Knoll, Inc.
Q3 2017 Earnings Call Transcript

Published: 24 Oct 2017

[Operator:]

Good morning, everyone, and welcome to the Knoll Incorporated Third Quarter 2017 Conference Call. This call is being recorded. This call is also being webcast. Presentation slides accompanying the webcast. In addition, this call may offer statements that are forward-looking, including without limitation statements regarding Knoll's future outlook for the industry and economy. These forward-looking statements are based largely on the Company's expectations and are subject to a number of risks and uncertainties, certain of which are beyond the Company's control. Actual results may differ materially from the forward-looking statements as a result of many factors, including the factors and risks identified and described in Knoll's Annual Report on Form 10-K and its other filings with the Securities and Exchange Commission. This call today will also include references to non-GAAP financial measures. Reconciliations of these measures to the most comparable GAAP financial measures are also included in the presentation slides that will accompany the webcast. Now, let me turn the call over to Andrew Cogan, the President and CEO of Knoll. Thank you.

[Andrew Cogan:]

Good morning everyone. Joining me on today's call is Charles Rayfield, our Senior Vice President and Chief Financial Officer. Our third quarter results mark an important inflection point, as sales stabilized and we returned to double-digit levels of profitability. For the first time in our Office segment sales of our newer workplace model and related products exceeded those of our legacy systems. Coupled with continued growth in our specialty and residential businesses, the initiatives we have taken over the past year to increase our market penetration and Office sales, position us well for a return to growth. While Office sales declined slightly in Q3, we are pleased that sequentially Office operating profit margins doubled to 8.6% and operating profits increased from $6.5 million to $15.5 million as volume return to normal levels. We talked last quarter about reaching a point where the initiatives we've taken to ramp up our sales coverage and see more of a broad based market opportunity beyond our core strength in the individual work spaces would marry up with our significant investments, the new product platform like the award-winning Rockwell Unscripted collection increased ergonomic seating and adjustable table offering and broader price points with our case family of products to improve our performance. That's exactly where we find ourselves today. Heading into the end of this year and the start of next, we are tracking a double-digit increase in the number of client engagement we are pursuing commensurate with our increased feet on the street in coverage of our highest opportunity dealers. While on a dollar basis, this translates into mid-to-upper single-digit increase in our funnel, it does validate than a market with fewer large projects, greater sales coverage is a warranted expenditure. Investments and training combined with our expanded offering are helping us to convert these opportunities to Knoll at a higher rate than a year ago. In the quarter, backlog ended up versus prior year and we expect that momentum to continue as we enter 2018 as new products like Rockwell Unscripted, adjustable tables and our case family of products gaining further market acceptance across both new and existing clients. We will be completing the rollout of these designs across most of our showrooms into early next year. One of the challenges in the evolution of our mix away from these legacy products to newer platforms is that we haven't had the same time to maximize our manufacturing efficiency or fully amortize the investment in these newer designs. So from a mix standpoint in the short-term that is a challenge. Additionally, we face accelerating inflation in certain commodities and the headwinds of a strengthening Canadian dollar although in recent weeks that has started to recede. Our operation teams are very focused on the need for improvement here and using lean tools are generating improvement across all our plants including our newest manufacturing lines. Until industry demand becomes more aligned with what we generally see as positive macro drivers, pricing will also remain competitive. Lastly, we expect Office operating expenses to move up as the full impact of our sales additions and more normalized incentive accrual levels start to comp versus prior year. Both our Studio and Covering segments delivered growth in the quarter led by those businesses like Holly Hunt with the greatest residential exposure. As we mentioned last quarter approximately a fifth of our total sales and half of our specialty sales are used in residential applications. Within these combined segments residential sales grew upward single digits where contract and hospitality applications were relatively flat year-over-year. Our Studio segment experienced growth of just over 4% including the benefits of the DatesWeiser acquisition. Although on a margin basis, our DatesWeiser conference and meeting table business accounted for virtually all of the margin percentage deterioration in the Studio segment, operating margins in the segment of just under 15% remained strong. The bulk of our investments enrolling our DatesWeiser nationally in key markets are now behind us and with the divisional sales team in place, we expect to see this acquisition begin to bear fruit in 2018 as we already have a backlog of awarded projects as a result of our collaboration. Coverings results and margins were stable as growth at Spinneybeck FilzFelt and Edelman offset sluggish performance at KnollTextiles. Lastly, I was particularly pleased with the performance of our knoll.com Web site this quarter. On the combined direct-to-consumer and workplace side of knoll.com we experienced a strong double-digit increase in traffic. In September alone, we set a record of half a million visits. While this reflected new marketing efforts around our KnollStudio annual sales, it also reflects I believe increasing interest in the expanded breadth and relevance of our newest workplace and specialty design for a new generation of clients and specifiers. Now, let me turn the call over to Charles to take you through our results in more detail.

