Good day, ladies and gentlemen, and welcome to the Kadant Inc. Q2 2016 Earnings Conference Call. At this time all participants are in a listen-only mode. Later we will conduct a question-and-answer session andinstructions will follow at that time. [Operator Instructions] As a reminder, this conference call is being recorded. I would now like to turn the conference over to your host, Michael J. McKenney, Senior Vice President and Chief Financial Officer. You may begin.

Thank you, operator. Good morning, everyone, and welcome to Kadant’s second quarter 2016 earnings call. With me on the call today is Jon Painter, our President and Chief Executive Officer. Before we begin, let me read 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 annual report on Form 10-K for the fiscal year ended January 2, 2016. Our Form 10-K is on file with the SEC and is also available in the Investor 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 second 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. With that, I’ll 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’ll give an overview of our financial results for the quarter. And we’ll then have a Q&A session. Jon?

Thanks, Mike. Hello, everyone. It’s my pleasure to brief you on our second quarter results and our outlook for the second half of the year. Overall, we had an outstanding quarter with record adjusted EBITDA, the second-highest – and the second-highest adjusted earnings per share in our history. It was one of those quarters when everything went right, which led to a strong beat on both the top and bottom line. I’ll begin today’s business review with the financial highlights of the quarter. We finished the second quarter with revenue of $112 million, up 14% compared to the second quarter of 2015 and well above our guidance of $103 million to $105 million. Our acquisition of PAAL completed early this quarter had better-than-expected revenue performance as did other businesses in our Stock-Prep product line. Our Doctoring, Cleaning & Filtration and Wood Processing product lines also had stronger-than-expected revenue performance in Q2. Gross margins in the second quarter continued to be strong at 45%. Our adjusted EBITDA was a record $18 million or 16% of sales, up 14% compared to Q2 of last year. Our GAAP diluted earnings per share of $0.75 in the second quarter exceeded the top end of our guidance by $0.22 and included a $0.04 negative impact from currency translation. Our adjusted earnings per share was up 13% to $0.88. Excluding the impact of FX, our adjusted earnings per share increased 18% over Q2 of last year. The one area that was somewhat disappointing was our bookings, which were down $98 million, up only 5% compared to Q2 of 2015 despite the inclusion of bookings from PAAL. The weaker bookings reflect the general softening of markets in North America, Europe and China, and I’ll provide more detail on this in our outlook for the second half of…

Thank you, Jon. I’ll start with our gross margin performance. Consolidated product gross margins were 44.9% in the second quarter of 2016, down 160 basis points compared to 46.5% in the second quarter of 2015. The decrease in gross margins from last year’s second quarter was due to the inclusion of PAAL’s results in the quarter. Excluding PAAL’s results, our gross margins would have been slightly higher than the second quarter of 2015. As we indicated in our last call, PAAL’s gross margins are lower than Kadant’s. And as a result, we revised our guidance and gross margins for the year to approximately 45% to reflect this. Our higher margin parts and consumables revenue represented 62% of total revenue in the second quarter of 2016 compared to 66% in the second quarter of 2015. Now let’s turn to Slide 17 and our quarterly SG&A expenses. SG&A expenses were $36.1 million in the second quarter of 2016, up $5 million from last year’s second quarter and included an increase of $5.1 million from our recent acquisition of PAAL and a favorable foreign currency translation effect of $0.5 million. Excluding PAAL’s SG&A expenses, related acquisition costs and the translation effect, SG&A expenses were up $0.4 million or 1.3% compared to the second quarter of 2015. SG&A expense as a percentage of revenue was 32.3% in the second quarter of 2016 compared to 31.6% in last year’s second quarter, an increase of 70 basis points. Let me turn to our EPS results for the quarter. In the second quarter of 2016, GAAP diluted earnings per share was $0.75 and our adjusted diluted EPS was $0.88. Adjusted diluted EPS excludes a $0.12 charge associated with the amortization of acquired backlog and profit and inventory and a $0.01 charge for acquisition costs related to the…

Thank you. [Operator Instructions] And our first question comes from the line of Dan Jacome with Sidoti & Company. Your line is now open.

Good morning.

Hey, Dan.

Good morning, Dan.

How’s your summer treating you?

Pretty good. Better than expected.

A lot in the call. Appreciate the info and candid comments. I had just four quick questions. I think you mentioned the spares market consumables for U.S. paper is seeing some challenges. Did I get that correctly?

Yes. You want to list them all?

