CSW Industrials, Inc. (CSW) Q3 2016 Earnings Report, Transcript and Summary

Greetings, and welcome to the CSW Industrials Fiscal Third Quarter 2016 Earnings Call. [Operator Instructions] As a reminder, this conference is being recorded. I would now like to turn the conference over to your host, Mr. Tom Cook, with ICR. Thank you. You may begin.

Thank you, operator. Good morning, everyone, and welcome to CSW Industrials fiscal third quarter investor call. Joining me today are Joseph Armes, Chief Executive Officer of CSW Industrials; Kelly Tacke, Chief Financial Officer; and Christopher Mudd, Chief Operating Officer. If you have not received the earnings release, it's available on our website at www.cswindustrials.com. This call is being recorded. A replay of today's call will be available. Details on how to access the replay are in the earnings release. During this call, we will be making forward-looking statements. These statements are based on current expectations and assumptions that are subject to various risks and uncertainties. Actual results can materially differ because of factors discussed in today's earnings release, in the comments made during this call and in the Risk Factors section of our information statement filed as an exhibit through our Form 10 and other filings with the SEC. We do not undertake any duty to update any forward-looking statements. This call will also include an analysis of adjusted operating income and adjusted net earnings, which are non-GAAP financial measures of performance. These non-GAAP measures should be used as a supplement to and not a substitute for net income computed in accordance with GAAP. For a more complete discussion of adjusted operating income and adjusted net earnings, see our earnings release. I would now like to turn the call over to our Chairman and Chief Executive Officer, Joe Armes.

Thank you, Tom. Good morning, everyone, and thank you for joining us on the call today. First, let me remind everyone that we are on a fiscal year ending March 31. So the results released today are for the third fiscal quarter of the year that will end March 31, 2016. We also acknowledge that our results are complicated due to the inclusion of several one-time items incurred in connection with our recent spinoff transaction and 2 acquisitions consummated during this quarter. Finally, please note that we are comparing our results for this quarter against the prior year quarter in which CSWI did not exist. Having said that, our third quarter fiscal year 2016 results were broadly in line with our expectation, in light of the effect of regular seasonality on demand in our HVAC end market and despite the deepening depression in the energy end market. Third quarter 2016 sales were $70.9 million compared to third quarter 2015 sales of $60.9 million. Year-over-year, the 16.5% increase was attributable to acquisitions completed in the past 12 months, partially offset by weakness in certain end markets, most markedly within the energy industry. To provide some additional insight into our organic growth trend, it is important to note that on a consolidated level, pro forma, to include Strathmore, our organic sales were down 3% for the fiscal year-to-date. This consolidated result reflects 2 very distinct trends in our business. Beginning with energy, which represented approximately 15% of our revenue mix in fiscal 2015, primarily in our Specialty Chemicals and Coatings businesses, organic sales declined approximately 51% year-to-date versus the prior year. In contrast, the remainder of our end market, which include industrial, HVAC, rail, plumbing, architecturally specified products and mining, organic sales were up 4.7% year-to-date. In particular, strong commercial construction cycle is reflected in our sales of architecturally specified building product. Looking beyond the next couple of quarters, we do not anticipate any improvement in our energy end market. Nevertheless, we do anticipate an improvement in operating trends in our business as volumes and products sold into the energy end market has become a much smaller portion of our overall mix. In addition, certain expense reductions will be realized as we continue to rationalize these businesses. On that point, we have now identified $7 million in annual cost synergies that will be fully realized by March 2017. Chris Mudd will provide more detail on that in a moment. Adjusted net earnings, normalized for taxes and excluding one-time items for the third quarter, were $3.8 million or $0.24 per diluted share compared to net earnings in the prior year of $6.4 million or $0.41 per diluted share. This decrease reflects the anticipated impact of SG&A expenses associated with acquired company, standalone public company costs and the effect of lower organic sales. During the quarter, we achieved several strategic milestones as we finalized a $250 million revolving credit facility, which will allow us to acquire strategic value-adding businesses pursuant to the acquisition strategy that we have previously articulated. This facility was $50 million larger than previously anticipated due to stronger-than-expected demand. We have consolidated essentially all of the debt across our business unit into a single facility, thereby benefiting from the strength of our consolidated balance sheet to reduce interest expense. We also extended the maturity of our outstanding debt in this favorable environment. Another benefit of this new credit facility is our enhanced ability to effectively manage our cash. To that end, earlier this month, we used cash on hand to reduce our debt outstanding by $21.5 million. Further enhancements to our capital management initiative will be affected once our cash management program is fully implemented in the current fiscal quarter. In order to better reflect our new operating structure, we also restructured and consolidated our leadership team to include 3 new business unit general managers, down from 6 portfolio company CEOs. Each of these business unit GM has full P&L responsibility and will be held accountable for growing their respective business unit. We see this as an important incremental step in the evolution our company as we develop a fully integrated structure with all senior managers focused on a single set of strategic priorities. Moving to our acquisition strategy. As we reported last quarter, we have been very active in the market and are diligently seeking additional opportunities to leverage our distribution channels and expand our reach in the end markets we serve. During the third fiscal quarter, we made 2 acquisitions. In October, we acquired the assets of Deacon Industries, a leading provider of unique, high-temperature, high-pressure sealant products, which we expect to cross over several of our end markets, including industrial, power generation and plumbing. In addition, in December, we acquired AC Leak Freeze, which is a leading product line of OEM-approved air conditioning and refrigerant leak repair solution. Each of these acquired businesses are being integrated into our sales efforts, and we expect to benefit immediately from their inclusion in our portfolio of products. Our integration of Strathmore continues to progress. And while this business is under some pressure due to the exposure to energy end markets, both directly and indirectly, this slowdown has provided us with an opportunity to accelerate several components of our integration process, which Chris will detail in a few moments. Before turning the call over to Kelly for a closer look at the numbers, I'd like to take a minute to provide an update on trends in each of our end markets, beginning with our largest, HVAC. We saw continued strong growth year-over-year in this end market despite sequential deceleration, which resulted from normal seasonality in the winter months. Rail, which is approximately 17% of our mix, continued to benefit from strong organic growth in consumable lubricants during the quarter. Turning to products sold into our energy, mining and industrial end market, which represent, in the aggregate, approximately 30% of our revenue mix, volume remained under pressure, as anticipated, as lower industrial activity and lower commodity prices continued to impact our business. Overall, we are pleased that our diversified product portfolio, coupled with a strong balance sheet, is allowing us to weather the storm in the energy end market and will, we believe, over time, be rewarded. We continue to focus on capturing synergies through operational excellence, and we believe that the recent additions to our senior management team is another important step in building a great company. With that, I will turn the call over to Kelly for a closer look at finances.

