Michael Ressler; Chief Financial Officer, Treasurer, Company Secretary; Flexsteel Industries Inc
Derek P. Schmidt; President and CEO; Flexsteel Industries Inc
Anthony Lebiedzinski; Analyst; Sidoti & Company, LLC
Operator
Good morning, and welcome to the Flexsteel Industries second quarter fiscal year 2025 earnings conference call. (Operator Instructions) Please note this event is being recorded.
I would now like to turn the conference over to Mike Ressler, Chief Financial Officer for Flexsteel Industries. Please go ahead.
Michael Ressler
Thank you, and welcome to today's call to discuss Flexsteel Industries second quarter fiscal year 2025 financial results. Our earnings release, which we issued after market close yesterday, Monday, February 3, is available on the Investor Relations section of our website at www.flexsteel.com, under News and Events.
I'm here today with Derek Schmidt, President and Chief Executive Officer. On today's call, we will provide prepared remarks, and then we will open the call to your questions.
Before we begin, I would like to remind you that the comments on today's call will include forward-looking statements, which can be identified using words such as estimate, anticipate, expect and similar phrases. Forward-looking statements, by their nature, involve estimates, projections, goals, forecasts and assumptions and are subject to risks and uncertainties that could cause actual results or outcomes to differ materially from those expressed in the forward-looking statements.
Such risks and uncertainties include, but are not limited to, those that are described in our most recent annual report on Form 10-K and updated by our subsequent quarterly reports on Form 10-Q and other SEC filings as applicable.
These forward-looking statements speak only as of the date of this conference call and should not be relied upon as predictions of future events. Additionally, we may refer to non-GAAP measures which are intended to supplement but not substitute for the most directly comparable GAAP measures. The press release available on the website contains the financial and other quantitative information to be discussed today as well as the reconciliation of the GAAP to non-GAAP measures.
And with that, I will turn the call over to Derek Schmidt, Derek?
Derek P. Schmidt
Good morning, and thank you for joining us today to discuss our second quarter results. We continued our strong momentum from the first quarter, delivering sales growth of 8.4% compared to the prior year quarter, which exceeded the top end of our guidance range and represents our fifth consecutive quarter of mid-single to low double-digit year-over-year growth.
In addition, we continue to expand our operating margin and deliver strong positive free cash flow which allowed us to pay off our remaining bank debt and begin accumulating cash.
While overall industry demand remained soft, many of our retail partners were encouraged by improved traffic trends and sales close rates during the recent holiday season, which provides optimism that demand declines may have bottomed and the industry could be positioned to start growing again, albeit modestly in calendar 2025.
Feedback from our recent participation at the Las Vegas market last week, further reinforced my confidence in our ability to continue growing. Retailer appointments were up 18% versus the prior year's market, engagement with top 100 retailers with especially strong and overall retailer response on new products we launched last October continued to be very positive and new placements for those new products continues to ramp. As we've demonstrated over the past 15 months, we can deliver attractive, profitable growth and gain share even in challenging industry conditions.
As it relates to our sales growth, I'm especially encouraged because our growth was broad-based. We solidly grew in our core markets while simultaneously delivering growth in all our new and expanded market initiatives, which includes Zecliner, Flex, Charisma, big box sales distribution and case goods product.
It's the breadth of our growth drivers in our business that gives me strong confidence in our ability to continue our growth trajectory despite lackluster industry growth prospects near term. I largely attribute our continued success to our exceptional talent and continued investments in product development, innovation, customer experience and marketing.
I'm also especially pleased with our progress driving meaningful year-over-year profitability improvement. Operating margin was 6.1% in the quarter, up compared to 4.6% in the prior year quarter and represents our sixth consecutive quarter of year-over-year adjusted operating margin improvement.
The levers driving our consistent profit improvement are unchanged and working effectively and include sales growth leverage, strong operational execution and productivity and product portfolio management.
As we look forward to the remainder of our fiscal year 2025, our current outlook for the industry and broader economy remains moderately positive. Although any major policy changes from the new Trump administration could have a meaningful and potentially adverse impact on our industry and company and could materially change our outlook.
More specifically, changes in tax, immigration, regulation and trade policies could be inflationary, which would create additional pressures on consumer spending and likely postpone reductions in mortgage rates and a recovery in housing.
Additionally, higher tariffs could be very disruptive given the high percentage of furniture that is currently imported into the US. Even for US furniture manufacturers, there remains a meaningful amount of product inputs like fabric, leather, mechanisms and switches that originate from outside the US and would be subject to higher tariffs.
