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Edited Transcript of TILE earnings conference call or presentation 26-Jul-18 1:00pm GMT

Q2 2018 Interface Inc Earnings Call

ATLANTA Jul 30, 2018 (Thomson StreetEvents) -- Edited Transcript of Interface Inc earnings conference call or presentation Thursday, July 26, 2018 at 1:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Bruce Hausmann

Interface, Inc. - VP & CFO

* Christine Needles

Interface, Inc. - Global Head of Corporate Communications

* Jay D. Gould

Interface, Inc. - President, CEO & Director

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Conference Call Participants

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* Brian Biros

Thompson Research Group, LLC - Associate Equity Analyst

* David Sutherland MacGregor

Longbow Research LLC - CEO and Senior Analyst

* Judith Lynn Merrick

SunTrust Robinson Humphrey, Inc., Research Division - Associate

* Mason Irwin Marion

Instinet, LLC, Research Division - Research Analyst

* Matthew Schon McCall

Seaport Global Securities LLC, Research Division - MD and Furnishings & Senior Analyst

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Presentation

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Operator [1]

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Good morning, my name is Denise, and I'll be your conference operator today. At this time, I'd like to welcome everyone to the Q2 2018 Interface, Inc. Earnings Conference Call. (Operator Instructions)

Thank you. Christine Needles, Global Corporate Communications, you may begin your conference.

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Christine Needles, Interface, Inc. - Global Head of Corporate Communications [2]

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Thank you so much, Denise. And good morning, and welcome to Interface's conference call regarding second quarter 2018 results hosted by Jay Gould, President and CEO; and Bruce Hausmann, Vice President and CFO.

During today's conference call, management's comments regarding Interface's business, which are not historical information are forward-looking statements. Forward-looking statements involve a number of risks and uncertainties that could cause actual results to differ materially from any such statements, including 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, in Item 1A of the company's annual report on Form 10-K for the fiscal year ended December 31, 2017, which has been filed with the Securities and Exchange Commission. We direct all listeners to that document. The company assumes no responsibility to update or revise forward-looking statements made during this call and cautions listeners not to place undue reliance on any such forward-looking statements. Management's remarks during this call refer to certain non-GAAP measures. A reconciliation of these non-GAAP measures to the most comparable GAAP measures is contained in the company's earnings release and Form 8-K filed with the SEC yesterday.

Lastly, this call is being recorded and broadcasted for Interface. It contains copyrighted material and may not be rerecorded or rebroadcasted without Interface's expressed permission. Your participation on the call confirms your consent to the company's taping and broadcasting of it.

Now I'd like to turn the call over to Jay Gould, CEO.

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Jay D. Gould, Interface, Inc. - President, CEO & Director [3]

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Good morning, and thank you for joining our second quarter results call. It's an exciting time at Interface. We delivered another solid quarter of operating results with strong top line performance. We also announced our intent to acquire Nora Systems, a global leader in performance flooring and the worldwide share leader in the rubber flooring category. I again want to thank the entire global Interface team for their continued focus on results as we all concentrate on execution to deliver our value creation strategy. I'm proud to work alongside such a talented team and appreciate all the team members around the globe for the hard work that was done to deliver another solid quarter. I also look forward to working with the entire team as we enter the second half of 2018, and look forward to our continued focus to create value for all of our stakeholders, including our share owners, our employees, our customers, and of course, the environment.

Let me talk through some of the highlights of the second quarter. Once again, we delivered solid performance down the P&L, with second quarter GAAP net sales growth to 12.7% year-over-year and organic sales growth of 10.6%. We continue to see these increases across our portfolio, with core carpet tile and LVT contributing equally to our sales growth in the quarter.

Turning to order momentum, our organic orders, we adjust for the impact of foreign currency fluctuations, were up 9.7% year-over-year. Overall, the strong revenue in order trends are on pace with our expectations. As you may recall, during our quarter 1 earnings release, we anticipated that in the second quarter net sales would grow in the 9% to 11% range. So we were pleased to see the second quarter actual results in line with those expectations.

There are a number of key factors driving our revenue and order growth, which is enabling us to continue gaining share in the marketplace. First, and perhaps most importantly, our sales transformation plan that we kicked off in 2017 continues to be on track and is delivering results. Our frontline sales team continued to become more comfortable with our new selling methodology, the training they received and the support tools they have to improve their effectiveness and productivity. This gives us an important advantage in the marketplace as we continue to understand our customers better, activate qualified leads more effectively and work with our customers to ensure that everyone wins.

