almost no long term debt which stood at less than $300,000 at March 31, 2013 and our total availability to borrow under our credit facilities was $79.9 million at March 31. Our balance sheet remains very strong. With that I would like to open up today's call to questions from analysts. Charlene do we have any analysts with questions in the queue.

[Operator:]

(Operator Instructions) The first question comes from the line of Todd Schwartzman from Sidoti & Company.

[Todd Schwartzman:]

First on the gross margin looking at last year from third quarter to the fourth, the gross margin improvement was 220 basis points more than two points, could you remind us of the factors present then that will not or won't likely play out again this year in the back half.

[Bob Schneider:]

The biggest change Todd is LIFO. We had I think it was $2.1 million of LIFO benefit last year Q4 and we are not expecting anything near that in this Q4.

[Todd Schwartzman:]

Just philosophically on the furniture side, ex the government just looking at commercial sales and orders, you seem to be holding your own with some of the larger competitors and I know that your goal has been to build the top line, but what are the cost factors, what are the other explanatory factors that lead you to post losses in the furniture segment.

[Jim Thyen:]

Well there's really two Todd one is the deliberate strategy to go through this period maintaining the capability to manage to handle the growth. And the cost structure is set with that in mind. I think its going to work out pretty well with the way we are seeing the orders trend up and the momentum that is starting to build. And the second is we've taken significant steps to dramatically improve our operational excellence and control of our cost in certain areas of our business, particularly in the furniture area. So we expect the margins to improve.

[Todd Schwartzman:]

Where are the costs still too high at this point such that the segment’s losing money.

[Jim Thyen:]

We need additional volume because of the cost structure we've set and the amount of utilization of our capacity and we need to improve on our execution and delivery of some of our projects.

[Todd Schwartzman:]

Just shifting gears for a second and get back to furniture a minute but for the fourth quarter, what should we expect as far as tax rate?

[Bob Schneider:]

I would look in the mid-20s. A very, very contingent on what countries we have our profitability. You know, we’ve talked a little bit about the loss in Q3, furniture related. That’s pretty much mostly domestic in the United States and as we often see that seasonality, the improvement in orders Jim referred to that we're seeing recently, will improve in Q4 and that will of course put profitability in the US and bring our effective rate up from the extremely unusual negative 3 or negative 6 that we had in Q3 but generally in the mid-20s as roughly we're ought to be relative to electronics being much, much lower and foreign and our US operations being at roughly 35% or so.

[Todd Schwartzman:]

Okay, and on the commercial side, just looking at the corporate customers ex the government, what were sales and orders for the quarter? What was the change?

[Jim Thyen:]

Our orders, particularly starting here in the fourth quarter are showing a nice uptick, it spread pretty evenly across the book of business for the furniture segment. We're seeing increased customer activity particularly on the increased size and projects and increased confidence to explore order activity much sooner. They are willing to commit on their decision sooner. The verticals are pretty well balanced across our furniture segment. Right now, we're looking for greater recovery in the luxury portion of the hospitality market. We feel it is coming. So overall, we feel pretty good about the outlook and it's pretty balanced.

[Bob Schneider:]

And Todd, I'd add we don't for competitive reasons break out the office furniture versus hospitality sales trend and order trend, but I will point out the overall open orders as we ended March were up 3% from a year prior and that's in spite of the difficulties on the federal government.

[Todd Schwartzman:]

Okay. Could you comment on without giving any numbers, were both hospitality and office orders positive for the third quarter that you just reported?

[Bob Schneider:]

Orders were down as I mentioned in my previous comments in office for competitive reasons we will go into the exact amount and hospitality orders were up.

[Todd Schwartzman:]

Right. When I mentioned office, I mean corporate office so ex-government, commercial end users?

[Bob Schneider:]

Those were up also again the specific percent, but those were up also.

[Todd Schwartzman:]

Okay. And in terms of the effect, the impact that discounting had, is there any way to let’s say to put a number to that sale dollars so what it cost you relative to the second quarter. So on a sequential quarter basis, how much better or worse things got in dollar due to discounting incrementally on furniture?

