Kadant Inc. (KAI) Q3 2012 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen, and welcome to the Q3 2012 Kadant Inc. Earnings Conference Call. My name is Sue and I am your Event Manager. [Operator Instructions] As a reminder, this call is being recorded for replay purposes. I would like to turn the call over to Thomas O’Brien, CFO. Please proceed, sir.

Thank you, operator, and good morning, everyone and welcome to Kadant’s third quarter 2012 earnings call. With me on the call today is Jon Painter, our President and Chief Executive Officer. Let me begin by encouraging all participants in our business review today to participate via our webcast. You may access the live webcast by going to www.kadant.com, select the Investors tab, and then select the listen live option for the webcast. To participate in the question-and-answer session at the end of our prepared remarks, you will need to dial in to the teleconference. The dial-in number is available in our press release issued yesterday. It will also be shown at the end of our presentation. Let me now remind everyone of our Safe Harbor statement. Various remarks that we may make today about Kadant’s future expectations, plans, and prospects are forward-looking statements for purposes of the Safe Harbor provisions under the Private Securities Litigation Reform Act of 1995. Our actual results may differ materially from these forward-looking statements as a result of various important factors, including those outlined at the beginning of our slide presentation and those discussed under the heading Risk Factors in our report on Form 10-Q for the fiscal quarter ended June 30, 2012. Our Form 10-Q is on file with the SEC. It is also available in the Investors section of our website at www.kadant.com under the heading SEC Filings. In addition, any forward-looking statements we make during this webcast represent our views only as of today. While we may elect to update forward-looking statements at some point in the future, we specifically disclaim any obligation to do so, even if our estimates change, and you should not rely on these forward-looking statements as representing our views on any date after today. During this webcast, we will refer to some non-GAAP financial measures. These non-GAAP measures are not prepared in accordance with Generally Accepted Accounting Principles. A reconciliation of the non-GAAP financial measures to the most directly comparable GAAP measures is contained in our third quarter earnings press release issued yesterday, which is available in the Investors section of our website at www.kadant.com under the heading Investor News. So with that, I will turn the call over to Jon Painter, who will give you an update on Kadant’s business and future prospects. Following Jon’s remarks, I will give an overview of our financial results for the quarter and we will then have a Q&A session. Jon?