No, no. I’ll just do it one by one. Can you just give us – tease that out a little bit with – is that a function of some of the capacity coming out? I would’ve thought – it seems like some of the guys on the uncoated side are seeing a slightly better pricing. I would’ve thought that, that pocket would have been a little bit better. So what am I missing?

So uncoated, you’re right, there’s slightly better pricing. The linerboard, which is the bigger part of the market, has slightly worse pricing. I think we’ve also – we’ve just seen more market related downtime from mills, a little bit more restrictions on their spending on spares and consumables. And fairly broad-based, I would say. So to me, that – we’ve had weakness in the other parts of the world. Europe’s sort of been weak. China has been reasonably weak. But the softening of the North American spare parts business is kind of a bit of a new thing. I don’t know whether it’s a trend or what have you, but it was – we felt it throughout the quarter, in the second quarter. And that is a major factor and are kind of – we expected a much stronger second half. And I would say now, we’re expecting a more steady year throughout the year.

Okay. No, that’s fair. And then – so PAALGROUP obviously driving a lot of the growth. I don’t know if you can comment. Just what does your acquisition pipeline look like right now? Are you satisfied with it? If anything, the things that are in it, are they similar consumables profile? And what about like the – I think you mentioned PAALGROUP is helping you a lot with cash conversion. Are those kind of themes you’re looking at or is there some sort of different playbook here?

Sure. I would say that the acquisition pipeline is pretty good, both North America and Europe. We’re looking at stuff that would be add-ons for PAAL for sure. But also, other extensions both for our wood processing business and our fluid handling businesses and really, all of our businesses. So yes, reasonable stuff. I’m relatively happy with, I would say, where we are now. It doesn’t mean anything is imminent or anything like that. I would say PAAL is extremely good on cash. I think we’re good on working capital. And they’re better. That’s a bit unusual. So in a normal acquisition, I often expect that the acquisition isn’t as good as us on working capital management, and frankly, isn’t as good as us on gross margins or high percentage of spares.

Great. And then turning to your long-term, I guess, 4% to 6% internal growth target. Just high level, what would be the kind of one or two biggest variables there as you guys look into the future that get you there? Kind of what do you think has to happen relative to what you’re seeing today? What would be kind of – what’s the switch?

Okay, that’s a good question. So the first comment – this is a – I’m going to copy out this like 15 times. But the first one is, the overall economic cycle makes a big difference. So I would say if you kind of took a 5- or 10-year period and you were in the starting point and the ending part were kind of in the same point in the cycle, we would – our goal would be to have that 4% to 6%. What causes year-to-year variability, one of the things is just timing of capital shipments, 2016, excluding acquisitions and FX, will be a down year because, as we’ve said all year long, because 2015 was such a great year in terms of that – we had some big – we had big capital shipments, particularly in our Stock-Prep business in North America and China. Fundamentally, what drives that 4% to 6% is the market growth rate, which is modest. And our – these 15 targeted internal growth initiatives, some of which are like that ceramic creping blade business I talked about. That’s a new business for us. That’s taking share from someone else. Another part – example might be the – getting into carbon fiber, which I talked about. So that’s kind of a double win because one, it’s sales. But more importantly, it’s sales in a market that’s growing orders of magnitude faster than our core markets. So you get a double hit from that.

Got you. And now is my last question. So on this – the creping blade, I mean, how are those conversations going? Is it like just a quick layup or is it something that’s slow and steady and is it a function of like you switching people over current customers that are using kind of steel? Or is it like a greenfield opportunity or – how does it work?

Okay. So as a general comment, one of the things about the paper industry and you know, Dan, our market share in almost every one of our product lines are extremely high. So we love the stability of market share. That said, it’s hard – when you’re the guy banging in, it’s hard to get customers to change. I think we have all the ingredients because we’re so strong in the apparatus that those blades go on. And essentially, there’s almost been kind of a monopoly to a large extent by one company. So I expected it to be a slow steady thing. They typically will trial it for a long period of time and they get in gingerly. And it’s mill by mill, truly one at a time.

Okay, gingerly, good word. Thanks a lot.

All right, you’re welcome.

Goodbye.

Our next question comes from the line of Walter Liptak with Seaport Global. Your line is now open.

So first one, I wanted to ask about the three buckets that, Mike, you put out there for the EPS, the pull-forward from the third quarter into the second, PAAL and the parts. I wonder, if we breakout as a percentage, how much came from each one?

About the percentage, maybe we can give him which is the biggest, which is the middle, which is the…

Yes. They’re relatively a close wall amongst the three, but the pull-in from the third quarter with the Doctoring, Cleaning, & Filtration and Stock-Prep capital shipments, that would be the biggest. Then followed by wood processing and then PAAL. PAAL’s performance is – actually, the delta amongst them in terms of EPS is relatively small.