[Bob Schneider:]

Todd, I don't have that, it had an impact but I don't have the exact number.

[Todd Schwartzman:]

Okay. It seems that you called it out to a greater degree than in Q2, did it just escalate a little bit in the third quarter?

[Jim Thyen:]

It did escalate little bit the third quarter being, particularly an office furniture being the seasonal low, brought about a few more competitive pressures in the hospitality industry and those are little delay and the recovery on the top side of the marketplace. And when you look at the lower price stratus in that hospitality industry, it is certainly more competitive and greater pressure on those prices.

[Todd Schwartzman:]

And relative to the third quarter, is discounting as prevalent in April or was it as equivalent in April?

[Jim Thyen:]

We are seeing a general increase across all of our furniture markets. We are seeing the demand just inching up bit by bit, day by day. We are running at a higher pace and we have the last year and the prior year.

[Todd Schwartzman:]

You are talking about demand.

[Jim Thyen:]

Yes.

[Todd Schwartzman:]

All right, but just from clearly isolating the discounting phenomenon, is that stabilized or has that stabilized in April versus the March quarter?

[Jim Thyen:]

Yes, it has stabilized. And I believe as customers have greater confidence, value they receive for the dollar, it will continue to stabilize and lessen just a little bit.

[Todd Schwartzman:]

Okay. And in terms of the mix, the segment mix, obviously ways pretty heavily we've seen this in the last year quarters on the gross margin. Can you give us any sense or how to think about the variability of the product mix maybe within each segment as well as the mix of the EMS to furniture, what kind of the floor and ceiling might be if you were to maintain the 60-40 split in any given quarter, what kind of floor and ceiling might you expect to see 300 million to 350 million volume level for any given quarter?

[Jim Thyen:]

When you look at the segments, I think it’s important to understand that we do not have a specific goal and on the segments, the mix is more of a result of the strength and the rhythm in those marketplaces. When you look at the electronic segment, our balance, our mix across the full verticals is becoming more even and more balanced, the four verticals being automotive, medical, industrial and public safety. Public safety today remains the smallest, but it has the fastest growth rate over the prior year and we are starting to experience pretty nice balance in those four. We also have good balance in the furniture side when you look across the vertical markets of office furniture and also when you look at the three major segments, if you will, of hospitality. We do see the contract portion of office furniture and we see the luxury portion of hospitality gaining more momentum this April. We see that momentum building and so we envision a nice balance there three months from now, perhaps six months from now.

[Todd Schwartzman:]

In the press release, you said you expect to see sequential improvement in furniture in the fourth compared to the third. Can you break that out by seasonal versus non-seasonal factors, the new products in there, I mean how much of that really would you attribute to just plain old seasonality and sequential pick up you would expect to see?

[Jim Thyen:]

It’s difficult to quantify that, there's a lot of moving parts as you know. Certainly the federal government was part of that seasonality. We do as any market thrives on new product introductions, that's an important aspect for our growth going forward and we continue to put a lot of emphasis on new products that we will be introducing and announcing, but there's no way that other than comparing with the definite measures and the PWC, other industry measures that we can judge that or quantify that.

[Todd Schwartzman:]

Is it the goal still a percent operating margin for the segment?

[Jim Thyen:]

Yes, it is, that's a long-term goal. We think it’s reasonable and appropriate and we've been interrupted on our progress to that goal and furniture, but that remains and we are going to aggressively push to achieve it.

[Todd Schwartzman:]

And Jim, I realized it’s a long-term goal, but with that said, can you envision anything that would lead you to increase or decrease that long-term goal.

[Jim Thyen:]

At this time, no, we are going to keep that goal as it is. We will continue to watch how the market evolves and what opportunities are unfolding in segmentation of markets that maybe carry different margins with it.

