Knoll, Inc.
Q4 2016 Earnings Call Transcript

Published: 13 Feb 2017

[Operator:]

Good morning, everyone, and welcome to the Knoll, Inc. Fourth Quarter 2016 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 the Knoll’s Annual Report on Form 10-K and other filings with the Securities and Exchange Commission. The call today will also include references to non-GAAP financial measures. Reconciliation of these measures to the most comparable GAAP financial measures are 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, everybody. 2016 was a good year for Knoll as our expanding constellation of high-design and high-margin brands and capabilities yielded strong results. We set an all-time record for revenue, grew sales faster than the market, expanded our industry-leading operating margins as committed by over 100 basis points, and laid the foundation for longer term growth with investments in new capabilities and ancillary categories with Rockwell Unscripted and the fourth quarter acquisition of the conference and meeting furniture company DatesWeiser. We are particularly excited about our ability to scale up DatesWeiser nationally and internationally through our dealers and global accounts as today the bulk of their sales are limited to a small handful of markets. Much of 2016’s margin improvement was the result of efforts to improve the profitability of our Office segment. In fact, we have been successful in significantly growing Office margins to 10.1% in 2016 from 8.1% in 2015, an increase of just over 200 basis points, this past year alone. And as we up our investment in lean manufacturing, the further rationalization of our manufacturing opportunities, we see further upside even if progress in the short-term is dulled by inflation and absorption pressures. Our residential and consumer strategy continue to yield both highly profitable organic increases and growth through acquisitions like Vladimir Kagan and we are actively evaluating a number of additional acquisition opportunities that would build on these successes. Our constellation strategy levers our historic relationship with architects, designers and decorators that combined with our disciplined approach to the management of our business and acquisitions has resulted in the creation of a singular entity. Clients around the world continue to use our designs to create inspired workplaces, education, hospitality and residential settings. North American office furniture represents a smaller part of our overall sales and profit. Our European business is highly profitable. Our residential strategy does not involve building out an extensive direct-to-consumer retail network and we don't have any exposure to mass supply-driven channels. And as the workplace evolves to a greater blend of individual and groups basis with both the commercial and residential feel, our constellation of capabilities positions us well for future success in the years ahead. While we did see the same slow down in business that others have been reporting in the latter part of 2016 tied in part we believe to uncertainty around the election period, the fourth quarter weakness in our Office business was primarily limited from both geographic and vertical market standpoint to financial services and energy and as a result, the northeast in pockets of the south/southwest. This weakness has been reflected in both the direction of equities in these spaces and the impact of decreased profitability and confidence and corporate investment and leasing activities. In fact recent data we've seen suggests in the key market like New York leasing activity was the lowest since 2009 and overall absorption data show a precipitous decline in Q4 from both prior year and prior quarter. Most other vertical segments and geographies had continued to grow modestly or been flat. While general business investment in new equipment has been on decline through 2015 and 2016, we see the seeds being planted for a turnaround particularly with our financial service and energy clients as witnessed by both the improved performance of stocks in these spaces and an expected favorable regulatory environment that should yield stronger build confidence and investments. Until then we expect to continue to see project size and number of million dollar opportunities trend downward. On our last earnings call, we talked about how the project business can be lumpy good as in our third quarter. It was the opposite in Q4 where we saw a 30% drop in the number of projects greater than $1 million. So, on looking at the back half where we grew 2.6% is probably a more balanced reflection of our performance. Looking ahead to 2017, we believe the weakness in our Office business that we experienced in Q4 will likely persist for a couple of quarters until the post-election improvement in business and CEO confidence as well as the benefit from potential changes to corporate tax, depreciation and repatriation rules, [5

[Craig Spray:]