Okay. And why did the pull forward happen?

Well, they were on jobs that are under POC, percent complete. So work just progressed quicker than originally planned.

Maybe I’ll give a little color on the PAAL thing, if I could, Walt. Typically, we do this often when we have an acquisition. When you have an acquisition, the selling entity gives projections. When you’re – in that time of your life that those projections are typically not very conservative. So we back off of that. And of course, then when we own it, it’s difficult for the new – the management, who are the sellers, to really change it. So we tend to put a little windage on our end on those forecasts. And frankly, I think in this case, the PAAL guys, being their first quarter, they were a little conservative. So between the two, we undershot in our forecast.

Okay. Okay. Well, good for you. They delivered, which is great.

Yes. And then I think they’re looking good for the rest of the year, I would say, at this point, too.

Okay, good. And then in your commentary, you broke out the parts sales, I believe, as a percentage of revenue. I just didn’t get the percentages.

I think it’s 62%.

62%, correct.

Okay. And it was at 67%?

Yes. And PAAL brings us down a little bit. Last year, for the year we ended on average, at 65%. So I think in the second quarter, we were a little bit higher than the average.

Okay. And going back to the conversation about the back half in parts and consumables. I just kind of ask sort of the same question. What do we think is happening? Is it just conservatism? Are macro factors impacting? Because I would think that with parts and consumables, you can’t really delay maintenance for very long.

No. And I look at – we look at production. Our parts and consumables in the second quarter was down more than production would lead you to believe. So there’s a very reasonable argument that things kind of revert to the mean and that when you have a down quarter, maybe it’s followed by an up quarter. But I can tell you, we haven’t seen it yet. We go through this before. These are not huge swings. You saw the numbers, they’re not massive. But it has been a real source of strength for us over the past bunch of years. And it’s – I would say it’s the first real period of sustained weakness we’ve seen though.

Okay, okay. And then the last one for me is just on – just listening to all the geographic regions and your comments on some systems orders. Without putting numbers to it, it sounds like you’re getting a few more systems orders and there’s some visibility in some projects going forward. Is that the case?

I’m glad you asked that. It’s probably worth repeating. I did say, and I don’t think I’ve said this for a long time, that we are seeing an uptick in project activity in China. I don’t think it affects revenue this year. It may not even affect bookings this year. But I think it’s going to affect 2017. So we are, in that particular region of the world, starting to see things percolate maybe up a tick. I’d also say that Europe is bumping along pretty well. We see projects in Europe happening.

Okay. What was Europe ex PAAL for bookings? 46% with PAAL?

Bookings were about $14 million.

Yes.

Okay. Ex PAAL, 14% is pretty good.

No, bookings were about $14 million for PAAL.

All right. So we can back it down and do the math. Got it.

Yes.

Okay. Okay, good. And then in North America, you commented on a couple of larger projects that were booked during the quarter. The same thing is that – are your starting to see more projects in the pipeline for next year?

I wouldn’t actually – I wouldn’t call it more projects in the pipeline. I’d call it there, frankly, a little bit of the softening in our outlook in North America is some capital projects didn’t go away, but they slipped out of this year into next year. So I wouldn’t say there’s an uptick in capital projects in North America.

Okay. All right, fair enough. All right, thanks guys.

All right, thanks, Walt.

And our next question comes from the line of Rudy Hokanson with Barrington Research. Your line is now open.

Thank you. I have several questions about the PAAL acquisition. Jon, in your comments, you were talking about the fact that, I believe, you’re seeing interest in North America for a similar type of business? And if you could maybe talk a little bit more about that? And if you’re actually going out and trying to build revenue for this year or is that just more of a sentiment comment?

Sure. So I think I might have made a little comment on the last call. But PAAL, just as a refresher, a very high leading market share in Europe. Just under 50% market share, we estimate, in Western Europe but basically zero market share in North America, in the U.S. in particular, which is the biggest market. They do have a position in Mexico. Two things have happened that encourage us – three things. One, there’s a perception in this market that the European manufactured balers are the high-end balers, kind of the Mercedes, BMW kind of view. The main European supplier in this market has gone through a little bit of a tough time. And they’re still in business, they’re still in this market, but I would say that they’ve lost some significant customers, it seems. Secondly, there’s been some consolidation in the industry, which usually provides an opportunity for new entrants. So I think the market conditions are great for us to do that. I do think it’s an area where we can help PAAL get into this market. It’ll take time because you have to build a service organization. These things when they – there’s the high cost of failure, which is one of the things we liked about the product, but it also means you can’t go selling it unless you have a good support infrastructure in place. So our efforts around how are we going to go to market in the U.S. and building out that service infrastructure, which may involve some manufacturing.