[Charles Rayfield:]

Thank you, Andrew. Knoll Inc., third quarter net sales decreased $0.8 million or 0.3% from a year ago. Our Office segment was down $4.6 million or 2.5%. The decrease in Office sales compared to prior year was due primarily to a decline in government sales, while Office commercial sales were flat. Our Studio segment sales increased $3.4 million or 4.2%, increased sales of Holly Hunt and the incremental sales from DatesWeiser were offset by a decrease in contract shipments at KnollStudio. Coverings segment sales were up $0.4 million or 1.5% driven primarily by higher volume in the Spinneybeck FilzFelt and Edelman businesses partially offset by volume declines in KnollTextiles. Gross margin decreased 200 basis points from 38.6% a year ago to 36.6%. This decrease was driven primarily by accelerated commodity inflation foreign exchange headwinds at an unfavorable mix related to the ramp up of newer product platforms. These declines were partially offset by continuous improvement in lean initiatives. Total operating expenses in the third quarter were $76.5 million compared to $77.6 million in 2016. The decrease was due primarily to lower incentive compensation from decreased profitability. Interest expense was up $0.7 million from a year ago resulting from an increase in the outstanding balance on our revolving credit facility in addition to an increase in interest rates. The increase in the outstanding balance on our revolving credit facility was due primarily to our discretionary pension plan contribution in the fourth quarter of 2016 as well as our recent DatesWeiser and Vladimir Kagan acquisitions. Our tax rate for the quarter was 29.9% down from 34.9% in Q3 of 2016. The decrease in the tax rate was related primarily to the reversal of evaluation allowance against certain deferred tax assets in a foreign jurisdiction. The tax rate was also affected by the mix of pretax income and the varying effective tax rates in the countries and states in which we operate. We estimate that our full year effective tax rate will be between 32% and 33% inclusive of the tax benefit recognized in the third quarter. Net income for the third quarter of 2017 was $19.1 million down from $21.6 million for the same period in 2016. Diluted earnings per share was $0.39 and $0.44 for the third quarter of 2017 and 2016 respectively. In regards to our balance sheet and cash flow, the cash and cash equivalents remain consistent with prior quarter to approximately $5.8 million. Operating activities provided $27.2 million of cash in the quarter. We use excess cash generated from operating activities to invest in the business, pay dividends and reduce our outstanding debt. Investing activities included capital expenditures for the quarter of $8.7 million compared to $10.4 million in Q3 of 2016. Capital expenditures related primarily to manufacturing equipment, information technology infrastructure and showroom investments. Total cash used by financing activities was $22.2 million. The primary uses of cash in financing activities during the third quarter of 2017 were the repayments of our revolving credit facility and the payment of dividends of $7.3 million. Our balance sheet continues to remain strong and while the reduction of EBITDA and increased outstanding debt modestly increased our leverage ratio from 1.37 at year-end to 1.52 at the end of third quarter. We remain comfortably within all debt covenants. Thank you. We'll now take any questions.

