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Executives

Bob Joyce - IR

Dan Hendrix - President CEO

Patrick Lynch - Senior VP, CFO

Analysts

Matt McCall - BB&T Capital Markets

John Baugh - Stifel Nicolaus

Keith Hughes - SunTrust Robinson Humphrey

Sam Darkatsh - Raymond James

Lance James - Voyager Asset Manager

Interface Inc. (IFSIA) Q1 2008 Earnings Call April 24, 2008 9:00 AM ET

Operator

Good day, ladies and gentlemen and welcome to the first quarter 2008 Interface Earnings Call. My name is Alicia and I will be your coordinator for today. At this time, all participants are in a listen-only mode. We will be facilitating a question and answer session toward the end of this conference. (Operator Instructions).

As a reminder, this conference is being recorded for replay purposes. I would now like to introduce your host for today's call, Mr. Bob Joyce with Financial Dynamics. Please proceed sir.

Bob Joyce

Thank you, operator. Good morning and welcome to Interface's conference call regarding first quarter 2008 results. Joining us from the company are Dan Hendrix, President and Chief Executive Officer and Patrick Lynch, Senior Vice President and Chief Financial Officer. Dan will review the highlights of the quarter, as well as Interface's business outlook. Patrick will then review the company's key performance metrics and the financial results. We will then have time for any questions.

If you have not received a copy of the results release, which was issued yesterday after the close of the market, please call FD at (212)850-5600 or you can get a copy off of the Investor Relations section of Interface's website. An archived version of this conference call will also be available through that site.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 risks and uncertainties discussed under the heading "Risk Factors" in item 1A of the company's most recent annual report on Form 10-K filed with the SEC. We direct all listeners to that document.

Any such forward-looking statements are made pursuant to the Safe Harbor Securities 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 replace undue reliance on any such forward-looking statements.

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

With these formalities out of the way, I would like turn the call over to Dan Hendrix. Please go ahead, Dan.

Dan Hendrix

Thank you, Bob and good morning to everyone. The first quarter was a good start to the year, as we continue to grow revenues, take market share despite operating in our seasonally slowest quarter. Our top line was driven by the strength of our modular carpet business, which grew 10% in the quarter primarily in Asia-Pacific and the Americas. We also increased our gross margin in the first quarter to 36% from 34% compared to a year ago. To improve leverage, we generated 56% increase in income from continuing operations compared to the same period last year. We continue to benefit from the secular shift to modular carpet which was a significant driver in our sales in both our modular and Bentley Prince Street businesses.

Also bolstering our performance was the ongoing execution of our segmentation strategy that provides us with sales opportunities in market segments such as hospitality, healthcare and education which has strong growth rates but different drivers and cycles than those of the traditional office market.

International sales in Asia-Pacific and in emerging markets also were significant contributors to our modular business. The corporate office market was softer in the first quarter particularly in Europe; however, through improve manufacturing efficiencies in operating leverage that we have created in our businesses, we were able to turn 10% sales increase in the modular business into a 15% increase in operating income. While Bentley Prince Street sales were relatively flat in the quarter, we are pleased with the continued growth of the modular component of this business which increased 20% in the quarter.

The start of the carpet tile backing line at Bentley Prince Street now complete, we're seeing improved manufacturing efficiencies which contribute to a 60% increase in operating income at the Bentley Prince Street business. We are also pleased with the progress we've made in our residential carpet tile business called FLOR, where Internet and catalog sales are growing nicely.

No doubt, we are now operating in a less certain economic environment, however, I believe Interface is well positioned to continue its strong performance throughout this cycle. I remain bullish about the potential for our business, and here are some reasons why we put them before. The sector shift from broadloom carpet to carpet tile is still at the early stage, it represents 90% of our business.

We are the clear leader in the modular market globally and we continue to take share both in the US and abroad. We have diversified the end-market segments we serve, having most of the success in the US, where about 55% of our sales are non-office, thus reducing our exposure to the office market.

We've diversified geographically as well, with about half our sales generated outside the United States. We're expanding manufacturing and distribution capabilities in the emerging markets such as China, India, the Middle East, which represent some of the fastest growing markets in the world for carpet tile. All the while, we focus on enhancing our financial strength, and today, Interface's balance sheet is as strong as it has been in years.

