Ethan Allen Interiors (ETH) Q3 2019 Earnings Call Transcript

Ethan Allen Interiors (ETD -0.90%)
Q3 2019 Earnings Call
April 29, 2019 5:00 p.m. ET

Contents:

• Prepared Remarks
• Questions and Answers
• Call Participants

Prepared Remarks:

Operator

Good afternoon, and welcome to the Ethan Allen 2019 fiscal third-quarter analyst conference call. [Operator instructions] Thank you. It is now my pleasure to introduce your host, Corey Whitely, executive vice president, administration, and chief financial officer. Thank you.

You may begin.

Corey Whitely -- Executive Vice President, Administration, and Chief Financial Officer

Thank you. Good afternoon, and welcome to Ethan Allen's conference call for our third quarter ended March 31, 2019. This conference call is being recorded and webcast live on ethanallen.com, where you will also find our press release, which contains supporting details, including reconciliations of non-GAAP information referred to in the release and on this call. As a reminder, our comments today will include forward-looking statements that are subject to risks and uncertainties, which could cause actual results to differ materially.

Please refer to our SEC filings for a complete review of those risks. The company assumes no obligation to update or revise any forward-looking matters discussed during this call. After I provide some brief details on the financial results, our chairman and CEO, Farooq Kathwari, will provide updates on the business and on ongoing growth initiatives. We'll then open up the telephone lines for your questions.

During the third quarter, improved gross margin, cost containment within our expenses and a lower effective tax rate helped drive a 233% increase in our diluted earnings per share, taking diluted EPS to $0.30, up from $0.09, in the prior-year third quarter. Adjusted EPS increased to $0.31, up 182%, from $0.11 per share. Consolidated net sales were $177.8 million, compared to $181.4 million. An increase of 1.5% for retail net sales was offset by a decrease of 8.9% for wholesale net sales.

The lower wholesale net sales were primarily due to a reduction in sales to the North American retail network. The prior-year quarter wholesale sales benefited from delayed shipments during the first half that were getting caught up during the third quarter. Contract sales was a source of strength during the current-year quarter, while international sales weakened. Consolidated international net sales for the quarter decreased 30.2%, primarily due to lower sales in China.

Our retail division written orders reflected a 1.4% increase for the third quarter. Gross profit grew by $1.7 million in the current-year third quarter, driven by a 200-basis-point expansion in our gross margin. For the three months ended March 31, 2019, gross margin was 55.3%, up from 53.3% a year ago, due to improved retail and wholesale gross margins, together with a change in the retail sales mix relative to total sales. Retail sales were 78.1% of consolidated sales, compared to a 75.5% in the comparable prior-year period.

Operating income was $10.7 million, or 6% of net sales, compared with $3.9 million, or 2.1% of net sales, in the prior-year period. Adjusted operating income was $11 million, or 6.2% of net sales, compared with $4.4 million, or 2.4% of net sales, for the same prior-year period. Significant growth in operating income was primarily due to reduction in national television advertising costs and the benefit of higher gross profit. The effective income tax rate was 24.8% in the current-year quarter, compared with 31.2% in the prior year due to tax law changes from the Tax Cuts and Jobs Act.

During the quarter, we paid $31.8 million of cash dividends, including a special dividend of $1 per share. Nine months year-to-date total dividends paid of $41.9 million reflect a 73% increase compared to the comparable prior-year period. Turning to the balance sheet. We ended the quarter with inventory of $164.6 million, cash and securities of $25.7 million and $8 million of bank debt outstanding.

With that, I'll turn the call over to Farooq.

Farooq Kathwari -- Chairman and Chief Executive Officer

Thank you, Corey, and thank you all for participating in our third-quarter conference call. I'm also pleased that we are also joined by Matt McNulty. He has joined us as the vice president and corporate controller. John Bedford, who was in this position for many, many years, has retired.

