Caesarstone Ltd. (CSTE) Q2 2018 Earnings Report, Transcript and Summary

Greetings and welcome to the Caesarstone Second Quarter 2018 Earnings Call. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. [Operator Instructions] As a reminder, this conference is being recorded. I would now like to turn the conference over to your host, Ms. [Indiscernible] with ICR. Thank you. Yyou may begin.

Thank you, operator, and good morning to everyone. I'm joined by Yair Averbuch, Caesarstone's Interim Chief Executive Officer; and Ophir Yakovian, our Chief Financial Officer. 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 of the company's current expectations and that 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, on this call, the company will make reference to certain non-GAAP financial measures, including adjusted net income, adjusted net income per share and adjusted EBITDA. Reconciliation of these non-GAAP measures to the most directly comparable GAAP measures can be found in the company's second quarter 2018 earnings release, which is posted on the company's Investor Relations website. Thank you. And I would now like to turn the call over to Yair. Please go ahead.

Thank you, Sarah, and good morning to everyone. Before I get into our performance, I will comment on our recent announcement regarding the executive leadership. As many of you are aware, in 2017, I announced my splendid culture and transition from Caesarstone. In July this year, the Board announced the appointment of Yuval Dagim as the company’s new CEO, and he will be in the position on August 12. Yuval brings decades of experience in global business sales and leadership across multiple industries. This improved management of blended products on several continents. Combined with Ophir who joined us as CFO earlier this year and the other members of the management team, I'm confident that Yuval will be able to lead the company to a new growth and the profitability by effectively leveraging our global operating platform, powerful brand and innovative products. With welcoming him on board, I'm now in final stages of completing my transition process. Over the past 8 years with Caesarstone, and in recent months serving as Interim CEO, it has been an absolute pleasure in the company to navigate slow and evolving industry landscape, while also getting a chance to meet many of you on the line to date. I'm very grateful for this experience. During the second quarter our results showed considerable improvement compared to our performance in the first quarter of 2018. This included a significant expansion in gross margin, which we will work hard to carry forward as the field will expand further. At the same time the competitive environment remained challenging in several key markets, especially in the U.S., we continue to make necessary changes to better position our sales in order to more effectively capitalize on the strong global market opportunity for products. While manufacturing throughput challenges need well associated mainly with the increased complexity of our products, the raw material cost inflation and efforts are likely to remain headwinds, we are making products to improve our U.S. sales operation and global manufacturing to achieve better performance in 2019. Now, I will refer to the second quarter financial highlights. Our second quarter revenue of $149.2 million was stable compared to last year. On a constant currency basis, our revenue declined by 1.5%. Sales improvement in Canada, Europe and rest of the world were offset by pleasures in The United States and Israel. Our adjusted EBITDA in the quarter was $24.6 million, representing margin of 16.5%. This compares to $29.6 million or margin of 19.9% in the second quarter of last year. This decline was anticipated and primarily reflecting the lower gross margin compared to the prior year. Our adjusted net income in the second quarter was $14.9 million and adjusted EPS was $0.43. Now, I would like to provide updates on each of the regions for the second quarter. In the U.S. sales were down 6.9% to $60.4 million compared to $64.8 million last year. Weakness in sales to IKEA due to changes in its promotional structure compared to last year was part of the reason for the decline. That's said, we've also experienced softness in our core business since the beginning of 2018. In response, we are making changes to an end our go-to-market strategy and strengthen the distribution capabilities. We are confident in our ability to resume growth in this market as we reline our execution and progress with our business plans. In terms of filling the permanent role for the President of the U.S Sales and Distribution Operations, the search is progressing and we will keep you updated as appropriate. In the interim, our Chief Commercial Officer is adding his role and working hard to reposition the U.S. business. Australia sales were $34.7 million, up 1.4% compared to $34.3 million last year. On a constant currency basis, Australia was up 0.6%. We are pleased with our performance in Australia configuring the soft housing margin condition mainly remodeling. In Canada, sales grew by 8.1% to $27.3 million. On a constant currency basis, Canada was up 3.8%. The sequential growth improvement was related to IKEA sales resuming growth as expected following the decline in Q1. This is a market where we believe that there is a meaningful growth potential for us going forward. Sales in Israel were down 15.9% to $9.1 million. On a constant currency basis, sales were down by 16.2%, reflecting intense competition and challenging housing market conditions. New York was a bright spot with sales up 31.1% to $9.1 million. On a constant currency basis, growth was 22% year-over-year, reflecting better product availability and leveraging the growth in the United Kingdom from our direct distribution operation. Revenue in the rest of the world during the quarter also benefited from better product availability and was up 27.2% to $8.5 million. On a constant currency basis, revenue was up 19.8%. I would like now to turn the call over to Ophir, who will provide more detailed view of our consolidated results and full-year outlook.

