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Participants
Matt McCall Vice President, Investor Relations and Corporate Development
Jeffrey Lorenger Chairman, President and Chief Executive Officer
Marshall Bridges Senior Vice President and Chief Financial Officer
Reuben Garner The Benchmark Company
Steven Ramsey Thompson Research Group
Greg Burns Sidoti & Company
Disclaimer: *NEW* We are providing this transcript version in a raw machine-assisted format and it is unaudited. Please reference the audio for any questions on the content. A standard transcript will be available later on the site per our normal procedure. Please enjoy this timely version in the interim.
Call transcript
Operator

[00:00:00] Good morning, my name is Lisa, and I'll be your conference operator today, I would like to welcome everyone to the HNIC Corporation, third quarter fiscal twenty twenty results, conference call. All lines have been placed on you to prevent any background noise. After the speaker's remarks, there will be a question and answer session.

If you would like to ask a question during this time, simply press star, then the number one on your telephone keypad.

If you would like to withdraw your question, press the pound key.

As a reminder, today's conference call is being recorded. Thank you, Mr. McCall.

You may begin your conference.

Matt McCall

[00:00:33] Thank you, Lisa. Good morning. My name is Matt McCall and vice president, investor relations and corporate development for Chennai Corporation. Thank you for joining us to discuss our third quarter fiscal 2020 results. With me today are Jeff Lorenger, Chairman, President and CEO, and Marshall Bridges, senior vice president and CFO. Copies of our financial news release, earnings presentation and Nongay Reconciliation's 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 risk. 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.

Now, I'm pleased to turn the call over to Jeff Lorenger.

Jeffrey Lorenger

[00:01:27] Jeff, good morning and thank you for joining us.

Our members delivered another solid quarter in an environment that remains challenging. And again, our results demonstrate much of what is unique about HNIC.

As we look ahead, we are prepared to confront the near-term macro challenges. And we also see opportunity and signs that our strategies are gaining momentum. [00:01:50] You will notice some changes to our normal quarterly earnings report and call format specifically, we have included more detail around our third quarter results and fourth quarter expectations in the release. [00:02:02] This allows us to focus our call commentary on the key highlights of the quarter, the key issues and opportunities going forward in our strategic efforts aimed at pursuing long term revenue growth, margin expansion and free cash flow generation. [00:02:18] Now, I will start with four key highlights from the third quarter, first, a residential building products segment delivered strong year over year growth. We generated nine percent year over year revenue growth in the third quarter or eight percent, excluding the impact of acquisitions. This is a substantial improvement from the second quarter, six percent year over year revenue decline. [00:02:42] Our third quarter order patterns indicate these positive trends should continue. Orders increased 13 percent year over year and consistent with most new home construction or remodeling indicators, order growth remains strong throughout the quarter are unique model in this business continues to provide a competitive advantage.

Our focus on operational excellence are vertically integrated structure, and our investment in regional distribution centers have allowed us to take advantage of accelerating demand.

We are competing better than ever in this space and we continue to drive strong financial returns with third quarter operating margins expanding 270 basis points year over year to a third quarter record of nineteen point six percent.

Second highlight of the third quarter was our workplace furnishings segment delivered solid profitability despite continued recessionary pressure. In general, customers remain in a holding pattern and third quarter revenue was down 27 percent year over year.

However, the segment still is able to generate a profit of nearly 17 million dollars in the quarter. We're seeing some signs that demand activity is becoming less bad in this segment, orders and workplace furnishings, excluding e-commerce, declined 25 percent year over year in the third quarter. This was an improvement from the thirty five percent ordered decline in the second quarter. Furthermore, order declines moderated as the quarter progressed. This trend is encouraging, but we are not expecting a dramatic improvement over the next couple of quarters. [00:04:16] Orders in our workplace furnishings e-commerce business increased 35 percent year over year in the third quarter. [00:04:22] That is strong growth, but it is lower than the triple digit border increase we generated last quarter. Much of the moderation in order rates was expected as was the result and was a result of tougher comps and supply constraints. We did see September orders reaccelerate and this improvement as a result of a continued strong demand environment combined with our improving inventory positions.

