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Operator
Good morning.
My name is Amy, and I will be your conference operator today.
I would like to welcome everyone to the HNI Corporation Third Quarter 2017 Fiscal Results Conference Call.
(Operator Instructions) As a reminder, today's conference call is being recorded.
Thank you.
Mr. Herring, you may begin your conference.
Jack D. Herring - Treasurer and Director of Finance & IR
Thank you.
Good morning.
I am Jack Herring, Treasurer and Director of Investor Relations for HNI Corporation.
Thank you for joining us to discuss our third quarter fiscal 2017 results.
Here with me are Stan Askren, Chairman, President and CEO; and Marshall Bridges, Vice President and Chief Financial Officer.
Copies of our financial news release, earnings presentation and non-GAAP reconciliations are posted on our website.
Statements made during this call that are not strictly historical facts are forward-looking statements, which are subject to known and unknown risks.
Actual results could differ materially.
The earnings presentation posted on our website includes additional factors that could affect actual results.
The corporation assumes no obligation to update any forward-looking statements made during the call.
I am pleased to turn the call over to Mr. Stan Askren.
Stanley A. Askren - Chairman, President & CEO
Thank you, Jack.
Good morning, everyone.
Marshall and I will share our assessment of the third quarter 2017, and provide some thoughts and our outlook for the fourth quarter of 2017 and then give a brief outlook for 2018.
And then as usual, we will open the call up for questions.
In the third quarter, we drove strong top line growth and delivered earnings as expected.
Our top line results were better than anticipated.
We generated more than 20% growth in our North American contract to international office furniture businesses.
We also drove solid growth in our supply-driven office furniture and hearth businesses.
Our strong sales results, combined with SG&A cost management, offset the disruption related to operational transformations and unfavorable business mix to deliver earnings as we expected.
As we look to the fourth quarter, we're expecting a proper decline as we work through 2 major challenges.
The first, the supply-driven marketplace continues to experience rapid transition resulting in increased investment on our part and lower near-term sales.
We now expect to see lower sales as wholesale shipments, which were relatively stable at third quarter, decline significantly as the wholesalers forgo their year-end program buys.
Second, our operational transformation projects have been more difficult than we anticipated and will negatively impact our fourth quarter profitability.
In retrospect, we took on too many strategic initiatives, and we underestimated the resources required to successfully execute them.
One of our big initiatives, BST, has required significant resources, which otherwise, would have been focused on these operational execution initiatives.
Though successful to date, we've made a proactive decision during the fourth quarter to defer the next phase of our BST implementation to February 2018.
Our decision, in a way, allows us to focus on customer needs, strengthen our operational network and align the implementation with historically slow seasonal demand period.
We understand the challenges in front of us.
We know where we want to go, and we know how to get there.
Our supplies-driven business is a strong platform for growth with market access, brands and scale unmatched by competition even in the new environment.
We are taking actions to increase our competitiveness, building out our direct service capabilities and leveraging our industry-leading platform to generate economic advantage for us and our resellers.
We have a long proven track record of successfully managing through operational challenges.
We're realigning people, structure and processes to address these issues.
I'm confident we're making progress, and I'm confident in our ability to drive profit improvement in the future.
I'll now turn the call over to Marshall Bridges to review some financial details, and then I'll return to discuss our views on 2018.
Marshall?
Marshall H. Bridges - VP & CFO
Thanks, Stan.
Okay.
Let's look at some of the details of the third quarter first.
Consolidated organic SG&A of 2.6% versus the prior year, including the impacts of acquisitions and divestitures, sales increased 2.5%.
In the office furniture segment, sales increased 12.9% organically and increased 2.3% in total.
Within the office furniture segment, sales in our supplies-driven business increased 5% organically or minus 6% including the impacts of divestitures.
Sales in our North American contract businesses increased 23% organically or up 11% in total.
Sales in our international businesses increased 21%.
In our hearth segment, sales increased 3.4%.
New construction sales increased 5% and sales of retail products, including wood, gas and pellet, increased 2%.
Non-GAAP net income per diluted share was $0.82 compared to $0.80 in the third quarter of 2016.
Versus the prior year, our improved earnings were driven by volume, which is mostly offset by input cost inflation, strategic investments and unfavorable business and product mix.
Okay, let's shift gears and look at the fourth quarter.
For the fourth quarter, we expect consolidated organic sales to be flat to up 3% or flat to down 3% when including the effects of acquisitions and divestitures.
Office furniture sales are expected to be down 1% to up 2% organically, or down 2% to 5% in total.
Organic sales in our supplies-driven business are projected to decline 2% to 5% or be down 6% to 9% when including divestitures.
We expect to see continued growth in our contract business, but not at the high third quarter levels.
We're forecasting sales in our contract office furniture businesses to be up 3% to 6% organically or down 1% to up 2% when including the impacts of acquisitions and divestitures.
