Knoll, Inc.
Q2 2015 Earnings Call Transcript

Published: 17 Jul 2015

[Operator:]

Good morning, everyone and welcome to the Knoll, Inc. Second Quarter 2015 Conference Call. This call is being recorded. This call is also being webcast. Presentation slides accompany the webcast. In addition, this call may offer statements that are forward-looking. 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 could 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. The call today will also include references to non-GAAP financial measures. Reconciliations 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 CEO of Knoll. Thank you.

[Andrew Cogan:]

Thank you. Good morning, everybody. The story this quarter was our return to double-digit operating margin and the year-over-year operating margin expansion in each of our reporting segments. It is rewarding to see our strategy of diversifying our sources of revenue and profitability across workplace and high-design residential settings is delivering the kind of improved profitability and double-digit margins we expect. While constant currency growth of 3% was slower than in Q1, we did benefit from a more profitable mix of business amongst and within our operating segments. In our office business, we have seen a greater quantity of small to midsize orders to-date and the larger projects that are shipping are spreading their deliveries out over our longer period, its clients’ occupied sequential floors or areas. This has been chewing North America, Europe and even in the Middle East. In general, these trends aren’t surprising to see as the larger projects involve more whole building and our new campus work compared to the renovation and upgrade work, which dominate the earlier phase of the recovery. Anecdotally, the bulk of my many client engagements at NeoCon were also very much related to new building in campus expansions. Interestingly, on an incoming orders basis in Q2, we started to see the mix of larger projects start to increase. And this is also consistent with a spike up in larger mockup activity we are currently experiencing that suggests we will see this trend come through on the shipment line later this year. Until then, we expect mix in activity levels comparable to what we saw in the second quarter. Across geographies, our office team is competing well and win rates have been steady. When we look at the performance of just our North American office business, we are very much performing favorable to overall industry trends. However, particularly in the Middle East, where 90% of our business is made up of larger $5 million to $10 million projects, the timing of the opportunities we are on and/or have secured are the inverse of last year, which means that we expect fewer projects to ship this year versus last year, but backlog to be higher heading into 2016. I continue to have great optimism for our office business. We had a very, very strong showing at NeoCon as we continue to position Knoll as a partner for clients looking to create high-performance workplaces. The breadth and depth of our offer, our ability to help clients with issues from worker well-being with our extensive adjustable and ergonomic offer to managing the plethora of power requirements around the workplace with our innovative new horsepower distribution system really resonate with clients at NeoCon and in follow-up conversations. While the office business is inherently spiky, I feel quite confident the plan we are implementing will continue to drive multi-year growth and margin expansion as demonstrated by the 270 basis point operating margin improvement year-to-date. On the plant side, our sites are performing well and service levels are strong as we gear up for busy end to the year. In the Studio segment, on a constant currency basis, sales were up 7%. If I exclude the non-recurring unusual large project, this period last year in Europe, we are up more like 16%. While this project comp and FX rates obviously hurt top line growth as you can see in the sales numbers for the segment, it was more of an optimal mix of business in exchange rates as we delivered a record 15.6% operating margin, an increase of 320 basis points over prior year. I am particularly pleased with the work of our team in Europe who also generated record levels of profitability. Our KnollStudio business in Europe and North America launch major new products in the quarter both at Salone del Mobile and then again at NeoCon in Chicago. We are particularly excited about our new Pixel meeting and training table collection, which allows us to significantly expand the markets we serve in corporate education and meeting facilities. Not only did Pixel win the Best of NeoCon Gold Award, but in the few weeks it’s been on the market. We already have a handful of very nice orders in standard programs. Holly Hunt had another record quarter of sales as our incremental investments in selling footprint, in depth of offer, coupled with strong growth and high-end residential and even contract work drove double-digit growth and margins. On the covering side, KnollTextiles was a standout performer as our focus on investing in growth, while improving the efficiency of our operations drove double-digit top line growth and strong contribution margins. Our NeoCon introductions were extremely well received with work by David Adjaye winning a Best of NeoCon Gold Award and our new impressions acoustic wall tiles extending the reach and market potential of our textile business. On the leather side, the winding down of a lower margin aviation program was a drag in the top line, but a help on margin coupled with favorable FX benefit, covering margins grew by 300 basis points to 23.7%. Overall, it’s a very exciting time at Knoll and I want to thank our associates and dealer partners around the world for their hard work and continued commitment to our success. Everyday, these are the folks taking our designs to market and fulfilling the commitments we make to our clients. Now, let me turn the call over to Craig to take you through our results in greater detail. Craig?

