Flexsteel Industries Inc

NASDAQ:FLXS

Earnings Call Analysis

Earnings Call Transcript 2024-Q2

[Operator]

Good morning, and welcome to the Flexsteel Industries Second Quarter Fiscal Year 2024 Earnings Conference Call. [Operator Instructions] Please note this event is being recorded. I would now like to turn the conference over to Mike Ressler, Chief Financial Officer for Flexsteel Industries. Please go ahead.

[Michael Ressler, executive]

Thank you, and welcome to today's call to discuss Flexsteel Industries Second Quarter Fiscal Year 2024 Financial Results. Our earnings release which we issued after market close yesterday, February 5, is available on the Investor Relations section of our website at www.flexsteelindustries.com, under News and Events.

I'm here today with Jerry Dittmer, Chief Executive Officer; and Derek Schmidt, President. 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 the comments on today's call 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 can 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'll turn the call over to Jerry Dittmer. Jerry?

[Jerald Dittmer, executive]

Good morning, and thank you for joining us today. I'd like to start by welcoming Mike Ressler, our new Chief Financial Officer. Mike has been with Flexsteel over 17 years in various accounting, finance and other cross-functional roles. Most recently as the Vice President of Manufacturing. His appointment as CFO reflects his leadership and contribution to the company's transformation over the past several years. And I'm excited for Mike to further expand his positive impact on the company as CFO.

I would also like to congratulate Derek Schmidt, on his appointment to President and to the Board of Directors. Derek's promotion reflects his leadership of the company's operations and growth strategy and aligns with his expanded responsibility since joining the company nearly 4 years ago.

With that, I am very pleased to share with you our second quarter fiscal year 2024 results. While headwinds from macroeconomic challenges and shifts in consumer spending towards experiences and away from things, persist in our industry, we continue to execute on our strategic initiatives and delivered sales growth of 7.5%, when compared to the prior year quarter.

In addition, our relentless focus on operational efficiency and cost savings, propel gross margin expansion and help fund additional investment in growth initiatives, while delivering significantly improved operating income, when compared to both the same quarter of the prior year and our first quarter fiscal 2024.

While we expect the business environment in the near term to remain challenged, our team isn't deterred and remains intensely focused on continuing to profitably grow our business throughout the remainder of fiscal year 2024 and long term. We will continue our positive momentum going into the third quarter and are confident in our ability to grow sales, both compared to last year and the second quarter.

I'll now turn the call over to Derek to discuss our results and an update on our growth initiatives. I'll be back at the end of the call with some closing comments on what we see ahead.

[Derek Schmidt, executive]

Thank you, Jerry, and good morning, everyone. Like Jerry, I am very pleased with our second quarter results. We are competing well in our core business and executing our market expansion initiatives, resulting in both sales and profit growth, even in a difficult business environment.

As Jerry noted earlier, we grew our top line by 7.5% in the fiscal second quarter. This year-over-year sales comparison continues to be adversely impacted by the elimination of ocean freight surcharges, which reduced revenue by approximately $3.5 million, compared to the prior year quarter. As discussed in our first quarter call, in the prior year, we used this surcharge mechanism to pass-through higher cost of ocean container delivery, which were significantly inflated due to supply chain issues.

Container delivery costs normalized throughout the last fiscal year and we subsequently eliminated this surcharge. Excluding the $3.5 million impact from this ocean freight surcharge elimination, sales growth related to unit volume and product mix was a robust 11.7%, further reinforcing our strong sales execution.

Despite challenging industry conditions, we remain confident in our ability to continue our growth momentum into the second half of fiscal 2024, from both continued share gains in our core business and increasing momentum in our market expansion initiatives.

In our core business, we expect to continue outperforming the industry by continuously improving and provide a differentiated customer experience, aligning ourselves with the strongest, most capable distribution partners and driving a constant stream of relevant and compelling new products. We define our core business based upon where the majority of our current sales are derived from, which is product designed for primary living spaces like the living room, which are sold through independent furniture retailers, and have a more traditional or transitional style that primarily appeals to Gen X and baby boomer consumers.

This core business is large and profitable and we will continue to defend and expand our penetration in this market. At the same time, we are pursuing growth in markets outside of our core that we believe are relevant and growing and where we have a clear right to win. If you recall from prior calls, these market expansion initiatives take 3 forms. First, consumer segments, namely Gen Z and Millennials, and Second, product categories outside of primary living spaces. And lastly, sales distribution outside of independent furniture retailers.