Our third highlight for the quarter was we continue to smartly manage our costs and expenses, we reported a decremental margin of 19 percent in the third quarter. This is better than our previously communicated target of 25 percent. Also recall, we were up against a strong prior year comp in the third quarter as our productivity efforts and cost management drove a 50 percent incremental margin in the third quarter of 2013.

We continue to manage through the near term recessionary environment in the workplace reducing segment while remaining focused on our long term strategies.

Finally, our fourth quarter, our fourth holiday of the quarter was continued. Strong free cash flow generation, our balance sheet strength and cash flow outlook provide ample flexibility to navigate through the period of softness in work workplace furnishings while maintaining our key growth investments in both segments. I will now turn the call over to Marshall to provide some additional details around our fourth quarter outlook.

Marshall Bridges

[00:05:42] Marsal. Good morning, everyone.

Let's start with the outlook for our workplace, for instance, first and the workplace furnishings segment.

We expect fourth quarter year over year revenue declines to be in the mid teens. That's better than what we've seen over the last two quarters and is based on three factors.

First, as Jeff mentioned, we have seen year over year order declines trend less bad.

As you stated in the press release, workplace furnishing orders were down twenty five percent for the third quarter and the declines moderated as the quarter progressed.

Second, we are expecting more growth from our e-commerce business, given the continued demand strength along with our improving supply position. And third, our fiscal calendar has an extra week this year, which we expect will add four to seven percentage points of growth to the quarter. I should note, it also adds cost.

So this growth delivers lower incremental margins compared to true organic growth. Shifting to our fourth quarter outlook for residential building products, recent quarter trends, housing construction activity and the extra week support, fourth quarter year over year growth rates in the mid to high teens.

Moving on to profitability, we would also like to emphasize what we are expecting for decremental margins for the full year, we expect decremental to be less than 20 percent. [00:07:05] This implies meaningfully higher decremental margins in the fourth quarter, primarily driven by unfavorable business mix, accelerating investment levels and the impact of the extra week.

We continue to target decremental margins of 25 percent over time.

Finally, I'd like to make some comments on our cash flow and balance sheet. Since the early days of the pandemic, our teams have focused on driving free cash flow.

As a result, our free cash flow through the first three quarters is tracking 70 percent ahead of prior year levels despite lower profitability. We ended the quarter with one hundred nine million dollars in cash on the balance sheet that balances more than quadrupled the balance from the end of last quarter. We've reduced our net debt by 65 percent or nearly one hundred twenty three million dollars, and our gross leverage ratio is zero point nine, well below our debt covenant of three point five.

So we have substantial financial flexibility and a high quality balance sheet, and we're not expecting any meaningful capital structure stress. I'll now turn the call back over to Jeff.

Jeffrey Lorenger

[00:08:13] Thanks, Marshal.

For the past six months have demonstrated how much of what is acceptable about. And I and I believe this experience has helped and I become a stronger company in many respects, which will serve us well as we move forward.

As I looked at 20, 21 and beyond, I would like to call it a few items.

First, we remain excited about the prospects for a residential building products segment are unique, vertically integrated model, with more than 20 percent of revenue coming from our own installing distributors, along with our recent success in managing through the spike in demand surrounding the pandemic puts us in a strong position as we move into 2021. [00:08:55] We have ramped up our investments in this business to better market directly to home buyers and consumers in both the new construction and remodel retrofit markets. [00:09:05] Our belief is that increased marketing in what has long been an under marketed industry will provide revenue upside that may not be fully appreciated. This will add to what is already a strong cyclical backdrop, as indicated by low housing inventory and increased household formation. And we will also benefit from encouraging secular trends such as urban blight, larger home sizes and increases in home ownership. In summary, we believe the revenue growth opportunity in this segment is strong and we will continue to invest aggressively to grow this addressable market and the categories in which we compete.

Second, while we remain cautious near term, we expect workplace furnishings revenue to continue to recover.

As we move to a more supportive environment.

Looking ahead to 2021, we expect a challenging first quarter as we lap pre covid conditions.

However, moving through the year, we expect more companies to return to offices.

While those return dynamics will likely take many forms, each will support improved demand. Longer term, we see positive trends emerging that line up nicely with our competitive strengths.