[Operator:]

[Operator Instructions] And our first question comes from Budd Bugatch from Raymond James. Your line is now open.

[Katherine West:]

Hi, Charles. Hi, Andrew. This is Katherine West on the line for Budd Bugatch. You cited new products, is it gross margin headwind over the quarter, how should we think about margins going forward with the new products becoming a larger part of the mix?

[Andrew Cogan:]

Thank you. Nice to meet you. Listen, we think -- we are very pleased that we are over now the headwinds of the legacy products the efforts we have made to modernize the portfolio to develop products that respond to how people are working today as truly gained traction. And we feel now that we are going to continue to build momentum. The good news is, those products ramp up, they start to better absorb the manufacturing overhead and the kind of start to amortize the cost that go into that. It will take, I think probably a couple of quarters for those products to get up to kind of the run rate margin of the legacy products that we have been making for one or two decades where we have kind of really automated and maximized those processes. So, our teams are very focused on using the lean technique and all the skills and the took kits we have to drive improvement in those products and I feel that as over time, the volume, those ramp up, that we will start to see the margins normalize with more of our legacy products. But, it will take a couple of quarters to get there I think.

[Katherine West:]

Thank you.

[Operator:]

Thank you. And our next question comes from Matt McCall with Seaport Global Securities. Your line is now open.

[Matt McCall:]

Thanks. Good morning, guys.

[Andrew Cogan:]

Good morning, Matt.

[Matt McCall:]

So, maybe expand that last question a little bit, if I think about next year, just maybe in the context of this year and start 2017, we had some ERP hit. I think the number in Q1 was in the $5 million range not sure what it was in Q2. But, you think about and then and you mentioned lean a few times, you mentioned maybe the investment in DatesWeiser kind of behind you, I think Charles, you mentioned that. So, if we put all this into one equation, what is the visibility to earnings next year look like kind of absent any assumption around the top line?

[Charles Rayfield:]

Let me start with the top line, Matt, if you don't mind.

[Matt McCall:]

Sure.

[Charles Rayfield:]

I think the important thing right now again is, as we look at the number of opportunities we are pursuing and the pipeline when you kind of dollarize those opportunities and then factor in the improved win rates that we are seeing in terms of our ability to translate those that potential pipeline into actual revenue. I think we are in much better shape than we were a year ago. And so, with backlog up now and with the good level of [cost sense] [ph] that backlog will be up more as we head into next year. I think one of the things we have been chasing in the first half of the year was under absorption and lower volume and I think now the office margins are returning to more normalized levels we are running at and more consistent levels our plants are performing well from a on time and service metric standpoint. I think we are in much better state as we start next year. So that said, I think an important point to make. In terms of the -- the kind of the gross margin and those challenges there definitely are a variety of headwinds that we will fight, so inflation for us has been more of a back half phenomenon than a front half phenomenon. So, we see some incremental inflation pressures probably in the first half of next year. The foreign exchange, again, a bit of wild card, I think the dollar was pretty strong in the fourth quarter, and then, weakened a little bit in the first. So, we think there still be some foreign exchange carry over. And then, as the new products continue to ramp up and whether some of the newer [indiscernible] products or Rockwell and we really start manufacturing those at levels that are kind of commensurate with what our plans for them are, we should see margins there improve as well. So, I think it's a mixed bag, I think also there is certainly some pricing pressure maybe a little bit more in the legacy products but definitely some ongoing pricing pressure. So, I think for the next couple of quarters, we will make margin improvement in 2018. But, I think it will be tempered by the factors I just took you through.

[Matt McCall:]

Okay. That's true.

