FLEXSTEEL INDUSTRIES, INC. (FLXS) Q3 2022 Earnings Call Transcript

FLEXSTEEL INDUSTRIES, INC. (FLXS -0.72%)
Q3 2022 Earnings Call
Apr 26, 2022, 9:00 a.m. ET

Contents:

• Prepared Remarks
• Questions and Answers
• Call Participants

Prepared Remarks:

Operator

Hello, and welcome to the Flexsteel Industries' third quarter FY 2022 earnings results conference call. [Operator instructions] Please note, today's event is being recorded. I'd now like to turn the conference over to Derek Schmidt. Mr.

Schmidt, please go ahead.

Derek Schmidt -- Chief Financial Officer and Chief Operating Officer

Thank you, and welcome to today's call to discuss Flexsteel Industries third quarter fiscal year 2022 financial results. Our earnings release, which we issued after market close yesterday, Monday, April 25, is available on the investor relations section of our website www.flexsteel.com, under news and events. I am here today with Jerry Dittmer, president and chief executive officer. On today's call, we will provide prepared remarks, and then we will open the call to your questions.

Before we begin, I would like to remind you that today's comments will include forward-looking statements, which can be identified using words such as estimate, anticipate, expect and similar phrases. Forward-looking statements, by their nature, involve estimates, projections, goals, forecasts and assumptions and are subject to risks and uncertainties that could cause actual results or outcomes to differ materially from those expressed in the forward-looking statements. Such risks and uncertainties include, but are not limited to, those that are described in our most recent annual report on Form 10-K as updated by our subsequent quarterly reports on Form 10-Q and other SEC filings as applicable. These forward-looking statements speak only as of the date of this conference call and should not be relied upon as predictions of future events.

Additionally, we may refer to non-GAAP measures, which are intended to supplement, but not substitute for the most directly comparable GAAP measures. The press release available on the website contains the financial and other quantitative information to be discussed today, as well as the reconciliation of GAAP to non-GAAP measures. And with that, I will turn the call over to Jerry Dittmer. Jerry?

Jerry Dittmer -- President and Chief Executive Officer

Good morning and thank you for joining us today. I'm encouraged by our execution in the third quarter, as we delivered solid results in line with our guidance on multiple fronts. First, we grew sales by double digits for the seventh consecutive quarter, a strong indication that we are competing well. Second, we restored profitability by dramatically reducing ancillary charges from the second quarter realizing additional pricing to offset inflationary pressures and prudently managing SG&A expenses.

While uncertainty lingers about economic growth and the trajectory of inflation, we are confident that we can sustain profitability in future periods. Third, we significantly reduced inventory without compromising service levels and as a result generated attractive cash flow, which enabled us to strengthen our balance sheet and reduce our bank debt by a sizable amount. These accomplishments were achieved despite navigating the supply chain and logistics challenges that continue to plague our industry. Disruptions and constraints in the supply chain have become the new normal and we remain focused on mitigating our supply chain risk and building greater agility and resilience.

Investments in two additional manufacturing plants in Mexico will enable us to achieve a better balance of mix between globally sourced product and North American manufactured product. At the same time, we are growing our global supplier base, both to expand capabilities and diversified countries of origin. This hybrid supply chain of mix sourced and manufacturing capabilities across a multitude of countries provides us the ability to adjust more rapidly to changing market conditions than many of our competitors and allows us to serve our customers well even in times of disruption. Furthermore, our investments in new or expanded distribution centers brings our product closer to customers with greater logistical efficiencies, less handling damage and a better overall customer experience.

While we can't anticipate every possible supply chain disruption or surprise, the investments that we are making will serve the company and its customers well in the coming years. While I feel we're well positioned to continue profitably growing and gaining market share longer term, we are faced with two major headwinds in the near term. The first significant issue is cost inflation as we continue to feel the cost pressures across all areas of our business, including material, domestic and global wage rates in all forms of transportation. We've been largely successful at offsetting these cost pressures through price increases to both our retail and e-commerce channel, although there is an inherent lag between the timing of cost and price realization that squeezes margins shorter term.

While we continue to evaluate additional pricing actions as needed to combat inflation, we are elevating the intensity of our efforts to drive cost savings to both improve margins and maintain our pricing competitiveness in the market. Our goal is to continue providing customers with products of superior quality, comfort and durability at attainable prices. The other headwind is slowing consumer demand for furniture, which is being driven by several factors. First, demand is reverting to more normalized levels after an extraordinary period of pandemic-induced consumer buying for everything related to the home.