I'm pleased with our solid progress in all 3 of these areas. First, to address younger consumers, we're repositioning our brand portfolio through a three-pronged approach. We are modernizing the Flexsteel brand. And last October, we launched a strong lineup of more contemporary product, at lower price points with exceptional comfort and quality. We're encouraged by initial placements and sales of these new products are ramping nicely. We also launched a new brand, Chrisma, last year to reach younger consumers with even lower price on-trend products.

In this year, we've invested in new talent and product engineering to support Charisma and we'll be launching multiple exciting new products at April's High Point Market to grow this new brand. Additionally, we continue expanding our new Flex Solution with broader accessories to further improve its modularity and appeal to younger consumers.

Moving on to our second market expansion focus. Which is to expand into newer product categories, we focused on Health and Wellness this year with our new Zecliner sleep chair. A recent third-party sleep study validated the superior sleep results from using Zecliner, which we are now leveraging in our marketing and demand generation initiatives. The product has now placed in over 960 retailers, and we are investing aggressively in additional innovation to protect our leadership position in this emerging market.

Our third market expansion focus is to broaden our sales distribution to position our brands, where and how consumers want to purchase furniture, both now and into the future. For example, our Flex Modular Solution, which I mentioned earlier, can be purchased not only in leading retailers, but also on Amazon, Wayfair, costco.com and our own online platform at flexsteelstore.com.

While I'm excited about our top line growth and future growth prospects, I'm equally energized by our improved profitability, which is being propelled by 4 drivers. First, new products with higher margin profiles. We've raised the threshold for new product margins and expect product life cycle management will continue to improve our gross margin over time.

Second, we're executing well operationally and delivering strong cost savings within our supply chain. Third, we've remained disciplined with pricing and pull back promotions where needed to improve overall profitability. And fourth, we are achieving leverage on fixed costs through higher sales volume which we believe will continue to be an important driver of operating margin improvement going forward as we grow the business.

As I noted earlier, differentiated customer experience is an important element of share gains in our core markets. As part of our ongoing commitment to improve the customer experience, the company announced the closure of our Dublin, Georgia manufacturing plant. While this decision was very difficult, it enables us to reduce customer lead times and handling damage to improve the overall customer experience, while also decreasing inventory, simplifying logistics execution and improving profitability.

Currently, the Dublin facility supports less than 5% of the company's sales, and we expect to retain virtually all sales through this transition. Closure of the facility is expected to occur by the end of our fiscal fourth quarter. As part of this transition, the company expects to incur pretax restructuring and related expenses between $2.5 million and $3.2 million. The onetime costs are associated with employee separations, inventory and equipment transfers and other expenses directly related to the closure and are expected to be incurred primarily in our third and fourth quarters of fiscal year 2024.

Once the closure is fully executed, the company expects annualized savings in the range of $4 million to $4.5 million. The Dublin facility will be listed for sale upon closure, and the company anticipates a future onetime gain in excess of the carrying value of the asset.

To summarize, we are growing and gaining share under challenging industry conditions. We have robust plans to continue that growth both through our core markets and expansion into new markets. We are rapidly improving profitability with more gains expected through fiscal 2024 and into fiscal 2025, we are generating strong free cash flow and strengthening our balance sheet, and we are investing to continuously improve our customer experience and to drive new innovation that will differentiate us and strengthen our market leadership long term. Future is bright and I'm excited about what lies ahead for our organization.

With that, I'll turn the call over to Mike, who will give you some additional details on the financial performance for the second quarter and the outlook for the third quarter of fiscal year 2024.

[Michael Ressler, executive]

Thanks Derek. For the quarter, net sales were $100.1 million, slightly above our guidance of $94 million to $100 million, provided during our first quarter fiscal 2024 earnings call. As Derek noted earlier, sales growth related to unit, volume and mix, which when excluding prior year quarter ocean freight surcharges was a strong 11.7% in the quarter. And we feel we have sustainable growth momentum throughout the rest of fiscal 2024 and into fiscal 2025.

From a profit perspective, the company delivered operating income of $4.6 million or 4.6% of sales in the second quarter, which exceeded our operating guidance range of 2% to 4%. A meaningful increase in our operating income was driven by an expansion of our gross margin to 21.9% in the quarter, compared to 17% in the prior year quarter.