The positive impact of vertical integration and operating at more normalized advertising expenditures resulted in the strong earnings growth, as Corey just mentioned. Despite lower consolidated delivered sales of 2%, gross margins increased to 55.3% from 53.3%, and adjusted operating income increased by 150.6%, and adjusted earnings per share increased by 181.8%. We have continued to return cash to stockholders. As Corey mentioned, our cash dividends of $31.8 million were paid during the quarter, 130% increase over last year.

As mentioned in our press release, we continue to strengthen our vertically integrated enterprise with many strategic initiatives including investing in talent, introducing relevant new products, repositioning our retail and our manufacturing and logistics network, investing in technology and operating our enterprise in a socially responsible manner. On April 17, we announced plans to further improve our vertically integrated operations with a number of initiatives including converting our 550,000-square-foot case goods manufacturing plant in Old Fort, North Carolina, to a state-of-the-art distribution center and consolidating case goods manufacturing to our Vermont and other plants. Also announced addition of 80,000 square foot to our 714,000-square-foot upholstery plant in Maiden, North Carolina, and moving our distribution operations from Passaic, New Jersey to North Carolina. We expect to have consolidation costs of $7 million to $8 million, 40% noncash, invest about $5 million in Maiden, North Carolina, in our upholstery operations and additional about $3 million in conversion of the Old Fort, North Carolina location.

We expect these changes to provide benefit to gross margins by $5 million to $6 million during fiscal 2020 and beginning in fiscal 2021, after the completion of the initiatives, provide the opportunity for 100- to 200-basis-point improvement to gross margin. We are strengthening our talent by adding several leaders to our retail network and business development, continuing to develop the strong 1,500 professional interior design management and interior designers. We continue to strengthen our marketing initiatives with the addition of relevant products and strong advertising initiatives. In June, we plan to introduce our new, modern, relaxed product programs and a very strong new consumer finance program.

We continue to position the design center network with relocations and renovations in both North America and internationally. While our business in internationally were somewhat down, as Corey just mentioned, we continue to be very proactive in opening new design centers with our partners in China, as well as Southeast Asia. We continue to focus on technology in all areas of our enterprise, including emphasis on customer experience. We have expanded our 3D digital capabilities and are -- and also implementing Salesforce CRM platform.

During the quarter, we were impacted by lower orders and shipments to China, as we have just mentioned. We have strong marketing programs and expect the orders to improve in this quarter. We're also pleased with the growth of the U.S. government and contract business.

With this brief introduction, happy to open for any questions or comments. 

Questions and Answers:

Operator

[Operator instructions] Our first question comes from the line of Bobby Griffin from Raymond James. Bobby, your line is now open.

Bobby Griffin -- Raymond James -- Analyst

Thank you. Good afternoon, Farooq and Corey. Thank you for taking my questions. The first I want to talk on was just the written orders.

I'm just trying to connect the dots between the 1.4% for the quarter and then the 5% number that we were told through the first two months of the quarter. Can you help me understand what happened in March? And did the business slow down? Or was there any timing impacts with shipments that impacted the 1.4% growth?

Farooq Kathwari -- Chairman and Chief Executive Officer

No. The -- in March, the income in written business was lower, and that impacted it.

Bobby Griffin -- Raymond James -- Analyst

What do you -- was there any changes in marketing message or anything or -- Farooq, I guess, in your high-level view and opinion, what do you think drove the change in trajectory?

Farooq Kathwari -- Chairman and Chief Executive Officer

No. It's hard. From month to month, I think that there are so many factors that people are concerned about, what is taking place in the economy, what's taking place internationally, all the news. So I think it was nothing, nothing particular.

It was just -- at most, I mean, I would think that some of that business just went to April.

Bobby Griffin -- Raymond James -- Analyst

OK. Did you see a bounce back in April? Can you give us any color on what April orders look like so far?

