Earnings Call Transcript - FLXS Q2 2024

Operator, Operator

Good morning, and welcome to the Flexsteel Industries’ Second Quarter Fiscal Year 2024 Earnings Conference Call. All participants will be in a listen-only mode. After today’s presentation, there will be an opportunity to ask questions. Please note this event is being recorded. I would now like to turn the conference over to Mike Ressler, Chief Financial Officer for Flexsteel Industries. Please go ahead.

Mike Ressler, CFO

Thank you, and welcome to today’s call to discuss Flexsteel Industries’ second quarter fiscal year 2024 financial results. Our earnings release, which we issued after market close yesterday, February 5 is available on the Investor Relations section of our website. I am here today with Jerry Dittmer, Chief Executive Officer; and Derek Schmidt, President. On today’s call, we 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 using words such as estimate, anticipate, expect and similar phrases. Forward-looking statements, by their nature, involve estimates, projections, goals, forecasts and assumptions and are subject to risks and uncertainties that could cause actual results or outcomes to differ materially from those expressed 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. Additionally, we 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 the reconciliation of GAAP to non-GAAP measures. And with that, I will turn the call over to Jerry Dittmer. Jerry?

Jerry Dittmer, CEO

Good morning, and thank you for joining us today. I’d like to start by welcoming Mike Ressler, our new Chief Financial Officer. Mike has been with Flexsteel over 17 years in various accounting, finance and other cross-functional roles, most recently as the Vice President of Manufacturing. His appointment as CFO reflects his leadership and contribution to the company’s transformation over the past several years. I’m excited for Mike to further expand his positive impact on the company as CFO. I would also like to congratulate Derek Schmidt on his appointment to President and to the Board of Directors. Derek’s promotion reflects his leadership of the company’s operations and growth strategy and aligns with his expanded responsibilities since joining the company nearly four years ago. With that, I am very pleased to share with you our second quarter fiscal year 2024 results. While headwinds from macroeconomic challenges and shifts in consumer spending towards experiences and away from goods persist in our industry, we continue to execute on our strategic initiatives and delivered sales growth of 7.5% compared to the prior year quarter. Our relentless focus on operational efficiency and cost savings propelled gross margin expansion and helped fund additional investment in growth initiatives while delivering significantly improved operating income when compared to both the same quarter of the prior year and our first quarter fiscal 2024. While we expect the business environment in the near term to remain challenged, our team isn’t deterred and remains intensely focused on continuing to profitably grow our business throughout the remainder of fiscal year 2024 and long term. We will continue our positive momentum going into the third quarter and are confident in our ability to grow sales, both compared to last year and the second quarter. I’ll now turn the call over to Derek to discuss our results and an update on our growth initiatives. I’ll be back at the end of the call with some closing comments on what we see ahead.

