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Knoll, Inc. (NYSE:KNL)

Q2 2014 Earnings Conference Call

July 18, 2014 10:00 AM ET

Executives

Andrew Cogan - CEO

Craig Spray - CFO

Analysts

Budd Bugatch - Raymond James

Todd Schwartzman - Sidoti & Company

Josh Borstein - Longbow Research

Operator

Good morning, everyone. And welcome to the Knoll, Inc. Second Quarter 2014 Conference Call. This call is being recorded. This call is also being Webcast. Presentation slides accompany the Webcast. In addition, this call may offer statements that are forward-looking. These forward-looking statements are based largely on the Company’s expectations and are subject to a number of risks and uncertainties, certain of which are beyond the Company’s control.

Actual results could differ materially from the forward-looking statements as a result of many factors, including the factors and risks identified and described in Knoll’s annual report on Form 10-K and its other filings with the Securities and Exchange Commission. The call today will also include references to non-GAAP financial measures. Reconciliations of these measures to the most comparable GAAP financial measures are included in the presentation slides that accompany the Webcast.

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

Andrew Cogan

Thank you for joining us this Friday morning. We are very pleased with the results we reported today. Against the backdrop of a flattish contract furniture market, we grew ourselves 24% and organically excluding the four quarters impact of our HOLLY HUNT acquisition, a still impressive 11.4%.

Gross margins improved 400 basis points to 36.6% and while the mix of higher margin HOLLY HUNT business helps, we saw meaningful gross margin improvement in our office business as well this quarter.

Adjusted operating profit for the quarter improved by 81% to $22.4 million and operating margins increased by 260 basis points to 8.4%. Earnings per share was $0.23, an improvement of 35% over prior year. Excluding the impact of depreciation of the U.S dollar against the Canadian dollar on the other income line, EPS would have been $0.26.

Across the board, each of our segments delivered improved sales and operating profits and importantly this quarter we demonstrated that as we increase the mix of our sales that come from a high design specialty into the trade consumer facing businesses, the less directly correlated with pure contract industry demand our overall results will become.

Q2 was a good quarter for our Office business. Its sales grew faster in the market, operating profits almost doubled and operating margins increased almost 200 basis points. For the first quarter since mid 2011, government sales increased year-over-year and our expectation of a relatively stable full-year demand environment in this vertical seems reasonable.

With the government drag more or less behind us now the share gains we’ve been making commercially in the past couple of years are easier to see. Here investments in training and other sales productivity tools combined with successful efforts to penetrate and capture global accounts are paying off.

Our Knoll Essentials day-to-day dealer marketing program had its best quarter in five years as we gained share within our dealer channel. Client visits, mockups, and renderings were all up double-digit and orders continue to grow in line with shipments.

From a product perspective, our most progressive work place offerings experienced the fastest growth. Margin wise, the benefit of our list price increase, better absorption of fixed costs and our supply chain transformation efforts, all helped to increase growth in operating margins in this segment. While at 4.1%, we’re still not at the longer term levels of profitability that we expect for our office business, we’re clearly making meaningful progress towards our multi-year goals.

It was an exceptionally strong quarter for our Studio segment, as we benefited from robust organic growth in Europe and North America combined with the benefit of a full quarter of HOLLY HUNT sales and profit. In total, sales in our Studio segment more than doubled as each business including HOLLY HUNT grew by double-digits.

Operating profits tripled and operating margins expanded by 360 basis points to 12.5%. In Europe, we experienced strong growth in the U.K. and France as several large projects shipped and our consumer facing activities continue to grow.

In North America, we had strong growth in our Knoll Studio, consumer channels as well as our government sales rebound. HOLLY HUNT continues to perform above and beyond our expectations. Many of our investments in expanding HOLLY’s footprint, both domestically and internationally begin to kick in Q3. So in the short-term, that may modestly pressure the margin, while laying the foundation for continued above expectation growth and profitability in the mid term.

Covering sales growth continued to outperform the market and margins in this segment expanded just over 100 basis points to 20.7%. In Q2, architectural application and increased interest in our new materials drove the top line growth. The strength across all of our segments carried over into NeoCon as well, where we had one of the strongest shows with attendance levels and crowds commensurate with improving interest in demand for Knoll Solutions.

Our NeoCon show responded to three compelling trends we see in the modern workplace, all of which expand our market opportunity and will help us grow Knoll. The first deals was maximizing the health and wellness of the individual worker. Here our new adjustable offerings like the Antenna Tone adjustable height tables and award winning Telescope benches, Remix ergonomic seating products and accessories like our Sapper monitor arms, combine to maximize the productivity and comfort of an individual’s work space.