Farooq Kathwari -- Chairman and Chief Executive Officer

Well, it's still -- I mean, as you know, as today and tomorrow, we should get about 20% to -- 20% -- between 20% and 35% of the businesses done the last two days of the month, so we'll see. But really, I think that we have strong programs in place. And I think that we should continue to grow our business as we move into this quarter.

Bobby Griffin -- Raymond James -- Analyst

OK. And secondly, I want to talk on the retail segment and maybe just a little further out view on how or what the pathway is for that profitability in that segment. Is there some structural changes that need to be done there from a cost perspective? Or is it just all sales growth-driven aspect?

Farooq Kathwari -- Chairman and Chief Executive Officer

Well, our business is sort of unique in the sense that you have to take a look at our overall margins because our retail margins, our retail sales impact our wholesale margins. So we have lots of program into place, and we expect our retail business to grow. And that will have a positive impact on the retail profitability and especially in the wholesale profitability. And if we were just only the retail business, the chances are some of the retail that we have, we may not have kept them, but they do have a positive impact on our wholesale.

End of the day, I want both retail -- I want all retail to make [Audio gap] but our retail does provide an opportunity of improving margins at our wholesale level. If you take a look at -- for instance, at operating margin of our wholesale was what, Corey, about 10% for the quarter?

Corey Whitely -- Executive Vice President, Administration, and Chief Financial Officer

Yes. Actually, it was about 12% on the quarter.

Farooq Kathwari -- Chairman and Chief Executive Officer

12% on the quarter. Despite some of our lowest -- I mean, somewhat lower sales -- delivered sales from the wholesale, we increased our gross margins. Part of that is of course efficiency. And also, the impact of the retail is very positive on our wholesale, so it's -- so we got to combine the two together.

That's the nature of our business.

Bobby Griffin -- Raymond James -- Analyst

OK. And then I guess lastly for me is just on advertising expense. You did mention you're now kind of going to run at more normalized levels here in the third quarter. Is that something we can run forward in our model as we expect the introduction of relaxed modern coming on? Is there going to be any big uptick in advertising expense for that introduction?

Farooq Kathwari -- Chairman and Chief Executive Officer

No. You see our advertising expense has run anywhere between 4% and 6%. If you take a look at the last -- so I would say at this stage between 4% and 6% of a normalized rate. In the last year, these two quarters were just extraordinary.

We didn't get the benefit we thought we would.

Bobby Griffin -- Raymond James -- Analyst

OK. I appreciate all the detail, and thank you again for answering my questions, and best of luck going forward

Operator

Your next question comes from the line of Brad Thomas from KeyBanc Capital Markets. Brad, your line is now open.

Farooq Kathwari -- Chairman and Chief Executive Officer

Hello, Brad. How are you?

Brad Thomas -- KeyBanc Capital Markets -- Analyst

Hi, Farooq. Good afternoon. I wanted to first ask about trends that you're seeing in China. Obviously, in your press release you referenced some softer trends there.

What are you seeing in that market? And what's your outlook there?

Farooq Kathwari -- Chairman and Chief Executive Officer

Yes. We have a number of factors impacted. First was that they had -- I mean, overall, our business in China has been weak for the -- in China for our partner as well as others. Secondly, last year, they purchased at somewhat of an excess inventory, so they had to get out of that inventory.

And third was this whole tariff situation did create issues. People were concerned and -- about the fact of, as you know, whether -- how much the duties are going to be and still are concerned to some degree. All those factors impacted us. Now as we move into the -- into our fourth quarter, things are somewhat stable in the sense that they are almost out of the excess inventories they had.

There is less of a tension on the whole issue of these duties, and I would -- and they were very aggressive. In fact, they just opened up two months back a major design center for us, this 15,000 square foot in Wuhan, China. And they are continuing to also develop some strong advertising and marketing programs as we move forward in the next two quarters. So I would think that it would appear to me that the worst is over, and we are moving toward more positive direction.

Brad Thomas -- KeyBanc Capital Markets -- Analyst

That's helpful. And then within the wholesale segment, can you give us some more color on where the state department came in, in terms of its contribution to 3Q, and how you're thinking about the trajectory of that business in your fourth quarter?

