Flexsteel Industries Inc (FLXS) 2019 Q3 法說會逐字稿

Good morning, and welcome to the Flexsteel Industries Third Quarter 2019 Earnings Conference Call. (Operator Instructions) Please also note, this event is being recorded.

I would now like to turn the conference call over to Ms. Donni Case, Investor Relations for Flexsteel Industries. Ms. Case, the floor is yours, ma'am.

Thank you, Mike, and welcome to today's call to discuss Flexsteel Industries Third Quarter 2019 Financial Results. Our earnings release, which we issued after market close yesterday, Monday, April 29, is available on the Investor Relations section of our website, www.flexsteel.com, under News & Events.

I'm here today with Jerry Dittmer, Chief Executive Officer; and Marcus Hamilton, Chief Financial Officer.

On today's call, management will provide prepared remarks, and then we will open the call to your questions. Before we begin, I would like to remind you that the comments on today's call will include forward-looking statements, which can be identified by the use of words such as estimate, anticipate, expect and similar phrases. Forward-looking statements by their nature involve estimates, projections, goals, forecast and assumptions and are subject to risk and uncertainties that could cause actual results or outcomes to differ materially from those expected in the forward-looking statements. Such risks and uncertainties include but are not limited to those that are described in our most recent annual report on Form 10-K as updated by our subsequent quarterly reports on Form 10-Q and other SEC filings as applicable. These forward-looking statements speak only as of the date of this conference call and should not be relied upon as prediction of future events.

Additionally, management may refer to non-GAAP measures, which are intended to supplement but not substitute for the most directly comparable GAAP measures. The press release available on the website contains the financial and other quantitative information to be discussed today as well as a reconciliation of the GAAP to non-GAAP measures.

And with that, I'd like turn the call over to Jerry Dittmer. Jerry?

Thank you for joining us today. As you all know, this is the first conference call that we have held in memorable history. First, we recognize that the third quarter results we reported today are not acceptable. We also don't think they reflect Flexsteel's potential once we tackle the operational issues that have distracted us from delivering the outstanding customer experience that is the hallmark of the Flexsteel brand.

Marcus will cover all the puts and takes of our financial performance in his remarks. For now, we want to focus on the top priorities of our management team and Board of Directors. Our first priority is improving the customer experience, which is a key competitive advantage in the pathway to value creation and growth. Second, by executing on our customer promise, we will become a stronger company capable of generating new levels of profitability. And finally, we are committed to a new era of transparent communications with our investors.

At the beginning of the year, I took over the role of CEO with my eyes wide open. I knew that the company had some challenges which contributed to its recent underperformance. And since I've been in the furniture industry for a large part of my career, I was familiar with the headwinds all manufacturers are facing today, such as tariff and raw material and labor inflation. I've spent the first 90 days since joining Flexsteel evaluating everything, the operations, different business lines, facilities and people. Our approach has been to look at Flexsteel with an open mind and with the viewpoint of future growth opportunities.

Concurrently, Marcus and I have visited our operations and met with key folks. We have a good team, many of whom have been with Flexsteel many years and they want Flexsteel to be around another 125 years. We have also had insightful conversations with many of our stakeholders who can see the value embedded in our company.

Thanks to the open collaboration of our entire team, we have learned a lot in a short period of time. First, I was able to validate some of the positives that drew me to Flexsteel. It has a 125-year-old legacy of being a strong competitor in the furniture industry with a high-touch, customer-centric business approach. We have great products. The patented Blue Spring is known for offering superior quality and comfort. We have a large and diversified customer base, a reputation for working together to achieve mutual success. We are innovative and adaptable to generational lifestyle changes, and we have a rock-solid balance sheet with a long history of rewarding shareholders through 309 consecutive quarters of divided payouts, which we plan to continue. In a nutshell, Flexsteel has all the elements for success if we execute, and execution is our #1 priority.

