Kimball International Inc (KBAL -0.89%)
Q3 2019 Earnings Call
May. 8, 2019, 11:00 a.m. ET
- Prepared Remarks
- Questions and Answers
- Call Participants
Good morning, ladies and gentlemen. My name is Dylan, and I will be your conference call facilitator today. At this time, I would like to welcome everyone to the Kimball International Third Quarter 2019 Financial Results Conference Call. (Operator Instructions)
As with prior conference calls, today's call, May 8, 2019, will be recorded and may contain forward-looking statements as defined under the Private Securities Litigation Reform Act of 1995. Actual results could differ materially from the forward-looking statements. Risk factors that may influence the outcome of forward-looking statements can be seen in the Kimball International Form 10-K and today's release.
The panel for today's call is a Kristie Juster, CEO of Kimball International and Michelle Schroeder, Vice President and Chief Financial Officer of Kimball
International. I would now like to turn today's call over to Kristie Juster. Ms. Juster, you may begin.
Kristine L. Juster -- Chief Executive Officer
Thank you, Dylan. Good morning, and welcome to the Kimball International third quarter 2019 earnings call. We announced our results yesterday after market close for the quarter, which ended March 31, 2019.
On our last earnings call, we committed to unveil our new growth and transformation strategy this quarter and I'm excited to share the details of that with you today, which we are calling Kimball International Connect. But first, we'll cover the market and our third quarter financial results. Before we get started, I wanted to inform you that we will be referencing the slide deck on our IR website throughout the call.
With that, let's begin by turning our attention to slide four. We experienced a strong quarter as we captured growth through solid execution in a market with favorable conditions. Sales growth finished at 10%, 8% of which was organic, as we saw demand for several of our key verticals, most notably healthcare.
Overall, order activity was strong as evidenced by our 16% increase during the quarter. Adjusted EBITDA finished at $14.5 million or 8.2% of sales, up 18% year-over-year. These positive results were primarily due to price yields, leverage from higher volume and savings realized from cost initiatives. EPS was also up a strong 38%, finishing at $0.22 a share. We are tracking to our plan of reducing costs by $10 million during the fiscal year 2019. Michelle will discuss third quarter financial results in more detail in a few moments.
Now let's turn to slide five. Several of the macroeconomic indicators we monitor closely are signaling continued growth in the market. BIFMA, which is the office furniture market industry association, is forecasting 3.3% growth in fiscal year 2019. The Architecture Billings Index by AIA, which serves as a leading indicator of non-residential construction activity, was 47.8, which fell below 50 for the first time in over two years. While a score below 50 indicates decreasing firm billings, other employment indicators remain positive and it is contrary to what we are experiencing in the market. That said, we will continue to watch this along with other metrics to determine if it's a beginning of a trend or more of an anomaly.
RevPAR, or revenue per available room, is a leading indicator for our hospitality business and showing estimated growth of 2.3% in calendar year 2019. Overall, the US lodging outlook remains stable, driven by continued increase in consumer spending, business investment and a relatively strong consumer confidence. Specific to our market, Las Vegas is strong driven by the move of the Las Vegas Raiders from Oakland, causing new construction and refurbishment in advance of the 2021 football season. We feel very good about the hospitality market, with activity and growth both remaining strong.
Turning to slide six. As you know, we've been focused on new product development over the past few years. Sales of new products, excluding hospitality, remains a key fuel to our growth. And we're very pleased with the traction, up 29% during the quarter, resulting in new products representing 27% of our total products sold excluding hospitality. That's up 500 basis points year-over-year.
We introduced five new products this quarter, which are pictured to the left. We expect the design of these new products to resonate well with the marketplace as they are integrated into our distribution. And we're excited about the launch of the Greer recliner as we continue to expand our reach into the patient room with healthcare facilities. While product innovation has always been a focus, it's of even greater importance with the market shift to ancillary furnishings and with our intent to accelerate growth in our healthcare vertical.
