Kimball International's (KBAL) CEO Robert Schneider on Q2 2017 Results - Earnings Call Transcript

| About: Kimball International, (KBAL)

Kimball International, Inc. (NASDAQ:KBAL)

Q2 2017 Results Earnings Conference Call

February 02, 2017, 11:00 AM ET

Executives

Robert Schneider - Chairman and CEO

Michelle Schroeder - VP and CFO

Analysts

Steven Ramsey - Thompson Research

Paul Sonkin - Gabelli

Operator

Good morning, ladies and gentlemen. My name is Michelle and I'll be your conference call facilitator today. At this time, I would like to welcome everyone to the Kimball International Second Quarter Fiscal Year 2017 Financial Results Conference Call. All lines have been placed on listen-only mode to prevent any background noise. After the Kimball's speakers opening remarks, there will be a question-and-answer period where Kimball will respond to questions from analysts and investors. [Operator Instructions]

As with prior conference calls, today's call February 2, 2017, will be recorded and may contain forward-looking statements as defined under the Private Securities Litigation Reform Act of 1995. Actual results could differ materially from the forward-looking statements. Risk factors that may influence the outcome of forward-looking statements can be seen in the Kimball International Form 10-K and today's release.

The panel for today's call is Bob Schneider, Chairman and CEO of Kimball International; and Michelle Schroeder, Vice President and Chief Financial Officer of Kimball International.

I would now like to turn the call over to Bob Schneider. Mr. Schneider, you may begin.

Robert Schneider

Thank you Michelle, and welcome everyone to our second quarter earnings conference call. The financial results for our second quarter ended December 31, 2016, were released yesterday afternoon. As in prior calls, an investor presentation slide deck has also been posted to the Investor Relations section of our website to accompany this conference call. The slide deck includes trending of - what we believe are very key metrics.

To help all of you with better clarity, as we did during the last call, we've gone back through our notes from prior investor discussions and have incorporated thoughts around the key questions from those calls into our prepared remarks for today. I will start with a few brief comments before I turn the call over to Michelle who will provide us with the key financial highlights for the quarter. We will then open the call up to questions from analysts and investors.

In summary thinking about the quarter, we continue our trend of year-over-year improvement in the second quarter with sales increasing 4% and net income increasing 34%. Excluding the restructuring charges in the prior-year, our second quarter net income increased a healthy 13%.

Now I’ll touch on a few of the key highlights for the quarter ending December 31. Regarding sales, the 4% increase in sales in the second quarter was led by strength in our hospitality and healthcare vertical markets. Our hospitality vertical sales were up 9%, growth in this market has slowed a bit from a year ago but the market continues to be strong with a lot of refurbishment and new hotel construction activity. And I have mentioned that healthcare also drove our sales this quarter, it was up a strong 15%.

Moving to office furniture, when comparing to office furniture industry data from Beth MA, we have to strip out the hospitality vertical to get a better comparison. Our sales excluding hospitality increased 2% in the second quarter. The industry also grew at an average rate of approximately 2% for the three months ending December as reported by Beth MA. The slowness of the industry we believe was in part driven election uncertainties which appear to impact day-to-day business.

Moving now to orders; overall orders for the second quarter declined 1% compared to last year. Our office furniture orders during the second quarter which excludes hospitality for better comparisons of Beth MA were flat compared to last year. It is a tough comparison to last year where our office furniture orders were up a strong 13% in last year's second quarter.

The average for the three-months ending December for the industry as reported by Beth MA was a decline of approximately 2%. So our orders being flat for the second quarter was a little better than the industry. That represents eight consecutive quarters of orders beating the industry, a key metric our team is very proud of.

Going deeper into our office furniture orders, our project based business is doing well. We saw a nice increase in project orders for office furniture during the quarter. However we have seen a slowdown in our day-to-day orders, similar to what we've recently heard from others in the industry. We believe customers are being somewhat cautious as everyone is trying to grab the impact that the policies of the new administration will have on business and how quickly they will be able to enact changes. Encouragingly our orders started out slower in the quarter but improved late November and December and in January orders were up nicely over last year.