As we look to the challenges we face, the roughly $100 million that has been invested over the last 5 years have yielded very anemic returns. Part of our path forward would be to unwind some of those investments. We have identified areas that need to be addressed in the near term to make Flexsteel a stronger and more competitive company. The obvious first step is to tackle our unsuccessful ERP implementation that caused immense business distraction and resulted in losing some valuable customers, especially in the e-commerce channel. This is a very specific issue and one that we are already addressing. The second step is rightsizing our cost structure. We need to vigorously evaluate costs to identify efficiencies across all our businesses. The third step is evaluating our processes and operating discipline as well as level setting our key performance indicators for improved performance. Fourth, we must optimize our physical assets, both our manufacturing plants and distribution centers. And finally, we need to make sure we have the right talent in place to execute as we set our plan and strategy.

A big part of that strategy will be to hold ourselves to a higher standard on investment choices and execution accountability to drive value creation and enhanced ROI for our shareholders. It's a tall order, and I know from the past experiences that these issues cannot be resolved in the quickest-possible way with outside -- without outside resources. Therefore, we have engaged AlixPartners who have a long and proven track record of helping companies accelerate improvement efforts to drive growth and profitability. With their industry expertise and extensive data analytic capabilities, we have already started to push ahead on all these fronts. Our mutual goal is to optimize cost and strengthen our key business processes.

We understand that many investors have been very patient with Flexsteel, and we have to ask for a little more patience so that we can sort through our key initiatives with discipline and purpose. Right now, we can share some early steps from our collaboration with AlixPartners.

Over the past 30 days, we have jointly completed a thorough diagnostic on key areas of opportunity and formulated into 6 work streams that address global sourcing and procurement, network and logistics optimization, customer and product profitability, sales and operations planning, 4-walls operations' cost and productivity and SG&A optimization. We have now entered into a heavy planning and sequencing phase, of which Marcus and I are directly involved in the independent oversight and execution of each work stream. Although it's too early to announce any specific details to the marketplace, we have moved a couple of initiatives from planning to execution and expect more to follow shortly.

As we move through this process, nothing is sacred. We're looking front to back to achieve the growth and profitability that we are capable of delivering. We are reinventing ourselves, challenging our status quo and preparing a strong foundation to create and deliver value to all our shareholders for the next 125 years. When our planning process is complete and we've fully entered the execution phase, we are committed to keeping you informed on our progress as well as providing you with metrics and time lines to track our progress. When appropriate, even if ahead of our quarterly release cycle, we will announce relevant news to keep you informed and up to date on our progress.

Now I will turn the call over to Marcus to discuss our financials and operations and some early stage financial implications of our plan overall. Marcus?

Thank you, Jerry. And thanks to everyone for joining us on our first earnings call. As Jerry indicated, we are not satisfied with the third quarter results nor the trend of our business and are extremely focused on value-added activities to deliver improved results.

Let me start with the bottom line. For the third quarter, we reported a net loss of $15.6 million or $1.97 per diluted share that compares to net income of $3.1 million or $0.39 per diluted share in the prior year quarter. The reported net loss excludes the pretax SAP/ERP system impairment charge of $18.7 million and a pretax defined benefit plan termination charge of $2.5 million, both of which I'll discuss in more detail. Excluding these expenses we reported adjusted net income of $0.9 million or $0.12 per diluted share as compared to adjusted net income of $5.5 million or $0.70 per diluted share in the year ago quarter. The adjusted results in the third quarter of 2018 included a pretax charge of $3.6 million for the Circular 106 environmental remediation order.

Net sales for the quarter were $111.5 million, down 12.1% compared to a year ago. Residential sales were down 10.9% and contract sales were down 18.1%.

I would like to take a minute and unpack the challenges we have faced to give you more context on our underlying quarter and year-to-date performance in our residential business. Our residential business includes 2 primary channels of distribution and some unique product attributes. First, our fully assembled case goods and upholstered home furnishings products are sold exclusively under the Flexsteel brand and distributed through traditional retail partners. Conversely, our ready-to-assemble flat-packed case goods products are sold exclusively under the Home Styles brand, distributed through e-commerce partners and shipped directly to end consumers from our warehouse.

