Interface's (TILE) CEO Daniel Hendrix on Q2 2016 Results - Earnings Call Transcript

| About: Interface Inc. (TILE)

Start Time: 09:00

End Time: 09:27

Interface, Inc. (NASDAQ:TILE)

Q2 2016 Earnings Conference Call

July 28, 2016, 09:00 AM ET

Executives

Daniel Hendrix - Chairman, President and CEO

Jay Gould - President and COO

Patrick Lynch - SVP and CFO

Greg Bower - VP

Analysts

Mike Wood - Macquarie Securities

Kathryn Thompson - Thompson Research

John Baugh - Stifel, Nicolaus & Co.

Keith Hughes - SunTrust Robinson Humphrey

Sam Darkatsh - Raymond James

Operator

Good day, ladies and gentlemen, and welcome to the Q2 2016 Interface, Inc. Earnings Conference Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session and instructions will follow at that time. [Operator Instructions].

I would now like to turn the conference over to your host, Greg Bower [ph], Vice President. You may begin.

Greg Bower

Thank you, operator. Good morning and welcome to Interface's conference call regarding second quarter 2016 results. Joining us from the company are Dan Hendrix, Chairman and Chief Executive Officer; Jay Gould, President and Chief Operating Officer; and Patrick Lynch, Senior Vice President and Chief Financial Officer.

Dan and Jay will review highlights from the quarter, as well as Interface's business outlook. Patrick will then review the company's key performance metrics and financial results. We will then open the call for Q&A.

A copy of the earnings release can be downloaded off the Investor Relations section of Interface's Web site. An archived version of this conference call will also be available through that Web site.

Before we begin the formal remarks, please note that during today's conference call, management's comments regarding Interface's business, which are not historical information, are forward-looking statements.

Forward-looking statements involve a number of risks and uncertainties that could cause actual results to differ materially from any such statements, including risks and uncertainties associated with the economic conditions in the commercial interiors industry, as well as the risks and uncertainties discussed under the heading Risk Factors in Item 1A of the company's annual report on Form 10-K for the fiscal year ended January 3, 2016, which has been filed with the Securities and Exchange Commission. We direct all listeners to that document.

Any such forward-looking statements are made pursuant to the Private Securities Litigation Reform Act of 1995. The company assumes no responsibility to update or revise forward-looking statements made during this call, and cautions listeners not to place undue reliance on any such forward-looking statements.

Management's remarks during this call refer to certain non-GAAP measures. A reconciliation of these non-GAAP measures to the most comparable GAAP measures is contained in the company's earnings release and Form 8-K filed with the SEC yesterday. These documents can be found on the Investor Relations portion of the company's Web site, www.interfaceglobal.com.

Lastly, please note that this call is being recorded and broadcasted for Interface. It contains copyrighted material and may not be re-recorded or re-broadcasted without Interface's express permission. Your participation on the call confirms your consent to the company's taping and broadcasting of it.

Now, I'd like to turn the call over to Dan Hendrix. Please go ahead, Dan.

Daniel Hendrix

Thank you, Greg. Good morning, everyone. I’ll start with the top line where our sales of 248 million were very solid, especially considering the slow start to the year with first quarter orders of only 222 million. This order of sales fill rate is the best we've had experienced in a decade.

Like the past year and a half, the best story of the second quarter was our improvement in gross margins, up 150 basis points to an all-time quarterly record of 39.9%. This is simply outstanding performance and I could not be happier with our progress here.

SG&A expenses were down slightly year-over-year and we’ve cut spending in each division across the company, but the revenue shortfall is causing SG&A as a percentage of sales to remain elevated above our targeted level of 26%.

Nevertheless, our improvement at the gross margin line made up for a lot of our lost ground and pushed our operating margins to 12.8%, up from 12.6% in the prior year period.

At the bottom line, the result of earnings per share of $0.32 which represents our second best quarterly earnings ever compared with the record $0.33 in the second quarter of last year.

For additional highlights of the quarter discussion of our outlook for the remainder of the year, I’ll turn the call over to our President, Jay Gould.