Second, our new product vitality is a strong as -- is very strong, as we've strategically planned our product development efforts in line with customer requirements across both carpet tile and LVT. In the second quarter, we launched a global carpet tile collection called Visual Code, which was designed by David Oakey who is a product designer exclusive to Interface. We've received very positive feedback from many customers who visited our showroom and our market space at this year's NeoCon.

Also, we launched our first in-house designed LVT called Drawn Lines, which was developed by Kari Pei, Interface's lead internal product designer. This new product earned the coveted interior design magazine HiP Award in the hard surface category at NeoCon. It was the first time that we ever submitted a resilient product in this category, and it was so great to win.

As we move into the back half of this year, we are on track to close the Nora acquisition in the third quarter, as we've planned. As explained during our announcement in June, this acquisition is a fantastic fit for us as it activates the second pillar of our value creation strategy to build a resilient flooring business. We expect the acquisition to accelerate growth as we expand our product portfolio in the performance flooring market and further penetrate key segments, which include healthcare, life sciences, and industrials where Nora is particularly strong. I'm really delighted with how smoothly this process is moving forward as we prepare to bring Nora into the Interface family. Bruce and I have already conducted Town Halls with over 650 of our new associates. We will have more to share about Nora in our integration plans on future earnings calls after the transaction officially closes.

Lastly, I'd like to highlight another important announcement we made at NeoCon during the second quarter. We are, once again, a leading industry as we are the first major global manufacturer to announce that all of our products, both carpet and LVT, are now carbon-neutral through our carbon neutral floors program. We offer this standard to every customer at no extra cost, which is a direct opportunity for our customers to meet their own carbon reduction goals and participate in our Climate Take Back mission. We were able to do this after significantly reducing carbon emissions of our products to already the lowest in the industry and then addressing the remaining carbon emissions through a modest carbon offset program. This is an incredible milestone for our company as we continue on our Mission Zero journey, and ultimately, endeavor to create a climate fit for life.

So with that, I'd like to turn the call over to Bruce for a review of our financial details. So Bruce, please go ahead.

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Bruce Hausmann, Interface, Inc. - VP & CFO [4]

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Good morning. Thanks, Jay. Good morning to everyone. And as a reminder, organic sales, organic sales growth and our great organic order growth adjust to exclude the impact of foreign currency fluctuations and the impact in Q1 last year, as we fully exit floor specialty retail.

In addition, adjusted operating income, adjusted net income and adjusted EPS adjust to exclude last year's Q1 charge related to exiting floor specialty retail and transaction costs related to the Nora acquisition.

Let's take a closer look at second quarter 2018 results. Second quarter GAAP net sales were $284 million, up 12.7% over the prior year period, and organic sales were up 10.6% year-over-year. Breaking our revenue down into more detail, net sales on the Americas grew 13.8% compared to Q2 last year with broad-based growth throughout the region. And in local currency, EMEA's net sales grew 5.6% year-over-year. In U.S. dollars, EMEA's net sales were up 13.9% year-over-year, as we benefited from currency tailwinds. And in Asia Pacific, net sales were up 2.8% compared to Q2 last year, with continued momentum in China.

Taking a look at global market segmentation. Core office saw a double-digit growth over the same period last year, and we continued to see increases in our non-office segments, including retail, healthcare, hospitality and education. Q2's organic growth were up 9.7% year-over-year, with carpet tile and LVT contributing relatively equally. Orders -- I'm sorry, Q2's gross margin was 38.5%, reflecting a 40 basis point year-over-year decrease as a result of delayed productivity initiatives due to increased sales volume and a change in this quarter's revenue mix that was more heavily weighted toward our Interface services business. And SG&A expenses were $75 million or 26.6% of net sales, which included $3 million of transaction costs related to the Nora acquisition. Now excluding these transaction costs, SG&A was 25.5% of net sales, which was a 10 basis point improvement year-over-year.

