Hni Corp (HNI) Q3 2023 Earnings Call Transcript

Good day, everyone, and welcome to the HNI Corporation's Third Quarter Fiscal 2023 Results Conference Call. Today's call is being recorded. All lines have been placed on mute to prevent any background noise. After the speaker's remarks, there will be a question-and-answer session. I will now turn the conference over to Matt McCall. Please go ahead.

Good morning, my name is Matt McCall. I'm Vice President, Investor Relations and Corporate Development for HNI Corporation. Thank you for joining us to discuss our third-quarter fiscal 2023 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 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 financial news release 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 now pleased to turn the call over to Jeff Lorenger. Jeff?

Thanks, Matt. Good morning. Thank you for joining us. During the third quarter, our profit transformation actions continued to accelerate reflecting the focus and dedication of our members. We delivered 31% year-over-year growth in non-GAAP earnings per share despite facing top-line headwinds from ongoing macroeconomic pressures. On the call today, I will highlight three key topics. First, we continue to deliver strong margin expansion in Workplace Furnishings. However, we are not finished and see more opportunities ahead. Second, the divestiture of Poppin will drive immediate financial benefits, and the integration of Kimball International is progressing nicely. KII accretion exceeded our expectations in the quarter, and we expect the rate of accretion to increase over time. Third, we demonstrated the resiliency of our Residential Building Products business model in the face of housing market weakness. Cost reduction actions enacted last quarter helped the operating margin in this segment remain unchanged compared to the same period of 2022. This was despite a year-over-year revenue decline of 22%. Following those highlights, Marshall will review our outlook, and I will then conclude with some general closing comments before we open the call to your questions. Moving to the first topic, we continue to deliver strong margin expansion in Workplace Furnishings. When excluding KII and Poppin, non-GAAP operating margin in this segment expanded 820 basis points year-over-year to 10.7% as our profit transformation plan continues to deliver results. This was the sixth straight quarter of year-over-year operating margin improvement, both operating profit margin and operating profit dollars reached the highest level since the third quarter of 2019, despite lower industry volume. We made strong progress with our profit transformation initiatives. However, there is still work to be done and we have a line of sight to additional improvement opportunities. As we have discussed on previous calls, our profit transformation plan in our legacy Workplace Furnishings business consists of four primary actions. First, we are driving increased productivity. Our focus on lean, cost reduction, and better efficiencies continues to deliver improvement, and we expect our recent investments in Mexico to provide outsized benefits as they mature over the next couple of years. Second, we have streamlined our cost structure, and in last year's third quarter call, we announced a $30 million corporate-wide cost savings program. Twelve months later, not only have we achieved that goal, but we have added to it. Our cost savings run rate now totals approximately $50 million across the Corporation. More specifically, in Workplace Furnishings, $25 million of that total is contributing to our margin expansion in 2023. Third, we continue to simplify our business as we focus our efforts on the most attractive markets. Examples of portfolio simplification actions taken over the past year include exiting Poppin, divesting our China business, and rationalizing our e-commerce offering, all of which are contributing to our improved margins. And fourth, price-cost improvement continues to benefit our profitability. These actions and our recent results demonstrate our profit transformation plan does not require volume growth. However, despite a mixed near-term picture, we continue to see encouraging trends related to future workplace furnishings demand, particularly given our market position. We continue to see growth in the small to medium-sized customer segment, where we have an unmatched competitive position. SMB orders grew 6% year-over-year in the third quarter and are up 9% year-to-date. In general, this segment has benefited from healthy dynamics. Small- and mid-sized firms have accounted for nearly 100% of net post-pandemic hiring. This segment has also benefited from population shifts to smaller secondary metros where office visits are nearly back to pre-pandemic levels. We believe this segment will continue to outperform. Switching to contract, recent demand has been down modestly. However, we are seeing encouraging signs for the future. Orders from contract customers were down 4% year-over-year in the third quarter and have declined 3% on a year-to-date basis. Those rates are consistent with lower return to office rates in the larger markets and lagging hiring activity by large companies. Looking forward, we see dynamics that support an increase in furniture buying events. I'll remind you that furniture events are the primary driver of demand in our industry. Replacing office furniture is an episodic event, generally driven by an office move or the need to refresh an environment for employee recruitment and retention. Going forward, the predictive acceleration of lease expirations and the need for companies to adapt their spaces for hybrid work support an increase in these events. Hybrid work has become the new normal. According to a recent Gallup survey, more than half of all remote-capable employees are now working in hybrid environments, with that number expected to move to 60% in the coming quarters. And office lease rollover activity is expected to more than double next year and remain elevated through 2028. These factors taken together support an increase in furniture buying events. Moving to my second topic, we completed the divestiture of Poppin, and the integration of Kimball International is progressing nicely. Excluding Poppin, KII added approximately $0.06 of non-GAAP EPS in the quarter. These results exceeded our expectations. Moreover, KII generated a strong operating margin of 10.6%, despite incurring $5 million of incremental purchase accounting costs during the quarter. Our confidence in the strategic and financial benefits of the combination with Kimball International continues to build. KII better positions us to lead in the evolving workplace environment and provides new opportunities for profit growth. Importantly, we continue to see the previously announced annual run rate synergy amount associated with the KII acquisition of $25 million as a floor with a strong potential for upside. The sale of Poppin, which we completed in early September, provides immediate financial benefits; recall Poppin had an annual operating loss of nearly $20 million prior to the sale. While KII's operating margin is already in double digits, cost synergies, the elimination of Poppin losses, and ongoing productivity efforts point to additional margin expansion opportunities in the months and years ahead. My third topic is we demonstrated the resiliency of our Residential Building Products business model in the face of housing market weakness. Third quarter operating margin in the segment remained unchanged versus the prior year and was up sequentially. This was despite a year-over-year revenue decline of more than 20% as this segment continues to face volume pressure in line with the overall weakness in the broader housing market. We continue to see $15 million to $20 million of our targeted cost savings benefiting Residential Building Products this year, with another $5 million to $10 million of benefit next year. These cost reduction efforts, along with normal seasonal patterns, will result in further improvements to segment profitability in the fourth quarter of this year. Importantly, demand trends in this segment continue to stabilize. Third quarter orders were 18% below year-ago levels, which represents an improvement compared to rates seen in the first half when segment orders declined 29% year-over-year. Both new construction and remodel retrofit activity have shown similar sequential improvement. Additionally, the improvement has continued in the early part of the fourth quarter. Although mortgage rates and affordability continue to weigh on housing, single-family new construction has been a bright spot. Year-over-year growth in new single-family permits averaged 5% in the third quarter, which supports further new construction improvement in 2024. Despite the near-term headwinds, we are bullish on the intermediate to long-term dynamics for the segment. The demand fundamentals remain strong. U.S. housing is undersupplied, demographic trends point to robust future construction growth, renovation activity will benefit from an aging housing stock, and there are indications that renovation activity will accelerate as existing homeowners are less likely to relocate given the current mortgage environment, with many having attractive lower interest rates. In addition to the strong long-term market fundamentals, we have unique growth opportunities. We continue to invest in our initiatives aimed at expanding the market, including in the areas of category awareness, new product innovation, online capabilities, and the expansion of our wholly owned installing distributor footprint. The market's fundamentals, our unique growth opportunities, and our category-leading positions point to the return of growth. I will now turn the call over to Marshall to discuss our outlook.