Thank you, Joe. Third quarter 2016 revenue of $70.9 million increased 16.5% as compared to the third quarter last year, mainly as a result of recent acquisitions and a higher year-over-year volume in HVAC, plumbing and architecturally specified products, partially offset by declining sales in the energy and mining end market. Consolidated gross profit increased to $32.1 million, or 45.3% of sales in the third quarter, an increase of 12% as compared to $28.7 million or 47.1% of sales in the third quarter last year. Higher overall gross profit resulted mainly from acquisitions completed during the past 12 months but pressured our consolidated margin profile as a result of an unfavorable margin mix, particularly from the inclusion of Strathmore. Operating expenses for the third quarter increased to $26.5 million compared to $19 million in the prior year. This increase is due to additional costs related to the integration of our recent acquisitions and the inclusion of standalone public company cost of $1.5 million in the quarter. On an adjusted basis, operating expenses were $25.6 million or 31% -- 36.1% of sales compared to $19 million or 32 -- 31.2% of sales in the prior year. Consolidated operating income was $5.6 million or 7.9% of revenue, which included acquisition costs related to Deacon and AC Leak Freeze, start-up costs following the spinoff from Capital Southwest and the Strathmore earn-out reversal. Excluding these items, operating income was $6.5 million or 9.2% of sales, which was down from $9.7 million or 16% of sales in the prior year. Our effective tax rate for the third quarter was 58.6% due to start-up and organization costs incurred in connection with the spinoff, which are not deductible for tax purposes. Net income for the third quarter was $2 million or $0.13 per diluted share. Excluding one-time items and normalizing the effective tax rate, adjusted net income was $3.8 million or $0.24 per diluted share compared to $6.4 million in the prior year period. Now turning to our business segments. Industrial Products third quarter revenue was $28.5 million, a 14.4% increase over the prior period of $24.9 million. The increase in sales volumes resulted from strong customer demand for existing product, particularly in HVAC and architecturally specified building products. Industrial Products operating income was $3.4 million or 12% of sales compared to $3 million or 12.1% of sales in the prior period. This increase in income relative to the prior year was entirely related to higher sales during the period. Coatings, Sealants & Adhesives third quarter revenue was $24.3 million, basically doubling over the prior period of $12.3 million. Essentially all of this increase was attributable to the acquisition of Strathmore. Coatings operating income, adjusted for one-time items, was $2.5 million or 10.5% of sales compared to $2.6 million or 21.6% of sales in the prior period. This was expected due to the lower margin profile of the Strathmore product. We have a path to improve margins in this segment, which will be further explained by Chris. Specialty Chemicals revenue was $18.1 million, a decrease of 23.4% from the prior period of $23.6 million. Lower revenues stemmed from lower volume in energy and mining end markets as commodity price pressure continued to decrease customer production volume. This decrease was partially offset by an increase in sales volume associated with rail. Specialty Chemicals operating income, adjusted for one-time items, was $2.2 million or 12.4% of sales compared to $4 million or 17.1% of sales in the prior year, primarily reflecting lower volume and operating leverage. Turning to our balance sheet. As of December 31, we had $51 million in cash and had long-term debt outstanding of $105.8 million, which resulted in a net debt position of $54.8 million. Earlier this month, we utilized $21.5 million of our available cash to reduce the amount outstanding on our credit facility. I would now like to turn the call over to Chris for an operations update.

