INTERFACE INC 10-Q

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Our discussions below in this Item 2 are based upon the more detailed discussions about our business, operations and financial condition included in our Annual Report on Form 10-K for the fiscal year ended January 1, 2023, under Part II, Item 7 of that Form 10-K. Our discussions here focus on our results during the quarter and six months ended July 2, 2023, or as of, July 2, 2023, and the comparable periods of 2022, and to the extent applicable, any material changes from the information discussed in that Form 10-K or other important intervening developments or information since that time. These discussions should be read in conjunction with that Form 10-K for more detailed and background information. The six-month periods ended July 2, 2023 and July 3, 2022 both include 26 weeks. The three-month periods ended July 2, 2023 and July 3, 2022 both include 13 weeks. Forward-Looking Statements This report contains statements which may constitute “forward-looking statements” within the meaning of the Securities Act of 1933, as amended, and the Securities Exchange Act of 1934, as amended by the Private Securities Litigation Reform Act of 1995. Important factors currently known to management that could cause actual results to differ materially from those in forward-looking statements include risks and uncertainties associated with the economic conditions in the commercial interiors industry as well as the risks and uncertainties discussed under the heading “Risk Factors” included in Part I, Item 1A of the Company’s Annual Report on Form 10-K for the fiscal year ended January 1, 2023. The Company undertakes no obligation to update or revise forward-looking statements to reflect changed assumptions, the occurrence of unanticipated events or changes to future operating results over time. 30 Table of Contents Executive Overview During the quarter ended July 2, 2023, we had consolidated net sales of $329.6 million, down 4.9% compared to $346.6 million in the second quarter last year, primarily due to decreased customer demand. Lower sales were primarily in the corporate office and retail market segments, partially offset by increases in the education market segment. Consolidated operating income was $28.9 million for the second quarter of 2023 compared to $34.5 million in the second quarter last year, primarily due to lower sales, lower manufacturing fixed cost absorption on lower manufacturing volumes, coupled with higher selling, general and administrative costs, partially offset by lower freight costs. Consolidated net income for the quarter ended July 2, 2023, was $15.8 million or $0.27 per share, compared to $16.8 million or $0.28 per share in the second quarter last year. During the first six months of 2023, we had consolidated net sales of $625.4 million, down 1.5% compared to $634.6 million in the first six months of last year, primarily due to decreased customer demand. Lower sales were primarily in the retail, corporate office and healthcare market segments, partially offset by increases in the education market segment. Consolidated operating income was $38.4 million for the first six months of 2023, compared to $61.9 million in the same period last year. Inflationary pressures on raw materials and lower manufacturing fixed cost absorption on lower manufacturing volumes adversely impacted our gross profit margin in the current year period coupled with higher selling, general and administrative costs and lower sales. Consolidated net income for the six months ended July 2, 2023, was $15.1 million or $0.26 per share, compared to $30.1 million or $0.51 per share in the same period last year. Cybersecurity Event As previously disclosed in our current report on Form 8-K filed with the Commission on November 23, 2022, we discovered a cybersecurity attack, perpetrated by unauthorized third parties, affecting our IT systems on November 20, 2022 (the “Cyber Event”). Promptly, out of an abundance of caution, we shut down certain systems including shipping, inventory management and production systems and engaged forensic experts to evaluate the extent of the Cyber Event and its impact to our operations. We took steps to supplement existing security monitoring, including scanning and protective measures, and notified law enforcement. We substantially resumed our operations within two weeks following the occurrence of the Cyber Event. During the first six months of 2023, we incurred approximately $0.9 million of additional expenses related to the investigation of the Cyber Event. These costs were primarily included in selling, general and administrative expenses in the consolidated condensed statement of operations. The investigation of the Cyber Event was substantially completed early in the third quarter of 2023. We have cyber risk insurance and anticipate that a portion of our costs and expenses related to the Cyber Event will ultimately be recovered by insurance. We expect to incur ongoing costs for enhanced data security against unauthorized access to, or manipulation of, our systems and data. Impact of Macroeconomic Trends The continued disruption in economic markets due to high inflation, increases in interest rates, the Russia/Ukraine war, a stabilizing but still challenging supply chain environment, a slow post COVID recovery in China, and significant financial pressures in the commercial office market globally, all pose challenges which may adversely affect our future performance. These impacts have increased our costs and adversely affected our gross profit margin. To mitigate these impacts, we plan to continue evaluating our cost structure and global manufacturing footprint to identify and activate opportunities to decrease costs and optimize our global cost structure. 