Thank you, Andrew. We are pleased with our 2016 results. We finished the year with net sales of $59.9 million or 5.4%. During 2016, adjusted gross margin improved 90 basis points to 38.3% from 37.4% in 2015. Adjusted operating profit improved 20% from $113.5 million in 2015 to $136.3 million in 2016. And adjusted earnings per share increased 10.5% from $1.52 to $1.68 per share. In the fourth quarter 2016, our net sales decreased $12.9 million or 4.2% from a year ago. The decrease was primarily result of an 8.4% decrease in our Office segment where weak demand was experienced in the aforementioned specific geographical regions and vertical markets. Net sales in Studio and coverings were 3.3% and 4.1% respectively. Adjusted gross margin for the fourth quarter of 2016 increased 30 basis points from 37.7% a year ago to 38%. The increase was related primarily to favorable net price realization and operational efficiencies partially offset by reduced fixed cost leverage from lower sales volume in the Office segment. Adjusted operating expenses in the fourth quarter of 2016 were $75.6 million compared to $81.5 million in 2015. The decrease in operating expense was primarily driven by lower commissions and incentive accruals resulting from decreased sales volume. Adjusted operating profit was up 5.6% from $33.9 million in the fourth quarter of 2015 to $35.8 million in Q4 2016. Adjusted operating margin improved 110 basis points from 11.1% to 12.2%. This improvement was primarily the result of the 150 basis point improvement in the Studio segment from 15.2% to 16.7%. Interest expense was $0.2 million lower than a year ago as we [11

[Operator:]

Thank you. [Operator Instructions] And our first question comes from Kathryn Thompson from Thompson Research Group. Your line is open.

[Kathryn Thompson:]

Hi. Thanks for taking my questions today. Just to follow-up on Office, how much – I know you specifically cited the financial and energy end markets as points of weakness for Office. But how much of the weakness on the top line was related to that? And also, could you clarify more the margin profile of these markets and how much they impacted segment profitability? Thank you.

[Andrew Cogan:]

Sure, Kathryn. Good morning. The bulk of the decline was basically all of that time, it was finance and energy and it was primarily in the northeast and south/southwest. From a margin standpoint, there's really not any differentiation of any of those verticals in particular. Other verticals, other geographies, either grew or were at worst flat.

[Kathryn Thompson:]

Okay. And then following up on the one-to-two-quarter lag, what gives you – are you seeing anything in terms of bid activity now that gives you confidence that you will see improvement? Or alternatively, are you seeing anything with bid activity that could accelerate that timeframe?

[Andrew Cogan:]

Sure. We just came from a national sales meeting, or actually an international sales meeting, in Atlanta two weeks ago where it was a wonderful opportunity to be with our entire office and studio sales force and kind of hear directly from them and correlate their outlook which is relatively positive with also the data that we look at as we kind of plan for a year. And what is quite encouraging is when we look at the pipeline of activity, in terms of the funnel that we're working on, we see that solidly up mid-single digits. And interestingly, we entered the year with a greater portion of that pipeline already awarded when compared to last year. So that's quite encouraging. Client visits, mock ups as we move through the fourth quarter now, some of it may be Rockwell-driven also were up nicely. The one big change we've seen which makes it a little more complicated is that there is a significant decrease in number of large million dollar plus opportunities. So it's taking a lot – it’s taking more people and a lot more activity to generate the same amount of revenue and everything. So we see the number – a significant increase in the number of opportunities that the team is working on, but again a decrease in the million dollar plus opportunities. So, again, overall, I think this is kind of more suggestive to us of we are kind of going through a pass here, I don’t think by any means the bottom is falling out of the market or anything like that and that given some of the macro things playing out and some of the factors that have impacted negatively and now hopefully positively business confidant, I think we do see the seeds for a kind of back half heading into 2018 resurgence of the office business.

[Kathryn Thompson:]

On the limited shipping the last week of March related to the ERP system, do you have an estimation of what impact they could have? Just it's really for more how we should think about weighting some of our – as we look forward to modeling, how many basis point impact do you estimate that may have on the business?

[Andrew Cogan:]

Well, we're just looking at mainly as we clear out the system and pull the new system up, we will lose about a little less than a week ago of revenue recognition. So it's really just the leverage on those sales is what the impact to be from margin perspective.

[Kathryn Thompson:]

Okay, helpful. That's it for right now. I'll jump back in the queue. Thank you.

[Andrew Cogan:]

Thanks, Kath.

[Operator:]

And our next question come from Matt McCall from Seaport Global. Your line is open.

[Matt McCall:]

Thank you. Good morning, guys.

[Craig Spray:]

Good morning, Matt.

[Andrew Cogan:]

Good morning, Matt. Welcome to your new gig [19

[Matt McCall:]

Thank you. Thank you very much. Excited to be here. So the detail around the margins ex the corporate expense side, that was really helpful. Thanks for providing it. Can you maybe talk about maybe the new way to look at target margins in each of the segments, ex those corporate expenses?