Could you give us a timetable that you’re working with right now as far as North American presence? I mean is it something that you plan to have in place by mid-2017 or the end of 2017 or when will we begin to see some influence of that thinking?

Okay. So take a lot of this with a little – it’s in flux, but I would expect that we would be out there selling in 2017. Then the question is, not unlike our paper industry customers, customers in this industry are conservative. And it will take – it’s a missionary work thing. So I do think it’ll take some time.

Okay. Then I was just wondering a little bit more about expectations on the wood, on Carmanah. Can you talk about anything that you’re hearing or seeing in terms of expectations on housing right now that would affect that? Could you explain that a little bit more?

Sure. I mean – so you know, but just for refresher for others, they make these stranders, which make the strands in oriented strand board, which is a – this is a replacement for plywood. And about – in the North American housing market, which is – that’s the place where wood houses are, 80% or so of the market is the strand boards rather than plywood. So the main driver for sure is housing. Housing starts have been excellent. The one – the last announcement last month was one of the highest since – for many, many years. And it looks strong for awhile mainly because of this under building that happened since the financial crisis. One thing that is kind of happening and we’re just watching, but it’s on the upside, is that the new houses tend to be more multifamily than single-family. Obviously, there’s less wood used in a multi-family. It’s these millennials that are more urban living. So we’re waiting them for – to have kids, get bikes, move to the suburbs like we all did. But that hasn’t happened so much yet. But it looks good and it looks good for many years. When we did the acquisition, we went out for like, I think, 2023 with the projections and they were quite strong for that period of time. On the international front, there is stuff going on internationally as well. In China, they use it for things like making crates. We’re making some very strong inroads in Europe, where we don’t have the leading market share. But we’re actually, I would say, gaining market share there.

And this is a question I haven’t asked it before. Thought about it. But with – you’ve seen some downtime in the paper industry, and thus some weakness is anticipated on the consumable side. Is that due to any particular maintenance that is required? Or is that something that you feel is being taken because the mills are concerned about maybe building inventory? Or can you tell at what level inventory may be right now so as to what it might take for them to decide they need to start up? Is there some variable or some level of production or product that we can watch to see where they are as far as any kind of – I don’t know how better to say it.

Yes. It’s complicated, I tell you. The mills, if you look at and if you were to listen like an International Paper or have someone of the big producers, their earnings are highly impacted by uptime. That’s one of the reasons our equipment is so important to them. They take annual maintenance downtimes every year. It’s actually good for parts because they sort of replace a lot of stuff. The stuff that’s less good is they also take market related downtime. And that’s where they say, hey, we’re going to cut back our production because we don’t want to build up inventory and we see that we’re – our production, the capabilities are ahead of the market. So there was little more of that this quarter, at least maybe we have a heavier [weighting for] the people who are our customers. But we saw more of that. It’s a good thing they do that. I mean it helps them maintain pricing right now, particularly in the North American market. You have – the top three players have probably 70% market share between them in liner. And they do this rather than let pricing go all to hell and make less money. The thing to look at to me, Rudy, is demand, consumption. What is consumption of paper? It’s been quite stable in the U.S. Slow growth, 1%, 1.5%.

Okay. Okay. So it’s basically been matching what GDP has been recently?

It’s typically a little bit less than GDP. Typically. It depends on the year. Sometimes, consumption will go – and I’m talking liner tissue, those are the better – printing and writing newsprint tend to go down. But those two grades will be, in general, a little bit less than GDP. I know GDP in the third quarter was – or the second quarter was weak. But generally, a little bit less than GDP.

Okay. Thank you, those are my questions.

All right. Thanks, Rudy.

[Operator Instructions] I’m showing no further questions in the queue. I would now like to turn the call back over to Jon Painter for closing remarks.

Thanks, operator. I want to conclude today’s call with what I think are several key takeaway points. First, we had another outstanding quarter in revenue, earnings per share and cash flow. Second, our integration of PAAL into the organization is going well and its performance has exceeded our expectations. And finally, we continue to expect 2016 to be a strong year despite the challenging market environment around the globe. I look forward to updating you next quarter. Thanks very much for your attention and support. Bye.

Ladies and gentlemen, thank you for participating in today’s conference. This concludes today’s program. You may all disconnect. Everyone, have a great day.