Interface, Inc.
Q2 2019 Earnings Call Transcript

Published: 27 Jul 2019

[Operator:]

Good morning. My name is Natalie and I’ll be your conference operator today. At this time, I would like to welcome everyone to the Q2 2019 Interface Inc. Earnings Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers remarks there will be a question-and-answer session. Thank You. Christine Needles, Corporate Communications, you may begin your conference.

[Christine Needles:]

Thank you, Natalie. Good morning, and welcome to Interface's conference call regarding second quarter 2019 results, hosted by Jay Gould, President and CEO; and Bruce Hausmann, Vice President and CFO.

[Jay Gould:]

Good morning, and thank you for joining us on this call. I’m pleased to share our second quarter results and discuss our outlook for the second half of the year. We delivered a solid second quarter with net sales up 26%, and organic sales up 2% versus the second quarter of last year.

[Bruce Hausman:]

Thanks Jay, and good morning to everyone. Second quarter net sales were $358 million, up 26% over the prior year, including negative currency impact of $6 million or 210 basis points year-over-year. Organic sales were up 2%, which was in-line with our expectations. Looking at revenue in more detail, legacy sales in the Americas were up 1%, compared to the second quarter of last year and excluding the previously mentioned large customer order in 2018, sales in the Americas grew 5%. Legacy sales in EMEA grew 2% in local currency, but were down 4% in U.S. dollars, due to currency headwinds driven by the euro to USD and pound sterling to USD exchange rates versus prior. Legacy sales in Asia Pac were up 3% in local currency, compared to the second quarter of last year, but were down 2% in U.S. dollars largely due to the Australian dollar to USD exchange rate versus last year. In our Global Market segments, second quarter growth was driven by corporate office, public buildings, and healthcare. Second quarter gross profit margin was 38.8%, which included 1 million of Nora purchase accounting amortization. Adjusted gross profit margin was 39.1%, a 60-basis point improvement over gross profit margin in the prior year period. We were very pleased with the progress of our productivity initiative, the impact on our margin results, which improved sequentially throughout the quarter and positioned us well as we enter into the back half of 2019. SG&A expenses were $96 million Q2 or 26.8% of sales. We incurred unusually high legal expenses in the quarter of approximately 2.7 million related to the SEC matter. Separately, on the income tax line, we had a $3 million net reduction to tax expense in the second quarter related to a liability adjustment. This item contributed to a favorably low tax rate in the second quarter. Now, looking at the operating income line, second quarter operating income was $43 million, compared with $34 million in the prior year period, excluding more purchase accounting in Q2 2019, Nora transaction-related expenses in Q2 2018. Adjusted operating income was $44 million in Q2 of 2019 compared to $37 million last year. In Q2, we recorded net income of $29 million, or $0.50 per diluted share, compared to net income of $21 million, or $0.35 per diluted share to last year. Adjusted net income was $30 million or $0.51 per diluted share in Q2 2019, compared to $25 million, or $0.42 per diluted share last year. Adjusted EBITDA was $57 million in the second quarter of 2019, compared to $48 million in the same period last year representing 12% growth in adjusted EBITDA.

[Jay Gould:]

Thank you, Bruce. Our transition into a commercial foreign company is working. Resilient flooring now represents 25% of our portfolio is growing at double-digits with accretive margins. And we also continue to take market share in carpet. So, despite the slowing macro environment, we continue to expect a strong year as we execute on our strategic agenda and we are targeting to achieve the following results in 2019. Total net sales growth of 14% to 15%. Organic sales growth of 2% to 3%. Adjusted gross profit margin to increase 100 basis points to 150 basis points versus the prior year, which equates to a range of 39.7% to 40.2%. Adjusted SG&A expenses of approximately 28.5% as a percentage of net sales.

[Operator:]

Certainly. Our first question comes from the line of Michael Wood of Nomura/Instinet. Your line is open.

[Michael Wood:]

Hi, good morning.

[Bruce Hausman:]

Good morning, Mike.

[Michael Wood:]

The third quarter to fourth quarter ramp, you mentioned the organic growth numbers that you are expecting in the second half, is there anything else that is contributing like SG&A timing or productivity timing?

