Knoll's (KNL) CEO Andrew Cogan on Q3 2016 Results - Earnings Call Transcript

| About: Knoll, Inc. (KNL)

Knoll, Inc. (NYSE:KNL)

Q3 2016 Earnings Conference Call

October 21, 2016 10:00 AM ET

Executives

Andrew Cogan – Chief Executive Officer

Craig Spray – Senior Vice President and Chief Financial Officer

Analysts

Budd Bugatch – Raymond James

Kathryn Thompson – Thompson Research Group

Operator

Good morning, everyone, and welcome to the Knoll, Inc. Third Quarter 2016 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 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 from the 10-K and other filings with the Securities and Exchange Commission. The call today will also include references to non-GAAP financial measures. Reconciliation of these measures to the most comparable GAAP financial measures are included in the presentation slides that will accompany the webcast.

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

Andrew Cogan

Thank you. Good morning. 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. In the phase of a more mixed demand environment, across our various contract and residential end markets, we’re pleased to continue to generate better than market top-line performance and expand our industry leading levels of profitability.

In the quarter, our HOLLY HUNT division completed the first of what we hope will be many tuck-in acquisitions with the purchase of Vladimir Kagan Design Group, known for its sensual, elegant, mid-century and contemporary designs, we believe this is a business we can leverage our HOLLY HUNT sales and showroom network to profitably grow in the years ahead.

Not only does our design reputation and track record of custodianship of important designers work make us the buyer of choice for these types of businesses, but the ability to directly market these designs to the trade in our residential clients through our dedicated showroom network can significantly enhance their sales and profitability.

Looking at our results for the third quarter of 2016, we continue to demonstrate the benefits of our strategy to diversify our sources of our revenue, broaden the markets we serve and improve the profitability of our Office segment. In particular, it’s worth noting in the quarter, that the office operating margins of 9.7% were just a hair shy of our longer term double-digital goal for this segment. Overall, our sales grew by 10.8%, well in excess of the 3% growth reported by BIFMA for the closest three-month period.

Gross margins continue to expand and adjusted operating profits increased from $29.1 million to $35.2 million with contribution margins north of 20%. Operating margins expanded by 120 basis points from 10.9% to best in class 12.1%. This is the highest operating margin we’ve reported since 2011. We feel confident that for the third year in a row, we will meet or exceed our goal of a 100 basis points of annual operating margin expansion.

Improvement in Q3 was due to particularly strong performance by our Office segment. Here growth of just over 15% was driven by complementary product categories we’ve been investing in, in core systems product. This growth combined with productivity improvements in our plans more than offset incremental pricing pressures and resulted in significant gross margin expansion. Combined with better leverage in our operating expenses, this drove our operating margins up 280 basis points from 6.9% to 9.7%. These are the highest Office segment margins we’ve reported since 2012.

Our pipeline of activity heading into the close of the year is solid. However, there is a noticeable decrease in the number of multimillion dollar opportunities and we are not impervious to the general slowdown in industry demand that others have already noted. While we believe this is more of a positive refresher than the start of something bigger, we will need to rely on our ambitious program of ancillary and complementary introduction in 2017 to fuel further market share gain.

In this regard, we continue to be very pleased with the number of client visits to our Chicago showroom for presentations around our award-winning Rockwell Unscripted collections. These are sizable project opportunities and we are on target to begin taking Rockwell Unscripted orders in the first quarter of 2017. Importantly, Rockwell Unscripted five product categories and 30 plus products are substantially additive to our offer today.

Studio segment sales continue to expand. In Q3, growth was led by KnollStudio and Knoll Europe, both contract and residential channels saw growth in these market. Increasingly here and in Europe, we are successfully pursuing high visibility project opportunities that are consistent with our brand. With some of the headwinds from slowing high end real estate sales, weakness in certain geographies and what I would say in the scheme of things was minor disruption from our ERP implementation at HOLLY HUNT, sales modestly declined in this business for the first time since our acquisition.