Jay Gould

Thanks, Dan. Well certainly the lead story of the quarter is our gross margin improvement, up 150 basis points to an all-time quarterly record of 39.9%. This achievement represents months of really hard work throughout our company. Each of our divisions contributed to the margin improvement.

And there were three main drivers of the year-over-year increase. First, raw material savings; secondly, improved manufacturing efficiencies; and thirdly, a shift in our product mix towards higher margin plank and other tapestry products.

Perhaps most impressive though is the gross margin increase was not driven by increased production volume. In other words, we achieved this record margin during a quarter in which we actually reduced production by 7% and drew down our inventories by $5 million, so truly wonderful progress throughout our organization.

The margin improvement made up for almost all of the 6% sales decline and let me give you a little more color on the topline. First, I’d like to point out we are facing a very strong sales comparative of $264 million in the second quarter of 2015. And as Dan mentioned, realizing sales of $248 million on the heels of only $222 million of first quarter orders is a great sequential fill rate.

Now, the drivers of the year-over-year sales decrease was mostly the same as those we talked about in the first quarter. In the Americas region, 65% of the sales decline was really the result of one account in the InterfaceServices business that has delayed but not canceled major flooring projects from the first half of the year and pushed them into the second half of the year. Also within the Americas region, we saw the effects of suffering oil and gas sector with particular influence in Brazil, Western Canada and Houston.

In Europe, the sales decline was attributed to geopolitical and economic issues including the uncertainty and hesitation in the region leading up to the June 23rd Brexit referendum, and we all know how that turned out. Now in addition to the Brexit, the region also dealt with other difficulties including a weakened banking of financial services sector, terrorist activities and of course the refugee crisis.

Sales in Asia were pretty solid, especially in India and China, but that was slightly more than offset with a decline in Australia. Now we did make progress in SG&A with flat or lower spending across every business unit and experienced a small year-over-year decrease in absolute dollars on a consolidated basis, but the revenue decline kept these expenses at an elevated 27.1% of sales for the quarter. Now that was much better than the 29.5% we saw in the first quarter but still higher than our target and higher than our prior year period.

We experienced flat or declining spend across the majority of our SG&A categories with the only substantial year-over-year increase being in marketing expenses. And on this particular point, we are making longer-term investments to support our growth initiatives such as branding, market development, and product introductions.

On the strength of our gross margin improvement, our operating margin improved 20 basis points year-over-year to 12.8% and our earnings per share were strong at $0.32, just a penny short of the all-time record of $0.33. So with our margins shaping up nicely, we are now even more focused on growing the top line. We have several key initiatives underway.

In the second quarter, we launched our new global product, the World Woven Collection which won a Best of NeoCon Silver award and the market reaction has been fantastic thus far. Worldwide, we are also introducing more products in lower price categories where demand has been accelerating and these new products are also margin accretive.

Sales in our InterfaceServices business should improve in the second half of the year, as the delayed projects that I mentioned earlier flow through in a shortened time window in the back half of the year. Among other tactics we’re also enhancing our dealer programs, driving sales in non-office segments such as hospitality and also targeting specific geographic growth areas.

With our core U.S. modular business remaining healthy and with the Asia Pacific generally on track, we believe that our biggest uncertainty now lies in Europe where the Brexit vote, terrorist activities, and other problems have disrupted business conditions and frankly severely impacted the value of the British pound sterling. About 7% of our annual sales are in the UK, so we do expect to see an impact on our business there with potentially spillover effects in mainland Europe.

But, at the same time, we believe it could give rise to other market opportunity as many businesses such as banks and other financial institutions look to expand or relocate to new offices outside of the UK. With the uncertainty in Europe, it’s somewhat difficult to forecast but we believe second half sales and earnings will be an improvement over the first six months of the year.

With that, I’ll turn the call over to Patrick for the financial details.

Patrick Lynch

Thank you and good morning everyone. Sales for the quarter were down 5.9% to 248.2 million versus 263.6 million in the second quarter of 2015. Currency did not have a significant impact on the consolidated comparison versus the second quarter of 2015 as the strength of the euro was offset by the weaker Aussie dollar.