Moving to the balance sheet and statement of cash flows. The company ended the quarter with $3.3 million in cash, working capital of $100.5 million and a balance on our revolving line of credit of $17.9 million. Our increased profit, combined with improved working capital levels, allowed us to pay down our debt by 46%, when compared to the fiscal first quarter.

Looking forward, we reiterate the sales guidance release with our preliminary results announcement on January 11, 2024. And while we expect onetime costs related to the closure of our Dublin facility, will adversely impact GAAP operating income, we still expect to achieve our fiscal 2024 operating income guidance on an adjusted non-GAAP basis. When backing out the onetime costs associated with the facility closure.

Specifically, for the fiscal third quarter, we expect sales between $101 million and $106 million. Which represents sales growth of 2% to 7%. Regarding profitability, we expect gross margin in the range of 21% to 22%. We expect gross margin to grow modestly throughout the remainder of the fiscal year and into fiscal 2025, driven by sales growth and continued realization of our cost savings initiatives. We will continue to prudently manage SG&A spending with a focus on investing in our growth initiatives and expect SG&A costs between $17 million and $17.5 million for the third quarter.

Due to onetime costs related to the closure of our Dublin facility, we expect to incur restructuring costs in the third quarter between $2.0 million and $2.5 million, primarily related to employee separation costs in the transfer of equipment and materials to other facilities.

We are projecting GAAP operating income as a percentage of sales in the range of 2.5% to 3.5% for the third quarter. Excluding onetime charges related to the closure of our Dublin facility, we expect adjusted non-GAAP operating income of 4.5% to 5.5%, consistent with our previously disclosed guidance.

The most significant driver of variability in our forecasted guidance ranges, our consumer demand changes, increases to ocean container rates resulting from the disruption in the Red Sea and competitive pricing conditions, all of which will be largely influenced by external factors.

Regarding our cash flow outlook in the second half of fiscal 2024, we expect improved profit and further inventory reduction to be a meaningful source of cash. Near-term priorities for cash remain reducing debt, resourcing new innovation and funding modest capital expenditures, mainly related to cost savings initiatives and continued modernization of our IT systems.

For the third quarter, we expect capital expenditures to be between $1.0 million and $1.5 million. We expect debt levels at the end of the third quarter to be in the range of $12 million to $17 million. And by the end of fiscal 2024, we expect debt levels in the range of $0 million to $10 million. The effective tax rate for fiscal 2024 is expected to be in the range of 30% to 32%.

Now I'll turn the call back over to Jerry to share his perspectives on our outlook.

[Jerald Dittmer, executive]

Thanks, Mike. While we remain cognizant of macroeconomic factors, which could impact our current outlook, I am optimistic about our ability to continue to gain share and confident we can maintain our profitable growth trajectory, both in the near and long term.

We have great momentum and are well positioned to successfully deliver improved earnings and an even stronger balance sheet over the remainder of fiscal year 2024 and into fiscal year 2025.

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

[Operator]

[Operator Instructions] The first question is from Anthony Lebiedzinski with Sidoti and Co, LLC.

[Anthony Lebiedzinski, analyst]

So first, a nice job in a tough environment for sure. So you guys talked about -- a lot about the market share gains in your core business. Just broadly speaking, is it -- are you doing more business with your existing clients? Or are you signing up new accounts? I mean just wanted to get a better sense as to where those share gains are coming from?

[Jerald Dittmer, executive]

Yes, Anthony, thanks for the question. This is Jerry. Yes, a lot of our growth is in our core strategic accounts and in our core business. Obviously, we're still out signing up new folks at all times, but most of it has come from us going deeper and getting more placements with our core accounts.

[Anthony Lebiedzinski, analyst]

That's very helpful. So the unit volume increase certainly is even more impressive than your total sales gains, so I guess in terms of your guidance going forward, how should we think about the split between unit volumes versus pricing?

[Derek Schmidt, executive]

Yes. I think -- Anthony, it's Derek. Going forward -- so in the third quarter, as we -- let's break pricing out between the surcharge impact and then just kind of normal pricing. So in the third quarter, there's about $2 million of impact of the ocean freight surcharge elimination. And then that comparison goes away in the fourth quarter. What we are assuming in terms of pricing is status quo, likely for the remainder of the calendar year.

The only caveat to that is, as you're likely aware, ocean freight container rates have gone up substantially. They've actually almost doubled since the beginning of December. So if they stay at that rate, we will have to consider certainly turning back on some types of surcharge mechanism. But all that aside, we would expect that the majority of the go-forward growth is related to the unit volume and mix and not pricing.