Second, as the amount of office space allocated to the individual’s reduce and the amount allocated to the group increases, collaborative lounge areas and formal meeting areas and the opportunity to create work zones within these spaces become more important.

Building on our Antenna Interpol products, this year we added a comprehensive well-priced lounge collection that compliments our more iconic lounge pieces to gain share on these emerging office areas.

Thirdly, we brought our expertise in materials and architecture to bear and partnering with ARO, the designers of our New York and San Francisco showrooms to create the Plank Series of applied and hanging felt products, designed to allow clients to create more effective focus in team areas using acoustic materials like felt to soften the shape of the work place.

And with our innovative Knoll Bounce app, we gave clients the ability to use technology to mobile phones to measure the efficacy of all these different spaces from the individual to the team and the larger group. As one industry newsletter wrote speaking of NeoCon “Knoll definitely has the strongest line up of new products among the majors”.

In total we were awarded five Best of NeoCon awards across all three of our reporting segment. Particularly rewarding with the gold award for our new remix work chairs. We believe the remix family of chairs has the potential to be as significant a new seating product as our generation family has been, were today’s sales annually exceeds $50 million.

The best of NeoCon judges, clients and dealers, all responded to remix with a broad scope and unique blend of more familiar high touch upholstered elements together with its innovative high-tech, high performance back design, which in total delivers an unparallel level of niche comfort and all day performance. Remix should start shipping in Q4.

There has been a lot of discussion about the subdued year-to-date BIFMA data. And while we concur that the thesis supporting a delayed cyclical recovery remains valid, we also believe the contract furniture industry has been fighting a secular headwind as denser workspaces with fewer panels and less furniture per worker impacts total market size.

However, we believe that the interest and adjustability which was a major focus of our NeoCon has the potential to reverse that trend. As the dollars per adjustable position can be 50% to 100% greater than our non-adjustable alternatives. It also explains the strategy we powerfully demonstrated NeoCon to evolve our product mix to capture more of our clients furniture spend in office seating, collaborative lounge, meeting table and ergonomic work tools, areas where we have not historically played as forcefully, but where we’re building strength.

This strategy allows us to both penetrate our dealers as we display smaller lines and increase the sales per worker on larger projects. All in all, it’s been an extremely positive start to the year, beginning in February with the acquisition of HOLLY HUNT and continuing most recently with our award winning NeoCon and strong second quarter results.

At the half way point, sales are up 19% and adjusted operating profits are up 53%. We are making substantive inroads in expanding the share of revenue that comes from a highly profitable Studio and Covering segment as well as the mix of our revenue that comes from high-end consumer markets and as the Q2 results demonstrate our Office business is now generating both top line growth and expanded operating margins, progress all around.

Now, let me turn the call over to Craig, to take you through our results in more detail. Craig?

Craig Spray

Thank you, Andrew. Second quarter sales increased 24% when compared to a year-ago, as we experienced increased sales across all of our reported business segments. Organically sales increased 11.4% from a year-ago driven by increased shipments in the Office segment and stronger activity in Studio.

Our Office segment sales increased 7.4% as both commercial and government sales improved on year-over-year basis. Organically Studio segment sales were up 32%. Including HOLLY HUNT, sales in the Studio segment were up 105%.

Coverings grew 4.8% year-over-year. For the second consecutive quarter, we experienced top line growth across all business segments. We expect continued year-over-year improvement as business activity continues to improve as reflected in presentations, client visits and mark up activities as well as improvement in day to day activities.

Gross profit as a percent of sales increased 400 basis points from a year-ago. This increase was primarily driven by two factors. First, improvement in North America office as our ongoing supply chain initiatives continue to positively impact plant efficiency and improvement in fixed cost absorption as we levered our fixed cost with the higher volume.

And second, the enriched business mix as the higher volume HOLLY HUNT business positively impacted our portfolio results. As we expected and previously communicated, we saw what we believe was the gross margin trough in our organic business in Q1, 2014.

During the quarter, operating expenses excluding restructuring costs of $0.2 million were 74.8 million or 17.3 million higher than a year-ago. The addition of HOLLY HUNT’s operating expenses accounted for the majority of the increase with the balance coming mainly from increased sales bonus and incentive accruals as our -- as a result of our improved performance.

