Good morning, and welcome to the Flexsteel Industries' Second Quarter Fiscal Year 2021 Earnings Conference Call. All participants will be in listen-only mode. [Operator Instructions] After today’s presentation, there will be an opportunity to ask questions. [Operator Instructions] Please note, this event is being recorded.

I would now like to turn the conference over to Derek Schmidt, Chief Financial Officer and Chief Operating Officer for Flexsteel Industries. Please go ahead..

Thank you, and welcome to today's call to discuss Flexsteel Industries' second quarter fiscal year 2021 financial results. Our earnings release, which we issued after market closed yesterday, Monday, January 25, is available on the Investor Relations section of our website at www.flexsteel.com, under News & 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'll 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 by the use of 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 forward-looking statements.

Such risks and uncertainties include, but are not limited to, those that are described in the 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 a reconciliation of the GAAP to non-GAAP measures. And with that, I'll turn the call over to Jerry Dittmer.

Jerry?.

Good morning and thank you for joining us today. Despite, facing a multitude of headwinds created by global supply chain disruptions related to COVID-19, we performed well in the second quarter, delivering strong top line results of $119 million, which represents year-over-year organic growth of almost 26% and solid GAAP net income of $8.5 million.

And non-GAAP net income of $5.9 million. Overall demand for residential furniture remains very robust and we are gaining market share due in part to our lead time performance relative to competition.

The actions taken at the end of fiscal year 2020 to refocus our organization solely on home furnishings and to reduce operational complexity through SKU rationalization have made us stronger and nimbler to meet recent surge in consumer demand for furniture.

Sales results in home furnishing products sold through retail stores were especially encouraging with year-over-year growth of almost 29% in the quarter. Year-over-year order growth for retail sales was a blistering 60% in the first quarter. And that momentum carried into the second quarter with order growth of 49% versus prior year.

As a result, our backlog for retail sales finished the second quarter at a record level of $101 million. Our teams are working feverishly to expand both manufacturing and sourcing capacity to meet this strong growth. And I'll elaborate on our capacity initiatives later in the call.

Sales in our Home Styles product, which are sold through e-commerce channels, grew double-digits, but the pace of growth at 11% during the second quarter was notably lower than the growth performance in the first quarter of fiscal year 2021 and the fourth quarter of fiscal year 2020.

The reduction in growth this quarter was largely a result of global supply chain disruptions, which constrained our inventories and ability to support higher sales. E-commerce continues to be a key strategic growth area for the company.

And we fully expect growth through e-commerce channels to accelerate once these supply chain challenges precipitate hopefully over the coming few quarters.

Based on market and customer feedback, we expect overall consumer demand for home furniture to likely remain strong through mid-2021, obviously the economic fallout of the pandemic combined with the ability of the federal government to mitigate that impact through both fiscal and monetary stimulus will play a determining factor in the sustainability of consumer demand throughout 2021.

While it was predictable that consumer demand will likely wane at some point when vaccines are widely distributed and consumers begin to return to normal activities outside of their homes.

We are working on exciting new products and other growth strategies to more than offset such anticipated demand softening so that we can continue driving long-term profitable growth for the company.

In the near-term, our biggest obstacle to supporting continued growth is overcoming a flurry of global supply chain challenges, which are currently facing. We are dealing with three major supply chain impediments right now.

First, availability of ocean containers, the reduction of ocean vessels, which occurred at the onset of COVID-19, combined with surging demand for numerous imported consumer products has significantly disrupted the flow of containers globally. And there is an extreme shortage of empty containers in Asia at the moment.

As a reminder, roughly 65% to 70% of our sales are derived from products that are sourced globally. So the containers shortage is having an outsized impact on our business near-term.

Many of our Asian suppliers who have ramped up capacity recently to meet our growing production order demand now find themselves with warehouses full of Flexsteel products, which cannot be shipped because of container shortages.

In some cases, our suppliers have been forced to stop production as they have no place to store product because of their warehouses are already full. As you can imagine, the supply chain imbalance for containers is also creating an egregious spike in ocean freight prices, which negatively impacts our gross margin short-term.

In some instances, we are now paying three times the amount of ocean transportation that we did prior to COVID-19. Unfortunately, this is a global issue and not just one that is confined to just Flexsteel or our industry. It's also not clear how soon the supply chain imbalance for containers may be resolved.

And as such, may pose a significant risk to our third and fourth quarter sales growth outlook. We are working very closely with our international freight partners to secure as much container capacity as we possibly can in the short-term. The second supply chain challenge is availability of key materials and components.