Thanks, Kelly. As Joe noted earlier, we have been active in our integration efforts since becoming a standalone company and are continuing to make excellent progress. We are finding opportunities to optimize our footprint and reduce operating cost. Notably, the ongoing consolidation of Jet-Lube's Houston production into our state-of-the-art Whitmore facility in Rockwell, Texas continues to remain on track and on budget. We plan to discontinue all Jet-Lube production in our Houston facility by October 1 of this year. By March of next year, we will be seeing the full operational benefits. In addition, I'm pleased to report that we -- as we progressed deeper into this process, our team was able to identify an additional $1 million in anticipated annual synergy savings, and we now expect this integration to deliver more than $5 million in annual synergy savings by March of 2017. Currently, we have transferred 80% of Jet-Lube operations to Whitmore. The remaining 20% of production represent lower volume and specialty niche production, some of which will be moved to Rockwell, some will be outsourced to third-party manufacturing in Houston, and some may be discontinued. To complete this integration, we remain on track for CapEx spend of $7 million during this fiscal year and approximately $3 million in the next. Turning to Strathmore. Our integration plans are progressing on track and on budget. However, as Joe mentioned, end market pressure is impacting volume, particularly in Coatings that serve the energy markets, which account for 15% to 20% of their total revenue. As a result, we are taking this as an opportunity to accelerate several of our long-term integration plans for Strathmore, which includes 4 discrete items. First, we took a close look at sourcing at Strathmore and have found that, as a result of CSWI's scale of purchasing, we were able to achieve $1 million in annual procurement savings, which we expect to see the benefits of by the end of fiscal year 2017. Second, we are rationalizing our manufacturing process through the elimination of an expensive third-party manufacturing agreement and bringing that volume in-house. Also, we're reducing our overall manufacturing footprint by combining our 2 manufacturing plants in Syracuse, New York. Third, we have begun a formal process of reviewing our product portfolio to identify portions of the business that are not profitable and adjusting pricing as needed. And lastly, we see a very significant opportunity to expand Strathmore's market share into adjacent applications and end markets that Strathmore already serves and several new end markets where CSWI has an existing presence. In energy, we see a strong countercyclical opportunity in coatings for above-ground storage thanks, barges and ships. And in rail, we're expanding from predominantly the OEM market into the countercyclical refurbishment market, just to name a few. We expect these initiatives into new applications to not only drive organic growth but also significantly reduce end market exposure in the longer term. Turning to Deacon and AC Leak Freeze. The integration opportunities for these acquisitions are primarily through leveraging the CSWI distribution network to reach a broader customer audience and expand end market exposure. For Deacon, we expect to cross-sell these unique high-temperature, high-pressure sealant to a variety of new end markets, including general industrial, power generation and energy, primarily downstream energy. For AC Leak Freeze, we see the primary opportunity to broaden the customer base in the HVAC market for its leading product line of OEM-approved leak repair solutions by capitalizing on our national footprint. We also remain diligent in our operational summit and are beginning to see tangible benefits from recent meetings. In December, we brought together our key manufacturing and procurement leaders across the entire corporation, and we were able to identify ongoing procurement savings of nearly $1 million per year, which is in addition to the $1 million in savings I discussed as part of the Strathmore integration. We have also begun the process to unify our environmental health and safety procedures and implement best practices to ensure continuous improvement across our operating locations. And lastly, we named 3 new business leaders last month. Don Sullivan, who joined us last year from Daikin Goodman and is the former COO of RectorSeal, has been promoted to General Manager of the Industrial Products division. Don will have full P&L responsibility for this business unit and will be tasked with creating and implementing business strategies to grow the Industrial Products division. Mark Lee has assumed the role of General Manager of the Coatings, Sealants & Adhesives division. He has complete P&L responsibility, including Strathmore, which was acquired in April 2015, plus the integration of Deacon Sealant acquired in October 2015. Mark joined us from Waukesha Bearings and Sealants, a division of Dover Corporation, where he held various general management roles, and was most recently Managing Director of Asia-Pacific located in Shanghai, China. Finally, Craig Foster has assumed the role of General Manager of the Specialty Chemicals division. Craig also has full P&L responsibility for this business unit and will also have administrative responsibility for Whitmore and Jet-Lube. Craig joined us from Zeon Chemicals, where he was VP and General Manager of the Elastomers division. We are grateful to have these experienced and proven leaders to run each of our 3 business units and are pleased to have them on our team. And with that, I would like to turn the call back over to Joe.