[Andrew Cogan:]

Matt, it’s Andrew. I mean, the corporate expenses for the full year are about 1.5 to 2 points of revenue. So, I mean, I think, you kind of can adjust the expectations on a pro rata basis based on that. I think you pick up kind of about 100 basis points of margin per segment or so. So I don't think it really materially changes anything. I mean our goals remain the same. We want to have north of 20% operating margins in coverings, we want to have north of 15% operating margins in the studio segment and we want to have double-digit margins in the office business. And I will say we were quite pleased to end the year at 12% – just over 12% operating margins across the enterprise, including corporate and all that. That's the strongest operating margin performance in many, many years. So we are very pleased with how we ended the year.

[Matt McCall:]

That's helpful. So in the past, Andrew, you've talked about getting 100 basis points of EBIT margin expansion annually. Is that still the target? And is that a reasonable bogey for 2017, given all the kind of puts and takes you just went through, both for the full year and for the first half?

[Andrew Cogan:]

Sure. I think 2017 is going to be tougher to achieve that kind of margin improvement and 2017 may very well be a pause in that journey. So I think we're not putting any number out there, but the goal remains. We want to keep improving operating margin. I do believe as we change the mix of our business, we certainly have a model that we've shown you over the last three years leads to a more diverse series of revenue streams, not purely dependent on the office part and we’re continuing to build a higher margin mix of our businesses. So I'm not going to put a specific OP improvement goal out there for this year because again we think that there’s a variety of cross currents in terms of headwinds and tailwinds that we need to see how they play out. But I can absolutely tell you longer term we don't believe we're done with the margin journey we’re on and as we implement lean across our operations. And we see significant opportunity to keep driving margins higher.

[Matt McCall:]

So is that – when you say a pause, is that a pause in the 100 basis points or a pause in margin expansion? You still get some margin expansion, just you might not hit that 100 basis points bogey?

[Andrew Cogan:]

I think it's a pause in margin expansion.

[Matt McCall:]

Okay, all right. So I assume, given that studio and coverings are pretty consistent, that mid-teens and 20%, I assume a lot of that is going to come in or a lot of that pause is going to come in the office segment. So when I think about –

[Andrew Cogan:]

I think that would be a fair assumption Matt.

[Matt McCall:]

Okay. Maybe can you just – I think missed or listed a few different items that would be sources of pressure. I know we are going to have top line pressure, but can you walk through some of those sources of pressure that are going to kind of result in that office segment margin pause?

[Andrew Cogan:]

Sure. I mean, obviously, top line absorption clearly would be one of those. I think there's some inflation out, I mean you hear about steel and some of those materials, you have some inflationary pressures there. So I think those are probably the two biggest thing. Now offsetting those, as you know, we’ve got a price increase going in place this coming week which we think will be helpful, we did some stabilization in price in the fourth quarter. And, frankly, as we shift our mix to more of these ancillary areas, those are higher margin areas. And then lastly, Matt – or actually next would really be the changing mix in our business because as we have fewer large projects which tend to be the most deeply discounted projects and more smaller and midsized projects on the $250,000 to $500,000 range that overall should also be supportive of some incremental price realization. And then lastly, we're getting very serious about some of the lean initiatives in our plants and manufacturing sites and I'm really excited about those initiatives, but again those take time to build throughout our network. So I’d say those are the cross currents that we’re talking about.

[Matt McCall:]

Okay. And last one on that subject. Just given the timing of some of those things, the anticipation of some improving trends, could it be a situation where the first half in the office segment is under a little bit of pressure, the back half maybe shows a little bit of expansion, given some of those issues and opportunities? And then that results in the full year being roughly flat? Is there a seasonal aspect to this, this year?

[Andrew Cogan:]

Well, I definitely think the front half will be weaker and the back half, if things play out, as you know, all the data we're looking at and the kind of business optimism that you kind of read about plays out that wouldn't be an unreasonable scenario. I can't tell you what that will mean for the full year at this point.

[Matt McCall:]

Okay, all right. Thank you. Thank you, Andrew.

[Andrew Cogan:]

Thank you, Matt.

[Operator:]

And our next question come from Budd Bugatch from Raymond James. Your line is open.

[Budd Bugatch:]

Good morning, Andrew. Good morning, Craig. Thank you for taking my questions. Let's talk a little bit about Rockwell Unscripted, because I thought that was a terrific offering at NeoCon. You are starting to see orders in it, and you are going to start taking orders at the end of the month. Is that what I understand? Can you give us a little color of what you're seeing in order size?

