Good afternoon, and welcome to the Ethan Allen fiscal 2019 first quarter analyst conference call. At this time, all lines are in a listen-only mode. Later, we will conduct a question and answer session, and instructions will be provided at that time. If anyone should require operator assistance during today's call, please press star then zero on your touch-tone telephone. It is now my pleasure to introduce your host, Corey Whitely, Executive Vice President of Administration and Chief Financial Officer. Thank you. You may begin.
Thank you, James. Good afternoon, and welcome to Ethan Allen's conference call for our first quarter ended September 30th, 2018. This conference call is being recorded and webcast live on ethanallen.com, where you will also find our press release, which contains supporting details, including reconciliations of non-GAAP information referred to in the release and on this call. As a reminder, our comments today will include forward-looking statements that are subject to risks and uncertainties that could cause actual results to differ materially. Please refer to our SEC filings for a complete review of those risks. The company assumes no obligation to update or revise any forward-looking matters discussed during this call. After I provide some brief details on the financial results, our Chairman and CEO, Farooq Kathwari, will provide updates on the business and our ongoing growth initiatives. We'll then open up the telephone lines for questions.
We had our fourth consecutive quarter of consolidated net sales increases with our fiscal 2019 first quarter sales of $187.8 million, increasing 3.6% compared to the prior year period. Our improved manufacturing efficiencies helped drive the 5.8% increase in wholesale sales and 2.6% increase in retail sales. The wholesale increase reflected strong shipments to our retail network and increased contract business, including strong GSA orders and shipments during the quarter. Our wholesale backlogs are current and reflect normalized levels. Our consolidated gross margin for the quarter was 54%, primarily reflecting increased raw material costs in our upholstery programs and the 77.3% mix of retail sales as a percent of consolidated sales, compared to the higher 78.1% mix in the prior year. We are closely watching the current international trade dispute situation to assess the potential impact on our gross margins.
Because we currently make 75% of what we sell in our North American workshops, we believe we are fairly well-positioned to minimize the impact from the international trade disputes. Our first quarter operating expenses were $89.7 million, an increase of 2%. The increase is primarily driven by variable costs related to increased sales and our advertising expense, which increased 12.8% during the quarter as we continue to expand our marketing programs. For the quarter, the operating margin was 6.3%, net income of $8.8 million, with EPS of $0.33, an increase of 17.9% over prior year adjusted EPS. Turning to the balance sheet, we generated $24.4 million of cash from our operating activities during the quarter. We paid $5.1 million of dividends, and we ended the quarter with cash and securities of $39.6 million. We had no debt outstanding under our credit facility.
Our effective tax rate was 24.9% of the quarter as a result of the Tax Cuts and Jobs Act. We expect our effective rate for the 2019 fiscal year will be in the range of 24.5%-25.5%. With that, I will turn the call over to Farooq.
Thank you, Corey. As we mentioned in our press release, our focus and opportunity are to differentiate ourselves in this fast-changing world impacting retail, manufacturing, and technology. In our opinion, brick and mortar and the selling of product as a commodity will continue to lose market share. Service is crucial. With our strong retail network providing a full range of interior design services, we believe we are positioned well to capitalize on this point of differentiation. 1,200 dedicated interior designers in our 200 North American interior design centers and 500 designers in our 100 design centers overseas offers personal service combined with technology, another critical point of differentiation. We continue to focus on five important areas. First is the development of talent. Second is a strong marketing program that includes relevant offerings and comprehensive advertising that encompasses both traditional and digital mediums.
Third, investing in manufacturing, logistics, and sourcing to provide products of the highest quality and well-managed inventories and margins. Fourth, investment in technology is critical in all areas, including manufacturing and retail. Fifth is a strong focus on social responsibility. We are positioned well for growth as 70% of our products have been refreshed in the last three years. This quarter, our artisan-inspired products were introduced and well-received. Two weeks from now, we will introduce our newest products to more than 500 team members at our annual convention at our Danbury headquarters, where we will also celebrate our associates' accomplishments and review our marketing programs, including the new products I just mentioned. The new products are inspired by modern casual living with a planned consumer launch in spring 2019. We continue to expand our marketing in various mediums.
