Steelcase Inc (SCS) 2005 Q3 法說會逐字稿

Good day, everyone, and welcome to Steelcase's third-quarter earnings conference call. A reminder, today's call is being recorded. For opening remarks and introductions, I would like to turn the conference call over to Mr. Terry Linhardt, Vice President Corporate Strategy and Investor Relations.

Thank you. Good morning, everyone, and thank you for joining us for the recap of our third-quarter and fiscal year 2005 results. Here with me today are Jim Hackett, our President and Chief Executive Officer, Jim Keane, our Chief Financial Officer, and Mark Mosing, Vice President and Corporate Controller.

Our third-quarter earnings release dated December 17, 2004 crossed the wire earlier this morning. That same release is accessible on our Web site. This conference call is being Web-cast. The presentation slides that accompany this Web cast are available on Steelcase.com. A replay of this call will be posted to the site later today. In addition to our prepared remarks, we will take questions from investors and analysts. At this time we are incorporating by reference into this conference call and subsequent transcripts the text of our Safe Harbor statement as incorporated in this morning's release.

Certain statements made within the release and during this conference call constitute forward-looking statements. There are risks associated with the use of this information for investment decision-making purposes. And for more details on these risks, please refer to this morning's press release and Form 8-K, the Company's Form 10-K for the year ended February 27, 2004, and our other filings with the Securities and Exchange Commission.

This Web-cast is a copyrighted production of Steelcase, Inc.; any reproduction, publication or rebroadcast without the express written permission of Steelcase is prohibited, copyright 2004, Steelcase, Inc.

And with that out of the way, I will turn the call over to our President and CEO, Jim Hackett. Jim?

Thank you, Terry, and happy holidays.

I'm pleased to report to you good news with our third-quarter results. A year ago on this call, we were frustrated that the industry recovery was progressing slower than we had hoped. It was going through fits and starts, since our forecast then suggested modest performance for the coming year. That was troubling to us. You'll see that with this quarter's results that we believe we grew faster than the market in North America and Europe.

The legacy of our Steelcase model for competing in this industry enabled us to grow to be the largest in the world, fueled by our ability to meet customer delivery and the quality requirements of our customers. Our success fed off the vertical nature of the manufacturing model we built. They worked hand-in-hand. Of course, this model came under severe stress when the topline shrunk and we were faced with many of those fixed costs, so we've been quite active all over the world in building a more flexible and lean environment.

As you know, one is never done with the work on building an environment that's lean, and we are working quite enthusiastically on a global supply system. We continue to learn of ever-better configurations to the supply chain and are committed to making the changes that will enable profitability while maintaining our reputation for delivering a great experience to our customers. Unrivaled choice with incredible speed has allowed Steelcase to be important to large companies, and now that those companies are buying again, I can confirm to you that the momentum of the recovery continues to build.

We have humbly and simply learned a great deal though, and are putting those smarter principles to work. I believe, however, that the nature of this recovery has been stunted by new forces that are just a matter of business today. They are not excuses, but they are issues we have to deal with.

You will see in our numbers some negative effects due to the high level of material inflation we discussed in the last quarter's call. And while one might imagine that inflation is offset with productivity improvements, that's just not the case in this state. You know we continually work on this end of the business, meaning we are continually active on productivity improvements. Pricing inflation hits you, and when it does, action is needed. We have taken a number of actions to offset price increases.

We've been very happy with the surcharge and other efforts to keep up with the pace of escalating raw material prices, but quite frankly there's no way to fully offset significant spikes that happen in raw material prices without passing on a portion of it to your customers. Additionally, the pricing in this quarter likely includes discount decisions made many quarters ago. We have to remember where we were then; we were in the midst of a deep recession. We can now see improving trends in our backlog.

I have to admit optimism given what I am seeing. We just completed our planning process for the next year. It projects a continued recovery, and while we won't be providing an annual forecast range for next year, I can assure you we have a plan to improve our performance. Before we dive into the numbers more deeply, I want to highlight some important aspects of performance in the last quarter.

Steelcase successfully launched a number of new products at our European trade show in October. This is known as Orgatec. It was heartening to see the results of our commitment to further invest in new products in Europe during the recession.

