Steelcase Inc.
Q3 2009 Earnings Call Transcript

Published: 23 Dec 2008

[Operator:]

Good day, everyone, and welcome to Steelcase's third quarter conference call. As a reminder, today's call is being recorded. For opening remarks and introductions, I would like to turn the conference call over to Raj Mehan, Director of Investor Relations.

[Raj Mehan:]

Thank you, [Mandy]. Good morning, everyone. Thank you for joining us for the recap of our third quarter fiscal year 2009 financial results. Here with me today are Jim Hackett, our President and Chief Executive Officer, Dave Sylvester, our Chief Financial Officer, Mark Mossing, Corporate Controller and Chief Accounting Officer, Terry Linhardt, Vice President, North America Finance. In addition, we've asked Gary Malburg, Vice President and Treasurer, to join us today to address any questions specific to the decrease in cash surrender value of the company owned life insurance and the resulting impact to our reported profitability this quarter. Our third quarter earnings release dated December 22, 2008 crossed the wires early this morning and is accessible on our website. In addition, this conference call is being webcast. The presentation slides that accompany this website are available on Steelcase.com, and a replay of this call will also be posted to the site later today. In addition to our prepared remarks, we will respond to questions from investors and analysts. Our discussion today will include references to non-GAAP financial measures. These measures are presented because management uses this information to monitor and evaluate financial results and trends. Therefore, management believes this information is also useful for investors. Reconciliations to the most comparable GAAP measures are included in the earnings release and webcast slides. At this time, we are incorporating by reference into this conference call and subsequent transcripts the text of our safe harbor statement included in this morning's release. Certain statements made within the release and during this conference call constitute forward-looking statements. There are risks associated with the use of this information for investment decision-making purposes. For more details on these risks, please refer to this morning's release and Form 8-K, the company's 10K for the year ended February 29, 2008, and our other filings with the SEC. This webcast is a copyrighted production of Steelcase Inc. Now, with these formalities out of the way, I'll turn the call over to our President and Chief Executive Officer, Jim Hackett.

[Jim Hackett:]

Thank you, Raj. Good morning. I appreciate having the opportunity to make comments prior to our CFO, Dave Sylvester, detailing for you a clearer picture about what is going on during a very murky time. All of us want clarity during these times, and yet we realize that these are economic times that seem to happen only in cycles of at least 70 years or so. Thus, let's be candid that there's no amount of speculation on our part that will help clear up what is going to happen in the economy, especially when the economy continues to mystify others who make the pursuit of the information their life's work. Our life's work is taking care of our customers and building the best company we can. However, it is vital, I believe, that those in the leadership roles be able to manage the difficult times by simultaneously paying a great deal of attention to our future while obsessively managing every detail now in order to have our company be as vibrant as possible. So let's first talk about what is going on now. First, we have been working on the issue of reducing complexity in our business by managing the right amount of diversity of products and brands with the optimal platforms to serve those concepts. Second, we've worked hard to diversify our customer base, especially with significant investments in vertical markets like health care and expanding geographies in Europe and Asia. Our investment in the health care market has been paying off and we expect this to continue to be a growth area for us. I'm proud to report that during the quarter, our Nurture by Steelcase subsidiary won two major awards for a product line called Sync that will start shipping in March of '09. We used our observational research methods to understand how caregivers work and how their space can best support them. The Sync stations are flexible, modular and designed to seamlessly connect health care professionals to the technology that they use. And Nurture isn't our only award winner. The Steelcase Showroom in Chicago that was totally redesigned for Neocon in 2008 and had a strong focus on sustainability was recognized by Interior Design Magazine with a best Showroom of the Year Award. Continuing, now, we made a dedicated commitment in March 2008 to continually invest in actions to improve our fitness. We define this state of fitness as the ability to compete on a global stage with any competitor who we might face. These actions are about building a very solid global industrial system that proudly has a firm footing here in the U.S. to serve our domestic markets. These efforts in March 2008 were targeted to save about $40 million and we anticipate another $40 million in cost reduction from the actions we announced earlier this month. That list includes accelerating our efforts to improve the fitness of our enterprise by turning our global reach into a sustainable advantage. This is a big deal. We will see additional operational efficiencies from closing another one of our North American manufacturing plants and we're preparing to further reduce the size of our salaried work force. Now with regard to the future, we're committed to investing in our long-term goals and protecting our growth strategies, this in a smart and disciplined way. Last month we opened our new Work Lab here in Grand Rapids. This is a customer center that we're using reclaimed factory space to enhance that customer experience and demonstrate our ability to create solutions. We had nearly 1,000 dealers and Steelcase salespeople in town last month to see the opening of this new space and get training on our new products. These products are on track to launch in the new fiscal year. Incidentally, the question of scrapping an event like this wasn't seriously considered because we're going to need the trained sales force of Steelcase and its dealers as our economy eventually returns to that growth state. Last quarter I told you we had won a major government award, but we weren't able to talk about it yet. Well, today I can provide a few more details. This is a five-year agreement that has the potential to be one of the largest contract awards in the company's history. The U.S. Department of Defense has selected Steelcase to provide up to $113 million in furniture, installation, design and other services, and the contract guarantees a minimum purchase of at least $3 million. We're already hard at work on the first phase of the contract; however, because of the nature of the Department of Defense's work, we won't be discussing more about our work in this agency's transformation. But trust us - it's a big deal as well. Dave Sylvester is about to go into detail on our performance and outlook for the fourth quarter. We recognize that this will be a challenging period, but our balance sheet, well, it's strong, and there are bright spots in our markets here and abroad. And Steelcase people, frankly, continue to amaze me with their ability to pull together, face these tough challenges, and build a strong and exciting future for our company. I'll close with my best wishes for a safe and restful holiday season and now turn it over to our Chief Financial Officer, Dave Sylvester.