[Craig Spray:]

Thank you, Andrew. Second quarter sales were up 1% when compared to a year ago as we experienced foreign exchange headwinds in all segments due to the strengthening of the U.S. dollar. On a constant currency basis, sales were up 3%. While these currency pressures muted our top line, we continued to experience foreign exchange driven savings as we source raw material as well as maintain manufacturing capacity outside of the U.S. On a segment basis, office sales were up 1.1% or 1.9% on a constant currency basis. Studio sales growth on an actual and constant currency basis was 1.8% and 6.8% respectively. Covering sales for the quarter were down 1.6% on an actual basis, but were about flat on constant currency. Gross margin improved to 37.7% for the quarter. Net price realization and foreign currency savings were the primary drivers of the 110 basis point improvement in year-over-year gross margin. Sequentially, gross margin was up 190 basis points. I will now move on to our operating expenses for the quarter. Operating expenses were $72.9 million or $2.1 million lower than a year ago. Increased showroom expenses associated with our Holly Hunt business and previously disclosed increase in pension expense continue to be offset with foreign exchange savings, lower incentive accruals and cost containment discipline. For the balance of the year and as we have previously communicated, we continue to expect operating expenses to average roughly $75 million per quarter. For the second quarter of 2015, operating profit improved to $28.3 million, or 10.5% of sales compared to $22.2 million and 8.3% of sales in the second quarter of 2014. Operating margin in the Office segment improved to 170 basis points to 5.7%. Studio improved 320 basis points to 15.6%. Coverings operating margin was 23.7% or 300 basis points higher than a year ago and 240 basis points higher than the first quarter of 2015. Interest expense was down slightly from a year ago due to lower rates on our term and revolving loan credit facilities. Other expense for the quarter was $0.2 million compared to $2.7 million from a year ago. As shared during our first quarter earnings call, we settled our intercompany receivable and payable with our Canadian subsidiary at the end of Q1 2015. As a result, foreign exchange volatility through other income expense is considerably reduced and we expect this to continue going forward. Our tax rate for the quarter was 34.3%, down from 38.4% at Q2 2014. Our tax rate is the direct impact of the varying rates and mix of earnings in the countries in which we operate. Note that we expect our tax rate in the back half of 2015 to be in the range of 36% to 37%. Finally, net earnings was $0.2 million or $6.4 million higher than a year ago. Earnings per share was $0.36 for the quarter, up from $0.23 a year ago. Next, I will discuss our balance sheet and cash flow. We ended the quarter with $10.3 million of cash and cash equivalents, down from $14.7 million as of Q1 2015. Changes in accounts receivable, inventory and accounts payable from the first quarter of 2015 provided approximately $12 million of liquidity. As a result of these improvements in working capital and net earnings, cash flows from operations was $33.5 million compared to $18.4 million in Q2 2014. Total cash used by investing activities was $7.8 million compared to $9.9 million a year ago. Capital expenditures for the quarter were $7.5 million compared to $9.9 million in Q2 2014. These expenditures are reflective of our continued commitment to improve information technology as well as ongoing investment in our manufacturing footprint. Total cash used by financing activities was $30.9 million compared to $9.4 million in the second quarter of 2014. As part of our financing activities for the quarter, we made progress in paying down debt, lowering our total debt outstanding to $274 million from $300 million a quarter ago. As a result of reduced debt outstanding and increased EBITDA, our leverage ratio improved from 2.55 at Q1 to 2.22 at Q2 2015. We remain comfortably in compliance with all debt covenants. Other financing outflows during the second quarter of 2015 also included the payment of dividend of $5.8 million. We will now take any questions.

[Operator:]

[Operator Instructions] Our first question comes from the line of Budd Bugatch of Raymond James. Please go ahead, you are now live in the call.

