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Knoll Inc. (NYSE:KNL)

Q3 2009 Earnings Call

October 15, 2009; 10:00 am ET

Executives

Andrew Cogan - Chief Executive Officer

Barry McCabe - Executive Vice President & Chief Financial Officer

Analysts

Budd Bugatch - Raymond James

Sean Connor - BB&T Capital Markets

Todd Schwartzman - Sidoti & Co.

Mark Rupe - Longbow Research

Operator

Good morning everyone and welcome to the Knoll, Inc. third quarter 2009 conference call. This call is being recorded. This call is also being webcast at www.knoll.com. 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 materially differ for the forward-looking statements as a result of many factors, including the factors and risks identified and described in the Knoll’s Annual Report on Form 10-K and its other filings with the Securities and Exchange Commission.

This 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 company’s earnings release, dated October 15, 2009 and presentation slides that accompany the webcast.

Now, let me turn it over to Andrew Cogan, the CEO of Knoll. Please proceed.

Andrew Cogan

Thank you everybody and good morning. As we anticipated on both a sequential and year-over-year basis, market conditions continued to deteriorate across all our product categories and geographies, yet we continued to deliver industry-leading levels of operating profitability.

On top of generating $16.8 million of operating profit and $23.4 million of adjusted EBITDA, calculated in accordance with our credit facility, we made significant progress in generating meaningful free cash from both operations and working capital to reduce our outstanding debt by $28 million in the quarter, ending with a leverage ratio under our credit facility of $2.59 million to $1 million, well under our four to one covenant.

While incoming orders have somewhat stabilized sequentially, stabilization does not equal growth and as we look into the fourth quarter and beyond major leading indicators, like service sector job creation, office based absorption and the Architectural Billing Index are all in very, very negative territory.

Accordingly, we are not relying on macroeconomic forces to change the trajectory of our results. Rather we continue to aggressively invest in the front end to gain market share in under penetrated product categories, while simultaneously carefully managing our costs across our businesses.

In this regard, I’m very pleased with where things stand with the rollout of our award-winning innovative Generation by Knoll work chair, as well as the rest of our robust Neocon introduction. In the quarter, we began full bore of commercial production of Generation. The supply chain and assembly operation for Generation are as innovative as the product itself.

Our development and operations teams have done an outstanding job putting such a lean and sophisticated operation together, and our people on the line are assembling consistently high quality products. We have now shipped commercial quantities of products to some of our first launch customers and the feedback has been extremely positive.

By the end of September, all our showrooms had Generation chairs on their floors and an ample supply of mock up and loaner chair. In October, we will be shipping a couple of thousand chairs to our dealers, so they can ramp up their marketing efforts with this new design.

Just since Neocon, we’ve become involved in opportunities for well over 50,000 Generation units and encouragingly, so many of these are with potential clients who have either bought our systems, but not our seating, or with clients who’d never buy anything from Knoll. The funnel of seating activity and the customer and architecture designer response to the chair gives us great confidence that Generation by Knoll will be a meaningful contributor to our results in the years ahead and help us gain share in the seating space.

On the cost side of the equation, our people have done an outstanding job of reducing overall spending, while focusing on investing in areas that will generate the best return. However, continued price pressure and the deterioration of the US dollar relative to the CAD will pressure gross margins going forward. As we begin our planning for 2010, we will be continuing to look at areas on both the fixed and managed elements of our spend to reduce costs and free up cash for both investment and further debt reduction.

Now, let me turn the call over to Barry, to take you through some of the highlights in our industry leading financial performance.

Barry McCabe

As Andrew stated in his opening comments, while business conditions are not improving, we are seeing some signs of stabilization on the demand side. In this difficult economic environment, we are aggressively managing our costs, reducing working capital to free up cash, continuing to invest in new product, and delivering industry leading financial performance.

These efforts reflect our ability and commitment to adjust our operating capital structures to maintain profitability regardless of the business environment. Our Universal Shelf Registration filing with the SEC was a proactive step to give us flexibility and options in the future should we need it.

Our sales decline has been across all product categories and geographies, but less in our specialty and complementary product. International has declined more than North America, due to both lower sales and currency devaluations. While we are seeing sequential customer orders stabilize, and we expect to see some sequential orders improvement in the fourth quarter from our new product introductions and previously awarded projects. We still expect sales to be relatively flat sequentially.