While going forward, the new ERP system at HOLLY HUNT will give us a competitive advantage into the trade decorator market. In the short-term, it delayed some shipments and increased our cost. As a result, overall Studio segment profits increased modestly when compared to prior-year. Operating margins were consistent with our average to date at just under 15%.

In Coverings, ongoing challenges in the private aviation market and weaker industry conditions continued to weigh on our Edelman Leather and KnollTextiles businesses. Declines here offset continued growth at Spinneybeck 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 under 5%, our market improvement from the 10% decline in Q2.

We continue to believe that both KnollTextiles and Edelman should lapse in more difficult comps and be growing again by the fourth quarter. With 20% plus operating margins coverings continues to generate meaningful profits for our overall enterprise.

In the quarter, approximately 37% of our sales and 50% of our profits came from outside of North America office segment. No contract furniture company could make that statement. We believe that 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 some more detail. Craig?

Craig Spray

Thank you, Andrew. Knoll, Inc. third quarter net sales increased $28.5 million or 10.8% from a year ago. Gross margin improved 20 basis points from 38.4% a year ago, 38.6%. The office segment continues to be the primary driver as operating efficiencies and improved fixed costs leverage and higher volume offset some net pricing pressures.

Total operating expense in the third quarter was $77.6 million, compared to $72.5 million in 2015. The increase in operating expenses was primarily related to expanded sales and product development investments as well as higher incentive accruals related to increased profitability. We continue to believe that operating expense for the year will average around 27% of sales.

Operating profit was up 22.6% from $28.7 million in the third quarter of 2015 to $35.2 million in Q3 2016. Operating profit margin improved to 120 basis points from 10.9% to 12.1%. This improvement was primarily the result of the 280 basis point improvement in the office segment from 6.9% to 9.7%.

Interest expense was reduced by $0.4 million from a year ago as we continued to reduce the balance on our term and revolving loan credit facilities. For Q3 2016, other expense was $0.7 million compared to other income of $1.8 million a year ago. Other income and expenses are primarily related to foreign exchange gains and losses. In Q3 2015, other income was primarily related to foreign exchange gains due the devaluation of the Canadian dollar.

During Q3 of 2016, we made $10 million in discretionary contributions to our pension plans. These contributions reduced our PBGC cash premium as well as our future pension expenses. We will continue to analyze pension funding alternatives in the future.

Our tax rate for the quarter was 34.9%, down from 38% in Q3 2015. The change in our tax rate was due to the mix of sales in the varying rates in the countries and states in which we operate. For the full year, we expect our tax rate to be approximately 35%.

Net earnings for the third quarter of 2016 were $21.6 million, up from $17.9 million for the same period of 2015. Diluted earnings per share was $0.44 for Q3 2016 and $0.37 for 2015. Regarding our cash flow, we ended the quarter with approximately $11.2 million of cash. Operating activities provided $49.3 million of cash in the quarter. We use the excess cash generated from operating activities to reduce our debt outstanding, invest in the business and pay dividends.

Investing activities for the quarter included the acquisition of Vladimir Kagan Design Group as well as capital expenditures of $10.4 million compared to capital expenditures of $7.2 million in Q3 2015. The Vladimir Kagan Design Group acquisition and capital expenditures are reflective of our strategy and continued commitment to invest in our manufacturing and information technology infrastructure.

Total cash used by financing activities was $22.1 million. The primary use of cash in financing activities was the repayment of debt. Other financing outflows during the third quarter of 2016 included the payments of dividends for $7.2 million. Our balance sheet remains strong. The continued combination of increased EBITDA and further reductions in our outstanding debt drove leverage from 1.99 a year ago to 1.25 at the end of the third quarter. We remain comfortably within all debt covenants.

We will now take any questions.

Question-and-Answer Session

Operator

Thank you. [Operator Instructions] And our first question comes from Budd Bugatch from Raymond James. Your line is open.