[Bobby Griffin:]

Good morning Craig and Andrew. This is Bobby filling in for Budd. Thank you for taking my questions. First for me Craig I was hoping maybe you could maybe talk a little bit about how the supply chain initiatives you guys have been working on over the past couple of quarters are progressing and maybe what those initiatives contributed to the margin expansion versus kind of the FX benefits and other buckets?

[Craig Spray:]

Well, we continued for transformation and it continues to layer in. So while we experienced improvements Q-over-Q, recall that we started this program several years ago. So when you look at the comps versus the year ago, you don’t see a significant increase in Q2 versus Q2 prior year.

[Bobby Griffin:]

Alright. Then maybe a different way to ask you would be what inning would you be in that transformation and do you still see a good bit of a runway in front of you or are we kind of getting towards later innings, how should we look at it that way then?

[Craig Spray:]

Well, I will answer that in two ways. One, I would say we are in the early innings, but recall we have a new Chief Operating Officer on board, who is analyzing the business and we have high expectations that he will continue to drive improvement in our operations.

[Andrew Cogan:]

Hey Bobby, it’s Andrew I would just layer in a couple of things. One, as you know, we set a very clear goal of 100 basis points to 150 basis points of operating profit improvement annually in our office business. We need to get from 2% to 4% to 6% and 8%. I feel very much we are on that trajectory such that this year will be in the 6% operating profit range in our office business, next year moving up to 7% and then 8%. So we are steadily layering in all those initiatives and then combined with the incremental benefits from FX, particularly as it relates to our Canadian factory. I think we are well on track to deliver our office operating margin objectives. So I am very pleased with the trajectory.

[Bobby Griffin:]

Alright. Thank you for that additional color. And then Andrew maybe just to touch quickly of those comments compared to when we spoke a couple of months ago on the last earnings call, excluding kind of the lumpiness that we are seeing shipment dates, has anything changed in your perspective about the health of the industry or kind of your outlook for the segment – for the office segment?

[Andrew Cogan:]

No. I mean I think as we talked at the beginning of the year we expect over the course of the year mid single-digit growth. And I think that’s we are tracking to. You will have some quarters that are higher, some quarters that are lower. I mean it is inherently spiking. And I think what I am quite encouraged about is when I look at just our North American office business, just that North American geography. So I take out some of the Middle East business and all that, we are tracking favorable to the industry there. So I think you have to just kind of factor in that some parts of the business are very, very lumpy, particularly the Middle East. And then some of the larger projects that we won and/or have won but not yet shipped are spreading out over a longer period of time, they tend to be big new buildings or campus projects and those ship every week we are making a shipment, but we are not shipping big lumps at a time, which is more what happened when we were doing more kind of office renovation and not new campus work. And I believe that’s a comment you all have heard from others as well and we are seeing the exact same trend in our delivery timetable.

[Bobby Griffin:]

Alright. Thank you for the color and best of luck going forward on the back half of the year.

[Andrew Cogan:]

Thanks, Bobby.

[Operator:]

Thank you. Our next question comes from the line of Josh Borstein of Longbow Research. Please go ahead, you are now live in the call.

[Josh Borstein:]

Hi, good morning everyone and congrats on a particularly strong earnings quarter. I wanted to talk about margins, but maybe just focus a little bit first on top line, particularly in office. And I know this data certainly indicates the sequential slowdown, so not surprise that you guys saw one as well, but just curious if the magnitude of the slowdown was any bigger or smaller than you thought?

[Andrew Cogan:]

No. I would say it was – when you look at our – again, when you do on a constant currency basis, in total I think we performed very much in line with all the results I have seen reported by everyone else. When I again – when I look at purely our North American office piece, we are performing better than the industry. So really it is the mix of some of the larger international projects and those are going to be lumpy. We have got a great pipeline of projects in the Middle East, but quite honestly they are going to book later this year. We don’t think a lot of them will ship this year, but we think we will enter 2016 with a really nice backlog of those projects. So that’s – that we have the kind of see beyond that noise. And when I look at the general direction of the business, I look at the initiatives we have made to invest in seating to improve our agronomic table opportunity. I am seeing tremendous traction from our new products in those areas. I look at what we layered into the portfolio in NeoCon. And the client response to some of our very cost effective power distribution option. I see great resonance there. I look at some products behind the scenes we previewed to select clients and dealers and great enthusiasm for those. So I am very optimistic about our office business. I think it’s going to be lumpy as we are at these levels, but I think we will continue to generate over the course of annual period, better than industry performance.