Thanks, Tom. Hello, everyone. It’s my pleasure to brief you on our third quarter results from a weather weary East Coast. Overall, we had an outstanding quarter highlighted by record adjusted diluted earnings per share and particularly proud of our results as they were accomplished in an increasingly challenging macro environment. I’ll begin my remarks with an overview of our financial performance in Q3. We finished the third quarter with revenues of $87 million, up 3% compared to the same period last year, despite a 4% unfavorable FX impact. Our gross margins were 43% in the quarter and demonstrate the sustainability of the productivity and efficiency gains that we’ve implemented. Most importantly, we generated adjusted diluted earnings per share of $0.66 in the third quarter, which was a 40% increase from Q3 of last year and the highest adjusted quarterly earnings per share in our history. Our EPS performance benefited from higher than expected revenues as well as a lower than expected tax rate, which Tom will discuss in his remarks. Our adjusted EBITDA for the third quarter was $12.1 million or 14% of revenue. Finally, our cash flow for operations was quite good at $13 million and our cash less net debt at the end of the quarter was $42 million. In summary, I think it’s fair to say that our operations are executing extremely well. Beginning this quarter, we’ve combined our Doctoring, Water Management and Other product lines into a single product line for financial report and purposes, and we now refer to these products under the catchy name of Doctoring, Cleaning, and Filtration product line. I think it’s a sensible way to look at our revenue as these products typically operate as a single business. Taking a look at our revenue performance by product line on slide six, our revenues in the third quarter were 3% higher compared to Q3 of last year, due largely to an increase in the aforementioned Doctoring, Cleaning and Filtration product line. Excluding FX, you can see that our Q3 revenues were up 7% compared to Q3 of last year. We had a disappointment in the quarter; it was our bookings of just over $69 million, which was down 27% from last year and is a reflection of the headwinds found in the macro economy. A significant decline in capital bookings particularly in North America and Europe was the key driver leading to this decline. Our capital bookings were down more than 50% compared to a very strong Q3 of 2011, which included two large chemical pulping equipment orders with the value of nearly $20 million. On a sequential basis, our capital bookings were down 19%. Looking a bit closer at our bookings by product line on slide seven, you can see that Stock Prep was down 48%. This was driven by a decrease in capital bookings due to the chemical pulping orders I just mentioned. In addition, our Fluid Handling line was down 19% due to slower activity in North America and Europe. On the other hand, our Doctoring, Cleaning and Filtration product line was up 3% as a result of stronger bookings in North America and China. The bookings and revenues trend chart on slide eight shows our quarterly revenue, which is the red line and our bookings, which are the blue bars. Revenues were up 4% sequentially led by our Stock Prep product line in China, which show revenues nearly doubled from the previous quarter. While revenues saw a modest sequential increase in the third quarter, the market and economic factors I mentioned led to a 10% sequential decline in bookings in Q3. Lower bookings in North America and Europe were partially offset by increases in China, but the increases were not enough to prevent an overall drop in Q3 bookings. Without a doubt our bookings, particularly for capital, had been adversely impacted by the concerns about the situation in Europe as well as the slowing global economy. That said, I do not think $69 million of bookings per quarter is the new normal. As I have noticed on previous calls, the timing of capital orders can also play a role in the quarterly booking rates and I believe that was the case in Q3, as we have several capital projects in the work - in the works, which I expect we’ll book in Q4. As you can see from the chart on slide nine, while our Parts and Consumables business is considerably more resilient than our capital business, it is not immune to the headwinds we’re seeing in the market. Looking at bookings, which are shown in the blue bars, you can see the bookings in Q3 increased 6% compared to a fairly weak Q3 of last year, but were down 5% sequentially. The declines were in North America and Europe, where the third quarter tends to be one of our weaker quarters due to summer holidays and the timing of annual maintenance shutdowns. China continues to be a bright spot for our aftermarket business with bookings up 14% over Q3 of last year and 25% sequentially. Similarly, our Parts and Consumables revenues were down 6% from Q3 of 2011, and 9% sequentially. Overall, our revenues for Parts and Consumables were $44 million, and represented approximately 50% of our Q3 revenues. I’d like to take the next few minutes to review our business activities in each of the major geographic regions of the world, starting with North America. Although, the economic recovery in North America has been sluggish, the