We still have a lot of headroom left in the increasing manufacturing efficiencies and reducing SG&A expenses to expand margins and build even greater leverage in our company. And then on top of all of that, Interface remains the first name when it comes to sustainability, which has moved from the margin to the main stream and our leadership position gives us enormous competitive advantages.

Overall, we're off to a nice start in 2008, and expect to grow our top line as we enter the seasonally stronger time of year. We are looking for robust sales in the education segment in the second quarter, which is the beginning of the buying season for schools and summer construction projects.

Our first quarter orders of $280 million outpaced shipments, pushing our backlog up 25% compared to the same period a year ago and orders continue to be solid in the first three weeks of the second quarter, up 13% versus a very strong comparison last year.

With that, I'll turn it over to Patrick.

Patrick Lynch

Thank you and good morning, everyone. I'll take a few minutes and outline some of the financial highlights from the quarter. Sales for the first quarter of 2008 were $261.7 million, an increase of 7.5% compared with $243.5 million in the first quarter a year ago. Please note that the 2007 first quarter included $2.2 million of sales related to our Pandel business that were not present in 2008 as this company was sold in March 2007.

As previously announced, the company also sold its fabric division in July 2007 and therefore, the financial statements for the first quarter 2008 and all other periods presented now reflect the fabric's division as discontinued operations.

Gross profit margin in the first quarter of 2008 was 36% compared with 34.2% in the first quarter of last year. With the improvement due to enhanced manufacturing efficiencies and higher sales levels.

SG&A expense in the first quarter of 2008 was $63.3 million or 24.2% of sales versus $57 million or 23.4% of sales a year ago.

Operating income in the first quarter increased 27.4% to $31 million compared with operating income of $24.3 million in the first quarter of 2007. As a percentage of sales, operating income increased to 11.8% from 10% in the first quarter of last year.

Interest and expense for the first quarter of 2008 was $7.8 million versus $9.1 million last year reflecting our debt reduction efforts. In the 2008 first quarter, income from continuing operations increased 55.7% to $14.1 million or $0.23 per diluted share, compared with income from continuing operations of $9.1 million or $0.15 per diluted share in the first quarter of 2007.

Net income for the first quarter 2008 was $14.1 million or $0.23 versus a net loss of $40.6 million or $0.66 per diluted share in the first quarter of 2007. Included in the first quarter of 2007, was a loss from discontinued operations of $49.7 million related to the US fabrics business.

Depreciation and amortization was $6.5 million in the first quarter of 2008 compared with 6.5 million a year ago as well. Capital expenditures in first quarter 2008 were $6 million versus $10.8 million in the 2007 first quarter.

Turning to the balance sheet at the end of the first quarter of '08, we have $59.3 million in cash, we have no borrowings outstanding under our domestic revolving facility, long-term debt at the end of the quarter was $310 million compared with $395.7 million at the end of the 2007 first quarter.

Now, I'll take a minute and review some of the details of our individual business segments. As Dan mentioned, we continue to see solid year-over-year growth in our modular business segment.

In the first quarter 2008, total segment sales grew 10.1% to $226.1 million from $205.2 million in the first quarter last year. Performance in this segment was especially strong in Asia and in emerging markets.

Operating income for the segment increased 15.3% to $30.9 million or 13.7% of sales from $26.8 million or 13.1% of sales in the first quarter last year.

At Bentley Prince Street, sales were slightly lower, down to 1.4% and $35.6 million from 36.1 million in the first quarter of last year. However, operating income increased 60% to $1.6 million compared with $1.0 million in the first quarter of 2007, primarily due to improved manufacturing efficiencies.

With that said, we will now open the call up for questions.

Questions-and-Answers Session

Operator

(Operator Instructions). The first question comes from the line of Matt McCall with BB&T Capital Markets. Please proceed.

Matt McCall - BB&T Capital Markets

Thank you, good morning everybody.

Dan Hendrix

Good morning.

Matt McCall - BB&T Capital Markets

Can you give us some kind of idea geographically, Patrick you mentioned that Asia was particularly strong, can you give us more color there in both what the trends were like this quarter, maybe how they trended throughout the quarter and then what the comps were by geography in Q1 of '07.

Dan Hendrix

Matt, we don't give all that kind of detail out, largely because of competitive reasons, but I can give you some color around it. Asia-Pacific was, it has been growing faster than the other two segments being the US and -- Americas and Europe. The slowest market was Europe, we're actually were down in local currencies in Europe, it did improve in the -- we had a very slow start in the first two weeks to the European business, it's like everybody has been on holiday.