[Dave Sylvester:]

Thank you, Jim. As Jim mentioned, our balance sheet is strong. As you'll hear in a moment, cash and short-term investment levels are in excess of $200 million. In addition, long-term investments, including our company owned life insurance and other securities, also exceed $200 million. And our $200 million untapped credit facility remains accessible to the company if needed. So as we enter this downturn, our liquidity position is solid. Equally as important, we are a different business than we were going into the last economic slowdown. We have executed well against our strategy to diversify our revenue base and modernize our industrial system, product offering, and business processes. And we are preserving our investments in growth initiatives as we know this cycle, like all others, will end, and when it does, we expect to maintain our momentum in the targeted growth areas of health care, higher education and government, emerging markets around the world, and new products that facilitate connections in the networked world. Now let me shift to the quarterly results. Today, we reported a small third quarter profit which compares to $31.3 million or $0.22 in the third quarter of last year. These results were slightly better than the estimated modest loss we anticipated on December 4. Revenue declined to $811.3 million in the quarter, which was also slightly better than our estimate earlier this month. The decline of 8.4% compared to a strong quarter in the prior year, when revenue grew by more than 10% compared to the third quarter of fiscal 2007. The North America segment experienced an 11.4% decline in revenue and the Other category realized a 14.8% decline. International revenue in the third quarter grew by 2.3% despite negative currency translation effects compared to the prior year. In total, third quarter revenue included an $18 million reduction from currency translation effects and a minimal net impact from acquisitions and divestitures completed within the past 12 months. Operating income excluding restructuring costs was $19.7 million or 2.4% of sales in the current quarter compared to $52.6 million or 5.9% of sales in the prior year. Current year restructuring costs of $4.7 million primarily related to the strategic actions communicated in March which are now nearing completion. Again, these actions included three plant closures and certain other product moves as well as white collar reinvention initiatives targeted to eliminate 200 to 250 jobs in North America over an 18 to 24-month period or 100 during the current fiscal year and 100 to 150 during fiscal 2010. You will also recall that the third quarter of last year included goodwill and intangible asset impairments related to PolyVision, which after the reduction of related variable compensation expense reduced operating income by approximately $15 million. We have included a copy of last year's webcast slide related to these adjustments with this quarter's materials on Steelcase.com for your reference. Beyond restructuring, current quarter operating income was also negatively impacted by a $27.5 million non-cash charge related to a reduction in cash surrender value or CSV of our company owned life insurance or COLI. This reduction in CSV in the current quarter compares to $2.1 million of income in the third quarter of last year. We estimate this $30 million variance, compared to the prior year, had the effect of reducing operating income by approximately $15 million, taking into account the related reduction of variable compensation expense. The reduction in bonus related to the COLI charge is obviously a higher percentage than what you would expect for typical operating income items due to the fact that annual plusses and minuses in CSV are exempt from income taxes. We've included a webcast slide to more clearly illustrate the impact on operating income by segment. The remaining reduction in third quarter operating income compared to the prior year was largely driven by lower volume and higher commodity cost inflation, which continued to outpace recent pricing actions. Although various commodity prices retreated during the quarter from their recent peaks and resulted in slightly less of an impact on cost of sales in the quarter than the $15 to $20 million previously estimated, we expect these cost pressures to continue into the fourth quarter until our supplier contracts automatically reset pricing or are renegotiated. Other income and expense net decreased by $4.9 million compared to the prior year quarter. Interest income decreased because of lower cash and investment balances and lower interest rates earned on those balances. In addition, the current quarter included foreign exchange losses compared to gains last year. We also recorded an $800,000 impairment charge related to one of our auction rate security investments during the quarter as we discovered the underlying assets of the fund had suffered losses due to aggressive investment strategies. We recorded $9 million of income tax expense, which was nearly equal to pre-tax income for the quarter. This unusual effective tax rate included the following