In the last quarter, we continued to see confirmation of adoption of our newer product lines. Two deserve mention, one I have talked about in the last quarter's call. Our Think Chair earned the highest award for environmental responsibility in the country of France. We are proud to receive one of the first awards given to the furniture industry from their Minister of the Environment.

The Universal Storage launch which we did over 18 months ago is doing quite well, and we will likely surpass our fifth-year sales goal 18 months into this project.

In November, we opened our newest WorkLife Center in Santa Monica, California. To remind you, a WorkLife Center is a living working showroom. It has been very well-received, and in a new way, the center demonstrates the strength of the collection of brands in the Steelcase enterprise. Expect a great deal of media coverage around this new center.

I might add that we're pleased that the Federal Prison Industry reform legislation was passed recently. We here at Steelcase, along with others in our industry, have simply asked to compete on a level playing field. We will now be able to compete for approximately 200 million of additional government furniture business each year, and we plan to get our fair share.

Now, I would like to dive more deeply into the numbers, and to do that, I went to introduce our Chief Financial Officer, Jim Keane. Jim?

Thank you, Jim. Today we reported a third-quarter profit of $10.1 million, or 7 cents per share, on sales of $674 million. Sales were better than we expected and earnings per share were higher than the range we estimated last quarter. Profits were higher than we had estimated, primarily because of a favorable adjustment to our tax reserve during the quarter, which I will explain later.

Sales of $674 million represent an increase of 9.7 percent versus the prior year and 3.5 percent versus the second quarter. When comparing to the prior year, consider that third-quarter sales benefited from $19.8 million in consolidated dealer revenue and about $11.2 million from currency translation effects. Third-quarter sales also included $9.6 million related to the steel surcharge implemented by the North America segment during the first quarter. Compared to the second quarter, third-quarter sales benefited by $3.7 million related to currency translation effects. This sequential-quarter comparison is not affected by the newly consolidated dealers or the steel surcharge.

We are very pleased with the growth we are seeing in our business and the fact that each of our business segments are continuing to report revenue growth versus the prior year. Orders were very strong throughout the third quarter and our backlog was relatively strong as we entered the fourth quarter. Now I will talk about profitability.

The $10.1 million profit we earned this quarter compares to a net loss of $9.5 million last year. Included in the profit is a $6.5 million reduction of a specific tax reserve. This reserve relates to a tax deduction that we took during fiscal 1997. The IRS later rejected this deduction and we booked a full reserve while we challenged this decision.

We worked with the IRS on this matter over the years without much progress until this past quarter, when the Tax Court ruled favorably on another case which is very similar to ours. Because we believe this precedent supports our position, we reduced our reserve during the quarter. Excluding the impact of the $6.5 million favorable tax adjustment, we continue to believe that our estimate of taxable income for the year will result in an effective tax rate of approximately 30 percent. We believe our longer-term rate is still about 37 to 38 percent.

This quarter's results included restructuring charges of $1.2 million after tax. That was within the estimate we provided you last quarter. The Web-cast slides include more detail about these restructuring charges, including a breakout by reporting segment.

Our cost of sales, which is reported separately from restructuring charges, improved slightly this quarter to 71.9 percent versus 72.1 percent a year ago. The benefits realized from prior restructuring efforts offset the increases in commodity prices and higher discounts. Gross margins of 27.9 percent were up on a sequential-quarter basis -- excuse me -- on a sequential-quarter basis, higher discounts, higher material costs, disruptions related to plant consolidations, and inventory adjustments caused margins to decline from 30 percent in the second quarter.

Operating expenses of $181.8 million were 27 percent of sales compared to 27.8 percent of sales in the prior year. When comparing actual dollars to the prior year, consider that newly consolidated dealers added $6.5 million to operating expenses and currency translation added $3.3 million.

Included in other income and expense during the third quarter are nonoperating gains of approximately $2.2 million after tax. The gains were related to the gain on the sale of a venture investment and our share of profits in a particular joint venture. We are also profitable on a year-to-date basis, with net income of $11.7 million. Year-to-date income from continuing operations is $10.7 million compared with a year-to-date loss of $27.5 million at the same time last year. Next, I will talk about the balance sheet and cash flow.