Now let's turn to slide seven, and our sales and orders by vertical. As you see, sales growth was broad based with expansion in five of our six verticals. Healthcare led the way, up $9.2 million or 47%, followed by hospitality, up $5.2 million or 12%. Healthcare growth was assisted somewhat by a weaker comp as it was down 14% in the year-ago period. Despite that, if you look over the two-year period, healthcare sales are still up 27% from Q3 two years ago.
Strategic focus in this marketplace, which includes aligning resources, building relationships and introducing new healthcare products continue to fuel this growth. We continue to feel bullish on this vertical, given the favorable long-term macro trends, specifically the changing demographics in the US.
Hospitality had a tough comparable where the vertical experienced prior year growth of 20%, which makes the 12% growth this year even more impressive. The only vertical that did not experience growth was finance, which was down less than $1 million on nearly $17 million base due to normal project volatility.
With that, I'll turn the call over to Michelle to provide more details on the financial results. Michelle?
Michelle R. Schroeder -- Vice President, Chief Financial Officer
Thank you, Kristie, and good morning, everyone. I'd like to turn your attention to slide eight, as I discuss our third quarter financial performance in more detail. Our sales ended at $177 million for the quarter, and as Kristie mentioned, that was an increase of 10%, or 8% on an organic basis. Sales were up across all verticals except finance with healthcare and hospitality leading the way.
Gross profit improved 80 basis points during the quarter driven by the benefits of price increases, cost reduction initiatives and leverage from higher sales. These improvements were partially offset by inflation and tariffs as well as the performance of our recently acquired David Edward operation, which we had anticipated. Inflation, which I'm including commodity, transportation and tariff, was up $1.7 million over the prior year. We are starting to see some pullback in fuel prices and transportation has stabilized, although at a higher level.
With regards to David Edward, our operation team continues to successfully execute on the operational improvement plan that we developed during our due diligence to eliminate the drag on our gross margins. Selling and administrative expenses increased $6 million or 15% during the quarter due to higher incentive compensation on the higher profits and commissions associated with the higher sales. Additionally, we experienced increases in compensation costs. And we also had selling and administrative expenses associated with the David Edward acquisition, which we didn't have in the prior year. We also invested $600,000 in strategic growth investments and incurred $300,000 in CEO transition costs.
Our adjusted EBITDA of $14.5 million, increased 18% or 60 basis points. We were really pleased with the margin expansion we had this quarter. On that note, we have made the decision to place greater emphasis on EBITDA as a key measure. We are going to continue to focus on operating income, but believe EBITDA is a more appropriate metric to measure the health of our business. A couple of reasons for making this shift; first, EBITDA is closely aligned to cash earnings, which correlates to shareholder value. Second, EBITDA is more often used by our investors to evaluate our performance. And third, we believe it enables better comparability to our peers, especially when acquisitions are a part of the mix, which they have been and will continue to be for us. We will continue to report on operating income, but we'll be placing greater emphasis on EBITDA going forward. Earnings per share grew 38% or $0.06, with $0.04 being driven by improved earnings and $0.02 because of the lower effective tax rate resulting from the Tax Cuts and Jobs Act.
Now turning to slide nine. I'd like to review quarter-to-quarter trends for some key financial metrics. Before I do, as a reminder, our third quarter is our seasonally low period, which is why you see the pullback in both sales and orders sequentially during the quarter. This quarter is not only slow for us, but is also seasonally slow for our industry as well.
Now turning to sales. We've seen strong organic growth in each of the last four quarters. Similarly, we have seen growth in organic orders in each of the last four quarters, with orders outpacing sales growth in each quarter except for the second quarter. Overall, our growth and demand remains strong. While our gross margins have been pressured by commodity inflation, transportation inflation and tariff over the last several quarters, we've been successful at offsetting these headwinds beginning last quarter with price increases, with improved efficiency, with leverage from higher volume, through product value engineering and through supply chain initiatives that were specifically to address the tariff.
While our gross margins are not yet where we expect them to be, we are encouraged by the recovery and remain confident that they will continue to improve as we grow our business and execute our new strategy that Kristie is going to be discussing shortly. Our SG&A has trended higher in fiscal year 2019 as we are investing in our growth, and we also incurred CEO transition costs.