Going forward, we expect operating expenses remain roughly at the Q2 levels for the remainder of 2014. During the second quarter of 2014, we recorded two one-time expenses. $0.2 million of restructuring charges which were associated with the closure of a warehouse facility in Toronto and approximately $0.3 million write-down of deferred financing associated with our prior credit facility.

Adjusted operating profit margin increased 260 basis points this quarter when compared to the prior year and 300 basis points sequentially over the first quarter as a result of higher sales, mix, improved (indiscernible) performance and better pricing.

Operating margin in Office improved almost 200 basis points to 4.1%. Studio improved 360 basis points to 12.5% and Coverings improved 110 basis points to 20.7%. Interest expense was approximately $1.9 million. $0.4 million higher than a year-ago, primarily due to our higher outstanding debt as a result of the purchase of HOLLY HUNT in Q1.

This quarter we refinanced our $450 million credit facility with a new $500 million credit facility. The new credit facility consists of revolver loan commitment in the amount of $300 million and a term loan commitment in the amount of $200 million. The new facility will provide us with additional flexibility and maybe used for general corporate purposes, including strategic acquisition, stock buybacks and cash dividend. The credit facility matures in five years.

During the second quarter of 2014, $1.9 million of deferred financing fees were recorded in conjunction with this new facility. Just one full quarter post the HOLLY HUNT acquisition, with improving EBITDA and continued debt pay down, our bank leverage ratio is already back below 3.1 -- back below 3 to 1.

Other income was unfavorable approximately $2.7 million compared to a year-ago, due to foreign exchange losses related primarily to the Canadian dollar. Our tax rate for the quarter was 38.2% due to the varying rates and mix of earnings in the countries in which we operate. Earnings per share was $0.23 for the quarter.

For the quarter, cash provided by operations was $18.6 million of which $10.8 million was provided from net income plus non-cash amortization of $5.1 million. Cash used in investing activities for the quarter included capital expenditures of $9.9 million. Cash used by financing activities was $9.6 million which included a $5.7 million dividend payment and $2.5 million of stock repurchases.

We will now take questions. Operator?

Question-and-Answer-Session

Operator

Thank you. (Operator Instructions) We have a question through it’s from the line of Budd Bugatch. Your line is open, please go ahead.

Budd Bugatch - Raymond James

I think that’s me Andrew, Budd Bugatch here. Congratulations on the quarter Andrew and Craig and to your team as well.

Andrew Cogan

Thank you.

Budd Bugatch - Raymond James

I guess, I want you to take your crystal ball and look a little longer term. You bought Holly Hunt changing a little bit of the character, the business a little bit more towards I think what you see is that, higher design client. And you’ve given us some targets now for, I think probably next year or so. Kind of would you go through what your thinking is now about the mediate -- the intermediate at longer term for Knoll and where do you see there might, those targets that you set up a couple of years ago go?

Andrew Cogan

Sure. I think, well listen, I think we’re very happy with how the mix of our business is evolving and with the performance of each of our operating segment. As you know we have multi-year goals for both Knoll, Inc. as well as each of our operating segments and each of those businesses is progressing along in a very positive direction. The goal is pretty simple. This year we talked about 7% to 8% operating margins, next year getting into the -- back into the low double digits and then 12% plus operating margins by the time we get to 2016. And as you slice and dice that by segments, really the bulk of the improvement we’re looking for is in our core North America Office business where I’m pleased that we’re gaining share. And you can now see that, I mean in the last quarter the industry didn’t grow at all and we delivered very strong growth in our North American Office business. We want to get to, this year -- right now we’re around 4%, I think 6%, then 8%. So we have very specific measures in each of those businesses and I really believe that we are investing and managing against those.

Budd Bugatch - Raymond James

So, let me just make sure I understand. You had great performance this quarter. I think you said it was primarily project business both and both government and commercial were up. How does the order book look for the next quarter or so, and I realize I’m moving from an intermediate …

Andrew Cogan

I think furthermore, actually it wasn’t project business, Budd. We actually had fewer projects in the second quarter of this year than last year. I was a lot of day-to-day and a lot of kind of midsize activity. We do see some larger projects in the pipeline. I was very encouraged to see the mark ups, client visits, all up significantly 20% plus. And that does board well I think for some larger projects in the fourth quarter and as we head into next year. Orders and sales basically grew at about the same rates across the enterprise.

Budd Bugatch - Raymond James

So, the third quarter looks like about the same then in terms of either absolute or year-over-year?