Moving to hospitality, orders list verticals declined 5% compared to the second quarter last year. As we've noted before, the project nature of the hospitality vertical causes significant swings in both orders and sales from quarter-to-quarter. As an example, we finished the first quarter of this fiscal year with orders up 24% in this vertical and then down 5% in Q2. Project based variability is the nature of this vertical.

On a year-to-date basis, orders were up 9% in the hospitality vertical. Our return on capital was a very healthy 21% for the second quarter. I want to highlight, make it clear that this concludes our cash and short-term investment balance of $72.3 million, as part of capital which we realize puts a drag on our return on capital.

Even with that underperforming capital, we are very pleased with an overall return on capital of 21% which is among the best in the office furniture industry. Relative to our public company competitors, it is the best. Our new products continue to perform well and gain recognition among designers and end-users.

KORE, that's spelled K-O-R-E which is one of our new open plan lines within our Kimball office brand was named a 2016 good design award winner by the Chicago Athenaeum Museum of Architecture and Design as one of the most innovative and cutting-edge product designs produced around the world. KORE was also named a winner of the EDspaces Innovation Award in the furniture category which recognizes excellence in product design for learning environments.

And Farrah Seating which is one of our new lounge seating lines within the National Office furniture brand recently won the Interiors and Sources Magazine Reader's Choice Award in the best furniture category. So very proud of the new products that we're bringing to market.

Looking forward as we move into the second half of our fiscal year 2017, we are seeing some positive signs in the economy as the labor market is healthy, nonresidential construction activity is up, and business confidence has improved significantly. The architectural billings index for December reached the highest level since 2007 and CEO confidence is the highest in several years.

However, auto levels in our markets have been choppy recently and that volatility could continue in the near-term as company's contemplate capital spending levels in light of potential changes under the new administration.

As I mentioned last quarter, we are exploring opportunities to invest for future growth including potential acquisitions. With the exit of our Idaho facility complete, we can now focus all of our resources on growth.

As we noted in the earnings release, our second quarter was the first with zero restructuring expenses since the date of the spinoff of electronics. The exiting and relocating of our of our facility of our Idaho facility to Indiana, the last couple years was probably the most complicated and time consuming restructuring we never undertaken. It's nice to have that behind us so we can now direct all of our attention and resources to grow. We have a very strong balance sheet and sufficient capital available to fund that future growth.

Now I will turn it over to Michelle for a brief overview of the financial results before we open the call to your questions. Michelle?

Michelle Schroeder

Thanks Bob.

Our second quarter sales ended at $169.9 million which was a 4% increase over last year and this was the 14th consecutive quarter we recorded year-over-year sales growth and that's something that we're really proud of. Our healthcare vertical market sales increased 15% in the second quarter. I've mentioned in prior calls how we've increased our marketing efforts, enhanced our product portfolio, and really put a heavy focus on this vertical market and it is paying off.

Sales to the hospitality vertical market increased 9% in the second quarter with that growth coming from our program business. RevPAR which is revenue per available room is a leading indicator for the hospitality industry and that is forecasted to grow 2.3% in calendar year 2017. Forecasted growth in RevPAR is slowing and that's in part due to the forecasted acceleration of supply growth outpacing demand. So growth in supply is good for hospitality business so while growth is slowing the market still remain strong.

Sales to the education vertical market also increased in the second quarter by 4%. Our government and commercial market sales were flat while the finance vertical markets declined. Sales from new office furniture products introduced in the last three years increased 21% compared to the second quarter of last year and that was about 27% of our total second quarter office furniture sales. So our new products continue to drive our sales growth.

