Knoll, Inc. (NYSE:KNL)
Q2 2016 Earnings Conference Call
July 28, 2016 10:00 am ET
Andrew Cogan - CEO
Craig Spray - SVP and CFO
David Vargas - Raymond James
Kathryn Thompson - Thompson Research Group
Good morning everyone and welcome to the Knoll, Inc. Second Quarter 2016 Conference Call. This call is being recorded. This call is also being Web cast. 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 may 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 will accompany the Web cast.
Now let me turn the call over to Andrew Cogan, the CEO of Knoll. Thank you.
Good morning everybody. Our pursuit of building a constellation of high design, high margin businesses that leverage our historic relationships with architects, designers and decorators, continues to produce strong results. As we exit the second quarter, we are pleased to continue to generate better than [ph] this from a top line performance and expand our industry leading levels of profitability.
We find this a particularly interesting to be in our business, as traditional boundaries between office, hospitality and residential settings erode and a new model for the workplace starts to emerge. Frankly, who better than Knoll, with nearly 80 years of modern design experience in both office and residential settings, to propose a new model of workplace design, and that's exactly what we did this past June at our annual NeoCon trade show, with a preview of our new Rockwell Unscripted collection.
Rockwell Unscripted is one of our largest new product efforts ever, consisting of over 30 products in six different categories, from walls to tables, storage, lounge, accessories and steps, with application potential spending from core primary, to growing ancillary spaces of the workplace.
While it was great that Rockwell Unscripted won many accolades from the best of NeoCon gold and silver awards, to a HiP Interior design award, and a Metropolis Likes Award. What was more heartening, was the broad embrace of the concept from our dealers, key clients and the [indiscernible] community.
When we begin shipping Rockwell Unscripted in the first quarter of next year, I am confident that it will meaningfully expand our penetration into a faster growing ancillary spaces in the workplace, where our share is under representative of our positioning of primary office environment.
Our strategy in these growing areas is about more than just Rockwell Unscripted. In fact, it is the importance of the total environment, is beginning to trump any one particular element. We are seeing clients allocating more of their furniture budget to ancillary spaces and architectural elements.
This is one of the reasons you are seeing some of these smaller players in the industry, gaining share from our larger competitors. For Knoll, given the breadth of our offer and the singular constellation of businesses from our innovative mix of office furnishings, KnollStudio Design Classics, meeting tables and lounge designs, Spinneybeck and Filzfelt architecture materials, and our broad range of Knoll textile covering materials, we are well positioned to capitalize on this spend to both capture more of our client's total spend, and elevate the profitability of these engagements, in ways that it doesn't for others. And we see opportunities to further deepen our capability here in the year ahead, as efforts to build up the breadth of our offer and our coverage of these markets accelerates.
Looking to our results for the second quarter of 2016, we continue to demonstrate the benefits of our strategy, to diversify our sources of revenue, broaden the markets we serve, and improve the profitability of our Office segment. In the context of a slowing market, we delivered 9.7% top line growth, well in excess of the 3% May year-to-date growth reported by BIFMA.
Gross margins expanded by 100 basis points from 37.7% to 38.7%, operating profits increased from $28.3 million to $33.5 million and operating margins expanded by 90 basis points from 10.5% to a best in class, 11.4%. Improvement in Q2 was more broad-based than in Q1, as both our Office and Studio segments delivered double digit top line growth and year-over-year margin expansion.
In our Office segment, growth of just over 11% was driven by complementary product categories we have been investing in and core systems products. This growth combined with productivity performance in our plants and favorable FX rates resulted in significant gross margin expansion. While some of this was offset by higher than usual incremental spending on NeoCon and incentive bonuses, overall operating margin still improved by 190 basis points from 5.7% to 7.6%. Year-to-date office operating margins are now running at 8.3%, up from 5% a year ago.
While so far, we have avoided the general slowdown in industry demand, heading into the balance of the year, pricing has become more competitive and growth has narrowed geographically.
Studio segment sales accelerated in Q2 to a very strong 13.9%, led by a rebound in Europe, where we benefitted from a particularly strong showing this past April at Salone de Mobile, we grew in both our contract and residential markets.