In the quarter and on a year-to-date basis, our sales are down in both our home furnishings and our ready-to-assemble products. First, let's discuss the ready-to-assemble products. These products represent approximately 10% of our total year-to-date sales and are down 33% in the quarter and down 30% year-to-date. In dollars, this represents approximately $14.5 million in sales decline on a year-to-date basis and just over 50% of the total residential sales contraction in the 9-month period. A majority of this decline was either directly or indirectly caused by the significant and prolonged disruption created by the implementation of the ERP system. Over the course of the past several quarters, the focus in this part of the business has been to stabilize the ERP system and begin rebuilding our credibility with e-commerce partners and end consumers. While we have significantly improved the customer experience within the channel by successfully taking orders and shipping in the required window, we acknowledge it will take a while to fully return to previous sales levels. In addition, we are experiencing higher-than-typical discounting and promotional allowances as we work to position ourselves back to the top of the page.

E-commerce is an area of tremendous opportunity for us and an important area to have the right talent in place to deliver the results. To that end, earlier in April, we brought on a new leader of our Home Styles ready-to-assemble furniture business with deep experience in the e-commerce channel to pivot the business, renew the category and revive the growth story it once was for Flexsteel. If you have not tried our Home Styles products, you would be impressed by the quality, look and feel of these ready-to-assemble products. They are truly best-in-class within the category. Our Home Styles team under this new leadership is focused on designing and bringing to market high-value products for this channel, enhancing our marketing capabilities and improving operational efficiencies to win back customer confidence.

Pivoting to our largest category, home furnishings, product sales were down 7.6% in the quarter and 5% year-to-date. Given the current trade environment, it's important to understand where our sales are being sourced. Roughly 44% of our total company sales are sourced from China. In the home furnishings space specifically, approximately 54% of our sales are sourced from China. We have seen the largest weakness in sales in home furnishings categories in products sourced from China. Therefore, we believe demand has softened for a significant portion of this business due to the implementation of the tariff surcharge in late September, followed by the overhang through February of a potential increase to a 25% tariff. This clearly has had and continues to have an adverse impact on our order patterns. With the 25% tariff on hold but still uncertain outcome lingering, we have not seen a pickup in orders. However, at the High Point Market in early April, we saw a significant increase in show orders for new products and are hoping to see this excitement transition to increasing order rates in the beginning of fiscal 2020 when products hit retailer floors.

If the U.S. and Chinese trade talks are successful, we believe there could be additional upside to current demand in ordering patterns. In the meantime, we are actively working with our supply base to determine what sourcing alternatives are available in addition to executing on productivity opportunities to mitigate the current and future impacts of the trade policies invoked by the U.S. and China. As we have said before, the tariff is a significant risk to our business and financial outcomes. We continue to monitor and take steps to insulate the business as best and as quickly as possible without jeopardizing delivery or quality.

I'd like to pivot now onto our contract business. First, some context for everyone as you think about this part of our business. The contract business is made up of different product lines, Vehicle Seating, Hospitality, Healthcare, Senior Living and Commercial Office. As Jerry mentioned in his commentary, we are looking at all of these product lines, understanding the market dynamics, growth potential and profitability to determine which offer the most opportunity for value creation and potentially deprioritizing ones which do not. A couple of these businesses have been struggling due to being subscale and lacking ability to offer a compelling value proposition to our customers. Others have been challenged due to poorly placed investments, which have increased costs, absent added value.

The business results over the year-to-date period have been consistent with this context. Within the quarter, there were some nuances, primarily in the Hospitality business where we had exceptionally strong comparatives due to a backlog catch-up in the prior year quarter for a major customer.

Vehicle Seating products demand continues to see strong quarter-over-quarter growth, up just over 21% year-to-date. However, with the change to our Alipay structure driven by the ERP implementation preparation work, building the new primary manufacturing facility and subsequent relocation to that facility, the cost structure in the Vehicle Seating business has suffered greatly both in terms of efficiency losses and fixed structural costs. These factors, together with exceptionally strong demand in the category, has led to lost opportunities and delivery delays.

