Caesarstone Ltd. (CSTE) Q4 2017 Earnings Report, Transcript and Summary

Greetings and welcome to the Caesarstone Fourth Quarter and Full-Year 2017 Earnings Conference Call. At this time, all participants are in a listen-only mode. A brief question-and-answer session will follow the formal presentation. [Operator Instructions] As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Allison Cain of ICR. Thank you, you may begin.

Thank you operator, and good morning to everyone. Certain statements in today's conference call and responses to various questions may constitute forward-looking statements. We caution you that such statements reflect only the company's current expectations and that the actual events or results may differ materially. For more information, please refer to the Risk Factors contained in the company's most recent Annual Report on Form 20-F and subsequent filings with the Securities and Exchange Commission. In addition, the company will make reference to certain non-GAAP financial measures, including adjusted net income, adjusted net income per share and adjusted EBITDA. The reconciliation of these non-GAAP measures to the most directly comparable GAAP measures can be found in the company's fourth quarter 2017 earnings release, which is posted on the company's Investor Relations website. With that, I would like to now turn the call over to Raanan Zilberman, Chief Executive Officer of Caesarstone. Raanan, please go ahead.

Thank you, Allison. Good day and welcome to our conference call to discuss our fourth quarter and full-year results as well as our outlook for 2018. I will start by providing some financial highlights from our fourth quarter. We grew our fourth quarter revenue by 9.8% to a new fourth quarter record of $148 million. On a constant currency basis, our growth was 7%. We continued to experience gross margin pressure in the quarter. This was primarily from lower throughput in Israel due to an increased portion of differentiated high products. We also so some pressure from the increased polyester prices. On the positive side, while we still have much work to do Richmond-Hill, our organizational and operational improvement have begun to deliver benefits and I will speak about it more later. The fourth quarter adjusted EBITDA was $21 million, a margin of 14.2%. This was within our guidance range but in the lower end despite the sustained stronger pace of sales growth. The adjusted net income was $8 million and our adjusted diluted EPS was $0.22. To be clear, this highlight and the annual numbers I will give excluding part of the $17 million legal expense we incurred in the quarter. This is mainly the result of an arbitration commenced back in 2011. I'd like now to discuss the full year of 2017. We grew sales by 9.2% to a record of $588 million with constant currency growth of 7.4%. Our 2017 adjusted EBITDA was $100.4 million. Adjusted net income was $50 million and our adjusted diluted EPS was $1.45. This has been a challenging year. We were pleased with our top line increase especially with out 10% growth in the U.S. after a flat year in 2016. We are also pleased with our first year of direct distribution in the UK which brought significant double-digit growth and we believe it represents a solid growth opportunity going forward. At the same time, our growing quartz category has continued to evolve with increased competition from manufacturers in low cost countries. Our intention is to accelerate the innovation stream of new products and to continue leading the global market with our premium brand and in addition, we have accelerated our efforts to diversify our production sourcing of design and colors to improve our competitive position. With respect to our manufacturing challenges, in Richmond-Hill the organizational changes that we have implemented in September have had a considerable positive impact. We saw a significant improvement from the third quarter in all the