In our first quarter, we increased our advertising spend, as Corey said, by 12.8%. Our objective is to continue strong programs to drive traffic to our digital mediums and importantly, to our design centers. We continue to invest in our infrastructure. As noted earlier, our retail network consists of 200 design centers in North America and 100 internationally. In North America, we remain focused on transitioning to stronger locations, with about 70% of our stores relocated within the past 15 years. Currently, new design centers are under construction in Albany, New York, Coralville, Iowa, Denver, Colorado, and Rancho Mirage, California. Internationally, we continue to grow with recent openings in Taiwan, Bangkok, and China. A location in Cambodia is under construction.
While we believe we received the bulk of the State Department contracts, the sales amounts and gross margins were negatively impacted due to low bidding by a competitor, which was in Chapter 11. Our North American manufacturing facilities produce about 75% of our furniture offerings. During the last two years, we have doubled our Mexico upholstery manufacturing to about 600,000 sq ft, increasing our workforce and investing in technology. We continue to invest in technology in our U.S. and Honduras manufacturing plants, and we also continue to invest in our logistics network, delivering products at one cost in North America and premier in-home delivery to our clients. Finally, we continue our strong focus on social responsibility with the philosophy of respecting our people, respecting the law, and respecting the land.
As I mentioned, we are well-positioned as a provider of interior design service, supported with relevant and desirable products, great quality, and excellent value. I'm now pleased to open the call for comments and questions.
James, we can go ahead and open the call.
All right, James, you there?
Apologies. Thank you, ladies and gentlemen. If you would like to ask a question at this time, please press star then one on your touch-tone telephone. If your question has been answered or you wish to remove yourself from queue, you may press the pound key. Once again, that is star then one to ask a question. Our first question comes from Budd Bugatch with Raymond James. Your line is now open.
Yeah, hi there.
Hello.
Name Budd. We got to fix your name.
Well, I think we'll have to work on that, Farooq. We have an extra syllable in the name today, so that was all good.
All right.
Talk to us a little bit about order rates. You talk in the release about the fact that rates were down because order rates were down overall in retail because of the Canada situation. Can you give us a little bit of a feel of how that developed over the quarter as well? I think you may have ended better than you began because of the introduction of the lifestyle product.
Sure. Yes. We did mention that. You're talking about orders in our retail division?
Yes, sir.
Right. There, what we see is that we increased them. They overall increased by about 0.9%. As I said, the Canadian design centers were down about 25%. Again, in July, our written orders decreased 8.9%. On August, increased by 4.1%, and September increased by 5.2%.
So far, we're in October now, and is the momentum continuing, or has it subsided?
Well, as you know, the last week of the month is where we get about almost 30%-50% of our business. Look, we have very strong programs. People are confident, but the next five, six, seven days will determine what happens in October. Overall, we've got very strong programs out there.
Okay. You say you've increased advertising by 12.8%. That number, is it about $8.3 million? Is that the number you have, or do we have a wrong beginning number?
No, that's exactly right. It's $8.3 million. Just, Budd, as you know, I'm sure this question will come on advertising. I'll also just mention it up front. As we move forward, last year, we spent $8.6 million, which was about 4.3% of advertising in our second quarter. We spent a lot of money in the third and the fourth quarter. As you know, in the third quarter, we spent $13.8 million. And in the fourth quarter, we spent $13.5 million, and it was on a very strong national television campaign. It did get our message across, but as we know, it didn't have as much of an impact in bringing sales. We all know that. This year, the good news is we'll spend money, strong money, but we are not going to spend $13.8 million in the third and the fourth quarter.
We'll still be strong, but we'll spend less money.
Okay. Can you quantify it for us, the amount of GSA orders or GSA revenues that are in the wholesale segment?
Corey, as I said, Budd, the orders have been negatively impacted because of the competitor was bidding at such low prices. Government benefited. It had an impact on lowering the sales and also lowering the margins. Corey, it is public information. What can we give?
Yeah. We don't give it out or won't get in the habit of giving it out every quarter, but it does fluctuate. We had about $6 million in sales in the quarter.
You're talking of this quarter, or are you talking about the last year, Budd?
I was talking about the current quarter, Farooq. Trying to understand what it is. That competitor is now gone, right? The equipment was auctioned off last week. Is that true or not?