The Commercial Office product offering of Flexsteel is heavily focused in veneer, which is a declining market. Over the past couple of years, there has been an effort to rationalize both product and customers to improve profitability with some success.

Lastly, our Healthcare and Senior Living category is relatively small category for us today, but with increased focus in resources, we believe this area to be another opportunity for Flexsteel to leverage its existing furniture sourcing and manufacturing capabilities to add value and grow profitably in a market which is very attractive.

I'd like to now take a few minutes to talk through our profitability results for the quarter. Gross margin as a percent of net sales in the third quarter was 19.1% as compared to 21.8% a year ago. Labor costs and productivity dampened the margin primarily due to onetime inefficiencies and expenses associated with the relocation of our facility in Dubuque. These onetime costs accounted for approximately 50 basis points of margin.

Outside of Dubuque, we are seeing improving productivity as compared to last year and even as compared to our second quarter, which is a very positive development. When compared to the second quarter, increased productivity in our manufacturing facilities excluding Dubuque added 110 basis points to margin.

Raw material increases, primarily in polyurethane and steel, accounted for only 20 basis points of the decline in gross margin when compared to 2018 as we continue to see raw material increases abate.

As anticipated, ASC 606, Accounting Standards Codification, Revenue Contracts for Customers (sic) [Revenue from Contracts with Customers], which requires the classification of certain rebates as a reduction in sales, adversely impacted the gross margin by approximately 80 basis points when compared to a year ago. As a reminder, we have one more quarter where ASC 606 will have this impact relative to the prior year, and then it will be apples-to-apples comparisons from there forward. Please also remember, for comparison purposes next quarter that in the fourth quarter of 2018, we did a year-to-date adjustment to correct previously misclassified rebates.

Selling, general and administrative expenses were 20.5% of net sales in the third quarter compared to 15.5% in the third quarter of 2018. In this quarter, we took a onetime noncash charge of $2.5 million due to the termination and settlement of a defined benefit plan associated with the prior wholly owned subsidiary, DMI Furniture. We do not expect any further costs associated with this plan. This charge unfavorably impacted SG&A by 220 basis points versus the prior year quarter.

The remaining year-over-year increase is predominantly related to ongoing ERP system support costs, which we expect to continue until further direction on implementation is determined. Secondarily, costs increased to support several key marketing programs to enhance the customer experience, data analytics and content management. One of the projects we've been rolling out are in-store kiosks that help to showcase our product and assist consumers on their furniture-buying journey. The increases in expenses were partially offset by reductions in incentive compensation due to financial underperformance.

Also due to ASC 606, the classification of certain rebates as a reduction in sales this quarter which were classified as SG&A expense in the prior year quarter resulted in a favorable comparison in the current quarter. Again, beginning in the first quarter of fiscal 2020, we will have lapped any comparative impact from ASC 606.

Now let me elaborate a little more on the impairment charge we recorded in the quarter. As we stated in the press release, we recorded an $18.7 million impairment charge for the ERP system work completed to date. This project began in late calendar 2016, and when implemented on roughly 20% of our business in April of 2018, it resulted in significant business and customer disruption that led to service level penalties and volume reductions. Since then, we have focused on stabilizing the system environment and restoring the customer experience, which, as I mentioned, has significantly improved.

We also have been performing a thorough evaluation of the work completed to date, its usefulness in the context of future deployments and the potential for revised project scope. This analysis, which was completed during the third quarter, resulted in our determining that there was an impairment of $18.7 million of the ERP system assets due to incomplete or abandoned software components and capitalized amounts that are not recoverable. As of March 31, 2019, there remains a capitalized asset related to the ERP system of $7.2 million in net book value. As we undergo the overhaul Jerry mentioned in his comments, we'll be taking a fresh look at the system requirements and infrastructure options to support our business for the long term without overcomplicating the solution, as we had done in the past. Should we decide that our option is not to proceed with any further rollout of the ERP system beyond the current implementation, $6.1 million of the remaining capitalized asset would be subject to potential impairment. We will keep you apprised of this situation.