aspects, throughput, yield rate and cost management. In Israel, we continue to experience lower throughput as a result of the increased portion of our differentiated products as well as the complexity level. While we expect some of the pressure to continue, we are working hard to implement the identified opportunities for improvement. In order to maximize revenue capture, we are building better level of inventories availability across all the regions. I would like now to provide an update on each of our regions for the fourth quarter and the full-year. In the United States, we grew our fourth quarter sales by 10.3% to $60.6 million compared to $55 million of last year. We believe that the United States holds a tremendous future potential for growth. For the full-year our sales growth in the United States was 10.2%, a significant improvement from last year's flat performance. We are determined to keep our growth at a healthy rate in the year ahead. Australia sales in the fourth quarter were $36.7 million, up by 1.7% compared to $36.1 million of last year. On a constant currency basis, Australia was down 0.5% in the fourth quarter. This primarily reflects the continued weakness that the overall housing market is experiencing. As you know, we are quite well penetrated in Australia and so we feel the macro pressure in our business. For the full year Australia sales were up by 5.1% to $137.6 million and on a constant currency basis the full year growth rate was 2.1%. In Canada, a consistently strong contributor to our growth, we grew the revenue by 15% [ph] to $24.7 million in the quarter. On a constant currency basis, growth in Canada was 9.5%. For the full year, Canada sales grew 14.1% to $97.8 million and on a constant currency basis full year growth was 12%. The sales in Israel were $9.9 million for the quarter up by 1.2% compared to last year. On a constant currency basis, sales were down by 7.4% and for the full year Israel sales were up by 4.6% to $44.5 million but down 2.1% on a constant currency basis. This trend reflects the challenging market condition and as you know this is a highly mature market. Europe sales in the fourth quarter were $6.4 million up by 22.7% compared to last year. On a constant currency basis, sales were up by 17.5%. For the full year Europe sales were $28.7 million up by 12% and up by 11.2 on a constant currency basis. The increase in the quarter and the full year primarily relates to our successful transition to direct distribution in the United Kingdom. Revenue in the rest of the world during the quarter was up by 31.8% to $9.9 million. On a constant currency basis, revenue was up by 23.1%. For the full year sales in direct of the world were $34.2 million up by 9.9% and up by 7.6% on a constant currency basis. I would like to discuss now our decision on dividend distribution. As we announced today, we have decided to distribute a special cash dividend of $0.29 per share enabled by our strong cash balance, our positive cash flow from operation as well as our confident outlook for the future. This is a return of excess cash that we believe is beyond what is required to fund our growth either in terms of capital expenditure or working capital needs. We also announced a new dividend policy where we intend to pay $0.10 to $0.15 per share on a quarterly basis subject to a certain condition and at the discretion of the Board of Directors. We believe that this is a very appropriate way to return value to our shareholders without scarifying our strategic options. As we announced today, we've appointed a new Chief Financial Officer, Ophir Yakovian. Ophir has a strong background in industrial and public companies traded in the U.S. and I believe he is a natural cultural fit for the company. I would like once again to thank you Yair for his many years of excellent service to the company in which he was an important contributor to our success. Yair, thank you very much and go ahead.