Overall, orders were up a very strong 16%, or 14% on an organic basis. The growth was across all verticals, except finance and government. The hospitality vertical led that growth and was up 29%, while healthcare and commercial were also up strong double digits or 27% and 20%, respectively.
Our backlog finished up 16% over the prior year. BIFMA reported that orders were up 7% during this quarter. I'm very proud of our team for their hard work growing our business and focusing on capturing market share during the quarter.
To wrap up my financial overview, please turn to slide 10, and I'll touch on cash flow and capital allocation. We generated free cash flow of $13.1 million during the quarter, equating to a strong 165% free cash flow conversion. Free cash flow was driven by our earnings as well as an $8.3 million improvement in our working capital. We really had a strong focus on managing our working capital. CapEx was $5.7 million for the quarter, relative to depreciation expense of $4.2 million.
We continue to invest in our corporate headquarters' remodel and equipment upgrades to streamline our operations in our Salem and Santa Claus, Indiana facilities. With respect to the headquarter renovation, we do expect this to be completed in the fall. And we really look forward to leveraging this as not only a platform to showcase our products, but to enable even more collaboration among our teams as we execute our Kimball International Connect Strategy.
Turning to capital deployment. We returned $2.9 million in cash to our shareholders in the form of dividends, and our balance sheet remains very strong with minimal debt. Return on invested capital this quarter finished at a strong 27.7%. You'll note at the bottom of the slide where we define return on invested capital as EBITDA after tax divided by equity plus net debt. We migrated to this measure from return on capital used in previous quarters, which was defined as no tax divided by equity plus debt. We believe this measure is a better indicator of the economic return on our invested capital. Year-to-date, free cash flow conversion is 93% and CapEx was $16.4 million, which is at a comparable level to last year.
With that, I'm excited to turn the call back over to Kristie to discuss our new strategy. Kristie?
Kristine L. Juster -- Chief Executive Officer
Thanks, Michelle. And now let me spend some time on the many exciting developments that are happening at Kimball International. For those of you who may not be familiar with our story, I became CEO last November, having served on our Board since 2016. Previously, I was the President
and CEO of the Global Writing Division of Newell Brands.
Turning to slide 12. I was honored to join a company steeped in legacy. From our start in 1950 as a contract manufacturer of residential furniture and
television cabinets, we have had a deep-rooted entrepreneurial spirit that remains so today, our guiding principles. Our customer is our business, our people are the company, the world is our home, profits reflect our success. Our guiding principles are our way of life and the spirit of Kimball International. Recently the company has undergone a significant financial turnaround, which positions us to move into the next transformational phase of our company's 69-year history.
I'm excited to announce today that we are launching a thoughtful organizationwide plan, the Kimball International Connect Strategy, which I am confident will leverage our strengths, address our limitations we currently face and ultimately enable us to achieve greater heights. To do this, we will strategically invest in our business. Our strong free cash flow generation as well as our capital availability will fund our strategic investment. We are also announcing long-term targets that are aligned with achieving our goal.
Moving to slide 13, as many of you know, our portfolio consists of three brands: National, which possesses resimercial design expertise and offers an industry-leading line of ancillary products; Kimball, a full-line offering for workspaces known for its innovation and high-quality craftsmanship; and Kimball Hospitality, which had built its reputation in the hospitality industry on custom and programmed product development and unparalleled service so critical to our clients.
Our brands share four characteristics that have been in place from the beginning: true craftsmanship, an unwavering commitment to quality, a dedication to our customers who come first and a caring culture. This is the heart of who we are as a brand company and a point of common ground from which we will spring forward.
Let me now take a step back and highlight our journey to this point. Please turn to slide 14. Over the past four years, we have been focused on a financial turnaround. And I'm happy to say that we have seen solid growth in sales, including a 6.7% CAGR from 2014 to 2018, a 550 (ph) bps improvement in adjusted operating margin and industry-leading return on invested capital.
