Annual Meeting - November 2014

Thank you Alan, and welcome everyone.

Topics I will cover today are:

• Overview of the 2013/14 financial year  
• Carpet business  
• Wool business  
• Yarn business  
• Issues facing the Group and strategic responses  
• Earnings outlook for 2015

2014 was mixed, with improved results in the broadloom and yarn businesses offset by reduction in profits from the carpet tile and woolscouring operations.  New Zealand sales and margins improved on 2013.  However, the Australian market was a challenge, particularly in commercial and the entry-level price-driven part of the residential market.

The consolidation of the Onehunga-based NEC tufting operation at the Cavalier facility in Papatoetoe was completed during the year - with the costs of this restructure provided for in the previous financial year.  There were no large restructuring or reorganisation costs in 2014.

The introduction of Cavalier’s high-end synthetic carpets under the Habitat Collection range in early 2014 exceeded expectations, and the programme continues to grow with the range currently being extended further.

The significant rise of the New Zealand dollar against the Australian, the increasing price of wool and a drop in wool grease price all impacted 2014 results, with the latter having by far the biggest impact on 2014 profit.

Reported profit after tax of $5.8 million for the 2014 financial year was an improvement on the $3.0 million for the previous year, but 13% down on the $6.6 million normalised tax-paid profit (that is, after reversing restructuring costs) due largely to the drop in our share of profit of the 50%-owned wool scouring operation.

The stocks required to support the introduction of the new synthetic and felted carpet ranges have been the main driver for a $9.9 million increase in stocks, and $5.6 million increase in net interest-bearing debt, during the year.

Shareholders’ equity reduced by $1 million to $93.0 million and total assets increased $1.4 million for the year.

Net cash flows from operating activities were a modest $615,000, with the large decrease from 2013 due largely to cash required to fund increase in stocks.

The carpet business comprises our broadloom carpet operations, Cavalier Bremworth and Norman Ellison Carpets in both New Zealand and Australia, and our carpet tile division, Ontera Modular Carpets, based in Sydney.

The broadloom business had a much better year than 2013 (when it made a small loss) with volume sold marginally up and the price of wool back at historical levels for much of the year.  As indicated earlier, sales of the Habitat Collection range of synthetic products were better than expected.

The result would have been better if it were not for the sharp rise in the New Zealand dollar against the Australian throughout the year and an increase in wool price impacting the results for the last couple of months.

The New Zealand market was reasonably robust, with business confidence stronger and the Christchurch rebuild well underway. In contrast, the Australian market was lethargic (and still is), particularly at the mid-to-low price-driven end of the market as a consequence of competition from imports.

The tile business had a difficult 12 months, with profit considerably down on the previous year. The sluggish Australian economy, where the majority of its sales are generated, and competition from imports impacted volumes and margins.  Historically, Ontera dominated the high-end of the market with its unique printing technology, but has been facing increased pressure from cheaper graphically tufted alternatives.

Our wool business comprises the Elco Direct wool acquisition operation and our 50% interest in commission woolscourer, Cavalier Wool Holdings or CWH.  

The wool acquisition business had another strong year, with satisfactory volumes and margins and a result almost identical to that achieved in 2013.

Our share of profits of CWH dropped $3.0 million or 59% from the previous year, mainly as a result of significantly reduced wool grease prices caused largely by a disease called Early Mortality Syndrome (EMS) that was affecting Asian shrimp farms.  As a result, demand for wool grease – from which cholesterol is extracted and used extensively as a feed supplement in aquaculture – dropped, leading to a reduction in wool grease price from USD6.90 per kg at the start of the year to just over USD3.00 per kg by the end of the year.

While the fall in the price of wool grease has continued into 2015, we have noticed an increase of late as demand picks up, and we are cautiously optimistic that it will continue to improve. At the same time, the weaker NZD:USD should also improve the returns from wool grease in NZD terms.

Most shareholders would have seen the announcement in October that subject to Commerce Commission authorisation, CWH is to merge its scouring operation with that of New Zealand Wool Services International or WSI. A transaction involving CWH and WSI has been on the cards for some time, but earlier attempts have failed for a variety of reasons.  While falling sheep numbers and decline in greasy wool available for scouring have stabilised, there is still excess scouring capacity, and this merger is therefore vital to addressing capacity and ensuring that New Zealand scouring remains internationally competitive.

The merged entity will also benefit from the more optimal utilisation of its assets and provide a springboard for further industry initiatives.

Radford Yarn, or RYT, is our specialist felted yarn manufacturer located in Christchurch.

RYT had a much better 2014, with the factory benefitting from Cavalier’s expansion of its felted carpet ranges - particularly in Australia - and operating at close to capacity for most of the year.  

Issues facing the Group and strategic responses

The issues facing the Group at the present time fall into two broad categories – the first emanating from the permanent structural changes to our markets that commenced in 2011/12 and the second coming from the current high NZD:AUD cross rate and wool price. I will now address each of these. Permanent structural changes to our markets Shareholders would recall that 2011/12 was a horrible year for the core broadloom carpet business. First, there was the extreme economic downturn on both sides of the Tasman. Then, there was the enormous and unprecedented spike in wool price that started the year before. And even as we were trying to manage our way through these, we were confronted by a flood of synthetic carpet imports into the Australasian markets brought on by the weak US dollar and the significant excess capacity offshore.