Farooq Kathwari -- Chairman and Chief Executive Officer

Right. We don't give the numbers, but I would say that it is positive, both in terms of sales and also margins, because, as you know, last year, we were committing against a business that was in bankruptcy, and it really impacted our margins, so we are back to normalized margins. And then also, the business is increasing. So I -- it's positive developments.

Brad Thomas -- KeyBanc Capital Markets -- Analyst

Great. And then just lastly from me, I guess as we think about the consumer backdrop, Farooq, a lot of questions about tax refunds and SALT taxes and such. I guess as you go back and look at your sales in your fiscal third quarter, do you think there was any particular noise or pressure that you experienced because of how tax rates have changed for your customers?

Farooq Kathwari -- Chairman and Chief Executive Officer

There is an impact, especially in -- if you are living especially, let's say, in the well-to-do East Coast communities there. People have been impacted with the fact that you can't deduct the taxes. And the taxes are -- real estate taxes are pretty high, so we have seen some. But overall, I think that even though there is a lot of -- a lot of competition is out there, as you know.

We have people selling a product at sort of pretty major discount. But I see overall things are somewhat positive as you go into the fourth quarter.

Brad Thomas -- KeyBanc Capital Markets -- Analyst

That's helpful. Thank you so much, Farooq.

Operator

[Operator instructions] Your next question comes from the line of Jeremy Hamblin from Dougherty & Company. Jeremy, your line is now open.

Farooq Kathwari -- Chairman and Chief Executive Officer

Yes. Hello. Jeremy.

Jeremy Hamblin -- Dougherty and Company -- Analyst

Hi. Thanks for taking the question. I wanted to come back to the commentary on China for a second. You've seen pretty significant expansion of the number of retail centers that you have in that geography, I think from 88 a year ago up to 102.

Given your comments that it's been sluggish for both you and your partner there, is there risk, is there concern that we potentially have a closure of the number of centers there? Can you give us a kind of state of affairs in terms of how your third-party partner there is looking at the business going forward?

Farooq Kathwari -- Chairman and Chief Executive Officer

Well, we have seen them being very proactive, aggressive, and I would say they're also being -- that's -- so they have not slowed down. But on the other hand, they have been impacted by a -- by the slower consumer attitude, more competition over there. But I'm -- we have not seen any slowdown from them as yet. In fact, if anything, they are growing.

And they are also making major renovations and in fact introducing our newer products in the next six months in somewhat of an aggressive manner. They have more competition. But so far, they're holding strong.

Jeremy Hamblin -- Dougherty and Company -- Analyst

OK. And then I wanted to come back to another point that was made. You talked about your wholesale segment, which sales were down about $10 million in that segment year over year, but you saw 500-basis-point improvement in the operating margins. And I don't know if that's entirely tied to, like, allocation of advertising expense or -- but I wanted to see if you could just walk us through that change in profitability dynamic, either you or Corey, just in how we're arriving at that 500 basis point higher op margin despite sales being down $10 million.

Farooq Kathwari -- Chairman and Chief Executive Officer

Yes. I'll have Corey again after me, but I would say it's a combination of lower advertising expenses. And our manufacturing operating at -- more efficiently, including this question of the state department, the government contract, all with higher margins. So I would say it's a combination of the two factors that has resulted in this increase in gross margins.

Right, Corey?

Corey Whitely -- Executive Vice President, Administration, and Chief Financial Officer

Yes. That's primarily it. The advertising benefit, that helped us well. But really, it's our manufacturing efficiency and improved production efficiency.

Farooq Kathwari -- Chairman and Chief Executive Officer

And now as you know, our objective -- we are one of the few ones which are still manufacturing as much as manufacturing as we have in the -- in North America, especially in the United States. These changes that we have made is -- will help us to increase our production in Vermont in case goods and continue to be very strong in upholstery in North Carolina, supported by our operation in Mexico. Our case goods is also supported by operations in Honduras. And keep in mind, we open all those -- both those plants in the last 12 years, Honduras six years back and Mexico about 12 or 13 years back, and those are very vibrant.

