Image source: The Motley Fool.
Kimball International Inc (KBAL)
Q2Â 2020 Earnings Call
Feb 5, 2020, 11:00 a.m. ET
Contents:
- Prepared Remarks
- Questions and Answers
- Call Participants
Prepared Remarks:
Operator
Good morning, ladies and gentlemen, my name is Crystal, and I'll be your conference call facilitator today. At this time, I would like to welcome everyone to the Kimball International Second Quarter Earnings Conference Call. Currently, all participants are in a listen-only mode. Later we will conduct a question and answer session and instructions will be given at that time. As with prior conference calls, today's call February 5, 2020 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. During today's call, the presenters will be making references to an earnings slide deck presentation that is available on the Investor Relations section of Kimball International's website.
On today's call are Kristie Juster, CEO of Kimball International and Michelle Schroeder, Executive 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
Thanks, Crystal, and good morning everyone. Welcome to Kimball International's second quarter earnings conference call. We are six months into the execution of our transformation plan that is fueling our Kimball International Connect Strategy and I am pleased to report our implementation in financial delivery is exceeding our expectations.
In today's call, we are increasing our estimated cost savings for fiscal 2020 from $16 million to $21 million. This performance paves the way for both improved profit and increased investment in growth as we move forward. In our material today, I will walk through the highlights of our Q2 performance, comment on market leading indicators and provide specifics around progress on Kimball International Connect Strategy. Michelle will then provide details of our financial performance and I'll wrap up with color on our path ahead before we open the call to Q&A.
Please turn to slide 4 for our Q2 highlights. Our net sales were in line with our expectations for the quarter, but short of our overall long term growth guidance of 4% to 7% that we've included in our three-year financial objectives. We ended the quarter with revenues of $192 million, a 4% decrease year-over-year against a difficult comparison to 13% growth in the prior year. Comps for the prior year from our three focused verticals were very strong, with Commercial up 29%, Hospitality up 16% and Healthcare up 20%. At the same time, our Kimball brand experienced an expected reduction in revenues as we continued our planned realignment of the business in the first half of the year.
Now turning to orders. Orders were strong, up 13% as we experienced broad-based growth across all verticals. We were particularly encouraged by the growth within Hospitality, up 31% assisted by strength in the Las Vegas market. Healthcare was up 10% against 22% growth in the prior year as our strategic focus and investment into this vertical by the Kimball brand continues. Our backlog finished the quarter at $173 million up 20% over prior year, positioning us well for a strong start to the back half. Our growth will be led by Hospitality and Healthcare markets, coupled with the continued traction of the National brand in the ancillary product categories. Michelle will provide more commentary on vertical market performance later in the call.
Operating income of 7.4% or 8.6% on an adjusted basis increased 220 basis points. Gross profit of 34% increased 170 basis points, giving us confidence in our sustaining improvement in gross margin. At the same time, adjusted selling and administrative costs decreased 50 basis points even while funding our strategic investments in Kimball International Connect. We expect our strategic investments will continue to ramp in the second half of our fiscal year in order to accelerate longer-term growth.
We are very pleased with the adjusted EBITDA performance of $20.9 million, up 23%, representing a margin of 10.9%, up 240 basis points. And finally, adjusted EPS increased 27% to $0.33 compared to $0.26 a year ago.
Turning to slide 5 for a view of the macroeconomic indicators we track for the industry. Business calendar year forecast for U.S. office furniture is 7.4% in 2019 and 2.2% in 2020. This December forecast is unchanged from the prior October forecast I reviewed last call. The deceleration of the 2020 forecast is attributed to the deceleration of the U.S. GDP from 2.3% in 2019 to 2.1% in 2020. The Architecture Billing Index by AIA, which serves as a leading indicator of nonresidential construction activity rose to 52.5 in December, up from 49.7 in September, with improvement in each of the last three months. Improvement is attributed to the business conditions rebounding from a period of softness throughout much of the spring and summer. We are encouraged with the improvement in this nine to 12 month leading indicator of nonresidential construction activity.
