Edited Transcript of Steelcase Inc earnings conference call or presentation Thursday, June 22, 2017.
we're reporting today on a first quarter that was consistent with our expectations, as we grew the top line by 4% on an organic basis and delivered earnings in the middle of the estimated range we provided in March. The revenue growth was driven by continued strength in our Asia Pacific region, which is included in the Other category and a solid beginning backlog of orders in the Americas. Earnings were similar to the prior year, as we increased operating expense investments in new product development and other growth initiatives.
I'll go through each region briefly, starting with our Asia Pacific business.
Over the last several years, we committed to growing our business by investing in new manufacturing capacity, new products and by adding people in key areas. During those years, we saw a very little operating leverage because we increased our operating expenses at about the rate of sales growth. Over the last few quarters, those investments really paid off with some key project wins and some new global account contracts.
In Q1, our Asia Pacific business posted record revenues yet again, and the Other category in which it's included had the highest profit margin percentage in the company. This is still a relatively small business, but it shows that our growth investments worked, and I'm excited about the future our team is building in Asia.
In EMEA, we knew our softer beginning backlog would lead to a challenging quarter. Behind the curtain, our operational performance continues to improve. Our dealer sentiment is positive. And we are pleased to see 6% growth in orders for the quarter compared to a year ago. We are focused on improving our project win rate, but we'd like to see a stronger opportunity pipeline in the U.K., France and some other areas. While the U.K. will likely remain a destabilized market, we're hopeful the French elections will, over time, lead to higher levels of business investment, a growing workforce and more furniture opportunities.
Americas sales and operating income were as we expected in the quarter. Orders grew in March, but then declined in April and May versus the prior year. This month, April orders were down 6%, and they have not yet published May order data. Our analysis of our orders reveals a significant decline in large projects and large customers, which is consistent with remarks of another public company in our industry. Yet we don't see any evidence of a broader slowdown in the economy, and our day-to-day orders did not see new declines this quarter. It's possible ongoing questions about tax reform and tariffs may be causing some companies to pause before starting new projects. On the other hand, our conversations with the A&D community suggest they are very busy, and they are often a leading indicator of demand for our products. That gives us reason to believe this is a short-term blip, although we'd feel better if we saw a stronger growth in our pipeline of future project opportunities.
Another consideration is the ongoing shift in large customer demand from legacy private office and cubicle applications, and towards more open benching, shared desking and ancillary applications. We saw a higher rate of year-over-year decline in our legacy product lines during Q1 and faster growth in new products aimed at the new applications.
The new products and product enhancements we launched in the last 3 years in the Americas grew more than 25% in the first quarter versus the prior year quarter. Our most recently launched products are ahead of first year expectations. So this commitment to product development is working, but we don't believe we are yet capturing the same share of customer spend as we did with the legacy products. Up until now, we've been able to offset the decline in legacy business, but we need to continue to expand our new products if we're going to grow.
It's also worth noting that these new applications are more efficient, so customers are able to spend less furniture dollars per white-collar worker as they make the shift. We could capture the same share of spend and still face downward pressure. So we need to increase our addressable market within our customers. This is why we're also expanding our offering to include architectural products, like reconfigurable walls, which is one of the fastest-growing categories this quarter. It is why we're doing more with technology, including our smart and connected offering coming later this year and the partnership we announced with Microsoft.
Our Health and Education businesses further expand our addressable market in the Americas. And we are broadening our furniture offering beyond our own product development efforts through partnerships like Blu Dot. Again, these initiatives are working, but we need to continue to expand the breadth of our business beyond core benching, desking and storage in order to grow.
The increasing breadth of our business was pretty evident at Neocon where the Steelcase space was awarded Best Large Showroom by IIDA, and our Education and Health businesses launched products that earned Best of NeoCon Awards. Designtex also won 2 awards for some very innovative new materials.