Moving to the orders for the quarter. Overall our orders declined 1% in the second quarter and as Bob mentioned we did see a slowdown in our day-to-day orders. We are watching this activity closely. By vertical markets orders in the commercial and government vertical markets increased while order in healthcare, hospitality, education and finance declined. The decline in the healthcare and education markets was due to some large projects in the second quarter last year plus we really had a tough comparison to prior year in the healthcare vertical when orders were up significantly last year.

Activity level remains high in the healthcare market. The consolidated open order backlog at December 31 was $122.2 million. This is a decline of 2% compared to December of last year but as Bob mentioned our officer furniture orders received during the prior year second quarter increased 3%, so again making the order backlog a tough comparison to last year as well.

Also to a lesser extent, the normal variation of hospitality furniture orders resulting from the project nature of that business impacted the comparison. As I move to operating income results, my comments reflect operating income excluding restructuring cost in the prior year. This is a non-GAAP disclosure and as reconciled in our investors slide deck.

Operating income excluding restructuring in the second quarter was $13 million which was $1 million or 8% higher than last year. The higher sales level in price realization contributed to the improvement and we also benefited from the savings realized as the result of the exit of our Idaho facility earlier this year.

Now partially offsetting these improvements were higher costs for marketing and other initiatives focused on growth, as well as higher employee benefit cost. One question we've received a lot recently as have you seen an increase in steel prices. We did see an increase in the second quarter compared to last year but we were able to offset the increase with other commodity savings. We are starting to see pricing pressure from some of our suppliers but as we said in the press release with the restructuring activity behind us, one of our focus areas is on continuous improvement initiative to help offset those commodity increases.

The effective tax rate for the second quarter was 33.2% compared to 36.6% in the prior year. Our rate was a little lower than normal this quarter due to an adjustment with our estimated domestic manufacturing tax deduction. We estimate our annual effective tax rate will be around 36% for fiscal year 2017. Net income excluding restructuring cost was $8.7 million for the second quarter compared to $7.7 million in the prior year.

Now moving to the balance sheet as of December 31, our cash, cash equivalents and short-term investments totaled $72.3 million. That was an increase of $9.6 million during the quarter. We had strong operating cash flow in the second quarter of $19.1 million compared to $8.9 million in the second quarter of last year. We returned $6.1 million to our shareholders during the second quarter through dividends of $2.3 million and share repurchases of $3.8 million.

And we regularly receive questions about our share repurchase plan. So we currently have approximately 1.8 million shares remaining under our Board approved share repurchase authorization. We announced back in September our plans to repurchase shares of up to $25 million over a 12 to 14 month period when market conditions are favorable. So we continue to monitor and will repurchase shares opportunistically.

Our capital expenditures totaled $3.5 million for the quarter. We get questions often regarding our planned capital expenditures. We expect our CapEx to be higher in the second half of the fiscal year. Year-to-date our capital spend is $5.9 million and we estimate approximately $13 million of spend in the remainder of the year bringing our estimated total capital spend for fiscal year 2017 to approximately $19 million.

The higher run rate in the second half of the year is in part driven by upgrading certain equipment, renovations to our headquarters to better reflect the new layout and design of offices today, some showroom renovations, and the replacement of tractors and trailers for our logistics operation. We have almost no long-term debt which stood at 216,000 at December 31. We have a $30 million credit facility and are in compliance with our covenants. Our balance sheet remains strong.

So with that, I'd like to open up the call to questions. Michelle do we have any questions.

Question-and-Answer Session

Operator

[Operator Instructions] Our first question comes from Catherine Thompson of Thompson Research. Your line is open.

Steven Ramsey

Good morning guys. This is Steven Ramsey on for Catherine. Got a couple of questions here thinking about older products versus newer products. I was trying to back into sales for products that would not be considered new and thinking about office furniture and if I'm calculating it correct, it looks like the older product sales were down in the low to mid single digits am I looking at that right and...

Robert Schneider

That is correct Steven, and when thinking about that - recognize the significant change in our industry last roughly three, four, five years in the types of products that are being purchased and so it frankly makes sense and it is not surprising that these older products would be down and the new products would be really taking off because the industry is not static last five years, it's been a monumental change in the types of products that customers want to buy.