We increased cash and decreased debt in the quarter. Our cash balance is $272 million at the end of the quarter, a $32 million increase from the second quarter and the highest cash balance we've had since we have been a public company. The increase in cash was driven by a number of items. Depreciation and amortization was about $32 million and capital expenditures were $12 million. The difference in these amounts represents a source of cash.

In addition, leased assets decreased $8 million, due to the sale of a relatively large lease and normal runoff, and reductions in dealer financing contributed $7 million in cash. We reduced debt by $4 million to a quarter-end balance of 325 million. Now I will discuss the operating results for each of our segments, starting with North America.

The North America sales were $368.8 million in the quarter. That's a 9.6 percent increase from the prior year, including $15.1 million from newly consolidated dealers and $9.6 million related to the steel surcharge. On a sequential-quarter basis, North America sales were up slightly.

North American revenue growth continues to be supported by double-digit growth in sales to our larger customers. North America gross margins of 23.3 percent improved 0.6 percentage points compared to the prior year, primarily due to lower restructuring costs in the current quarter. Restructuring costs included in gross margins were $800,000 in the current quarter versus $2.9 million in the prior-year quarter. However, gross margins declined 2.5 percentage points versus the second quarter. This decline was primarily because of an increase in competitive discounts and rising raw material prices.

We anticipated these trends and we talked about them in this call last quarter, but the impact was greater than we expected. Higher discounts in the third quarter versus the second quarter reduced gross margins by $7 million. Discounts were higher because we had a greater mix of business from larger customers and because project business is particularly strong. Higher material costs in the third quarter versus the second quarter also reduced gross margins by $7 million. The higher material costs include commodity price increases, disruptions due to the restructuring of our wood business and other factors. Overhead reductions and lower restructuring costs helped to offset some of these increases in discounts and material costs, but the impact was still quite significant.

Orders in our backlog at the end of the third quarter appear to be less heavily discounted than the orders we shipped during the third quarter. This improvement is because of a shift back to a more typical mix of business and because North America took some steps earlier in the year to adjust pricing strategies. Because of leadtimes, it takes a while for pricing decisions to show up in reported results.

North America and many of the SDP companies also announced during the third quarter an average 4.5 percent list price increase, which will begin to take effect in January. This is an annual increase, and the amount of the increase considers the inflationary pressures we are seeing in material costs. The impact of the list price adjustment will be immaterial to fourth-quarter results and is expected to build from quarter to quarter during fiscal year 2006. The steel surcharge remains in effect and will continue until steel prices fall below certain levels. These actions will help over time, but in the short run we remain concerned about rising material costs.

North America operating expenses were 22.6 percent of sales, down from 23.4 percent in the prior year. Compared to the prior year, third-quarter operating expenses included $4.3 million from newly consolidated dealers. There were no restructuring costs included in operating expenses in the current quarter or prior-year quarter. Operating expenses of 22.6 percent were down from 23 percent in the second quarter. North America had operating income of $2.6 million for the third quarter and $6.3 million on a year-to-date basis.

SDP sales were $83 million in the quarter, an 18 percent increase compared to the prior year and a 3 percent increase versus the second quarter. The year-over-year growth was in core products across all SDP companies. SDP gross margins of 37.6 percent were significantly better than 35.9 percent in the prior year. Prior-year margins included increased reserves for slow-moving inventory in the fabric and wall covering business.

Current quarter gross margins of 37.6 percent were lower than second-quarter gross margins of 39.3 percent, primarily due to inventory and tooling write-offs and higher raw material prices. SDP operating expenses were $23.5 million, or 28.3 percent of sales. This represents a significant improvement over 30.6 percent in the prior year and 29.7 percent in the second quarter. There were no restructuring costs recorded in the current quarter and -- compared to operating expenses -- related to operating expenses, compared to $700,000 in the prior year. SDP operating income of $7.7 million represents a 9.3 percent operating margin and compares to operating income of $3 million, or 4.3 percent, in the prior year.