We are consistently hearing from our customers that both online and retail furniture traffic has shifted downward. Although demand is slowing, our view, which is shared by many in the industry, is that consumer demand can remain above pre-pandemic conditions for the foreseeable future. The second factor influencing demand is macroeconomic uncertainty, especially regarding inflation, which has driven consumer sentiment to a decade low recently. The surge in food and gasoline prices are clearly taking a psychological toll on consumer spending habits.

Third, the mix of consumer spending is shifting away from goods and back toward travel, entertainment and services that were largely abandoned during the peak of the pandemic. This shift is likely to be evident in the coming months as summer travel picks up. For furniture manufacturers like Flexsteel, slowing demand will be further exacerbated by retailer inventories, which remain stubbornly high. I had an opportunity to speak with dozens of retailers several weeks ago at our High Point Market event, who consistently told me that their warehouses were full of containers of product that they had ordered six to nine months ago, but just recently arrived due to supply chain delays.

Until they can move some of this product, they won't have room to replenish their flexible inventories in the short term. While the near-term demand scenario depicted may seem pessimistic, we remain bullish on the long-term prospects for the industry. The next six to nine months may be a bit choppy for the reasons I cited. But the longer-term horizon outlook is optimistic due to the structural factors like the purchasing power growth of millennials, strong household formation projections and the robustness of housing demand.

More encouragingly, I feel great about Flexsteel's position to compete effectively and outgrow the industry longer term. The transformation the company has undergone in the past three years combined with investments in talent, products and processes has positioned us to expand our addressable market and grow through new customers, new markets and new product categories in the years to come. Now, I'll turn the call over to Derek to discuss our financial and operational results, and I'll be back with some closing comments on what we see ahead.

Derek Schmidt -- Chief Financial Officer and Chief Operating Officer

Thank you, Jerry, and good morning, everyone. Third quarter net sales were $140.4 million, up $22 million or 18.6% compared to $118.4 million in the prior year period. Our sales results were at the midpoint of our $135 million to $145 million guidance range despite ongoing supply chain challenges. Sales performance in our retail channel continued to be strong as sales increased $22.9 million or 22.1% versus prior year.

With the addition of our third manufacturing plant in Juarez, Mexico, we've been able to aggressively work down the large pandemic-induced backlog that was built last year and expect lead times on our manufactured product to be reduced to pre-pandemic levels of four to six weeks by early June. Many of our competitors continue to quote significantly longer lead times. So we feel that we will be advantaged in the market near term. Additionally, we continue to benefit from the gains in retail product placements made over the past year, as well as our healthy inventory position and service levels of in-stock products.

On the e-commerce side of our business, sales performance was modestly lower than prior year by $900,000. While we are competing well, several of our large e-commerce customers are reporting sizable declines in online traffic compared to last year's robust results that were spurred by pandemic-driven buying. Although the downward shift in traffic is expected to remain a near-term headwind, we remain positive on the long-term prospects for growth in our e-commerce business as we are pursuing aggressive plans to gain share through new customers, new product launches and improved content and advertising effectiveness. From a profit perspective, we returned the company to profitable growth in the third quarter delivering operating income of 4.1% as a percentage of sales, net income of $5.8 million and earnings per diluted share of $0.82.

Gross margin as a percent of net sales in the third quarter was 15.7%, which was a notable improvement over second quarter's results of 6.7%. The sequential improvement from prior quarter was largely driven by a reduction in ancillary costs associated with eight ocean containers of over $10 million, as well as the realization of additional pricing taken in February. Profit performance was also supported by strong SG&A spending controls as third quarter SG&A expense dropped to 11.6% as a percentage of sales, the lowest quarter of the fiscal year. Moving to the balance sheet and cash flows, the company ended the quarter with a cash balance of $3.4 million, and working capital of $138.4 million, which represents a reduction of $32.7 million during the quarter, largely driven by a $24.9 million decrease in inventory.

As a result of the strong working capital management, operating cash flow during the quarter was $37.1 million. As previously communicated, debt reduction is a priority, and we reduced our outstanding borrowings by approximately 30% or $18.1 million in the quarter. The strong cash flow also enabled us to fund $18.3 million of share repurchases in the period, which reduced our outstanding share count by 13.7% versus the prior quarter. Looking forward.