The carpet tile business has also not been immune, with the strong AUD:USD opening the doors to cheap imports into its main market, Australia.

The structural changes brought about by the flood of imports into New Zealand and Australia on our broadloom and tile businesses are permanent.

And what have we done about these?

In 2012, we consolidated three yarn spinning plants into two and combined two Auckland-based warehousing and distribution centres for our broadloom carpet business. In 2013, we consolidated all broadloom carpet manufacturing at Papatoetoe, Auckland, completing - in the process - the rationalisation plans aimed at reducing our cost base and better matching capacity with demand.

At the same time, we also addressed our product portfolio and our relationships with our customers while also simplifying the way we do business. These initiatives include –

(1) the launch of our premium-end synthetic carpet offerings under the Habitat Collection range in both New Zealand and Australia; 
(2) the formation of strategic alliances with Mohawk, the world’s largest flooring manufacturer, and Milliken, a US-based global leader in floor coverings; 
(3) the establishment of new, and strengthening of existing, relationships in our rest of world markets (more particularly, North America, China, UK and Western Europe) where wool carpet remains an aspirational purchase and future growth of woollen carpet sales are likely to come from; and
(4) supplementing our own-manufactured top-end highly-differentiated broadloom carpet and carpet tiles with imported products to plug the gaps in our existing product ranges or to meet required price points in the market as we move towards a blended distribution model.

The launch of the Habitat Collection has gone extremely well and we are anticipating the sales growth we have experienced to continue into the foreseeable future as new products are added to the collection.

The other initiatives are at varying stages of development, but I can advise that we have already started distributing Mohawk broadloom carpet and Milliken carpet tiles in Australia. And in the last few days, I have had confirmation that in December Mohawk are launching a collection of Cavalier Bremworth woollen products under the Karastan brand to its network of retailers in the US and Ontera has been appointed exclusive distributor of Mohawk tiles in Australia. Also in January, we’ll be launching a residential wool collection in Canada through a national retailer network.

These initiatives to grow sales take considerable effort, but I am confident that the improvement in sales volume will gather momentum given time.

So all in all, given the unprecedented structural changes in the market place and challenges we have had to confront, we have done a huge amount to reposition ourselves.

That said, we are continually striving to improve business performance. Unfortunately, the turnaround in results and performance has been slower than we originally anticipated.

And what about the second category of challenges which I will refer to broadly as the headwinds – the high NZD:AUD and wool price, which I will now deal with.

• Increase in the NZD against the AUD – 

Over 50% of our broadloom carpet sales are denominated in Australian dollars and every 1 cent movement in the NZD:AUD cross rate affects EBIT by between $500,000 and $600,000 per annum. The graph that you now see illustrates the historical movement of the NZD:AUD cross rate and, in particular, the move from around 0.84 at the start of the 2014 financial year to just over 0.90 currently (at one point in 2014, the rate got to almost 0.95). While the significant foreign exchange cover taken throughout 2012/13 sheltered us from much of the appreciation in the NZD:AUD during 2014, most of this cover has now been utilised leaving us almost fully exposed to the current strong NZD in 2015.  Unfortunately, we expect that we will continue to be adversely affected by the NZD:AUD, with market commentators picking the rate to remain at current levels for at least the next 12 to 18 months.

• Increase in wool price - 

With over 40% of our broadloom carpet sales now non-wool, we are no longer as exposed to the increase in wool price as we used to be. Even so, every 10 cent movement in a clean kg of wool delivered to the spinning mill still affects EBIT by around $330,000 per annum. 
The graph that you now see illustrates the historical wool price movements and, more particularly, the latest spike that commenced in mid-2013. 
The effect of increase in wool price alone is an estimated reduction in EBIT of approximately $3.0 to $3.5 million in 2015 when compared with 2014.

While it is only natural for the market to focus on these headwinds and the impact they are currently having on earnings and dividends – and in turn, share price - it is just as important that we do not lose sight of the strategic responses we have in place and the medium to longer term prospects of the Company.

While we were aware of the headwinds discussed earlier and their adverse financial impact, we were also anticipating that volume increases from various growth initiatives would be enough to compensate - hence the reason why our budgets for the 2015 year were indicating a marginal improvement on 2014 results.

However, volume traded in the first quarter (while in line with 2014) was below expectations, with the growth in sales volume - which we still believe will eventuate - taking longer than expected.

Carpet tile performance has also been below expectations.

As a consequence, the Directors have concluded that their current estimate of normalised tax-paid earnings for 2015 was in the range of $1 million to $4 million, which shareholders would already have learnt from last Friday’s announcement to NZX in accordance with the requirements of continuous disclosures.

Staff

I would like to once again thank all the loyal staff at Cavalier for their hard work and dedication in trying times.  Current conditions make trading tough, but we have a positive and dedicated team who are striving to make Cavalier a success.  

Concluding remarks

In 2012, I said that our carpet world had changed structurally and irreversibly and that we had to reinvent ourselves.

In 2013, my message was that the worst was behind us and we wanted to focus on completing the restructuring and improve profitability.

This year, the message is still very much about improving profitability, but that it will take us longer than we originally anticipated.

Ladies and gentlemen, that concludes my presentation.

Thank you.

Colin McKenzie 
Managing Director

For more information regarding this address, please contact Colin McKenzie on 09 277 6000 or 027 292 4080.

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