RevPAR, revenue per available room is a leading indicator for our Hospitality business. Forecast for calendar 2020 estimate growth of 0.7% which is in line with 0.9% forecasted growth in 2019. We continue to see strong activity, especially as it relates to the second half of our fiscal year, driven by the strength in the Vegas market. All these forecasted metrics were released prior to the recent Coronavirus outbreak in China. We are diligently managing this very fluid situation. The safety and well-being of our employees is our number one priority and we are keeping in close contact with our small employee base in China. We have implemented a travel ban to and from China. With minimal sales outside of North America, the impacted area for us is our supply base. Approximately 15% of our total material spend for office furniture is sourced from China. And our Hospitality business imports approximately 50% to 60% from our supply partners in China. We have some buffer inventory because of our planning in anticipation of the Chinese New Year. The circumstances are very fluid at this time and so it is difficult to determine what level of impact this may have on our business. We are keeping in close contact with our employees, suppliers and our customers while actively building contingency plans.
Setting aside this unique situation, we are in a very healthy place supported by both our improving margins driven by our transformation work and available capital, setting us up to take advantage of the opportunities and at the same time, manage the volatility. We believe this landscape gives us a solid foundation for execution of our Kimball International Connect Strategy and related transformation plan as we pursue our three-year financial objectives.
Moving on to our progress updates in the deployment of our Kimball International Connect Strategy. We introduced slide 6 in our last call, which is a depiction of our brand positioning, relative size of the brands today and more importantly the path and differentiation we're driving through our Connect Strategy. As a reminder, the vertical axis is a continuum from standard to custom product type and the horizontal axis reflects from Commercial to Hospitality environments. You will continue to see how the actions we are taking directly relate to the repositioning of our brands. Our portfolio strategy is grounded in maximizing our expertise across the intersection of Hospitality and Resimercial with an expansion into higher growth markets and product platforms such as custom. Each of our brands in our business units play an important role in this evolution.
Turn to slide 7 where we will focus on the progress made in each of our four pillars of the Kimball International Connect Strategy during the quarter. First, is Inspire Our People. On January 13, we announced the creation of two new executive positions at Kimball International. First, with the newly declared consolidation of our global manufacturing operations. Greg Meunier has been promoted to Executive Vice President, Kimball International Global Operations. Greg's deep experience gained over the course of his 31-year tenure with the company will be an incredible asset in the transition. Greg's relationship with our people and knowledge of our business will allow and deliver immediate impact on the significant opportunity we see ahead. Second, we are implementing a companywide approach to all corporate business practices, including legal compliance and environmental, social and governance, ESG. Mark Johnson will be joining the company as Chief Legal Governance Officer and Corporate Secretary. Mark has deep experience in these areas and served as Deputy General Counsel at a publicly traded Fortune 500 company. I'm excited about the value that both of these individuals bring to our executive team, lending both deep experience with fresh ideas.
Continuing with our focus on talent, I wanted to touch on our ELEVATE, high potential development program. As you may recall, this initiative was launched one year ago and focused on 14 of our top talent. The proprietary program engaged selected talent in executive level development, action learning and a direct engagement with the executive team to actualize our new strategy. It was an overwhelming success, both for the participants' development and the value that this team brought our organization. From this program, four of the participants have already been promoted to highly impactful rules that will be critical in successfully executing our strategy.
During our last call, we announced the opening of our newly redesigned corporate headquarters. It has certainly exceeded our expectations with regards to creating a collaborative environment for our team while leveraging it as a working showroom for our customers. Just in the last quarter, we have shared our new state-of-the-art working facility with our employees and families, hosted an open house for Jasper and the surrounding communities and held our Global Supply Summit, sharing our vision with representatives from our top-40 domestic strategic suppliers. And this week the Kimball brand is holding their National Sales Meeting and select dealer conference in our new home. The customer tours are in full swing and the feedback from all of those interactions have been extremely positive. We are so proud of our new home and know that this investment will provide ongoing returns.