[Todd Schwartzman:]

Okay. And on EMS, are there any customer and program wins and maybe end of life to programs to call out for this past quarter in Q3 as well as perhaps more importantly expected over the next 12 months or so?

[Jim Thyen:]

I believe we move by, and the moves passed, that special cause variation that we had in our medical segment and certainly if we had something like that that we're aware of, we would disclose it.

[Operator:]

Thank you. Our next question is from the line of Josh Borstein of Longbow Research. Mr. Borstein, please go ahead.

[Josh Borstein:]

Just to make sure I understand the press release correctly, excluding hospitality sales and office furniture, consolidated sales were up year-over-year despite a double-digit decline in the sales to the federal government. Is that correct?

[Bob Schneider:]

Yeah, we were up 6% for the year and federal government was down significantly in the quarter. And so in spite of that, we were still up.

[Josh Borstein:]

Okay. And what were some of the verticals that really shined for you to help offset those declines in government?

[Jim Thyen:]

Certainly, the financial services, healthcare, generally the professional and business area, the bulk of the marketplace was up. Selected state governments were up nicely.

[Josh Borstein:]

One of the questions I had was the how state and local governments were holding up relative to the federal government, but it sounds like they are doing much better at this point.

[Jim Thyen:]

For us, they are holding up, yes.

[Josh Borstein:]

Okay. And any sense, you know, getting back to the federal government piece, any sense on those large declines might or do you believe that when GSA does buy them out, it's going to stay at lower levels or is there any indications that sales might ramp again?

[Jim Thyen:]

I think the noise and communication on our country is going to handle the debt and deficit challenges are, they are extremely fuzzy. And I don't know that it's very predictable at this stage. We have a strategy to try to maintain our balance in these verticals and furniture, and so we want to aggressive grow the top line but I don't know that we see a bouncing back to where it was, before the decline.

[Josh Borstein:]

Okay. Thanks for that and then with the strength that you’ve seen in some of those verticals that you pointed out financial in a professional business, but what are the some of the key drivers there. Is it so mainly churn were leases are coming due and businesses are moving and buying some office furniture along the way; is it, transition to more open, collaborator environments or is there something else going on to explain that strength.

[Jim Thyen:]

I don't believe there is anything unusual, there is a good rhythm, good momentum building and in each one of those verticals and we are continuing to line ourselves with winners in those market places and so we are focused on growing their success so we can continue to succeed. But I don't think there is anything particularly. Healthcare is seeing a lot of consolidation you know that from the regulations and usually consolidations brings about rebranding and trying to improve the quality and improve the synergy. But in the other vertical there is no dominant factor.

[Josh Borstein:]

Okay and then just last one from me. Do you subscribe to the business point of view based on what you are seeing right now that the second half is going to be a lot better than the first half for office furniture?

[Jim Thyen:]

Well, we certainly know the put a lot of effort in our forecast. And it's an important forecast it's a view of the entire industry and at this time at this point in time we do see a more strong over second half. We also know that things can change rather rapidly and there is a lot of uncertainty a lot of flux in the March place but we are using it in our business judgment, we have confidence in it.

[Josh Borstein:]

Okay, and then I know for 2014 they have a more robust outlook, I think they are projecting up 9% any obviously visibility on the 2014 isn’t great but that a view point that you see as possible as well.

[Jim Thyen:]

You know visibility in the climate they were in, the economic climate were in tends to be fairly crisp and real short term and it tends to be fairly clear real top long term, and the middle gets awful fussy. Don't really know all of the elements that they have got in that forecast. So we take it and use it in our planning, but we don't look that and those the only measure that we use to forecast our results.

[Operator:]

Thank you. Our next question from the line of [Richard Greenbag of Funnel Smith & Co]. Please go ahead.

[Unidentified Analyst:]

Back on the furniture you guys are running at roughly this $500 million sales level and in then the past you know 10 years the pick was somewhere little in excess of $600 million but at that point you are achieved the margin of 3%, so I guess it’s a two part of question, one that I do that you guys are preserving the cost structure, you can probably double yourselves you said but you know that is, there's a tendency to hurt margins by not undertaking the cost of actions so is that really the right strategy because you clearly are not going to be doubling your sales from here and Bob if you have any sense as to what sales level you would need to hit to get close to that 8% margin goal.