Well, they sold off their name. They sold off other things. I do not know if they sold this contract or not, or whether they can even sell it. Most likely not. I think that as we move forward, the chances are that we have four more years with this contract. That's the good news. We have an opportunity of doing well. One of the reasons we did very aggressively bid on it, even though we didn't make much money. We did make money, but was the fact that we wanted our products in all the diplomatic homes internationally, and that had a very positive impact because people like what we do, and they were happy that we were able to provide the Ethan Allen products and programs. I think it looks very positive, Budd.
In the release, you gave some cautionary language about international revenues. I take it that must be China, because that's where the bulk of your international stores are located. Could you give us some flavor of what's happening over there?
Well, there are a number of factors. First is, they are very positive about the Ethan Allen programs. They're projecting them very strongly. They are, in fact, in the process of repositioning their offerings in most of their flagship stores, reflecting our newer products. As you know, it's interesting. I mentioned we've changed 70% of our product line. Two years back, in China, the markets were somewhat interested in more, what you might say, formal and traditional. Now they are much more interested in our new product lines, which are somewhat more, you might say, more towards the classic, but with a modern attitude. They are very eager and aggressively going to reposition the design centers. Having said this, they've also been cautious on this whole issue of tariffs.
That has been an issue, although from our perspective, because of the fact we make most of our products in North America, they will be less impacted. I think overall it's positive. Some impact. They were cautious. They held up some orders, but as I see it, Budd, the chances are we're going to be all right and keep on building our very good business in China and in some other countries in Southeast Asia.
Okay. Well, my last comment is thank you very much, Corey, for getting in the queue, out with the release. Appreciate that very much, and good luck on the quarter.
Yeah. Thanks very much.
Bud.
Thank you. Our next question comes from Brad Thomas with KeyBanc Capital. Your line is now open.
Yeah. Hello, Brad.
Hi. Good afternoon, Farooq and Corey. This is actually Andrew on for Brad. We were hoping you would comment a little bit more on the cadence of the business in the quarter and how you feel about the business in recent months.
Well, as I mentioned earlier, that our business was progressively increased in the months starting in June. In July, we had an decrease of 8.9%. August increased 4.1%, and in September increased 5.2%. We did see good growth as we went into the last quarter, as our advertising, with strong advertising programs. A lot of it was spent the latter half of August and September, and we started seeing the results. Now, of course, it's a little bit early for this quarter. We'll see how the month ends. We have strong programs, and we are looking forward at this stage of continuing our positive trends.
Great. Then could you just remind us, we know you touched a little bit on this with the prior questions. We know you are operating a lot of stores in China. Do you mind sharing any comments regarding the health of the consumer in that region?
Yeah, no, it's a good question. In China overall, as we read, that the Chinese consumer is also becoming cautious. On the other hand, the competition for home furnishings and other areas is increasing considerably. There is more competition, and it is more competitiveness, competitive in terms of their pricing, what they have to do. Overall, while there's some caution, I would say still, it is a question of major growth, not as much as what they did the previous year.
Okay. Thanks, Farooq.
All right. Thanks very much.
Thank you. Our next question comes from Jeremy Hamblin with Dougherty. Your line is now open.
Hello, Jeremy.
Hi. Good evening. Thanks for taking the questions. Wanted to come back to the commentary about the kind of struggling competitor going out of business here as it relates to the government contract. Corey, can you quantify what the basis point impact was to margin on the quarter, both from a consolidated basis, but then also specific to just the wholesale business?
Jeremy, that's a tough question, he can. Corey, can we give specifics? I mean, what information can we give?
Yeah. We don't really break out the gross margin by the product lines to that degree. It did have an impact on our wholesale margins with the Gio going out of business or the Chapter 11. I would say around 50 basis points, probably on the close to 50 or 40 basis points on the consolidated gross margin line was the impact from the lower wholesale margin.
Okay. I ask because wholesale margins were down 70 basis points overall, despite the fact that you had 5% growth in that segment. I would say most companies would probably provide some color if there was an unusual circumstance.
That was on the wholesale margin line, Jeremy. It was also raw material cost increases that had an impact on that, as well as the low pricing due to the competitive bidding on the State Department contract.