Thank you for the kind words Raanan and good morning to everyone. I will now refer to our income statement for the fourth quarter. Global revenue in the fourth quarter increased by 9.8% to $148.1 million compared to $135 million in the fourth quarter of last year. On a constant currency basis, revenue grew by 7%. Gross margin in the quarter was 31.3% compared to 38.1% last year. Relative to last year, the primary factors for the decrease in margin were lower production throughput in Israel as Raanan described, higher material costs related mainly to polyester prices, lower average prices in some regions and increased component of fabrication and installation revenue which comes with lower margin mainly related to our growth with IKEA. Operating expenses in the first quarter were $51.3 million or 31.6% of revenue versus $32.3 million last year which was 23.9% of revenue. This increase was mainly attributable to a $13.9 million increase in legal settlements and loss contingency expenses related mainly to the arbitration results with Kfar Giladi as previously disclosed. I would note that following the publication of the award by the arbitrator Kfar Giladi submitted a motion to correct the damage amount by approximately $3.7 million which we objected and is pending the arbitrator decision. Excluding legal settlements and loss contingency expenses, operating expenses in the fourth quarter would have been $34.3 million or 23.1% of revenue compared to $29.2 million which was 21.6% of revenue in the third quarter last year. This increase primarily reflects higher marketing and sales efforts in the U.S. and the startup of direct distribution operations in the UK. Our first quarter GAAP operating loss was $4.9 million compared to operating income of $19.1 million in the fourth quarter of last year. Adjusted EBITDA in the fourth quarter which eliminates share-based compensation and legal settlement and loss contingencies was $21 million, a margin of 14.2% compared to $30 million and margin of 22.2% last year. These reflect the changes in gross margin and SG&A items just discussed. Finance expenses in the first quarter were $1.1 million, up slightly from $1 million last year. Expenses related to exchange risk fluctuations were up by $0.6 million but the increase was offset revival interest income from our bank deposits and reduced bank fees. Taxes in the fourth quarter were $35,000 compared to $2.8 million last year. We recorded a small tax expense this quarter despite the consolidated loss before taxes given a higher portion of taxable income generated outside of Israel where tax rates are higher. I want to note that we recorded a one-time credit of approximately $1 million related to the recent U.S. Tax reform given our net deferred tax liability balance in this region. Adjusted net income attributable to controlling interest in the fourth quarter was $7.7 million, compared to $18.1 million last year. Adjusted diluted earnings per share in the quarter were $0.22 compared to $0.53 in the same period last year; both figures are on 34.4 million shares. Now, I would like to quickly review our full year financial performance. Revenue for the full year was up 9.2%, growth of 7.4% on a constant currency basis. Gross margin was 33.5% in 2017 compared to 39.5% last year. Similar to the fourth quarter, the annual change in margin was driven by combination of lower manufacturing throughput in Israel, higher raw material cost related to polyester prices, increased portion of production in Richmond-Hill and increased component of fabrication and installation revenue. Operating expenses in 2017 were $156.7 million or 26.6% of revenue compared to $119.7 million or 22.2% of revenue last year. I would point out that legal settlement and loss contingency expenses were $24.8 million in 2017 compared with $5.9 million last year. Excluding legal settlement and loss contingency expenses, operating expenses would have been 22.4% of revenue compared to 21.1% of revenue in 2016. That reflects mainly the planned investment in marketing and sales capabilities that are supporting better growth in the United States and the newly established direct distribution operations in the United Kingdom. GAAP operating income was $40.5 million compared to $92.8 million in 2016. Our adjusted EBITDA was $100.4 million, a 17.1% margin, down from $130.3 million last year a margin of 24.2%. This decrease primarily reflects the gross margin pressure and the investments made within our business this year in sales and marketing. Our taxes for the year were $7.4 million compared to $13 million last year. As a percent of income before taxes the 2017 rate was 21.2% compared to 14.5% in 2016. The effective tax rate increase is related to a larger portion of our taxable income being generated outside of Israel mainly in the United States where tax rates are higher. In addition, the proposition of non-deductible expenses out of the taxable income was significantly higher in 2017. Adjusted diluted earnings per share in 2017 were $1.45 compared to $2.33 in the prior year. Turning to our December 31 balance sheet, we had cash, cash equivalents and short term bank deposits of $138.7 million with $38.3 million in free cash flow generated doing the year. In addition to our comments on the decision regarding the dividend which I certainly agree with, I will note the dividend record date is February 21, 2018. The dividend is payable on March 14, 2018 subject to applicable revolving tax. With respect to our view of 2018 and our guidance we are expecting revenue in the range of $612 million to $632 million. With respect to adjusted EBITDA we are guiding to a range of $102 million to $110 million. In this respect we would like to note that we expect Richmond-Hill overall year-over-year impact to be positive due to operating improvements partially offset by its becoming a larger portion of our total production. In addition, we expect a continued negative impact from increasing polyester prices. Given our strong performance in the fourth quarter of 2017 we expect the first quarter to be the most challenging year-over-year comparison on both revenue growth and adjusted EBITDA. Thank you and I will turn it back to Raanan for closing remarks.

