Interface’s 3Q’11 EPS exposes sensitivity to Business Cycle

Interface (IFSIA) the company that invented “carpet tiles” and the notion of lifetime corporate sustainability, had lackluster earnings for the Third Quarter 2011.  The earnings report was even worse than 2Q’11 with another earnings miss large enough to get management’s attention (i.e., restructuring).  In the graphic below, note how earnings estimates trended lower:

Source: WSJ

Management’s tone during a conference call was flat & weak, as they were clearly saddened over Ray Anderson’s passing.  Ray Anderson was the carpet industry’s Steve Jobs.  He founded Interface, later shocking investors with his revolutionary 1994 speech on Sustainability.

Summary & Key Points:
  • Revenue growth slowed, +8.1% (to $273MM) down from 18% in 2Q’11, 13% in 1Q’11.
  • Operating income of $25MM.  This translated to 9.3% of sales, down from 9.8% in 2Q’11, and 11% the year earlier period.
  • Orders were $284MM, up 6.8% from a year ago.  Down sharply from 13% in 2Q’11. 
  • Cash Flow from Operations, at $31MM was a pleasant surprise, rising 63% from a year ago.  The large increase was mostly attributed to Deferred Income Taxes, rather than earnings, so the increase may be transient.
  • Book Value grew a decent 16%, likely surpassing cost of capital, especially debt costs (as the company refinanced bonds in January’11)
  • EPS was $0.19 vs the same a year ago.  Earnings were clean (negligible charges or non-cash gains/losses)
  • The flat EPS was victim to 2 factors we’ve discussed several times.  1) input cost pressures, and 2) slowing demand in Western Europe (and Australia/Japan).  Management, which already increased prices 3x this year, will not increase prices during 4Q’11.
Click image to enlarge
Given the above, management’s proactively slimming its cost-structure in 4Q.  This will result in costs of $6.5MM to $8MM.  (Cash costs likely under $7MM for severance,etc.).  Management’s expecting profits to increase by $11MM/yearly and we expect these savings will be reaped in 2012.

Geographic & End Market notes: 
  • The German market continued to remain “robust” (see PMI Output chart on bottom).
  • Pockets of weakness in several mature markets including Japan, Australia and certain countries of Western Europe.
  • The new factory in China continues to ramp up well.  During quarter, added a second shift. This “scaling up” of production will allow the factory to become profitable for the first time next quarter (4Q’11).
  • The Commercial Office market is moderating, however, management believes this may just be a short-term phenomenon
Biggest Positive Surprise:
What we had once feared of draining management resources and costs, the Flor see link retail stores, are turning out to be successful.  Interface opened a new store in Dallas during 3Q’11 (5 stores total) and two additional stores will be opening by Nov/December.  Speaking of Steve Jobs, the stores are very cheek-looking and trendy.  In fact, the first one opened in the Hip SOHO area of NYC, just 2 blocks from Apple’s. 

 How are earnings affecting the stock price ?

  • Based on 9Mos numbers, Full Year 2011 EPS likely $0.65-$0.75 per share, yielding a Price-Earnings multiple of ~ 19x.
  • A high Beta (GoogleFinance) of 2.4x, a P/E of 19x, and high operating leverage continue indicating these are risky shares.
  • Though, IFSIA’s shares already partially-discounted the recent earnings reports as they had already declined from $20 to $12 between July’11 and Aug’11.

Euro-Crises is likely to be the “tail wagging” the stock price:

We believe IFSIA will remain sensitive to global economies.  Hence, we view the progression of the Euro-Crises as a key influencer of IFSIA’s shares.  As a reminder, IFSIA is a global company – over half its business is from overseas, including Asia, and Western Europe.
What’s the state of Global Economies?   We believe the Chinese economy is in a long-term (real-estate) bubble, the United States is stable (1-2% GDP growth) and the weakness in Europe will worsen.  Stubbornly high bond yields to PIGS countries (especially in key country Italy) indicate that the Eurozone bailout plan of October 27, 2011 will likely fall flat with investors.  Even if the bailout plan (which could run as high as EUR1 trillion) is successful, the EU must initiate an austerity plan.  This fiscal plan is likely to push the EU in recession and continue stemming demand for industrial/commercial products such as Interface’s floor carpet tile.  This informative graph from Markit Economics gives a telling story.  It not only shows the Eurozone PMI (purchasing managers index) but the discrepancy between Germany and the rest of Europe.  (On 11/2/11, the PMI declined to 47.1, a 27 month low.)
Disclosure:  the author is long IFSIA

Interface 2Q’11 Earnings analysis & opinion

Interface 2Q’11 Earnings: were on the mark.  However, they weren’t as good as previous quarters as they missed consensus earnings estimates.  Relative to peers, they were quite good.  However, business intelligence for the industry is pointing towards tough Euro-headwinds.