[Jay Gould:]

Well on the top line, I mean first of all, I would say we have lower comps, easier comps in the fourth quarter than we have in the third quarter. So, that is a driver of it. Secondly, we have got continued push into resilient floor and we’re expecting even greater growth in the LVT business in the fourth quarter.

[Michael Wood:]

Great. You mentioned the longer-term margin goals that you have, can you just give us some of the next major milestones, when you work towards those or are there going to be any disruptions or bumps in a row that we should be aware of and can you remind us how much of the savings may be you’ve achieved so far?

[Jay Gould:]

Well, there is a lot. Let me unpack that a little bit. First of all, our gross margins from 2014 to 2019 will have expanded 600 basis points. A key piece of that is that our U.S. asset transformation that we’ve been working on for three years that project will be complete by the end of the year, and we will have harvested $30 million that we anticipated with that project.

[Michael Wood:]

Great. Finally, can I just ask what the reduction of 30 basis points in gross profit in your guidance would contribute to that? In your outlook.

[Jay Gould:]

Yes. It’s – we’re still anticipating the productivity initiatives that we expected as we started the year. So, $20 million of gross productivity offset by roughly $10 million of inflation to yield $10 million of net productivity, which is at 100 basis points to 150 basis point improvement in gross margins. So, we’re expecting the 20 basis points miss versus our going in assumption is largely coming from some reduction in manufacturing volume in Europe, and some mix issues related to some nora volume, particularly in China where we took a very large order at a government facility, but it came at significantly reduced margins. So, a little bit of mix, little bit of fixed cost leverages out of Europe.

[Michael Wood:]

Great. Thanks so much.

[Jay Gould:]

Thank you, Mike.

[Operator:]

And our next question comes from the line of Kathryn Thompson of Thompson Research Group. Your line is open.

[Kathryn Thompson:]

On the resilient segment, could you get more granularity on the LVT and rubber separately sales and order growth in the U.S. versus the European market? And also, just clarify today where we are today in terms of the geographic breakout of sales and U.S. versus Europe and other markets for the broad resilient category? Thank you.

[Jay Gould:]

When the Nora business is a very globally based business, but about a third of that business is in the United States and we had a really strong growth in the first half of the year in the United States on rubber. We also had great growth in Germany, in what we call the dark region, which is the German-speaking countries of Germany, Australia, and Switzerland really strong first half performance there. Little bit weaker across the rest of Europe. We also saw very strong growth in China albeit with reduced margins for the first half of the year.

[Bruce Hausman:]

numbers around that Kathryn. It is Bruce. Roughly 55% of our revenues are in Americas, roughly 30% is in EMEA, and about 15% in Asia, Asia Pac.

[Kathryn Thompson:]

Four specifically resilient categories?

[Bruce Hausman:]

That isn't total. I am giving you the total numbers. We actually don't, we don't really break out by product category with .

[Kathryn Thompson:]

But as it grows to be more important category that will be something that would be helpful going forward just in terms, because if you're having double-digit growth in that category versus flat for carpet pile it helps to build the bridge for the growth story. So, the second question clearly has more to do on what you are seeing more specifically in Europe and trying to understand obviously not surprising to see softening trends in the European market, but you could give a little bit more color on where in Europe you’re seeing a little bit better or a little bit weaker markets and also clarify a little bit more some of the challenges you’re seeing in China just as the U.S. company operating in China right now.

[Jay Gould:]

Yes. I would say on the quarter legacy business we’re still seeing strong growth in the dark region, and a slowdown pretty much across the board. The UK is very soft, South Europe has been soft so far this year, the orders look interesting. So, it’s a pretty broad slowdown of the market across Europe. China has been very difficult on the legacy business I think that there is some, you know anti-American sentiment going on. And then overall, slowdown of the China economy, you can literally feel you know that Kathryn. So, keeping an eye on that business, where I would say that revenue and orders have been weak coming out of China. The offset for that for us, India will have another fabulous year in India and many of our global accounts continue to new offices in India. So, very pleased with the performance there.

[Kathryn Thompson:]

Okay. And finally, just a follow-up question on Nora as you are continuing to roll it out, understand you’re getting some good synergies on the top line, what end-markets are you seeing particular strength and are there any new markets that really hadn't been fully penetrated? Are there any new markets that are – geographic markets that are seeing particular strength? Thank you, very much.