Although Jay’s already discussed this, I do think it bears a quick repeating. Our record-breaking gross margin performance is at the high point of the quarter and continues the trends we've been seeing. Although raw materials are starting to see some small upticks in the second half of the year, we still expect an average that our input prices will be lower in the second half of '16 versus the second half of 2015.

In the Americas, we saw a sales decline of about 6% but as mentioned is largely the result of continued customer delays in our services business as well as softness in Canada and Latin America. On a positive side, our hospitality and healthcare markets experienced double-digit increases for the quarter and our gross margin performance continue to improve over very impressive second quarter of 2015.

Sales in Europe were down approximately 9% in local currency and 8% as translated in U.S. dollars. The decline was mostly experienced in the corporate office market which was down 11% of local currency and 9% in U.S. dollars, as buying decisions were deferred amongst the Brexit uncertainty.

Non-office segments were down to a lesser degree with the decline in education, partly offset by increases in all other non-corporate office market segments. Despite the sales top line decline, the region saw gross margin expansion of nearly 150 basis points which led to an operating profitability that was close to our record second quarter of 2015.

Gross margin again was a bright spot across our Asia-Pacific region and despite a sales decline of 2%, we experienced expanded operating profitability as a percentage of sales in absolute dollars. Our gross margin there was up over 200 basis points for the quarter and when coupled with a steady SG&A, expense result was a very strong second quarter on our Asia-Pacific region.

I feel better about the direction of our SG&A spend for the quarter as we were below the 2015 levels in terms of absolute dollars. And as Jay mentioned, we’re still not where we want to be as a percentage of sales but we're happy with the sequential trend here and continue to invest in initiatives that support our longer-term growth.

Thanks to our gross margin performance and in spite additional SG&A spending and the sales decline, operating income of 31.8 million was within striking distance of our operating income of 33.2 million we turned in for the second quarter of 2015. It’s also important to note that our operating margin increased to 12.8% in the second quarter of 2016 versus 12.6% in the same period of 2015.

Outside the gross margin expansion, the second most impressive number in the quarter is our cash flow generation. Despite repaying $7.5 million in debt and using 10.4 million to repurchase and retire 660,000 shares of our outstanding common stock, we were still able to generate 5 million in cash during the quarter.

If you remember from our first quarter call, we increased our share repurchase program to a maximum of $50 million. Our balance sheet is in great shape and leaves us with the flexibility to invest as necessary in the business, as well as continue to return capital to our shareholders. As a result, we increased our quarterly dividend to $0.06 per share per quarter.

Depreciation and amortization was 7.5 million in the quarter compared with 7.8 million last year. Capital expenditures in the second quarter were 8.3 million compared with 7.6 million in the comparable period in 2015. And for the full year of 2016, we expect our capital expenditures to be in a range of 35 million to 40 million.

With that, I’d like to turn the call over to the operator for questions please.

Question-and-Answer Session

Operator

Thank you. [Operator Instructions]. Our first question comes from the line of Mike Wood with Macquarie. Your line is now open.

Mike Wood

Hi. Good morning. First question on the services business. Is the gross profit margin profile materially different from your average core gross profit margins?

Daniel Hendrix

I wouldn’t say that it’s materially different but it trends to be lower in our services business, slightly lower than our traditional core modular business. But it is lower.

Mike Wood

Got it. And on price, just curious, your thoughts on the idea of what happened maybe with price sequentially 1Q into 2Q, and how long do you think you can hold price or continue to push price higher in this type backdrop that we're in?

Patrick Lynch

I think sequentially pricing is pretty neutral on a year-over-year basis. We are up a little bit in pricing but there certainly is some pricing pressure in the market, and we’ll continue to monitor that over the next couple of quarters. But right now it seems to have kind of stabilized.

Mike Wood

Great. And just a final question. You mentioned you're not happy with SG&A as a percentage of sales. Does that absolute dollar number though, is there still room to push that lower? And can it near term be sustained at this 65 million level of sales or in this area going forward?

Patrick Lynch

I think sequentially for the balance of the year you’ll see right around these dollars in absolute and will get better as a percentage over the second half of the year.

Mike Wood

Great. Thank you.

Operator

Thank you. Our next question comes from the line of Kathryn Thompson with Thompson Research. Your line is now open.