[Charles Rayfield:]

Let me just finish the operating level. I do think you will start to see operating expenses start to normalize in a more normal rate. Obviously, this year, whether it was commissions or other incentives, those came in some come down that will start to return to a more normal level in the fourth quarter and hopefully through next year. The additions in sales head count really were a back half phenomenon so you would have -- you have some of those fixed cost now certainly in the first half of next year. So, again, I think there are a variety of puts and takes, I do believe we can generate margin improvement. But, I wouldn't want to get ahead of ourselves at this point on the magnitude of that quite yet.

[Matt McCall:]

Okay. You are right. Lots and puts and takes there. So, maybe, first hit that the ERP hit, what was that ERP hit to start the year, did I have that number right, $5 million in Q1 and did you have any impact in Q2?

[Charles Rayfield:]

I think we talked about $10 million to $12 million of revenue that we kind of missed out on or passed on in the first quarter or two, I don't recall the exact amount of that.

[Matt McCall:]

Okay. I will reference back. But, also recall potentially some cost saves and part of I think what was -- maybe was surprising early this year was the impact of the top line on the overall profitability improvement. So, part of the story was that we are going to see pretty consistent profit improvement kind of outside the top line obviously, I understand the impact. But, now that we have got the top line coming back, do we have the ability to go and pursue some of these margin opportunities, these cost save events, from the remaining lean, I think you quantified some of those in the past. But, are those part -- the puts that maybe we need to incorporate into that equation for next year?

[Charles Rayfield:]

I think we have been very aggressive on our lean work. We've had something like 38 different lean event now across all our plants on average saving, just south of $100,000, with very high return on the resources that were deploying there. And so, and even in the quarter that just ended, and looking ahead we see strong continuous improvement and lean improvement. I think the challenge is, that we do have incremental inflation. We had a pretty good lock on some of our commodity cost in the first half of the year. We don't have those in the back half nor do we have those in the first half of next year. So, I definitely see, steel, aluminum, some of those kind of commodities that's inflation we really didn't have earlier this year. I see that coming back. I see some of the foreign exchange pressures which we are seeing now in the back half of this year carrying over and anniversarying into the first half of next year. So, as I look at the first half of next year, I think some of the things that are kind of compressing margins particularly on the office side in the back half of this year, on the gross margin side will effect the gross margins in the first half of next year. And then, I think by the time you get to the back half of next year, I think assuming those normalized at the run rate they are at. And we get all the improvements in the new products and the ramp up of those. Then, I think you can see a more back half acceleration in the growth margins of the business.

[Matt McCall:]

Okay. Got it. I want to try one more maybe way to understanding -- put it all together. When I look at 2017 where we are probably going to come out from larger perspective, when compared to 2016, you think 2018, can we get back to kind of 2015 level, 38.3 gross margin, 11.7x operating margin, is that given all these puts and takes and the opportunity on the top line is -- are we potentially going to get back to that level and essentially be flat with where we were in 2016?

[Charles Rayfield:]

I can't give you a firm answer right now on that Matt. I mean obviously we are -- we can emit the planning process. But, I think that maybe a little ambitious in terms of the out year margins. I do believe that we will be solidly double-digit and that we should improve operating margins from where we are this year. But, I definitely think factors of inflation, foreign exchange pricing, will offset -- more than offset some of the lean to continuous improvement and then we still have to work through this evolution of our mix as the newer products continue to ramp up. So, I'd be a little more cautious on the kind of margin expectations for next year. We talk about every year we want to 50 to 100 basis points of operating margin improvement absolutely this year was a step back. I think we'll get more on that trajectory next year from where we are this year. But, I don't know whether it would be 50 or 100 basis points.

[Matt McCall:]

Okay.

[Andrew Cogan:]

And Matt, you also have to remember we do have the normalization of operating expenses as a lot of the investments that we've made to get the growth going again, now we have to start paying of course, so the additional headcount, things like that will start to, show up in the run rate going forward. And I think those are all good investments, I think we're seeing the benefit of those now in our pipeline and I think you'll start to see that in our top-line in the fourth quarter and into 2018.