[Andrew Cogan:]

Sure. We are really excited about what Rockwell Unscripted can mean for us. And I think what's important about it is there's really nothing in that collection and it’s five or six different categories and over 30 products that we really sell today. So from the freestanding walls to the kind of lounge and bar height tables and ancillary pieces that go with that, that's all additive to our collection. We – as I mentioned, we just had the sales meeting. Our Atlanta showroom now is fully built out with Rockwell and I urge any of you in the Atlanta area to go check that out because it is an inspiring statement of what the workplace can be and we were incredibly heartened by the reaction that our sales teams who hadn't been through Chicago, their reaction to that product. We are working on close to 200 different Rockwell opportunities of varying sizes and scale, but what's exciting about those is there – a good chunk of them are opportunities we are already on where we're seeing greater opportunity to capture an increased part of our clients spend. And other than with our opportunities, we wouldn't have even got in the game for if we hadn't had that capability. So I’m quite excited about what that can be and if our sales teams reactions – and they are usually our toughest critics – are any indication, I think this will be strongly additive to our business. We'll take orders beginning the end of the month and kind of order entry in about three phases, so that will kind of roll up over the next couple of months and we will be shipping the entire collection in the second quarter. So we’re excited about what it can mean and the outlook for it.

[Budd Bugatch:]

What's the definition of success in terms of a revenue lag [ph]? 30 –?

[Andrew Cogan:]

I think I talked about it in the last call, but our goal is when we introduce some major new platform, we expect $50 million to $100 million of revenue over annually over a three to five year period and I would hope this would and expect this would ramp up on that schedule.

[Budd Bugatch:]

And is it also in New York? Can we come to Sixth Avenue or –?

[Andrew Cogan:]

We are – we have bits and pieces of New York, we are still in the midst of kind of reconfiguring our New York showroom, so I would say right now Atlanta is the kind of most robust demonstration of it, but I imagine by the end of March New York will be installed, we have a new showroom opening in Los Angeles and then we will – Philadelphia, Charlotte. So we will be rolling out across the country during the course of the year and that’s also one of the comments I made about greater frontloading of spending in the first half of the year, and that’s another factor we need to take into consideration.

[Budd Bugatch:]

And you want to quantify any of that or – of that?

[Andrew Cogan:]

No, you are better at that than we are Budd.

[Budd Bugatch:]

I doubt that. The lean journey – it's something that's near and dear to my heart. Can you give us a little more color of what's going on so far in that? A lot of times, you do lean and you make small step progresses until you can make a large progress. And where are you in that journey?

[Andrew Cogan:]

I think we are just at the beginning. I think the first step for us was putting a management team in place at this site that was prepared to broadly embrace. I think the second step was to start to introduce it in one location at a time where we could make sure that our people were truly engaged in that journey and that they saw it as a benefit as well. And I think we began a couple of events towards the end of last year that have built real enthusiasm that have generated a really nice payback in a very short period of time that have taken out waste, that have reduced cycle time, taken out inventory, improve quality, reduce transportation cost and generally the way our team is going about this is, we are starting at those activities that are a little bit closer to the customer and then seeing how that pulls its way through each of our site. So, again, we are just at the beginning stages here but we now have leadership in place that is experienced at this and we will be over the course of the year each of our sites, our four main manufacturing sites, will begin a significant program of lean events that we hope will only continue to build on themselves. So we are quite excited about it and it’s a major investment of time and people and talent.

[Craig Spray:]

Yes, I’ll say about that. The more we do, the more opportunity we see. So I know a year ago, we said we’re at the beginning of this, here we are now a year later, we still feel like we're at the beginning, only because we continue to see more opportunity in front of us as we move forward.

[Budd Bugatch:]

Okay, a couple of more questions from me. I heard you say you're putting in a price increase effective this weekend. Is that correct? Can you give us a qualification of that?

[Craig Spray:]

2.5%, 3.0% increase pretty much across the board to hopefully mitigate some of the inflation that we’re seeing now.

[Budd Bugatch:]

And that's onto list price, so therefore we'll have to have to see what the discounting is from there and how that plays out competitively? Is that correct?

[Andrew Cogan:]

Exactly but I’m a little more optimistic on price realization here given that I think everybody is increasing price number one. And number two again this changing mix of fewer large projects and more smaller projects. We have a much better record of realizing price on those opportunities than on the large project bids.