Budd Bugatch

Good morning, Andrew. Good morning, Craig. Congratulations on a really terrific quarter. I guess the first question is on David Rockwell. You said you’re going to start taking orders in the first quarter. Andrew, when do you think, you’ll be starting to see deliveries, how soon after that when will we see that?

Craig Spray

Rockwell Unscripted, we will take orders on Rockwell Unscripted at the end of the first quarter and begin shipments at the start of the second quarter. We’ll be bringing all our people into train them in the end of January and we’ll be rolling it out to between four and five flagship showrooms, at the end of this year and the beginning of next year.

So, we have a pretty robust plan to bring that to market and we remain very heartened by the client response to this visits to Chicago and again, as again I said in my remarks, there are nice sizable opportunities and it should be very incremental to where we are and very much targeting areas of the market we believe are outperforming other areas of the market.

Budd Bugatch

Then, how can we – is there any way for us to size that to get a feel, quantify the potential impact on 2017 results and maybe beyond, then what the opportunity is?

Andrew Cogan

Yes. I think, it will probably be hard to quantify for 2017, but in general, but when we do a major platform, our goal is to create a $50 million to $100 million stream of revenue over a three-year to five-year period. And I think we have a good track record of doing that with project – products like, Antenna and so forth, and Rockwell feels like it will be on that trajectory. But you’re talking $10 million, $15 million for a year-one kind of ramp-up.

Budd Bugatch

Okay. That’s kind of where I was thinking it would come to.

Andrew Cogan

Yes. That’s right.

Budd Bugatch

Thank you. Can you give us a walk from either the 38.4% gross profit of the third quarter of last year, to 38.6% this year or from, it looks like gross profit has found its high water mark. Is there a way to quantify for us with some other components of the changes in gross margin on?

Andrew Cogan

Yes, really on the year-over-year margin change, it was three things, it was leverage and net pricing that kind of netted each other out, and then we had our continuous improvement to our manufacturing efficiencies that fell through.

Budd Bugatch

And what about the Canadian dollar change year-over-year, is that stopped having an impact in one way or another?

Andrew Cogan

Yes, not a material effect at all Q3. Budd, one of the things that has helped us a little bit gross-margin-wise this year is we’ve had some protection on steel. So we have not been hit with the bulk of the steel inflation, and that will be a headwind for us in 2017 and we are evaluating our pricing actions appropriately.

Budd Bugatch

You normally take a pricing action about the beginning of the year, do you not, and is that still a rational expectation?

Andrew Cogan

I think given some of the higher inflationary expectations, I think it’s important that we do take some price up early in 2017.

Budd Bugatch

We have started to see some disruption in the foam market particularly with chemicals of MDI and TDI, that’s not necessarily domestically, but in other parts of the world that I worry will could lead over to our markets here. Are you seeing any of that? And I’m sure you are cognizant of it as well?

Andrew Cogan

Yes, we don’t use a ton of foam, so we haven’t seen any big impacts or supply disruptions on yet. And we’re not anticipating anything dramatic.

Budd Bugatch

That doesn’t worry you as much. Okay, I understand. On the…

Andrew Cogan

Steel is a real headwind.

Budd Bugatch

No question. Okay. And that market is – really has a lot of political effects on it, too, between what goes on in China and other parts of the world, right? Is that the way to think about that?

Andrew Cogan

Yes and you watch the debate and they all talk about steel. So, yeah, it’s something we’re watching.

Budd Bugatch

Yes, you’ve almost ruined my morning with that thought. Kagan is a fabulous old name. I’ve got to tell in the past life I actually sold some of that product. What can you tell us about the size of that now? I think he has passed away. Is that right? And…

Andrew Cogan

It’s a wonderful brand. We had the pleasure, Holly introduced us to Vladimir Kagan, she has known him, maybe as long as you’ve known him, Budd. And we actually started talking with Vladi before he passed away. It was very unfortunate that during the negotiations, because we would have loved to have him stay on with us and continue to create, he was really creating work at the end of his life.