I would say, Jeremy, 70% because of the State Department impact, 30% due to increases in costs.
Okay, and on that point on cost, that was my next follow-up. What are you seeing? It looks like we've seen some change in trend on costs in the last month or two. How should we think about that in terms of impact here on the December quarter?
Well, we also took in October as a price increase because of the fact we were impacted, as raw material was increasing, especially relating to more on the upholstery side. Also with all the major changes in our product offerings, Jeremy, we still have to continue to sell product from our floors and the clearance product. That also has an impact on our overall gross margins. And it has been taking place in the last few years because in the last three years, we've changed 70% of our offerings. That also will continue in the next year. I would think that the impact of price increases, I would also say this, that we've had to also provide some more higher discounts at retail. All those factors combined, I would think that the gross margin approximately where we are now is something that what we are expecting.
In other words, what you just saw, like the 54% in Q1, that's kind of about the level you're thinking for the December quarter and maybe the next couple of quarters?
At this stage, it's possible it could potentially go up, but I would say using that would be good to use it, Jeremy.
On the flip side, on the cost basis, you noted that, I think what you said was that your marketing spend would be down on an absolute dollar basis in this December quarter. Did I catch that correctly?
Not in the December quarter. Last year, you're talking December, yeah. Last year, we spent in the December quarter, $8.6 million, which was 4.3% of sales, pretty close to what we spent. I was referring to the third and the fourth quarter, Jeremy.
Overall, if I just look at a high level, over the last couple of years, we have seen sales certainly come down from the high point in fiscal 2016. They're up slightly from fiscal 2015, but you have seen a pretty significant jump in your overall SG&A costs. Have you identified or have you kind of developed any comprehensive plan to I mean, if your margins are down, is this maybe another lever that you can pull to get your SG&A costs down somewhat from where they were last year?
Jeremy, in the third and the fourth quarter is where we have an opportunity while still maintaining a strong advertising program, our marketing expenses will go down. In the last year, we did impact our margins also, gross margins also. We also increased our production capacities. We want to increase our business, and that's our objective, and we will increase our business. If we are not able to service it, then it's a vicious cycle. We are not interested in buying a lot of product from overseas and having inventory and then selling it and increasing a tremendous amount of inventory. That's not our model. Our model is to be extremely conservative on inventories. We did take a position, as I mentioned, increasing our capacities in Mexico, in Honduras, and also investing in Vermont and North Carolina.
That did increase some of our costs, some SG&A, but also on our cost of production. As we move forward, the opportunity that we have is to leverage what we have with more sales. We have a very strong operating leverage. We can see that. We can go at a wholesale level from 8%, 10%-15% relatively fast, depending upon the incremental volume that goes through our wholesale. That's why our retail network is very strong for us. Because of our vertical integration, our operating leverage is strong with more output and sales. That's where our focus is. I think we are controlling our SG&A very well, where we have this opportunity, as I mentioned, was in the marketing.
Okay, great. Thanks for taking my questions. Good luck.
All right, Jeremy.
Thank you. Our final question comes from the line of Cristina Fernandez with Telsey Advisory Group. Sorry. Please go ahead.
Hello, Cristina.
Yeah. Hi, good afternoon. I had a couple of follow-up questions on some of the previous ones that have been asked. On the government orders that were a lower margin, that $6 million. Were a lot of those already delivered here in this first quarter, or how much of that impact can we still see in the upcoming December quarter?
Well, with Corey also will mention that in addition to that $6 million, we also had received for the last fiscal year, because he was just referring to this fiscal year, which is basically this quarter. We also had received, what was the backlog, $12 million or so?
Yeah, our backlog was about $10 million.
$10 million that we had received in the previous year at those low margins will be delivered in this fiscal year, in the first or second quarter. We do have some impact, and then after that we will see as the new bidding starts, what happens. We do have close to $18 million at wholesale at the lower margins, which we won.
That you still have to deliver, is that the right way to read it?
Yep, that's right. That's what we have to deliver. Yep.
Okay. Thank you. Then, if I go back and look last year at this first quarter, you had a lot of one-time or what seemed like one-time headwinds from the hurricanes and also from the first run production costs. You talked about manufacturing efficiencies. Are you already at the place where you want to be and can manufacture that product at a profitable rate?