[Anthony Lebiedzinski, analyst]

Understood. And I was going to ask about the ocean freight costs. So those have gone up certainly from the bottom here. Okay. But at this point, you have not passed along any higher sort of charges because of the Red Sea conflict. So -- okay. Understood. All right, and then I guess I just wanted to dig in a little bit deeper in terms of the gross margin improvement, obviously, very strong year-over-year.

Maybe if you could just kind of parse out maybe over the kind of the puts and takes as to what drove that. I know you talked about some cost savings initiatives. Obviously, you have fixed cost leverages there as well. So maybe if you could just go over some of the details behind the gross margin improvement and your confidence level about being able to sustain that?

[Michael Ressler, executive]

Anthony, this is Mike. Yes. So I think as Derek highlighted, we have kind of 4 key drivers of the gross margin improvement. One, cost savings. So we've taken some actions to reduce structural costs. In the prior year, we took a distribution center off-line, which lowered our structural costs. In addition, on the cost savings side, we have pretty strong operations team that are executing save initiatives, both in our sourcing, manufacturing and then also in our logistics and distribution network.

We feel like those processes are sustainable here going forward. The second thing, Derek mentioned was introduction of new products and using product life cycle management to improve profit kind of on a go-forward basis. So we're leveraging our cost savings initiatives, as well as kind of our value engineering activities to continue to bring out new products that have a better margin profile than the legacy products, we have that we're discontinuing.

And then kind of the third piece would be the volume leverage. As we -- we're really thoughtful about reinvesting back into our structural costs, so that way we get to leverage on our sales growth initiatives. And then lastly, we've just been able to be more strategic around our promotional activities as it relates to moving -- slower moving inventory and things like that.

[Derek Schmidt, executive]

The one thing I'll add, Anthony, is I think the magnitude of impact from those 4 levers will change over time. I think in the near term, as Mike alluded to, operationally, we're executing really well. Lots of cost savings from that. And I think the pricing discipline has been a really big profit lever in the near term. As we look at the quarters ahead and the years ahead, what are going to be the main drivers of gross margin improvement going forward are going to be the product life cycle management.

So as we've explained, again, we've raised the hurdle rates on new product as that becomes a larger and larger amount of our portfolio that's going to raise the overall margin profile. And then I think the operating leverage from growth. So again, I think the mix of drivers will kind of evolve here over the coming quarters and coming years, but we still feel confident in terms of our ability to continue to expand margins.

[Anthony Lebiedzinski, analyst]

Understood. Yes. And then I guess -- so -- as far as the Dublin, Georgia facility closure here, you mentioned that it's going to result in annualized cost savings of -- the bottom end of that is $4 million. But I noticed that you didn't change your guidance for fiscal '25. Is this just function of you guys trying to be conservative? Or just wondering if you will be reinvesting those savings elsewhere? How should we think about that?

[Michael Ressler, executive]

Anthony, this is Mike. So when we built our fiscal 2025 guidance ranges, we modeled out several different structural cost change scenarios, and we still feel good about what we put out there for our fiscal 2025 guidance range, on both top line as well as from an operating income perspective.

[Derek Schmidt, executive]

We had several scenarios, even though we had not made a decision in terms of closing Dublin at the time we provided '25 guidance. There was multiple options to drive manufacturing efficiency, which, as Mike said, we built into that fiscal year '25 guidance. I think we'll be in a better position here at the end of this fiscal year, early next, to determine if there's potentially additional savings beyond what we've estimated that would meaningfully change our fiscal year '25 guidance.

[Operator]

Next question is from Budd Bugatch with Water Tower Research.

[Beryl Bugatch, analyst]

Jerry, Derek, and congratulations to you, Mike. And to you Derek as well. A couple of questions on the order book, if I could. Can you talk a little bit about the quality of orders in terms of the product vitality? How much of that new business? I know you said most of it's coming from existing strategic accounts, but I was curious as to what you're seeing, in terms of new placements, increased penetration in those accounts and with new product versus old product?

[Jerald Dittmer, executive]

Yes. So at the highest level, Budd, a lot of them are getting new placements on the floor. We do have, obviously, our Flex and Zecliner products are doing very well. And those obviously are also driving a big piece of that.

