Sep 19, 2013
Executives
Raj Mehan James Patrick Hackett - Chief Executive Officer, Director and Member of Executive Committee David C. Sylvester - Chief Financial Officer and Senior Vice President
Analysts
Joshua Borstein - Longbow Research LLC Todd A. Schwartzman - Sidoti & Company, LLC
Operator
Good day, everyone, and welcome to Steelcase's Second Quarter Fiscal 2014 Conference Call. As a reminder, today's call is being recorded.
For opening remarks and introductions, I'd like to turn the conference call over to Mr. Raj Mehan, Director of Investor Relations.
Raj Mehan
Thank you, Sam. Good morning, everyone.
Thanks for joining us for the recap of our second quarter financial results. Here with me today are Jim Hackett, our Chief Executive Officer; Dave Sylvester, our Chief Financial Officer; Mark Mossing, Corporate Controller and Chief Accounting Officer; and Terry Lenhardt, Vice President, Finance for the Americas, EMEA and Asia Pacific.
Our second quarter earnings release, which crossed the wires yesterday, is accessible on our website. This conference call is being webcast, and the webcast is a copyrighted production of Steelcase Inc.
The presentation slides that accompany this webcast are available on ir.steelcase.com, and a replay of this call will also be posted to the site later today. Our discussion today may include references to non-GAAP financial measures and forward-looking statements.
Reconciliations to the most comparable GAAP measures and the risks associated with the use of forward-looking statements are included in our earnings release and webcast slides. We are incorporating, by reference into this conference call, the text of our Safe Harbor statement, included in yesterday's release.
Following our prepared remarks, we'll respond to questions from investors and analysts. And with that, I'll now turn the call over to our Chief Executive Officer, Jim Hackett.
James Patrick Hackett
Thank you, Raj, and good morning to everyone. For the last few quarters, I've emphasized on this call that I believe our business is situated at the crossroads of great opportunity.
It's the intersection of outdated spaces and our ideas about how customers can not only upgrade their spaces, but modernize how they work. This is the primary topic of my conversations with leaders in major corporations today.
I am a bit reflective today as this will be my second to last call in the role as Chief Executive Officer of Steelcase. As I have done close to 50 of these calls in my tenure, I realize that this ceremony is really critical to helping our shareholders understand not just what is behind our performance but also the opportunities and the risks that we see.
So there's no doubt in my mind that Steelcase is a much stronger company today than a few years ago, and that's in no large part due to the hard work of our people around the world to reinvent the industrial model, develop new products based on the knowledge of the workplace, which really has changed the very nature of our business. Thus, we're reporting on another good quarter today specifically because of the better-than-expected results in the Americas segment.
In fact, I think they are extraordinary given the recent history. Now as Dave will explain in a few moments, several factors aligned in Q2 to create outstanding performance in the Americas.
In any case, seeing a 14% operating margin, which is the highest earning segment in a decade, it makes me very proud of all the work we've done to improve our fitness and to change our business model. I'm proud that we've demonstrated our ability to anticipate the future for the targeted customers that we serve.
We saw the trend from individual work to collaborative work or as we call it from I to we space. We saw the shift from fixed to mobile work with the office becoming a place where people can now work anywhere but want to come together and collaborate.
And now we're implementing ideas supporting the deeper integration of technology and everything that they want to do. This is a message that continues to gain traction with our customers and as you see, especially in the Americas.
We believe its acceptance in other parts of the world is being delayed a bit by economic condition that makes price a factor, but that's going to change with the eventual recovery in these other geographies. And because we've made the tough decisions to navigate our way out of 2 major downturns, we're confident that we can make the necessary adjustments to safeguard our competitiveness in western Europe.
We're applying portions of our playbook from the Americas transitions, including the alignment of our sales force and ramping up the level of what we call global integration. Like you, we're far from satisfied with our EMEA results, and we took steps to reduce operating expenses earlier this year that will show up in future quarters.
And as noted in our release yesterday, there's more to do. But first, we need to work with the teams in the countries involved to define potential projects aimed at protecting our competitiveness, and therefore, we can't really get into more information today.
I want to emphasize that. We are working on project aimed at protecting our competitiveness, and we can't really provide more information today.
I do want to stress that while we're not happy with the competitiveness in Europe, we are very confident in our people and our market strategy in this region. I'm proud of our teams for staying afloat in some very stormy economic seas.