[Jim Thyen:]

Well, let me make a comment on the strategy and then Bob can add in. We have done significant -if you are in a period that you are citing and the period you are looking at we have done significant realignment and restructuring and scaling in the furniture side of our business to have a very sharp focus of our capital aligned to the markets that we are competing in and the reserving of the core and what that means to our cost structure is really a more near term comment as we saw this international liquidity crisis developing in ’09.

[Bob Schneider:]

Richard I would add in terms of the level of volume it would take to get to the 8% that's really a tough question because its not just a factor of keeping our margins where they are today and barely increasing the sales number to get to that because our margins need to improve not in all of our businesses but in select businesses and we are taking actions to improve those margins and a lot of it goes to as Jim touched on its better execution. And but in terms of the actual dollar level of sales coupled with that improvement in execution impact on margin I don't have that off hand.

[Unidentified Analyst:]

Okay, but I think its fair to say that you've talked back to that $600 million annualized level you would fully expect your margin to be in excess of the roughly 3% that you achieved last time?

[Bob Schneider:]

Yes, our breakeven sales Richard have dramatically reduced in our businesses over the last four, five years. Going back to the point that you’re using as a baseline, we have dramatically reduced our breakeven sales. We will still work on the margin, but in terms of cost structure, we've taken it down significantly.

[Unidentified Analyst:]

Okay. And then on the EMS segment, you know fantastic performance and you guys really should be congratulated for recovering from the bear loss. Is this you know -- should we consider this new margin level of 4.9% and the sales that you are achieving now in excess of $100 million a quarter, is this sustainable or is it too optimistic to think that you can remain in excess of your 4% goal?

[Jim Thyen:]

4% is a very valid long-term goal that we very careful set for the EMS market and it recognizes the upfront capital requirements that occur in that kind of market. We are past the European consolidations, we are past the end of life contract hold, and we have very successfully diversified our portfolio, but it would be prudent to expect variation around that 4%. It’s a very competitive market. And if you just look back at a couple previous markets, we had the 3% range. There's variability in that goal. It’s not an absolute hard goal.

[Bob Schneider:]

And Richard last call we talked about all the work that was done to backfill bear with diversified business, much, much better margin business than what bear was and we've been working that for almost three years, probably 2.5 years and we said at the last call it’s coming and as you look at quarter we just ended, it occurred, we backfilled it. The back order level you will see in our 10-Q is up 21% at the end of March compared to a year ago, which gives a little bit of perspective in terms of continuity of the volume levels that we have ramped up to in the quarter we're in right now.

[Unidentified Analyst:]

That’s great. And then just finally, Jim, I have had conversations with Bob about this whole issue of what you do with the cash and are you guys heading towards more acquisition or why not do a stock buyback with your stock discount to book, I think it's clearly at a discount where you think the long-term value of the company is. I don't think you need all this excess cash. Why not have a program in place? When your stock looks cheap to you and certainly below and understated book value, why not just allocate whatever it is, 10 million to 20 million of that cash to get you started on that?

[Jim Thyen:]

Well, it certainly is a topic that we continue to examine in discussion with our board and it's a valid topic to debate. We believe smart acquisitions make good sense. We believe liquidity crisis brings opportunity and we believe that all of our growth cannot just be organic, but I understand what you are saying, I understand the attractiveness of that in terms of our short-term stock price and we will continue to examine it carefully at the board level.

[Operator:]

(Operator Instructions) We have no further questions. I would like to hand the call back over to Mr. Thyen for closing comments.

[Jim Thyen:]

All right, thank you, Charlene. Thank you, and that brings us to the end of today’s call. We appreciate your interest and look forward to speaking with you on our next call. Thank you. Have a great day.

[Operator:]

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