Knoll, Inc. Q3 2008 Earnings Call Transcript

Oct.16.08 | About: Knoll, Inc. (KNL)

Knoll, Inc. (NYSE:KNL)

Q3 2008 Earnings Call

October 16, 2008 10:00 am ET

Executives

Andrew B. Cogan – Chief Executive Officer & Director

Barry L. McCabe – Chief Financial Officer & Executive Vice President

Analysts

Matthew S. McCall – BB&T Capital Markets

Analyst for Michael J. Rehault – JP Morgan

Chad Bolen - Raymond James

Christopher Agnew – Goldman Sachs

Mark [Roop]

Operator

Good morning everyone and welcome to the Knoll, Inc. third quarter 2008 conference call. (Operator Instructions)

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 accompany the webcast.

Now let me turn the call over to Andrew Cogan, the CEO of Knoll.

Andrew B. Cogan

Thank you. Good morning, everybody. We are pleased with the strong results that we just reported. We are the custodians of one of the greatest design brands in the world today and by focusing on high design content businesses we’ve created a diverse portfolio of products that appeals to a broad range of clients in many different segments around the world. Our brand has attracted a team of talented associates and committed [inaudible] who work so hard to meet the needs of our customers. We combine all of this with a rigorous, proactive, environmentally responsible business philosophy that has for over a decade, in good times and bad, generated industry leading levels of profitability. Obviously we all know that we can be in for a bumpy ride ahead, but I could not be more confident in our seasoned team’s ability to navigate through it.

I don’t believe Knoll has ever been in better shape. Our product portfolio is more diverse than ever with significantly reduced dependence on North American office dynamics. We have some of the most important new products in our pipeline for 2009 and 2010 with the potential to accelerate our market share gains. We are more international than ever and see our focus here generating continued growth.

In the face of historic levels of inflation, we’ve actually been able to expand our margins, and while we expect margins will contract in Q4 as inflation peaks, we believe that falling commodity prices and the strengthening US dollar relative to the CAD and the Euro should be margin supportive in the future. Our balance sheet is very strong. In the quarter we were able to continue to buy shares while reducing our debt, dropping our leverage ratio to 1.95:1, and improving our liquidity such that at the end of the quarter we had between cash on hand and revolver availability over $183 million of liquidity.

Our team is excited about the future and as more people around the world engage in office work and reside in modern homes, we intend to be there to meet their needs with beautiful and innovative products as we’ve done for the past 70 years.

Now let me turn the call over to Barry to very briefly walk you through our results.

Barry L. McCabe

As Andrew stated in his opening comments, we were very pleased with our results when you consider the current worldwide economic environment in that we are continuing to pay higher prices for key commodities. Our commodity cost will continue to increase as we have delayed accepting many of the price increases throughout the year. As yet we have not benefited from the falling commodity prices. As we review our results, sales for the third quarter were $283.5 million, an increase of 11.6% over the prior year period, reflecting growth in all our businesses. Again, we are pleased that our diversification strategy is allowing us to grow despite the challenges facing the office category in North America.

The backlog for the third quarter was $203.1 million, a 19.6% increase over prior year. Sales activity as represented by client visits, mock ups, and million dollar orders were ahead of last year. Gross margin for the quarter was 36.8%, a 210 basis point increase from a year ago. The increase was primarily due to the higher sales with favorable mix, price realization, continuous improvement programs in our factories, global sourcing, and favorable foreign exchange more than offsetting the higher inflation.

Operating expenses were $63.1 million, or 22.3% of sales, an increase of 100 basis points above last year. Actual spending increased $9.1 million, which was primarily the SG&A related to the Edelman Leather acquisition completed in the fourth quarter last year and some incremental spending on our growth initiatives and compensation.

Operating income as a percent of sales was 14.5% for the quarter, an increase of 100 basis points from last year. This increase was the result of the higher sales in gross margin. Interest expense was $3.8 million, a decrease of $1.9 million from a year ago due to lower rates despite $34 million of higher date. Other income was $2.1 million which compares to other expense of $0.8 million for the third quarter of 2007 due to foreign exchange gains and losses on currency.