Guidance for the fourth quarter sales is between $120 million and $135 million. As Jerry noted earlier, while we are competing well, consumer traffic for furniture, both online and in-store has recently slowed, albeit still above pre-pandemic levels. Many of our large retailers also have warehouses full of sourced product which finally showed up after months of supply chain delays and their heavy inventory positions will further dampen demand for our in-stock inventory in the near term. We do expect demand for our North American manufactured products to accelerate given how competitive our lead times currently compare to other manufacturers.

But the increase in this part of our business will still be overshadowed by headwinds in sourced product. Lastly, our sales guidance range is slightly larger this quarter than in past quarters, as we are expecting a large amount of incoming containers of product in June that is currently in our backlog, which may either shift to customers in June or July, depending on supply chain conditions, and the timing of when we receive the product. Regarding profitability, while there is still much uncertainty on cost inflation near term, we are projecting operating income as a percent of sales in the range of 3.5% to 4.5%, which is relatively consistent with third quarter results. Compared to the third quarter, we expect gross margins to improve to 16% to 17% in the fourth quarter, driven by continued reductions in ancillary charges, as well as additional price realization.

Combined, these items will deliver approximately $4 million of additional gross profit, which will help offset the anticipated profit reduction from lower sales. However, the improvement in gross margins is expected to be masked by deleverage of SG&A costs due to lower sales. For the fourth quarter, we expect SG&A dollars to be in the range of $16.5 million to $17 million, which is slightly higher than the third quarter. Returning to ancillary charges.

We are confident that we have these costs under control as we've realigned with a select group of freight forwarders who are performing more effectively and managing the physical flow of our containers and reducing ancillary fees, and we've implemented sustainable processes to track and monitor fees on a daily basis. Regarding our cash flow outlook, working capital is expected to be a source of cash flow in the fourth quarter as we anticipate inventories to decline another $10 million to $15 million in the period. Near-term priorities for cash remain funding capital expenditures and reducing debt. For the fourth quarter, we expect capital expenditures between $4 million and $6 million or $7 million to $9 million for the full fiscal year.

The larger spend in the fourth quarter relates to equipment for our new production facility in Mexicali, Mexico. While not a priority, we may continue to be opportunistic with share repurchases at modest spending levels if the stock price remains at a significant discount to our view of intrinsic value. Lastly, the effective tax rate for fiscal 2022 is still expected to be in the range of 26% to 27%, and restructuring expenses are estimated at $1 million for the full year. I'll turn the call back over to Jerry to share his perspectives on our outlook.

Jerry Dittmer -- President and Chief Executive Officer

Thanks, Derek. I remain energized by our prospects for long-term profitable growth. Even though consumer demand for furniture is expected to moderate near term compared to the extraordinary high levels from a year ago, we will continue to pursue new sources of growth, including new customers and products. Our recent investments to expand North American capacity will both support growth and build supply chain resilience.

Production at our third and newest manufacturing plant in Juarez, Mexico has accelerated the reduction of our backlog, and we expect our lead times for manufacturing products to be four to six weeks by early June. Construction of our new facility in Mexicali, Mexico remains on target for completion in late summer and we are aggressively selling the incremental capacity to generate new business. Our new distribution center in Greencastle, Pennsylvania started up this past quarter and is supporting improved service levels and growth in the East Coast. These initiatives, combined with ongoing investments in talent, brands, product innovation and digital capabilities position us well to achieve our longer-term growth ambitions.

With that, we will open the call to your questions. Operator?

Questions & Answers:

Operator

[Operator instructions] And the first question comes from Anthony Lebiedzinski from Sidoti & Company.

Anthony Lebiedzinski -- Sidoti and Company -- Analyst

Good morning and thank you for taking the question. So first, just a couple of housekeeping items here, if I may. Just wondering, as far as if you could comment on the level of price increases taken in the quarter that you just reported? And do you have the backlog also at the end of the quarter?

Derek Schmidt -- Chief Financial Officer and Chief Operating Officer

Yeah. In terms of the pricing, we actually pushed through a price increase, Anthony, in February, February 1. And so, given kind of normal lag, we are just now starting to realize a good majority of that in the fourth quarter and that increase was 8% across most aspects of our line. In terms of the backlog, we finished the quarter at $99 million.