On the growth side, we focused on accelerating new product development, and over this period we launched many new products across the portfolio. The Vitality Index improved from 15% in 2014 to 21% in 2018 and is trending at 26% fiscal year-to-date. We also sharpened our design focus with an increased emphasis on healthcare and seating and grew our legacy accounts.
While we are growing our top line, we were also committed to increasing profitability. We did so by emphasizing high-margin products, streamlining our facilities footprint and initiating cost savings plan. We've seen a little pullback on margins recently as higher transportation and commodity costs put pressure on margins, which was common throughout the industry. Our margin improvement since fiscal year 2014 has been significant.
Moving to slide 15. When I came in as CEO in November, I had the opportunity to dig deeper into our businesses and personally get to know our great employees, the positive views I had of our company as a Board of Director was further strengthened. Our employee base comprise of hard-working people who are passionate about the products we create and genuinely thoughtful and helpful. Kimball International is a great place to work.
But we also have several opportunities to build an even stronger organization. To that end, there are four overarching themes I took away from my meetings with our employees, our customers, and our shareholders. One is that we have amazing strong legacy. It cannot be highlighted enough, which is why I began this call talking about what Kimball International stands for. It is what drives this organization every day. To build on this great foundation, we are uniting our culture and vision through our newly articulated purpose linked and embedded in Kimball International Connect.
The second observation is that we have a highly rigorous culture. What we set our minds to do, we execute. But we have done so by building plans from the business unit perspective versus top down, and that has led us to more short-term planning. Kimball International Connect is a top-down strategy with clear and distinct choices across the portfolio.
Along these lines, we currently operate in a siloed fashion. For the most part, our brands function independently and this has led to a level of inefficiency and duplication. We will leverage Kimball International in a way that creates efficiency and builds capabilities across our company.
Finally, we had historically focused on investments that serve the more immediate today and even restraining choices for tomorrow. Our transformation plan will free up funds to invest for the future, while continuing to improve profitability year-over-year. Clearly, there is a tremendous opportunity to address these factors, and that is why we have developed the Kimball International Connect Strategy.
Please turn to slide 16. I'm excited to share with you our plan for the future of Kimball International. The Kimball International Connect Strategy connects our purpose, our people, our brands and our operating process to be a powerhouse in our industry. Through a more centralized approach, we will be able to make more strategic investments across our platform that support profitable growth over the long term. We'll be able to move with greater speed and increase our capacity to scale, and I truly believe we'll be able to further empower our people.
So now let me drill down into how we're going to do this. On slide 17, there are four pillars to our Connect Strategy: inspire our people, build our capabilities, fuel our future, all leading to accelerating our growth. Now let's take a look at each one of these for more detail.
Please turn to slide 18. To inspire our people, we are leveraging our strong legacy of a bold and entrepreneurial spirit in cultivating a high-performance caring culture. We are launching a new purpose organizationwide on May 9. And we are investing in training and development in systems to remain an employer of choice. Initiatives include renovating our headquarters with our design-driven innovative furniture, which will provide an inviting collaborative work space for our employees to engage; implementing elevate, a top talent professional development
program; and opening an employee healthcare center to promote and support wellness.
Turning to slide 19, build our capabilities is focused on two core themes: center-led functions and centers of excellence. We're in the process of creating center-led e-function, including establishing global finance, IT and HR organizations. We are also consolidating our supply chain operations under one effort with a near-term focus on direct material sourcing. We believe strongly there's a significant opportunity in creating centers of excellence, for example, a digital center of excellence. Given how digital transcends our brand, this will enable faster decision-making, strategic acceleration and enhanced growth execution. We will establish other centers of excellence as needed throughout our journey.
And we are not starting from square one today. We have already appointed a new VP of Strategy and Transformation. We are pleased for this executive role to take on the leadership position of driving focused process and accountability of all our transformational changes and orchestrating the evolution to our new vision. This role brings a new and unique set of experiences and skill set to our senior leadership team. We are also establishing a program management office, PMO, to focus on key change priorities, deploying planning tools and resources and ensuring execution.