We expect hearth sales to be up 3% to 6%.
Within the hearth segment, new construction sales are forecasted to be up 5% to 8%, and we are projecting retail hearth sales to be up 2% to 5%.
Non-GAAP gross profit margin is expected to be approximately 38%.
Non-GAAP SG&A, which includes freight and distribution expense, is expected to be 31.5% to 32% of net sales.
In the fourth quarter, our tax rate will be negatively impacted by a one-time adjustment related to the estimated future benefit of foreign tax items.
As a result, we estimate our full year tax rate will be approximately 36%.
Our estimate of non-GAAP earnings per diluted share for the fourth quarter is in the range of $0.38 to $0.45.
Our resulting estimate of non-GAAP earnings per diluted share for the full year 2017 is now in the range of $1.88 to $1.95.
Stan?
Stanley A. Askren - Chairman, President & CEO
So looking forward to 2018, I like our opportunities, and I'm confident we will return to profit growth.
We will conclude our operational transformation, stabilize our network and deliver benefits from core productivity improvement and structural cost reductions in 2018.
At this rate, the supplies-driven market will continue to be dynamic.
We will effectively navigate those market transitions.
We hold a unique competitive advantage through brand, product and capabilities, allowing us to correctly serve the market, which no other manufacturer can match.
I remain confident our investments will deliver growth, solidify our position as the best total cost producer and drive long-term profit improvement for our shareholders.
We continue to believe we owe shareholders our best current outlook for the business.
For that reason, we're providing initial forecast estimates for next year.
Our current estimate of non-GAAP earnings per diluted share for the full year 2018 is in the range of $2.15 to $2.65.
This is based on the assumption of 2% to 5% consolidated organic sales growth.
We're expecting 1% to 4% growth in office furniture and 3% to 6% in our hearth business.
We're confident in our strategies and in our ability to deliver profitable growth and create long-term value for our shareholders.
With those comments complete, we'll now open it up to questions.
Operator
(Operator Instructions) Your first question comes from the line of Matt McCall with Seaport Global.
Matthew Schon McCall - MD and Furnishings & Senior Analyst
So Stan, maybe expand on that last -- yes, let's start -- expand on the last comments.
You gave some kind of view of 2018.
Can you walk through some of the components of your margin outlook?
I don't think you gave the specifics around margins specifically, but maybe some of the components that we should think about as we look out into next year, trying to gauge kind of the visibility that you have in the margins next year either cross stage or a little elimination of pressures that are hurting you in '17?
Marshall H. Bridges - VP & CFO
Yes.
Sure, Matt.
As you look into what the big assumptions that are behind that $2.15, $2.65 non-GAAP EPS estimate, there's really 3 big assumptions.
The first is brand market growth.
And so we're assuming slow market growth kind of low single digits in office furniture and mid-single digit growth in hearth.
The second big assumption is around net productivity.
We've obviously not generated the growth that we've expected this year, and we are expecting to get back on track next year and get the operational transformations behind us and return to driving cost savings.
And we're assuming that we can drive favorable net growth keeping our structural cost reduction in the range of $25 million to $35 million next year.
The third big assumption has to do with pricing and input cost inflation.
So we're assuming that we can offset inflation, which we do expect to be lower this year with price.
So we should have 0 price cost gap.
And there's some other things we had to deal with as well, which I will note.
We have kicked off the amortization of our BST asset in the third quarter.
And so as we enter next year, we'll have some wraparound of the amortization, that'll be about $8 million of additional expense, all else equal.
And we've also had some favorable adjustments from a P&L perspective to the variable comp programs, which should reset next year, and be another $8 million of headwind we have to overcome.
Matthew Schon McCall - MD and Furnishings & Senior Analyst
Okay.
All right.
No, that's helpful.
So -- maybe on the supply side, can you talk about the anticipated pressure?
Maybe quantify some of the buckets of cost that kind of caught you off guard, if it was impacting that supplies segment.
And then how long is this going to persist on -- you've given the guidance for -- or the outlook for next year but is it we have to continue to face this pressure for another quarter, another 2 quarters and then it starts to get better?
How do we model out the next year as it pertains to the supplies issues and the moves that you're making to address those issues?
Marshall H. Bridges - VP & CFO
Yes, Matt.
So for the fourth quarter, I'll answer that question first.
Roughly speaking, 3/4 of our decline are expected to decline versus the prior is really driven by the supplies-driven business.
And so there's really 3 big factors there.
First, is sales, and that's primarily driven by weakness with the wholesalers.
The other is we continue to invest in that business, and that the biggest investment there is our quick ship fulfillment, a model which we're building out.
And then we're also experiencing some input cost inflation, which we partially offset with price, but similar to earlier in the year, what -- we had a negative price cost gap in the fourth quarter.