North America Studio benefitted from the success of recent product introductions in the meeting area, again a piece of our ancillary strategy, some very nice project wins, as well as some growth in our residential and consumer channel.
In HOLLY HUNT, we saw continued top line growth in margin expansion, as we continue to benefit from the investments we have made in the showroom footprint, product breadth and inventory. That said, growth in Q2 was spottier, as some showrooms in the higher end residential market, experiencing macroeconomic weakness were impacted.
From an operating profit standpoint, Studio operating profit margins expanded by 40 basis points, [indiscernible] 16%. Our Studio segment does have some exposure in the U.K. and we will be carefully monitoring the impact, both on margins and demand moving forward.
In Coverings, ongoing challenges in private aviation and weaker industry conditions, continue to weigh on our Edelman Leather and Knoll Textiles businesses. Declines were offset, continued growth at Spinneybeck and Filzfelt, where our architectural product applications, again a part of our ancillary strategy, are delivering significant growth.
As a result, overall segment sales declined by just over 10%. We have new leadership in place in our textiles business, and there are signs that both Textiles and Edelman should lap in more difficult comps, and be growing again by the fourth quarter. With 21.7% operating profit margin, Coverings continues to generate meaningful profit for our overall enterprise.
In the quarter, approximately 40% of our sales and 60% of our profits, came from outside our North America office segment. No contract or company [ph] can make that statement.
We believe over the long run, our diversification efforts and strategy will continue to result in a more profitable and less cyclical enterprise.
Now let me turn the call over to Craig, to walk you through our results in more detail. Craig?
Thank you, Andrew. Knoll Inc. second quarter net sales increased $26.1 million or 9.7% from a year ago. Our Office segment was up $18.4 million or 11.4%. Growth in Office was driven primarily by our core Office system and recently introduced continuity [ph] products, like adjustable tables and storage products.
Our Studio segment sales grew up $10.8 million or 13.9%. The increase was led by Europe and Knoll Studio in North America. However, all of our Studio segment businesses continue to grow across both commercial and residential clients.
Our covering segment sales were down $3.1 million or 10.4% of continued year-over-year growth in Spinneybeck and Filzfelt, was offset by weakness at Knoll Textiles and Edelman.
Gross margin improved 100 basis points at 37.7% a year ago to 38.7%. The Office segment continues to be the primary driver of operating efficiencies and improved fixed cost leverage and higher volume, offset from net pricing pressure. Compared to Q1 2016, gross margin improved 80 basis points.
Total operating expenses in the second quarter were $80.6 million compared to the $72.9 million in 2015. The increase is due to investments in the NeoCon Trade Show, product development, sales training, additional headcount, as well as higher incentive tools from increased profitability. We continue to believe that operating expenses for the year will average about 27% of sales.
Operating profit was up 18.5% from $28.3 million in the second quarter of 2015, to $33.5 million in Q2 2016. Operating profit margins improved 90 basis points from 10.5% to 11.4%. This improvement was primarily the result of a 190 basis point improvement in the office segment, from 5.7% to 7.6%.
Interest expense was reduced by $0.5 million from a year ago, as we continue to reduce the balance on our term and revolving loan credit facility. For both Q2 2016 and 2015, other expense was $0.2 million. Other income and expense, was primarily related to foreign exchange gains and losses.
Our tax rate for the quarter was 33%, down from 34.3% at Q2 2015. The change in our tax rate was due to the mix of sales and varying rates in the countries and states in which we operate, as well as a favorable Canadian tax position. For the full year, we expect our tax rate to be approximately 35%.
Net earnings for the second quarter of 2016 were $21.3 million, up from $17.2 million for the same period of 2015. Diluted earnings per share was $0.44 for Q2 2016 and $0.36 for 2015.
Regarding our cash flow, cash was managed down to $1.8 million for the quarter to approximately $3.5 million. Operating activities provided $24.6 million of cash in the quarter. We use the excess cash generated from operating activities to reduce our debt outstanding, investment business and pay dividends.
Investing activities included capital expenditures for the quarter of $8 million compared to $7.5 million in Q2 2015. These expenditures are reflective of our continued commitment to invest in our manufacturing and information technology infrastructure.