Thank you, Chris. In closing, we continue to believe that our broadly diversified product portfolio and end markets provide stability for our business. We have a very strong balance sheet and we are growing free cash flow. The recent management changes will result in a renewed focus on operational excellence in each of our business segments. And we believe that, together, we can create sustainable value for you, our shareholders. Finally, let me take this opportunity to thank all of my colleagues here at CSW Industrials as we continue to serve our customers and to steward well the capital entrusted to us by our shareholders. Thank you for your interest in CSW Industrials. Operator, we are now ready to take questions.

[Operator Instructions] Our first question comes from the line Jon Tanwanteng with CJS Securities.

Can you provide an update on these systems that you're putting into place to get more real-time data from the businesses? And have you gotten a good sense of what things look like heading into January and February?

Yes. We are in the middle innings of the implementation of a one-stream product, which is a consolidation and planning and reporting tool that we think is going to fit very, very well for our business. We expect that to be fully implemented in May and that should begin to bear dividends shortly thereafter. We are going to load our 2000 -- fiscal year 2017 budget into one stream as we complete that here in the next couple of months, and that will be a significant benefit to all of us in managing our business and providing us with more real-time data.

And just on January and February and the trends heading in?

Yes. Absolutely, Jon. The 3 kind of drivers for this quarter, I think, were obviously the energy downturn, which continues. And we don't see any change there over the next couple of months or over the next couple of quarters even. Number two is seasonality, and I'm not sure that our no-guidance policy did us any favors this time. But seasonality in Q3 was completely consistent with the seasonality that we have seen in the past with this quarter, both in volume and in margins. So the seasonality does affect our -- it's primarily our HVAC end market. It is -- affects our largest -- that's our largest end market and our largest and most profitable business segment. However, that seasonality hits its low watermark in this third quarter, and we have not seen anything this year that is inconsistent with prior year's seasonality. So there is no concern there whatsoever. Thirdly is Strathmore. And without question, Strathmore has disappointed. That is, in part, energy exposure; part of it is some weakness in rail, which may be indirectly affected by energy; but it's also some management disruption and distraction and slower-than-hoped-for integration. And so that has our full attention. Chris and his team are working on that very, very diligently. We have new leadership there, and I think the trend from here is favorable and much better. And so as we look out for the next -- for this next quarter -- again, we don't give guidance, but I will say that it will be much closer to Q1 than it was Q3.