Near term, tariffs are the most significant risk, and we're working multiple plans to mitigate the risk. Since the pandemic, we've made significant strides in building supply chain agility and resilience to maneuver potential challenges like this, and those efforts continue.
Today, our primary tariff exposures reside in Vietnam and Mexico. Vietnam production supports roughly 50% of our current revenue and our Mexican operation supports almost 40% of sales. The executive orders announced this weekend to implement 25% tariffs on Mexico and Canada introduced significant uncertainty and could materially change our business outlook given our sizable operations in Mexico.
The current situation is dynamic and the magnitude of the profit and free cash flow impact on our business is dependent on the ultimate amount and duration of tariffs. To mitigate these risks, we have and will continue to identify new sources of high-quality supply in countries with lower tariff risk. We also are broadening the amount of product that can be dual sourced from multiple countries to provide additional agility.
While reconfiguring our global supply chain in response to major tariffs would not be easy or fast and tariffs could inevitably have a material impact to margins in the short term, I do feel confident that we are as well prepared as any of our competitors to swiftly optimize our network in response to such a reality.
Additionally, if it becomes evident that the likely duration of new tariffs will be extensive, we will need to consider taking additional pricing but only after contemplating the potential impact of such pricing on both consumer demand and our competitive position.
In summary, we are executing well on what we can control, continue to wisely invest in key enablers to drive long-term growth and remain confident in our strategies and ability to deliver growth, exceeding the industry barring a highly disruptive external event. We're encouraged by our earnings momentum and believe that continued sales growth could drive meaningful operating leverage and margin expansion long term.
The business environment is dynamic right now, but that has been true for the better part of my five-year tenure at Flexsteel. And as a result, we've learned as a company to prepare for and be highly adaptive to new situations. I'll be back momentarily to share my thoughts on our outlook.
With that, I'll turn the call over to Mike who will give you some additional details on the financial performance for the second quarter and the financial outlook for the third quarter. Mike?
Michael Ressler
For the second quarter, net sales were $108.5 million or growth of 8.4% compared to net sales of $100.1 million in the prior year quarter. As Derek mentioned, this marks our fifth consecutive quarter of year-over-year sales growth and exceeded the high end of our guidance range of $103 million to $107 million.
From a profit perspective, the company delivered GAAP operating income of $11.7 million or 10.7% of sales in the second quarter. When excluding a $5 million pretax gain from the sale of our Dublin, Georgia facility, adjusted operating income was $6.7 million or 6.1% of net sales. The 6.1% adjusted operating margin was within our guidance range of 5.5% to 6.5% and a 150 basis points increase from the prior year quarter.
Sales growth, leverage and cost-savings initiatives are the primary drivers of operating margin expansion compared to the prior year period. From a balance sheet and cash flow perspective, the company generated $6.7 million of operating cash flow in the quarter and ended the quarter debt-free.
The company received $6.7 million in proceeds from the sale of our Dublin, Georgia facility in the quarter and invested an additional $1 million in CapEx, primarily for modernization of ERP systems. We ended the quarter with $98.1 million of working capital, a cash balance of $11.8 million and no balance on our line of credit.
Moving to our outlook. Sales guidance for the third quarter is between $110 million and $115 million, reflecting 3% to 7% growth compared to the prior year quarter. Sales growth will be driven primarily by unit volume growth and to a lesser extent, pricing from ocean freight surcharges that remain in place to offset higher ocean freight costs.
Regarding profitability, the situation of tariffs is dynamic, as Derek noted, and we will assess the impact from potential tariffs on profitability in the coming days and weeks as we gain additional clarity on whether or not the US can reach a timely resolution with its North American trading partners to avoid a protracted trade war.
Excluding tariff impacts, we expect gross margin between 21.0% and 22.0% in the third quarter, with sales growth leverage more than offsetting dilution from higher ocean freight costs and Mexico wage inflation.
We expect SG&A costs between $16.5 million and $17.2 million, and we will continue to prioritize high ROI investments and new product innovation and marketing to accelerate our growth strategy. Excluding tariff impacts, we project operating margin in the range of 6.0% to 7.0% for the third quarter and expect free cash flow for the quarter in the range of $4 million to $7 million.
Near-term priorities for cash remain resourcing new innovation, customer experience initiatives and funding capital expenditures. For the third quarter, we expect capital expenditures between $0.7 million and $1.0 million, primarily for modernization of ERP systems and supply chain maintenance.