paper industry has performed relatively well, and analysts expect producer margins to remain fairly stable in the near-term. In addition, input costs appear to be under control and inventory levels are fairly low. Containerboard continues to be a bright spot with operating rates at 96% in September and slightly above 95% year-to-date. In addition, a $50 a ton price increase recently took effect. As you may recall, containerboard is an important grade for our business and containerboard and along with tissue typically makes up nearly 60% of our customer base. Our Q3 revenues in North America were $35 million, up 9% compared to the same period last year. This uptick was due in large part to revenue increases in our Stock Prep product line. However, on a sequential basis, our North American revenues were down 13% due to weaker revenue performance in our Fluid Handling and our Stock Prep product line. Bookings in North America were down 24% in Q3 compared to the same period last year and 10% sequentially. Our third quarter bookings reflected general slowdown in business activity in North America particularly for capital orders. The decrease in bookings was primarily driven by a decline in our Stock Prep and Fluid Handling capital business, which was down significantly compared to a very strong Q3 of last year. Turning to Europe; Europe’s struggles with its sovereign debt issues continue to impact its economy and the regions slipped into recession going to 2013. As you might expect, this macro environment has impacted the demand for paper products. Our revenues in Europe were down 19% compared to Q3 of last year and down 4% sequentially. Bookings in Europe were down 48% compared to a strong Q3 of last year due largely to declines in our Stock Prep product line. As you can see from the chart, for the three quarters prior to Q3, the bookings rate was right around $19 million a quarter. Our quarterly bookings dropped to $15 million in Q3, but I believe that the timing of capital orders was a factor in this as I mentioned earlier. Now let’s take a look at China. The economy in China continues to slow GDP growth dropping to 7.4% in Q3. Although, the rate of growth has slowed, the important thing is that it’s still growing and the economy continues to absorb the capacity that recently came online. We do see some producers beginning to make plans for capacity expansion, but the timing of orders remains uncertain. Our Q2 revenues in China increased 59% sequentially, but were down 8% year-over-year. The sequential increase was due in large part to higher revenues from our Stock Prep as well as our Fluid Handling product lines. Bookings more than doubled from a weak Q3 of 2011 driven primarily by our Stock Prep product line. During the quarter, we booked several OCC Stock Prep systems with a combined value of $8 million and also booked an order for our tissue [indiscernible] with a value of approximately $1.2 million from a major tissue producer. Our efforts to increase our aftermarket business continued to produce results with bookings for aftermarket products up 14% over Q3 of last year and 25% sequentially. Before finishing my regional review, I want to take a few - make a few comments on our business activity for the rest of the world. As you can see on slide 14, revenues have been on an upward trend for the past three years. Q3 revenues were up nearly 50% year-over-year and 27% sequentially, with the majority of these increases coming from South America and India. Bookings in the rest of the world regions generally have more variability due to the impact of capital orders. In Q3 for example, we booked an order for a Korean tissue producer for our next generation de-inking equipment as well as capital equipment orders for high-efficiency thermal compressors in Brazil and Ecuador. A few weeks ago, our senior managers from around the world met to review our progress on key initiatives and outline our near-term and longer-term strategic goals. I can tell you that increasing our presence in the faster growing, developing world continues to be a major focus of ours, and we have several action plans in place to accomplish this that are being implemented. I believe as we expand our global footprint deeper into these developing regions, we will not only increase our revenues, but we will see a higher proportion of our revenues coming from these faster growing emerging markets. I’d like to close my remarks with a few comments on our guidance for the fourth quarter and the full year 2012. Our biggest concerns going forward continue to be the weak global economic environment and uncertainty facing our customers. This uncertain macro environment has affected our bookings for the last several quarters, particularly for capital projects. For the fourth quarter, we expect to generate $0.35 to $0.37 of diluted earnings per share on revenues of $77 million to $79 million. We’re increasing our full year guidance and we now expect to achieve GAAP diluted earnings per share from continuing operations of $2.18 to $2.20 on revenues of $331 million to $333 million, and that’s up from our previous guidance of $2.05 to $2.10 on revenues of $305 million to $330 million. I’ll now pass the call over to Tom for additional details on our financial performance. Tom?