Thank you, Yair. Looking ahead at our 2018 challenges and opportunity, I can see the following vectors. We will continue to experience headwinds from the following vectors, one as you mention, and as I mentioned before, evolving low cost competition in the USA. Two, is external factor is the increase of polyester prices and number three, which I mentioned as well before, softer housing conditions in few power markets including Australia, Canada and Israel. At the same time, we expect to benefit from tailwinds due to; one, the improvement in the manufacturing of Richmond-Hill, this is going on a good direction; two, our new and differentiated exciting products; three, the strong brand position; and four, the fundamental goals that exist in the categories. We will remain focused on the high end of the quartz market; however, with the developing and growing opportunities that exist today in the mass market we will seek for opportunities on the high end of those segments. In terms of performance as we just guided we are planning to continue and grow the top line between 4% to 7.5% and increase our adjusted EBITDA between 2% and 10%. Thank you and we are now ready to open the call for any questions.

Thank you. [Operator Instructions] Our first question comes from the line of Michael Rehaut with JPMorgan. Please proceed with your question.

Hey, good morning this is [indiscernible] in for Mike. So I guess starting on gross margins, I appreciate your commentary there, but I guess you have given the result this quarter in your guidance implying roughly flat EBITDA margins. How do you think about gross margins in 2018? And then I guess there was a significant piece of that the shift to big box or what do you see as improving or is it sort of the level you expect to persist for two to three quarters?

Thank you for the question and so, I mean if you take our mid range guidance it implies basically same EBITDA margins of 2017. I prefer to not break the guidance by P&L item, but we do expect some operating expense leverage this year. And therefore the conclusion is that there will be slightly lower gross margins, taking into account polyester prices and increased fabrication and installation.

Just to make sure that we're all aligned, total dollar of gross margins are going to go up. Okay? And if you'll do the math as Yair said you will see that it will be around $10 million. The margins are going to stay more or less the same as Yair mentioned. Okay? But total dollar are going to go up.

Okay, that's helpful and so I guess just looking at marketing and selling and G&A, I mean do you see that as kind of continuing to increase with further investments as you're continuing the U.S. strategy or is that sort of flat lining?

So, we made a big investment in 2016 and 2017 in the U.S. We also started our distribution operation in the UK which was another, a point of investment. We, while we intend to grow the expenses we believe that our top line goal will leverage this. So in percentage we believe that operating expenses should be lower than last year excluding legal settlements and loss contingencies.

Okay, that’s helpful.

Thank you. Our next question comes from the line of Susan Maklari with Credit Suisse. Please proceed with your question.

Hi this is Chris on for Sue. Thanks for taking our questions. I want to touch on some of the lower ASP you guys are seeing in some of your regions. I know you said it's driving some of the gross margin pressure, so I was wondering if you could touch on what regions you are seeing those pressure and whether or not, what's driving the lower selling price there?

Yes, looking at the ASP, I’ll first refer to your question on the region primarily it's coming from the U.S. and Australia. However, we see low cost competition coming also in China in other markets, but as I said the main markets right now are U.S. and Australia. Now, you have to look inside the price pressure because it's very interesting. If you look at the same model like-for-like there is clear erosion in prices. However, the way we protect ourselves to try and to cope with it is in two ways. First, what we do is that we are coming ongoing basis with new and exciting products that allows us to charge for higher pricing, so this is offsetting some of the mix, some of the like-for-like price erosion and naturally we are selling more and more in the States and less and less in countries like Israel or the rest of the world and this is I think as well. So if you look from the top, you don't see really price erosion. However inside there is a price pressure and the way to cope with it again is those unique and differentiated product which bring to them the toll of more longer cycle times, more complicated production, higher cost and therefore longer cycle time and the pressure on the gross margin is coming in instead of from the top, it's coming from the bottom. So I hope that this was a good enough explanation.

Yes, thanks. That was very helpful. And then as my second question I was hoping to touch on the U.K. growth strategy. I was wondering if you could explain if there's any differences in the landscape or U.S. or Australia or some of the other regions and what’s kind of driving success there?

Yes, U.S. market is a pretty virgin island, so we have only one major competitor and therefore and we still see a fundamental demand that exists in the market. What works for us as well is that we moved from distributor to a direct distribution, so we take more responsibility on the entire supply chain and with that we feel that we are enhancing the relationship with the our value chain. We feel that there is a lot of work to gain in the market. It's not a market of hundreds of, hundreds of millions of dollars, but it is a market of let's say around $100 million that we can still continue and go significantly. So we see it as a good opportunity and we've got a good outlook for the markets.

Okay, thanks for that.

Thank you. Our next question comes from the line of John Baugh with Stifel. Please proceed with your question.