Production at our North American manufacturing facilities was suboptimal during the second quarter due to a limited availability of key input items. Many of the mechanisms in our motion furniture source from Asia and the flow of these items to our factories has been interrupted by the same ocean container shortages that I mentioned earlier.

Poly foam which is used in all of our seating product has been on allocation from suppliers since the beginning of the second quarter. These material constraints are expected to continue throughout the third quarter and we'll restrict our ability to increase manufacturing production significantly in the near-term.

The third big supply chain challenge is labor availability, notably in the U.S., despite high unemployment and recent wage rate increases across Flexsteel's production facilities and distribution centers.

We continue to encounter challenges in recruiting qualified candidates for our locations and for driver positions supporting our dedicated transportation fleet. Another item which we noted during last quarter's earnings call and is worth mentioning again, is uncertainty in U.S. trade relations with Vietnam. The U.S.

Trade Representative office recently completed its Section 301 investigation of Vietnam practices and concluded that unfair acts, policies and practices related to currency manipulation by Vietnam have harmed U.S. workers and businesses. However, the U.S. government has stopped short of implementing any tariff or punitive measures thus far.

It's not clear how the incoming Biden Administration will handle the situation with Vietnam. While the situation with the global supply chain that I just described, may seem quite dour in the near-term. Our team is not deterred by the adversity and is working all available options to best support our customers.

We are cautiously optimistic that these conditions will not persist beyond the next six to nine months. So we continue to aggressively invest for longer term growth in anticipation of normalized global supply chain conditions to support such growth. In summary, I'm pleased with our first half performance in fiscal year 2021.

I feel we are competing well, are managing the short-term global supply chain headwinds as effectively as we can and are well positioned to deliver strong sales growth and financial results longer term. 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..

Thank you, Jerry, and good morning, everyone. Second quarter net sales were $119.1 million, up $16.2 million or 16% compared to $102.9 million in the prior year period.

Despite the supply chain challenges, which Jerry mentioned, our sales results were at the high end of our $110 million to $120 million guidance range, driven by strong sales execution and favorable lead time performance relative to competitive alternatives.

We saw increases in both our home furnishings products sold through retail stores of $22.4 million or 29% and products sold through e-commerce of $1.8 million or 11%. The sales increases were partially offset by a decline of $8 million due to the exit of our vehicle and hospitality product lines during the fourth quarter of fiscal 2020.

Excluding these exited product lines, our organic growth was 26%. This growth was supported by a record backlog at the end of the first quarter and a very strong finish in December.

From a profit perspective, we reported a fiscal second quarter net income of $8.5 million or $1.13 per diluted share that compared to a net loss of $5.4 million or minus $0.68 per diluted share in the prior year quarter.

The reported net income included an $800,000 pre-tax restructuring expense, a $1.3 million pre-tax bad debt expense due to a customer bankruptcy and a $5.2 million pre-tax gain for the sale of our Dubuque, Iowa and Lancaster, Pennsylvania facilities.

Excluding these three items, the second quarter non-GAAP adjusted net income was $5.9 million or $0.79 per diluted share as compared to a non-GAAP adjusted net loss of $1.5 million or minus $0.19 per diluted share in the second quarter last year.

Please see the non-GAAP disclosure included in the earnings release for a detailed reconciliation of GAAP to non-GAAP adjusted net income. Gross margin as a percent of net sales in the second quarter was 20.5%, which was at the midpoint of our 20% to 21% guidance range and was significantly higher versus a report at 15.6% in the prior year quarter.

The 490 basis points year-over-year improvement in gross margin was primarily due to structural cost reductions, operational efficiencies and fixed cost leverage on higher sales volume during the second quarter as compared to the prior year quarter.

As expected, a surge in ocean container rates coupled with material wage and transportation inflation, pressured margins in the second quarter compared to the first quarter. Pricing actions which were taken in the second quarter to offset those costs increases do have a lag, it will not be realized until the third quarter.

Selling, general and administrative or SG&A expenses increased $800,000 to $18.9 million compared to $18.1 million in the prior year quarter. SG&A as a percentage of net sales in the quarter was 15.9% compared with 17.6% in the prior year quarter.

The 170 basis point decline was primarily due to reductions in non-essential spending in response to COVID-19, lower depreciation expense due to assets being held for sale and cost leverage gained from higher sales, partially offset by 110 basis point increase related to the previously mentioned $1.3 million bad debt expense due to a customer bankruptcy.