If we look to next year, Matt, the sales side of that will still be in transition.
But as I said earlier, we're not expecting to see that price cost gap and these -- and some of these investments will anniversary and not be incremental next year.
Matthew Schon McCall - MD and Furnishings & Senior Analyst
Okay.
And then -- I guess that's -- raised my final question.
So the investments that you've had to make, what -- can you remind me what the total is going to be in '17 and what you're anniversarying?
Is that included in that $25 million to $35 million number?
Or is that $25 million to $35 million number more tied to the facility moves?
Marshall H. Bridges - VP & CFO
Yes.
The $25 million to $35 million number is tied to the facilities and just driving poor operational productivity.
As it relates to the investments we're making in the kind of quick ship fulfillment model, that will be $7 million, $10 million in 2017.
Matthew Schon McCall - MD and Furnishings & Senior Analyst
And that should not recur?
Is -- will the spending largely be behind us by the time you get through Q4?
Marshall H. Bridges - VP & CFO
Yes.
That's a fair assumption.
As we ramp that volume up there, there'll be incremental investment, but it won't be nearly at the same level.
Operator
Your next question comes from the line of Kathryn Thompson with Thompson Research.
Kathryn Ingram Thompson - Founding Partner, CEO, and Director of Research
Working backwards and tagging onto the cost reduction initiatives, you had focused on $35 million to $40 million annual cost reduction by fiscal '18.
Is this something that you've outlined in the past?
You previously have targeted $24 million to $30 million in '17 and $10 million to $15 million in '18.
Obviously, a lot of this has changed.
One thing just to help us better understand why -- help us understand why the shortfall in '17 in those cost saves.
And then I just want to be clear, you did outline in your prepared commentary that the saves would be for '18, but I just want to make sure that we're on the same page with that.
Stanley A. Askren - Chairman, President & CEO
Yes.
Good questions, Kathryn.
I will start with why the shortfall and let Marshall fill in sort of the specific details.
So what happened in '17, it did not develop as we thought.
First off, the year started off a little slower and then -- and some of that had to do with the transition of wholesalers.
And then we got hit with really kind of an inordinate amount of demand, which put us in a pretty intensive sort of production environment.
When we got to that situation, we basically pulled resources from some of our cost-reduction transformations.
We arrested, we stopped some of the moves simply to take care of existing customers that had placed existing orders to make sure that we didn't disappoint them.
And so we kind of had a multiple series of factors there happen at one time.
The result of that is we simply didn't get done the things that we wanted to get done.
And then in addition, as this wholesaler transition became more dynamic and began to develop, then -- they went through periods where we didn't get the orders that we thought we might.
And so then that impacted costs as well.
So basically, what we're saying is we believe in '18, we're going to stabilize and get those moves done, number 1. Number 2, let me comment on this BST while I have the platform.
BST has actually gone well.
We've taken it very, very serious and it's on track.
We chose, when things were a little bit rocky, to delay that.
And one of the implications are that we -- that quite frankly, I underestimated is, we had an A team on making sure that the BST transition transformation changeover would go well, and we did not get the A team on these major cost reduction initiatives.
And so they didn't get done as fast and get done as well.
The good news is that BST is on track.
The good news is, I think, as we deferred going live on that whole new system until February when our system would be -- or our production environment would be more stable, and it's historically a period where there's few orders, so there's sort of less stress and tension on the overall system, and I think that puts us in a good spot.
Marshall, do you want to comment on some of the specific questions?
Marshall H. Bridges - VP & CFO
Yes.
Kathryn, as it relates to that $35 million to $40 million of structural costs, we're now expecting to hit about $11 million, $12 million in '17 and about $15 million in '18.
So part of that $25 million to $30 million sort of net productivity and structural cost reduction that I mentioned to Matt is -- includes this $15 million of additional structural cost reduction.
And then the balance of the $35 million to $40 million will hit 2019, early 2019.
Kathryn Ingram Thompson - Founding Partner, CEO, and Director of Research
Yes.
Right.
Helpful.
And you mentioned in your prepared comments, there wasn't as much year-end buy from wholesalers.
What percentage of supply sales are year-end buys to wholesalers that typically hit into Q4?
Really, what we're trying to do is get a better sense of the magnitude of that year-end buy and impacting the shortfall versus other fundamental weakness.
Marshall H. Bridges - VP & CFO
Yes, that's a good question, the wholesalers typically pursue these program buys in the fourth quarter, in which they increase their inventories.
I guess the -- a way to answer your question is to say that we're expecting the -- our year-ending inventory as the wholesalers hold to be down about $20 million.
It's a pretty significant impact on the quarter.
Kathryn Ingram Thompson - Founding Partner, CEO, and Director of Research
Okay.
All right.
Following in just pulling the string a little bit more on the whole supply transition.