Yair, good luck in your future endeavors and thank you for your support. I guess a question first on the inventory. It's up 30% roughly year-over-year. Is that a good thing or a bad thing? Is that planned or what’s the composition of inventory finished versus work in process? Are you in a better stocking position any color on the inventory?

So, generally speaking, we've taken a principled decision to increase our inventory and there is a need that we are coming into days where people, there is a much, a lot of competition out there in the market and people are - the consumer are expecting to a quick response. There were days when we were alone and people were willing to wait a few weeks to get those slabs, not anymore. So actually what you see is just the beginning. We've taken the decision to increase the inventory in 2018 by a little bit more let's say another half of a month in the USA in terms of inventory and here and there in some other places. So all in all, we see it as a positive thing and we believe that with better inventory, there will be better availability and better serving the needs. So it's absolutely not coming from lack of control, it's a managerial decision and it's going to continue.

Okay and then there was commentary about diversifying sources and I would assume that this is the commodity course you're selling but not making. I guess I'm trying to get a sense of how much of your business currently is sourced and then what in terms of a cost benefit you see in ’18 or beyond in sourcing from other areas?

Well, John let’s start from first the principal, the principal is that with the low cost competition there is a very interesting phenomenon, a new market is emerging, market that was not exists before. Historically we were working, we were inventing and working in the high premium market and that’s where we pointed all the years and these were our consumers and customers and with low competition it's more for the world and people that could not afford in the past are consuming now cores. Serious don’t need to decide if we want to take part in this market. We can stay where we are today serving the premium market or we can say, let's look at the mark-to-market, maybe not compete in all of the range, but let's take the premium part of it, the upper part of it and be relevant to people over there. A good example is the Big Box, but it's not just in Big Box, it’s happening in all the segments, it’s happening in the K&B, it’s happening in the - with the contractor. This is a strategic decision that we are now debating now days. And one of the way to address that competitive market is to be relevant both, with the cost of the product but also with the supply chain. This is the motivation to try and diversify the sourcing of the commodities product. I think at this stage we don't want to reveal how much if it is done internally or externally, but I would say that it’s not a major thing, the majority of what we do, we do on our production line and with our full control. By the way the entire OEM production is under our control and our specification, but not just the ethical one, including our people at the source, making sure that the quality is maintained as the level that we expect to have and [indiscernible].

So Raanan, not to put words in your mouth, but are you trying to say that while Caesarstone will stay at the high end whether it's K&B or possibly Big Box or builder channel that you need a product offering in a lower price point to be competitive or maybe win the high end business along with the growth in the middle or lower price points, is that essentially the strategy or the shift here?

To some extent I would say it's fair, but it is even more than they think about OEM as kind of a muscle that you want to have A, to answer certain range of your demand, but also is a muscle that gives you flexibility to fluctuation of inventory need or supply need, et cetera. So I think most of the manufacturers today, definitely the big manufactures today, try to maintain certain degree of flexibility with outsourcing and it’s a new era of work, it's the year. First year went pretty well and we are considering to strengthen that muscle absolutely.

Okay and my last question relates to capital spending, the dividend decision, and maybe production capacity. In theory, I think you have a $100 million capacity per line, you have seven lines. You gave us your revenue guidance and I believe it takes two years give or take before production can be gained from decision to commit capital. So it would appear that paying a sizeable dividend and no one else plans to add capacity that you plan on growing your revenue through a lot more sourced product or am I wrong and you have plans to expand capacity, just haven't announced it yet?

John, it’s a fair observation. I would say a mixture of reasons, which means, one we believe that we have sufficient money. By the way, the dividend is relatively not a big dividend and let’s take it in proportion talking about small numbers. However, one we still believe that we have enough money to invest if we will decide to invest in capacity. Nevertheless, it’s true what you say. In the short-term I believe and it goes with what I I said in the past that the company needs to step-by-step move the center of gravity from an industrial company to a commercial company. I believe that building the muscle of OEM, allowing us to use capital and the resources to the commercial side of the business so in the future through M&A if it's needed, I think it’s a decision that is not in conflict with the decision to bring some value in a marginal way or in a reasonable way with the dividend. So to cut a long story short, there's no conflict and yes the needs that we will have in the short term probably we will have sufficient resource to use or will be used by outsourcing.