Steven Ramsey

Very interesting. And then I guess thinking further about that. Do you guys have a medium or long term goal of new products as a percentage of sales for office furniture and do you think that acquisitions are a key part in getting to higher levels of new product sales?

Robert Schneider

Yes. Our new product sales as a percent, the mix was 27% Michelle, 20% of our sales from new products, our goal is generally net low to mid 20s and I think most of our competitors, I think we're actually a little bit higher than they are in terms of our actual percentage of new product sales in terms of that mix but anyways we are already actually higher than we think long-term that we would be in this metric.

Steven Ramsey

And our margins for these newer products, are they comparable or superior to older products?

Robert Schneider

Lot of them are better Steven, I would say probably the majority of them are better.

Steven Ramsey

Excellent. And then thinking about just cost on a growth - cost to sales line and SG&A line, how much of those would you say, how much is variable and then thinking about SG&A do you expect SG&A to stay in that low $40 million level going forward.

Robert Schneider

The aspect of variable, if you're trying to get the contribution margin, generally speaking our leverage on sales is 25% to 35% which is pretty strong. As you think about SG&A it moves with our sales because of commissions and other types of marketing costs as our sales are going up. So when you look at the dollar amount of the SG&A we expect the dollar amount to go up. You saw this quarter as a percent of sales we were actually down slightly which I'd like to see as we go forward and grow but the dollars were drop and that will happen because of commissions and things like that.

Michelle Schroeder

And incentives as well and profit goes up, those costs go up.

Robert Schneider

Yes.

Steven Ramsey

Excellent. And then last question, how much cash do you guys feel that you need to keep around to retain optionality for the buyback down the road in potential acquisitions.

Robert Schneider

Our targeted cash is around 20 million or so Michelle if I remember correctly. We're obviously way, way higher than that and we also have to factor into that our credit facility which gives us a lot of liquidity for fluctuations and cash needs.

So, if you look at our capital structure today Steven, we have absolutely no challenge sort to speak to be able to fund the buyback that we have remaining. And with the excess capital we have, plus borrowing ability we have a lot of capital to fund, the fund growth through acquisition.

Steven Ramsey

Excellent. Thank you.

Operator

[Operator Instructions] Our next question comes from Paul Sonkin of Gabelli. Your line is open.

Paul Sonkin

Good morning. I guess, I didn't notice this before but when you calculate return on invested capital you should remove excess cash. Of course you're not showing the true economics of the business and I don't believe that your peers are similarly capitalized.

Robert Schneider

All as we did that, we would significantly go pass all of our peers on return on capital. And we frankly included that cash in the calculation to avoid the [indiscernible] you have this capital and you need to get a return on it. So it puts a little bit more pressure on us to deploy that capital and get a much better return than what we own it presently but I totally understand your point but we give it to be extremely conservative and even doing so we still are tops in the industry.

Paul Sonkin

Yes, I guess two comments well then, on is I don't think it's conservative I think it's not a relevant figure. And then the other thing is, since when is pressure bad thing and then the other thing is that you need to come up with good answers as to why you're not deploying that capital which again I'm happy to help you with. So it seems as though your return on invested capital would be close to 31%...

Michelle Schroeder

It would be in the 30s.

Paul Sonkin

Yes, if you assume that you needed a little bit of cash to run the business, now the question that I have is that in terms of acquisitions, can you - are there any acquisitions that are generating that kind of return and if they are generating that kind of return, people are going to want a pretty high valuation so, can you just talk a little bit about your acquisition criteria in regards to that.

Robert Schneider

We would look very, very closely Paul at the return on an acquisition relative to the cost of capital. Clearly our return on capital is extremely strong and I think exception with your comment earlier in terms of it not being conservative to approach it the way we did in terms of the disclosure because I would not want to imply to some investors who may look at 31%, 32% return on capital and maybe be mislead to think that's our total capital deployed.