I was proud of our team's work on the Steelcase showroom. It can be so tempting to mimic the fashion trends and fads we see in our industry. And frankly, a lot of industry experts are clear about what customers don't want, and by that, I mean traditional corporate spaces, and not so clear about what they do want and how it will help drive business results. Historically, these are not proud moments for our industry. In the past, we'd see everyone rushing out to buy foosball tables and lava lamps, and then the fad would end, and we'd all look a bit ridiculous. I think we won the showroom award because we focused on real people and real work, creative work. And we represented authentic spaces inspired by our experience and our research into the real work of creativity. Sure, these spaces use new materials, new colors and a new freedom to blend different styles. They are on trend, but at its core, our showroom was about a new kind of work that's likely to be important for quite some time. Along with Microsoft, we were able to demonstrate how new technologies can augment human creativity and how space can bring these forces together. I believe we have the right story to help our customers make sense of the changing workplace and help them reach higher levels of productivity by enhancing creativity.
I feel strongly that we need to continue to ramp up the level of investment and the pace of our product development and partnerships to update our portfolio to reflect the new way of working and the new spaces customers are demanding. With the increasing decline in the legacy business, we're taking additional steps to reduce our spending in some areas to help fund these investments. But in total, we will still sustain a higher level of innovation-related spending than in the past. We've seen our most recent product development investments have exceeded expectations and are on track to earn a very good return on investment.
One more thing, we are also broadening our product line to deliver Steelcase performance at lower price points. We revealed our new seating product called Series 1 on the first day of NeoCon. It meets all our quality standards and includes ergonomic technologies like LiveBack, 4D arms and a weight-activated mechanism, but at a more accessible price. We think it will introduce new customers to Steelcase dealers and to the Steelcase family of products. We also think it's a great choice for existing customers to use in shared spaces, meeting spaces and other fast-growing applications where a higher performing task chair like Gesture might not always be necessary. Customer feedback and dealer feedback was outstanding as folks saw this a chair very relevant to today's market, and we believe it will help us capture a greater share of our dealers' business. This chair was made possible by the increased investments we made in product development last year, and we believe these investments are critical to maintaining our market leadership. We expect to begin seeing revenues from this product in our fourth quarter.
Our outlook for the second quarter reflects the weaker Americas backlog because of the factors I discussed, including large customer order patterns. This is somewhat offset by the continuation of strong demand in Asia Pacific. Our operating income outlook reflect the continuation of the increasing investment in product development and sales force capabilities we began last year. Again, we're taking some additional steps to reduce spending in some other areas, but those efforts will not materially affect the second quarter.
And with that, I'll turn it over to Dave.
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David C. Sylvester, Steelcase Inc. - CFO & Senior VP [8]
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Thank you, Jim.
I will cover our financial results first, noting where results differed from our expectations and highlighting year-over-year and sequential quarter comparisons. And then I will talk about our balance sheet and cash flow before getting into our order patterns and outlook.
As Jim said, we were pleased to report revenue and earnings within the estimated range we provided in March, which included the impact of annuitizing 3 of our smaller defined benefit plans.
Order patterns in the Americas were soft during April and May, and I will provide more detailed commentary about that in a moment. But first, I want to share a few other highlights, some of which Jim just referenced.
First, Asia Pacific posted record levels of revenue and operating income again this quarter, realizing a $6.5 million profit improvement compared to the prior year, which resulted in a strong double-digit operating income margin this quarter. As we have said on previous calls, we are continuing to secure more and more business with leading organizations headquartered in China and India, and our level of customer order backlog and pipeline of project activity remains strong.
Second, the level of demand for our new products in the Americas has remained strong, as revenue from new products as a group continues to exceed our revenue, gross margin and return on invested capital expectations. In addition, revenue from products which have been significantly enhanced during the last 3 years, also grew, and the rate of growth was well above the Americas average growth in the quarter. At the same time, demand for our legacy panel-based furniture systems continues to decline. And the market remains dynamic, particularly around ancillary trends, price points and the integration of technology. Thus, we intend to remain invested in our product development and new business strategies.
Third, we were pleased to report order growth in EMEA during the quarter, driven by project activity in Eastern Europe and the Middle East as well as vended solutions at our owned dealers. In addition, day-to-day business in France, Germany and Iberia has continued to grow.