[Matt McCall:]

Okay. All right. I apologize still as one quick question, Charles, the 32% to 33% tax rate this year is that that's the right direction for next year or do we revert back to that higher number?

[Charles Rayfield:]

No. I don't think that's the correct number for next year, I think you're probably back in the 35, 36 range for next year.

[Andrew Cogan:]

Hopefully, we get some sort of corporate tax released and we're in a even better position Matt.

[Matt McCall:]

Right, right, all right. Thank you guys.

[Operator:]

Thank you. And our next question comes from Greg Burns with Sidoti. Your line is now open.

[Greg Burns:]

Good morning. I don't know if you quantified these items, but could you give us the amount that the backlog was up this quarter and maybe an indication of how bookings were trending for the quarter? Thank you.

[Andrew Cogan:]

Yes. Sure, Greg. And we don't do that specifically, but I can say that backlog was up above mid single digits this quarter and we would expect to end the year with backlog up low double digits based on the pipeline and the orders, positive order strength we're seeing.

[Greg Burns:]

Okay. Thank you. And in terms of the investment in the sales on the feet on the street do you feel like you have the coverage that you need now or is there room for further investment on that front?

[Andrew Cogan:]

No. I feel like we're really well positioned that we've got people and talent in place in the all the markets we've identified. And that's been a major, a major initiative and I would say our feet in the street is up somewhere around 15% to 17% from where we were a year ago. So, now it's really getting those people trained and maximizing their efficiency and coverage, but we are starting to see a good return on that investment.

[Greg Burns:]

Okay. And in terms of regaining varied share with your dealer network, do you feel that the order systems and the integration between studio and the contracts side of the businesses where it needs to be or is there room for improvement on that front to make it easier for them to order across the Knoll's variants?

[Andrew Cogan:]

Our dealers all our major brands and platforms are the same dealer system. So they can do that today. So there is no problem there, but that said I do think there is continued room for better coordination between our varied sales forces about covering the full range of, the full set of opportunities with any particular client engagement. And we are very focused on maximizing that engagement across all the Knoll brands on the particular client account.

[Greg Burns:]

Okay. And then, lastly, your COO, Joe Coppola stepped down, any risk of some operational hiccups in terms of the lean issues given that change of management?

[Andrew Cogan:]

Well first of all Joe didn't step down, he took a medical leave of absence and we are hopeful that, Joe is able to come back. But, what I will say is we were prepared for this, it's something we've been planning for a long time. And we have a very strong Senior VP of Operations who is been in place for a while now. And he is got tremendous lean experience and so I believed on slightly we've lost the beat in terms of any of our initiatives and as I see the work our sites are doing under his leadership and work going into our planning cycle, very encouraged, and I don't think we'll drop a beat here.

[Greg Burns:]

Okay. Thank you.

[Operator:]

Thank you. And our next question comes from Kathryn Thompson, Thompson Research Group. Your line is now open.

[Kathryn Thompson:]

Hi. Thank you for taking my questions today. Just a clarification on the office side. Was a great news to hear about new product sales, spring in the quarter. But, if you look at the greater driver of out performance, how much of that was driven by new product sales versus legacy systems and maybe if you could give a little bit more color on how legacy products performed because there would be some indication of -- if you are getting any type of realization of increased sales? Thank you.

[Andrew Cogan:]

Couple here. First of all, when I look at the mix again, this was the first quarter that we have seen the newer platforms in total dollars out exceeds some of the -- some of the legacy platform. So you are talking about strong double digit growth 25%, 30% whatever percent in some of those legacy category -- in some of the newer categories. And then, you know, I say high single, low double digit erosion in some of the legacy products. But, now that we are at a point where those newer products are a bigger part of the mix, I feel confident that going forward, we will start to see the net result of all this big growth in the office business. So, we are definitely at that inflection point. And I do think, we will start to see at some point, I would expect the legacy products to stabilize. I mean people are still working in individual areas, work stations and private areas and people are still a part of what our clients are doing. We have actually had some very nice wins lately with those legacy platforms where people are doing whole buildings and stuff like that. So, I do think we still start to get some more stabilization there and then we can really see the benefit of the newer platform starting to run.