31 Table of Contents Analysis of Results of Operations Consolidated Results The following table presents, as a percentage of net sales, certain items included in our consolidated condensed statements of operations for the three-month and six-month periods ended July 2, 2023 and July 3, 2022: Three Months Ended Six Months Ended July 2, 2023 July 3, 2022 July 2, 2023 July 3, 2022 Net sales 100.0 % 100.0 % 100.0 % 100.0 % Cost of sales 66.1 66.3 66.8 64.8 Gross profit 33.9 33.7 33.2 35.2 Selling, general and administrative expenses 25.9 23.5 27.5 25.2 Restructuring, asset impairment and other charges (0.8) 0.2 (0.4) 0.3 Operating income 8.8 10.0 6.1 9.7 Interest/Other expense, net 2.4 2.5 2.8 2.5 Income before income tax expense 6.4 7.5 3.3 7.2 Income tax expense 1.6 2.6 0.9 2.6 Net income 4.8 % 4.9 % 2.4 % 4.6 % Consolidated Net Sales Below is information regarding our consolidated net sales, and analysis of those results, for the three-month and six-month periods ended July 2, 2023, and July 3, 2022: Three Months Ended Percentage Change Six Months Ended Percentage Change July 2, 2023 July 3, 2022 July 2, 2023 July 3, 2022 (in thousands) (in thousands) Consolidated net sales $ 329,582 $ 346,605 (4.9) % $ 625,374 $ 634,607 (1.5) % For the quarter ended July 2, 2023, consolidated net sales decreased $17.0 million (4.9%) versus the comparable period in 2022, primarily due to lower sales volume (approximately 10%) partially offset by higher prices (approximately 5%). Currency fluctuations had a negative impact on consolidated net sales of approximately $0.8 million (0.2%) for the second quarter of 2023, due primarily to the weakening of the Australian dollar, Chinese Renminbi and Canadian dollar against the U.S. dollar, partially offset by the strengthening of the Euro against the U.S. dollar. On a market segment basis, the sales decrease was primarily in the corporate office, retail, consumer residential and leisure market segments partially offset by increases in the education market segment. For the six months ended July 2, 2023, consolidated net sales decreased $9.2 million (1.5%) versus the comparable period in 2022, primarily due to lower sales volume (approximately 5%) partially offset by higher prices (approximately 4%). Currency fluctuations had a negative impact on consolidated net sales of approximately $8.0 million (1.3%) for the first six months of 2023, due to the weakening of the Australian dollar, Euro, Chinese Renminbi, Canadian dollar and British Pound sterling against the U.S. dollar. On a market segment basis, the sales decrease was primarily in the retail, corporate office, healthcare and consumer residential market segments partially offset by increases in the education and public buildings market segments. 32 Table of Contents Consolidated Cost and Expenses The following table presents our consolidated cost of sales and selling, general and administrative expenses for the three-month and six-month periods ended July 2, 2023, and July 3, 2022: Three Months Ended Percentage Change Six Months Ended Percentage Change July 2, 2023 July 3, 2022 July 2, 2023 July 3, 2022 (in thousands) (in thousands) Consolidated cost of sales $ 217,796 $ 229,899 (5.3) % $ 417,715 $ 411,102 1.6 % Consolidated selling, general and administrative expenses 85,522 81,371 5.1 % 171,776 159,863 7.5 % Consolidated Cost of Sales For the quarter ended July 2, 2023, consolidated cost of sales decreased $12.1 million (5.3%) compared to the second quarter of 2022, primarily due to lower sales and freight costs. Currency translation had a positive impact on consolidated cost of sales in the second quarter of 2023 and partially reduced our costs by approximately $0.6 million (0.3%) compared to the same period last year. As a percentage of net sales, our cost of sales decreased to 66.1% for the second quarter of 2023 versus 66.3% for the second quarter of 2022. For the six months ended July 2, 2023, consolidated cost of sales increased $6.6 million (1.6%) versus the comparable period in 2022, primarily due to inflationary pressures on raw material costs and lower manufacturing fixed cost absorption on lower manufacturing volumes that have adversely impacted our gross profit margin. Currency translation had a positive impact on consolidated cost of sales for the first six months of 2023 and partially reduced our costs by approximately $5.7 million (1.5%) compared to the same period last year. As a percentage of net sales, our cost of sales increased to 66.8% for the first six months of 2023 versus 64.8% for the first six months of 2022. Consolidated Gross Profit For the quarter ended July 2, 