The second pillar of our strategy is build our capabilities. As mentioned on January 13, we announced the streamlining of our manufacturing for all our brands into one world-class global operations group. The global operations team will include manufacturing, supply chain, engineering, logistics, R&D, safety and environmental, repositioning this into a center-led function servicing the brands will enable us to leverage our manufacturing strengths across the organization and align our capabilities with the needs of our evolving product portfolio in the most cost efficient way.
We announced the first step of our Kimball International manufacturing optimization to the organization this past week. What was the David Edward acquisition for the Kimball brand 18 months ago is now being developed into a high-end upholstered seating facility for both the Kimball brand and Kimball Hospitality. As part of this plan, we have announced that we are consolidating the Red Lion production facility into the Baltimore production facility. Our focus is investing in new equipment in a redesign layout in Baltimore, that will allow us to substantially increase capacity and reduce lead times. All while delivering on the high design, high-quality products that the David Edward brand is so well known for. Expanding our Kimball healthcare portfolio and accelerating our expansion of Kimball Hospitality seating.
One of the key cornerstones of our transformation has been our formal and rigorous approach to the build of the program management capability. This expertise brings us consistency, operating rigor, efficiency and broad understanding in ways of working. We have invested in these capabilities through external training in over 12 formal change management roll outs across the various parts of the organization. We are very pleased with our accelerated capability build in the area of program management and it will serve our ongoing transformation efforts.
The third pillar of our Kimball International Connect Strategy is fuel our future. Our companywide commitment to operational excellence and adoption of new enterprisewide processes has proven our approach to funnel delivery is working. The early adoption not only gives us confidence to increase our fiscal '20 target, but also enables us to see our fiscal '21 plan taking shape and we are actively working on some of the deals, projects today.
The combination of our center-led process approach to cost savings, capability built-in program management and newly announced consolidation of global operations provide confidence in the ability to fuel our future through ongoing cost saving efforts. We will share more specifics on this as we press through our fiscal year.
All of these actions enable the fourth pillar, accelerate our growth. Our ongoing commitment to new products has been the primary fuel for organic growth and we are pleased with the new product metrics displayed last quarter, driving 29% of our combined brand sales. As we enter the back half, you will start to see organic growth agenda broaden with our entrance into two new product categories. National launched a new assortment of task seating in December. In our new ancillary sub-brand etc in January. Both of these platforms offer new incremental opportunities for our business. Task seating is one of the largest volume categories in North America office furniture and is a true match for the National brand. And we believe the new etc collection of lighter spec product with the perfect answer to the designers need for forward design reduce complexity, shorter lead times, but still with the assurance that it is consistently delivered by National.
For the Kimball brand, we announced the launch of the David Edward collection by Kimball at our sales meeting this week. The team has been working on this since our acquisition. The collection will be comprised of the signature David Edward products plus ongoing new addition supported by a new website, marketing materials and a blended selling model through both independent reps in our own Kimball selling organization. We are excited about the reinvigoration of the David Edward brand in the role it can play in the Kimball brand portfolio.
Finally, I'd like to take a moment to update you on the focused initiatives to turn the Kimball brand into a sustaining growth-driven business model. As we stated last quarter, we anticipated these wholesale changes would cause a drag on our revenue growth through the first half of 2020 into progress in the second half. We have been very attentive on the same three initiatives to drive a different level of sustaining business performance for the Kimball brand. The first initiative is the realignment of selling resources to higher growth markets. This reallocation of resources to higher growth markets is showing traction as we see orders ramping in the back half of this fiscal year.
The second initiative is an intense continuous improvement focus to correct margin issues within the systems category. While the Kimball brand made solid progress in the front half, we do expect the newly established global ops team and our commitment to best practices drive additional benefit. The last initiative is a commitment to training, development and talent within our healthcare vertical. During the quarter, we hired a Kimball brand healthcare sales leader to drive focus on sales strategy and growth plan within this vertical. Additionally, we have rolled out what we are referring to as Bootcamp training to our field sales to increase the knowledge related to our sales approach and products.
Healthcare sales were up 19% on a two year stack basis and we expect continued growth in this vertical going forward. We are pleased with the progress on the Kimball brand realignment and no it plays a critical role in our portfolio.