Backlog declined as shipments continued to outpace orders, but should begin to reverse this quarter. Gross profit as a percentage of sales declined 300 basis points, primarily due to unfavorable fixed cost absorption in our factories due to the lower sales, and price erosion from the very competitive market environment.

Although commodity costs are lower than a year ago, and we are benefiting from our global sourcing and continuous improvement efforts, we could not offset the negative fixed cost absorption and pricing. With these pressures continuing and with the Canadian dollar strengthening, gross profit percentage could be lower by another couple of hundred basis points until business conditions improve.

Operating expenses are now below $195 million annual run rate, as we have benefited from our previous restructuring efforts, cost reduction programs, and lower sales and performance related compensation. We expect operating expenses will be sequentially higher as we accelerate placement of our Generation chairs in the field and complete the rollout of the rest of our Neocon product introduction in the fourth quarter. The interest rate swap that was put in place last year fixing our LIBOR rate at 3.5% from June 2009 until May 2010 has increased our interest expense. Our effective pretax interest rate is now approximately 4.25%.

Other expense continues to be impacted by exchange rate fluctuations of the Canadian dollar on our inter company balances. When the Canadian dollar strengthens, the impact is negative, and when it weakens the result is positive. Although the negative result this quarter was $0.04 of EPS, since these transactions are primarily non-cash, they do not impact our EBITDA calculation. Our tax rate was higher for the quarter due to the mix of our earnings in annual true-up of our effective tax rate. We still believe our annual rate to be between 37% to 39%.

Our working capital reduction efforts, particularly in accounts receivable, allowed us to reduce our bank borrowings by approximately $28 million and we still have additional opportunities at these lower sales levels. We are incompliance with our bank covenant and our bank leverage ratio, as Andrew stated earlier, is 2.59 to 1. Our bank agreement allows us to add back restructuring costs, non-cash compensation and non-cash currency transaction adjustments in calculating EBITDA for covenant compliance calculations, which benefits us over a traditional EBITDA calculation.

We had $13.6 million of cash at quarter end. Maintaining a strong balance sheet and aggressively freeing up working capital remains a top priority. For the quarter, cash provided by operations was $29.5 million, of which $15.1 million was provided from net income, plus non-cash amortizations, plus $14.4 million of favorable changes in assets and liabilities, primarily in accounts receivables.

Cash used in investing activities for the second quarter of 2009, included capital expenditures of $1.2 million and purchases of intangibles totaling $0.8 million. Cash used in financing activities was $29.1 million, which included net debt repayments of $28.1 million, $0.9 million of dividend payment, and $0.1 million of common stock purchases.

We will now take the questions.

Question-and-Answer Session

Operator

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

Budd Bugatch - Raymond James

Nobody likes congratulations when you have the kind of sales performance which you are all facing and the market conditions you’re facing, but the 9.3% operating margin is quite notable and needs to be lauded. Barry, you said in the fourth quarter, you think gross margin will be 300 basis points less. Is that less than the third quarter or less than the fourth quarter of 36% a year ago?

Barry McCabe

I’m saying sequentially.

Budd Bugatch - Raymond James

Sequentially?

Barry McCabe

Could be, depending on the CAD and some of the other factors, so I would just caught otherwise just…

Budd Bugatch - Raymond James

The Canadian dollar is the biggest issue there you think?

Barry McCabe

Excuse me?

Budd Bugatch - Raymond James

Say again?

Barry McCabe

No, I was asking you to…

Budd Bugatch - Raymond James

The Canadian dollar will be the biggest issue?

Barry McCabe

I think both the Canadian dollar as well as pricing pressures.

Budd Bugatch - Raymond James

Can you kind of quantify for us what pricing pressures you’re seeing and how is that being reflected in…?

Barry McCabe

I think the whole industry, based on the volume levels that everybody is experiencing on any large project and again we’re more project based. You see very, very competitive pricing and we expect that will continue.

Budd Bugatch - Raymond James

What kind of impact might that have had on margins in the third quarter?

Barry McCabe

I don’t want to give that.

Budd Bugatch - Raymond James

Could you give us some flavor of what the international business was down versus the U.S. or versus North America?

Barry McCabe

Well, the international business was worse. I would say, only slightly worse in terms of sure volume percentages, orders being down and then, it even makes it worse is the currency.