Total cash used by financing activities was $19.3 million. The primary use of cash in financing activities was the repayment of debt. Other financing outflows during the second quarter of 2016, included the payments of dividends of $7.2 million.
Our balance sheet remains strong. The continued combination of increased EBITDA and further reductions in our outstanding debt, drove leverage from 2.22 a year ago to 1.4 at the end of the second quarter. We remain comfortably within all debt covenants.
We will now take any questions.
[Operator Instructions]. And our first question comes from Budd Bugatch from Raymond James. Your line is now open.
Good morning Craig. Good morning Andrew. This is David Vargas on for Budd. Congratulations on a good quarter. I wanted to start out with a question on Studio operating margin; you have done a really good job of getting it up, I mean, it was like 15.9% this quarter. Just wondering where you think you can get to from here, and if you have a longer term out there, maybe a target for the year than longer term?
Hey David, its Andrew. I think we are very happy with the Studio operating margins in the 15% ranges. You know, this varies quarter-by-quarter. I think it was what, 12%-13% in the first quarter, then kind of 15%. If we can average 15% over the course of -- over a year, we'd be happy. I think the most important thing for us in terms of getting to above 11% operating margins really is continuing to drive the profitability of our Office business. And that's right around 7%, 8%, right now, and as you know, our goal is to get that up to high single, low double digits. That will take the operating margin of the whole business up, and we remain very focused on that, and that's something we think we can achieve over the next few years.
Okay. Great. And within Office, I don't know if you did break it out, but it's not. Can you give an idea of what the percentage mixes of the new -- the extended complementary products categories that you are expanding into, as well as the legacy and the other categories?
Yes. We don't break that out specifically. But what I can tell you is, both categories were quite strong in the quarter. Our complementary products were the fastest growing category, and again, investments we have been making in adjustable products and a variety kind of ergonomics of core products have performed very strongly. But also, our core systems have done well, and I think it’s a bit of a myth that cubicles are going away. We had a very strong quarter in our core workstation business as well.
Great. And then last from me, on raw materials, with steel prices increasing as well as other raw materials, what are you thinking about in terms of the impact there? Are you feeling it yet, or do you think that's more of a 2017 issue that you will be facing?
So at this point, we are not seeing a whole lot of pressure. This depends on when you lock-in contracts year-over-year and how those things bode to your P&L. But we don't see a whole lot year-to-date. Just like everyone else, we start to see that in the back half and we will continue to address that as we see it.
Got it. And do you lock in on an annual basis for the contracts?
No. This depends on specific vendors and products and what we think is the right thing to do for Knoll at the point in time.
Got it. Okay. Thank you very much for taking my questions.
Thank you. [Operator Instructions]. And our next question comes from Kathryn Thompson from Thompson Research Group. Your line is now open.
Hi. Thanks for taking the questions today. First is going to the newer products that you introduced at NeoCon, particularly focused on your complementary products. More strategically, where do you see that business growing, as a percentage of your total sales, let's say over the next three years? Second, would you discuss the margin profile, and finally on that, what has been the initial feedback from your customers to this product offering?
Great. Thank you, Kathryn. I will start backwards. The feedback has been outstanding, but I mentioned, some of the awards we won. There have been some follow-up articles in some of the trade publications, where people have commented on the show, and I think Rockwell Unscripted has universally been one of the highlight people have mentioned. And most importantly, we are using that space in Chicago to regularly bring customers through right now, to expose even more people to Rockwell Unscripted, but we are really encouraged. And particularly also encouraged by our dealers response.
When we look at that whole ancillary category, we have a very strong share of the business our dealers do in kind of the core workstation and private office market. But as we look at what they do in all those ancillary areas, and whether you are talking about the walls, the lounge pieces, the tables, we have a very small share.
Talking to some of our dealers at NeoCon, they will often have to use 20 or 30 different suppliers to fill out all the requirements that our clients have, and it's so much more in their self interest, and obviously our self interest, if we can provide more of those total solutions, and that's very much what Rockwell and other things were doing, are targeted to achieve. And I feel very confident that over the next two, three, four years, this will become a meaningful part of our office portfolio.