But combination of our United States and the rest of these North American plants is a competitive advantage and, as we go forward, should further help our margins, operating margins, gross margins at the wholesale level.

Jeremy Hamblin -- Dougherty and Company -- Analyst

OK. That's helpful. And then I just wanted -- your backlog looks like it's down about 12% in your retail segment. It's down 22% in your wholesale segment at the end of Q3, and you had a pretty strong Q4 last year where sales were -- total sales were up 5.5%.

I wanted to just get a sense of -- I know you don't provide quarter-to-quarter guidance. But with those kind of starting points on your backlog and lapping some pretty tough compares from last year, how should we be thinking about the June quarter? Is this kind of an assumption that sales will be down, given that the starting point is on your backlog, as well as written orders that were -- there wasn't significant growth in Q3?

Farooq Kathwari -- Chairman and Chief Executive Officer

Well, I think Corey can also add to this, but I would just say the two perspectives on this. In the last year, our delivered sales were -- got benefit from the high backlogs we ended up in the third quarter due to a number of factors, including that we got a fair amount of state department orders that we had, and we delivered those in the fourth quarter. So our consolidated deliveries last -- I mean, successive were $2 million and $5 million. But when you take a look at last year on our written orders, our written orders in our retail division were down 10.8%.

Our wholesale was down 5.9%. So if you take a look at that, we have the opportunity. On one hand, yes, the delivery is the challenge. The written gives us an opportunity because, last year, it was soft.

Corey Whitely -- Executive Vice President, Administration, and Chief Financial Officer

And there was lower backlog. We've had the benefit now of being able to ship products much more timely this year without those high backlogs that we were fighting in the prior fiscal year so --

Farooq Kathwari -- Chairman and Chief Executive Officer

I mean, we had higher sales. But this time, it's much more efficient.

Jeremy Hamblin -- Dougherty and Company -- Analyst

Understood. Last question from me, I also -- I noted that you did access some long-term debt for the first time in a while. My assumption is that maybe part of that was being used to fund the special dividend. And it's not a significant amount but I think just under $9 million.

Why don't you just see if you can give some color on thinking about capital structure and use of debt going forward? Is that something where you feel comfortable with your cash flow, and you may access a little bit more debt to fund buybacks or other things? Or can -- any color that you might be able to provide on that would be helpful.

Farooq Kathwari -- Chairman and Chief Executive Officer

First is we wanted to please all our analysts by taking debt because everybody says, "You folks have got to do it yet." So I hope the analysts are happy. But having said this, we gave, what was that, over $30 million of dividends. And that debt was -- yes, we needed some cash in the short term to some degree to use our cash on hand and the debt. As we go forward, we're going to take a look at what makes good sense.

I mean, I'm not interested -- as you know, I've gone through all kinds of -- we had 90% debt, and we had all kinds of stuff. I've gone through all those things. You know that. So we -- I don't mind taking debt and -- but if it makes -- but as we go forward, we'll continue to return money to the stockholders.

In the past, we have done it and the repurchase of our company stock. We purchased -- we spent -- we have over $600 million of stock we have purchased. And so when you take a look at this as we go forward, we'll see whether we need to have some debt, but I'm not going to have too much debt. I've gone through that period.

Jeremy Hamblin -- Dougherty and Company -- Analyst

Got you. Thanks for taking the questions. Good luck.

Operator

[Operator instructions] Your next question comes from the line of Cristina Fernández from Telsey Advisory Group. Cristina, your line is now open.