Andrew Cogan

I think we got out of the prognosticating business a couple of years ago. So we’ll leave that to you. I think in general what I would say Budd is, our strategy is working. Our individual business units and segments are executing, and we see lots of runway in opportunity ahead of us. I think it’s a great place for Knoll to be right now.

Budd Bugatch - Raymond James

Okay. And my last question then, BIFMA has got a heady set of forecast for next year, I think double digit orders and shipment growth, and I just wanted to know if you had a comment about your outlook on that. You’ve been pretty good about comment about what you think about the industry in the past.

Andrew Cogan

Yes, on BIFMA, I mean, I think, listen, I mean the macro, BIFMAs model is just macroeconomics data that gets filtered into something and spits out a number. It doesn’t really, I think account for some of the kind of secular changes that have been impacting demand. And as I mentioned on the call, I think some of the things we’re doing are all driven to capture more dollars from that individual workers office space. If we can continue to see them doing that, there’s a lot less correlation with BIFMA. Clearly, the recovery has been delayed. We would hope to see more exciting BIFMA numbers as we end this year and begin next year. But that’s not going to stop us as you saw this quarter from driving our own performance.

Budd Bugatch - Raymond James

Okay. Thank you very much.

Andrew Cogan

Thank you, Budd.

Operator

Thank you. The next question is from the line of Todd Schwartzman from Sidoti & Company. Please go ahead.

Todd Schwartzman - Sidoti & Company

Hi, Andrew. Hi, Craig.

Andrew Cogan

Good morning.

Todd Schwartzman - Sidoti & Company

Can you point to any specific economic factors perhaps that are making project demand choppy at present? Is it the Middle East? Is it domestically? Is the U.S. economy? Maybe can you also speak to the difficulty of comps, perhaps if that’s a factor that you’re facing?

Andrew Cogan

No, I don’t think comps were a factor. I think project demand is choppy. The recovery has been uneven. You even see it in the BIFMA data you can be up one month down the next, but you’re basically treading water. Again as business confidence gain some momentum, as I think we in the industry do things to drive change within our client base, as we start suggesting new alternatives and models that excite our clients, which is what we are very much focused on doing, on ways that they can work more hopefully and more productively. I think that’s going to generate increased demand and those kind of secular factors together with an eventual cyclical recovery with buildings going up and people, clients being more optimistic and moving, will I think get the BIFMA numbers going higher over the next couple of years.

Todd Schwartzman - Sidoti & Company

And what did you see order entry wise in terms of projects overseas in Q2?

Andrew Cogan

We had a strong Q2 in Europe, and there was some definite project activity there. I’m very encouraged by the funnel of activity we have internationally with some of our North American products for the back half of the year particularly Q4. So, I definitely see some encouraging trends on the horizon and opportunities for us.

Todd Schwartzman - Sidoti & Company

And turning to the Studio segment, your organic sales growth there was excellent for the quarter. But was there anything from last years Q2 that lowered the bar a little bit?

Andrew Cogan

No, I mean we recovered very nicely in Europe this quarter. And so there definitely was some snapback in Europe particularly on some of the larger project side of the business. But even if you take out those large projects, we had double digit growth in our high design consumer decorator to the trade facing businesses both in North America and in Europe.

Todd Schwartzman - Sidoti & Company

Got it. That’s very helpful. Also, to what extent has Holly Hunt afforded you the opportunity to cross-sell perhaps Knoll products?

Andrew Cogan

We’re really not doing any cross-sell at Holly Hunt. They’re operated as standalone independent entity. They’re doing a great job. We want to let them do their thing. Behind the scenes there have been some lovely synergies.

Todd Schwartzman - Sidoti & Company

And is there anything in particular about the business, it’s still fairly early in your ownership, but the results have -- sounds like they’ve exceeded your expectations. Is there anything that you learned that was surprising to you?

Andrew Cogan

That the opportunity is even greater than we thought going in. I think this is a business we can continue to grow and expand. The loyalty of their clients, the quality of the team is very, very high. And it’s a great group to spend time with. They know their business exceptionally well. I have been to most of the showrooms now, and I’m just impressed with the youth and the energy in the business, and the opportunity set to do more with it at very good margins.

Todd Schwartzman - Sidoti & Company

Yes, I know obviously it was a pretty good quarter for Office, a little bit better than what I was looking for. But you had previously I think spoken to year end ’14 as you’re getting to a 40% mix of the non-core, non-office specialty business. As you’re already there now, what do you -- do you care to revisit that projection?