We're also proud of our people in Asia Pacific because they've been facing their own economic up and downs, but they're continuing to build for the future as well. So let me move to an update on our new products.
We've talked about them in past calls, and we've been telling you all year, there will be some significant launches in this year. We're excited about the upcoming move from the pilot phase into full production, which will require that we spend more of the incremental dollars that we've been talking about since the start of the year.
This is a good thing because we're getting to market. Our expected first order entry for the Gesture chair is a little more than 6 weeks away, and we've already had commitments from 10 major customers for orders that will ensure our production pipeline is filled from Day 1.
And I believe the media coverage of this chair to the consumer market, with something like 150 articles around the world, including a recent feature in the New York Times, is unprecedented. We've generated a buzz around this chair, and our research about the implications of the way people are using technology tools is really working.
Our V.I.A architecture portfolio is also in the presell phase, and we accepted our first significant customer order this week for a pilot space at a major energy company. There's been tremendous momentum around this project and product since we showed it at NeoCon in June, as there are for products such as Regard, that's the waiting room furniture in health care applications; and the new offerings that we demonstrated from Coalesse.
So in summary, we've made good investments in the products and applications designed for where work is going in the future, which is going to allow us to build on a good performance we're reporting again this week. But as I said, we're also focused on the need to improve our competitiveness in the underperforming EMEA segment, and we'll have more to say about that as soon as we're able to talk about it.
I'll turn it over to Dave for more details.
David C. Sylvester
Thank you, Jim. I will start with a few high-level comments about the second quarter results and balance sheet, provide some additional color and commentary around our order patterns and outlook for the third quarter of fiscal 2014.
And then, we will move to your questions. On the second quarter results, I will first talk about the results versus, our expectations and then move into the year-over-year and sequential quarter comparisons.
Overall, earnings per share were consistent with our expectations despite revenue falling slightly short of the range we communicated last quarter. From a revenue perspective, the Americas, PolyVision and Designtex were in line with our expectations while EMEA and Asia Pacific fell short.
From an earnings perspective, adjusted operating income in total was consistent with our expectations while strength in the Americas -- with strength in the Americas offsetting weakness in EMEA and Asia Pacific and higher operating expenses in corporate. Nonoperating results were negatively impacted by reductions in the cash surrender value of variable life company-owned life insurance or COLI, which was driven by recent increases in interest rates and our investment allocation being heavily weighted toward fixed-income securities.
We expect reduced volatility in variable life COLI income go forward, as we have adjusted our investment allocation to more heavily weight money market funds as we expect, in the near term, to extract a portion of the value from these policies. Lastly, the effective income tax rate approximated our estimate of 40%, but there were a number of components which I will cover in more detail in a few minutes.
On the segments, in the Americas, stronger-than-normal seasonality in the second quarter was consistent with our expectations. You will recall that first quarter order patterns reflected requested shipment dates that were more heavily weighted toward the second quarter, which resulted in a higher backlog coming into the second quarter.
The adjusted operating income margin of 14% was significantly better than expected due to favorable business mix and lower operating expenses, which are expected to ramp up in the back half of the year. For EMEA, the adjusted operating loss was larger than expected primarily due to volume shortfalls across much of western Europe, as well as shortfalls in Africa.
The impact of lower-than-expected volume was partially offset by lower operating expenses, some of which have been deferred to the back half of the year. Despite the challenging environment in western Europe, we believe that we are gaining market share in most markets, reflecting the great efforts by our resident teams to align our strategy with the rest of the world and position our business for eventual economic recovery in the region.
Similar to EMEA, Asia Pacific fell short of our expectations largely due to volume shortfalls, which were linked to the general economic slowdown in China and various project installation delay. The team offset some of this impact by cutting back on operating expenses.
In addition, the devaluation of currencies in Japan and India are having negative consequences on our business models in these regions. Lastly, corporate costs were higher than expected due to increased reserves for environmental remediation costs associated with a previously owned manufacturing site, higher accrued earnings on deferred compensation and costs associated with the sublease of excess showroom capacity.
On a year-over-year basis, revenue in the second quarter grew modestly after adjusting for the favorable impacts of currency translation and net acquisitions while adjusted operating income increased by approximately $5 million or 10%. Organic revenue growth in the Americas of approximately 4% represented the 14th consecutive quarter of year-over-year growth and reflected favorable business mix, recent pricing benefits, restructuring benefits, manufacturing efficiencies and other cost-reduction efforts and modest volume growth.