Specifically, we are particularly well positioned to benefit from increasing work from home demand.

Our unmatched price point breadth, our product depth and our distribution capabilities put us in a strong position to benefit from elevated work from home activity. A recent example of our efforts in the Home Office space is a win with a large enterprise client. Their employees, which number in the tens of thousands, will be able to choose Home Office furniture from a pre-set selection of our products. There are many more opportunities like this in the pipeline. [00:10:47] We are also uniquely positioned to benefit from trends tied to the urban ization for urban flight. This tends to lead to more satellite offices away from city centers and in smaller markets, these markets, these are markets that play to the strength of our go to market models and where we have strong competitive positions.

Next, we believe densification of office space, which was a headwind for this segment for years, will stabilize, if not reverse in a post covid world.

Finally, we believe office space layouts will change, the exact layout of the office of tomorrow remains up for debate. It will not look like the office of yesterday. Change is good for our workplace furnishings businesses.

Third, our cash flow outlook is encouraging and our balance sheet will remain strong. Marshall discussed our cash flow and balance sheet outlook as we look toward 2021, our targeted uses of cash continue to be ongoing dividend support.

We have not cut our dividend in over 65 years of paying. Investment and growth opportunities in M&A, in both workplace furnishings and residential building products, and finally opportunistic share buybacks, a conclusion I'm extremely proud of all of our 89 members and the company's collective focus and ability to adapt.

Over the last six months, 20/20 has presented and continues to present challenges that were unforeseen just a few short months ago.

However, as we emerge from this period, we will do so. A stronger company, well-positioned to grow revenue, expand margins and generate cash flow will now open up the call to your questions.

Operator

[00:12:29] Thank you.

As a reminder to ask a question, you please press star one on your telephone to withdraw your question. Press the pound or hash key. Please stand by while we compile a Q&A. Laughter. And our first question comes from the line of Reuben Garner from the Benchmark Company.

Your line is open.

Reuben Garner

[00:12:48] Thank you. Good morning, everybody.

Jeffrey Lorenger

[00:12:49] Morning.

Reuben Garner

[00:12:53] Maybe can we start with the fourth quarter decremental margin outlook? You mentioned business mix and increased investments, I guess. Can you elaborate on on those two a little bit? Were you seeing the mix intact? Obviously, you're going to get a benefit from the building products business getting growing and in the office business declining. What mix are you referencing? And then on the investment side, can you just go into detail into which businesses that would be where those investments would be, and then the anticipated benefit to those as we move into next year?

Marshall Bridges

[00:13:33] Yeah, sure, Ruben.

So maybe the mix issue first, I think we talked about this in the last call that, you know, we're seeing increased government mix in the workplace furnishings business and that typically comes with a little bit lower profit profile.

So that's the business mix we're referring to there. The investments are interesting.

You know, we're expecting to invest five to seven million dollars incrementally in the fourth quarter. And about a third of that is in the horse business around marketing efforts and category expansion initiatives. And the other the other big item there is investments in digital and data analytics, which include things like e-commerce infrastructure, Apsara, our trade partners, visualization tools and things like that. And the rest is really run operational productivity.

Reuben Garner

[00:14:25] Ok, thanks, Marshall, and the investments that you're making to grow the category in half and just grow the business in general, are you already are you already seeing benefits from this? I mean, the third quarter, eight percent organic growth, the low double digit kind of implied organic growth for the fourth quarter. I mean, that's that definitely seems higher than any other inside the home building product categories, you know, at least that we've seen that eat a contractor in the house. Can you just talk about kind of the end markets there versus maybe some of the internal initiatives that might be driving faster growth?

Jeffrey Lorenger

[00:15:05] Yeah, Ruben, I'd say first and foremost, first and foremost, as I said in my remarks, it's really the initial growth based on our model. I mean, we have you know, we have just a strong, vertically integrated model that has been very responsive to the market and broad in product depth and price point.

So that's that point one. Point two is the market. The investments in category expansion and basically consumer awareness are really just getting going.

So they are starting to to, I think, show some signs. But for the most part, those are going to be, you know, outward looking investments that probably pay back more middle middle to late next year.