Thanks, Jeff. Let's start with our expectations for demand in the fourth quarter. In Workplace Furnishings, we expect organic revenue to be approximately flat with fourth quarter 2022 levels. That outlook is consistent with recent order patterns; it excludes Kimball International, and it assumes continued SMB outperformance. In Residential Building Products, we expect revenue declines to further moderate in the fourth quarter with revenue declining at year-over-year rates in the high single digits to low teens. That outlook assumes new construction will outperform remodel retrofit. Let's shift to the expected impact of Kimball International. For the fourth quarter, we expect KII to add $140 million to $150 million of revenue. We also project KII accretion will be consistent with third quarter results. An additional note on KII, earlier, Jeff mentioned $5 million of incremental purchase accounting costs in the third quarter, of that $5 million, approximately $3 million is associated with inventory step-up and should be considered one-time in nature. That points to an adjusted operating margin for KII of approximately 12.5% in the third quarter. Fourth quarter non-GAAP EPS is expected to solidly increase year-over-year to be modestly below our just-reported third quarter results; this is consistent with normal seasonal patterns. Recall we typically see lower sequential volumes and margins in workplace furnishings as we move from the third quarter to the fourth. Shifting to the balance sheet, we ended the third quarter with total debt of $509 million, which was down significantly from the $598 million outstanding a quarter ago. Our working capital dynamics continue to improve and return to historical levels that drove free cash flow per share of more than $2 in the third quarter. In terms of leverage, our gross debt to EBITDA at the end of the quarter was 2.2 times. Our reasonable leverage and strong cash generation will continue to provide flexibility for the dynamic environment and ongoing investment.