[Operator:]

(Operator Instructions) Your first question comes from Budd Bugatch - Raymond James.

[Budd Bugatch:]

I want to make sure I understand where we're going now. You've got a number of restructuring and reorganization actions ahead. Can you go through what's left to be done and what the financial impact is in total of each one of those, where you are?

[Dave Sylvester:]

Yes, I'll summarize the March actions and where we are and then give you a replay of the actions we announced earlier this month. On the March actions, if you recall, we announced the closure of three facilities - the City of Industry plant, a plant in Corona, and also a plant in Oakland, California. The Corona facility related to PolyVision has been closed for more than a quarter, and the City of Industry and Oakland facilities are nearing closure some time later this quarter. We also announced back in March the launch of the reinvention initiatives, as we've termed them, around white collar initiatives. And in that part we expected to eliminate up to 100 jobs in fiscal 2009 and another 100 to 150 next fiscal year, and has been progressing throughout the fiscal year and is on track to accomplish the 100 by the end of the fiscal year. It will be another 150 next year, which is included in the announcement that we made earlier this month, which included broadly a number of white collar jobs as well as a further consolidation of manufacturing and distribution center activities in the South. So what we said for the March actions is we would spend $40 to get $40 pre-tax cost and savings, and while we think we'll spend somewhat less than the $40, we still think that we'll get the savings of around $40, some of which have started to accrue benefits during the fiscal year. And then the actions that we announced in December, we are planning to take action on the white collar headcount reductions during the fourth quarter and the facilities in the South are expected to close and consolidate over the next six to nine months. So think of that second $20 to $25 million of restructuring cost as being spread somewhat over the fourth quarter and the first two quarters of next year and the benefits in a similar way.

[Budd Bugatch:]

And the reinvention, is that in the $40 for $40?

[Dave Sylvester:]

The first 100 of the targeted 200 to 250 was in the $40 to get $40.

[Budd Bugatch:]

Wasn't that a three-year program?

[Dave Sylvester:]

No, 18 to 24 months is what we said in March.

[Budd Bugatch:]

Talk a little bit about what you think you're getting in pricing and what kind of realization you will have kind of at the midpoint of guidance. I think we're calculating sort of a 1% kind of number for the fourth quarter.