SG&A expense as a percent of sales was modestly higher than our 13.5% to 14% guidance range as we accelerated several strategic growth investments related to growing our digital assets, increasing our global supplier base and expanding our future DC network.

Now turning to income taxes, during the quarter, we reported a tax expense of $1.5 million or an effective rate of 15.5% compared to a tax benefit of $1.6 million in the prior year quarter or an effective tax rate of 22.8%.

The effective tax rate in the quarter was lower than our anticipated 25% to 26% rate due to a favorable tax impact from the sale of assets in the quarter. The effective tax rate for the remainder of the year is expected between 25% to 26%.

Now moving onto the balance sheet, we ended the quarter with a strong cash balance of $33.3 million and no outstanding balance on our $25 million line of credit. Our working capital defined as current assets minus current liabilities at December 31, 2020 was $126.3 million compared to $128.4 million at June 30, 2020.

The decline in working capital was due to a decrease in cash of $14.9 million, a decline in other current assets of $6 million, primarily due to a tax refund, a decline of $11.7 million in assets held for sale and a $4.9 million increase in payroll and related items partially offset by $14.1 million increase in trade receivables and a $21.5 million increase in inventory.

The decline in cash of $14.9 million was primarily due to $20 million in share repurchases, cash used in operating activities of $10.9 million partially offset by $18.5 million of proceeds from the sale of the companies, Dubuque, Iowa, Lancaster, Pennsylvania, and Harrison, Arkansas facilities.

Capital expenditures for the six months ended December 31, 2020 were approximately $700,000. During fiscal 2021, we anticipate spending $2 million to $3 million for capital expenditures and believe we have adequate working capital to meet those requirements. We continue to progress well on our restructuring initiatives.

During the second quarter, the company incurred $900,000 of restructuring expense, primarily for ongoing facility and transition costs. We anticipate total restructuring expenses for the fiscal year 2021 of roughly $2.5 million to $3 million.

During the quarter, we completed the sale of our facilities located in Dubuque, Iowa and Lancaster, Pennsylvania, resulting in total net proceeds of $15.7 million and a total gain of $5.2 million. Our remaining properties listed for sale are in Starkville, Mississippi and Harrison, Arkansas.

Looking for guidance for the third quarter is a bit challenging due to the highly volatile conditions with ocean container shortages and container rates, which Jerry noted earlier. The situation is shifting on a daily basis and could have a material impact on both sales and gross margin dollars and percentage.

That said, our best estimate for third quarter sales is between $105 million and $120 million with the availability of ocean containers and flow of source product being the largest determinant between the high and low end of the range.

Gross margins are expected in the range of 20% to 21.5% with ocean freight rates and the quantity of containers shipped in the quarter being the primary determinants of the range.

Excluding the volatility of ocean freight rates, we would otherwise expect gross margins to improve sequentially compared to the second quarter as we realized the benefit of the pricing actions taken in the second quarter.

SG&A guidance for the third quarter is less volatile and best provided as a dollar range, which we expect to be between $17 million and $18 million as we expect to make additional strategic growth investments in new product development, digital capabilities and supply chain capacity expansion.

While adjusted operating income margins will be modestly strained in the near-term as we work through the myriad of supply chain challenges previously discussed, we remain confident in our ability to deliver adjusted operating income margins at or above 7% in fiscal year 2022 when supply chain condition stabilize.

I’ll turn the call back over to Jerry to share his perspective on our outlook..

Thanks. As Derek outlined, operating margins might be a bit choppy in the next few quarters due to the evolving situation with the global supply chain.

But we take a longer term view of the potential of the business and feel good about the strategic progress we’ve made so far in fiscal year 2021, and have confidence in our long-term plan and ability to deliver consistent profitable growth.

To accelerate our pursuit of new growth, we’ve recently recruited a new member to our leadership team in the role of Vice President, New Business Development.

This position will be instrumental in building out meaningful consumer insights to uncover new business opportunities and will lead the charge in expanding Flexsteel’s reach into new consumer segments, product categories and price points. To realize our growth potential, we’re working plans to aggressively expand our overall supply chain capacity.

On the manufacturing front, we added several new lines to both our Dublin, Georgia and Juarez, Mexico facilities in the first quarter. And we recently signed a new building lease for an additional production facility in Juarez, which should start initial production in March and ramp up capacity throughout the remainder of the calendar year.

Additionally, we’ve recently retained consulting services to help us expand our global supply chain, diversify our sourcing country exposure and build a more resilient supply chain.