Kathryn Thompson

Hi. Thanks for taking my questions today. First touching on raw materials given the stabilization of energy prices and slight pickup that you mentioned in your prepared comments, what are your expectations for raw material impact the balance of 2016? I believe you had previously forecasted a $7 million to $8 million tailwind. And really basically has that changed and how should we think about the second half?

Daniel Hendrix

Yes, right now we’re looking at – will still be lower year-over-year but it’s going to uptick a little bit here. Right now the current projections are about $2.5 million increase in yarn cost for the balance of the year, based on some recent pricing we took on yarn. So that $7 million to $8 million is coming down by about 2, 2.5 for the second half of the year.

Kathryn Thompson

Okay. And could you give color on how orders trended in the quarter and any color into July would be helpful? Thank you.

Jay Gould

Sure. Orders April, May, June; we finished April down 6%, May was up about 5% and then June was a very difficult comp, probably our single largest month in our history. We came in around 10% down in June. So the net effect for the full quarter was down about 5% and we’re currently trending about down mid-single digits here in the first three weeks of July. July continues to be a tough comp. The comps get easier in August in September.

Kathryn Thompson

Okay. And more color if you could just remind us what drove the tough comps last year? Was it a large order or is it anything unusual that we should think about?

Jay Gould

Well, I think it really goes back to the end of 2014 where we really saw softness in '14 and early part of 2015 and then came through pretty strong Q1, Q2 and midway through Q3, kind of that worked its way through, which created a pretty strong environment for two-thirds of the year there in 2015.

Kathryn Thompson

And are you seeing a difference in the types and size of projects? What we've seen in our other coverage of everything from basic materials to office furniture or just seeing a greater number of smaller projects versus mega projects? What are you seeing in terms of order trends for types of projects, at least in the U.S.?

Daniel Hendrix

I think we’d be consistent with that, Kathryn. We’re seeing – 80% of our business is renovation, which tend to be smaller projects like people tend to do a floor at a time as opposed to a building. So I would say we’re consistent with the trends you’re seeing from other building products.

Kathryn Thompson

Okay, great. Thank you very much for the last question. Thanks very much for the color on the drivers for the gross margin improvement. But of the buckets that you outlined, is there any one bucket that was a greater driver of the gross margin improvement?

Patrick Lynch

It really was the production manufacturing efficiencies and the benefit of a lot of lean manufacturing initiatives around the world are really paying some pretty significant dividends right now to more than offset a 7% decline in production. Our folks have really done a tremendous job to create some really positive manufacturing variances, despite lower volumes. So I would say manufacturing efficiencies was really our biggest driver.

Kathryn Thompson

Great. Thank you very much.

Operator

Thank you. Our next question comes from the line of John Baugh with Stifel. Your line is now open.

John Baugh

Thank you. Good morning, Dan, Jay, Patrick. Congrats on a great margin quarter.

Daniel Hendrix

Thank you.

John Baugh

I think I heard Australia was down. That had been I believe recovering nicely since the fire. Could you just go into some of the dynamics you're seeing in that market?

Daniel Hendrix

Well, they were down for the quarter. We have seen a rebound overall in Australia and we expect growth for the full year. So a bit of an anomaly in last year’s numbers in the comparative. We had a big order in last year’s second quarter numbers.

John Baugh

Great. Thank you for that. I'm sorry, I got on a little late. Did you make any comments on FLOR retail, either revenues or margins, EBIT there? Thank you.

Patrick Lynch

I would say no we didn’t. We haven’t really covered that yet, John. I would say FLOR had a tough quarter. We were down double-digit top line. We lost about $1 million in the quarter operating. Our June promotion didn’t kind of meet our expectations there. So it was a bit of a tough quarter for FLOR in Q2.

John Baugh

Okay. And then lastly, you made a comment about the back half I think in revenue and earnings being better. Was that a Europe-specific comment, Patrick, or was that consolidated company?

Patrick Lynch

Consolidated company, John.

John Baugh

Great. Thanks for the color and good luck.

Patrick Lynch

Thank you.

Operator

Thank you. Our next question comes from the line of Keith Hughes with SunTrust. Your line is now open.