[Josh Borstein:]

Okay. And I guess certainly cognizant effect that quarters can be lumpy, so but it sounds like with the sequential slowdown here that no way perform translate and do you think industry has slowdown or that you guys are in any way loosing market share?

[Andrew Cogan:]

Well, listen I mean I think you said that industry sequentially was a little bit slower from a growth standpoint. Again, we expect mid single-digit growth for the year. And I don’t want to be broken record, but when I just look at our North American office business, which is the bulk of the office piece, that business is performing on an incoming orders basis, better than the industry. But again our results are skewed by large Middle Eastern activity last year that’s not going to repeat on the same kind of quarterly schedule it did in the past. And then if I move beyond North America and I look at our Studio segment and we had one very large – $5 million, $6 million project in France last year. If I take that out and I take out the FX impact because the European business is 30% less just on an FX basis. And I factor all that and that net segment actually grew 16%, so significantly faster than the industry. Holly Hunt is growing double-digits. KnollStudio in North America is growing high single-digit. So I see very robust growth in the Studio segment. And in Coverings, textiles grew double-digits, but we had a particularly large low-margin aviation contract, which we consciously decided not to continue to support at that level of profitability and walked away from it. So our focus is building the most profitable enterprise we can and we will manage out on profitable relationships that we need to do that. And so overall, I am very encouraged where we are at the mid-year point. And I think we are doing exactly what we said we would do, which is mid single-digit growth and deliver double-digit operating margins. I mean, we delivered record operating margins in the Studio and Coverings segments. I think we have never generated margins that high in those two businesses. So I am very pleased with how we are doing.

[Josh Borstein:]

Great. And just one more question on the top line for me, just could you qualitatively speak to the order patterns of the markup activity and just how the quarter played out whether you saw any deceleration or acceleration as the quarter progressed?

[Andrew Cogan:]

Yes. I think the quarter started out slowly and build momentum as we move through it from an order standpoint and the growth standpoint. I can tell you right now, I am here in Greenville, we were with the teams yesterday, markup activity is the highest it’s been all the year. So we are preparing for a ramp up. But again, as I think it’s what said in the comments, the third quarter looks pretty similar to what we just did. And then we think we will see some nice acceleration, both sequentially in year-over-year as we move into the fourth. And frankly, right now, it looks like that momentum is going to carry over to the first given the timing of what’s going on.

[Josh Borstein:]

Yes. Okay, great color. I appreciate that, Andrew. One more for me on the margins, last quarter you guys said your company could deliver 100 to 200 basis points of operating margin leverage. You know halfway through the year here, do you think we are closer to the 100 basis points of improvement or the 200 basis points of improvement?

[Andrew Cogan:]

It looks like we are heading towards the 200 basis point of improvement.

[Josh Borstein:]

Yes, okay. And then considering the particularly strong quarter, have you considered you might see something greater than 200 basis points this year?

[Andrew Cogan:]

I think the wildcard is worth some of the FX stuff and all that continues to play out. Right now that continues to move in our favor. I do think as we get into – the mix of business was very favorable this year, this quarter, within the Office segment. The number of orders was up high single-digits, even though the dollars were not. So, that’s – I think as we move into particularly the fourth quarter, you will see more large projects that we wouldn’t expect that same favorability of price. So, it’s going to move all over. But I think we are probably closer to 200 basis points of operating margin improvement year-over-year than a 100.

[Josh Borstein:]

Great. I appreciate all the color. Good luck in the back half.

[Andrew Cogan:]

Thanks, Josh. Appreciate it.

[Operator:]

Thank you. Our next question comes from the line of Matt McCall of BB&T Capital Markets. Please go ahead.

[Matt McCall:]

Thanks. Good morning, guys. So, Andrew, you talked about the record profitability in studio and coverings, I was just curious about some of the drivers of the improvement year-over-year, how sustainable is it or we are looking at those as the new – kind of the new baselines as we move forward, because if I remember correctly, it’s mostly a variable cost model. I am just trying to figure out where that improvement came from?