It improved for 4 weeks, 5 weeks then it actually turned down again and the last four weeks has been pretty good. And when that happens, you have this sort of spotty, roller coaster ride that is going on and most of it is attributable to the office market actually in Europe. In the US, we continue to see close to 10% orders in that business and a lot of that actually is coming from the segmentation, now the office market was actually flat there.

Matt McCall - BB&T Capital Markets

And can you do the comps across the different geographies and across those end segments, what's the general trend, as we progress through '08?

Dan Hendrix

I would say that the comps pretty much were the same throughout the year last year; you had pretty much the same kind of growth in Asia, Europe and US last year. So, the comps get pretty tough in the US because of the seasonality of the education business, but I think we're going to be very good in the education business this year as well. So from a comp standpoint, Europe progressed during the year, improved during the year last year. And the US business was pretty consistent growth through the year, our year-over-year comparisons, if you go '06 to '07, in Asia, about the same way.

Matt McCall - BB&T Capital Markets

Okay, so it sounds like the high single digit trends that you saw in Q1 wouldn't be -- you wouldn't be that surprised to see that continue through the rest of the year.

Dan Hendrix

Well, I got visibility so far in the first quarter -- the second quarter looks that way.

Matt McCall - BB&T Capital Markets

Okay. I was surprised, well, I was not surprised, but you mentioned, Dan, the SG&A leverage, I guess what I was surprised about was the fact that SG&A moved up as a percent of sales despite the year-over-year increase. Can you give me an idea of what the outlook is there and I guess, first, can you give me an idea what the year-over-year impact was and Patrick, what the items were that pressure that year-over-year?

Patrick Lynch

Actually some of that is currency, you are getting the benefit on the top line and you are getting the negative benefit, I guess on the SG&A when you translate it from Euros to dollars. I would say that if you back and look at historically, the first quarter percentage SG&A is a little higher than the rest of the quarter because the sales obviously are better in the second, third and fourth quarter, so you get the benefit of the expansion in SG&A going down as you have increased sales. But I'd say we continue to invest in product development and we are continuing to invest in segmentation.

Dan Hendrix

Some of the marketing costs are front-end loaded, as the budgets were built for '08 and dollars allocated, they tend to be a little lumpier and they come down throughout the second half of the year. The marketing was probably the biggest contributor in the first quarter. And I think last year as well, the first quarter SG&A as a percentage of sales were at its highest and then trended down to the remainder of the year and we expect to see that through the remainder of '08.

Matt McCall - BB&T Capital Markets

Okay, and so from a percent of sales perspective, nothing really surprised you in the quarter.

Dan Hendrix

Well, I love the fact that we were able to increase our gross margins in this environment.

Matt McCall - BB&T Capital Markets

And then, Dan you mentioned SG&A leverage as an opportunity other than just a seasonal trend that Patrick spoke about, is there --

Dan Hendrix

I think we're going to hold the line on the SG&A.

Matt McCall - BB&T Capital Markets

Okay.

Dan Hendrix

And I think we're going to see some leverage come out of the growth that we're going to get with the top line.

Matt McCall - BB&T Capital Markets

Okay, okay, thank you all.

Dan Hendrix

Thank you.

Operator

The next question comes from the line of John Baugh with Stifel Nicolaus, please proceed.

John Baugh - Stifel Nicolaus

Good morning. Can you quantify the FX impact both on revs and EBIT for the quarter?

Patrick Lynch

About $5 million in sales and probably about $1 million in EBIT.

John Baugh - Stifel Nicolaus

Okay, and any material changes year-over-year in the quarter in either cost of raw materials or your price per unit, how is that delta?

Dan Hendrix

I'd say our price per unit is up slightly; we had about 3% price increase in January. So I would say that we're up a little bit in price. And we had raw material price increase as well, but the benefit we're getting is we finally got the Australian plant contributing and we're still running it 24/7 and we've been able to manage through that and the Thailand plant is now running well and Bentley Prince Street is improving, so we're seeing the improvement of some manufacturing efficiencies where we struggled with that throughout last year.

John Baugh - Stifel Nicolaus

Good, on the US residential FLOR is that -- where is that Dan, in the growth cycle, in the investing, willing to take an EBIT loss, breakeven -- what's your thinking on that.