But it’s a business that, we think, is small. It’s in the handful of millions of dollars. But I think what’s interesting about it is, it was – Vladimir Kagan Design basically wholesale their designs to others who then retailed them.

Budd Bugatch

Right.

Andrew Cogan

And I think the opportunity for us now is – and they had extremely limited distribution, two door, three doors at most, four doors maybe. And now we can move it through our 10 to 12 Holly Hunt Showroom. We can capture the full margin of that business. And we believe there’s a lot of wonderful things in the archive and potentially new work under the Vladimir Kagan name and vocabulary that can be created.

And I think, we’ve got a very strong track record of being custodian of greats like Mies and Saarinen and Bertoia and I think this continues that legacy. We chose Holly Hunt as the vehicle because I think it’s – we think it’s more appropriate to the high design to the decorator trade than a contract market, but obviously we’ll – we’ll exploit contract opportunities. They are exquisitely manufactured sofas.

Craig Spray

Yes. Well, some of the – some of the rockers and classic designs, I thought would actually marry well with Rockwell in churn of the resimercial kind of environment...

Budd Bugatch

It probably does – the price points are such that you could probably get an entire Rockwell and scripted off an office for a Vladimir Kagan Sofa. So...

Craig Spray

Yes. Well, I didn’t need to have to go and manufacturer quite that way because he actually did measure manufacture stuff or have stuff in a much a more commercial arena...

Andrew Cogan

Yes, I know. Listen – and we think there’s opportunity with some of the side shares and some of the other products he’s done to improve the price competiveness of some of the work they do. So I think it’s a great little tuck-in, it’s kind of exactly high margin, high design, it’s exactly the kind of the thing I think we should be doing and obviously we would love to do more of those kinds of things.

Budd Bugatch

Okay. And then last for me. You’ve been working on getting manufacturing improvement, you talked a little bit about the leverage and impacted gross margin. Where are you on the lean journey, what’s going on in that particular arena for you?

Andrew Cogan

Bud, I’m glad you asked. Firstly, under the leadership of Joe Coppola, our Chief Operating Officer and really we reenergized site leadership teams we have, I mean, our plant teams are sourcing, purchasing logistics organization, I think are doing a really strong job, and they’re driving a lot of that work, but we’ve also – we also believe we’re just at the beginning of that lean journey and we are dedicating some meaningful additional resources in both talents and investments to try and accelerate that and I think we have plenty of runway to be a lot better than we’re being but we’ve come a long way in the last three years.

Budd Bugatch

Okay. Well, good luck, Andrew, and thank you very much. Good luck, Craig, and thank you.

Operator

And thank you. Our next question comes from Kathryn Thompson from Thompson Research Group. Your line is open.

Kathryn Thompson

Hi, thank you for taking my questions today. First, I want to focus on Office segments was the – really delevers for the top-line growth, just want to get a better sense of what drove that mid teens growth? And if you could breakout between what is new product introduction, so your complementary products versus share gains versus perhaps a large project that can create some lumpiness in comps, really just want to be able to separate what that – the different drivers versus just core low industry growth? Thank you.

Andrew Cogan

Thank you. We’re happy to try and do that. In general from a product standpoint, we saw a good performance out of our core systems business. That was the systems invention was the fastest growing product category followed by our complementary work, and we’ve talked about the investments we’ve been making, and adjustability, and ergonomics, and all those trends, and that’s – those have been the two primary product drivers. But I will say there were some meaningful projects that shipped out in the quarter.

And I just remind everyone that it’s going to be a lumpy business, sometimes its lumpy good like in the third quarter, and other times you don’t have the same favorable lumpy projects. And so it is – there is that dynamic and it was – we benefited by that in the third quarter.

In general, right now, as I said in our prepared remarks, there are fewer large projects out there. When I look at our pipeline for the balance of the year, it’s pretty flat year-over-year. Now the good news is when I look at our pipeline, we look at our pipeline beyond there is good growth as we look at the kind of 12 to 18 months-out pipeline. But there definitely are fewer large projects, and so, you have to just do a lot more smaller transactions to get to the same place.