Second quarter operating income was $34 million or 11.9% of net sales compared with $34 million or 13.3% in the prior year period, and adjusted operating income was $37 million or 12.9% of net sales. And Q2's GAAP net income was $21 million or $0.35 per diluted share compared to $21 million or $0.33 per diluted share in Q2 of last year, and adjusted net income was $25 million or $0.42 per diluted share, which compares to $0.33 per diluted share last year.

Moving to the balance sheet and cash flow statement. We ended Q2 with $67 million of cash on hand, $244 million of debt and strong liquidity as we had $163 million available under our revolving credit facility. Interest expense was $2.3 million in the second quarter compared with $1.7 million in Q2 of last year. In Q2, depreciation and amortization was $8.5 million compared with $7.5 million in Q2 of last year. And Q2's capital expenditures were $9 million compared to $7 million in Q2 of last year.

Lastly, I'd like to mention that as part of financing the Nora acquisition with debt, the company's existing credit facility will be amended and extended to effectively refinance all of the company's current debt and incorporate new debt from the Nora transaction. Now depending on future LIBOR rates, it's anticipated that the near-term weighted average cost of debt under the refinancing will be 3.5% to 4%, and the new maturity date of the company's credit facility will be 5 years from the Nora transaction close date. This is a fantastic outcome for Interface as we're able to finance the Nora transaction at very favorable rates, refinance our existing debt and push the maturity dates of both components out for 5 years. As mentioned previously, when we close the Nora transaction, we will expand our net debt leverage ratio to approximately 3x EBITDA at closing, and we anticipate decreasing that ratio to approximately 2x EBITDA by mid-2020.

And now I'd like to turn the call back to Jay to provide an update on our fiscal year 2018 outlook.

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Jay D. Gould, Interface, Inc. - President, CEO & Director [5]

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Thanks, Bruce, so happy you are on the team. We continue to focus on execution of our strategic agenda to become the world's most valuable interior products and services company. And with the planned acquisition of Nora systems, we anticipate to accelerate our value creation. In the first half of 2018, we delivered EPS growth consistent with our expectations, a 30% increase in year-to-date GAAP EPS and a 26% increase in year-to-date adjusted EPS. This growth rate puts us on track to deliver our full year commitments.

Let me walk you through the building blocks of our 2018 outlook, again, before we wrap up our prepared remarks.

Looking at the full year of 2018, Interface's existing carpet tile and LVT business is targeting to achieve a 4% to 7% organic sales growth, gross profit margin of approximately 39%, and SG&A expenses that are relatively flat to 2017 as a percent of sales. Depending on the exact date of the transaction formally closing, which will determine when Nora's business results start being included in the Interface's business results, the Nora acquisition is anticipated to have the following impacts on Interface's targeted full year 2018 results: it will increase gross profit margins by 30 to 50 basis points; will increase SG&A expenses as a percentage of net sales by 70 to 100 basis points; it'll increase the company's effective tax rate to 27% to 28%; and it'll improve adjusted EPS by $0.03 to $0.06 in 2018.

Full year post-closing company interest and other expenses are projected to be $17 million and $19 million, which includes interest expense related to funding the Nora acquisition through a term loan facility. Capital expenditures for the full year post closing are expected to be $50 million to $60 million. Based on historic seasonality, current forecast and prior year comparables, the company continues to expect a strongest operating net income growth in the second and third quarters, with softer growth in the first and fourth quarters.

In summary, 2018 will be a very solid year with meaningful progress on our strategic agenda. Sales force transformation, innovation that drives incremental growth, investments in our global supply chain and enhanced productivity continued progress in our industry-leading sustainability programs and upgrading talent and capabilities for future growth. And our financial performance in 2018 marks another high-water spot for the company.

And so with that, I'll turn to the operator for questions.

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Questions and Answers

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Operator [1]

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(Operator Instructions) Your first question comes from Brian Biros with Thomson Research.

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Brian Biros, Thompson Research Group, LLC - Associate Equity Analyst [2]

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Given the slight drop in margins due to the productivity delays from the increased volumes, you know it's a good problem to have. Can you add any color to how we think about that going into the back half of the year? And if continued sales volume growth might cause any further delays? And if that poses any risk to reaching the full year at 39% guidance?