As it relates to revenue in the first quarter, the organic growth of approximately 4% included exceptional strength in Asia Pacific, which drove 20% organic growth in the Other category. The Americas, PolyVision and Designtex also grew revenue in the quarter, while the organic revenue decline in EMEA was driven by a 17% decline in customer order backlog entering the quarter.
Revenue across the segments was largely consistent with our internal estimates, but I will make a few comments about our business mix and other factors in the Americas, EMEA and Asia Pacific.
For the Americas, the 3% organic growth was driven by project revenue, which exceeded 50% of our total revenue in the quarter and included revenue from the very large project we have mentioned on previous calls. Revenue from continuing agreements and marketing programs was lower than the prior year. This business mix, along with some shifts in our product mix, had an unfavorable impact on our gross margin percentage compared to the prior year, which included $6 million of warranty retrofit charges.
For EMEA, the 4% organic revenue decline was broad-based, with the exception of the Middle East, which benefited from a relatively large project. With the improvement of economic and political sentiment in France and Germany, we are beginning to see modest growth in our pipeline of project activity compared to the prior year. And we believe the opening of our new learning and innovation center in Munich will contribute to an improvement in our win rate as we compete for larger projects across the region.
And in Asia Pacific, the exceptional revenue growth was driven by India, but we also posted strong double-digit growth rates in China, Japan and Southeast Asia. And our optimism in this region continues given the current level of customer order backlog, our pipeline of project activity and growing demand for our new products.
From an earnings perspective, the $0.15 per share in the quarter included a $7.3 million charge related to annuitizing 3 of our smaller defined benefit plans, which reduced our earnings per share by approximately $0.03 after consideration of related variable compensation and tax effects. Operating income approximated the level contemplated in our earnings estimate and benefited from a record level of quarterly profit in Asia Pacific that was better than expected, which offset modest shortfalls in EMEA and the Americas. While lower volume prevented us from reporting year-over-year improvements in EMEA operating results again this quarter, we were pleased with the fact that the record level of profitability in Asia Pacific substantially offset EMEA's operating loss.
Other income net was consistent with our forecast in total, but included better-than-expected results from our unconsolidated affiliates, offset by $2 million of foreign exchange losses driven by reductions in the strength of the U.S. dollar relative to other currencies.
In addition, our effective tax rate of 36.3% included an unfavorable impact of adopting the new accounting standard related to stock compensation, largely offset by favorable discrete tax items.
Switching to year-over-year comparisons. Adjusted operating income decreased by $3 million. Note that the current year results included the $7.3 million of charges related to the defined benefit plan annuitizations, and the prior year results included approximately $6 million of warranty retrofit charges. The operating leverage generated by the organic revenue growth in the quarter was more than offset by higher operating expenses and the unfavorable shifts in business mix that I mentioned previously. The increased spending included investments in product development, sales, marketing and information technology that support our strategies, including developing new products, enhancements in applications, such as the smart and connected workplace and creative spaces. It also included expanding our ancillary offerings, addressing certain product gaps and pursuing other areas.
Sequentially, first quarter adjusted operating income was lower compared to the fourth quarter due to seasonally lower revenue, the impact of annuitizing the defined benefit plans, higher spending in support of our strategies and the unfavorable shifts in business mix that I mentioned previously.
Moving to the balance sheet and cash flow.
Cash used in operating activities was largely consistent with our seasonal trends, totaling $51 million in the current quarter compared to $66 million in the prior year. The reduction was driven by lower variable compensation payments and increased customer deposits, offset in part by increased working capital and timing of VAT recoveries.
Capital expenditures totaled $17 million in the first quarter. And we continue to expect fiscal 2018 to fall within a range of $80 million to $90 million, driven by our intention to sustain a high level of product development, strengthen our industrial capabilities, enhance our information technology systems and continue to invest in our customer-facing facilities.
We returned approximately $16 million to shareholders in the first quarter through the payment of a cash dividend of $0.1275 per share. And yesterday, the Board of Directors approved the same level of dividend to be paid in July. The share repurchases during the quarter were associated with the vesting of equity awards and satisfaction of participant tax obligations.
