Armstrong Flooring Inc (AFI) Q4 2018 Earnings Conference Call Transcript

Looking at the transformation of our business on Page 4, we are confident that fundamentals remain strong for future growth in Resilient, where we have spent the past several years enhancing our exposure to the right product categories and markets and channels. LVT is now our largest product category representing nearly 1/3 of 2018 sales.

Vinyl composition tile, which is primarily commercial represents just over 1/4 of our sales. Commercial and residential sheet together are also around 1/4 of our sales. With the mix of our business more heavily weighted toward LVT, we expect to better realize a significant growth in that category, which continues to take share from all other flooring categories.

Several actions have shifted our business toward commercial in recent years, including the purchase of additional VCT assets in 2017 and a realignment of our sales and marketing efforts to focus more heavily on commercial and national accounts in 2018. With the completion of the Wood sale, our sales are now approximately 60% commercial where our margins are generally better. We believe our current end market mix is not only more balanced but situates us for stronger and more predictable results.

Roughly 3/4 of our sales are for renovation projects, which provides a less cyclical and more stable growth dynamic. Additionally, approximately 75% of our 2018 sales were through distribution, where we are able to leverage the local expertise of our distribution partners to get the right products in front of any users with exceptional service. Moving to our four strategic priorities on Page 5. All of these attributes I just described are aligned with our goal of gaining leadership in LVT supported by our growth strategies to drive innovation across our entire product portfolio, strengthen our distribution partnerships, particularly in commercial categories and leverage our strong position in other commercial categories.

In LVT, we achieved double-digit growth for the full year and fourth quarter, helped by our new innovative products that have allowed us to grow faster than the market. Following recent tariff developments, we believe there are meaningful opportunities to increase output of our domestically produced LVT, primarily through investing in and repurposing existing assets. In combination with our strategic sourcing initiatives, we are poised to continue taking share in LVT.

The Armstrong Flooring LVT portfolio was recognized by floor covering weekly's ReCo Market Intelligence Report as number one in retail residential brand recognition. And by the SPEC STAR Award by designer pages as the top specified brand by architects in commercial applications. These independent recognitions validate our investments in innovation and support our growth objectives in this attractive category. Innovation remains key to our success in all of our flooring categories, including advances in design, durability, installation, maintenance and material composition.

Our proprietary award winning Diamond 10 Technology continues to have good traction with customers in LVT, VCT and vinyl sheet. Three categories, which represent collectively about 85% of our sales. At the International Surfaces Event in January, we debuted several new products in LVT, including larger format Alterna Plank with Diamond 10 Technology and exciting new designs across our rigid core portfolio. In addition, we highlighted our domestic VCT with Diamond 10 Technology, which reduces total cost of ownership by 40%.

Beyond these products, we have an exciting pipeline and we plan to continue to invest in our broad and compelling portfolio of high demand products. In distribution, in 2018, we completed our go-to-market pivot, which has allowed us to allocate more of our marketing and sales efforts on commercial and national accounts where we believe we can better leverage our scale. We anticipate that our increased exposure to commercial through our exclusive focus on Resilient will amplify the benefits of this strategy.

On the residential side, the transition has been smooth and our distributors are in a position to provide the merchandising support for the retail customers, customized to their local needs. Not only will this increase the efficiency of our sales ecosystem, but it will also better serve local customers. We look forward to gaining additional share of wallet and aligning ourselves with partners who are best positioned to support our growth strategy.

The shift in distribution is directly aligned with our strategic objective to leverage our strong position in commercial, which represents a significant portion of our LVT products and the majority of our traditional categories. Our team is dedicated to improving our performance in commercial categories through innovation and cost efficiencies to more effectively grow our market presence.

Overall, we are actively augmenting our business across our products, channels and operations to drive better performance. We have simplified our business, improved our financial profile and strengthened our balance sheet to take advantage of significant opportunities ahead. We are committed to investing in our business to strengthen our position as a leader in resilient flooring.

I will now turn the call over to Doug to walk through the details of our financial performance.

Doug Bingham -- Chief Financial Officer

Thank you, Don, and good morning to those on the call today. I'll begin with the review of our full year results on Page 6. As a reminder, our results reflect our continuing operations, which are purely Resilient. For the full year 2018, net sales improved 3.4% to $728 million as compared to $704 million in the prior year.

The improvement in net sales was due to favorable mix and overall higher selling prices in response to inflationary pressure. LVT grew double-digits, helped by new products, market gains and the growing popularity of that category. Overall volume was lower due to softer shipments in traditional categories, especially residential sheet, which is now roughly 10% of our total sales.

Full year 2018 adjusted EBITDA improved 3.3% to $57.5 million as compared to $55.7 million in the prior year. The increase in adjusted EBITDA was primarily due to higher net sales, improved productivity and lower SG&A spending, which more than offset significant input cost inflation pressure. Excluding adjustments in connection with the Wood Flooring business divestiture, adjusted EBITDA under our prior basis of presentation was $59 million in 2018.

Now looking at our fourth quarter results on Slide 7, in the fourth quarter net sales decreased 3.5% to $154 million as compared to $159 million in the fourth quarter of 2017. The decrease in net sales was primarily attributable to lower volumes partly offset by improved mix and overall higher selling prices in response to inflationary pressure. While LVT achieved double-digit growth in the fourth quarter, our overall volume was impacted by two macro factors, particularly into year-end. We experienced soft end market demand, which was further compounded by a departure from normal seasonal trends and the timing of customer purchases. This was due to ongoing uncertainty regarding the eventual outcome of US tariff negotiations on Chinese imports.

To explain that a bit more, in the third quarter of 2018, we announced price increases on imported product, effective October 1, in response to the first round of 10% tariffs on Chinese imports. We also proactively announced further increases effective January 1 with the expectation that tariffs would increase to 25% as previously announced by the administration. The tariffs had a large impact on customer buying behavior across the overall market. In the middle of the fourth quarter, the January 1 tariff increase was called into question and eventually delayed by the administration. This created an air pocket in demand in the fourth quarter as a result of significant customer purchases pulled forward in the third quarter of 2018 ahead of price increases implemented in October. This was followed by muted pre-buy activity in the fourth quarter due to the delay of our tariff related price increase originally scheduled for January 1. Therefore, we experienced elevated inventory levels in the distributor channel during the fourth quarter. Lower sales and increased input cost inflation were the primary drag on adjusted EBITDA performance for the fourth quarter, partially offset by improved productivity and cost savings.

Turning to our free cash flow and liquidity on Slide 8, during 2018, we generated operating cash flow of approximately $63 million consistent with prior year. The timing of net working capital movements in Q4 was a favorable factor in this performance. For the full year, we invested $35 million on CapEx, which for a third straight year was below our run rate depreciation. Overall, we were pleased with our free cash flow performance of $27 million for the year.