[Dave Sylvester:]

As I said in the scripted remarks, inflation continues to outpace our pricing actions. You know we did the surcharge effective September 1st and we had list price increases in the summer, and you know how the list price changes work their way into our results over several quarters. During the third quarter, inflation continued to outpace the benefits of those pricing actions and we expect that to continue into the fourth quarter. Beyond that, I'll let Terry comment.

[Terry Linhardt:]

Budd, as you know, we had price adjustments worldwide in the second quarter, July timeframe. Those take upwards of a year to get fully implemented. And to date they are progressing about as expected so, as we get into next year, we'd expect to continue to accrue similar prior year patterns.

[Budd Bugatch:]

And the quantification of all of the actions of both the price list and the surcharge, how should we think about that?

[Dave Sylvester:]

As not being enough to offset inflation in the third quarter and fourth quarter.

[Budd Bugatch:]

Can you give us relative numbers on both?

[Dave Sylvester:]

It's not double digits, absolute dollars.

[Budd Bugatch:]

But not in the fourth quarter, but in the first quarter of next year you think you'll start to offset both? I mean, you should because inflation's got to be moderating now as you reset contracts and renegotiate.

[Dave Sylvester:]

Yes, we should.

[Budd Bugatch:]

If you would, let Gary talk a little bit about what the future looks like for the CSV in the COLI. Obviously, that's - I guess you might want to ask us more and I sure don't know the answer.

[Gary Malburg:]

Yes, that is kind of a little bit of a who knows, but I can give you a mix of what's in those policies just to give you a sense. So you can see in the earnings release, we put a chart in there that shows the difference in the two types of policies. So on the whole life policies, there are floors on the dividend rate such that we'll expect a positive return. Then the variable life policies are the ones that we have allocated cost of capital markets and a 75% equity, 25% debt or fixed income mix, and you should think about that as being roughly representative of the broad capital markets. So I guess you can see kind of the base of the CSV assets in each of those two categories and you'll get a sense that the largest piece at this time is the whole life policies that we'll see positive growth on. And then, you know, it's going to be dependent on how the capital markets move for the variable life policies.

[Budd Bugatch:]

Are there any changes you can or have made to those policies, the variable life, to take some of that volatility out of them?

[Gary Malburg:]

Well, the way we think about it is we want to keep a long-term view there because, as you know, they're earmarked to fund long-term obligations. And so it's our belief that we should keep a long-term allocation of assets and so it does mean it could be a little more volatile in the short run. Now, hopefully we don't see anything like we've seen, you know, in the last number of months, but for that base of variable policies, we'll still experience the volatility of the capital markets. There's some things, you know, you might do to take the volatility out, but you give up the upside on the returns as well, and so we decided it just doesn't make sense to do.

[Budd Bugatch:]

And the accounting of that, it has to flow through the operating income as opposed to going against other comprehensive income? Is that right, Dave? It's the way that that has to work?

[Raj Mehan:]

We had a little technical difficulty. We were talking about the COLI structure. Dave and Gary were explaining the nature of why it isn't in the balance sheet, placed in income. Dave, you want to go back to that?

[Dave Sylvester:]

Yes, Budd. I was just saying because the COLI is earmarked to fund the longer-term employee benefit obligations that are expensed in cost of goods and in operating expenses, we're required to allocate the income in a similar fashion. Historically, it has been in a 5% of kind of a return neighborhood; a little bit higher in some quarters and a little bit lower in other quarters, which we've called out in our transcripts over the last several quarters. This is really the first time that I can recall that it varied dramatically.

[Budd Bugatch:]

The dispositions, you got it for $16 million in revenue impact this quarter. Custom Cable was, I thought, $8 million last quarter. Was there anything else in the dispositions and how much more of that to run off?

[Dave Sylvester:]

The bulk of it is CCI. They had a strong quarter last year in the fourth quarter and then there were some small International acquisitions. So think of it as about 75% was CCI and the remainder's International.

[Budd Bugatch:]

And how many more quarters do we have? What do we have to come off of?