The business mix impacts reflected a significant decline in the lower-margin federal government sector and significant growth in the higher-margin education vertical market. In addition, various projects across other vertical markets were more heavily discounted in the prior year compared to comparable projects in the current year.
These factors contributed significantly to the 280-basis-point improvement in cost of sales and the $17.5 million increase in adjusted operating income, which resulted in a 14% operating margin for the quarter. In addition, operating expenses grew less than expected primarily due to timing, which further contributed to the strength of the Americas results in the second quarter.
As you saw on the release, EMEA experienced a 13% organic revenue decline in the quarter, which was larger than expected but not entirely surprising given the prior year organic growth rate of 17%. The revenue decline was broad-based and was the biggest contributor to the larger operating loss compared to last year.
The benefits of lower operating expenses were offset by unfavorable shifts in business mix and inefficiencies in manufacturing and distribution linked to the lower volumes. For the other category, adjusted operating income decreased by $1.4 million while revenue increased by the same amount.
The reduced operating results were largely driven by Asia Pacific. And for corporate costs, the $3.9 million increase compared to the prior year was driven by the factors previously mentioned.
Sequentially, the biggest drivers of the $30.5 million improvement in adjusted operating income were attributable to the seasonally strong organic revenue growth and the favorable business mix previously mentioned. Restructuring costs in the quarter were somewhat higher than our expectations and were entirely attributable to the EMEA activities which were initiated during the first quarter.
These actions are expected to be completed in the coming months and yield a few million dollars of annualized savings thereafter. As it relates to the North America plant consolidations, we estimate year-over-year net benefits approximated $4 million in the second quarter.
Regarding my quote in the press release about EMEA, we are not prepared today to say anything more than what was indicated in the release, that is we expect to work with our EMEA teams to initiate procedures within the next 30 to 60 days with employee representatives in the countries involved regarding potential projects aimed at safeguarding our competitiveness. Once these procedures have been initiated, we will be in a position to provide more details, but until then, we will respect the processes required to be followed.
Now I will spend a few minutes on income taxes. Last quarter, we communicated that we expected to record unfavorable tax adjustments of approximately $2 million, which could increase our effective tax rate to approximately 40% in the second quarter.
We did record approximately $2 million of unfavorable discrete tax adjustments but we also recorded a $3 million discrete tax benefit associated with the tax planning strategy. In addition, we recorded an effective tax rate of approximately 40% against pretax income, which we currently estimate to be the effective tax rate for the balance of fiscal 2014.
Plus, we recorded a year-to-date catch-up adjustment to bring the first quarter effective tax rate to this higher level. The higher rate is being driven by losses in EMEA, which result in deferred tax assets in various jurisdictions that currently weren't full valuation allowances to be recorded against the assets, thus negating the benefit of recording the deferred tax asset.
A bit complicated for sure. The takeaway, however, is that our effective tax rate is expected to be closer to 40% for the balance of the year and thereafter until EMEA achieves breakeven or better operating results.
Moving to the balance sheet and cash flow. We generated $56 million of cash from operations during the second quarter.
Working capital increased by $20 million in the quarter primarily due to higher accounts receivable in the Americas, which was linked to revenue growth. Capital expenditures totaled $18 million, similar to the first quarter and are currently expected to approximate $80 million for the full fiscal year.
We've returned approximately $13 million to shareholders in the second quarter through the payment of a cash dividend of $0.10 per share, and yesterday, the board declared the same level of dividend to be paid in the third quarter. As it relates to order patterns, I will start with the Americas, where our orders in the second quarter grew approximately 10% compared to the prior year.
Order patterns were strongest in August, growing 16% over the prior year compared to a modest decline in the prior year, and customer order backlog for the Americas ended the quarter up approximately 19% compared to the prior year. Across quote types, orders related to large projects and orders from our marketing programs aimed at smaller day-to-day businesses grew significantly while orders from continuing agreements were flat compared to the prior year.
Vertical market order growth rates in the Americas were the strongest in the insurance, energy and manufacturing sectors. Health care, education, Technical/Professional, financial services and state and local government also grew while federal government and Information Technology posted single-digit-percentage declines against the prior year.
Switching to EMEA. Order patterns in constant currency remained mixed, declining by approximately 12% in total compared to the prior year.