During the quarter, we reported a tax benefit of $4.5 million or an effective rate of 22.6% compared to a tax expense of $1.4 million a year ago or an effective tax rate of 31.7%. The tax benefit was primarily a result of the large impairment charge in the associated net operating losses. Going forward, we estimate our tax rate to be in the range of 25% to 27%.

Now turning to the balance sheet. During the quarter, we generated $12.5 million in cash from operations and ended the quarter with $28.6 million in cash and cash equivalents and investments. This is down from $43.6 million at June 30, 2018; a majority of the cash use during the 9-month period was capital expenditures of $20.6 million including $13.3 million for our new manufacturing facility in Dubuque. For the balance of the year, we expect capital expenditures to be approximately $0.4 million. Going forward, excluding any activities associated with the work Jerry mentioned, we would expect a normal run rate on capital expenditures to be around $5 million to $6 million per year.

With that, I'll turn the call back to the operator so we can take your questions.

(Operator Instructions) And we have a question from JP Geygan of Global Value Investment Corp.

I have a few questions. First, I was under the impression that the implementation of a new ERP system was somewhat necessary to facilitate the growth of the business. If you opt not to complete the implementation, either partial or complete, of the ERP system that you've already selected, how do you plan to adapt your technology infrastructure?

Yes. This is Jerry. So during our prepared remarks, one of things that we talked about is that we are looking at all our options. Those options could include continuing on the current platform that we've gone on, the SAP, or looking at other options. We have several other options we're looking at. And our plan is in the next 60 days to make that assessment whether we're going to continue on or look at the other options that are available to us. One of the options is if it's not acceptable, we will not stay on our current platform, we will not be able to do that.

Okay. And then what are the reactions of your customers been to the developments with your ERP systems from a qualitative basis as you work through these issues?

So we really have only gone live on our e-commerce business, and I guess, the best qualitative measure we have is we did lose some customers. We're in the process now of bringing them back. We are now able to shift, do our EDI, order inventory, et cetera. Most of those are behind us, and we're back to our same shipping that we were at before we went live. But one thing we are also working through is trying to get some of those customers back because, obviously, when you disappoint customers, they don't just come right back. That's really what we're working to right now.

Great. And then my final question is, Jerry, you're a few months into the job now, how do you really assess the progress you've made in the state of the business? And I'd note that you've brought in a few new hires to, I presume, help you make some changes.

Yes. I'm really excited. I mean it's something we came in, we knew we had an opportunity to improve ourselves. There's some low-hanging fruit that we're obviously going through. We've changed some management folks out, brought in our first-ever CIO. We've brought in a new person to head up manufacturing. We've got a new group that's working with us on some of the other areas of the business. And we -- that's the other reason we brought in AlixPartners to help us through some of this. We're 30 days through the diagnostic, and we're really excited about the future for the company. And we're really excited to look and see what we look like in 12 to 18 months from now.

(Operator Instructions) Okay. Well, showing no further questions, we'll then conclude our question-and-answer session. I would now like to turn the conference call back over to Mr. Jerry Dittmer, Chief Executive Officer, for any closing remarks. Sir?

Thank you. I want to thank our shareholders for their support and patience as well as thank our dedicated employees for their effort as we work together to put our business back on a path to profitable growth. I am very enthusiastic and optimistic about capturing the opportunities at Flexsteel we outlined today. Our leadership team and our Board are fully committed to improving our customer experience while unlocking value for our shareholders. As I mentioned earlier, if there is meaningful news, we will share it in a timely way and not necessarily wait until the next quarterly conference call. We look forward to continued communication with you on the progress we are making. Once again, thank you for participating in today's call. Thanks.

And we thank you, sir, and also to the rest of the management team for your time also. Again, the conference call has now concluded. At this time, you may disconnect your lines. Thank you. Take care, and have a great day, everyone.