[Dave Sylvester:]

CCI was sold in the second quarter, so we'll have something in the first quarter, but it'll be probably closer to the number that you cited for the last quarter, the $8 million number.

[Jim Hackett:]

And I think the International dealers are about done.

[Dave Sylvester:]

Yes.

[Budd Bugatch:]

Okay. And that's already run off, those International dealer revenues are done?

[Dave Sylvester:]

I think the fourth quarter might be the last quarter. It's either that or the first quarter.

[Budd Bugatch:]

But it's not meaningful?

[Dave Sylvester:]

Small numbers.

[Budd Bugatch:]

Not sizeable. And lastly, the auction rate securities, where are we? Can you recap where we are on that? You had to take a bit of a charge this quarter.

[Gary Malburg:]

In terms of the charge this quarter, you know, we take a look at those each period and we relook at the valuations and we make sure we're monitoring the underlying assets. And we made a determination this quarter that in one of the pieces, one of the securities that we own, it's a piece having to do with insurance reserves. As we looked at the way those underlying insurance reserves were reinvested, we thought there'd been some degradation in the quality of those underlying investments, and so we made the determination that it was other than temporary, the impairment that we had taken, and so we moved that to the P&L.

[Budd Bugatch:]

And how much left is there left in auction rate securities now?

[Dave Sylvester:]

Well, we've still got the -

[Gary Malburg:]

On the balance sheet, Budd, it's just under $24 million.

[Dave Sylvester:]

Our value's $26.5, I think.

[Gary Malburg:]

And then the Canadian commercial paper is at $4 million and we had taken a $900,000 impairment a few quarters ago.

[Budd Bugatch:]

Right. And you still think that's an accurate valuation for the balance?

[Gary Malburg:]

Yes, we do.

[Dave Sylvester:]

Yes.

[Operator:]

Your next question comes from Matthew McCall - BB&T Capital Markets.

[Matthew McCall:]

I have two questions. I'm going to follow the instruction. Just kidding, Budd. Let's see. First, you mentioned there was some Q3, some of the March $40 million recognized in Q3 and some expected to be recognized in Q4. Can you give us a little more detail there as to how much you've recognized thus far?

[Dave Sylvester:]

Of the $40 million of savings targeted from the March actions, I would say that through the third quarter we've realized less than 25% of that. That's a rough estimate. And I would tell you that the majority really starts to kick in in the latter half of the fourth quarter as the larger manufacturing facilities that we're closing will impact [inaudible].

[Matthew McCall:]

So within the roughly breakeven guidance, there's $15 - $20 million maybe included in that number? I'm not trying to pin you down; I'm just trying to - it kind of leads to the next question. Looking at the -

[Dave Sylvester:]

Annualized benefit, right?

[Matthew McCall:]

Absolutely, yes. Yes, I'm sorry. I should have said that word. So looking at the guidance for Q4, roughly breakeven on, I mean, I know we can adjust for the FX and say it's $650 to $700, roughly $700 million number, you're breaking even about that level. I looked back and it looked like breakeven was a little bit below that, maybe in the low 6s in the prior downturn. I know there's a lot of changes to the model, changes to the situation, but just help me understand what would impact the breakeven level that dramatically? I guess getting to breakeven this quickly was a little surprising. I'm wondering if there's something structurally in the model that I'm not thinking about.

[Dave Sylvester:]

There's a couple of different things. First, currency is certainly a contributor. The euro to dollar was significantly different back in the last downturn than it is today. We also have inflation working against us relative to our pricing actions, which we've talked about a couple of different times. That's another factor. And we've been talking about these dealer consolidations and some of our business turnaround efforts for a number of quarters. That's contributing modestly as well. But I would also tell you, Matt, that we have been, as I've said in the last three calls or so, we've been investing in our growth initiatives, expanding our presence in Asia as well as in Eastern and Central Europe and launching a number of new products this year, which we were not doing in the downturn last time. And so all together that's pushed our breakeven up, which we pay close attention to. But we also are going to try to hold firm on continuing to invest in our future.