[Kathryn Thompson:]

If you saw high single, double digit erosion sales in legacy in the quarter, are there any notable trends that would give you confidence that you are seeing greater stabilization, in other words smaller declines overall there, are you seeing anything like that?

[Andrew Cogan:]

I think we are seeing smaller declines in legacy and greater growth in newer platforms. I mean Rockwell is an example. Again, it's still pretty small when I compare to the ramp up of products like antenna, it's ramping up, right on the pace and antenna today is, over $100 million platform. So, we are very encouraged that the things we have done are resonating with clients. We are seeing it in the funnel. We are seeing it in the win rate. We are seeing it in the orders activities as we go into the fourth quarter here.

[Kathryn Thompson:]

Okay. And just wanted a clarification, I know there have been a lot of questions in gross margins but in your prepared commentary that 200 basis point decline you said it was driven by three main buckets, accelerated commodity cost, new product ramp and FX. But, in that mix also volume obviously have some type of impact and really what we are trying to determine is, how much or things that will pass, so things have really -- how much is volume versus the other categories that you outlined?

[Charles Rayfield:]

Volume was relatively a non-issue in terms of the margin in the third quarter.

[Kathryn Thompson:]

All right. And so, of the commodity new product FX because the new product ramp that was a majority of the decline theoretically that should anticipate little more quickly versus commodities which are a big question mark. And so, I'm trying to get an understanding of what's something that is, you could see a path toward [indiscernible] yourself to something where you're just not sure.

[Andrew Cogan:]

Well, I think we kind of gave them in the order that they impacted us. So, I think it was kind of commodity inflation mix FX.

[Kathryn Thompson:]

Okay.

[Andrew Cogan:]

And again, I think inflation will be an issue for the next few quarters, but again, I think by the time we get to the back half assuming some stability in steel and some of the other major commodities that should stabilize, change moves around a lot, we probably have one more quarter of real exchange challenge in the fourth. And then, exchange kind of I think becomes a non-issue, and then, as we move through the 2018, I think you will start to see mix be less of a drag. So, again, I think the margin pressure will be with us for the next two or three quarters, but I would expect as we get in the back half of 2018 borrowing any big change in inflation and/or foreign exchange that you will see gross margin start to move back up.

[Kathryn Thompson:]

Okay. And on office government sales have noted that they were little weaker in the quarter, but this segment has been a laggard for a bit -- could you remind us what percentage today government is for office and then also -- are you seeing any type of embracing by government of the newer format of the office and really trying to understand, is there anything other than the obvious that could be -- lead to a slower government itself?

[Andrew Cogan:]

Well, actually -- government orders were up in the quarter, so shipments were down, but government orders were up. I think that this is relatively flattish right now maybe down mid single digits on an annual basis and it's not a humungous factor on our total revenue or activity the way it used to be 7 or 8 years ago. So, I think it's a manageable segment, and remember it's very much split between both federal and state local -- actually in the state local piece now is larger than the federal piece. So, it's a much more diversified client base than it's been in the past. So, that's not something that we see as a major driver one way or another.

[Kathryn Thompson:]

Okay, great. Thank you very much.

[Operator:]

And I'm not showing any further questions at this time. I would now like to turn the call back over to Andrew Cogan for any further remarks.

[Andrew Cogan:]

Great. Thank you all for your continued interest in Knoll and we look forward to seeing you at some of the upcoming conferences and talking again with you in early 2018. So, take care everybody. Good bye.

[Operator:]

Ladies and gentlemen, thank you for participating in today's conference. This does conclude today's program and you may all disconnect. Everyone have a wonderful day.