Derek Schmidt, President

Thank you, Jerry, and good morning, everyone. Like Jerry, I am very pleased with our second quarter results. We are competing well in our core business and executing our market expansion initiatives, resulting in both sales and profit growth even in a difficult business environment. As Jerry noted earlier, we grew our top line by 7.5% in the fiscal second quarter. This year-over-year sales comparison continues to be adversely impacted by the elimination of ocean freight surcharges, which reduced revenue by approximately $3.5 million compared to the prior year quarter. As discussed in our first quarter call, in the prior year, we used this surcharge mechanism to pass through higher costs of ocean container delivery which were significantly inflated due to supply chain issues. Container delivery costs normalized throughout the last fiscal year, and we subsequently eliminated this surcharge. Excluding the $3.5 million impact from this ocean freight surcharge elimination, sales growth related to unit volume and product mix was a robust 11.7%, further reinforcing our strong sales execution. Despite challenging industry conditions, we remain confident in our ability to continue our growth momentum into the second half of fiscal 2024 from both continued share gains in our core business and increasing momentum in our market expansion initiatives. In our core business, we expect to continue outperforming the industry by continuously improving and providing a differentiated customer experience, aligning ourselves with the strongest, most capable distribution partners, and driving a constant stream of relevant and compelling new product. We define our core business based upon where the majority of our current sales are derived, which is product designed for primary living spaces like the living room, sold through independent furniture retailers and appealing to Gen X and Baby Boomers consumers. This core business is large and profitable, and we will continue to defend and expand our penetration in this market. At the same time, we are pursuing growth in markets outside of our core that we believe are relevant and growing, and where we have a clear right to win. If you recall from prior calls, these market expansion initiatives take three forms: first, consumer segments, namely Gen Z and Millennials; second, product categories outside of primary living spaces; and lastly, sales distribution outside of independent furniture retailers. I’m pleased with our solid progress in all three of these areas. First, to address younger consumers, we’re repositioning our brand portfolio through a three-pronged approach. We are modernizing the Flexsteel brand and last October we launched a strong lineup of more contemporary product at lower price points with exceptional comfort and quality. We’re encouraged by initial placements, and sales of these new products are ramping nicely. We also launched a new brand, Charisma, last year to reach younger consumers with even lower-priced, on-trend product. This year we’ve invested in new talent and product engineering to support Charisma and we’ll be launching multiple exciting new products at April’s High Point market to grow this new brand. Additionally, we continue expanding our new flex solution with broader accessories to further improve its modularity and appeal to younger consumers. Moving on to our second market expansion focus, which is to expand into newer product categories. We focused on health and wellness this year with our new Zecliner sleep chair. A recent third-party sleep study validated the superior sleep results from using Zecliner, which we are now leveraging in our marketing and demand generation initiatives. The product is now placed in over 960 retailers, and we are investing aggressively in additional innovation to protect our leadership position in this emerging market. Our third market expansion focus is to broaden our sales distribution to position our brands, where and how consumers want to purchase furniture, both now and into the future. For example, our Flex Modular Solution, which I mentioned earlier, can be purchased not only in leading retailers, but also on Amazon, Wayfair, Costco, and our own online platform at flexsteelstore.com. While I'm excited about our top line growth and future growth prospects, I'm equally energized by our improved profitability, being propelled by four drivers: first, new products with higher margin profiles; second, we're executing well operationally and delivering strong cost savings within our supply chain; third, we've remained disciplined with pricing and pulled back promotions where needed to improve overall profitability; and fourth, we are achieving leverage on fixed costs through higher sales volume, which we believe will continue to be an important driver of operating margin improvement going forward as we grow the business. As part of our ongoing commitment to improve the customer experience, the company announced the closure of our Dublin, Georgia manufacturing plant. While this decision was very difficult, it enables us to reduce customer lead times and handling damage to improve the overall customer experience, while also decreasing inventory, simplifying logistics execution and improving profitability. Currently, the Dublin facility supports less than 5% of the company's sales, and we expect to retain virtually all sales through this transition. Closure of the facility is expected to occur by the end of our fiscal fourth quarter. As part of this transition, the company expects to incur pretax restructuring and related expenses between $2.5 million and $3.2 million. The one-time costs are associated with employee separations, inventory and equipment transfers, and other expenses directly related to the closure and are expected to be incurred primarily in our third and fourth quarters of fiscal year 2024. Once the closure is fully executed, the company expects annualized savings in the range of $4 million to $4.5 million. The Dublin facility will be listed for sale upon closure, and the company anticipates a future one-time gain in excess of the carrying value of the asset. To summarize, we are growing and gaining share under challenging industry conditions. We have robust plans to continue that growth both through our core markets and expansion into new markets. We are rapidly improving profitability with more gains expected through fiscal 2024 and into fiscal 2025. We are generating strong free cash flow and strengthening our balance sheet, and we are investing to continuously improve our customer experience and to drive new innovation that will differentiate us and strengthen our market leadership long-term. The future is bright, and I'm excited about what lies ahead for our organization. With that, I'll turn the call over to Mike, who will give you some additional details on the financial performance for the second quarter and the outlook for the third quarter of fiscal year 2024.

Mike Ressler, CFO

Thanks, Derek. For the quarter, net sales were $100.1 million, slightly above our guidance of $94 million to $100 million, provided during our first quarter fiscal 2024 earnings call. As Derek noted earlier, sales growth related to unit volume and mix, which when excluding prior year quarter ocean freight surcharges was a strong 11.7% in the quarter. We feel we have sustainable growth momentum throughout the rest of fiscal 2024 and into fiscal 2025. From a profit perspective, the company delivered operating income of $4.6 million or 4.6% of sales in the second quarter, which exceeded our operating guidance range of 2% to 4%. A meaningful increase in our operating income was driven by an expansion of our gross margin to 21.9% in the quarter compared to 17% in the prior year quarter. Moving to the balance sheet and statement of cash flows, the company ended the quarter with $3.3 million in cash, working capital of $100.5 million and a balance on our revolving line of credit of $17.9 million. Our increased profit, combined with improved working capital levels, allowed us to pay down our debt by 46% when compared to the fiscal first quarter. Looking forward, we reiterate the sales guidance released with our preliminary results announcement on January 11, 2024. While we expect one-time costs related to the closure of our Dublin facility to adversely impact GAAP operating income, we still expect to achieve our fiscal 2024 operating income guidance on an adjusted non-GAAP basis, when backing out the one-time costs associated with the facility closure. Specifically, for the fiscal third quarter, we expect sales between $101 million and $106 million, which represents sales growth of 2% to 7%. Regarding profitability, we expect gross margin in the range of 21% to 22%. We expect gross margin to grow modestly throughout the remainder of the fiscal year and into fiscal 2025, driven by sales growth and continued realization of our cost savings initiatives. We will continue to prudently manage SG&A spending with a focus on investing in our growth initiatives and expect SG&A costs between $17 million and $17.5 million for the third quarter. Due to one-time costs related to the closure of our Dublin facility, we expect to incur restructuring costs in the third quarter between $2.0 million and $2.5 million, primarily related to employee separation costs and the transfer of equipment and materials to other facilities. We are projecting GAAP operating income as a percentage of sales in the range of 2.5% to 3.5% for the third quarter. Excluding one-time charges related to the closure of our Dublin facility, we expect adjusted non-GAAP operating income of 4.5% to 5.5%, consistent with our previously disclosed guidance. The most significant driver of variability in our forecasted guidance ranges are changes in consumer demand, increases to ocean container rates resulting from disruptions, and competitive pricing conditions, all of which will be largely influenced by external factors. Regarding our cash flow outlook in the second half of fiscal 2024, we expect improved profit and further inventory reduction to be a meaningful source of cash. Near-term priorities for cash remain reducing debt, resourcing new innovation, and funding modest capital expenditures mainly related to cost savings initiatives and the continued modernization of our IT systems. For the third quarter, we expect capital expenditures to be between $1.0 million and $1.5 million. We expect debt levels at the end of the third quarter to be in the range of $12 million to $17 million. By the end of fiscal 2024, we expect debt levels in the range of zero to $10 million. The effective tax rate for fiscal 2024 is expected to be in the range of 30% to 32%. Now I'll turn the call back over to Jerry to share his perspectives on our outlook.