Thank you, Jon. I’ll start with a review of our gross margin performance. Consolidated product gross margins were 43.4% in the third quarter of 2012 up 70 basis points compared to 42.7% in the third quarter of 2011. Margins were notably stronger than last year in the Stock Prep product line largely due to better margins of several large systems projects in both North America and China. Product mix had a small unfavorable effect on consolidated gross margins in the third quarter of 2012 compared to the third quarter of 2011. On that point although capital gross margins were markedly higher than the last years’ third quarter, they represented a higher proportion of revenues and therefore have the affect of decreasing the consolidated gross margin results. Looking ahead, we expect the consolidated gross margins will be approximately 44% for the full year 2012 or slightly higher than last year. Now let’s turn to slide 18, and our SG&A expenses. SG&A expenses were $26.2 million in the third quarter of 2012, essentially the same as last years’ $26.1 million and included a favorable affect of $1 million or 4% from foreign exchange. As you can see on the chart, SG&A expenses have been relatively flat for the past several quarters. Operating leverage improved, with SG&A expenses as a percentage of revenues declining from 30.9% a year ago to 30.2% in the third quarter of 2012. Looking forward, we continue to expect that SG&A expenses will be approximately 31% of revenues for the full year 2012. Let me turn to our EPS results for the quarter on slide 19. Diluted EPS from continuing operations was $0.66 in the third quarter of 2012, and was a record high when compared to prior quarters on an adjusted basis. As we analyze EPS, let’s start with the left hand side of the chart, where we show the reported results from continuing operations in the third quarter of 2011. There we reported GAAP diluted earnings per share from continuing operations of $0.80, which included income of $0.17 from discrete tax items, and a gain of $0.16 from the sale of assets. Excluding these two income items, adjusted diluted EPS was $0.47 in the third quarter of 2011. Now, let’s compare the $0.66 of diluted EPS in the third quarter of 2012 shown at the far right of the chart to the adjusted diluted EPS of $0.47 in the third quarter of 2011, an increase of $0.19. This increase of $0.19 in diluted EPS between the two periods consists of the following; increases of $0.07 from higher revenues, $0.05 from a lower recurring effective tax rate, $0.05 from a higher gross margin percentage, and $0.04 from lower weighted average shares outstanding. These increases were offset slightly by a decrease of $0.02 associated with higher operating expenses. Collectively included in all the categories I just mentioned was an unfavorable foreign exchange translation effect of $0.02 in the third quarter of 2012 compared to last year. Our effective tax rate was approximately 21% in the third quarter of 2012, considerably lower than the 30% rate, which we included in the third quarter guidance. The lower rate, which had the effect of increasing diluted EPS by approximately $0.08 from guidance, resulted primarily from higher than expected utilization of foreign tax credits, which have been fully reserved in prior periods. The higher foreign tax credit utilization is in turn associated with increases in both our estimated foreign source income and our profitability in the U.S. in 2012. For the full year, we believe that our effective tax rate including discrete items will be approximately 26% to 28%. Now, let’s turn to our cash flows, working capital and debt leverage starting on slide 20. Operating cash flows from continuing operations were $13.2 million in the third quarter of 2012, a very strong performance and one of our better quarters, and compares to $12.3 million in the third quarter of 2011. During the third quarter of 2012, we sold approximately $2.5 million of bank notes for cash in China, and this amount is included in the operating cash flow results. Our major non-operating uses of cash were relatively low in the third quarter of 2012. We purchased $700,000 in CapEx, we incurred debt issuance costs of $600,000, and we purchased $1.4 million of our common stock, representing approximately 56,000 shares at an average purchase price slightly over $22.20 per share. In the first nine months of 2012, we have purchased approximately $9.8 million of our common stock or approximately 45% of the net income generated during that period. As you can see on slide 21, we made good progress in two of our three key working capital metrics in the third quarter of 2012. Most significantly, days in inventory decreased by 12 days on a sequential basis and were 26 days lower than in the third quarter of 2011. Much of this improvement resulted from shipments of several large system orders in China. Days in receivables are also down sequentially from 74 days in the second quarter of 2012 to 70 days in the third quarter of 2012, although still eight days higher than a year ago. Our AP days were unfavorable that is lower on both a sequential basis and compared to the third quarter of 2011, but the effect here on our overall working capital position was relatively minor. Putting all this together, our overall working capital performance as measured by working capital compared to the last 12 months’ revenues remained quite strong at 13.4%. Some analysts use the measure of overall working capital performance called the cash conversion cycle, which is calculated by taking days in receivables plus days in inventory and then subtracting days in accounts payable. By this measure, our cash conversion days were 113 in the third quarter of 2012, down from 122 days in the second quarter of 2012 and 129 days in last year’s third quarter. With the strong operating cash flows and relatively low level of non-operating uses of cash, our net cash position improved considerably during the quarter and is at its highest level in over seven years. Net cash that is cash less debt at the end of the third quarter of 2012 was $41.5 million, an increase of $11.4 million compared to the second quarter of 2012 and up $10.8 million compared to the third quarter of 2011. During the quarter, we took advantage of the favorable credit market environment and entered into a new five-year unsecured revolving credit facility, replacing our former facility which was scheduled to expire into February 2013. The new facility which was arranged by RBS Citizens and Wells Fargo Securities as joint leader rangers includes a committed aggregate principal amount of $100 million as well as an uncommitted, unsecured facility of an additional $50 million. The principal on any borrowings made under the facility will be due in August 2017. And on slide 24, you can see that our leverage ratio has declined substantially since the end of 2009 and now stands at 0.05 at the end of the third quarter of 2012. Under our new credit facility, this ratio must be less than 3.5. That concludes my review of the financials, and I will now turn the call back to the operator for our Q&A session. Operator?