2023, gross profit, as a percentage of net sales, was 33.9% compared with 33.7% in the same period last year. The increase was primarily due to higher pricing and lower freight costs mostly offset by lower manufacturing fixed cost absorption as discussed above. For the six months ended July 2, 2023, gross profit, as a percentage of net sales, was 33.2% compared with 35.2% in the same period last year. The decrease was primarily due to inflationary pressures on raw material costs and lower manufacturing fixed cost absorption as discussed above. Consolidated Selling, General and Administrative (“SG&A”) Expenses For the quarter ended July 2, 2023, consolidated SG&A expenses increased $4.2 million (5.1%) versus the comparable period in 2022. Currency fluctuations had no material impact on consolidated SG&A expenses in the second quarter of 2023 compared to the same period last year. SG&A expenses were higher for the second quarter of 2023 primarily due to (i) higher marketing expenses of approximately $1.5 million due to an increase in the cost of product samples, (ii) higher professional fees of approximately $1.0 million, (iii) higher severance costs of approximately $0.7 million driven by headcount reduction and cost saving initiatives, (iv) Cyber Event costs of approximately $0.4 million, and (v) the continuing impact of inflation. As a percentage of net sales, SG&A expenses increased to 25.9% for the second quarter of 2023 versus 23.5% for the second quarter of 2022. For the six months ended July 2, 2023, consolidated SG&A expenses increased $11.9 million (7.5%) versus the comparable period in 2022. Currency translation had a positive impact on consolidated SG&A expenses for the first six months of 2023 of approximately $1.1 million (0.6%) compared to the same period last year. Compared with the same period last year, SG&A expenses in the first six months of 2023 included (i) $6.1 million of higher selling expenses due to sales and marketing initiatives, (ii) higher severance costs of approximately $3.0 million driven by headcount reductions as discussed above, (iii) Cyber Event costs of $0.9 million and (iv) the continuing impact of inflation. As a percentage of net sales, SG&A expenses increased to 27.5% for the first six months of 2023 versus 25.2% for the first six months of 2022. 33 Table of Contents Restructuring Activities On September 8, 2021, the Company committed to a new restructuring plan that continued to focus on efforts to improve efficiencies and decrease costs across its worldwide operations, involving the closure of the Company’s manufacturing facility in Thailand at the end of the first quarter of 2022. During the second quarter of 2023, the Company completed the sale of the Thailand manufacturing facility and recognized a gain of $2.7 million. See Note 15 entitled “Restructuring and Other Charges” and Note 16 entitled “Assets Disposed” of Part I, Item 1 of this Quarterly Report on Form 10-Q for additional information. Interest Expense During the quarter ended July 2, 2023, interest expense was $8.3 million, an increase of $1.1 million from the comparable period in 2022, primarily due to higher interest rates on outstanding term loan borrowings under the Facility. For the six months ended July 2, 2023, interest expense was $16.8 million, an increase of $2.8 million from the comparable period in 2022, primarily due to higher interest rates as discussed above. Segment Operating Results AMS Segment – Net Sales and Adjusted Operating Income (“AOI”) The following table presents AMS segment net sales and AOI for the three-month and six-month periods ended July 2, 2023, and July 3, 2022: Three Months Ended Percentage Change Six Months Ended Percentage Change July 2, 2023 July 3, 2022 July 2, 2023 July 3, 2022 (in thousands) (in thousands) AMS segment net sales $ 201,281 $ 206,810 (2.7) % $ 370,522 $ 363,319 2.0 % AMS segment AOI (1) 24,034 28,389 (15.3) % 35,303 49,527 (28.7) % (1) Includes allocation of corporate SG&A expenses. Excludes Cyber Event costs, property casualty loss, and restructuring, asset impairment, severance and other costs. See Note 11 entitled “Segment Information” of Part I, Item 1 of this Quarterly Report on Form 10-Q for additional information. During the second quarter of 2023, net sales in AMS decreased 2.7% versus the comparable period in 2022, primarily due to lower sales in the retail, hospitality, and consumer residential market segments partially offset by increases in the education, corporate office and healthcare market segments. Higher selling prices partially offset a decrease in sales volume in the current quarter. During the first six months of 2023, net sales in AMS increased 2.0% versus the comparable period in 2022, primarily due to higher prices. The sales increase was primarily in the corporate office, education, healthcare and residential living market segments partially offset by decreases in the retail and consumer residential market segments. AOI in AMS decreased 15.3% during the second quarter of 2023 compared to the prior year period, primarily due to lower sales and lower manufacturing fixed cost absorption on lower manufacturing production volumes in the current period. AMS SG&A expenses as a