Jerry Dittmer, CEO

Thanks, Mike. While we remain cognizant of macroeconomic factors which could impact our current outlook, I am optimistic about our ability to continue to gain share and confident we can maintain our profitable growth trajectory both in the near and long-term. We have great momentum and are well positioned to successfully deliver improved earnings and an even stronger balance sheet over the remainder of fiscal year 2024 and into fiscal year 2025. With that, we will open the call to your questions. Operator?

Operator, Operator

Thank you. The first question is from Anthony Lebiedzinski with Sidoti & Company, LLC. Please go ahead.

Anthony Lebiedzinski, Analyst

Yes. Good morning and thank you for taking the questions. First, a nice job in a tough environment for sure. So you guys talked a lot about the market share gains in your core business. Just broadly speaking, are you doing more business with your existing clients? Or are you signing up new accounts? I just wanted to get a better sense of where those share gains are coming from?

Jerry Dittmer, CEO

Yes, Anthony, thanks for the question. This is Jerry. Yes, a lot of our growth is in our core strategic accounts. Obviously, we're still signing up new clients, but most of it has come from us going deeper and getting more placements with our core accounts.

Anthony Lebiedzinski, Analyst

That's very helpful. The unit volume increase is certainly even more impressive than your total sales gains. So in terms of your guidance going forward, how should we think about the split between unit volumes versus pricing?

Derek Schmidt, President

Yes. I think, Anthony, it's Derek. Going forward, in the third quarter, let's break pricing out between the surcharge impact and normal pricing. In the third quarter, there’s about $2 million of impact of the ocean freight surcharge elimination, and then that comparison goes away in the fourth quarter. What we are assuming in terms of pricing is status quo, likely for the remainder of the calendar year. The only caveat is that ocean freight container rates have gone up substantially. If they stay at that rate, we will have to consider turning back on some types of surcharge mechanism. All that aside, we expect that the majority of the go-forward growth is related to unit volume and mix and not pricing.

Anthony Lebiedzinski, Analyst

Understood. Yes, thanks Derek. Yes, and I was going to ask about the ocean freight costs. So those have certainly gone up from the bottom here. At this point, you have not passed along any higher charges because of the Red Sea conflict? So, okay, understood. And then I just wanted to dig in a little deeper in terms of the gross margin improvement. Obviously, a very strong year-over-year. If you could kind of parse out the drivers of that; I know you talked about some cost savings initiatives. You have fixed cost levers as well. Maybe if you could just go over some of the details behind the gross margin improvement and your confidence level about being able to sustain that?

Mike Ressler, CFO

Anthony, this is Mike. Yes. So as Derek highlighted, we have four key drivers of the gross margin improvement. First, cost savings; we've taken some actions to reduce structural costs. In the prior year, we took a distribution center offline, which lowered our structural costs. Additionally, we have a strong operations team executing cost-saving initiatives in our sourcing, manufacturing, and logistics and distribution network. We feel like those processes are sustainable going forward. The second thing is the introduction of new products and using product life cycle management to improve profit over time. We're leveraging our cost-saving initiatives as well as our value engineering activities to continue bringing out new products with better margin profiles than the legacy products we have that are being discontinued. The third piece is volume leverage. As we thoughtfully reinvest back into our structural costs, we get leverage on our sales growth initiatives. Lastly, we have been more strategic around our promotional activities.