[Bruce Hausman:]

We’re seeing great growth in healthcare and some growth in education on the Nora piece of the business. So, very encouraged with that. We saw that as an opportunity, I think to better address rubber in the office market where it's used in code base and in stair treads. So, there is an opportunity for us to do a better job there. And I think we will accelerate our growth in the back half of the year with that cross-sell.

[Kathryn Thompson:]

Perfect. Thank you very much.

[Bruce Hausman:]

Thank you, Kathryn.

[Operator:]

And our next question comes from the line of Keith Hughes of SunTrust. Your line is open.

[Keith Hughes:]

Thank you. Just wanted a question on SG&A, you ticked that up to the 20.5, did you talk about the contributions to get those numbers up?

[Bruce Hausman:]

Well, I mean, we’re still amazed when we talk about at start of the year . We do have some added legal expense, will be a full-year expense. I think 2.7 million have floated to the second quarter. So, that is going to have a full-year impact. We’re trying to pull back on SG&A to keep it as a percent of sales as our top line softened a little bit. We’re making some reductions on our total SG&A dollars.

[Keith Hughes:]

Okay. And the accounting investigate that you announced last quarter, is there any update on that?

[Bruce Hausman:]

No, we don't have an update. I mean it’s going in the government space. So, we’re responding to request and trying to get to the process.

[Keith Hughes:]

And final question, I don’t know if it is just me, I am having a hard time hearing you, could you just read off again the geographic growth, excluding currency in local currency?

[Bruce Hausman:]

I got that Keith. Can you hear me okay?

[Keith Hughes:]

Yes, barely. If you could just read it one more time.

[Bruce Hausman:]

Okay. I hope you can hear me now. So, was up 1%, compared to second quarter last year and excluding the large customer order that we mentioned that we had in 2018, sales in the Americas grew 5%. Our legacy sales in EMEA grew 2% in local currency, but were down 4% in U.S. dollars, due to currency headwinds that were driven by the euro GST, and pound to USD exchange rates versus last year. And legacy sales in Asia Pacific were up 3% in local currency, compared to the second quarter of last year, but were down 2% in U.S. dollars, again more currency headwinds really driven by Australian dollar to USD exchange rate versus last year.

[Keith Hughes:]

Okay, thank you.

[Operator:]

And our next question comes from the line of Matt McCall of Seaport Global Security. Your line is open.

[Matt McCall:]

Thank you. Good morning guys.

[Jay Gould:]

Good morning Matt.

[Matt McCall:]

So, you gave the adjusted Americas growth 5%, ex the one large order, I think that also impacts Q3, so when I look at that Q3 growth of 0.2 or 0 to 2%, what is the growth excluding that large order or the impact of that large order last year?

[Bruce Hausman:]

Matt, this is Bruce. It will be a similar impact in Q3 as we had in Q2.

[Matt McCall:]

Okay. And so, I guess same question when I think about the full-year, so you get about four points of impact in Q2, four points of impact in Q3, does that imply that there is maybe, what was that, two points for the full-year so that 2.2% to 3% organic growth kind of on the adjusted basis for that large order would maybe more than like or something like that?

[Bruce Hausman:]

Yes. I have said a lot. That’s 250 basis points for the year probably, Matt. So, yes, I mean you could add 200 to 250 basis points to the organic growth rate beginning on a normalized basis.

[Matt McCall:]

And so that kind of leads to the next question, Jay, the long-term view for carpet tile is the mid-single-digit, the right number, is GDP growth the right number, and then how important are some of the new product moves, and I'm talking carpet tile specifically in some of the manufacturing moves in helping you offset some of the maybe the secular pressures that you are facing there?

[Bruce Hausman:]

I don't know if it is secular pressures, I certainly think it’s a couple of year pressure point as resilient flooring is making a bigger dent, particularly in the office market. I do see that moving back and we will get back to the kind of GDP growth on carpet tile because it’s a superior flooring surface in commercial in general, but in particular for the office market because of its benefits. So, I see the category growth rate coming back over time and we would anticipate 3% to 4% growth carpet tile, both from that category, as well as continued market share gains. We do believe, I mean our new part of vitality for the portfolio is 38% right now. So, our new products are definitely capturing demand in the market, if you know the customers are responding to that. Additionally, as we move into next year, we’ll have a broader portfolio in carpet tile, including some non-PVC backing, which has been a gap in our portfolio really forever. So, I think, Carpet Neutral Floors, and as we move into be even more aggressive around carbon conversation coupled with design innovation, we’ll have a portfolio that should allow us the market share.