Cristina Fernandez -- Telsey Advisory Group -- Analyst

Yes. Hi, good afternoon, Corey and Farooq. I have a couple of questions on the gross margin. So to start on the -- on this quarter, how should we think about -- of the 200-basis-points improvement, just the natural sort of help from the mix between retail and wholesale versus sort of lapping with those manufacturing inefficiencies you have last year because it seems like that could have been sort of the biggest component of the benefit this year?

Farooq Kathwari -- Chairman and Chief Executive Officer

There was a number of factors. We did take a price increase last September, October, which also contributed to increase in gross margins. But on the other hand, we're also giving even bigger savings. So yes, we can have, on one hand, higher margin, but then we give it away on savings.

So we got to balance all of these factors. So you've got higher -- we got a price increase, but then we have higher savings. We have better manufacturing margins. And as you can see, our retail margins and wholesale margins both improved.

The wholesale margins improved the gross margin level. And obviously, it improved at the operating level because of this question of this advertising. So as you go forward, it's hard to say. But I think the levels that you see is -- there's an opportunity of maintaining those levels.

Cristina Fernandez -- Telsey Advisory Group -- Analyst

And then looking to fiscal year '20 and beyond with the plant consolidation you're doing, you quantify $5 million to $6 million to next year. Beyond that, another 120 basis points. Can you help us understand is the initial part just cost savings? And what needs to happen to be able to capture that next leg, the 100 to 120 basis points longer term from this specific plant consolidation you're doing?

Farooq Kathwari -- Chairman and Chief Executive Officer

Well, the -- by producing, by increasing our volumes in Vermont, that has an opportunity of increasing our gross margins in Vermont. Second, it will also to some degree add products in our Honduras plant, which has higher margins. Thirdly, some of the products will be outsourced. That also increases margin.

So those are three factors that will help us increase our gross margins at the wholesale level and that we see going forward.

Cristina Fernandez -- Telsey Advisory Group -- Analyst

And when should we expect this to start contributing next year?

Farooq Kathwari -- Chairman and Chief Executive Officer

Well, as we said in our press release that we're going to have some benefits in our next fiscal year, and then -- and we'll continue. I -- you should -- we should see some benefit next year because we will be consolidating this production. We're already doing it and -- into Vermont and two other plants. And it'll also give us an opportunity of -- certainly, there is some start-up cost, something of that nature.

But I think we should start seeing the benefit of it starting next fiscal year.

Corey Whitely -- Executive Vice President, Administration, and Chief Financial Officer

Yes. Mostly in the second half.

Farooq Kathwari -- Chairman and Chief Executive Officer

Of next fiscal year.

Corey Whitely -- Executive Vice President, Administration, and Chief Financial Officer

Yes, yes.

Cristina Fernandez -- Telsey Advisory Group -- Analyst

And then one last question on marketing. If my math is correct, I estimate about 3.5% of sales was spent at the marketing this quarter. I think in prior calls, you talked about 5% spend for the year. Is that still the target? Or should we -- should that come in below that 5%?

Farooq Kathwari -- Chairman and Chief Executive Officer

No. We spent -- advertising this year, if you're taking this, is about 4.1%. So this is what you were -- if you take a look at it, that's what we spent this third quarter. And as we go forward, it's going to be between 4% and 5%.

Cristina Fernandez -- Telsey Advisory Group -- Analyst

OK. Thank you.

Operator

[Operator instructions] At this time, there are no question on queue. Presenters, you may continue.

Farooq Kathwari -- Chairman and Chief Executive Officer

All right. Well, thank you very much, and thanks, everybody. Any questions, comments, anything else, please let us know. Thanks very much.

Operator

[Operator signoff]

Duration: 33 minutes

Call Participants:

Corey Whitely -- Executive Vice President, Administration, and Chief Financial Officer

Farooq Kathwari -- Chairman and Chief Executive Officer

Bobby Griffin -- Raymond James -- Analyst

Brad Thomas -- KeyBanc Capital Markets -- Analyst

Jeremy Hamblin -- Dougherty and Company -- Analyst

Cristina Fernandez -- Telsey Advisory Group -- Analyst

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