Andrew Cogan

No, its going to move around based on projects and things like that. But I think in general that seems like a reasonable assumption.

Todd Schwartzman - Sidoti & Company

Sound’s good. Thanks a lot.

Andrew Cogan

Thanks, Todd.

Operator

Thank you. The next question is from the line of Josh Borstein from Longbow Research. Your line is open, please go ahead.

Josh Borstein - Longbow Research

Hi, Andrew and Craig. Thank you for taking my question’s, and congrats on a nice quarter. In the Office segment, can you discuss how the quarter played out over the three months? Just trying to get a sense for how things might have changed as we left the harsh winter weather behind and entered into the summer?

Andrew Cogan

I mean, it played out pretty normally.

Josh Borstein - Longbow Research

Did you see any strain …

Andrew Cogan

Weather is not a huge factor in our business. I mean summer is going to make it harder to shift stuff out. But it moved pretty much along as we would have expected.

Josh Borstein - Longbow Research

Did you see a pick up in the business at all as you exited the quarter or were the quarters really -- the months really consistent?

Andrew Cogan

I don’t have the monthly data in front of me. In general, as I mentioned, I think to Budd, we saw orders and sales grow about comparable amounts. But I wouldn’t say it accelerated at the end of the quarter. I think it was pretty steady across the quarter. That’s your question.

Josh Borstein - Longbow Research

Okay, that’s helpful. And Andrew, with another three months of perspective, are you any more positive, less positive on the rebound in Office as you were back on the 1Q call when you -- you seemed to be pretty optimistic?

Andrew Cogan

Eventually I think there’s going to be a rebound in the Office business, but what I’m probably more encouraged by is how we’re performing with the lack of a rebound. We are not letting it stop us. We have great share opportunities. Again, I think the last couple of years we’ve had these government headwinds. They have obscured the great work our team has been doing on the Office side gaining share commercially with large corporate accounts, at multinational accounts with day-to-day penetration of our dealers, and you all haven’t been able to see that. And now I think you’re starting to see that. So, I’m very pleased with how our team there is performing.

Josh Borstein - Longbow Research

And just touching on GSA, you had mentioned first year-over-year increase since mid-2011 which is pretty remarkable. Was that expected or do you have a different view now on GSA? It sounds like you’re projecting more flattish, more …

Andrew Cogan

I still think for the full year its going to be flat to down 5%, 10% something like that. But again it’s not material in terms of its make up. I think right now the whole, our exposure across the enterprise is about 12% of our revenues. It’s the lowest it’s been ever. So, I feel pretty good about all that. I think this quarter there were some good projects government wise that we had booked last year that shipped out frankly, that helped.

Josh Borstein - Longbow Research

Okay. And then just last on the OpEx, I think you helped us out there a little bit saying 3Q should be similar to 2Q. Is that on a dollar basis or a percent of sales basis?

Craig Spray

Yes, in absolute dollar basis. It will move around depending on business needs et cetera. But over the next couple of quarters kind of in that range is what we’re expecting.

Josh Borstein - Longbow Research

Great. I appreciate it. Thanks and good luck.

Operator

Thank you. We have no further questions. So, I would like to turn the call over to Andrew Cogan for closing remarks.

Andrew Cogan

Thank you everybody. In closing I just want to comment on Design Within Reach for a moment. We’ve had an excellent relationship with Design Within Reach. And I have been personally assured that the change in ownership will not have any impact on the business we do together. And I take them at their word, and I wish them all the success. Since Holly Hunt, we’ve seen a tremendous increase in deal flow. But we have a very disciplined approach to analyzing these opportunities. Direct-to-consumer retail all at DWR is really not an area we have a lot of expertise, certainly not a channel expertise, and it’s really a whole different kettle of fish.

We are much more comfortable with to the trade channel that’s heavily influenced by architects, designers and decorators where we have excellent relationships to both business and individual clients and with designing great product is really the core attribute of the business. Lastly, I’ll just comment that we are very value sensitive, and maybe it’s the discipline of debt. But we won’t pay prices that don’t make sense to Knoll or our shareholders. So, as we filter through the opportunities set out there, I thought it was important everyone understood that. In closing let me thank you for your continued interest in Knoll, and we look forward to talking to you at the end of the third quarter. Have a great summer everybody and goodbye.

Operator

Thank you. Thank you for your participation in today's conference. This concludes the presentation. You may now disconnect. Have a very good day.

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