Well, we were always profitable. It was just a question about how much. We've been operating at fairly good operating margins, but not as high as what we have been used to. The good news is, yes, we are well-positioned. Our backlogs are under control. Our manufacturing is geared to not only service, but can even service more production. We're in a good position. That's why our focus is really to get more sales, and as we do that, we have the ability to produce it, because last year at this time, we had high backlogs, because of the fact we had lots of new products being made for the State Department, and it did create a lot of disruptions last year in the second quarter, even flowing into the third quarter. This year, we're in a much better position.
My last question, can you talk about the performance of your new stores in metro markets like Flatiron Chicago, some of the new stores you've opened in high traffic locations. What has the ramp-up been on those stores? Are you happy with those?
Well, we're not happy because the rents are so high. It has been tough, both in Downtown Chicago. We opened Downtown Chicago, we opened Downtown Manhattan, we opened in the Puckett area. They're all gearing up, but still, we have some ways to go, where we would be somewhat happier in terms of losing less money. Because in these very, very expensive markets, the costs are so high, the objective is to lose less. That's what our plan is.
Okay. Thank you. Good luck with this next quarter.
All right, Cristina. Thanks.
Thank you. We do actually have a follow-up from Jeremy Hamblin's line. Your line's back open.
All right, Jeremy.
Thanks for taking one more here. I wanted to see, can you give me what your online sales as a % of total were in the quarter?
Corey?
Roughly.
It's less than 5%.
Yeah.
It's under five.
It's less than five, Jeremy, because our biggest opportunity, what we really want for folks to do is come into our design centers and interact with our designers. That's really our focus, although it has increased, but still relatively small.
Right. You caught my attention with your opening comments about brick-and-mortar, that you expect to continue to lose share in brick-and-mortar. I agree that service is the key, but your competitors are seeing a much higher penetration rate in terms of online sales as a % of total, even your competitors that are at similar price points. I just wanted to get a sense for what you think is not connecting with Ethan Allen or the brand or the service model on why that penetration rate is not significantly higher, and frankly, double digits at this point, which most of your competitors are well in excess of that.
Jeremy, that's a good question. There are a number of factors. First is some of these competitors that you mentioned, a lot of their business is basically on accessories and smaller items. That's where they do a lot of business. That's number one. The second is that our focus is to bring people into our design centers to meet our designers. That's where we get, not only we provide them great service, it also helps us have controlled service, less returns. Return is a big factor on furniture. I think those are two factors. I know that the number of the competitors that you may be referring to, they have fairly large, some furniture, but a lot of it is also non-furniture products, which they promote and they sell. We don't promote a lot of non-furniture as they do.
Is that a consideration then to potentially get more aggressive? If I think back a couple of years ago, when you had kind of your last run of nice success, you had a lot of new products, but you also got a little more aggressive on your promotions, and you saw a pretty significant jump in sales that allowed that operating leverage you mentioned, that financial leverage to really kick in. Is that something where that'd be a consideration here over the next couple of quarters, maybe to get a little more aggressive on that aspect of your business?
Well, we've got to see how we accomplish it, but it's critical that we take the opportunity of increasing sales because the leverage we have is major. Our whole focus is to increase sales. Now, as I said, our competitive advantage with having 1,200 interior designers is a major advantage. We want them to be the ones working with clients. We are recognizing 250 of them in two weeks. We do that every year. It's almost like our Academy Awards. It's a different business model because we are uniquely positioned as having, I would say, one of the best interior design networks. Yes, our focus here is to increase our sales because that has a major impact on our operating margins.
Okay, great. Well, thank you for taking the extra question.
Thanks very much, Jeremy.
Thank you. I show no further questions in queue, I'd like to turn the call back for closing remarks.
Well, thank you very much. As I mentioned in my opening remarks, and in fact also said in my comments in the press release, that more and more I see this opportunity of using our positioning, our strength as an interior design company with 200 great locations, 1,200 designers here, plus 500 others internationally, to bring traffic in, and then be able to utilize our vertical integration to increase sales and profits. Thanks very much. Any further questions, please feel free to give us a call.
Thank you. Ladies and gentlemen, that does conclude today's conference. Thank you very much for your participation. You may all disconnect. Have a wonderful day.