Our tax rate for the quarter was 39% compared with 33.9% rate a year ago. The increase in the rate is primarily due to the mix of business in the countries in which we operate and last year we benefited from adjustments to our contingent tax reserve. All of this resulted in net income of $24.1 million or 8.5% of sales. An EPS of $0.52, an increase of 41% when compared to net income of $18.4 million or 7.2% of sales and an EPS of $0.37 a year ago.

Year-to-date net cash provided by operations was $97.5 million of which $83.7 million was provided from net income plus non-cash amortizations less $13.8 million of favorable changes primarily in working capital in deferred taxes in current liabilities. Capital expenditures were $9.8 million for the 9 months. Cash used in financing activities was $75.5 million which include net debt repayments of $26.1 million, $34.3 million of common stock purchases offset by $1.9 million of common stock proceeds, and related tax benefit and $17 million of dividend payments.

If we look at liquidity we have $28.6 million in cash at quarter end and another $154.3 million available under our revolver. We are in compliance with all of our debt covenants and our leverage ratio is 1.95:1. We are pleased with both our strong financial operating performance and strong balance sheet with increased liquidity. In the quarter we were able to reduce our debt by $21 million while simultaneously taking advantage of our low share price to purchase over 1 million shares of our stock. As of today we have acquired approximately 2.8 million shares this year at an average price of $13.32.

As we look forward, we expect inflation to continue with commodity costs peaking in the fourth quarter as we have lagged the spot market on key commodities and will only begin to see the benefits of falling prices in 2009. We will continue to actively manage our balance sheet and cash flows with the same vigor that you have come to expect from us on our operating results. For the fourth quarter of 2008 we expect sales to be in the $278 million to $283 million range, essentially flat with last year. We expect EPS to be $0.44 to $0.47.

We will now take questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Matt McCall of BB&T Capital.

Matthew S. McCall – BB&T Capital Markets

So backlog about 20%, I know you’re up against... I think a seasonally stronger comp from a year ago. Can you talk about the order trends as you’ve progressed through the quarter and what they’ve been like since?

Barry L. McCabe

Backlog is up which speaks for itself. I think one of the things when you look at the backlog and we’re encouraged by it is a piece of that backlog probably more so than historically is product that will probably ship in the first quarter and not in the fourth quarter. Again we talked about activity in terms of million dollar orders, mock ups, customer visits, and those continue to remain strong.

Matthew S. McCall – BB&T Capital Markets

No change in patterns in recent weeks?

Barry L. McCabe

I say no.

Matthew S. McCall – BB&T Capital Markets

Okay. So you said commodity costs are going to get more difficult. I know you’ve got some pricing actions in place. Can you talk about the net pressure or net benefit from either price or cost in Q3? What’s expected in Q4 and how that should look I guess directionally, I think you said it should get better in ’09, by how much?

Barry L. McCabe

I think we’ll have to wait to look at ’09 and see if the deflation in the commodity costs continue. Again, as we said and I said in the script, we have been able to postpone a lot of the price increases that have been coming everyone’s way and they will peak in the fourth quarter and until then, spot prices come down to what we’re paying, we really won’t see the benefit, so in terms of pure inflationary pressures, it will be higher in the fourth quarter than any of the other quarters this year for us. But on the positive side, we expect those to peak and we expect to benefit in the end of 2009 if everything continues the way we see it today.

Matthew S. McCall – BB&T Capital Markets

How much variable is the benefit or was there a benefit from the Canadian dollar, I think you mentioned the Euro as well, in Q3, and what’s the expectation in Q4?

Andrew B. Cogan

I think the way we always do our forecasting, we look at what the currency is at the end of the month going into the quarter and we really plan off of that so I think you can go back and look at the Canadian dollar at the end of September, I think it was in the $0.90 to $0.92 range.

Matthew S. McCall – BB&T Capital Markets

And that’s what you based your guidance off of?

Andrew B. Cogan

Yes.