[Operator Instructions] Your first question comes from the line of Joe Bess, ROTH Capital.

Jon, I was curious, could you talk a little bit about maybe - talk about what sort of end markets you’re seeing strengthen in right now when you look at it versus last year, is it then paper or tissue versus containerboard or have you seen any sort of trends with end markets?

Yes, I would say, overall, and this quarter being no exception, the stronger quarters are containerboard and tissue, and the weaker quarters are printing and writing and newsprint. So that is the structural trend that will continue for the next several years. There may be little blips up and down, but more or less you’ve got good stability in containerboard and tissue, and some structural weakness in printing and writing and newsprint, due to the digital iPads that kind of stuff.

And then, can you give us an update on what you guys are seeing in the M&A pipeline, is there any opportunity there for you guys at this point?

We continue to actively look. I would say we’re -as I think I might have mentioned in one of the earlier calls, we’re probably focusing more on product line extension tuck-in type acquisitions as opposed to larger ones, but we’re seeing some stuff that could be interesting.

And your next call comes from the line of Walter Liptak, Barrington Research.

I wanted to ask about, a little bit more color on the trend in China because we did see a pick up there, but that runs a little counter to, I think, some of the things that we’ve been seeing. Is it - do you think it’ll sustain - you mentioned a few things about maybe some projects and some expansion that could happen. What do you think needs to be happen for those - those projects to get led?

Well, I mean, the - yes, if you look at - maybe put up slide 13, can we, if you look at China, yes, it started quite weak in the year and it strengthened every quarter this year. That said, one thing I know about China is it won’t be a nice neat stair step in any particular direction. It’s got more volatility. We’re - I would say most of the activity we’re seeing is in linerboard and it’s - it does run a little counter to the overcapacity that they have. I think that it will probably take them a period of time to absorb that completely, and then we’ll probably see a stronger set of bookings, but for right now it’s nice to see them sort of steadily strengthening I guess.

Okay. And are you thinking that we’ll continue to see the stair step up through the end of this year or is it in 2013, where we get that to improve?

I just - if you look at the history, it doesn’t have anything that’s neat stair step style. It will be - there will be some volatility. So I - just because you see a trend of three quarters, I wouldn’t necessarily assume the fourth quarter will be stronger per se, but I would say - I tend to look over a longer period of time that economy is growing, they’re going to absorb that capacity and they’re going to need more. So whether it happens next quarter or the quarter after or mid-2013, I don’t know exactly, but as far as our plans, we can - we know that economy continues to have some big structural advantages and should sort of steadily grow at that 6% to 8% rate over time.

Okay. Okay good. And if I could switch over to North America, I wondered, if you could talk about the mix here, is it more aftermarket? And I think you mentioned less in capital projects, and one thought that that we had was with natural gas prices being down, does that impact some of the energy efficiency spending?

Okay. Sure. So if you could have slide 11 up there, so you can see kind of on that slide is actually opposite of China, and I would say as an overall observation if comparing now to the beginning of the year, you have China strengthening from a very weak start and the U.S. weakening somewhat from a very strong start in Q1. I would say that there is a couple of factors going on in that. One is this that I would say there is general, somewhat slower project activity from again a very strong Q1. The other thing, particularly when you look at the change from really from Q1 to Q2 to Q3, the Parts business in North America is a big factor there. We said before that Q1 tends to be our strongest quarter for Parts, because people are - and Q2 the second and Q3 the worst, and that has a little bit to do with the seasonal nature of vacations and stuff like that in North America and Europe as well as customers buy parts for the shutdowns that come in the summer and the spring. So if you look the drop from Q2 to Q3 was about $4.3 million. Of that about $2.6 million was Parts, so Parts is more than half of the drop. And frankly our granules business, our fiber-based product business, which is very seasonal that’s tied to the agricultural cycle, that was a $1.5 million of that $2.5 million drop. So I would say that there is a big aspect of seasonality in the Parts decline in Q2 to Q3 and that’s the bulk of the sequential drop. That said, I would say, it’s not as strong - the U.S. is not as strong as it was in the beginning of the year.

Okay. But it sounds like there is nothing structural - structurally wrong, just concern over the general macro, the fiscal cliff...

Yes.

And maybe some of these things starting to turn and getting a good bookings period in the first quarter next year?

Yes. If I was to speculate a little bit, I would say the Parts business will resume its seasonal nature and will be fine. And the capital business, you never know what’s going on with projects, but when people hear about fiscal cliffs and elections and all that kind of stuff, change in tax laws, it tends to affect capital much more than it does Parts and it tends to affect big capital projects types even more.

Thank you. You have no questions at this time. [Operator Instructions] If there are no further questions waiting. I would now like to turn the call over to Jon Painter for closing remarks.

Okay. Thank you, operator. Let me conclude with just what I view as a couple of key takeaways for the quarter. First, we had an excellent quarter and achieved record adjusted earnings per share. We certainly don’t want to forget that. Secondly, well some of Walt’s question kind of highlighted, there is some uncertainty in the global economy and that’s definitely had impacted our Q3 bookings, but I would say that the timing of capital orders also played a role. And finally, we are raising our full year guidance, and we now project to beat last year’s record diluted earnings per share. I look forward to updating you on our fourth quarter and full year results on our next call. Thank you very much for listening. Bye-bye.

Thank you. Thank you for your participation in today’s conference. This concludes the presentation. You may now disconnect. Good day.