[Matt McCall:]

Okay. That’s helpful and then one last question on SG&A maybe following up on, I think it was key to ask, last quarter when you gave guidance on SG&A, how much legal was in that projected range, how much legal related to the SEC issue specifically was in that guidance last quarter?

[Jay Gould:]

It was modest, to be perfectly honest with you. I mean we didn’t expect spending at the levels we did in the second quarter. And frankly, we don't think those levels will continue that high. So, it was a bit of a surprise in the second quarter of how much we had to invest there.

[Matt McCall:]

So, what is the, can you quantify where you thought it was going to be now where do you think it’s going to be, and then what I’m trying to get at is, what you’ve actually pulled that you said you pulled some SG&A back, I'm trying to figure out exactly how much you pulled back and then I guess the bigger question is what are you pulling back?

[Jay Gould:]

I mean, it was pulled back significantly $5 million or $10 million for SG&A for whatever was this legal expense was going to be. I mean, we honestly don't know. We have got to just go through the process with the government, Matt. And that’s not – and little we pulled it back and then pulled back some incentives because we're not going to deliver on our expectations for the year. And we'll trim the tabs everywhere. We're trimming the tabs a little bit on in Europe right now because it is soft.

[Matt McCall:]

Okay perfect. Thank you, guys.

[Jay Gould:]

Thanks Matt.

[Operator:]

And our next question comes from the line of Sam Darkatsh of Raymond James. Your line is open.

[Sam Darkatsh:]

Good morning Jay, good morning Bruce. How are you?

[Bruce Hausman:]

Good, Sam.

[Sam Darkatsh:]

Two or three questions. The Nora growth that you called out the 11% on a like-for-like basis. That’s obviously terrific and higher than when you originally bought Nora. I think you were targeting kind of the mid-single plus. I know you mentioned a large order in China, but I also know that you made a number of synergistic moves to sell Nora more holistically. When you look now at the next two or three years or so, what sort of steady-state growth rate might we expect now from Nora, best you can tell?

[Bruce Hausman:]

You know, I think in the 4% to 5% range it was much more like the . Look, I am thrilled with the 11%. The Nora sales team has done an absolutely fabulous job and kind of coming into the Interface family. I don't think of long-term prospects are double-digit growth.

[Sam Darkatsh:]

So, how sustainable over the next, I don't know, two or three, four quarters or so might this high-single-low double-digit rate last?

[Bruce Hausman:]

I think for a while. I think with the expanded geographical reach we have with Interface will help and I also think kind of getting deeper in some of our core markets will help. We are the Interface selling systems with the deeper and things like offers where I think we could take market share there.

[Sam Darkatsh:]

Next question. Capital allocation, it appears though you have finished your share repo at least your current authorization, you're evaluation is still modest although I think you have had roughly 3 times debt-to-EBITDA, so talk about priorities going forward repo versus debt paydown, where is the imperative at this point and why?

[Bruce Hausman:]

Hey Sam it’s Bruce. Really there are three priorities kind of go on this order. First, is investing in the business. And the investments that we’re making in the business are showing up as productivity on the P&L. So, we want to continue that momentum. That’s just driving the margin expansion we are seeing today and that’s what gets us to the product 42% as well. The second is paying down debt and deleveraging which we are also focused on. And then I think you're also aware we also have a competitive dividend as well that we pay.

[Sam Darkatsh:]

So, you did not include share repurchase in there. So, what’s the optimal capital structure now as you see it is roughly two turns from the three today?

[Bruce Hausman:]

Yes. I think that’s what we’re targeting toward as we continue to deleverage.

[Sam Darkatsh:]

Got it. And then my last question, I apologize for jumping on the horse with the legal cost again, but do they continue or do you anticipate them continuing as long as the SEC process continues or is it just a kind of an initial upfront legal cost and then it kind of windows away until there is a decision one way or the other?