Paul Sonkin

Well that's a footnotes for…

Robert Schneider

And so that's why we listed that way and make it clear that that's what we - how we computed it. But clearly when we look at acquisitions to find companies that have that type of return on capital it would be very, very difficult to find companies like that and if you did the premium being paid for them would be absolutely huge and it would be tough to sustain that return on capital. So totally aware of that and a part of our thinking.

Paul Sonkin

Okay. So if you say that you're looking for acquisitions which [evil] [ph] do you look at? Do you buy something with a subpar return on invested capital with the intent of getting it up to your return on invested capital over time or do you overpay?

Robert Schneider

Certainly don't want to over pay but whatever the specifics are on that target company, we look very, very closely on where can we get some synergies that the marriage of that company and ours can drive value that exceeds our cost to capital.

Paul Sonkin

Well, if you - even if your cost of capital is like 10% or 12%, it will probably be fairly easy to find something that is above that hurdle rate but it would be dilutive in terms of overall bid business.

Robert Schneider

I'm not sure it would be easier to find that in this environment Paul because of valuations on companies today. I wish it was that easy but it...

Paul Sonkin

Yes, so then the question becomes as like how hard are you looking for acquisitions then?

Robert Schneider

We are looking very hard as we are also on organically growing our company.

Paul Sonkin

Okay. Because actually the answer I probably to [indiscernible] that you're not looking hard at acquisitions given…

Robert Schneider

We like to turn over all stones Paul and see what's under and hopefully we will find - that's a great marriage.

Paul Sonkin

Yes. The other thing is, on the last conference call you mentioned that you felt that the market was discounting a recession and I just wanted to get kind of a little bit of how you feel about that now?

Robert Schneider

I think we had some major domestic and world events since our last conference call that dramatically changed the optimism in the U.S., CEO confidence being as high as this, I mentioned earlier, lot of the metrics looking very positive. And as I look at the coming year, the coming couple of years, I think there is a lot of things pointing in the direction of growth and this country that is going to expand GDP much beyond I hope and believe - I think it was 1.9% in the fourth quarter and I'm not sure if we've gone over 2% for the last -I don’t know how many years, so I'm much more bullish Paul now than I was at the last call.

Paul Sonkin

Okay. And then in terms of the health of the hospitality market like can you just give us a little bit more definitive into that?

Robert Schneider

RevPAR for 2016 was up 3.2%. The estimates of the industry going into 2017 is still growth but slower. The latest estimate for 2017 is 2.3% of growth, I'm hopeful that this market still has significant steam left in it and I think with what's happening in terms of CEO confidence et cetera in this country that there is still many innings left of the expansion in the hospitality cycle.

So time will tell but we are very, very active with customers with projects and it is very, very busy right now. So I just think what is transpired with the election has ended so many things in terms of trends and thinking in this country that it's hard to get a sense of just when that growth is going to start and how expensive it might be.

And we are watching it very, very closely but the indications we are getting from customers is very, very positive.

Paul Sonkin

Got you. Well for us hope is a four letter word but have the RevPAR estimates proven to be accurate and is the 2.3% estimate was that made after the election?

Robert Schneider

It’s the latest PWC report and it was after the election.

Q - Paul Sonkin

Okay. And has that proven to be accurate in the past.

Robert Schneider

Generally so.

Paul Sonkin

Okay, okay. All right, well thank you very much. I appreciate it.

Operator

[Operator Instructions] I'm showing no further questions. I'd like to turn the call back over to Bob Schneider for any closing remarks.

Robert Schneider

Thank you Michelle, and thanks everyone. In closing, we are very pleased with our solid performance in the second quarter given the market challenges and are looking forward to continued improvement in growth. Thanks everyone for your interest in Kimball International and have a great day.

Operator

At this time listeners may simply hang up to disconnect from the call. Thank you and have a nice day.

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