Some of the larger wholesalers, as we discussed in the past, are struggling -- or developing private label options that potentially could be a direct competition to your product.
To what extent do you think that this competitive label products and supplies business versus just that acceleration of the model shift could impact either the current quarter trends or future trends?
Stanley A. Askren - Chairman, President & CEO
Well, that's a complex question.
The answer is their -- private label initiatives are significant.
They are real -- I mean, it's real competition for us.
I think it's not the big story.
I think the bigger story is simply large customers wanting to go direct, looking for better connection with us, more direct connection.
And -- so I think that's the big story.
I think that's the -- and then the secondary story is that just private label competition.
We're seeing private label competition amongst the -- all of these sort of private label.
And this private label has been there for some time, and we've been dealing with these for some time.
And we're actually responding aggressively to that and coming out with products that are value profile down that match up directly and providing those same solutions directly to our resellers versus having them buy them through really an intermediary or somebody who's sourcing those from some place else and package them and then deliver.
We think we have a better model to produce them domestically most of the time, often, we can source them better and then we can add more value and give them better experience overall.
So I think we can meet that challenge.
It is a challenge, but it's not to me the big story.
Kathryn Ingram Thompson - Founding Partner, CEO, and Director of Research
Okay.
The bigger story is in more structural versus private label because we're just trying to make sure that we understand it.
Sometimes it's not that direct but there can be some of the direct factors impacting.
Stanley A. Askren - Chairman, President & CEO
Yes.
I think you've got it.
You can just characterize it.
Well, the big story is this transition from intermediary to direct.
And then throughout the market is this competition from private label, low branded, unbranded sort of product and business models.
Kathryn Ingram Thompson - Founding Partner, CEO, and Director of Research
When you talk about higher costs, one area I wanted to focus on, just as you get to that more direct model, to what extent is higher freight costs impacting higher cost in Q4 and 2018 expectations?
Because there's still -- you're paying for freight ahead of selling to customers with this new, more direct model.
Just help us understand how that freight layers into your cost expectations.
Marshall H. Bridges - VP & CFO
Yes.
When I mentioned earlier about that $7 million, $10 million we're investing in the quick ship fulfillment, Kathryn, most of that is going to be in the freight expense line.
There is some expense related to setting those recent centers up, et cetera, but most of it's in freight.
In the fourth quarter, it's about $3 million.
Operator
(Operator Instructions) Your next question comes from the line of Greg Burns with Sidoti & Company.
Gregory John Burns - Senior Equity Research Analyst
What percent of your office segment is supplies and what percent of that is wholesale at this point?
Marshall H. Bridges - VP & CFO
Yes.
Greg, we -- about half of office furniture is the supplies-driven business.
And we're down to about 20% of that supplies-driven business flows through wholesalers as of this point.
Gregory John Burns - Senior Equity Research Analyst
Okay.
And if the bigger trend here is the transition of demand to more -- to move more direct, do you feel like you're missing out on some sales opportunities in the near term as you build your directs ship infrastructure that maybe you'll be able to pick up over time?
Or is that not a dynamic that's happening?
Marshall H. Bridges - VP & CFO
Well, it's a good question, Greg.
I -- certainly, the transitions are never linear and smooth.
And so I would guess you probably are missing out on some short-term sales just as this goes through the convulsion of change.
But putting our finger on that is very, very difficult.
I would expect -- our intent is to make this transition as fast and smooth as possible.
And when we get to the other side, then we should be advantaged in that we're able to more efficiently and effectively supply our largest customers, our largest resellers with furniture.
And that we should be more effective in helping them sell through, and we should be more efficient as we run the -- all the way from manufacturing to logistics network to solve that.
Short term, I have no doubt that these transitions will lose some things through the cracks.
And we're working that intensely, but I can't put my finger exactly on what's happening there.
Gregory John Burns - Senior Equity Research Analyst
Okay.
And given the significant decline in wholesale channel inventory, do you feel that, that level of inventory's sufficient to support your demand outlook through that channel?
Or do you think it's kind of lean where they may have to -- you might have some stronger quarters as they fill that inventory maybe over the next couple of quarters?
Stanley A. Askren - Chairman, President & CEO
I can't speculate on that, Greg, because I don't know what their demand horizon looks like, and I don't know what their -- intent is to order.
But you're tapping into a dynamic that we're going to need to watch and track as we go forward, I mean, certainly, we value these wholesalers, and we want to help them as they go through the transition.
How it all plays out is yet to be determined.
Operator
This concludes our question-and-answer session.
I would now like to turn the call back over to Stan Askren for closing remarks.
Stanley A. Askren - Chairman, President & CEO
Well, thank you very much.
We appreciate your interest in tuning in to our third quarter call.
We look forward to talking to you all in the future.
Have a good day.
Bye bye.
Operator
This concludes today's conference call.
You may now disconnect.