[Bruce Hausman:]

Honestly, you never know, it is almost impossible to give you a definitive answer, but if you were to say what’s our best guesstimate. You know we had a little bit of a hump to get out of, we had a little bit of for expense that we had incurred this quarter, but we don't – our best estimate is that’s not ongoing leverage.

[Sam Darkatsh:]

So, something half of that rate might be something we should bake in at least until there is resolution?

[Bruce Hausman:]

That’s not what I’m saying. I’m not saying half or quarter, I'm just saying I wouldn't, I think that was unusually high and I would be disappointed if it was, if it continued at that rate. It’s not something that we’re anticipating. But with these kinds of matters you have to just spend money that you need to spend.

[Sam Darkatsh:]

Understood. Thank you very much gentlemen. Appreciate it.

[Operator:]

And our next question comes from the line of David MacGregor of Longbow Research. Your line is open.

[David MacGregor:]

Jay, congratulations on a good quarter.

[Jay Gould:]

Thank you, sir, appreciate it.

[David MacGregor:]

What percentage of your project wins now include LVT and Nora and how does that compare with year ago?

[Jay Gould:]

Well, I mean all I can really tell you is the percent of orders that include both, and it’s roughly 40% and it continues to grow.

[David MacGregor:]

What would have that been a year ago?

[Jay Gould:]

I would have said 20 or less. I mean it is really working. This idea about selling an integrated folding design has really helped and the fact that our products are interchangeable they are the same size has really helped the design community. And as odd as that sounds, I'm not aware of any of our competitors who will do the same thing.

[David MacGregor:]

That’s remarkable 40 versus 20. The jobs you aren’t winning is it due to price or breath of offering, just talk about the ones to get away?

[Jay Gould:]

Well, we don't compete in the low price point categories as you know. So, I'm going to take those of the table. The ones we don't lose from a design perspective, it's – unfortunately, there's a belief in the market that needs to be some democracy amongst players and what we're trying to do is win our rightful market share, which I tell our salespeople it is a 100%. Because that is what I believe. As our rightful market share is 100% and the deals we lose is because we don't have enough time to spend with our customers.

[David MacGregor:]

So, people are just spreading the business around?

[Jay Gould:]

Yes.

[David MacGregor:]

On Nora. I guess, we’re about the anniversary of the acquisition, it’s obviously been a very successful acquisition, what’s the expected first year accretion?

[Jay Gould:]

From an EPS perspective?

[David MacGregor:]

Show that works.

[Jay Gould:]

So, we really don't break out the legacy business from the Nora page on the contribution, David.

[David MacGregor:]

Well at the time you acquired the company you thought you could do $0.15 to $0.20 in the first year, so I guess how do we measure against that initial expectation?

[Jay Gould:]

So, what we do from an – I think we provide, we will provide revenue accretion every quarter, which is what we're trying to do. It’s also accretive to the GP line and accretive to the oil line. We don't necessarily break out the components of the two different businesses and frankly the two businesses are being integrated so well together. Over time, it becomes difficult to, they become an integrated one of two separate companies.

[David MacGregor:]

Sure. But I mean you’re communicating your accretion expectations at the time of the purchase, it seems fair to be able to circle back around with a year later and just see how you held up against that initial expectation and just trying to guess, if you can quantify it, are you ahead of where you thought you would be or are you behind or are you in-line, just how does that stack up?

[Jay Gould:]

No, I think the, as you mentioned the acquisition has been a great acquisition as very, very much on track. And it’s, as you can see from the growth rates and from the synergies that we are getting out it, we're very pleased.

[Jay Gould:]

Look, I think that’s fair. We will circle back at the end of the year. So, at the end of the third quarter when we see results, we will talk more about that. We will have a full-year under our belt. I would say, I mean, what is working and what are some of the challenges. Top line is working. The integration of the selling organization from the cross-selling, I feel like that’s working really well in the United States and Germany. What has been a challenge quite frankly for the margins, you know, they work deludedly in the first quarter. We talked about that to our gross margins, and we’re continuing to get our arms around the manufacturing environment in hindsight. We're participating in a whole new category. We’re wanting to work with the new works council in Germany and that’s been a little bit slower than I would have liked, but it’s coming around. So, at the operating income line, it has been positive. We haven't gone through the stage of going through any kind of headcount reductions yet, which is going to be an opportunity to better find synergies as we get our systems in place. So, we're going live with our order cash integration starting in the fourth quarter of this year and there will be a couple of quarter rollout as we pick that global, which will give us an opportunity to better organize consistently. So, I think fundamentally it’s working. It has added to our bottom line and that’s been good at a time when frankly carpet tile has been a little bit soft.