Besides tariffs, the most significant driver of variability in the third quarter guidance range are consumer demand, competitive pricing conditions and ocean freight rates, all of which will be shaped by macroeconomic factors.
To reiterate, our outlook assumes no major economic impact from near-term US policy changes, including trade and tariffs, which could materially change our business forecast. Given our sizable operations in Mexico, we anticipate that a potential tariffs on Mexican imports impact on our profitability and free cash flow, but the current situation is dynamic and the profit impact is dependent on the ultimate magnitude and duration of such a tariff as well as subsequent changes in foreign exchange rates.
If we gain better clarity and there is a material change in our outlook, we will update our guidance. As Derek noted, we have multiple strategies that we are working to both strengthen our supply chain agility and resilience and mitigate tariff risks.
Now I'll turn the call back to Derek to share his perspectives on our outlook.
Derek P. Schmidt
Thanks, Mike. While the impact of tariffs remains a large risk near term, I believe that our commitment to customer experience and innovation, combined with the other foundational growth investments we've made have positioned us well to drive continued top line growth throughout fiscal year 2025.
We have a balanced, diversified portfolio of growth initiatives, supported by tight alignment of both financial and human resources that gives me confidence that our growth momentum is sustainable. We have ample manufacturing and distribution capacity to support continued growth with minimal fixed cost investments, and as such, believe the earnings growth potential of the company is compelling with additional sales volume leverage.
In summary, Flexsteel is financially strong, growing sales, improving profitability, generating cash and aggressively investing for the future. We have confidence in our ability to continue delivering healthy results in fiscal year 2025 and as important, to position the company for sustainable, long-term profitable growth.
With that, we will open the call to your questions. Operator?
Operator
(Operator Instructions) Anthony Lebiedzinski, Sidoti & Co.
Anthony Lebiedzinski
Certainly a nice job in a still tough operating environment. So I have a few questions about the quarter, and then I'll follow up about tariffs. So as far as the top line, what were the main reasons for your revenue being better than your guidance that you provided a couple of months ago? And if you could -- as a follow-up to that, maybe if you could just parse out the growth of your core business versus the growth initiatives?
Derek P. Schmidt
Yeah. Good morning, Anthony. So in terms of really the driver for the outperformance, as I alluded to in my opening comments, really pleased with the broad-based growth that we're seeing across just about every element of our business, maybe with the exception of our home styles ready-to-assemble brand.
So why the outperformance? I think we just continue to gain momentum. What's working really well for us right now is this combination of driving relevant new product development and providing compelling values to the market. We're driving innovation.
We're ramping up our marketing, and we're seeing great results and return from that. And simultaneously, we continue to enhance the customer experience and ensure that we are the preferred partner for our retail partners. So I think it's really the combination of those four things that is enabling us to continue this momentum.
To provide a bit of additional details in terms of growth levers, we do talk about the core markets, which I can parse out into Flexsteel brand versus our home style brand. What I was really encouraged by is our Flexsteel branded core markets were up 7% in the quarter. So again, we are continuing to drive new product development innovation that's resonating really well, and we're gaining momentum there.
Now on the flip side, we've got the small home styles ready-to-assemble brand that's largely sold online, Amazon, Wayfair, homedepot.com, that category continues to struggle. It's lower price points. It's been hypercompetitive due to a really low-cost Chinese imports. And so that business was almost down 30% in the quarter.
And then when you look at our expanded market initiatives, and that includes everything from the Zecliner, Flex, case goods, Charisma, each one of those actually contributed to year-over-year growth in terms of our results. In total, growth for our expansion initiatives were up 92% year-over-year.
So again, when you think about how we're executing in our core markets with the Flexsteel brand and then you add on top of it the success we're having in terms of our new expanded market initiatives, it really gives me confidence that our growth trajectory and our growth momentum is sustainable here as we pivot into the second half of the fiscal year.
Anthony Lebiedzinski
That's great to hear. And then in terms of the gross margin, there was some impact from ocean freight costs. Just wondering what are you seeing with these costs? Do you expect to continue with ocean freight surcharges? What is your thinking on that?
Michael Ressler
Yeah, Anthony, this is Mike. So as far as what we've seen with rates is that they remain volatile. They are lower than what we were paying in kind of the first quarter, but it certainly has a dilutive effect on our margin as we're just passing that cost through to try to maintain as good retail price points as we can for our partners.
But we're going to continue to assess the situation. We look at rates regularly, and our plan would be to adjust accordingly, but certainly to try to recover those costs, but not try to margin up on them.