International sales were $155.5 million in the quarter, a 5 percent increase compared with the prior year. Compared to the prior year, current-quarter revenue benefited by $11.2 million in favorable currency effects and $4.7 million from newly consolidated dealers. Third-quarter sales were 18 percent higher than the second quarter, which reflects the typical seasonal pattern, plus higher volume in Germany and the UK. Third-quarter sales benefited by $3.7 million in favorable currency effects compared to the second quarter. The sequential-quarter comparison is not affected by the newly consolidated dealers because they are included in both periods.

International gross margins were 29 percent, an increase over the 28.4 percent in the prior year. This improvement was primarily due to lower restructuring costs and the benefits realized from prior restructuring activities. These were partially offset by inventory and other adjustments that increased cost of sales in the quarter.

International operating expenses were $46.2 million in the quarter versus $43 million in the prior-year quarter. However, for purposes of this comparison, current-quarter operating expenses included $2.2 million from newly consolidated dealers and $3.3 million related to currency translation. Current-quarter expenses were up $2 million from the second quarter, primarily because of currency translation effects of about 1.1 million. Restructuring costs related to operating expenses included a net gain of $100,000 in the third quarter, compared to expenses of $700,000 in the prior year. International reported an operating loss of $1 million in the quarter.

Now I will review our order trends and outlook. Incoming orders increased across all business segments in the third quarter and our backlog is strong as we enter the fourth quarter. It is typical for orders to slow down during the fourth quarter, particularly in North America, and we are seeing some signs of that pattern developing in early December. But because backlog is so strong, we expect fourth-quarter shipments will reflect significant year-over-year growth. Fourth-quarter sales are expected to be approximately 20 percent higher than the prior year, including approximately $20 million from newly consolidated dealers and approximately $9 million from the impact of the steel surcharge.

Now, for profitability. In the fourth quarter, we expect earnings to approximate breakeven, including 3 to $6 million of after-tax restructuring costs. That would be a significant improvement over the $13.9 million loss from continuing operations incurred in the prior-year quarter. Fourth-quarter profitability is expected to be lower than the third quarter for a couple of reasons.

First, the third quarter had the benefit of the $6.5 million tax reserve adjustment and $2.2 million of after-tax nonoperating gains. Our fourth-quarter estimates do not include these benefits. And second, restructuring costs are expected to be higher in the fourth quarter. We are expecting 3 to $6 million of after-tax charges compared to $1.2 million in the third quarter. These relate to the completion of our wood restructuring effort and to restructuring activities in our international segment which were announced last week in those locations. Since we have earned $11.7 million year-to-date through the third quarter and we are expecting to break even in the fourth quarter, we expect to be profitable for the year.

During the third quarter we completed our internal planning process and have updated our three-year plan. Our long-term goals remain the same -- gross margins of 35 percent, operating expenses of 25 percent and operating income of 10 percent of sales. We have a lot of work ahead of us to achieve those goals.

Now, we will turn it over for questions.

(Operator Instructions). Susan McCleary (ph), UBS.

Can you maybe give us a little bit of an update on your capacity utilization? I know that you said that your backlog and your orders seem to be much stronger. Can you give us a sense of where you are now versus last year?

The capacity defined as physical capacity, meaning buildings and equipment, continues at the same pace. We have substantial excess capacity or available capacity when and if growth continues, so we're not concerned at all about that. From a labor perspective, we're -- our labor hours are rising, and we're seeing some overtime now in our plants, which is a good thing because it helps our people. And if that were to continue, we would take steps to adjust the labor force. But we're not concerned about capacity, either in terms of labor or physical capacity.

And in fact, Susan, the lean process as we tour factories today, we're finding as volume goes up -- this is the great thing about lean -- we're actually reducing floor space usage at the same time. So this is a continual journey, and as Jim said, on the other side of this based on demand, we would not be worried about having capability to respond to that.

Okay. And if we kind of take the flip side of that, given all the work that you have done around lean manufacturing and closing plants and reducing your head count, and the really strong trend that you're guiding us to for the next quarter, it seems like you're just not getting maybe as much of the margin benefit as we would have been hoping for here. Can you help us just kind of understand that a bit more?