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Jay D. Gould, Interface, Inc. - President, CEO & Director [3]

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Well, first of all, we would feel very confident in the 39% that we've talked about. We began the year saying the range was going to be 39% to 39.5%. We've had about a $5 million delay in some of our productivity initiatives. So that's a 50 bp hit for the year. We do anticipate back-half margins being slightly stronger than front-half margins, as our productivity programs will achieve the targeted number. We are not experiencing input cost inflation from raw materials that we've heard other companies talk about. I think we appropriately forecast those for the year, and all of our raw materials are coming in as planned.

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Operator [4]

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Your next question comes from Michael Wood with Nomura Instinet.

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Mason Irwin Marion, Instinet, LLC, Research Division - Research Analyst [5]

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This is Mason Marion on for Mike. So last night, one of your peers reported that they are experiencing issues sourcing enough LVT. Were you impacted by these shortages during the quarter? Are you seeing shortages currently?

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Jay D. Gould, Interface, Inc. - President, CEO & Director [6]

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No, we're not. We're not seeing any shortages. And the other thing I would add to that, Mason, is we are not subject to the tariff conversations. We are not sourcing out of China. We actually sourced out of Korea. And we made the decision because we went into the business in an asset-light way, we went heavy in the working capital. So we've got plenty of inventory to support the growth of LVT, which, by the way, is exceeding our expectations. LVT continues to do really well in the market.

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Mason Irwin Marion, Instinet, LLC, Research Division - Research Analyst [7]

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Great. And then you reported another quarter of strong growth here. Is there anything you'd call out that's driving this order growth? Or was there perhaps another large order in there like you called out in 1Q?

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Jay D. Gould, Interface, Inc. - President, CEO & Director [8]

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No, I mean, we're doing really well with one of our retail customers in the U.S. who are remodeling a bunch of stores. But we've seen broad-based growth really across the portfolio, whether it's carpet or LVT plus geographically. I think Bruce talked a little bit about the strength in the U.S., but seeing Europe come back with 6% organic growth in local currency, really strong. So we're feeling the impact, I think, of 2 big things: one, our salesforce transformation efforts that we started last year; and two, our new products are really driving incremental growth.

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Bruce Hausmann, Interface, Inc. - VP & CFO [9]

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The other thing I would add, Jay, is the segmentation was so strong this quarter. We had growth in core office, we had growth in retail, healthcare, hospitality and education. And so just from a segmentation standpoint, it was a fantastic quarter.

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Jay D. Gould, Interface, Inc. - President, CEO & Director [10]

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Yes.

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Operator [11]

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Your next question comes from Matt McCall with Seaport Global Securities.

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Matthew Schon McCall, Seaport Global Securities LLC, Research Division - MD and Furnishings & Senior Analyst [12]

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So maybe hit those -- that $5 million again. I just wanted to understand a little bit more. So you said there were 2 things you called out. You talked about mix pressures and you talked about productivity delays, I guess. What -- how -- is that $5 million, does it encompass both of those sources of pressure?

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Jay D. Gould, Interface, Inc. - President, CEO & Director [13]

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Yes, it does, Matt. On the labor front, I'll say 2 things. I mean, we've had to add more people on the plants to produce this amount of volume; and we've run every Sunday for the last 4 months, which is a labor rate issue. So the mix issue is related to our services business. Although we make a similar margin on selling carpet, we make a much lower margin on labor because it's not our own labor, we use sourced labor. So we don't mark it up as much. So the gross margin on that piece of business is lower.

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Matthew Schon McCall, Seaport Global Securities LLC, Research Division - MD and Furnishings & Senior Analyst [14]

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So out of the $5 million -- go ahead.

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Bruce Hausmann, Interface, Inc. - VP & CFO [15]

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Yes, I just want to clarify, as you know, we're on a journey to capture $30 million of cost productivity, we captured $10 million last year. We're going to -- we're still going to capture that $10 million of this year. It's just a little bit of a pause, and then we're going to capture $10 million next year or so. This is just a short-term pause, and we continue to be on track across the company on our journey.

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Jay D. Gould, Interface, Inc. - President, CEO & Director [16]

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Yes, we'll exit '19 exactly where we expected to be.

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Matthew Schon McCall, Seaport Global Securities LLC, Research Division - MD and Furnishings & Senior Analyst [17]

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And then when you talk about the cost-savings initiatives and the manufacturing changes in South Georgia, can we -- can you talk about the steps along the way? What -- I understand the cost savings and that's helpful, but what's occurring? And then, beyond the cost savings, how much of that is going to help eliminate the productivity issues and the need for temporary laborers working Sundays, things like that? I'm just trying to understand, as we hit these thresholds, what actually occurs at the facilities?