Budd Bugatch - Raymond James

Obviously, with Generation starting to get out there, you are probably gaining some share I think in seating. How would you look at that versus systems, which has been such an important part of Knoll for an extended period of time?

Andrew Cogan

Budd, this is Andrew. I mean, systems continues to be the core strength of the company and I’m very pleased again with our overall systems performance, although it did decline more than some of the complementary categories, but our Neocon introductions in the systems’ space have been very well received, and I think we’ve got an exciting pipeline of activity in that area as we head into 2010.

Nonetheless, I mean the demand for the product category just isn’t there. So as you know, we’ve all focused heavily on seating, and I am very encouraged, when again I look at sequentially at the development of the results, there was strong sequential improvement in seating orders and in seating shipments.

So we are really starting to move the needle in that area and that’s with very little impact in the quarters from Generation. So I think we’ll see some more impact in the fourth, but I clearly see trajectory in that category moving up on a sequential basis because of all the activity that we’ve had in that space.

Budd Bugatch - Raymond James

Hadn’t you told us before the Generation would be a drag on margin until probably next year as you populate your dealer base with…?

Andrew Cogan

No, I think not a drag on gross margin, but I think in the fourth quarter on operating expenses, we have a lot more sample chairs going out. I mean, our strategy really has been to get as many chairs out there as we can, and the next big wave of those is happening this month.

So I think there’s some incremental expense there. It is not just Generation, the rest of the Neocon product are also being rolled out mostly in the fourth quarter into our showrooms, into our dealerships, our new Monitor Arms, our Template Storage Systems, which has been very well received.

So there definitely will be incremental operating expenses as we move into the fourth quarter, so I appreciate your congratulations on the 9% operating margins. We are very pleased at these levels to be running at that, but again as Barry said, I think there are a couple of hundred basis points of pressure on gross margin. I think operating expenses could tick up a couple of hundred basis points. I think that’s pretty realistic and that will position us well, I think, for going forward.

Budd Bugatch - Raymond James

So, fourth quarter op margin could be in the mid-single digit level, if we read that right. Is that what you’re…?

Andrew Cogan

I think that it’s entirely possible. It also depends how the quarter shapes up, we’re only two weeks into it. So we usually do a little better than we think.

Budd Bugatch - Raymond James

One last quick question, on the purchase of intangibles, I take it that maybe were some former acquisitions if you’ve got to make payments on their performance?

Barry McCabe

Actually its upfront payments on some new products, licensing them, which will benefit us in the future and those costs will be amortized later.

Operator

Your next question comes from Sean Connor - BB&T Capital Markets.

Sean Connor - BB&T Capital Markets

Looking at the SG&A line, quite a bit better than what we had projected and just looking at the sequential decline, along with the sequential revenue decline, it looked like they reflect pretty equally.

With the incremental spend on the Generation Chair, what adjustments were made that are permanent that we can model going forward? What kind is that, run rate looking into fiscal ‘10, assuming flattish top line? We’ll make an assumption on what that actually does.

Barry McCabe

I will answer the annual. I did state in my script that we now have our annual run rate below $195 million. With that said, and I think we will aggressively look at that and maybe there is a couple of millions, maybe $10 million more. If we get really aggressive we might squeeze out of that.

The comments we were making are going forward. We expected honestly, this quarter to have a little more of the new product introductions, maybe in the third, that now has moved into the fourth and that’s why we cautioned a little bit that the fourth might be higher.

The other thing that we had in our earnings release is we did pick up $1.1 million gain as a reduction of our post retirement medical expenses, and that’s an item that won’t repeat itself in the fourth quarter. We feel on an ongoing basis that we’re probably, without some fluctuations, north of $45 million or around $45 million run rate.

Sean Connor - BB&T Capital Markets

Are you talking about flattish top line in Q4, which I guess is a little bit worse than normal seasonality?

Barry McCabe

I’m not so sure. It’s hard to, based on the macroeconomic environment to talk about seasonality, because there’s been nothing seasonal about what we’ve been going through.

Sean Connor - BB&T Capital Markets

I was just kind of saying if orders are starting to stabilize maybe we can get to that point, where we can start looking at normal seasonality going forward. Is that reasonable or are we still not quite to that point yet?

Barry McCabe

The only thing I’ll comment on in seasonality is, I think in a little bit on the order side with the government’s calendar year ending, and as well with commercial customers that may have unspent capital budget kind of money, we normally see a little pickup in orders in the quarter.