Sure. If you think about our gross margins, I will just talk about North America specifically here. Our gross margins in North America this quarter were 23.3 percent, which were slightly better than margins in the prior year. But if you remember then, I was talking about discount material trends if we compare the third quarter to the second quarter. And just in that one quarter, we saw a $7 million gross margin reduction because of discounts rising and a $7 million reduction of gross margins because of material costs rising. So what's happening in effect is that the savings we're getting from restructuring activities just in this last quarter have been consumed by these other two factors. But we are definitely seeing the benefits in terms of overhead reduction, productivity improvement. But we're also (indiscernible) offset by these other factors.

And so therefore, as we kind of head into '06, and you get some of the benefit of the price increases that you'll be seeing early in the year, and maybe any kind of relief in the raw material prices, we should expect your margins to grow a bit faster than we saw this year?

We would certainly expect that as the price increase takes effect, we should see some improvement. And then it all depends on what happens with material costs and other factories next year.

It's why I said earlier that here we are in the midst of the recovery; things are going well, the consolidation is ahead of plan. For example, our wood move was on budget relative to the costs we associated with it. It caused a little bit of disruption because demand happened to increase at the same time. So here we are. Things like that are tracking quite well, and then we have these material price increases that are dramatic, unlike anything in 25 years. As I said, this is business today. We just have to deal with it, and the organization is.

So your instincts are right. We would have expected a better performance at that margin level. And you factor these two issues that Jim just discussed in that and you actually would be seeing that. So, I have to kind of step back and say that means we are on the right track, and we just -- maybe if there's any issue here, we would move faster and more aggressively on the price increase. But we were the first to lead in that regard, and I think in retrospect we did about as well as you could expect.

Sure. Just one last question. Can you give us a sense in terms of demand where you are seeing the most increase from? Is it systems versus seating, or what kind of product is selling better than another?

In terms of product, the increases are really across the board, but we are definitely seeing this larger customer segment, particularly in North America, the larger customer segment increasing their purchases at sort of double-digit rates. And we've talked about this with you in the past, that that was the group that really cut back their spending during the downturn. And we had seen that pattern develop earlier this year and we're seeing it continuing.

We're also continuing to see good growth in our Turnstone business, which serves smaller orders or more medium-sized customers. But I would say the headline would really be, at least for North America it's the growth in that large customer segment.

Budd Bugatch, Raymond James.

This is Chris Thornsberry on behalf of Budd. Follow-up questions for you on the overall trends you're seeing with larger contract jobs versus smaller orders. You said you've seen substantial increases from larger customers, and that kind of impacted some of what happened in the quarter with discounting. Going forward, as we're seeing larger customer orders, do you see the pricing environment in terms of discounting and the competitive pricing getting a little bit more difficult, or do you see that improving a little bit?

Well, I've got to be cautious about discussing future pricing actions, but I want to have you think about the past performance this way -- the pricing that is flowing through on the shipment basis is pricing that -- I suggested much of it was set in the depth of the recession. Many of these customers that we're shipping large projects right now made the decision to buy a year, year-and-a-half ago, and to their benefit, negotiated at a good time.

The issue that we're reflecting in terms of growth now in larger customers has to do with our order, or our backlog. And in that regard, I would say to you that we look at these trends beginning to abate a little bit. And this is what Jim is suggesting, is that there is a point in the recession where pricing correlates to the depth of it, and there's a point in the recession recovery, I think, where pricing improves. And that's about as far as we can describe it. But I went to caution you to separate the past issues relative to when those pricing decisions were made, and the new book of orders that are a reflection of the environment today.

Speaking of the backlog trends, you said you had a good backlog going into Q4. Would you care to break that out in terms of domestic versus international? Have you seen much more of an increase in domestic versus international recently?

Well, let me talk about domestic first. We've seen an improvement in backlog. Let's say North America segment is seeing an increase in backlog that is double-digits, actually close to 20 percent. And our SDP companies are seeing increases in backlog that are higher than that. International really goes market by market. I'm not going to go through all that detail. There are signs that we're seeing some improvement in business in Germany, as I mentioned earlier. But after that, you kind of have to go market by market. In general, the international business seems to be lagging a little bit in the recovery, as we expected. They entered the downturn after North America, and they seem to be coming out at a slower pace. So that's about as far as I can go.

