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
 
Restructuring:
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

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