Keith Hughes

Thanks. A couple of questions. One, we’ve been hearing – I know you've been doing some share repurchase and carrying a pretty heavy cash balance for some time. Is there any plans to start redeploying this faster in terms of share repurchase?

Patrick Lynch

I think we’ll continue to be opportunistic as we have been. Right now I have to – a lot of that cash right now is overseas. It’s going to take me three or four months here to reconfigure a few of our legal entities and so forth to get that cash repatriated. But hopefully have that done by the end of the year and that will facilitate some of the share repurchases and so forth.

Keith Hughes

And on your last answer, second half of the year being better than the first half, are you talking specifically on EPS there or EBITDA or what metric?

Patrick Lynch

I think broadly speaking across most metrics. Seasonally Q3, Q4 have historically been better than the first half of the year and we kind of expect that trend to continue here in '16.

Keith Hughes

And final question on sales. You had referenced in the press release that your tile business, excluding the service stuff that's already been discussed, is up 1%. That looks slightly above where the industry is. Given kind of your order pattern once we hit the easier comps starting in August, September, do you think you'll start to comp positively in the United States towards the end of the year?

Daniel Hendrix

Yes, based on our current trends we expect that to be the case.

Keith Hughes

Okay. Thank you.

Daniel Hendrix

Thank you.

Operator

Thank you. Our next question comes from the line of Sam Darkatsh with Raymond James. Your line is now open.

Sam Darkatsh

Good morning, Dan, Jay, Patrick. Excellent job on gross margins this quarter. A couple, two, three questions. Regarding gross margins as you look into the back half, constructively you took production lower during this quarter so I'd imagine that production would normalize and that would help your throughput. But you also have the input costs rising and then we are getting close to the long-term target of 40%. So how should we look at gross margins going forward? Is there still expansionary possibilities there or is this the level that we should assume?

Patrick Lynch

I think for the back half of the year, I think we’ll be consistent kind of where we’ve been in the mid- to high-39 range. As you called out, we do have a couple of things working against us in terms of raw materials and then perhaps some downward pressure on the top line related to the Brexit across EMEA. But I think what we’ve done in our efforts there we’ll probably still stay around the mid-39 to high-39 range for the balance of the year.

Sam Darkatsh

And Patrick you just gave me a good segue for my next question which would be the UK anecdotally. It doesn't sound like it's affecting you yet at all. It sounds like maybe your July orders in Europe were okay. Anecdotally, what are you hearing from your sales force in terms of the appetite of the UK customers for large-scale discretionary purchases in the back half?

Patrick Lynch

We have certainly been hit by the decline in the pound just as we translate that back. People are concerned but you’re right. The order pattern in Europe is still pretty strong. Now the UK is a bit weak but the rest of Europe has more than made up for that thus far. So right now it’s a watch-out, a warning signals but that hasn’t translated to the order sheet yet.

Sam Darkatsh

A final question if I could. InterfaceServices, a drag in the second quarter. I think you're suggesting that some of the large projects were delayed into the second half. What might be the benefit or the tailwind that you get from services in the back half versus the headwind that you saw in the front half?

Daniel Hendrix

So the first half of the year was impacted by $10 million or $11 million from that one customer. We don’t think we can execute that full boat there but I think we can get 75% of it in the back half. That also is a drain on gross margin. It was a positive in the first half; it’s a drain in the second half.

Sam Darkatsh

But accretive to EBITDA I'm guessing, right? A drag on gross margin but accretive to the profitability?

Daniel Hendrix

Yes.

Sam Darkatsh

Okay, all right. Thank you, gentlemen. Again, well done on gross margins.

Daniel Hendrix

Thank you.

Operator

Thank you. [Operator Instructions]. I’m showing no further questions in the queue. I’d like to go ahead and turn the call back over to management for any further remarks.

Daniel Hendrix

Well thank you for listening to the call and hopefully we’ll have great news in the third quarter. Thank you.

Patrick Lynch

Thank you.

Operator

Ladies and gentlemen, thank you for participating in today’s conference. This concludes today’s program. You may all disconnect. Everyone, have a great day.

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