Thank you, Yair, and good morning, everyone. Global revenue in the second quarter of 2018 was $149.2 million, an increase of 0.2% compared to $148.9 million in the second quarter of last year. On a constant currency basis, revenue declined by 1.5% versus last year. Gross margin in the quarter was 32.4%, compared to 34.9% last year. The decrease in margin reflects the following. Inventory and logistical inefficiencies along the higher raw material costs impacted margin unfavorably by approximately 300 basis points. Lower production throughput at our Israel facilities impacted margin by roughly 200 basis points. These factors were partially offset by significant improvement in throughput ending at our Richmond Hill facility in the U.S., which continues to ramp up and contributed about 250 basis points. With the volatility in our gross margin during the first half, we are also providing additional color on our second quarter performance compared to the first quarter to enhance visibility in our margin moving forward. On a sequential basis, gross margin improved by approximately 700 basis points compared to the first quarter of 2018. The main factors that drove this sequential improvement were as follows. Higher average selling prices and volume benefitted our margin by 300 basis points. Approximately 100 basis points of the sequential gross margin improvement came from reduced inefficiencies related to inventory and logistics mainly in our U.S. distribution operation. Finally, roughly 300 basis points of the sequential gross margin improvement primarily reflects better operating performance in our manufacturing in Israel and the U.S. Compared to the first quarter of 2018, we view the combined 400 basis points from better operating performance and the improvement in efficiencies related to inventory and logistics and good proxy for sustainable gains through year-end. Operating expenses in the second quarter were $35.1 million or 23.5% of revenue versus $32.6 million last year, which was 21.9%. Excluding legal settlement and loss contingencies, operating expenses increased to 21.7% of revenue compared to 20.9% in the prior year quarter, mainly due to higher marketing and sales expenses in addition to non-recurring expenses of approximately $1.2 million mainly related to the relocation of our U.S. supplier. Our second quarter operating income was $13.3 million compared to $19.3 million in the second quarter of last year. Adjusted EBITDA in the second quarter was $24.6 million, a margin of 16.5% compared to $29.6 million, a margin of 19.9% in the prior year quarter. The decline in adjusted EBITDA margin primarily reflected the lower gross margin. Finance expenses in the second quarter were approximately $0.5 million compared to $1.4 million in the last year. This swing was mainly related to FX fluctuations. Our tax rate on adjusted income was 13.4% compared to 17% in the prior year quarter due to lower nondeductible expenses as well as the lower tax rate in the U.S. Adjusted diluted earnings per share in the quarter was $0.43 compared with $0.49 in the same period last year, reflecting lower adjusted net income on stable share count. Turning to our June 30, balance sheet, we had cash and cash equivalents and short-term bank deposits of $104.6 million, and net cash position of $95.6 million. Based on our profitable performance during the second quarter and the first half of 2018, our Board of Directors declared a dividend of $0.15 per share with a record date of August 22nd and payment date of September 12, 2018. Moving to our outlook for 2018. Since we provided our sales outlook last quarter, currency rates have moved unfavorably. More specifically, the U.S appreciated in comparison to our main other currencies. As a result this has created an adverse currency exchange impact of roughly $10 million to our 2018 sales outlook. Therefore we expect revenue to be at the low end to midpoint of the previously announced range of $590 million to $610 million. With respect to adjusted EBITDA, we continue to anticipate full year to be at the range of $74 million to $82 million. Thank you. We are now ready to open the call for questions.

[Operator Instructions] Our first question comes from the line of Michael Rehaut with JP Morgan. Please proceed with your question.

First question, I just wanted to get -- make sure I understood the comments around gross margin in terms of what was sustainable and what was not. I believe you said that of the 700-basis-point sequential improvement that the 300 and 100, I believe both related to better operating performance to reduce inefficiencies or what’s viewed as sustainable. And to understand from that, of the 32 type percent gross margin that you did in 2Q that -- of the 700-basis-point performance that only 400 is what viewed as sustainable and we should be looking more like a 29% type of gross margin in the second half. I just want to make sure I’m understanding that correctly.

Yes, you got it right. That’s correct.

Okay. The 29% in the back half. And I guess the second question kind of relating to that. So the 300 basis points that wasn’t viewed as sustainable relating to -- was that relating to the higher ASP in volumes? And why is that view -- is that kind of the temporary? Why is that viewed as more of a temporary benefit I guess?

Well, it's not -- I say that the way we see the results of headwind going forward in a sequential basis expected in headwind for us as we mentioned. [Indiscernible] pricing effect is increasing actually and its impact relative to sequentially. So there is some pressure that leads us to believe that gross margin level will be a little bit below the 32 level.