We experienced order growth in the export markets of eastern, central and southern parts of Europe, while northern Europe and Germany were relatively flat. Orders in France, Iberia and the export markets of the Middle East and Africa also declined but the comparison was against the strong prior year.
Customer order backlog for EMEA ended the quarter up approximately 5% compared to the prior year, which was more a function of low backlog last year than current quarter order patterns. Within the other category, orders grew by more than 20% in Asia Pacific and at PolyVision.
While orders at Designtex declined by a mid-single-digit percentage. We are continuing to monitor the Chinese market closely as order patterns have remained relatively soft, and we expect challenges in Japan and India given the recent currency devaluations and the fact that our business models in those markets are largely dependent on imports.
To summarize, our order patterns and quarter end backlog in the Americas remain solid. We continue to face a challenging environment in EMEA, and we are keeping a close eye on a few markets in Asia Pacific.
Turning to the third quarter. We expect to report revenue between $755 million and $780 million, which compares to $727 million in the third quarter of fiscal 2013.
After giving effect to currency fluctuations and a recent divestiture, we estimate organic revenue growth in the third quarter will approximate 4% to 7% compared to the prior year. Sequentially, the third quarter revenue estimate represents a range of down 1% to up 3% on an organic basis, which is somewhat lower than typical seasonality due to the strength of the Americas in the second quarter and ongoing volatility in EMEA.
We expect the mix of project business in general across the Americas, EMEA and Asia Pacific to remain higher than business from continuing agreements. However, we are not anticipating the favorable business mix in the Americas during the second quarter to continue into the third quarter as higher-margin business in certain vertical markets is expected to be replaced by lower-margin business in the federal government sector.
In addition, the mix of large project business in the third quarter is expected to be more deeply discounted compared to the second quarter. For operating expenses, on a sequential quarter basis, we expect the costs associated with our new product introductions and other initiatives to increase our operating expenses compared to the second quarter.
Finally, our third quarter earnings estimate contemplates an effective income tax rate of approximately 40% as previously discussed. As a result of these factors, we expect to report third quarter earnings within a range of $0.23 to $0.27 per share, including restructuring costs of approximately $0.01 per share.
This compares the $0.19 per share in the third quarter of the prior year, which included restructuring costs of approximately $0.03 per share. From there, we will turn it over for questions.
Operator
[Operator Instructions] Our first question comes from Budd Bugatch of Raymond James.
Unknown Analyst
It's Bobby [ph] filling in for Budd again. Just want to kind of get your guys' thoughts on business forecast for the calendar year 2014, where you guys feel they're at compared to where you guys see the industry going?
James Patrick Hackett
Well we're aware the business calling next year up quite significantly. And I would say, for us, it's a bit early for us to comment on -- on calendar 2014.
We go through our extensive planning process in the fall. So towards the fourth quarter, we'll be in a better position to comment about next year specifically.
Although I would tell you that our thesis remains unchanged, that we think the world is largely installed on an outdated model and it needs to modernize. And as long as the economies continue to stay reasonably okay, we think companies are going to continue to invest to update their spaces.
Unknown Analyst
Appreciate that. I just had another follow-up question.
I know you guys were talking about northern Europe, but just kind of a little bit more color on maybe the trends in Europe and if you guys still are seeing some areas strengthening and if you expect that to carry forward maybe a little bit into the third and fourth quarter.
James Patrick Hackett
It's really been more of the same story we talked about last quarter, where we suggested that we were seeing positive trends in northern Europe, which was a change from previous quarters. Those are continuing to play out.
Our expectations are that we will continue to see some strengthening of our business in that part of EMEA. Middle East and Africa and the export markets of eastern and central Europe and southern Europe as a group, we feel -- continue to feel pretty good about.
Germany is hanging in, and France is doing okay. Those are really the biggest question marks.
If anything, maybe Spain notched down another bit, bit of a notch in the past quarter. But it still feels like they're in a sandy bottom.
Like, it's not like they've broken through to a new level, it's just a little squishy along the bottom. So we'll wait and see.
But it's kind of the same story for the last several quarters, relatively mix, flattish in total. Now this past quarter of Q2, you go, "Wait a minute, you were down 13%."
But I'll remind you that last year in the second quarter we were up 17%.
Operator
Our next question comes from Josh Borstein of Longbow Research.