Matthew S. McCall – BB&T Capital Markets

Okay and then two more quick ones. You mentioned a bumpy ride, I think Andrew, on the cost front, it sounds like you’re still pretty bullish about new term trends but anything on the shelf that you could pull off to address some costs should the bumpy ride turn bumpier than expected?

Andrew B. Cogan

I think we have been through the mother of all bumpy rides from 2001 to 2003 where the industry declined 36% or something like that. I think Knoll is fundamentally better positioned going into this cycle than we were in that cycle. I also think when you look back at 2001 to 2003 you really had demand bubble that collapsed. I just think the levels we’re at today, the industry’s around what, $11 billion, $11.3 billion. I just don’t see that kind of demand bubble as having formed this time around so could we easily see a decline? Absolutely. I think we’d be very prepared to handle that. I also think we are just so much better off in terms of diversification of our revenues.

As you will recall back in early 2000, 80% or 85% of our revenues and profits come from our Knoll Office North American business. Today that’s maybe two-thirds of our revenues and less than half of our operating profit so we have really diversified this company in a very significant way. I also believe the deflationary headwinds we are going to see are significant as Barry talked about. I mean the Canadian dollar this morning was around $0.84. I think we averaged $0.98 so far this year. That’s $14 million of tail wind that we will have an annual basis if you throw in the benefit we should expect from lower transportation costs which have also been a head wind as well as steel and other metal costs which have also been head wind.

We really should see some nice cost deflation and that can offset a meaningful hit on the top line. So I think the net net of that will be fine and that we do have as always a commitment to flexing our SG&A costs based on where we see demand and I would just point out that even in the trough of the last cycle we had, our industry leading margins bottomed at 10% and today we’re close to 15% and I think probably no one expected us to deliver the kind of margins that we’ve delivered in this environment even with all this inflation. So I think the net net of that is that I think we’ll be just fine and are more than capable and have a strong track record of navigating through whatever the future may bring.

Matthew S. McCall – BB&T Capital Markets

That’s helpful and one more, I’m sorry to go so long. Barry, interest expense, you’ve got LIBOR spiking a little bit and all over the board, can you help us understand what we should expect on the interest expense line in Q4 and as we move into ’09 based on where LIBOR is today?

Barry L. McCabe

It’ll be interesting to see where LIBOR moves. We’re not experiencing today the higher LIBOR primarily because we had locked in at a lower rate. I think LIBOR and where it ends up would be more of an issue going into next year than it is for the quarter and I think if the liquidity opens up in the financial markets then LIBOR should move more in line from where it is today. I think today, the last time I looked it was still above 4%. Our spread on that is LIBOR plus 100 basis points and as we lower our leverage ratio it’ll be 75 basis points going into the quarter.

Operator

Your next question comes from Michael Rehault from JP Morgan.

Analyst for Michael J. Rehault – JP Morgan

This is actually Ray [inaudible] for Mike. On the third quarter sales I wonder if you could help out with giving a break out or a component break out of the 12% sales growth between pricing, foreign exchange, and volume, and also what Edelman contributed in the quarter.

Andrew B. Cogan

I think the good news was we had our strongest organic growth of the quarter for the entire year in the third quarter and it was significant so Edelman obviously continues to help from an acquisition standpoint. As you know that anniversary is at the end of the third quarter so we will not get any help from that on an annual basis going forward but we had nice organic growth. The growth was really led by our international businesses and our European businesses and while we see some softening in markets like the UK we also see some very strong growth in other markets in the Middle East. Our specialty businesses also continue to grow nicely and I was really pleased with the progress in our complementary products. Those are our seating, storage, and case good products, and that’s a category that I have enormous enthusiasm for as we move into 2009 and have some very, very significant new introductions in that space and then our systems business was pretty flat.

Analyst for Michael J. Rehault – JP Morgan

Also speaking of the market share gains and the new products in 2009 and 2010, I wonder if you could provide a little more detail about that. Is that primarily the seating and storage and is that more targeted towards the lower end or higher end or it’s kind of across the spectrum?

Andrew B. Cogan

You’re absolutely right. It is significant introductions both in the seating space and in the storage space. In seating more than one product initiative and we’re very much going after the performance segment of the work share market where we see a tremendous opportunity to really innovate in a way no one has to date at a price point that we think will be very viable in a more constrained market environment.