[Andrew Cogan:]

I think the improvement came from a couple of areas, some we can take credit for and some we can’t take credit for. Clearly, FX on a cost basis is a significant improvement. The bulk of our studio and coverings products are sourced out of Europe. So, we are getting big benefit from a weakening euro. So, we can’t take credit for that. That’s happening. What I think we can take credit for in the coverings segment is we have restructured some of our cost basis and we have been more selective about some of the client engagements we have entered into. And that combination has really I think set them on a new course operating margin wise. So, I feel very good about where – listen, it’s going to move around and so I don’t want to promise that 23%, we said 20% was our goal. I don’t want to promise that 23% is going to be our goal, but I think we can potentially even do better. So, I am pleased about – I am pleased about that. In the studio segment, I think there are a couple of things going on. Firstly, in Europe, we are generating record operating margins in Europe now. So, the team over there has done a very good job of doing some restructuring in the last year within their plans and also changing the mix of their business, where they are driving more of the high margin residential part of the business and that’s something as well. So, that’s shifting there. Then in North America, we had a big step up over the last 12 months, which we are now really – we have almost completed anniversarying in the Holly Hunt business. So, we took a bit of a margin hit over the last year, but now with Holly Hunt’s double-digit growth over a fixed cost basis, which in the showrooms that they now have, we are starting to see incremental contribution margin at a much higher rate. I am very encouraged about that. So, when you kind of factor all that in, that’s how you get to a 15% studio margin. Again, we said our goals were 12% to 13%, but the FX kicker in the leveraging of those fixed cost is definitely helping. So, again, I don’t want to promise if 15% is the new norm, but in general, I think we are heading in a positive direction. And I do believe that every single one of our segment will deliver year-over-year margin improvement that is all supportive of trying to get to that 100 to 200 basis points of full year improvement math.

[Matt McCall:]

Okay. Thank you, Andrew. And maybe I don’t either you or Craig, Craig you might have it, well the FX benefit by segments or how much of that 15.6 or the 23.7 was due to FX benefits?

[Craig Spray:]

I don’t have that specifically in front of us, Matt, but probably 100 to 200 basis points.

[Matt McCall:]

Okay. And then the other question I had – well, the second question I had, when I look at the sequential move and look at gross margin – gross margin up, I understand the impact of mix, my thought would have been that SG&A would have likely gone up as a percent of sales also because of mix, am I understanding that the wrong way or was there something else that impacted SG&A helping it to show some leverage sequentially?

[Andrew Cogan:]

I think SG&A is more timing than anything else. So, I definitely think as we move into the back end, you will see higher SG&A then you saw. It also has to deal a little bit with the timing of incentive accruals and all that. So, I think as Craig said in his comments, we are targeting on average about $75 million of operating expenses. I think you will see in the back half numbers more in line with that average as opposed to in the first quarter, but it’s mostly timing product rollouts, investments and things like that.

[Matt McCall:]

Okay, perfect. And then the last one I had that you made some encouraging comments about just demand trends in some of the leading indicators and project activity, can you talk about systems demand within that broader demand trend, what are you seeing from a systems category perspective?

[Andrew Cogan:]

Well, in the second quarter, systems led our revenue growth. So, that was – I think that was encouraging to see, particularly some of the newer systems that we have been – the antennas and products like that. On an incoming orders basis though, actually demand growth was really led by some of our seating and adjustable table products. So, I would expect as we move into the back half of the year some of those categories to take over the growth leadership from systems, which is encouraging and better margin for us.

[Matt McCall:]

Okay, that’s – so it’s better – is there estimate on the margin benefit those two product categories versus systems?

[Andrew Cogan:]

Not particularly.

[Matt McCall:]

Okay.

[Andrew Cogan:]

They are a little higher. Again, I think in terms of our revenue expectations, I do think that third quarter going to be kind of similar to the second quarter, but we definitely see a building up of order activity that I think bodes well for the fourth and frankly again for the first quarter of next year given these large projects that we have already been awarded and the timing now of when they are going to book and ship.

[Matt McCall:]

Okay, got it. Thank you.

[Andrew Cogan:]

Okay. Thanks, Matt.

[Operator:]

Thank you. Our next question comes from the line of Kathryn Thompson of Thompson Research Group. Please go ahead.