Thanks, Marshall. Our strategies are delivering results. Operating margin in Workplace Furnishings continues to expand, reaching 10% in the third quarter. Our profit transformation initiatives have momentum, and we expect continued year-over-year profit improvement in the segment. The integration of Kimball International is doing well. KII is already strengthening our business and delivering earnings accretion, which will only increase as our synergies mature. KII better positions us to lead in the evolving workplace environment and provides new opportunities for profit growth. And we are increasingly confident in the combination of strategic and financial benefits. In Residential Building Products, we have adjusted the cost structure and demonstrated the resiliency of our margins. While continuing to invest in our growth strategies, leading brands, and operating platforms. Although the near term remains dynamic, we are uniquely positioned to drive high-margin growth as housing recovers. In summary, we remain committed to our core strategies of continuing to expand margins of Workplace Furnishings and drive long-term high-margin revenue growth in Residential Building Products. I want to thank all HNI members, including our new members from KII. Our results reflect their collective effort and dedication. We will now open the call to your questions.

Thank you. We'll take our first question from Steven Ramsey with Thompson Research Group.

Hi, good morning. Maybe to look at SMB up again and outperforming contract, do you expect this to persist for a few more quarters even though contract is stabilizing? Is there anything in the pipeline that may show directionally how the two customers drive results in the next few quarters?

Yes, Steven, I mean, look, I think we continue to think SMB will outperform. You know, as I laid out in the prepared remarks, we have a strong position there. That's part of it. The market is healthy, they've been hiring, returned to office, and even though they returned, they're still looking at furniture events in those spaces. So our belief at this point is SMB will continue to outperform and contract will stabilize. That's a good way to think about it.

Okay, helpful. And then on the population shift. It's clearly helping the Workplace segment as you've discussed for a few quarters now. Can you talk to how this is or could help the Resi segment over time? Do you have the distribution in place where the population shift is occurring?

Yes, that's a good question, Steven. We do, we've added. First of all, we have a strong independent network that is servicing those markets, and we've also added some wholly owned distributor footprint in some of those markets recently, and we continue to keep an eye on all of that. So I do believe that the population shift will also benefit over time the Resi business.

Okay, helpful. And then last one from me again on the Resi business curious, the dynamic you're hearing on the ground for the R&R side of resi hearing from others that it's sluggish, but steady out there and not continuing any kind of demand degradation on a sequential basis, but I'm curious if that's how you would describe spending on fireplaces.

Yes, I think overall, Steven. We're seeing demand kind of decline moderate. New construction is a relative bright spot there, specifically related to remodel retrofit. We're also seeing declines moderate, but not nearly as much as in new construction. We still have pretty low existing home turnover, which drives remodeling events, and of course consumer sentiment is not helping there, but certainly the trend is improving, although still down year-over-year.

Okay, that's helpful. Thank you.

Okay. We'll take our next question from Reuben Garner with Benchmark Company.

Thank you. Good morning, everyone. Congratulations on a strong quarter. To begin with Workplace margins, Jeff, you mentioned that there is room for improvement. Could you provide more details? I understand that the savings might exceed expectations. Was that $50 million figure a recognized-to-date number or a run rate? When you say there is more potential, is this more than a 10% legacy figure likely to be sustainable without an increase in volume due to your initiatives, or was there anything in this quarter, such as a mix effect or a one-time event, that enhanced it?

Yes, Reuben, so several questions in there. The first one is that the $50 million, as Jeff mentioned, is our cost savings program that was really enacted starting early this year, and we're expecting another tranche kind of midyear. $40 million to $45 million of that will hit 2023, with another $5 million to $10 million rolling over into '24. The part that rolls over into '24 is mostly associated with the Residential Building Products segment. As it relates to Workplace Furnishings, about $25 million of that total $50 million hits that segment, all of which impacts this year. In terms of where the margins can go, we do see continued opportunity. The reason we were up so much year-over-year in the third quarter is really three things: favorable price cost, better productivity, and better SG&A efficiency. We see opportunity in all three of those to continue, maybe not all at the same rates; on top of that, we’ve had this investment in Mexico that will begin to mature and help out subsequent years.