And in terms of the U.S. sales decline, you mentioned two main drivers of that; first being weakness to IKEA, and second being softness in your core business. I was hoping to get a sense of the 7% decline, if you can kind of give us a sense of which of these two factors, how much that each contributed to that decline? And how should we be thinking about, I assume that's probably that is not going to be easily turnaround in the next quarter if we should be expecting further declines in the back half?

So, I would say without getting into too much detail that the impact of IKEA was significant, but even without it we would have been down. So it's -- I would say, impact maybe IKEA slightly lower indicating than they call decline. And I think that the market in the U.S. is now currently very, very competitive for us. We offset as we mentioned before we have made many changes in our organization to get that sales execution and better distribution and stabilities and improve our supply chain. So we believe that we will see some improvement on year-over-year basis compared to the first half and the second half.

And when you say improvement, Yair, you are talking about dollars sequentially or year-over-year growth?

Both.

Do you expect year-over-year growth in the back half and in the U.S?

Yes. We are.

[Operator Instructions] Our next question comes from the line of Susan Maklari with Credit Suisse. Please proceed with your question.

Good morning. My first question is you mentioned enhancing some of your U.S. strategy in terms of how you distribute and maybe market or sell the product, can you just give us a little bit more color on what’s your planning there and how we should think about that coming together?

Yes, so I think there are three elements I would say to the plant improvement in our U.S top line growth. One is, as we mentioned before, we needed to strengthen our sales execution capabilities. There was a leadership change announced in Q1. And this has followed up by additional changes that have been made or continuing to be happening now in the U.S. All of which I believe will down the road contribute to a better performance on our part. So there are organizational capabilities especially on the sell side. And when we brought some important talent in recently, I believe this again will take -- it will bring it all down the road. The second thing is we have a major focus on client penetrating to the big boxes. We’ve been discussing it for quite a while. There are some positive things happening. And I hope that it will result in something that we can announce sometime soon. But it's definitely a major focus on our part in the U.S. And we believe that the big boxes are big channel across the overall demand, so it's important for us to be there. And the sales -- the distribution -- the operational distribution performance and this has two sides for it. One is the ability to have the right product at the right place at the right time, which means not losing revenue on logistical element. And the second one is just to reduce the cost structure because it's too costly as relatively to the benchmark that we have experienced before in relative to what we believe should be the benchmark. On those things, we have few initiatives that are now started to be on the pipeline. I prefer not to provide --it's so competitive to provide information. So I prefer not to get into detail on that part.

Got you. Okay. That’s not a problem.

That was clear thing … there are clear things on the pipe.

There is what?

There are clear things on the pipe happening and developed.

Got you. Okay. And then I guess can you also give us an update on the U.S facility? It sounds like things are definitely improving there in terms of your volume and your throughput. Can you just give us a little more color on that?

Yes, I think that Richmond Hill performance was the most the brightest side of this quarter affected from our meeting what we've planned to do in Q2, and recovering from Q1 performance. Richmond Hill was a by far the shining star. And the improvement sequentially was just unbelievable. And it's converging to the Israeli plant performance very rapidly soon enough, I believe, we will just stop talking about that. And but in throughput, basically -- in throughput they are in power now with the Israel on better line capacity on better line productivity. On the yield side, which is how many goods leads out of the total throughput, how many of demand has been good versus not good. There we see some improvements despite the major leapfrog that they did. And on the cost per square meter, which is what matters then the most. And they converge very rapidly. So we believe there will be still some gas because labor cost in -- primarily because labor costs in the U.S. is much more expensive than in Israel, but it's converging very nicely into what we know.

Thank you. Mr. Averbuch, there are no further questions at this time. I'll turn the floor back to you for final comments.

Thank you. Overall, we made good progress during the second quarter, but there are still many challenges to resolve. Fortunately we have a strong global platform, a powerful brand, leading products and the financial strength to generate stronger returns over time. It has been a pleasure serving Caesarstone, and I'm proud to believe in the place -- to be living in place a strong team, which is highly aligned with the implementing the targeted goals, to resume growth and achieve higher margin. Additionally we look forward to evolve working diligently with the team to further refine our strategy and strengthen our brand's premium position at the top our category. Thank you for your attention this morning.

Thank you. Mr. Averbuch, we do have one more question from the line of John Baugh with Stifel.

I don't know what happened there, Yair and Ophir. But thanks for taking a quick question and good luck in your future endeavors. I guess, I wanted to ask quickly but two things. The mention of competition in Israel, do you have a very large share there. I'm curious is to what precisely you are seeing there?

I'm sorry. I'm sorry for the confusion. This does end our call. Thank you for your participation.