And to wrap up, I'd like to summarize our transformation savings in Q2 in our new full-year target on Slide 8. Our operational excellence cost savings delivered $3.8 million through strong execution of our priority projects. For example, equipment automation in one of our casegoods facilities in sourcing optimization of a top-performing Kimball seating platform and focused value engineering through material optimization.
Our center-led cost savings was on track at the $800,000 in the quarter in our new ways of working through previously disclosed showroom closures and a reduction of selling resources dedicated to low growth markets delivered expected savings of $2.5 million. Fiscal year-to-date savings were $12.7 million, as you can see we are ahead of our $16 million cost savings pace we initially targeted in the year. That said, we do see expected cost savings decelerating a bit in the second half as we anniversary portions of the $10 million savings generated in the prior year. This led us to increase the savings target to approximately $21 million from the original $16 million. Again, I am very proud of our entire organization as we embrace this new way of working, resulting in an exciting new cost efficient operating model.
With that, I will turn the call over to Michelle, where she will do a deeper dive into the quarterly financial results. Michelle?
Michelle R. Schroeder -- Executive Vice President, Chief Financial Officer
Thanks, Kristine, and good morning, everyone. I'd like to turn your attention to Slide 9, as I discuss our second quarter financial performance. We ended the quarter with $192.2 million in sales, which was a decrease of 4.4%. Our net income increased 17% to $11 million. Our adjusted EBITDA of $20.9 million increased 22.9% and resulted in a margin of 10.9%, which was up 240 basis points versus a year ago. Adjusted EPS increased 26.9% to $0.33 compared to $0.26 a year ago.
Turning to Slide 10. I'll take you through the details of our financial performance in the quarter. Gross margin improved 170 basis points to 34%. We've made progress over the last three quarters in achieving sustaining year-over-year gross margin improvement. Savings from our transformation plan has been a key contributor of that improvement as we realized the $3.8 million of savings this quarter, which resulted in a 200 basis point improvement in margin. Pricing realization also contributed to the improvement to the tune of 200 basis points this quarter. Partially offsetting this improvement was the loss of leverage on the lower revenue, an unusually high employee healthcare claims during the second quarter with an increase of $1.5 million over last year on the gross margin line. We feel really good about where the improvement is coming from and that the improvement is real. Selling and administrative expenses increased 30 basis points to 25.9%.
On an adjusted basis, where we exclude CEO transition costs and SERP, selling and administrative expenses improved 50 basis points to 25.4%. Adjusted selling and administrative expenses decreased $3.3 million, despite investing $1.8 million in growth initiatives tied to our Kimball International Connect strategy. We expect growth investments to increase during the remainder of the fiscal year. For the quarter, benefits from the transformation plan of $3.3 million and reduced sales commissions of $1 million were partially offset by higher healthcare expense of $700,000, which is in addition to the $1.5 million increase I mentioned earlier, that's included in the gross margin line.
We were happy with the level of earnings improvement over the prior year, considering the expected modest decline in sales. We continue to anticipate some variability in our results as we execute our strategy to realign the Kimball brand and invest for growth. We believe the order growth experienced during the quarter, the actions taken within our Kimball brand, and the hospitality opportunity in the Las Vegas market sets us up well to deliver revenue growth in the second half of the fiscal year.
Our transformation plan gives us the ability to accelerate our pull back on growth investments based upon top-line performance and the delivery of the benefits from our transformation plan. All of this assumes no major disruption due to the Coronavirus, which as Kristie mentioned is very fluid right now.
Moving to Slide 11, you will see the chart indicating new product sales performance for our National and Kimball brands. New product sales mix remained at a strong level of 29% of combined in National and Kimball brand sales and grew 2% over the prior year. The National brand experienced new product growth of 28%, resulting from new ancillary product introductions, new product development remains a key aspect of our growth plan. Let's turn to Slide 12 to discuss sales by vertical,
Four of the six product verticals reported sales declines, led by a 12% decline in commercial and 8% decline in hospitality both government and education delivered growth at 15% and 11% respectively. As Kristie mentioned, sales declines were driven by a difficult prior year growth comparisons of 29% in commercial, 20% in healthcare and 16% and hospitality. In the prior year quarter, the commercial vertical had a higher than normal concentration of projects contributing to that growth.