Thank you.

Thank you. Our next question comes from the line of Lena Rogovin with Chardan Capital. Please proceed with your question.

Hello, thank you for taking my questions. Actually I have two, the first is about revenue growth in the year actually in Q4 which is some acceleration compared to previous quarter. So the question is, what was the reason for that? Is that that the market in general was stronger or is it because of the product mix? And what should we expect in the next quarter? And my second question is about production issues in Israel. When you say that you expect pressure to continue, is that something you know how to manage in the foreseeable future or that’s you added the production of the differentiated product? Thank you.

Okay, so hi Lena. On the revenue growth side indeed revenue, we were pleased with the revenue results for the quarter and it was above the growth rate that we demonstrated in the second and the third quarter primarily because of the U.S. gross rate and the gross rate in Europe and in the indirect market in general, partly because of UK growth. Yes and which by the way UK growth just, it's an easy comp to be fair and say that it's an easy comp because last year in the second half of the year and when we had to terminate the distributor it was very tough there, so just want to make a note.

I was asking about the U.S. growth specifically.

Oh, so US growth was again was in Q1 was better 17%, then it was 8% and 6% and then back to 10% we had a very good cover off this quarter. It compared to Q2 and Q3 and actually the growth rate of IKEA decelerated a bit.

Yes, so just to work on what Yair said, I do agree we had a very strong Q1 and a very good Q4, in the middle it was a little bit softer, but I take the opportunity to stress what Yair already mentioned before that due to the fact that we had a very strong Q1 in 2017 we are expecting in terms of growth a little bit softer growth in Q1 this year. And as you know, our company is based on a lot of fixed costs and if Q1 is going to be a little bit softer in terms of the growth, then it means that the margins will follow. So if you ask about the outlook of the or the development of the quarter during 2018 it will be fair to say, that we will start a little bit slower than, what we are expecting the year to end. In regards to your question about the Israeli plant it's a good question and I must admit that it’s a little bit different case than the one in Richmond-Hill. So in Richmond-Hill when I came, when I joined I recognized that there is too many issues. One was leadership issue in the plant and the second was know how transfer. And therefore we assembled a solution that was kicked off in August and immediately brought the result and I believe that we are on a good path. And as Yair said, I believe that this it is the last year that it was a negative contributor to the margin. In Israel it’s a different situation. I think I've mentioned to you in the past that I've been travelling and I've seen and quartz manufacturers all over the world, some of them we wanted to buy, some of them are our suppliers and et cetera, et cetera. The throughput I can tell you the throughput in the Israeli plants are the best in the world. I don't know any quartz manufacturer in the world that has such a throughput as the throughput in Israel. However, it will be fair to say that we are mounting more and more complexity on those plants in order to differentiate from the rest of the market and with that we are suffering the slowest throughput. Now the way to cope with this is not to change somebody or not to move transfer from the United States, those are not going to help. What we need to do is what you do in industrial life is very, very bit competent so work of operational excellence, Kaizen and team and et cetera, et cetera to try and to improve it. I can say that we definitely rocked the boat. We hired an external company to work with the team on Kaizen events. We are putting a lot of efforts. We are changing the incentive system in the plants. We are focusing on a daily base on the issues, but it's those kinds of things that you don't solve overnight. In our assumption that was also translated to the guidance, we took a target in 2018 to stabilize the erosion that we've seen in the throughput deal in 2018. So I'm expecting this very slow stabilization and then step by step ramp up, be smarter in quarter or two from now and we can discuss it further.

Thank you very much. That’s very helpful.

Welcome.

Thank you. There are no further questions at this time. I would like to turn the call back over to Mr. Zilberman for any closing remarks.

Now, I'd just like to say thank you for your time and attention today. We look forward to updating you on our business next quarter and talk to you soon again. Bye-bye.

Thank you. This concludes today’s teleconference. You may disconnect your lines at this time. Thank you for your participation and have a wonderful day.