[Christopher White:]

Hey, good morning guys. It’s Chris calling in for Kathryn today. Our construction industry primary research is showing early cycle building materials such as aggregates and steel studs are seeing high single-digit volume growth in the current market and we would expect later construction type of products such as ceiling tiles to a follow a 9 to 12 months. I was wondering if you think there is a similar correlation to early building materials to office furniture and if so can you talk about the strength of that correlation and how long of a lag do you think there might be?

[Andrew Cogan:]

I have never looked at it exactly that way before, but it sounds like logical thinking to me.

[Christopher White:]

Okay. We will do some work on and get back to you. Thanks for taking my question.

[Andrew Cogan:]

Thank you.

[Operator:]

Thank you. [Operator Instructions] Our next question comes from the line of Josh Borstein of Longbow Research. Please go ahead.

[Josh Borstein:]

Just one follow-up for me touching on something that brought up an SG&A, for the full year, it looks like SG&A in the sales will come down for the first time in two years. How should we think about SG&A looking now? Do you think that trend continues and we continue to see the SG&A as a percent of sales come down further in 2016?

[Andrew Cogan:]

Yes, I wouldn’t make that assumption for 2016 at this point. You don’t forget on the operating expense line, we are also getting some benefit of FX there and that maybe why you are seeing what you are seeing.

[Josh Borstein:]

Okay. So, you think 2016 looks something more similar to what we saw in 2015?

[Andrew Cogan:]

We will get into the planning season here in the next quarter. So, we haven’t taken a strong look at it. I would just – Josh, I think we are at a point where we are still working towards 100 to 150 basis points of margin improvement a year, I mean, 100 to 200 basis points. The real leverage I think is going to be on the gross margin line, particularly in the office part of the business. And I think that’s really where we are focusing and again this year we are getting a lot of help on that, exciting from some of our supply chain transformation efforts. But again, I think there is a lot more we can do on the office gross margin side. So, to me that’s going to be the biggest area. And yes, we will get some leverage on SG&A. But I don’t think SG&A will be the key driver of our margin expansion. It’s going to have to come on the gross margin side of the equation, because we want to take some of these incremental profits that we doing and generate them into – increase marketing activity, more feet on the street. And so I think you will see the SG&A invested back in. And so I would not count on that dramatically improving as Craig suggested.

[Josh Borstein:]

Okay, that’s helpful. Thank you.

[Operator:]

Thank you. Our next question comes from the line of Budd Bugatch of Raymond James. Please go ahead. Thank you.

[Bobby Griffin:]

Hi guys. Thank you for letting me get one more question here. Andrew, you referenced the North America order growth a couple of times that kind of in your thoughts on the industry can you tell us where orders were up for North America for the Office segment?

[Andrew Cogan:]

We don’t report that, but I can tell you that orders outperformed sales, in terms of percent growth. And again…

[Bobby Griffin:]

Organic sales the 3% that was reported…?

[Andrew Cogan:]

Yes. Orders were – orders apples-to-apples organically were better, grew at a faster rate than sales did. And again, I just would point out that when you carve out the lumpy Middle East part of the business, we are in the upper single-digit range in our core North American office business. So we are right on pace. I am pleased with how that team is doing. And again we are going to have lumpiness. And again, that’s the nature of this business. But even with that lumpiness we are generating the kind of margin improvement and I think more efficient operations that we would be expecting.

[Bobby Griffin:]

Thank you. That’s helpful. I appreciate additional color and good luck going forward.

[Andrew Cogan:]

Okay. Thanks, Bobby.

[Operator:]

Thank you. I would now like to turn the call over to Andrew Cogan for closing remarks. Thank you.

[Andrew Cogan:]

Great. Thank you everyone again for joining is in the call today and your continued interest at Knoll. I think at the mid-year point and looking at our outlook for the full year we are very much on track with our expectations in terms of mid single-digit growth and 100 basis points to 200 basis points of operating margin improvement. And we believe the kind of improvement we are generating will be sustainable over the next couple of years and we will continue to generate industry leading results. So thank you for the call and have a great summer and we look forward to talking to you in the fall.

[Operator:]

Thank you for your participation in today’s presentation. You may now disconnect and have a great day. Thank you.