As we turn next to Slide 13, you will see that all verticals reported order growth in the quarter with hospitality leading with 31% coming from strength within the Las Vegas market. The healthcare vertical grew 10% or 32% on a two-year stacked basis, driven by the Kimball brands continued investment and strategic shift to this higher growth vertical. The strength in orders, along with the 20% growth in backlog positions us well for a solid Q3 and strong finish to our fiscal year.
Turning to our cash flow performance on Slide 14, we generated $2.3 million in cash flow from operations and used $3.8 million in free cash flow. Cash flow was negatively impacted in the quarter by a one-time change in the payout timing of our annual cash incentive plan and the timing of our final accounts payable run at the end of December. We continue to focus on working capital management, capex finished at $6.2 million for the quarter, which included completion of the headquarters remodel.
We returned $4.6 million of capital to shareholders during the quarter, including $3.3 million in dividends and $1.3 million in share repurchases. Our balance sheet remained strong with minimal debt. Return on invested capital for the quarter finished at 38.4%. Growth in our earnings and discipline in investing our capital over the years have contributed to this impressive performance and we rank among the best relative to our public office furniture peers.
On Slide 15 you will see both our acquisition framework and acquisitions, we have completed over the last few years. As a reminder, the key takeaway here is that we intend to grow our business both organically and through acquisitions. We look for acquisition targets that align with our purpose and our Kimball International Connect strategy. These targets would have higher growth products that complement our existing portfolio, new product categories and/or new channels of distribution. An important financial consideration is that the expected return exceeds our weighted average cost of capital within three years post close of the transaction.
Turning to Slide 16, we recap our three-year fiscal 2020 through 2022 financial targets which are unchanged from last quarter. On the top-line, we are expecting 4% to 7% organic growth, we're targeting 150 to 250 basis points of improvement in adjusted EBITDA margin by 2022 and forecasting EPS growth of 10% to 15%. Our outlook is based on assumptions for GDP growth of 1.5% to 2.5%, a flat share count and excludes the impact of any potential acquisitions.
I will now turn the call back over to Kristie, to provide color on our path forward. Kristine?
Kristine L. Juster -- Chief Executive Officer
Thanks, Michelle. Although we do not provide short-term guidance, I think it is important to find some insight, given the patching this we expect as we execute our transformation plan and invest in our Kimball International Connect strategy. We expect our full fiscal year 2020 growth to outpace this most 2020 calendar year growth forecast of 2.2% supported by the strong growth in orders, we saw across all verticals in Q2.
Our Kimball Hospitality growth will be back-half loaded, due to the installation timing of the Vegas projects. We are now on track to deliver $21 million cost savings for the fiscal 2020, up from the original estimate of $16 million. Our organic growth agenda will start to take shape, as we have strong proof in our ability to drive a more cost-efficient operating model. Our growth investments year-to-date of $2.8 million or rent to accelerate future growth. We expect to invest approximately $30 million in capex for the full fiscal year 2020. Fiscal 2020 is shaping up to be a strong confirmation in our ability to deliver on our new Kimball International Connect strategy.
And with that, I'll turn the call over to Crystal, and we'll be happy to take your questions.
Operator
Thank you. [Operator Closing Remarks] And I'm showing no questions in the queue at this time, I'd like to turn the call back over to Kristie Juster, CEO of Kimball International.
Kristine L. Juster -- Chief Executive Officer
Thank you, Crystal. And thank you for joining us today and we appreciate your continued interest in Kimball International and we look forward to keeping you informed on our progress. Have a nice day.
Operator
[Operator Closing Remarks]
Questions and Answers:
Duration: 33 minutes
Call participants:
Kristine L. Juster -- Chief Executive Officer
Michelle R. Schroeder -- Executive Vice President, Chief Financial Officer