So versus prior year, at the same time, we were at $140 million for retail. So it's come down a good amount. Hence, why we're really confident that -- from a manufacturing standpoint, we're going to be at four to six-week lead times here very shortly, which we believe is going to be a competitive advantage in the marketplace.

Anthony Lebiedzinski -- Sidoti and Company -- Analyst

Got it. OK. Thanks for that. And then, in terms of the guidance, I know you guys talked about just overall slower retail traffic that you're seeing? Are you seeing that across the board in all your markets or any of markets doing better than others?

Jerry Dittmer -- President and Chief Executive Officer

So it's pretty well -- this is Jerry, Anthony. So it's pretty well across the whole country. It's not certain markets. We are seeing the slowdown both in our home furnishings and in our home sales online business.

We've actually seen it in both. And really, we really started to see it really probably in the last 75 days. From February through now, we've seen a pretty drastic slowdown. But like I said, there's really not any part of the country.

There're pockets all over.

Anthony Lebiedzinski -- Sidoti and Company -- Analyst

Got you. OK. And then, in terms of the sequential improvement in the gross margin that you expect in the June quarter, what are the primary drivers of that? If you could just share more details about that that'd be great.

Derek Schmidt -- Chief Financial Officer and Chief Operating Officer

Yeah, there's really two primary drivers, Anthony. One is continued improvement in ancillary charges. So we were able to get ancillary charges in total down below $4 million in the most recent quarter, and we believe that we can take out another $2 million sequentially going into the fourth quarter. So that's one driver.

And then, also, we started to realize a little bit of the price increase that I just alluded to earlier in the third quarter, but we'll fully realize that in the fourth quarter. So those are the two drivers.

Anthony Lebiedzinski -- Sidoti and Company -- Analyst

Got you. OK. And then, longer term, you guys talked about new product and new customer opportunities. Can you just expand on that? And whether do you expect to achieve that organically? Or do you need to make some acquisitions in order to have more new products and new sales channels.

Jerry Dittmer -- President and Chief Executive Officer

Yeah. So organically is where we'll see most of that over the next several quarters. Acquisitions is something that we've always got out there as a possibility but there's really nothing teed up at this time that we would see in the short term. So a lot of these new products are getting us into new markets and new channels that we haven't been in before.

And as you know, it takes three, six, nine months, sometimes to see some of those, but we're working those very hard at this time.

Anthony Lebiedzinski -- Sidoti and Company -- Analyst

Got you. OK. And then, -- go ahead.

Derek Schmidt -- Chief Financial Officer and Chief Operating Officer

Anthony, the only thing I was going to add, so we've got many pursuits around new customers. As we've kind of shared in the past, we're looking to expand our footprint in retail, specifically with big box customers. And so, we're actively working relationships with a multitude of new customers on that front. And then, we continue to look to expand our portfolio of e-commerce partners as well.

Anthony Lebiedzinski -- Sidoti and Company -- Analyst

Got you. OK. And then, lastly, as far as longer term, obviously, I know there are some short-term headwinds here with all the cost pressures and so on. But longer term, can you share with us how you guys think about operating margins? What's your goal? I know you previously, I believe, talked about 6% to 7% op margins.

If you could just discuss that that would be great.

Derek Schmidt -- Chief Financial Officer and Chief Operating Officer

Yeah, Anthony, we haven't come off of that target. Again, we still aspire to get operating margins north of 7%. I think that will be a bit challenging to accomplish in fiscal year '23, given some of the headwinds in the demand environment. But as we look at fiscal year '24 and kind of beyond, we still feel that's very attainable.

And so, the composition of how we get there is a gross margin above 20%. And maintaining SG&A as a percent of sales below 14%.

Anthony Lebiedzinski -- Sidoti and Company -- Analyst

OK. Very helpful. Thank you very much and best of luck.

Derek Schmidt -- Chief Financial Officer and Chief Operating Officer

All right. Thanks, Anthony.

Operator

Thank you. And the next question comes from Jeff Geygan with Global Value Investment Corp.

Jeff Geygan -- Global Value Investment Corp. -- Analyst

Good morning, guys. Thanks for taking my call.

Derek Schmidt -- Chief Financial Officer and Chief Operating Officer

Hey, Jeff.

Jeff Geygan -- Global Value Investment Corp. -- Analyst

Just a couple of open items. You mentioned your global supplier base as expanding. What else can you say about that?