[Budd Bugatch:]

But no surcharge kind of things that we've seen in the past or any of that kind of stuff? It's basically a list price.

[Andrew Cogan:]

I don’t think we ever did surcharges. It’s really hard to manage.

[Budd Bugatch:]

Yes, they are. I totally concur. A couple of other things. On looking at the difference between the segment data and the corporate expense data, it looks to me like there was some heavy expense that was reallocated out of office in one of the prior periods, a $475,000 difference in the fourth quarter versus an $8.3 million difference for the year. Can you help us, Craig, understanding what some of those corporate expenses that moved – some of those segment expenses that moved to corporate?

[Craig Spray:]

Yes, I can, Budd. That’s part of the reason why we pulled this out so you could see a little bit more clearly. But really as relate to that change, most of that is couple of things. One, just some lower management incentive that you see year-over-year. And then don't forget we had a few changes to our pension over the last couple of years and how that rolled through corporate sent some volatility through that line item.

[Budd Bugatch:]

Okay. And that's where I was going next, the pension. You made a $43 million contribution to pension. Is that correct?

[Craig Spray:]

In Q4, yes sir.

[Budd Bugatch:]

In Q4. So you were $63 million underfunded last year, the PBO actually went down as I saw it, and I think PBO is likely to go down if general level of interest rates rise. Where are you in a funded relationship to the pension now?

[Craig Spray:]

So from an accounting perspective, Budd, we are effectively 100% funded.

[Budd Bugatch:]

So you are evenly funded right now. And last year –

[Craig Spray:]

PBGC premium on the variable side to pay it all.

[Budd Bugatch:]

Okay. And last year – pension expense last year, between service and interest costs looked like something just under $20 million? Is that right?

[Craig Spray:]

I have to pull it up, that’s pretty close.

[Budd Bugatch:]

So what would go down this year? The interest cost likely will have to go down if you have a better match. Right? And what happens to the service cost?

[Craig Spray:]

Well, don’t forget last year you had some one-timers through there as well just because we had shut off the down going pension. So as we move forward, the key to this is twofold, one, we will lower our expense based on this funding but even more importantly as that PBGC premium continue to go up, we won’t have those cash payments off the door and those cash payments represent a fairly significant premium to what we pay in interest. And so even with our variable interest model we felt really good about that opportunity.

[Andrew Cogan:]

So this was a good arbitrage, Budd, in terms of what the premium penalty would have been versus the interest expense and it’s quite accretive.

[Craig Spray:]

And that continues to go up in 2018 and the out years as well.

[Budd Bugatch:]

I don't doubt that. I'm sure that you all have done that properly. I'm just trying to quantify what happens to pension expense going forward. It looks like around $20 million. What's the delta? Is it $4 million, is it $5 million, is it $7 million? What is the per-year delta that should be at least flowing through the operating line?

[Craig Spray:]

We will see about a $5 million improvement year-over-year based on that funding. And I would say the service cost that we have are primarily the admin cost and the fixed piece of the premium at this point.

[Budd Bugatch:]

And is that ratable over the year? Is that quarter-by-quarter? So $1.25 million a quarter? Or is it…

[Craig Spray:]

That will be evenly applied post our valuation, now we’ll apply that evenly over 2017.

[Budd Bugatch:]

Okay. And when will we see the K that we can kind of get a little bit?

[Craig Spray:]

We’ll have the K out right on schedule.

[Budd Bugatch:]

Which is when?

[Craig Spray:]

That is in, I believe – I can look up the date for you, Budd. March 02.

[Budd Bugatch:]

Okay, terrific.

[Craig Spray:]

We'll have that filed.

[Budd Bugatch:]

All right, I think that exhausts me, if I'm not mistaken. Thank you very much guys, and good luck for the balance of the season and for the year.

[Craig Spray:]

Thanks, Budd.

[Andrew Cogan:]

Thank you, Budd.

[Operator:]

And at this time, I’m showing no further questions. I’d like to turn the call back to Andrew Cogan, President and CEO for any closing remarks.

[Andrew Cogan:]

Great. Thank you all for the call, for your attention to time in the call and continued interest in Knoll, and we look forward to checking in with you all again in April. So take care everybody, good bye.

[Operator:]

Ladies and gentlemen, thank you for your participation in today’s conference. This concludes the program. You may now disconnect. Everyone have a great day.