Kathryn Thompson

And maybe pulling the string on that a little bit, intra-quarter trends for many of our building products and materials and companies with whom we speak were very choppy starting off, very weak in July, we had two to three fewer selling days, but mostly ended on a stronger note. Could you comment if you saw a similar trend, either – not necessarily in sales but for orders? And also if you could give any additional color regarding the ability to win business so, is there a greater prevalence of discounting to win that business?

Andrew Cogan

We didn’t see any noticeable differences in the trends during the quarter, and I mean, I think the things others have reported we’ve seen. It’s definitely, again there are fewer large projects and makes it actually a little bit less choppy in that sense. The deepest discount pressures tend to be on the larger projects, as there are fewer of those, yes, you get some incremental price pressure maybe in some middle size opportunities. But, nothing significant actually – we probably saw a little more price stabilization given to a little bit less of a big project mix actually.

So, no, we didn’t see any noticeable different trends in the quarter, but it’s a – it’s definitely a more challenged environment, it’s a more an even environment geographically, and there are fewer large opportunities, which helped us in the third quarter that was a nice benefit.

Kathryn Thompson

Okay. That’s helpful. Thank you. On the office, once again focusing on gross margin improvement, how much would you say that is leveraging volume growth versus the ongoing internal improvement – operating improvement initiative?

Andrew Cogan

Well, I look at – you look at volume and you think about pricing to realize that volume and really those are kind of offsetting from a margin perspective. So those, if you kind of think about them in the same way. So really the improvement you’re seeing is the CI dropping through, yes.

Kathryn Thompson

Okay, perfect. On coverings, I know it’s not a – as big of a portion of the business overall for you. But still, one of the things I want to get more help and better understanding as we look forward for that top line, maybe if you could, as we did in office, give the buckets for the greater drivers for a softer top line? And how that mix impacts margin performance.

Andrew Cogan

Margin performance across coverings is pretty even, there is not really any mix implication. It’s been the same trend we’ve been talking about, I think all year, which is weakness in aviation, weakness in some of the high end residential market has impacted businesses like Edelman to an extent. And KnollTextiles also just I think the more kind of anemic contract market. It hasn’t really helped KnollTextiles either. But the good news is both of those businesses are gaining to a point where I think the fourth quarter was not a great fourth quarter for them last year and I do believe they are stabilizing. I also believe the actions we’re taking to drive the top line, in the case of Edelman, we believe there are other products we can move through their showroom network.

We have begun doing that and some of those are in the rugs and other decorative leather areas and initial signs are showing positive traction there. On our KnollTextiles business, I am also seeing stabilization, I’m seeing a very strong new product pipeline, actions to improve our internal performance, our inventory levels and then our sales coverage and responsiveness. So, I see actions that are driving the positive – the lessening deceleration, and I do believe that they all kind of flatten out by the end of the year and hopefully, we can try and get some growth out of them next year.

Kathryn Thompson

Okay. Helpful. Just going back to steel, could you remind us of what percentage of cost that is sold is steel?

Andrew Cogan

We don’t break that out, but it’s certainly one of our larger commodities.

Kathryn Thompson

Okay, how much of just raw materials is – could you remind us how much raw materials is cost of goods sold?

Andrew Cogan

Well, we buy both raw steel, and we buy fabricated part. So, I think the raw steel is probably bigger than the fabricated part, but it’s a headwind. What’s the magnitude of it? It’s in the million, and the upper million, not the lower million.

Kathryn Thompson

Okay. Thank you very much.

Operator

Thank you. [Operator Instructions]

Andrew Cogan

Okay. Well, if there are no further questions, I want to thank Budd and Kathryn for their continued coverage of our stock in our space and I want to again, thank our teams internally, our dealer partners for the strong work they’ve done. And we look forward to chatting with you all at the beginning of 2017. So, thank you for your continued interest in Knoll. Have a good day, everyone.

Operator

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

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