Joshua Borstein - Longbow Research LLC
With respect to EMEA, I know you're limited in what you can say with respect to the steps you're taking there, but can you tell us if the steps you're trying to initiate represent a change in your thinking about the EMEA business since we spoke 3 months ago?
James Patrick Hackett
No. There's no change in our thinking.
We're continuing to push their strategy to be more consistent with our global strategy, focusing on large leading organizations and building distribution and product platforms to support it. So no change in strategy by any means.
Joshua Borstein - Longbow Research LLC
Okay. And the phrase safeguarding your competitiveness, you mentioned, can you unpack that phrase a little bit, what exactly you mean by that?
James Patrick Hackett
It really is left best as that description. It really means that.
Joshua Borstein - Longbow Research LLC
Okay, fair enough. And then what gives you confidence that you're taking market share in Europe right now?
James Patrick Hackett
Well, it is not as easy to measure in Europe as it is in the U.S. We don't get as often the same amount of information in Europe that we get in the U.S.
[indiscernible] here. But what we do see from the market data gives us confidence that, not every market, but in many of the markets, we feel like we're gaining share.
Now some of that share, frankly, is coming in markets where companies are just simply going out of business because they can't sustain the downturn any longer. In that, therefore, what's left in the industry is being spread to fewer players and in some cases, to the stronger players, which is us.
Joshua Borstein - Longbow Research LLC
Okay, great. And last one for me.
In the Americas, can you just tell us the number of customer visits, the total number of mock-ups, as well as the average value of each mock-up in the quarter?
James Patrick Hackett
I don't know the actual numbers off the top of my head, but I do know that the patterns that we've been talking about for the last few quarters have remained consistent, meaning the level of project activity has been very good and the average dollar value associated with those projects has been up over the prior year. And I can tell you, as also the executive at Steelcase who has corporate aviation reporting to him, our aircraft are essentially full through the end of February.
Operator
[Operator Instructions] Our next question comes from Todd Schwartzman of Sidoti & Company.
Todd A. Schwartzman - Sidoti & Company, LLC
What is your outlook, say, 6 to 12 months outlook, for steel cost?
James Patrick Hackett
I think they're going up. I mean, we've had a recent uptick in cold-rolled steel that will affect us in another 90 days or so.
If you remember, our contracts lag the market by 90 days. So we had a recent uptick.
And our forecast is that we do see it up -- increasing modestly going forward.
Todd A. Schwartzman - Sidoti & Company, LLC
As far as pricing action?
James Patrick Hackett
Well, we have put pricing in place over the last couple of years as needed. And so if inflation were to continue to go up or we were to experience -- continue to experience inflation, we would likely deal with that as we have in the past.
Todd A. Schwartzman - Sidoti & Company, LLC
Got it. I know there's been a lot of discussions, some disagreement over to what extent construction, non-res construction, really is necessary to fuel growth in your industry.
But are you seeing any geographic pockets of strength in North America where you're seeing -- or maybe where there's been a recent pickup in non-res construction translating at this early juncture to furniture orders?
James Patrick Hackett
Not specifically. I mean, anecdotally, Todd, there are -- some of the customer visits or projects we're working on are new construction.
But I wouldn't call any of them necessarily a regional trend.
Todd A. Schwartzman - Sidoti & Company, LLC
Okay. And Dave, what does your own model indicate for fiscal '15 tax rate?
David C. Sylvester
Well, it really, is a bit early but it is highly dependent on what EMEA results look like next year and whether or not we're able to book the benefit of deferred tax assets or not. So what I said in my scripted remarks is I think you should use 40% for the balance of this year and thereafter until you assume that EMEA will be back to breakeven or better.
Todd A. Schwartzman - Sidoti & Company, LLC
Okay. And lastly, were there any timing issues or do you anticipate any timing issues in the current quarter that we should be aware of regarding shipments?
James Patrick Hackett
No. We had a few slippages here and there where customers delayed installation.
But to be honest, we have that every quarter. I couldn't tell you whether this quarter was higher or lower.
It didn't feel like it had more conversation than normal.
Operator
And at this time, I'm not showing any further questions. I'd like to turn the call back to Mr.
Jim Hackett for any closing comments.
James Patrick Hackett
Thank you, everybody. Appreciate your attention today, and we look forward to reporting improved results.
Operator
Ladies and gentlemen, thank you for your participation in today's conference. This does conclude today's program.
You may all disconnect. Everyone, have a great day.