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Jay D. Gould, Interface, Inc. - President, CEO & Director [18]

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Well, we are building extensions on to an existing manufacturing location. So the first step, Matt, was, 18 months ago, we put in a proof of concept tufting operation to prove that we could run this long-run facility. Then over the course of last year, we were in the process of then installing more tufting machines. So we now have 7 tufting machines. We'll ultimately have 12 to 14 tufting machines, but we had to build an extension on to the building. So that's in process right now. That will be fully complete by the end of this year. So we'll add the other 5 to 7 tufting machines. Then we have to build another hundred-thousand-square-foot extension on to that facility, which is already planned but we haven't started construction on that. We'll complete that at the end of 2019. So then that facility will be fully built out and will be delivering on the $30 million of savings that we promised. We actually have another initiative that starts in '20 and will go through '20 and '21, which will bring additional productivity benefits, so beyond the $30 million. So we still have a lot of room left in that productivity funnel.

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Matthew Schon McCall, Seaport Global Securities LLC, Research Division - MD and Furnishings & Senior Analyst [19]

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Okay, and then -- thanks, that's very helpful, Jay. I guess, the way of your question will be, give me an update on that CapEx plans associated with this. How they're going to layer in over the next few years, including -- are there any additional -- is there any additional spending tied to that 2020 to 2021 plan?

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Jay D. Gould, Interface, Inc. - President, CEO & Director [20]

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Well, I mean, I just said, we're going to spend $50 million to $60 million this year, which includes Nora, by the way. So we're slightly delayed a little bit inside our -- build out it in La Grange. But we're fine, we'll probably spend a similar amount next year, $50 million to $60 million, as we tackle that 100,000-square foot addition. We'll give some guidance for next year, probably as we get into the fourth quarter because we need to get through Nora, to be honest with you. They have relatively modest capital spending, but we just want to make sure we need to dive into their planning.

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Matthew Schon McCall, Seaport Global Securities LLC, Research Division - MD and Furnishings & Senior Analyst [21]

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Okay. And I'm sorry, one more question for me. You talked about the strength in office and -- but if you talked about this segmentation benefits in the quarter. But can you just talk about your overall cyclical view point, Jay? As we come to some of these policy changes in Washington, we've seen some of the macro indicators, we watched kind of show some improvement. What's -- have you seen any changes -- obviously, the top ones are working pretty well, but have you seen any changes? And then, how has it changed your outlook as we move out in the '19 just from pure cyclical perspective?

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Jay D. Gould, Interface, Inc. - President, CEO & Director [22]

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Well, look, I think a lot of the conversations coming out of Washington is purely negotiation tactics. If tariffs are enacted, we've got our assets deployed globally, so we're fine. We forecast no penalty if the tariffs do get enacted. I think, yesterday, we made progress with Europe. So it's feeling still pretty robust. I mean, we're going to see global GDP announced, I think, later this week, but we're feeling the positive impact of global economic growth. And even on our European business, I mean, being up 6%, Matt, in the quarter, I mean, that's a pretty solid growth for us.

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Operator [23]

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Your next question comes from David MacGregor with Longbow Research.

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David Sutherland MacGregor, Longbow Research LLC - CEO and Senior Analyst [24]

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Jay, if I could just start on LVT, and you kind of set this question up a little bit earlier in responding to the sourcing question, but the 2 things are really, sort of, distinguish your LVT business to me is, number 1, you're not really sourcing. You've got a contract manufacturing arrangement, if I understand that correctly, which is -- as maybe some nuanced differences, but it's more reliable supply channel. And then secondly, as you pointed out, it's Korea rather than China. So I guess, the question here is as these tariffs start to unfold, then whether they actually ultimately come to pass or whether this is a bunch of saber rattling, I guess, remains to be seen. But let's assume for a moment, it does come to become some kind of a meaningful impediment for foreign floor in the U.S. market. How much of a competitive advantages that's expected to provide to you and if you size that at all?