Anthony Lebiedzinski
Got you. Okay. And then, so your SG&A was certainly lower than what we had expected and actually lower versus last year. So how should we think about SG&A going forward even beyond the current quarter? Just wondering if you could provide some color on that.
Derek P. Schmidt
Yeah, Anthony, I think we're going to continue to be very thoughtful about where we add structural costs into the business. Just given kind of the volatility in some of the uncertainties we have around trade, et cetera, so our -- the way we're thinking about SG&A is try to manage it in that 15% to 15.5% of sales range, but we certainly want to continue to reinvest in the high ROI initiatives to accelerate our growth strategy.
Anthony Lebiedzinski
Got you. Understood. Okay. And then in terms of the tariffs, so obviously, it was great to see a pause for a month as far as Mexico is concerned. I know you talked about some strategies. But I guess if for some reason, there is no definitive agreement longer term about tariffs, I mean if there is a 25% tariff put in place, how should we think about broadly as far as the financial impact on your business?
Michael Ressler
Yeah, Anthony, obviously, the situation is very dynamic, right? And the ultimate impact will be a matter of what's the actual rate end up being, what would the duration of the tariff be, what happens to FX rates, et cetera. But just to give you some color, if you just put a 25% tariff increase in on our Mexico cost, it could be a $1.5 million to $2 million increase in our cost per month.
Now certainly -- and I let -- Derek can weigh in on some of the strategies we have, but we would certainly implement some initiatives to mitigate that from vendor price negotiations to relooking at cost structures, to resourcing products, to lower-cost manufacturing opportunities, et cetera.
Derek P. Schmidt
Anthony, I'll add a little bit more color. So obviously, we knew prior to the inauguration that there was a risk around tariffs. And so the team has been working diligently, I think, to accelerate our planning around this. So we've taken multiple -- actually, we've taken multiple steps over the last several years and continue to accelerate that, but we've identified potential sources of, again, high-quality supply in a multitude of different countries.
Obviously, the biggest risk right now in near term is tariffs on Mexico, but there is a relatively large trade imbalance with Vietnam. And as you know, there is significant product that's imported from Vietnam across the industry. So we continue to look for diversified suppliers outside of Vietnam.
We continue to develop products that can be dual source made in both Mexico as well as Asia, which will put us in a position certainly that if things don't get resolved on the trade front and there becomes a permanent or semipermanent 25% tariff on Mexico, we will have to adjust our -- the structure of our global supply chain. So we're prepared to do that.
Obviously, we showed last time there was tariffs on China. We recalibrated our supply chain. We did it effectively. We can do it again. It is not something that happens overnight, but we do have plans in place to restructure our supply chain if and when needed.
And as Mike suggested, in near term, we have plans in place to try to manage cost differently, potentially to partner with our suppliers to subsidize part of a tariff hit. And then we would have to take a close look at some level of potential pricing surcharge to push through the market.
The point is here is I think we're -- we've got a playbook documented that we're ready to run, depending on ultimately how the situation evolves. I will say though that we are intensely focused on continuing to run the business and executing successfully the way we have been.
And while we'll adjust certainly to a tariff situation, we would not do anything shortsighted to derail the momentum that we have in the market.
Anthony Lebiedzinski
Understood. Okay. Well, yeah, it sounds like you certainly are remaining agile on all fronts. So that's great to hear. And then lastly, just switching gears to the balance sheet, certainly nice to see you guys paying off the debt as you said you would, building up some cash. So as you look forward, how should investors think about just overall your cash priorities as you start to build up that cash?
Michael Ressler
Yeah, I think near term, Anthony, probably feel comfortable having a little bit of cash on the balance sheet for a cushion, given kind of what's going on externally until we get a little bit better clarity around trade, et cetera.
But our capital allocation strategy kind of remains intact in that we want to reinvest 70% back into the business on high ROI initiatives. In the event that we do not have attractive options, we'll consider returning capital to shareholders in similar manners as we've done in the past.
Operator
(Operator Instructions) And this concludes our question-and-answer session. And I would like to turn the conference back over to Derek Schmidt for any closing remarks.
Derek P. Schmidt
Thank you. And in closing, I do want to thank all of our Flexsteel employees for their hard work and dedication in driving the company's strong performance during the second quarter. And I'm also thankful to all of you for participating in today's call.
Please contact us if you have any additional questions, and we definitely look forward to updating you on our next call. Thank you, and have a great day.
Operator
The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.