Operator

Your next question comes from Chad Bolen from Raymond James.

Chad Bolen - Raymond James

Barry, in the $2 million of other income attributed to foreign currency transactions, could you just maybe help me understand that a little bit? Is that something continuing? How should we think about that?

Barry L. McCabe

I think if you look at the foreign exchange, obviously it’s the movement of the Canadian dollar and to the extent that the Canadian dollar continues to fall, you’d seen improvement there, and it’s also the Euro which I think moved from closer to $1.50 something now to where it’s a $1.38 or maybe even lower than that. So to the extent that that trend continues, you’ll see continuous improvement there.

Chad Bolen - Raymond James

So the weakening of the Canadian dollar helps at the gross margin line but it also... I guess I don’t understand the mechanics.

Barry L. McCabe

It helps at the gross margin line because the bulk of the sales are in US dollars and the cost of sales are in Canadian dollars. It also helps on our inner company account with Canada which is in the other expense line. So in other words, is that a comp? Watch your weights from month to month and the currency moves, you can pick up a gain there.

Chad Bolen - Raymond James

Okay, that’s very helpful. In most recent quarters your use of cash flow has been pretty balanced between debt repayment, share repurchase, and the dividend. With your leverage now under two times and the stock price where it is, do you sense that pendulum swinging more towards share repurchase in the future or do you feel the need to be more conservative given some of the economic uncertainties? How are you feeling about that right now?

Barry L. McCabe

I think we’ll look continually at the liquidity in the market, what’s taking place, and as [Liv] said, look at balancing between debt payment, share repurchase, and we’ll still continue to look at acquisitions and look at what we think is the best use of our money. We are paying more attention clearly to our debt levels and liquidity.

Operator

Your next question comes from Christopher Agnew from Goldman Sachs.

Christopher Agnew – Goldman Sachs

Question on the strength in your orders, mock ups, and client activity. It really seems to be at odds with what we’re hearing in the economy, corporate spending, unemployment, credit availability. I’m just wondering, Andrew, can you shed any more light on this? Do you think you’re taking market share? Is it more international? And can you give us some color on the various end markets you’re looking at, government, financial services, etc.

Andrew B. Cogan

We are a late cycle business. So again a lot of the decisions and the volume we’re benefiting from are from decisions that were made prior to certainly the latest stage of this cycle or crisis so I think we do benefit from that and I would expect us for the next quarter or so to continue to benefit from that and then we’ll have to see how that plays out as we go into 2009. I think the weakness is where you think the weakness would be in areas like investment banking, that’s really drying up, and then that would correlate with markets that are major financial centers where you would see some weakness geographically.

On the flip side, we’re making strong progress in education. We see some very significant education opportunities as we end this year. Energy, that space is going up. Accounting, legal, we’re seeing progress there, and our health care as a share of our business is going up. I think we really diversified ourselves. We do expect continued weakness in financial services and continued weakness in markets that are associated with that and that would be places like New York, places like the UK. I think you would see that, but again we are more diverse and we still see plenty of markets both in terms of vertical and in terms of geographies that are growing and we’ll keep focusing our resources on where the opportunities are.

I’d also point out because the employment data, vacancy rates, that’s all moving in the wrong direction . We’re not going to be impervious to that of course. But you know the ABI billing index hasn’t collapsed. There’s still people leasing space and frankly through some of these massive integrations and mergers that are going on, so far clients we’ve been aligned with have been on the surviving end of things and I think that’s encouraging for the long term.

Christopher Agnew – Goldman Sachs

Maybe a similar-ish question on international. Again hearing a lot of bad news, falling oil price, I’m wondering how that affects the Middle East. What light can you shed on the specialty business which is very important for your international growth and you’ve been doing very well. How much visibility do you have into that business, you know hospitality’s under pressure in the US but maybe how’s it been affected internationally as well?