Okay. And then on the residential side, you mentioned existing home sales. Just curious how much fireplace activity, retrofit activity is tied to inspection that a big part of what can drive demand, and if we do see a rebound in home sales when rates drop, that can kind of get the R&R segment turned around?

Yes, I'm not sure we have precise data on inspections. But we do know that remodeling events are pretty highly correlated with the purchase of a new home. Usually, remodeling events occur within a year or two after the purchase; given the new homes are not selling as much and existing homes not selling as much, we're definitely seeing some softness in that segment. But if we do see existing homes tick up, we would see renovations tick up eventually.

Okay, and last one for me. Nice snapback in margins in the Residential business. I think if I'm looking at it correctly, comparable to a year ago on a much lower base. Is there any positive price cost in there as well, or is all of that from the initiatives you've put in place earlier in the year?

Yes, we were flat at 17.7% operating margin in Residential Building Products in the third quarter, and yes, there are multiple factors contributing to that. The same three factors I mentioned: we did have favorable price cost there, we also had better productivity, as well as some better SG&A efficiency.

Okay, great, thanks, guys.

Thanks.

We'll take our next question from Greg Burns with Sidoti & Company.

Good morning. The outlook for flattish Workplace growth. I think last quarter you were talking about low single-digit growth in the second half. So a little bit of a reduction there. Could you just talk about what changes you're seeing in the demand environment there to lower your outlook?

Greg, I want to stress this is a major change. We did talk about low-single-digits. I think organic revenue in Workplace excluding Poppin was 1.7% in the third quarter, so right in that range, and then flattish may put us at the low end of low single digits for the back half, but I wouldn't call it a major change.

Okay. Kimball had a good size health business, can you just talk about maybe some of those adjacent markets like healthcare education where maybe you could drive incremental growth if the core office segment isn't recovering to pre-COVID levels like what initiatives do you have in place, and I guess specifically how was Kimball's Healthcare business this quarter?

Yes, Greg, good question. I think where the activity has been pretty solid throughout the year and starting to build in the health segment, and KII had quite a bit of product pipe in that piece of the business that will be coming online in '24 as well. So we like that position, and we do believe that's an opportunity for growth overall. Education has been strong in education, similar to our legacy business both have had a pretty solid year-to-date. We see the education vertical as an opportunity for growth going forward as well. And then I would mention, they have a hospitality business that's competing well at this point. We see some good second-half growth in their hospitality business, kind of pent-up demand to catch up from post-COVID remodel activity and refresh rates for hotels. So all three of those—healthcare, education, hospitality—we can rotate into and lean into notwithstanding core commercial.

Okay, great. Thank you.

We'll take our next question from Budd Bugatch with Water Tower Research.

Good morning, and thank you for taking my question, and congratulations on a very good quarter, to your team and to your members. Really impressive. Marshall, I would love to get—maybe if you could walk on the workplace, the Legacy Workplace even just on a GAAP basis from a $5.6 million operating profit last year to $39.6 million this year. I can't remember if the $5.6 million included much of Lamex as a drawdown of that. I thought that might have been all involved in the gain number. So maybe you could give us some more color on that—a walk from those margins because that's pretty impressive.

But there is a bit of Lamex in the GAAP numbers in the prior year, both sales and profit as well as the gain. If you look at the non-GAAP, it's probably a little cleaner. The segment, excluding KII and Poppin, is up $31 million in operating profit year-over-year. And there are really two big items there. You got price-cost favorable about $21 million, and net productivity was up about $11 million. And so there's some rounding there. But those two things really drove that $31 million profit improvement in the segment.

So the $11 million continues? Or does that continue and then anniversaries and the $21? How do we think about that going forward? How do we think about that kind of 2:1 ratio?

Well, the productivity is going to continue. We certainly see benefits from our ongoing lean initiatives as well as the Mexico investment as we look out. Price-cost, this is — we're anniversarying some lower price periods, and we have pretty stable commodities. So I don't think that's going to continue at the same rate, but it's not going away immediately.