Interface earnings Highlights:
Investors are requested to view IFSIA’s earnings release link, as this article is a commentary of them, not a rehash. Highlights:

  • Revenues rose sharply, up 18% to $268MM
  • Orders grew 13%, and backlog continued to rise
  • Chinese plant, while not profitable, continues to ramp up.  It achieved breakeven performance during the month of June.
  • Operating Margins continued rising (from 9.5% last year to 9.8%)
  • EPS of $20 cents/share slightly missed analysts’ estimates.

    What we liked:
    Despite all the talk of a decelerating US economy and Euro-Crises, revenue was quite good, especially compared to competitors.  Margins continued rising, albeit at a slower pace than previous quarters.

    And not so much..
    IFSIA has been able to pass costs through to customers.  We think this is getting increasingly difficult.  Other than higher raw material costs, the company is also getting hit with continued Start-up costs in China, and its relatively new strategy of opening company stores.  These stores don’t comprise a large part of Interface’s overall costs, but the trend is there.   The company had 5 stores as of quarter’s end and several more are expected by YE.  Cash flow from operations was also weak, but likely short-term due to higher inventory (i.e, hoarding) ahead of price increases from its suppliers.  Also attributed to higher receivables and paying off its vendors more quickly.

    We believe the shares of Interface, which had performed quite well until the Euro-Crises reemerged, will be very sensitive to European and US economic activity (regardless of the company’s sound business operations).  Also, note the shares have a high Beta, hence higher volatility is to be expected.

    What to look for in 2012:
    As such, we expect Interface to issue a cautious outlook for the rest of this year and into 2012.  We believe there already is a Euro-Crises, and that it’s been with us for nearly 2 years now.  In our estimates, things could only get worse in Europe given political deadlocks, austerity measures and a stubbornly tight ECB (on the monetary side).  Traditionally Interface’s key drivers were 2, now they are three:

    1. Residential Construction
    2. Commercial Construction
    3. Europe

    On the domestic side, the US economy is also witnessing slower government growth, which should slow demand from that end-market.  We will expand on specific economic data points and charts in our upcoming 3Q’11 review.

    What’s happening on the Corporate Social Responsibility front:
    I’d like to highlight this “win-win” situation the company initiated during the quarter.  It essentially participated in a knitting program as it introduced a new floor tile that looks like yarn.

    The project produced a smashing number of squares, nearly 10,000 ! It also produced hats and other knitted garments.  This “Knit a Square” program was part of KasCare, a charity providing warm clothing to orphaned children with AIDS in South Africa.   See these links for additional info: knit-a-square.comknitting-for-charity.

    Background of the company:  

    Interface, Inc. is the world’s largest manufacturer of modular carpet, which it markets under the InterfaceFLOR, FLOR, and Bentley Prince Street brands.  Interface’s main goal, other than serving its investors, is to help make the world a better place via its widely heralded Sustainability program.

    Disclosure:  The author is long Interface.

    Ray Anderson: In Memoriam

    In Memoriam:
    Apologies for the tardiness of Interface’s earnings report, but Ray Anderson’s passing came out of left field to me, even more so than Steve Jobs’.  Ray died on August 8, 2011 after a 20-month battle with cancer.  Spent a few emotional nights tearing over the many tributes given to him during his memorial service.  If ANYONE doubted this man’s authenticity and sincerity in making the world a better place, I suggest this website:   Below is what might be Ray’s last video, when he was receiving chemotherapy.

    Ray Anderson, who was born in Georgia, always talked about climbing the Mountain of Sustainability.  He said he wasn’t going to be around to see the other side of the mountain but was happy that we would.  Interestingly, another man from Georgia also had a vision of a “promised land” across the mountain-top; that man, of course was Doctor King.  Anderson and King were two different people, but Oh, in some ways, so much the same!

    Ray, you will be MISSED !

    On September 1, 2011, Ray left 62% of his total assets to his foundation, a trust fund devoted to environmental causes, with the remainder going to his family.

    Interface churns out another good quarter (1Q’11)

    On April 27, Interface (IFSIA) reported First Quarter 2011 earnings.  Highlights…

    • Revenues rose 13% to $245.4MM
    • Operating Income was 7.8% of sales (up 27.4%)
    • Net income was $9.8MM vs. $4.9MM.
    • The above translates to EPS of $0.15 vs. $0.08
    • EPS met analysts’ consensus estimates.
    • Note: all of the above exclude charges.  1Q is the company’s slowest quarter.
    • link to 1Q’11 Press Release 

    Overall:  Interface continues to perform as expected, and the company has experienced few downside surprises.
    Click the image above for clearer wording.  Source: Interface.