Moving on to the third pillar of our Kimball International Connect Strategy, Fuel Our Future, on slide 20. First, we're committed to elevating our current strong operating process to world-class standards. We will continue to drive Lean throughout our facilities and are exploring several areas to further optimize our operational footprint and processes as well as elevate our production and accelerate our process automation. Finally, we will continue to seek ways to enhance our margin through product engineering excellence.
Second, we're employing a more metrics-based approach. This entails adopting common practices and ways of working. We have duplicative processes as a result of our business units operating independently and we will remove that duplication and set up standardized efficient processes across the company. We've established a more rigorous operating rhythm and enabled more best practices sharing among the brand, but there's still room to grow.
All of these actions will enable us to accelerate our growth as outlined on slide 21. We have identified three areas where we believe we can have sustainable impact. First, we will continue to advance new product development. We have seen great traction on this over the past several years and are now focused on building a deeper task seating offering. In addition, we are targeting the middle market segment by creating a contract lite solution that will be for lighter-use application or areas where product is refreshed more frequently. And finally, we are establishing a new product development process organizationwide that I believe, once deep-rooted in our operations, will drive even greater product differentiation.
The second growth platform is expanding select verticals and channels. Specifically, under the Kimball brand, we'll continue ramping our efforts in healthcare, which has experienced great traction for four consecutive quarters. In Kimball Hospitality, we are going after the custom and seating markets to grow share. And in National, we are piloting a new e-commerce digital program to drive greater sales.
Finally, the third growth focus is on commercial excellence. This is going to entail making it easier to do business with us, reallocating selling resources to higher-growth markets and training our team on consultative selling. But let me be clear, our efforts to grow are not just organic initiatives.
On slide 22, we detail our acquisition framework, which was just 15% of our total free cash deployment over the past three years, and will be a bigger emphasis going forward. In 2017 and '18, we acquired two great brands, David Edward and D'style that added design capabilities and expanded our manufacturing footprint. The integrations are going well, and we are working diligently on operational synergies and improvements identified with our David Edward acquisition.
We will remain disciplined as we evaluate each opportunity with a focus on strengthening our core, whether that is acquiring higher-growth product categories or expanding current product offerings, into new categories or new channels. Culture is a critical factor for us, and we will ensure alignment with our guiding principles.
So how are we going to fund our efforts? Let's move to slide 23. With strong cash flows, the savings generated from our transformation work and our capacity to borrow, we are confident that we can fund our efforts.
On slide 24, we are introducing a three-year fiscal 2020 through 2022 financial targets. On the top line, we are committing to 4% to 7% growth, targeting 150 to 250 basis point improvement in adjusted EBITDA margins by 2022 and EPS growth of 10% to 15% over that time frame. Our outlook is based on a GDP of between 1.5% and 2.5%, a flat share count and excludes acquisitions.
I am confident in our strategy and our employees to deliver these results. If you would turn to slide 25, our senior leadership team comprising seasoned knowledgeable and dedicated executives along with our experienced board, who is a great partner and has provided a tremendous level of support and are committed to successfully executing our profitable growth plan to drive value creation and achieving our goals.
In closing, on slide 26, we have spent several months evaluating our business and developing a thoughtful, clear and executable vision to driving profitable growth. We are excited to share Kimball International Connect with you today and equally as excited to roll out in a companywide event tomorrow in Jasper, Indiana. It is a true honor to be working with our 3,000 employees on this new invigorating journey for Kimball International.
Thank you for your interest in Kimball International, and we are now ready to take your questions.
Questions and Answers:
Thank you. (Operator Instructions) I see no questions in the queue at this time. I'd like to turn the call over to Kristie Juster, CEO of Kimball International.
Kristine L. Juster -- Chief Executive Officer
Thank you, Dylan. In closing, first I want to thank you for joining us today and tell you that we are really excited about our new chapter and look forward to keeping you updated on our journey. Thank you.
Thank you, ladies and gentlemen, for attending today's conference. This concludes the program. You may all disconnect. Good day.
Duration: 33 minutes
Kristine L. Juster -- Chief Executive Officer
Michelle R. Schroeder -- Vice President, Chief Financial Officer