[Jim Hackett:]

I would add, Matt, that you can also look at breakeven as a function of let's just call it enterprise growth in headcount. We didn't have that from the last downturn to now. We actually were able to generate the growth in the core business without adding any people back. And so, as Dave just said and I won't be redundant, we isolated most of the change was variable comp plus the investment in new ideas and new notions. We just did a summary of all those in our quarterly Board review last week just to look at how each of the investments are doing, and I feel really good that they're smart ideas based on where they are in their toll gate right now.

[Matthew McCall:]

And with that, Dave, I guess taking into account the headcount and the expected reductions and the total of the cost savings and also maybe some expected deflation with some pricing yield, should we expect that breakeven to continue to move lower as we move into 2010, taking into account, of course, the continued growth spending?

[Dave Sylvester:]

Absolutely.

[Matthew McCall:]

And can you summarize the magnitude of that breakeven? I mean, right now you're looking at roughly $700 million. Where do all the puts and takes go?

[Dave Sylvester:]

That'll take us down less than $700. How's that?

[Operator:]

Your next question comes from Todd A. Schwartzman - Sidoti & Company, LLC.

[Todd A. Schwartzman:]

Are you happy with Nurture's existing price points or might you swim upstream or downstream, perhaps both, in the not-too-distant future?

[Jim Hackett:]

When you say that - I want to make sure when I hear price points - do you mean more of a luxury or are you talking about range of applications? What's your instinct when you ask that?

[Todd A. Schwartzman:]

The former. In other words, becoming more inclusive, hitting what you may perceive to be relatively underserved initiatives and price points, both lower and higher, for a particular product category than you are now.

[Jim Hackett:]

I think the way I'd have you think about that is that the health care segment in this, as it parallels the office segment, don’t directly connect that way, in a good, better, best way, and the reason is in the office, because of the historic contribution of very famous architects, luxury and great design and iconic design and high price point were all kind of bolted together. In health care, I think that one of the notions will be around performance and great design and price points. So to the degree, for example, that you have a chair that articulates a number of different axis because the patient needs more assistance than they would getting out of an office chair, let's call that higher performance, then you're going to have a higher engineered solution that will cost more than them buying, let's call it, a simple office task chair. If you could transfer what we made now for offices into a patient room, some of the new health care ideas will cost more. But I don't want to correlate it to the office segment, as I just described, because I'm not sure that transfers. Let me leave one other insight for you, which is, as much of the opportunity that you might see in niches going up and down, there's so many areas in health care that have performance potential, performance improvement potential. There just wasn't the kind of dedication in my mind of the kind of engineering and design capability that we can bring to this segment. As we now look, like with the Sync award that I just talked about, and some of the new stuff on the drawing boards here, I believe there's still lots of potential as you just look at the opportunity for us to bring higher performance, higher engineered and design performance to health care.

[Todd A. Schwartzman:]

Just to refresh us, how much of the brand's revenue is outside North America?

[Dave Sylvester:]

Nurture, we're talking about?

[Todd A. Schwartzman:]

Yes.

[Dave Sylvester:]

It's a relatively small thing. And it's an opportunity that can take some of our consideration as well.

[Jim Hackett:]

You realize that the social system for health care in Europe, for example, changes the nature of the market's behavior. But there's other segments, other countries that look to mirror the way North America behaves.

[Todd A. Schwartzman:]

Did you give the dollar amount of the auction rate security impairment taken in third quarter?

[Dave Sylvester:]

Yes, $900,000.

[Operator:]

(Operator Instructions) Gentlemen, we have no further questions. This concludes today's conference call. We will now return to Mr. Hackett for closing comments.

[Jim Hackett:]

They are very quick and brief. I want to wish everyone a happy holiday and it is a time of the year where it's worth all of us to take a moment and reflect on the blessings that we have and the opportunities that sit in front of us, spend more time with our families and those closest to us. I thank you all for your time today.

[Operator:]

Thank you, ladies and gentlemen. This does conclude today's conference call. You may disconnect your phone lines at this time and have a wonderful day. Thank you for your participation.