Great. Chris, you provided a pretty good breakdown on what's going on under the hood at Strathmore. Are there any other specific operating adjustments you're making in the rest of the businesses as a result of macro headwinds you're seeing?

Well, that's good -- thanks for asking, Jon. I think, our recent organizational announcement that was made in December was kind of the start of being able to look at how best to manage our 3 business segments. And so one of the things that I've tasked each of our newly-named general managers is to look for exactly that. So within the Coatings segment, obviously, we've got a lot of activities that are ongoing within Strathmore. At -- in the Specialty Chemicals segment, we've got the Jet-Lube, Whitmore integration project, which is nearing -- more than 80% complete, and that one is on track. But within all 3 segments, we think that there are more opportunities for cross-selling, for sharing of technology and innovation, for optimizing our manufacturing footprint. There are just a lot of additional things that these managers are looking at right now, and we certainly hope that there will be additional synergies that we're able to find going forward.

Okay. Great. And how much of the $7 million in synergies that you've identified has already been realized in the current quarter?

Very little. The $7 million really is -- I think, we indicated we would be fully realized March of 2017. Of course, $5 million of that is related to the integration of our lubricant and grease manufacturing into Rockwell, and so we really don't see the savings on that until towards the end of this fiscal year, early [ph] next fiscal year. The procurement will start to roll out over time. The $2 million of procurement savings is something that we are actively working. And I think, over time, as we go forward through this fiscal year, we will start to see more and more of that, and by the time we get into the beginning of next fiscal year, we should be fully realized on that as well.

Okay. Joe, I assume the market and energy turmoil has helped M&A valuations out there. Can you tell us what the pipeline looks like, and if there's anything that's changed in the last couple of months on that front?

Sure. And Jon, I misspoke earlier. What I meant to say is that Q4 will be closer Q2, not Q1, sorry. Q1 is the high watermark from a seasonality standpoint. Q2 is more of a steady-state quarter. So Q4 is more likely to look like Q2 than it is Q3. That's what I [indiscernible]. Yes, acquisition pipeline. We're actively looking. We are pleased with the activity. One of the results of the organizational changes is David Smith, who has run RectorSeal for the last 25 years and has done such a fantastic job of these product line extensions, these add-on acquisitions; he's done 26 in 25 years or so. David is working with me directly on acquisition and helping us to kind of implement and affect our acquisition strategy. And David and I stay close. He is out speaking to business owners and folks that he's begun relationships with years ago and continuing those conversations and beginning new conversations. And so we have a real focus on that. I would say that the product line extension, smaller, bolt-on acquisitions are really bread and butter for us. And so we continue to pursue those aggressively. They have little integration risk or -- integration is much easier than a larger acquisition, and so we feel like that's a repeatable business process and something that we're spending a lot of time on. So we feel good about that. Deacon and AC Leak Freeze are fantastic examples of the types of acquisitions that we'd like to do on a very, very regular basis.

Great. That actually leads in my next question. Can you tell us how accretive you think Deacon and AC Leak Freeze might be in this year or next?

Well, I think, what we have -- I think we have announced their earnings -- or their LTM EBITDA in each of those, and combined, it's about $4 million of EBITDA. And then, with respect to those businesses, we expect those businesses to grow top line at double-digit growth.

[Operator Instructions] Our next question comes from the line of Peter -- I'm sorry, it seems that we have no further questions at this time. I'd like to turn the floor back to Mr. Armes for any final concluding remarks.

Yes. Again, we thank you for your time and interest today. We do believe that, despite this quarter's headwinds, that this is not an indication of any trend or any indication of the health of the business. We do recognize and acknowledge we have a lot of work to do. And we, as your management team, are committed to growing profits, creating value for you, our shareholders. And we take very, very seriously the responsibility that we have to you, our shareholders. And so thank you, and we appreciate your support.

Thank you. This concludes today's teleconference. You may disconnect your lines at this time. Thank you for your participation.