Derek Schmidt -- Chief Financial Officer and Chief Operating Officer

So we've talked, I think, fairly openly about our intended kind of desire to diversify our supply base. Certainly, with the amount and magnitude of global supply chain disruption, that we've experienced in the last 18 months. I mean, we are looking for partners that are closer to the United States. So, we're actively developing relationships with new partners in Mexico, South America.

We're actively looking in Europe, specifically kind of Central Europe. So again, this is a long-term strategy to make sure, again, we've got a resilient and diversified supply base and feel good about the inroads that we're making on that front.

Jeff Geygan -- Global Value Investment Corp. -- Analyst

Yeah. Glad to hear it. Thank you. With respect to your China source product, what percentage of your production comes from China today? And how does that compare to pre-tariffs, say, 2017?

Derek Schmidt -- Chief Financial Officer and Chief Operating Officer

Yeah, Jeff, it's below 10% at this point. I think if you were to rewind and go all the way back to pre-tariff, it was as high as 60% to 70%. And so, we've largely transitioned away from China. The only exception is our metal-based outdoor furniture.

That is largely China-based for the entire industry. Now, that said, we still have exposure to China in terms of some raw materials. So the mechanical parts, the switches, fabrics. So we're constantly working the supply chain on the raw material side to diversify that as well.

Jeff Geygan -- Global Value Investment Corp. -- Analyst

Thank you. A leading container liner cited a reduction in container demand earlier today. What are you currently seeing with availability and pricing?

Jerry Dittmer -- President and Chief Executive Officer

Yeah. So from an availability standpoint, it's improved. It's obviously not where it was a few years ago, but it's improved some. The costs have moderated.

So the costs have come down a few thousand dollars but we're still running $12,000, $15,000 higher than we were back before the pandemic.

Jeff Geygan -- Global Value Investment Corp. -- Analyst

Great. All right. And final question. You mentioned your home style online business is declining modestly.

What do you attribute that to? And how does that sync up with your expectation to gain market share?

Jerry Dittmer -- President and Chief Executive Officer

So a couple of things there. One is different than our home furnishings business, there is not a backlog there. So we see immediately what's going on. And as we mentioned, we have some customers that have slowed up there.

We obviously took some price increases and have got those in. And then, just overall demand has slowed. And if you go out and look at just kind of the e-commerce market in general, you'll see that, especially for big ticket items in furniture, especially.

Derek Schmidt -- Chief Financial Officer and Chief Operating Officer

And anecdotally, Jeff, I mean our customers tell us that relative to our peers we're performing well in the categories. But as Jerry alluded to, I mean, we are starting to see not only a downward shift in overall consumer spending, but I think there's a sizable mix shift that people are spending more of their disposable incomes on travel, entertainment, those things that they largely avoided during the pandemic. I think we're going to see that continue at least here throughout the summer. So, I think conditions are going to be choppy here for the next six months and depending again how the Fed handles kind of inflation, maybe we can get back to a more normalized environment here later in the calendar year.

Jeff Geygan -- Global Value Investment Corp. -- Analyst

I appreciate you have challenges ahead. But congrats to you progressively going to the market to buy your shares, I think retrospectively, that will accrue very favorably to us as equity holders. So thanks and good luck.

Derek Schmidt -- Chief Financial Officer and Chief Operating Officer

Thanks, Jeff. 

Jerry Dittmer -- President and Chief Executive Officer

Thanks, Jeff.

Operator

[Operator instructions] All right. As there is nothing else at the present time, I would like to return the floor to management for any closing comments.

Jerry Dittmer -- President and Chief Executive Officer

Great. Thanks. In closing, I would like to thank all our Flexsteel employees for their outstanding performance and service during the third quarter. I'd also like to thank you for participating in today's call.

Thank you for your questions today, and please reach out with any additional ones, and we look forward to updating you on our next call. Everybody, have a great day. Thanks.

Operator

[Operator signoff]

Duration: 31 minutes

Call participants:

Derek Schmidt -- Chief Financial Officer and Chief Operating Officer

Jerry Dittmer -- President and Chief Executive Officer

Anthony Lebiedzinski -- Sidoti and Company -- Analyst

Jeff Geygan -- Global Value Investment Corp. -- Analyst

More FLXS analysis

All earnings call transcripts