Derek Schmidt, President

The magnitude of impact from those four levers will change over time. In the near term, we're executing really well operationally, with cost savings from that. The pricing discipline has also been a significant profit lever in the near term. Looking ahead, the main drivers of gross margin improvement are going to be product life cycle management and operational leverage as we grow, which will evolve over time. We feel confident in our ability to continue expanding margins.

Anthony Lebiedzinski, Analyst

Understood. Yes, thank you for that. Regarding the Dublin, Georgia facility closure here, you mentioned annualized cost savings is at the lower end of $4 million. However, I noticed you didn't change your guidance for fiscal 2025. Is this just a function of you trying to be conservative, or are you planning to reinvest those savings elsewhere? How should we think about that?

Mike Ressler, CFO

When we built our fiscal 2025 guidance ranges, we modeled out different structural cost change scenarios, and we still feel good about what we put out there for our fiscal 2025 guidance range on both top line and operating income perspective.

Derek Schmidt, President

We had several scenarios, even though we had not made a decision in terms of closing Dublin at the time we provided 2025 guidance. There were multiple options to drive manufacturing efficiency, which we built into that fiscal year 2025 guidance. We will have a better understanding at the end of this fiscal year to see if there are potential additional savings that would meaningfully change our fiscal year 2025 guidance.

Anthony Lebiedzinski, Analyst

Understood. Thank you very much, and best of luck. I'll pass it on to others.

Jerry Dittmer, CEO

Thanks, Anthony.

Derek Schmidt, President

Thanks, Anthony.

Operator, Operator

The next question is from Budd Bugatch with Water Tower Research. Please go ahead.

Budd Bugatch, Analyst

Good morning, Jerry. Good morning, Derek. And congratulations to you Mike, and to you Derek as well. A couple of questions on the order book, if I could. Can you talk a little about the quality of orders in terms of product vitality? How much of that is new business? I know you said most of it's coming from existing strategic accounts, but I was curious about new placements, increased penetration in those accounts, and with new product versus old product?

Jerry Dittmer, CEO

At the highest level, Budd, a lot of them are getting new placements on the floor. We do have, obviously, our Flex and Zecliner products are doing very well, and those are driving a big piece of that.

Derek Schmidt, President

We actually measure what percent of our overall sales come from new products. For the last three years, that's close to 25%. We feel good that we are driving relevant new products that resonate with the market. We expect that new product would make up at least 25% of our overall sales, if not more, going forward.

Budd Bugatch, Analyst

So looking at that on a weighted or continuing moving average, how has that changed over the last 12 to 18 months?

Derek Schmidt, President

It's definitely increased. We've been more aggressive around launching new products and that trajectory will continue.

Budd Bugatch, Analyst

I think, and correct me if I'm wrong, my memory is faulty, but I do believe you told us a couple of years ago that the target gross margin was in the low 20s. We seem to be there. What does that look like going forward?

Derek Schmidt, President

From a gross margin perspective, certainly, we're striving for 23% or more in the mid to long term which we believe we can achieve.

Mike Ressler, CFO

Three to five years.

Budd Bugatch, Analyst

So am I correct that your guidance for 2025 indicates an intention to have no debt? Is that the interpretation I should make?

Derek Schmidt, President

Yes, that's correct.

Budd Bugatch, Analyst

So you aim to reduce debt to zero. Once debt is zero, what does your cash use look like? What's your thought process?

Derek Schmidt, President

In terms of capital allocation, we are looking for value-enhancing acquisitions that would accelerate our penetration into key market areas. We would want to focus on potential outdoor companies, direct-to-consumer companies, or modern mid-price lifestyle brands. We expect to potentially accumulate cash in the balance sheet and proactively look for value-enhancing acquisitions.

Budd Bugatch, Analyst

And does that take you out of manufacturing or into retail or out of furniture?

Derek Schmidt, President

No, we're squarely focused on residential furniture. We do not desire to be in retail ourselves, so this is leveraging our core competence while bringing in new capabilities in furniture wholesaling.

Budd Bugatch, Analyst

Thank you very much. Congratulations on the quarter, and best of luck for the rest of the fiscal year and beyond.

Derek Schmidt, President

Thanks, Budd.

Jerry Dittmer, CEO

Thanks.

Operator, Operator

This concludes our question-and-answer session. I would like to turn the conference back over to Jerry Dittmer for any closing remarks.

Jerry Dittmer, CEO

In closing, I'd like to thank all our Flexsteel employees for their dedication and outstanding performance during the quarter. Thank you all for participating in today's call. Please contact us if you have additional questions, and we look forward to updating you on our next call. Everybody, have a great day. Thank you.

Operator, Operator

The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.