    What’s Changed vs. our Initial View:  Based on what I’m hearing from the street and economics departments, the carpet industry will continue to be weak at best.  New Construction will remain lackluster, so the company’s growth will depend on increasing market share in the office market and getting the word out to consumers (as it tries to compete in the retail market).  Based on earnings data and conference call comments, we believe both Operating and Free Cash Flow will be somewhat lower than initially forecast (see below for additional information.)

    What we liked in the 1Q’11 report:
    Interface has been able to increase profitability despite rising raw material costs and the weak construction market.  Plants are running smoothly.

    IFSIA remains committed to sustainability with recycled fiber reaching a high of 40%.  Though, Interface will not stop there, as its long-term goal is 80%.  An interesting remark on the call was that few consumers were interested in buying green carpets, and that Interface’s ESG won’t be in the headline marketing for the retail business. This demonstrates management’s authenticity in my view.

    Interface: Historical data on Recycled Materials

    What we didn’t like:
    As mentioned earlier, company is spending heavily on promoting its carpets (new direct retail channel), and increasing manufacturing production.  This is pressuring Free Cash Flow, indirectly via higher SG&A, higher Capex, and working capital.

    What’s Interface worth?
    Interface’s shares appear fully-valued using Price-to-Earnings data, and earnings estimates.  I believe a corporation’s P/E ratio primarily reflects earnings growth, of which is then adjusted for industry structure and the firm’s leadership position.  As such, the current P/E of 21x appears to fully reflect earnings growth for 2012.   This number is lower than the 27x when we first wrote about IFSIA; however growth is expected to slow in 2013 (unless economic growth picks-up).

    Earnings & Cash Flow Quality:
    Perhaps it’s appropriate to add a few comments given that this website’s “raised Hell” about the earnings quality of Green Mountain Coffee Roasters–>STORY.

    Compared to the same quarter last year, both earnings and quality of cash flow was High.  Interface continued to incur start-up costs at its plant in China.  It could have separated these in its earnings presentation to make earnings appear better.  Though, management chose not to.  Last year the company had bond retirement and restructuring charges that were presented separately from GAAP earnings.  This quarter’s earnings release was “cleaner” as it only presented GAAP earnings.  Operating Cash Flow was depressed from higher inventories (see comments below) and a speedier payoff of short-term bills/payables.  Hence, we also rate Cash Flow quality as HIGH.

    Click the image for clearer wording.  Source: Interface.

    1Q’11 Earnings Highlights:

    • Revenues rose 13% and business is tracking well.  Though the first month of the quarter started weak because of bad weather both in US and Europe.  2Q’11 is off to a good start.
    • Geographically:  Growth witnessed in all regions.  Though some parts of Asia growing slowly, however, Australia is doing well.  Europe is doing ok, with strength in Italy (small market) and Germany.  Biggest opportunity is Germany which has the lowest modular carpet penetration and the biggest volumes.  However, overall European business is too low, keeping capacity use at just 60%.  This hinders profitability. Management specifically stated that it needed the UK to kick in.
    • Orders grew 10% Y/Y.  This is okay, but lower than previous quarters. Though, momentum rose as quarter progressed. (In fact, an analyst from Raymond James Financial was concerned over the Book/Bill ratio on the conference call.)
    • Profitability: Interface is able to maintain and increase profit margins.  So, far it’s been able to pass along price increases. There will be another increase in May.  SG&A expenses, which increased as we expected, are now forecast to decline in the coming quarters both on a % of sales basis, and in dollar terms. (Though, we acknowledge this seems inconsistent with the company’s plan to increase market share.)
    • Direct-Channel:  Retail stores are doing better than expected.  Chicago’s same-store-sales rose 50%, and the new store in SOHO, New York City had a successful March opening.  Note that this is a new business area, and S/S sales data may not represent true secular growth.
    • Operating Cash Flow for the quarter was weak (an $18MM deficit) due to high working capital usage. Interface spent 38% more on inventories Y/Y as it was worried that it would repeat the under-investment of 2010.  It also over-ordered some raw materials before expected price increases.
    • China plant (and costs thereof) continue as planned.  No surprises.  I’ve seen photos of the plant; it appears modern and well designed, and will include both a showroom, and open views of the factory floor (which is also great for transparency). See image below, courtesy of Interface Inc.
    • Will add 50 salespeople to boost share in non-traditional end markets.

       DisclosuresThe author is long IFSIA.  Information for the above report based on industry data, the company’s press release, Investor Presentation 2010, conference calls, and data provided by sell-side equity analysts.

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