Dan Hendrix

We're still growing the online catalog business at 30% plus, I don't see that actually slowing down any time soon, so we're going to continue to invest in that and we may pull back on some of the other marketing side there. My idea is that we'll start looking at breakeven probably in the latter part of this year.

John Baugh - Stifel Nicolaus

Okay.

Dan Hendrix

But I still love the catalog business and I love what we're doing with FLOR and I think it's going to be a contributor to our profitability. And I don't see why we wouldn't continue investing in that part of the business.

John Baugh - Stifel Nicolaus

And is there any update on the back and forth on patent infringements, entropy amongst your competitors...

Dan Hendrix

That's still -- we're actually out of discovery now and so we're in the course now.

John Baugh - Stifel Nicolaus

Okay. And help me with the core European, in other words, not the Eastern Europe and Middle East. Update me on where you are at segmentation, what with office weakening there, where that market may go this year and how well positioned you are to maybe sell into some of these other markets this year given the office weakness?

Dan Hendrix

I would say that if you looked at the European business, you got the UK and France really and Holland are the weakest markets we have there from an office standpoint. The segmentation there is about 35/65 overall, but their exposure to that European business is probably about 45% in the, I call it, Western Europe markets.

Our segmentation, we're growing that to 20% in Europe, it's just a lesser mix than the US, the US were 45 office and 55 non-office and Europe's almost the reverse of that. So, you know, I think the office market is going to continue to be under pressure in the UK and France and Holland and we're going to have to run real fast in Eastern Europe and the Middle East and segmentation to offset that. So, my hope is that we can keep Europe somewhat flat this year.

John Baugh - Stifel Nicolaus

Okay, and then lastly, on the expansions; Australia, China, and India, help me with the CapEx numbers, the timing of the spending, and then the possible timing of any incremental start-up cost as we go forward.

Dan Hendrix

I would say that the -- I need to be careful here, I don't want to give our competitor the whole roadmap of us, but we are going to build a plant in China over the next 12 months. The start-up of that plant will not happen until '09, so you're not going to really see any issues around starting up a plant. The Australian, we're going to continue to expand our footprint and we should have that pretty well, hopefully done by the third quarter.

The total CapEx in Asia-Pacific, we are going to probably delay some of the China plants so, I think the total CapEx there will be probably closer to $20 million throughout the year. So you shouldn't see any issues around Australia and you won't see any issues in China until '09.

John Baugh - Stifel Nicolaus

Okay, so that $20 million includes Australia and I think it wasn't a $20, roughly for just China alone, so somehow China goes into '09 now?

Dan Hendrix

Yeah, right, right.

John Baugh - Stifel Nicolaus

Okay, and that would bring total CapEx for '08 for approximately where, and any guess on where '09 might pan out?

Dan Hendrix

I would say you're probably looking 40-45 in '08 and you're probably looking at probably 40 in '09.

John Baugh - Stifel Nicolaus

Great, thanks for that detail. Good luck.

Operator

The next question comes from the line of Keith Hughes with SunTrust, please proceed.

Keith Hughes - SunTrust Robinson Humphrey

Thank you. As we head into the second half of the year which is historically the cash flow rich period for you guys, are you still looking to just pay down debt by purchasing bonds in the open market or what will be the plans for cash?

Dan Hendrix

Keith, I would say that we're going to look at purchasing bonds in the open market, or putting cash on our balance sheet and being selective when we do that.

Keith Hughes - SunTrust Robinson Humphrey

The next dead issue is not due until 2010, is that correct? Is there a -- has it got a sliding scale, if you were to call those bonds back in?

Dan Hendrix

Yeah, there would be, I mean as you get closer to maturity theoretically, it would get cheaper, yeah.

Keith Hughes - SunTrust Robinson Humphrey

Okay, and on raw material side, what's your outlook in the next couple of months on Nylon prices?

Dan Hendrix

We're hearing some noise about it, hadn't got it yet, but we're hearing noise about it.

Keith Hughes - SunTrust Robinson Humphrey

What about the other materials you use, have they been moving up as of late?

Dan Hendrix

A little bit, yeah, the backing has been moving up a little bit.

Keith Hughes - SunTrust Robinson Humphrey

All right, thank you.

Operator

(Operator Instructions). And the next question comes from the line of Sam Darkatsh with Raymond James, please proceed.

Sam Darkatsh - Raymond James

Good morning, Dan, good morning, Patrick.

Dan Hendrix

Hey Sam.