And commodities, are they stable? Or are they starting to—or have they fallen—and are we having to do any—are we worrying anything about pricing having to be retraced?

For the year, commodities are pretty stable. We had some inflation when you include everything early in the year, and we had a little bit of deflation here recently. As we look to the fourth quarter, we're starting to see a little bit of pressure from diesel and some other commodities. But in general, input costs are pretty stable.

And we think pricing will kind of hold in there where it's at today, that's kind of what we're seeing in the marketplace.

And we typically do a once-a-year price increase, do we not usually have that adjustment? Is that usually a beginning of the year kind of thing? And I know in this environment, nothing is usual, but trying to—I’m showing my age.

But yes, Budd, it's typically kind of in the first quarter. It moves around a bit depending on the cycle, but it's typically in the first quarter.

Okay. And this has been part of your strategy, Jeff, of getting the Workplace Furnishings margins back to this kind of level. So the other side is RBP and having that grow, keeping the kind of great profitability you have there. Are there any new programs that you are anticipating to try to maybe spark a little bit more of the RBP stuff, or is the environment just too tough?

No, look, we're continuing to invest in that. You hit it right on the head, Budd. This has been our goal to reset margins and have a line of sight for more, and we've been talking about that for a couple of years, and that will continue. RBP—look, we like our operating model. We're going to continue to invest in that business because it's only a matter of time. And the fact that we've been able to hold our margin profile in that business, notwithstanding the volume decline, we like where that can go. I'd say, right, the third piece of this, though, is the integration of KII. That's where we're working hard. I commented on their business in healthcare and hospitality and also integration in synergies. So that would be the two items we've been talking about: continuing to lean into the workplace margins and RBP growth investments, and then bring KII on and kind of mine that profit and that model; it's got strength, but there's more to do.

That got right to my third area of questioning, was on Kimball. What kind of RCII or RCI programs do you see going for that? They have had a number of divisions that might not have been performing up to snuff. Anything that you feel comfortable talking about at this point in time?

Yes, Budd, really, all I would say is we had—we disposed of the Poppin thing. That was kind of job one as we got in there. And now we're getting our arms around the synergies and the team. They're doing great. And there'll be more details on that going forward. But right now, I'd say, at 50,000 feet, it's going great. I love the team and what they bring to the table, and we're continuing to invest in that business as well.

Budd, I would just add to that. Look, healthy margins in that business right now are very strong. We do see synergies moving forward. In the run rates we see right now in their profitability are about $10 million of annual improvement related to duplicative corporate costs. So that's $10 million of the $25 million of synergies that we expect as a floor. And so the other $15 million, we see coming over the next couple of years and feel real clear line of sight to that. As Jeff mentioned, there is strong potential for more that we'll communicate as we get further into it.

And how does that feather in? I mean how much have we seen so far? And how much feathers in over the next couple of quarters, quarterly rate?

Yes, we're averaging about $2.5 million a quarter right now. So we've got about a $10 million run rate as we sit right now. Probably add $5 million to $8 million next year, and then we get the full incremental $15 million in 2025 for a $25 million run rate. When you take that $25 million plus the $20 million benefit from exiting Poppin plus the strong profitability that KII had before the acquisition. Again, we're looking at an EV to EBITDA multiple on the acquisition near $5 million; it really speaks to the value creation opportunity that we have.

Wow, okay, last for me is corporate overhead looks—is this the current run rate of $20-some million? Or how do we think about that on a quarterly basis? And how much of that was variable comp?

Corp—if you look at the fourth quarter, we do think it's going to be up $6 million or $7 million, being that $21 million to $22 million range, not just up a little bit from the third quarter. And yes, the big drivers of the year-over-year increase are variable comp. It was pretty low last year, and it's rebounded this year. We got some variation in insurance programs that also contribute to that variation.

Okay, thank you very much. Congratulations again on a really impressive performance in the third quarter.

Thanks, Budd.

And there are no further questions at this time. I'd like to turn the call back over to Jeff Lorenger for any additional or closing remarks.

Great. Thanks, everybody, for joining us today. Again, once again, thanks to all HNI members. Have a great day.

And that concludes today's presentation. Thank you for your participation, and you may now disconnect.