percentage of net sales in the second quarter of 2023 increased approximately 1.1% due primarily to higher marketing expenses and inflation, which also contributed to the decrease in AOI for the current quarter. As a percentage of net sales, AOI decreased to 11.9% during the second quarter of 2023 compared to 13.7% in the same period last year. AOI in AMS decreased 28.7% during the first six months of 2023 compared to the prior year period, primarily due to higher raw material costs as a result of inflation and lower manufacturing fixed cost absorption in the current period. AMS SG&A expenses as a percentage of net sales for the first six months of 2023 increased approximately 1.2%, which contributed to the decrease in AOI for the first six months of 2023. As a percentage of net sales, AOI decreased to 9.5% during the first six months of 2023 compared to 13.6% in the same period last year. 34 Table of Contents EAAA Segment – Net Sales and AOI The following table presents EAAA segment net sales and AOI for the three-month and six-month periods ended July 2, 2023, and July 3, 2022: Three Months Ended Percentage Change Six Months Ended Percentage Change July 2, 2023 July 3, 2022 July 2, 2023 July 3, 2022 (in thousands) (in thousands) EAAA segment net sales $ 128,301 $ 139,795 (8.2) % $ 254,852 $ 271,288 (6.1) % EAAA segment AOI (1) 3,827 10,131 (62.2) % 7,756 19,635 (60.5) % (1) Includes allocation of corporate SG&A expenses. Excludes purchase accounting amortization, Cyber Event costs, Thailand plant closure inventory write-down, and restructuring, asset impairment, severance and other costs. See Note 11 entitled “Segment Information” of Part I, Item 1 of this Quarterly Report on Form 10-Q for additional information. During the second quarter of 2023, net sales in EAAA decreased 8.2% versus the comparable period in 2022. Slower economic recovery and decreased customer demand in Asia resulted in approximately 35% lower net sales in Asia during the current quarter compared to the same period last year. Higher prices partially offset lower EAAA sales volume. Currency fluctuations had no material impact to EAAA sales for the second quarter of 2023 compared to the same period last year. On a market segment basis, the EAAA sales decrease was primarily in the corporate office and healthcare market segments. During the first six months of 2023, net sales in EAAA decreased 6.1% versus the comparable period in 2022, primarily due to lower sales volume in Asia as discussed above. Higher prices partially offset lower EAAA sales volume. Currency fluctuations had a negative impact on EAAA sales of approximately $6.4 million (2.3%) for the first six months of 2023 compared to the same period last year due to the weakening of the Australian dollar, Euro, Chinese Renminbi and British Pound sterling against the U.S. dollar. On a market segment basis, the EAAA sales decrease was primarily in the corporate office, healthcare and retail market segments. AOI in EAAA decreased 62.2% during the second quarter of 2023 versus the comparable period in 2022 primarily due to the impact of lower sales volume, higher raw material costs as a result of inflation and lower manufacturing fixed cost absorption on lower manufacturing production volumes. Currency fluctuations had no material impact to EAAA AOI for the second quarter of 2023 compared to the same period last year. As a percentage of net sales, AOI decreased to 3.0% during the second quarter of 2023 compared to 7.2% in the same period last year. AOI in EAAA decreased 60.5% during the first six months of 2023 versus the comparable period in 2022, primarily due to the factors discussed above for the second quarter period. Currency fluctuations had a negative impact on AOI of approximately $0.9 million (2.6%) for the first six months of 2023 compared to the same period in 2022. As a percentage of net sales, AOI decreased to 3.0% during the first six months of 2023 compared to 7.2% in the same period last year. 35 Table of Contents Financial Condition, Liquidity and Capital Resources General At July 2, 2023, the Company had $92.9 million in cash. At that date, the Company had $174.1 million in term loan borrowings, $7.0 million in revolving loan borrowings, and $1.6 million in letters of credit outstanding under our Facility, and we had $300.0 million of Senior Notes outstanding. As of July 2, 2023, we had additional borrowing capacity of $291.4 million under the Facility. We anticipate that our liquidity is sufficient to meet our obligations for the next 12 months, and we expect to generate sufficient cash to meet our long-term obligations. The Senior Notes are unsecured and are guaranteed, jointly and severally, by each of the Company’s material domestic subsidiaries, all of which also guarantee the obligations of the Company under its Facility. The Company’s foreign subsidiaries and certain non-material domestic subsidiaries are considered non-guarantors. Net sales for the non-guarantor subsidiaries were approximately $142 million and $283 million for the three-month and six-month periods ended July 2, 2023, respectively, and net sales for the non-guarantor subsidiaries were approximately $152 million and $296 million for the