[Derek Schmidt, executive]

The other color that I'll add, Budd, is that we actually measure internally what our sales -- the percent of our overall sales from new products. And we measure new products over the last kind of 3 years and that's close to 25%. So we feel good that we are driving relevant new product that's resonating with the market, and we would expect going forward that new product would make up at least 25% of our overall sales, if not more going forward.

[Beryl Bugatch, analyst]

And Derek, that's pretty much a classic definition of product vitality there. So when you look at that on a weighted or a continuing moving average, how has that changed over the last 12 to 18 months?

[Derek Schmidt, executive]

It has definitely increased. We've been we've been more aggressive around launching new products, and that trajectory will continue.

[Beryl Bugatch, analyst]

Okay. And so if you look at it basically on just on 1 -- instead of a 1-year basis, instead of a 3, it would be higher than 25%, would be that weighted -- that moving average? Is that the way to read that answer?

[Derek Schmidt, executive]

Well, it's difficult to compare 1 -- I mean 1-year versus 3-year because you've got a lot more product in the 3-year. But if you look at that 3-year percentage what it is today. And if you were to rewind and go back 12 months ago, it was lower than the 25%. So again -- and we do expect going forward that number to increase throughout time. Does that help?

[Beryl Bugatch, analyst]

I think so. I always try to put numbers to things. I know the color is qualitative and the numbers are quantitative and that's definitely a weakness of the analytical community, when it could be more quantitative and wanting numbers. I'm also curious as to the change in the composition of costs and how to look at maybe something like a contribution margin, going forward with taking Dublin out and the facilities are left, what's the variable cost structure look like the MLO and D&T kind of components of cost on a normalized basis. And what is the fixed cost component look like?

[Derek Schmidt, executive]

Yes. It doesn't change -- I mean, that meaningfully from what we've shared previously with you, Budd. If you look at the composition of the $4 million to $4.5 million savings from Dublin. A little less than $2 million of that is from structural cost reduction. The rest of it is efficiencies around variable costs.

[Beryl Bugatch, analyst]

So looking at -- you had, I think, and correct me if I'm wrong, my memory is -- I'm old and my memory is faulty. But I do believe you told us a couple of years ago that I think the target gross margin was in the low 20s. We seem to be there. What's that look like going forward?

[Derek Schmidt, executive]

Yes. From a gross margin perspective, certainly, we're striving, we're aspiring to 23% or more kind of in the mid, long term. And maybe based...

[Beryl Bugatch, analyst]

Does mid, long term, have 2 years...

[Derek Schmidt, executive]

3 to 5 years, you've to get...

[Beryl Bugatch, analyst]

All right, and if I -- do I read the guidance right that for '25, you're saying that you're going to have no debt. Is that the way to read that? I was trying to make sure I understood the table.

[Derek Schmidt, executive]

Yes, that's correct.

[Beryl Bugatch, analyst]

So you do want that down to 0. And once debt is 0, what's the use of cash look like? What's your thought process?

[Derek Schmidt, executive]

Yes. In terms of capital allocation, Budd, so I laid out earlier in the call, these pursuits to expand our penetration in new markets, we would look for value-enhancing acquisitions that would accelerate our penetration into one of those 3 areas, either help us address the needs of younger consumers, expand our product category penetration beyond the living room or expand our sales distribution beyond the independent retailer.

So the areas that we've kind of talked about in terms of acquisition priorities would be potential outdoor company, a direct-to-consumer company or a company with a modern, mid-priced lifestyle kind of brand. So we would expect to start to potentially accumulate some cash on the balance sheet and more proactively look for value-enhancing acquisitions.

[Beryl Bugatch, analyst]

And does that take you out of manufacturing or into retail or into -- or out of furniture or out of...

[Derek Schmidt, executive]

No. No. We're squarely focused on residential furniture. Certainly in the midterm, we do not desire to be in retail ourselves. So this is again -- this is leveraging our core competence and bringing in new capabilities, within furniture wholesaling for lack of a better term.

[Operator]

[Operator Instructions] this concludes our question-and-answer session. I would like to turn the conference back over to Jerry Dittmer for any closing remarks.

[Jerald Dittmer, executive]

Great. Thank you. In closing, I'd like to thank all our FlexSteel employees for their dedication and outstanding performance during the quarter, and thanks to all of you for participating in today's call. Please contact us with any additional questions. And we look forward to updating you on our next call. Everybody, have a great day. Thanks.

[Operator]

The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.