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Jay D. Gould, Interface, Inc. - President, CEO & Director [25]

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Let me first validate a couple of your assumptions, and then I'll talk about the tariffs. Absolutely, this is contract manufacturing, not sourced. We design the product and then went to look for a world-class manufacturer to make it for us. We chose a company in Korea. It's actually owned by a Japanese company. So we have redundant manufacturing capabilities in 2 different countries in Asia. We -- when we launch a business, we said we do $50 million in the second year, and we are well on track to actually beat that. Are there upsides? Potentially. We haven't really factored that into our outlook because I don't know how to factor it in. All I can say is the business continues to gain momentum around the world.

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David Sutherland MacGregor, Longbow Research LLC - CEO and Senior Analyst [26]

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Yes. If you were to pick up an extra 10% market share, 5% market share, can you quantify what that increment would represent in terms of revenue?

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Jay D. Gould, Interface, Inc. - President, CEO & Director [27]

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That's massive, and I'd like to say, so the carpet tile business globally commercial is $4.4 billion growing at a couple of percent. Our metrics would say, the commercial LVT business is $2.7 billion category growing at 10-plus percent. So we're just skimming the market right now with our $50 million business, right. We have a plenty of room to grow. If we picked up 5 share points, it would be huge.

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David Sutherland MacGregor, Longbow Research LLC - CEO and Senior Analyst [28]

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Okay, I got that. Just a couple of questions. You've got some competitors right now that are bringing on carpet tile capacity in both U.S. and Western Europe. Could you just talk about the degree of overlap with your offering and how you're responding to that?

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Jay D. Gould, Interface, Inc. - President, CEO & Director [29]

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Well, despite the threat that the sky is falling, we haven't felt any of that. As you know, those -- the majority of that expanded capacity is in a piece of the industry where we don't really compete, which is $10 square yard carpet tile, and our average selling price is north of $20. So in the dealer market and the low end of the market, I think engineered floor is going to make progress. I mean, I think Bob [Shawl] is a really smart guy. But we haven't seen any impact on our business at all. And as the numbers would show, David, we are taking market share.

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David Sutherland MacGregor, Longbow Research LLC - CEO and Senior Analyst [30]

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Yes, that would appear to be the case. Interface services, is this kind of a one-quarter event? Or should we anticipate this continuing through the second half?

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Jay D. Gould, Interface, Inc. - President, CEO & Director [31]

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We're also anticipating a really strong third quarter overall and with services. I think we'll have 8% to 10% revenue growth in the third quarter -- organic revenue growth in the third quarter.

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Operator [32]

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(Operator Instructions) Your next question comes from Judy Merrick with SunTrust.

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Judith Lynn Merrick, SunTrust Robinson Humphrey, Inc., Research Division - Associate [33]

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Judy in for Keith. Just to clarify a couple of items. You've talked about the double-digit growth in the core office, is that in Americas or is that global or kind of all across your geographies?

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Bruce Hausmann, Interface, Inc. - VP & CFO [34]

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Yes, Judy, it was all across. We had a really strong progress in office in all 3 of our regions.

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Judith Lynn Merrick, SunTrust Robinson Humphrey, Inc., Research Division - Associate [35]

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And it was kind of consistent through the quarter from the -- would you say?

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Bruce Hausmann, Interface, Inc. - VP & CFO [36]

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It was. It was. It was a good, smooth quarter.

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Judith Lynn Merrick, SunTrust Robinson Humphrey, Inc., Research Division - Associate [37]

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Okay, great. And also, in the first quarter, you mentioned a large customer order hitting sales in 2Q and 3Q. Do you -- is that still your expectation? And also, can you remind me of that? Mostly LVT, or carpet tile or kind of a mix for that large customer.

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Jay D. Gould, Interface, Inc. - President, CEO & Director [38]

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Yes, it was the large retail customer that are remodeling a bunch of stores here in the U.S. And it primarily is impacting Q2 and Q3. Sorry, what was the other part of the question? Oh, it's mostly carpet.

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Operator [39]

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And there are no further questions queued up at this time. I'll return the call back over to Jay Gould.

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Jay D. Gould, Interface, Inc. - President, CEO & Director [40]

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Thanks, Denise. Thanks, everyone, for participating. We feel very good about the quarter, and the year is shaping up exactly as we thought it would. Really pleased with the execution across the company and look forward to the next quarter call. Thanks for participating.

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Operator [41]

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This concludes today's conference call. You may now disconnect.