Lastly, we’ve initiated a study of our DC network to not only determine optimal expansion plan, but also ensure we improve our fulfillment capabilities to better serve our existing customers and to rapidly grow our direct to consumer sales. The future of Flexsteel is exciting. We have a clear vision of where we want to go and a plan to get there.

It all starts with building an organization that truly aspires to create a great experience for our customers each and every day. When we do that, we’ll grow faster than the market and deliver attractive returns to our shareholders. I look forward to sharing more of our progress in this journey in the quarters ahead.

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

We will now begin the question-and-answer session. [Operator Instructions] The first question comes from Sandy Mehta of Evaluate Research. Please go ahead..

Yes. Good morning and congratulations on the strong income performance in the quarter. Several furniture companies have talked about price increases to offset some of the shipping and other costs and you have alluded to that as well. And you said that many of those price increases we will see during the third quarter.

Would that – with the price increases once they’re fully implemented, would that fully offset some of these increases in shipping costs and other supply chain costs, please? Thank you..

Yes. Sandy, this is Jerry and Derek can fill in the blanks behind me. They will not. And I’ll tell you why is that it’s such a fluid time right now. The price increases are happening all the time. We’re looking at both putting price increases and surcharges for the freight, but the price increases are coming in non-stop.

And so what we’re doing is we put some in, we plan to continue to put some in, we’re hoping this does diminish over time. I wouldn’t say that we’re necessarily behind. But we’re definitely not ahead of it. And our retailers and customers obviously are having a struggle with passing these on, out into the marketplace to the end users.

So this is a very fluid thing. So the quick answer is no, we do not have them all covered, but we will continue to look at pricing actions. We used to look at pricing actions once a year, now we look at them once a week and we’re going to continue to look at them the best we need to..

Yes. Sandy, as Jerry alluded to, the fact is – so when we started to see significant inflation, both in terms of materials, transportation, labor and the ocean freight, we took pricing actions back in November that will largely be realized here in mid February, kind of early March.

Since that time, freight rates, ocean freight rates have continued to increase. We’ve gotten additional increases from various kind of suppliers of both materials and finished goods. So again, we’re constantly evaluating those and pushing pricing back to our customers where it makes sense.

But there is a lag from the time that we announced pricing to the time we work through our backlog and we actually realized that. So in most cases, that’s a two- to three-month lag on the manufacturing side..

And the $20 million of repurchases, can you comment at what average price? And with your stock price appreciation, how do you look at repurchases going forward vis-à-vis dividends or special dividends? Thank you so much..

Yes. So let me answer your second question first. Our priority for capital deployment first and foremost is to invest back in the business. We see attractive kind of opportunities to reinvest. We’re going to invest in inventory support, new products, product category expansion, new sales distribution.

We’re going to continue to make investments in manufacturing and DC machinery and equipment to support capacity expansion. Assuming though, after we make those investments, we still have excess cash. Then we’ll return capital back to shareholders either in the form of higher dividends or share repurchases.

And we have a constant dialogue with our Board and they give consideration not only to shareholder preferences, but tax considerations. And as it specifically relates to share repurchases, we look at the price of stock relative to our intrinsic value. So, we have a dialogue every quarter with the Board regarding our view of intrinsic value.

So we update that quarterly. And just from a governance standpoint, we actually had two external firms validate that view of intrinsic value.

So, in terms of your question around kind of share repurchases, it depends upon the attractive investment opportunities that we have to invest back in the business, but we have excess cash and the stock is trading at a significant discount to our belief over intrinsic value, then we’ll continue to use that as a mechanism to return cash to our shareholders..

And this is Jerry. The answer to your other question you asked about the average price. And you’ll see this and we file our Q at the end of the week that we’ve paid an average price per share of $21.31 over the last six months or repurchasing the shares..

Great. Thank you so much..

The next question comes from Mike Hughes of SGF Capital. Please go ahead..

Good morning. Thanks for taking my questions. The first one, just if you could talk a little bit more about the capacity expansion plans in Mexico on the labor front. Because I know a number of your peers have actually announced the last few months that they plan to start producing some case goods in Mexico.

So is that tightening the labor market there?.

Yes. This is Jerry. So I’m not really – we look at all different parts of Mexico and really have a couple things. One is we’re looking at other OEM suppliers. The capacity we mentioned in our statements here a little bit earlier had to do with us.

Going -- we’ve now gone from one to three plants in the Juarez area, and there appears to be more than enough adequate labor for us going forward..

Okay. And then second question, where are your lead times now? And you’ve mentioned that you have shorter lead times than your competitors, which is resulting in market share gain.