[David MacGregor:]

Great. That’s helpful. I appreciate the candour, Jay. Just last question from me. There has been new industry capacity brought into carpet tile in U.S. and in Europe, so just talk about how that additional industry capacity may be influencing you competitively?

[Jay Gould:]

We haven't seen it at all David. So, once again, I will say even with our - from my expectation, our second quarter gross margin was about 100 bips miss. I wanted to be in 40, and we delivered 39.1. None of that was coming out of the U.S. We actually hit our target in the Americas. So, the added capacity in the Americas has had no impact on our margin structure. Europe is soft, but I don't think it’s because of the added capacity in Europe. Our numbers are a little bit soft in Europe because the top line is soft in Europe. We actually produced a lot less volume because we took inventory down in Europe. So, we had some fixed cost leverage challenges in our manufacturing environment in Europe. It’s not really from competitive price. Hopefully that helps.

[David MacGregor:]

It does help. Are you expecting those production curtailments to continue into the third quarter in Europe?

[Jay Gould:]

Yes.

[David MacGregor:]

Okay. Alright. Thanks very much guys.

[Operator:]

And our last question comes from the line of John Baugh of Stifel. Your line is opened.

[John Baugh:]

Thank you, and good morning. I just had a quick question on the carpet tile in the U.S. I'm curious Jay, what are you seeing in terms of mix, it strikes me that there is a low end of times where most of the growth is, and of course you operated the high end. Are you, where are you with the strategy to make more to stock versus custom order? What are you seeing in terms of orders in carpet tile in terms of high versus low price points, just general mix commentary around the U.S. tile business? Thank you.

[Jay Gould:]

It’s ironic, we’re selling a lot of $15, $16 carpet, but we’re also selling a lot of $35 plus carpet. We have a booming business in the commercial top selling carpet tile as area rugs, and a lot of that is the floor branded product, which again sells at $35 plus a square yard. So, there is, one of the things you did a few years ago John, you might remember is in our design approach and in every design, we have a good, better, best approach. And so, we can kind of value engineer ourselves as we get into the purchase strength. So, we’re seeing growth at the low end and the high-end of our portfolio.

[John Baugh:]

Okay. And then just back to Nora really quickly. If you exclude the China order, which is obviously not U.S., I’m trying to get a sense of whether in the early innings of owning this, you're seeing benefit to Nora from Interface, and integrated sales, and you mentioned that commercial is a big opportunity, of course you were strong in that area. So, it doesn't sound like that’s occurred yet, but I'm just curious whether you’re seeing any winds in the U.S. that you would chalk up to Nora being part of Interface?

[Jay Gould:]

Well, I think the answer is yes. Both in the U.S. and Germany, which really are two markets of scale. You know, it’s still early days, but the sharing of needs, the sharing of opportunities bringing one salesperson into another account is working. And I mean there is countless numbers of individual deals that I can read off have worked.

[John Baugh:]

Great. Thank you. And good luck.

[Jay Gould:]

John, by the way, it will get better when we all get on the same CRM platform. So, in May we took the Interface people live in our new salesforce.com platform. The Nora people will go live in the fourth quarter. And having one integrated system, so we can look at all the deal activity will actually help accelerate that.

[John Baugh:]

Thank you.

[Jay Gould:]

Thanks John.

[Operator:]

And there are no further questions at this time. I will now turn it over to Jay for closing remarks.

[Jay Gould:]

Thank you, Natalie. Well once again thanks to the Interface team around the world for another very solid quarter. I’m excited that we continue to take market share. I’m thrilled with the progress and the transformation of the company into a growing company, and to everyone on the call, I appreciate your continued interest in investment and Interface. Thank you. Talk to you next quarter.

[Operator:]

This concludes today's conference call. You may now disconnect. Have a great day.