And so, can it be 10% of our office business? Sure. It could be more, it could be less, but I think that could be a revenue number in terms of something we would expect this whole ancillary category to be, because again, clients [indiscernible] where they are growing their investments in the workplaces. Our dealers are seeing that business, they don't have a full range of Knoll solutions yet, and as we come into 2017, I think we will be much bigger player in those markets.
So we are really excited about it, and I think as you saw the totality of the offer, its much bigger than any one of the elements.
In terms of the margin profile, how would you characterize this?
Again, I think it would be -- it certainly should be above our average office margins where they are today. So I think it will be very supportive of our goal of getting to double digit office operating margin.
Okay, perfect. And speaking of the gross margin progress in Office, it's our understanding that you have made obviously a lot of progress, but still relatively early in the innings. If you look at the levers or margin improvement in the quarter, what were the greatest drivers of the upside?
So for us, it was really twofold, and which dwarfed everything else going on to the P&L, was one, our continuous improvement program that we talked about previously, and the second is the leverage of our fixed costs. And so those two items, were by far, the biggest two.
Okay. Perfect. And then just really a broader question that would focus on the tightened size of customers, are you seeing a differentiation in terms of the size of projects being bid versus say a year ago, and in the other color in terms of similar markets that are showing greater relative strength or not?
Sure. I think in general, what I would say is, we are seeing -- well the number of $1 million plus projects in the quarter was relatively flat year-over-year. We aren't seeing the super big $5 million, $10 million type projects out there. So it is requiring a lot more smaller projects to generate the same or an increased amount of revenue. I think that's associated with some weakness obviously in Texas, but even in some parts of the Northeast, where we aren't seeing as robust financial service performances we see in the past. The west continues to be very strong, we have some nice opportunities in the Central part of the country, where we are probably less penetrated than we are on the coast.
And so, I'd say that's kind of the gist of the market. When I look ahead, the leading indicators are encouraging. Our funnel of business is up over prior year. Our client's visits are up. Our custom product requests are up. Our mock-ups are up. So I think it's all indicative of an overall, okay environment. But its taking a lot more transactions to achieve the same amount of dollars. Is that helpful?
That's super helpful. Thank you very much for answering that question.
Thank you. Our next question will come from Ted Richardson from West Hill Capital [ph]. Your line is open.
Hi guys. Just wanted to get some detail on sort of usage of cash going forward, you made nice progress on delevering the balance sheet, and just sort of thinking about the dividends or acquisitions, but just love to hear any detail you have on sort of priorities there? Thanks.
Sure. Thank you for your question. Our priorities remain the same. I mean, we continue to focus organically on investing the business, both in terms of new products, as you saw at NeoCon like Rockwell Unscripted and some other meaningful things in the pipeline, as kind of the primary use of our capital.
Then we look at continuing to pay a good dividend, continue to delever the business, and where it makes sense, add on acquisitions. And we have been, I think a very disciplined buyer from an acquisition standpoint. I can tell you, we have a very significant funnel of transactions that we are always looking at. Very much in support of our strategy of diversifying these high design residential businesses, or growing ancillary categories, where we think bolt-on acquisitions, where we can leverage the sales and distribution capability we have, or have a particular cost synergy are meaningful, we will continue to pursue those as well, but we are a very disciplined buyer in terms of the prices we are willing to pay.
And I'd say, those are the primary uses. We continue to -- with the Board, look at our capital allocation strategy regularly and annually. We tend to look at the dividend. Obviously we talked about being comfortable with the leverage of two to 2.5 times, we are well under that right now. I think we are trying to keep our powder dry in terms of meaningful opportunities to accelerate our transformation and growth.
Thank you. And I am currently showing no further questions from our phone line. I would now like to turn the conference back over to Andrew Cogan for any closing remarks.
Great. Thank you everyone for your continued interest in Knoll. If you did not get to visit with us in Chicago, please get in touch with Craig or myself, we'd welcome the chat [ph] during our regular visits there to take you through what we think will be a really exciting growth engine for us in the years ahead. Take care everybody. Goodbye.
Ladies and gentlemen, thank you for participating in today's conference. This does conclude the program and you may all disconnect. Everyone, have a wonderful day.
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