Sam Darkatsh - Raymond James

I signed on a little bit late, so I apologize if you have already covered this. Outside of Europe, with the sales progression in Q1 and into April similar in the US also and that January was softer and than February and March and April picked up, or was that just Europe that you were referring to?

Dan Hendrix

That's pretty much the US as well.

Sam Darkatsh - Raymond James

US as well. How would you explain that? I mean that seems to be a curious cadence to the quarter particularly based on the fact that what we're seeing on a macro sense that things are gradually slowing, as the quarter progresses; how would you explain that disconnect?

Dan Hendrix

I think part of it is the segmentation, Sam. I would say that the education business, we're going to have a very good second quarter and going to third quarter with the education business. And I think we're gaining momentum in hospitality and healthcare, so I think from our standpoint, there's a different seasonality to it versus the office market. And that's the only way I can explain it to you. The office market clearly is slower than it was a year ago.

Sam Darkatsh - Raymond James

But in Q1, education doesn't mean that much to you though, in Q1 seasonally?

Dan Hendrix

It's not a lot, but I thought you said in the April, so it --

Sam Darkatsh - Raymond James

Yeah, I'm just trying to get a sense of how the quarter progressed, and then into April, because it sounds like February and March were much better.

Dan Hendrix

They were.

Sam Darkatsh - Raymond James

And I'm trying to get a sense of it, is it just --

Dan Hendrix

That's typically how our business works, Sam, January comes every year, so we say and then February and March, we fill the orders. Now that's been our pattern.

Sam Darkatsh - Raymond James

Right, I follow that, but you're still looking on a year-on-year change, so your January would be comparing against January of last year, so that should take into effect the seasonality. That's why I'm just trying to get a sense of what happened as the quarter progressed. I can take that offline, that's okay.

Second question, Bentley Prince Street profits were better at least than what I was looking for and perhaps with better than what you were looking for as well. Is that trajectory now in tact? And the second question to that would be if you back out the modular piece of BPS, are you profitable in broadloom or all the profits coming from modular?

Dan Hendrix

That's kind of hard to look at that way because it is integrated plant, then you got share, you've got obviously shared manufacturing and allocation so it's very difficult to try and break out a product line that is integrated in that plant. I would say that the margins on modular are better than broadloom and the broadloom business pretty much track the industry, the commercial industry, it was down about 5%.

Sam Darkatsh - Raymond James

Would you suspect though that you're now on track to maintain and grow the profitability in BPS?

Dan Hendrix

Yes, that's obviously been what we have been telling the Street for a while, and yes, backing line --

Sam Darkatsh - Raymond James

Last question --

Dan Hendrix

The backing line is up and running, we should get the benefit of that and the modular piece is growing.

Sam Darkatsh - Raymond James

I believe, Patrick, you had said that your free cash flow expectation for the year was, if I recall around $35 million or so, does that still hold?

Dan Hendrix

Yeah.

Sam Darkatsh - Raymond James

Okay. And CapEx roughly $45 million to $50 million or so?

Dan Hendrix

$45, yes.

Sam Darkatsh - Raymond James

Okay. All right, thank you very much gentlemen.

Dan Hendrix

Thank you.

Operator

The next question comes from the line of Lance James with Voyager Asset Manager. Please proceed.

Lance James - Voyager Asset Manager

Hi, as always, terrific job this quarter, a quick question. Gross margin obviously expanded in the quarter, I'm just trying to get a feel for what the impact of the higher raw material costs are and whether if we get some moderations in oil or other commodities that there's, just how sensitive your gross margins are to that, whether there is further room down the line if we get some moderation?

Dan Hendrix

I would say Lance that historically, we raised prices when raw material price increases and we pass it along and that's been what we've done since I've been here for 25 years. When the oil prices go down, there's probably some opportunity particularly in the backing materials to lower prices. I would say on the yarn side, you rarely see them coming down on price but they could if it came down a lot. It's really tied to capital (inaudible)

Lance James - Voyager Asset Manager

Okay. Great, thanks.

Dan Hendrix

Thanks.

Operator

(Operator Instructions). At this time, we have no additional questions in the queue. I'd like to go ahead and turn the call back over to management for closing remarks.

Dan Hendrix

Thank you everyone for listening to the call and hope to report a great second quarter. Thank you.

Operator

Ladies and gentlemen, thank you for joining today's conference, this concludes your presentation and you may now disconnect. Good day.

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