Thank you. One final question for you. With the high cash balance you guys have in this quarter, you just said it was a record since you've been a public company, what are your uses for cash going forward, in terms of maybe dividends or stock repurchase? And kind of looking at that and couching (ph) with the $300 million shelf registration you guys did, how does that look in terms of potential acquisitions going forward?

As we have said, we're very comfortable having a high cash balance, and the cash balance is there because we enjoy having a strong balance sheet. We also enjoy the fact that our debt has been coming down. So we're very comfortable with that situation. In terms of some of the things you talked about, the Board has available to it a number of options to return value to shareholders. Dividends has always been the primary way we return value to shareholders, but there is a connection between the level of dividends and the level of profitability over medium or longer-term. So I would see that there is a correlation there in the Board's thinking, and so we will see what happens here as profitability improves.

As it relates to share repurchases and other vehicles, those are also available to the Board, and those things are considered from time to time. As it relates to acquisitions, we really think about acquisitions in terms of their value to strategic initiatives. So as we're looking at going into a new market or a new customer segment, we consider acquisitions in that context, rather than as a way of using the cash. Obviously, having cash gives you more options to consider in that realm as well, but it really doesn't drive the decision making; what drives the decision making are the strategies themselves.

Okay. And where do you see potential opportunities? I mean, is that going to be further expansion in government or healthcare, or something else?

In terms of growth strategies for the Company, we have said before that we're interested in several vertical markets. Markets such as healthcare, markets such as education are interesting to us. We're in those markets today. In many ways we're leaders in those markets, and they remain important to us. We also have talked about geographic expansion as another alternative. We also continue to implement our architectural and technology strategies. So all of those are growth strategies for the Company which may or may not include acquisitions.

(Operator Instructions). Peter DeFrino, Iron Horse Capital.

I want to ask a question about insider selling, and I do understand the positive side effects of the increased liquidity in Class A shares, but I'm concerned about how the selling is being done, the execution of the divesting. I guess I would like a little more color on who the insiders are and what portion of the sellers are actually considered insiders and that are restricted during blackout periods, and what portion of the sellers are controlled by trust, and then, I guess, have a right to sell all the way up to the day of your earnings release.

Peter, I think the technical nature of that question really requires that Sheila Dayton (ph), who is a Vice President in our legal group and handles the SEC compliance for the Company, to respond. So Sheila, I'm going to turn that one over to you.

In terms of specific sales in the last quarter, many of the transactions were done by trust and other vehicles such as limited partnerships, which are controlled by corporate trustees that have no access to the Company's inside information and they are not covered by the Company's blackout. So, I'm not sure if that gets to your question, but it seemed to.

It does. I just have one follow-up. I guess the further part of my question is what are your thoughts on how to sort of transition the sellers better -- I mean, either secondary offerings followed by lockups, or now that your balance sheet is improving, free cash flow generation to do some sort of buyback from the families. And it seems like a great story, but the thin nature of the stock is frustrating to have a constant seller in the market.

Well, we've been pleased with the way we've moved from the point we were at following the IPO many years ago to where we are today. Our public quote is up significantly, average daily trades are up significantly. And although there has been some trading by these trusts that Sheila talked about, the performance of the stock, arguably, has held up fairly well. I haven't looked at the data today, but as of a short time ago we had exceeded the S&P 500, for example, in return over that prior year. So there isn't a lot of evidence that that has been holding the stock value down. In terms of vehicles, the vehicles that are established by the government in terms of these limits seem to be working okay for many shareholders. We also, as you mentioned, did a shelf registration recently which provides a possible other vehicle, although there is no immediate plan to use that shelf in the short run.

I also think, Peter, it's not self-serving but it needs to be said -- our family shareholders are some of our better shareholders in terms of the conviction and commitment to the success of the Company. So I like them as shareholders long-term.

(Operator Instructions).

(technical difficulty) for your attention today, and wish everyone a blessed and happy holiday, and we look forward to our next call. Thank you very much.

Thank you, ladies and gentlemen. This does conclude today's conference call.