Turning to order patterns.
I will start with the Americas segment, where our orders in the first quarter declined by approximately 3% compared to the prior year, reflecting a 4% decline in orders for our branded solutions and growth from other products and services sold by our own dealers. We posted modest order growth in March, followed by mid-single-digit percentage declines in April and May. Customer order backlog at the end of the quarter was 6% lower compared to the prior year, and order patterns through the first 3 weeks of June have grown over last year, though continuing to be up and down week-to-week. The order decline in the quarter was driven by a significant reduction in demand from our largest corporate customers compared to the prior year. Historically, this group has accounted for more than 20% of our business and has also driven our largest orders booked in a quarter. Based on our internal analysis, we do not believe we are losing any share of wallet from this group as it relates to their investments in the workplace, but rather, we are likely feeling the effects of a reduction in total capital investment across the group, which we determined based on our review of publicly available information.
Turning to vertical markets in the Americas. Order patterns were mixed, reflecting declines from 6 of the 10 vertical markets we track and growth from the other 4. The declines were most significant across the information technology, manufacturing and insurance sectors. And growth rates were the highest across the energy, education and financial sectors. Across quote types, project orders declined by 6%, and day-to-day business declined by 2%, reflecting a 9% decline in our marketing programs aimed at smaller day-to-day business, partially offset by modest growth in orders from continuing agreements.
Throughout the previous 4 quarters, we talked about the year-over-year strength we were seeing in our pipeline of large project activity in the Americas. You will recall, our pipeline calculation includes project business that we have already been awarded or that we believe we have a significant probability of winning, and that when aggregated, is expected to result in at least $3 million of revenue from each customer over the next 4 quarters. For the first time in 4 -- 5 quarters, this pipeline at the end of the first quarter was lower compared to the prior year. The reduction is due to the recent substantial completion of the very large project we won during the first quarter of the prior year and thereafter included in the pipeline prior to it being ordered. Excluding this large project from the comparison, the pipeline still grew year-over-year, but at a rate lower than previous quarters. This lower growth rate could be a function of our current and expected win rates, but we also see a similar pattern across our entire pipeline of project activity, which includes business with medium to lower levels of confidence. It's only one piece of data and this is contrasted by the strength -- by the continued strength in CEO and small business sentiment. But based on what we are seeing, it seems the pace of large-company investments has cooled somewhat, similar to what we experienced in the fall of 2015.
For EMEA, the order growth of approximately 6% in the current quarter was driven by project business in Eastern Europe and the Middle East as well as blended products sold by our own dealers. Order patterns across the balance of the region reflected growth in France and Iberia and declines in Germany and the U.K. Order backlog in EMEA ended the quarter down 2% compared to the prior year, a significant improvement over the 17% year-over-year decline entering the first quarter. Order patterns through the first 3 weeks of June reflected year-over-year declines.
Within the Other category, orders in total grew 20% compared to the prior year and included very strong orders in Asia Pacific again this quarter as well as double-digit growth rate at PolyVision and a mid-single-digit growth rate at Designtex. The order strength in Asia Pacific continues to be led by a strong growth in India and China, but most other markets also grew orders compared to the prior year.
Turning to the second quarter of fiscal 2018. We expect to report revenue in the range of $750 million to $780 million, which reflects a range of an organic decline of 1% to organic growth of 3%. Our revenue estimate contemplates significant growth from the Other category in the second quarter and an organic decline in the Americas. Related to EMEA, we expect to report year-over-year improvements in the level of our operating loss in the second quarter, primarily due to the elimination of disruption costs and inefficiencies incurred in the prior year. In the Americas, we expect some improvement in our business mix in the second quarter compared to the first quarter. And we expect sequentially higher operating expenses, reflecting our commitment to increase the level of investment in product development and other growth initiatives. In total, we expect to report a year-over-year increase in operating expenses in the second quarter similar to the first quarter. As a result of these factors, we expect to report second quarter earnings within a range of $0.21 to $0.25 per share.