Andrew B. Cogan

I think you’re absolutely right. Our specialty businesses don’t tend to be as long of cycles as some of our office businesses so they can show shorter term trends and impacts sooner, and some of the retail business and some of the textile business and we are seeing signs of slowing down demand both in North America and in some of the international markets. But that said, there are still some very large opportunities internationally. Oil’s still at $75 a barrel, it’s a lot more than it was a couple years ago and those economies are still investing very heavily in infrastructure whether it’s hospitality, whether it’s education, whether it’s health care, so I think there’s going to be a good trail of business for the next couple of years in some of those markets.

I think the good news is if you went back to 2001, 2002, we weren’t even in those markets. We weren’t even positioned to play in those markets and increasingly we are playing in those markets so we’ve increased international as a percent of our revenue, we’ve increased specialty, we’ve increased complementary. Again I just want to reiterate that we’re not going to be impervious to what goes on in the world but we are better diversified and better able and much less vulnerable than we were to a decline in North American Office systems.

Christopher Agnew – Goldman Sachs

Great and the final question and maybe it’s for the bigger picture, your margins held up is tremendously strong despite a different inflationary environment. I mean if volumes do hold up next year, we assume they’re flattish, and with inflationary pressures receding, theoretically do you think that... Or maybe the right question is structurally, do you think you have a higher level of normalized margins, maybe gross margin, than you’ve achieved in the past?

Andrew B. Cogan

I do, Chris. We set a goal when we went public back in 2004 of trying to get to 15% operating margins. It has been a circuitous route with some setbacks and some gains together, but basically this quarter I think, 14.5%, round it up to 15%. We delivered what we said we were working hard towards and I really want to applaud our associates in the plants and in our manufacturing team and really our dealers and our sales team have done a tremendous effort, collective effort, it took to get there. We really delivered on what we said we would do.

So in a deflationary environment it’s going to be easier. FX is coming our way. I think we’re one of probably a few companies in our space actually to benefit from a strengthening US dollar. The strengthening US dollar lowers our costs and the products we bring from Europe and lowers the cost of the products we make in Canada. I think that’s unique to us. I’m feeling good about that side. But I think it’s unrealistic to expect us to get through 2009 without some sort of impact on the top line. We’re going to get hit. But I think the good news is I don’t think we’re going to get hit anywhere near where we were hit in the last cycle and this deflationary and foreign exchange help is going to mitigate a chunk of that and I think that’s good news.

Christopher Agnew – Goldman Sachs

Maybe an add on to that thinking longer term as well, the complementary products which you hope to gain share so it should grow faster in your role of business and I guess specialty continues to, that should be additive to your gross margin as well. Would I be right in that assumption?

Andrew B. Cogan

Yes you would be.

Operator

Your next question comes from Mark [Roop].

Mark [Roop]

On the specialty, is there any way you can kind of give us an idea how important Edelman was to the growth this year and then what kind of impact that had been lapping? Obviously as you lap Edelman, how much of an impact it might have on gross in the specialty section for next year?

Andrew B. Cogan

Again as we said, we had our strongest quarter of organic growth in the third quarter of this year. Edelman clearly has been helpful overall but we’ve had better than industry organic growth for the year and I’m very pleased.

Mark [Roop]

Would you say Edelman is less exposed to the cyclicality of the economy relative to the core [inaudible]?

Andrew B. Cogan

I would say all our businesses are exposed to the cyclicality of the economy. With that said I think the most vulnerable category historically has always been North American Office systems. Those products can sit in buildings for a long time, people can defer those, they don’t break, they’re going to last a long time. That’s the category I think would be... And historically has been most pressed in a downturn. Everything else has done better. The good news is, 75% of our business was in the category that did the worst in the downturn. Today a significantly lower, less than 50% of our business, is in a category that will be the most pressured in a downturn. Huge change for this company over the last 6 or 7 years.

Mark [Roop]

I know government is a decent portion of your business. Does that provide any offset or is that kind of in the same boat looking out to the next 12 months?

Andrew B. Cogan

Government has been strong and we would expect it to continue to be strong.

Operator

You have no further questions at this time.

Andrew B. Cogan

Thank you everybody and we look forward to talking to you all in February. Take care. Goodbye.

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