three-month and six-month periods ended July 3, 2022, respectively. Total indebtedness of the non-guarantor subsidiaries was approximately $140 million as of July 2, 2023. Included in this $140 million is $102 million of indebtedness from the non-guarantor subsidiaries to guarantor subsidiaries as of July 2, 2023. Total indebtedness of non-guarantor subsidiaries was approximately $43 million as of January 1, 2023. There was no indebtedness from non-guarantor subsidiaries to guarantor subsidiaries as of January 1, 2023. Balance Sheet Accounts receivable, net, were $166.3 million at July 2, 2023, compared to $182.8 million at January 1, 2023. The decrease of $16.5 million was primarily due to customer collections in the first six months of 2023, including the impact of delays in customer billings from the Cyber Event, in which the due dates for those delayed billings were pushed from the fourth quarter of 2022 to the first quarter of 2023. Inventories, net, were $288.2 million at July 2, 2023, compared to $306.3 million at January 1, 2023. The decrease of $18.1 million was primarily due to lower manufacturing volume and lower freight costs. Analysis of Cash Flows The following table presents a summary of cash flows for the six-month periods ended July 2, 2023 and July 3, 2022, respectively: Six Months Ended July 2, 2023 July 3, 2022 (in thousands) Net cash provided by (used in): Operating activities $ 47,924 $ (12,708) Investing activities (4,738) (9,127) Financing activities (49,063) 21,518 Effect of exchange rate changes on cash 1,248 (5,282) Net change in cash and cash equivalents (4,629) (5,599) Cash and cash equivalents at beginning of period 97,564 97,252 Cash and cash equivalents at end of period $ 92,935 $ 91,653 Cash provided by operating activities was $47.9 million for the six months ended July 2, 2023, compared with $12.7 million of cash used in operating activities in the prior year comparable period. The increase in operating cash flows was primarily due to a greater source of cash from working capital during the first six months of 2023. Specifically, customer collections in the first six months of 2023 contributed to a decrease in accounts receivable, primarily attributable to delays in customer billings from the Cyber Event, in which the due dates for those delayed billings were pushed from the fourth quarter of 2022 to the first quarter of 2023. The 2022 six-month period also included a greater use of cash for working capital attributable to an increase in inventories compared with the six months ended July 2, 2023. 36 Table of Contents Cash used in investing activities was $4.7 million for the six months ended July 2, 2023, which represents a decrease of $4.4 million from the prior year period. The decreased use of cash from the comparable prior year period was primarily attributable to proceeds of approximately $6.6 million from the sale of the Company’s Thailand manufacturing facility in the second quarter of 2023, partially offset by higher capital expenditures due to increased capital investment. Cash used in financing activities was $49.1 million for the six months ended July 2, 2023, compared with $21.5 million of cash provided by financing activities in the prior year comparable period. The increased use of cash from the comparable period was primarily due to higher repayments of term loan and revolving loan borrowings in 2023 as a result of cash generated from operating activities as described above. The prior year comparable period also includes repurchases of the Company’s common stock that did not occur in 2023, which partially offset the increased use of cash for financing activities. Outlook We anticipate that net sales will potentially be flat, but more likely down in the third quarter of fiscal year 2023 compared with the third quarter of fiscal 2022. We are also anticipating decreases in the cost of raw materials and freight offset by continued lower manufacturing fixed cost absorption versus the comparable prior year period. As a result of these impacts, we are anticipating improvement in gross profit margin percentage in the third quarter of fiscal year 2023 compared to the comparable prior year period. We are also anticipating higher selling, general, and administrative costs in the third quarter of fiscal year 2023 versus the comparable prior year period primarily due to inflation. Cash flows from operations, cash and cash equivalents, and other sources of liquidity are expected to be available and sufficient to meet foreseeable cash requirements. However, the Company’s cash flows from operations can be affected by numerous factors — including raw material availability and cost, demand for our products, and the timing of accounts receivable collections and the timing of payments for accounts payable and accrued liabilities. Backlog As of July 23, 2023, the consolidated backlog of unshipped orders was approximately $214.7 million. As disclosed in our Annual Report on Form 10-K for the fiscal year ended January 1, 2023, backlog was approximately $197.4 million as of February 5, 2023. The increase in the backlog is due to the impact of delays and timing of construction projects and flooring installations. 37 Table of Contents