So, you know, netnet the model itself is is strong in the short term and the investments are well underway to continue that that growth going forward.

Reuben Garner

[00:16:03] And Jeff, you mentioned, I think, that there was that that the growth opportunity for the category was maybe underappreciated. Do you have a target for how you know, how much faster you can grow than the market over the next couple of years? Last year, the market I mean, you know, if I told you that housing was going to grow X percent and Arnab was going to grow Y percent, what kind of a growth above the categories can you see in your in your building costs of.

Jeffrey Lorenger

[00:16:34] Well, Ruben, we don't we're really looking at it that way, it's a good question.

I think what we're talking about is, you know, 68 percent of homebuyers say a fireplace is a must have, yet only 40 percent actually buy one.

So that's that's really what we're focused on. We're focused on, you know, growing the addressable market through that effort. And that's in how that's going to translate. I mean, you know, there's a bunch of trajectories there. But but the bottom line is we're going to move, you know, that 40 percent, up to 68 percent in a perfect world through those efforts. And then the other thing, we got existing homes in the remodel space. We got, you know, 30 million older gas and wood burning units installed in need of an upgrade.

And so we know where those units are at, where many of those units are at, and we're increasing our efforts there to ramp replacement activity.

So those are the two the two big awareness plays.

Reuben Garner

[00:17:35] Great, and then switching gears a little bit, I'm going to sneak one more in about the Home Office opportunity for you guys.

You know, I guess can you can you one touch on and elaborate on the e-commerce supply constraints? I think you mentioned accelerating growth in the fourth quarter.

So can you tell us, you know, maybe how you're getting around those? And then you mentioned in Enterprise, when can you tell us how that set up is that is the customer buying furniture for their employees to use at home? And is it the same product that you would normally sell into the office, or is it the things that you're selling through the e-commerce channel like, you know, through the Amazons and wafers of the world? And thanks and congrats on the quarter. Good luck navigating through the rest of the year.

Jeffrey Lorenger

[00:18:22] Yeah, let me let me hit the Ekom supply first. I mean, you know, basically we we were in a really strong position, but the business was so robust, we stocked out of some of our our top running cayuse. And we're reloading those as we speak.

I think if you look and there's a lot of supply constraint is port constrained is container constraint. There's still a lot of that out there. But we've been able to you know, we got on it early. We've been able to get it into a pretty solid stock position going into the fourth quarter.

So we think for the most part, those constraints will will subside. And then the question on the enterprise enterprise client. Yes, you know that first of all, let me just say we're seeing all kinds of discussions and those types of opportunities take all different kinds of forms.

You know, some clients provide a stipend. That's what happens to be the case here. And they will be products that aren't so much. These are more core workplace products, commercial products from some of our our our companies, not what I would call core ekom Amazon type products that are going going into that program in particular.

So but like I said, those those are all over the map. But there's a lot of discussion there. And we are seeing those those start to land.

Reuben Garner

[00:19:50] Great, thanks again. Yeah, thanks, Robert.

Operator

[00:19:55] Our next question comes from the line of Stephen Ramsey from Thompson Research.

Your line is open.

Steven Ramsey

[00:20:03] Hey, good morning, I guess to start with a quick follow up on the Ekom inventory issue, that inventory cause lost sales or did that push what would have been sales into orders and that benefits to for Doug?

Jeffrey Lorenger

[00:20:20] Stephen, it's in that in that world, it's a lost sale. They move on, they move on to another another SKU or they or they maybe live they back out live to relook later. But it's not it doesn't operate like the core business where it just it lead times out and then pushes.

Marshall Bridges

[00:20:38] And Stephen, I would point out that this was pretty common in that in that segment, that the demand was so strong that a lot of players in the space had similar issues to what we've experienced.

Steven Ramsey

[00:20:51] Great. OK. And then I think, you know, we're eCom. [00:20:57] You know, if you think about the next six to 12 months in moving this business forward and and people start going back to the office to a larger degree, does that shift your investment priorities and maybe discussions internally as you start to think about this business being a greater profit contributor than what it already is over the next one to two years is the pandemic impact, say?