Operator

Your next question comes from Todd Schwartzman - Sidoti & Co.

Todd Schwartzman - Sidoti & Co.

I’m just going to join the fray here in seeking a little bit more color on the gross margin. Sequentially from Q2, would you say pricing pressure accelerated a bit?

Andrew Cogan

Yes.

Todd Schwartzman - Sidoti & Co.

Where do commodities enter into your thinking as far as Q4 margin vis-à-vis Q3?

Andrew Cogan

I think commodities will still be really helpful. I mean we didn’t get a lot of commodity relief really until the back half of the year. The first half of the year we were actually experiencing inflation. So I think the single biggest drag on gross margin going forward is going to be the FX impact of the dramatic and rapid.

I think the CAD depreciated 20% in three months. So the dollar has weakened relative to the CAD. So I think, most serious source of margin pressure going forward and I think as Barry said, that could knock a couple of hundred basis points of gross margin going forward and still business starts to turn and stabilize and we start doing better on the absorption end. I think we will be under some gross margin pressure going forward.

Todd Schwartzman - Sidoti & Co.

With respect to the CAD, the prior year comp is not terribly easy, is that…?

Andrew Cogan

No, exactly, when the CAD, I think started to kind of plunge when the financial crisis began, and so we’re running relatively negative comps on the CAD now as we go into the fourth quarter.

Barry McCabe

The CAD a year ago started to move favorably in the second half of the year and it’s the opposite this year.

Todd Schwartzman - Sidoti & Co.

Barry, on the comment on SG&A around that $45 million run rate, is that assuming the volume stays at $195 million or less?

Barry McCabe

I think there will be a lag in SG&A, if and when the volume starts to pickup. I mean it’s not going to increase dramatically right away. So it’ll be there for a while I think.

Todd Schwartzman - Sidoti & Co.

Finally, any numbers, any projections you care to throw out as far as the potential, the long run potential of Generation?

Andrew Cogan

Again, I continue to believe as a potential, it’ll be one of the most significant new products, we’ve ever introduced.

Operator

Your final question comes from Mark Rupe - Longbow Research.

Mark Rupe - Longbow Research

Has there been any kind of changes on kind of some of the regional aspects of the industry like Manhattan, any signs of life there?

Andrew Cogan

Not particularly, no.

Mark Rupe - Longbow Research

So it’s pretty much standard to across the board regionally?

Andrew Cogan

Yes, where the government is better, a larger factor, it’s obviously better, where it’s less of a factor is worse.

Mark Rupe - Longbow Research

As it relates to your systems exposure and kind of the mix shift probably toward specialty and complimentary versus the last downturn; I mean that had a good positive impact on kind of the margins during this downturn versus the last one?

Andrew Cogan

Yes, I think rather than comparing to the last one, what I would say again is mix shift for us is going to be positive. So we’re talking to you about the CAD, but the CAD is only an impact on part of our systems margin, so it’s the mix shift, if we get into a situation where the volume stabilizes, so absorption is no longer a challenge.

I think the shift that we are engineering and certainly we’re not giving up shifting, it’s really gaining share in one category and holding share in the systems category, which we very much believe we’re doing. We should see favorable gross margin trends and I think we are seeing those. They’re being somewhat disguised by some of the pressures that the CAD is putting on our systems margin.

Mark Rupe - Longbow Research

Then just lastly, your commentary on kind of the sequential shipment and orders on the seating, is that indicative kind of the day-to-day stuff for you, or is that unique to seating?

Barry McCabe

I think it’s more unique to the activity we’re doing in the category. I think the day-to-day business has been pretty dreadful.

Operator

At this time, we have no further questions. I would like to turn the call back over to Mr. Andrew Cogan for any closing remarks, sir.

Andrew Cogan

Great, thank you for your continued interest. We’re very pleased with the results. We’ve been continuing to report, I think industry leading operating margins, better than industry top line performance in the face of the worst decline in the history of our industry is something we’re all proud of and I think during this downturn we have made, and will continue to make the investments that I think we’re going to drive this company forward over the long term and as things eventually turn, which they eventually will, we’re going to be in great, great shape here. So thank you and I guess we’ll talk to you all in February.

Operator

Thank you for your participation in today’s conference. This now concludes the presentation. You may know disconnect, and have a great day.

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Source: Knoll Inc. Q3 2009 Earnings Call Transcript
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