So how do you convert the short-term market share gains to long-term market share gains?.

Yes. So as in current state, our lead times for manufactured product are running kind of in that 15- to 17-week timeframe, which is much longer certainly than we desire long-term, but our competitors in some cases are out, six months or even longer. So we believe that we’re still competing from my point of advantage.

I think our belief is that we have to continue to aggressively expand our capacity to keep those lead times down. And we will gain kind of mind with share both consumers as well as our retail sales associates, if we can perform better than the competitive alternatives. And that’s how we gained, share long-term..

Okay. Thank you very much..

The next question comes from JP Geygan of Global Value Investment Corporation. Please go ahead..

Hey, good morning, and congratulations on the strong quarter, the success of your restructuring plans is evidenc]e in your financial results. I just have a few questions today and I think you've touched on aspects of all of them, but first, I think this is a question for Derek.

You discussed reinvestment in the business, dividends and stock repurchases, but can you address capital allocation more generally, including your appetite for acquisition?.

Yes, we're still very much an acquisitive company. What I would tell you at the moment though is that the companies that are probably highly attractive to us that are in growing segments, e-commerce, et cetera, have significant price premiums.

So certainly, while we're looking at acquisitions, we want to make sure that any deal that we would do would have a clear path to shareholder value creation. So we'll be disciplined in terms of kind of what we pursue.

And our intent is to keep enough dry powder on the balance sheet, so that if the right acquisition does come along at the right price, we have the capability to pursue that. So between our cash on hand in available credit, we feel like, we want to keep enough capacity in our back pocket to pursue such opportunities.

And beyond that, like I said, capital deployment, it is – we are going to continue to reinvest back in the business to expand in areas that have attractive returns. We've talked here I think, extensively about our plans to expand supply chain. That includes not only manufacturing capacity expansion, but also expanding our DCs.

And so we would deploy capital to support those endeavors..

Was there a follow-up, Mr.

Geygan?.

Yes, please. Thank you. You've got into CapEx of $2 million to $3 million for fiscal year 2021.

I presume that you've spoken to many of the growth strategies that you have in mind, but other than your DC capacity, your supply chain capacity, particularly your Juarez addition, can you speak to anything else that falls into the category of growth strategies, particularly new product development?.

Yes. I think most of our growth kind of investment is going to P&L rather than CapEx. But there's really kind of four key areas as we start to think about investments.

One is clearly around new product development and I think you'll find here in the coming year or two years, we're going to have a very healthy and attractive pipeline of new products that start to reach potentially categories that we haven't participated in.

They're going to reach price points that allow us to touch, I think different consumers than what we've gone after in the past. And you'll see products with different styling, more modern, more transitional that appeal to, again, other consumer segments than maybe we've targeted in the past.

We're going to continue to aggressively invest around e-commerce and digital capabilities. We believe that that channel is absolutely critical to our long-term success. And we're going to build the talent and the capabilities to kind of support that area.

We're going to continue to invest in supply chain capabilities and talent while we're certainly expanding manufacturing capacity, our suppliers have a critical role, and we want to continue to make sure that we've got the talent, tools and capabilities to kind of grow that aspect of our business.

And I think the fourth area that we're going to invest in is expanded sales distribution, pursuing alternative kind of distribution channels than maybe what we've traditionally gone after..

Great. That helps a lot.

Final question is, can you characterize your inventory right now? How much of that is available to be sold in the short-term versus tied up in transit versus stuck in a warehouse in Asia if any?.

Yes. So if you look at the balance sheet, it looks like quarter-over-quarter, our inventory is up $16 million, from the beginning of the year was up $22 million. The reality is almost all of that increase in inventory is either on the water, on a boat coming from Asia or it's in transit.

It's either sitting on a boat at a port or it's en route on a train. So given all the supply chain challenges that Jerry went through earlier, our challenge right now is we we've got a lot of orders out there. We've got inventory in motion. We just need to receive it in our DCs so that we can get it up to consumers.

So the balance sheet is a bit misleading because we have so much in transit right now..

Great. Thanks for your comments. That's all for me..

Great. Thank you..

[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..

Thanks Andrew. In closing, I would like to thank all our Flexsteel employees for their outstanding performance and service during the second quarter. I couldn't be more proud. We have strong momentum and are executing well. The supply chain issues will diminish in time and we plan to continue our strategic investments for long-term profitable growth.

I would like to thank all of you today, who did participate on today's call. We thank you for your questions, and please reach out if you have additional ones. We look forward to updating you all in our next call. Thanks again. Everybody, have a great day..

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