Jeffrey Lorenger

[00:21:29] You know, Stephen, I think, you know, what I would say is it's going to continue to we're going to invest in this business. It's going to continue to be a big part of our of our kind of go forward model.

I think at this point, you know, it's it's been incremental up to, you know, pre pandemic. And now, you know, I think it's also been going to settle out, you know, in the long run is incremental business. I do believe that the vast majority of employees will ultimately sell out working, you know, some some of the homes, some at the office, and both are going to require furniture in both locations.

And so so the way we look at that business is it's you know, we're going to invest in it. [00:22:12] It will become core, more core over time and and support kind of where we believe the future work is headed.

Steven Ramsey

[00:22:23] Excellent. OK, and then thinking about switching to the sea, the ready market regarding Q3 results and the Q4 outlook, can you discuss if there is any mixed impact or temporary cost reductions, driving margins there and then discussing the ability to drive high margins and red the long term offset by some growth investments that were already discussed? And maybe that's why Q3 was so much better than than expectations, even as you make those investments and how that plays out over the next two to three quarters.

Marshall Bridges

[00:23:08] Sure, yeah, Stephen is relates to the margins in residential building products. There wasn't really anything abnormal in the third quarter. We just had really strong volume. And of course, you know, we had we had, you know, adjusted our cost structure for a much lower volume level and it came in much stronger.

So that's the big the big issue there as we move forward. Margin expansion is really not our goal.

You know, we really want to grow this business.

You know, Jeff talked about our efforts, you know, to create awareness and grow the category sorry, and continue to invest pretty strongly there. But we'd expect to be able to hold margins at levels like we see here recently. And they're very strong, really getting good ROIC. And, you know, the recent results really reflect the strong operational model we have there, combined with some healthy market.

Steven Ramsey

[00:24:01] Great and last quick one on on the RedZone market. How is the performance of the recently acquired distributors compare to expectations or or acquisitions over the past couple of years? And then what is the pipeline like for more deals going forward?

Jeffrey Lorenger

[00:24:20] Yeah, I think the performance is that team does a great job with those the performances in line as we as we model and as we expected, and and they were in some nice markets for us. And we we are continually looking looking across the network to see where it makes sense to to continue to add those to our our own network.

Steven Ramsey

[00:24:44] That's what thank you.

Operator

[00:24:46] Thanks.

Our next question comes from the line of Greg Burns from Sidoti.

Your line is open.

Greg Burns

[00:24:53] Morning.

In terms of the order patterns on the the office side of the business, can you talk about maybe where, where, if any, where specifically you saw that Improvement's wasn't on the kind of build supplies business or more of the contractual steel side of the business? Or maybe it was, you know, across broad based. But can you talk about that?

Jeffrey Lorenger

[00:25:20] Yes, let's talk about workplace first, excluding e commerce, and when I tell you there that we didn't see a lot of difference between the contract business and the small to midsize business or the businesses, as you mentioned, but we were down orders were down like 35 percent in the second quarter. And we we progressively got better as we move through the quarter.

So we exited September down in the high teens. I'd tell you that, you know, the last five weeks were in the low 20s.

So it's consistent with our outlook that A is going to moderate to the as a moderate in the fourth quarter. But B, we're not expecting it to come back really quickly in either side of the business. To your original question, Greg.

Greg Burns

[00:26:06] Ok, great, thanks. And I think you mentioned what that extra week added will add in terms of your growth outlook for the fourth quarter for the the workplace. But I don't think you can quantify that for residential building products. How much is the the actual week adding to the outlook for that part of the business?

Jeffrey Lorenger

[00:26:27] Now, the extra week is for both businesses, it adds four to seven percent for both businesses.

Greg Burns

[00:26:34] Ok. OK, great, thanks. OK, thank you.

Operator

[00:26:41] And we have no further questions in queue, I'd like to turn the call over to Jeff Lorenger for closing remarks.

Jeffrey Lorenger

[00:26:49] Thank you again for joining our third quarter call, we continue to be excited about what is ahead. We look forward to speaking with you next quarter. Have a great day.

Operator

[00:27:00] Ladies and gentlemen, this concludes today's conference call. Thank you for participating.

You may now disconnect.