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

Thank you, Nicole. Good morning everyone, and welcome to Kadant's second quarter 2018 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. These forward-looking statements are subject to known and unknown risks and uncertainties that may cause our actual results to 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 December 31, 2017, and subsequent filings with the Securities and Exchange Commission. 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 and the slides presented on the webcast and discussed in the conference call, which are available in the Investors section of our website at www.kadant.com under the heading Investor News. 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'll give an overview of our financial results for the quarter, and we will then have a Q&A session. Jon?

Thanks Mike. Hello everyone. Thank you for joining us this morning to review our second quarter results and discuss our outlook for the second half of the year. Overall, we had another terrific quarter with strong growth in bookings and revenue and a solid earnings per share beat. Let me begin with the financial highlights of the quarter. We had near record bookings of $176 million, up 47%. The contribution from our recent acquisitions as well as strong capital bookings in all our major markets led to this growth. Q2 revenue was up 41% to a record $155 million. Gross margin came in at 44% due to the inclusion of recent acquisitions and the larger percentage of capital orders we shipped in the second quarter. Adjusted EBITDA was up 37% to $26 million or 17% of revenue. GAAP diluted earnings per share was up 50% to $1.08, while our adjusted earnings per share was up 3% to $1.07. Cash flow from operations which was definitely one of the highlights of the quarter at $28 million left us in a net debt position of $146 million and a leverage ratio of 1.56 at the end of the quarter. As you can see on Slide 6, foreign currency translation had a favorable effect in the second quarter and the newly acquired businesses also made a significant contribution to our financial performance. Our internal revenue growth which excludes FX and acquisitions was 10% continuing the strength we've seen in the last few quarters. Internal growth and bookings was also very healthy at 11%, and I'm pleased to report that our internal revenue growth of parts and consumables is 6% while booking for parts was up 7%. Turning to Slide 7. Following our record bookings levels set in Q1 of this year, we had…

Thank you, Jon. I'll start with our gross margin performance. Consolidated gross margins were 44% in the second quarter of 2018, down 390 basis points compared to 47.9% in the second quarter of 2017. Our second quarter 2017 gross margins were one of the best quarterly performances ever and were influenced by a high percentage of parts and consumables in our overall product mix. Our parts and consumables revenue represented 61% of total revenue in the second quarter of 2018 compared to 64% in the second quarter of 2017. In addition to the lower percentage of parts and consumables in 2018, the most significant factor reducing gross margins in the second quarter is the inclusion of the lower margins from businesses we acquired last year, which includes some product lines that have lower margins in our legacy business. I should also note that they have lower SG&A costs as well. The remainder of the change is due to lower gross margins achieved on capital equipment sales. Margins on capital equipment sales are very order specific, and as a result can fluctuate between periods. The gross margins on our legacy parts and consumables were essentially the same in both periods. Now let's turn to Slide 16 in our quarterly SG&A expenses. SG&A expenses were $45.1 million in the second quarter of 2018, up $6.2 million from the second quarter of 2017. This included an increase of $6.9 million from our acquisitions and $1.1 million from an unfavorable foreign currency translation effect. SG&A expenses in the second quarter of 2017 included $4.1 million of acquisition costs. SG&A expenses as a percentage of revenue decreased to 29.1% in the second quarter of 2018 compared to 31.6% in the second quarter of 2017, when acquisition related costs are excluded in the prior year period.…

[Operator Instructions] And our first question comes from Walter Liptak from Seaport Global. Your line is now open.

Congratulations on the good quarter. It looks like all the fundamentals are going really well for you. I wanted to ask about the $0.19 FX headwind in the guidance. And I wondered what assumptions did you make about the U.S. dollar for the back half? Did you take the dollar where it is right now and project it forward, or was there some assumption that you made?

Yeah, it's a good question, Walt. We're essentially using the spot rate at the end of the second quarter. So, we're really not making any assumption on the dollar weakening or strengthening. We're just looking at the spot rate at the end of the second quarter.

Okay. Are there any – so, it just looks like, the $0.19 looks like a big number. You know in the second quarter, was there headwind from foreign currency? Or is it just in the forward?

Yeah. Yes, it was about $2.5 million looking at the guidance we gave back in April.

$2.5 million on revenue. How about on EPS?

That was about $0.02, just for the second quarter. And so, yes, of course there was an impact in the second quarter.

Okay, and so it ramps up, because of comps, I guess?

Yeah.

Okay. Are there any other assumptions in that 2018 guidance that we should know about that are headwind you called out the tariffs, obviously is there anything else that we should know about.

No, I mean we're assuming, as I kind of said in my remarks that you know we – our plan is to mitigate the tariffs through sourcing and pricing, but it will be – you know have relatively little impact in 2018, and in 2019 will sort of be continuing stuffing it up. I think our goal is eventually you know to mitigate it a 100%, but I don't know that we would do that in 2019, and we certainly are having minimal impact in 2018.

Okay. And the reason that you don't take up prices, because these are contracts that you've already signed prior to the tariffs?

Exactly. You saw our big backlog building up. Much of that was done before the tariffs were really in place. So, in the end it's not that huge of an impact on us, so it's not the kind of thing you can go back and renegotiate a contract you've signed.

Okay good. If I can switch gears to Asia, I guess that was a nice surprise in the quarter, you know for I think at least six months, you guys have been talking about China orders that are going to slow because of the U.S. waste paper restrictions. But I guess the pickup in orders outside of China are you know – are obviously extremely strong. And so, I wonder about the investment funnel I guess, so as you look into 2019 and 2020, you kind of alluded to big projects that are out there. Can you give us an idea of what the order could look like, what the opportunity is for Asia ex-China?

That's a great question Walt. You know, I would say also that is the – to me the most important thing that we're talking about on this call, is this build-out of pulping capacity outside China. We had you know, as you know Walt, for a while we were saying that we expected the Stock-Prep capital orders within China to dissipate in the second half, nothing to do with the waste paper. It was more just the fact that they've done a lot of building. And I think that's still the case, but it is well, well more than offset by this need to build out pulping capacity outside of China. And, to put it a little bit in perspective, China right now exports around 20 million tons of fiber every year in the form of boxes to the U.S. and Europe, primarily the U.S. and they've imported about 25 million tons. You know they've just OCC and mixed office waste is cut in half from what it was, they were importing about 7 million tons so far this year. Last year they had about 14 million tons. So, big, these are huge changes and of course if they ban all imported waste paper, they are going to have to – they're going to have to figure a way to get fiber into that market to the tune of 20 million tons, or 25 million tons. So, we are we – the bookings we talked about are you know less than – sort of less than 5 million tons. They're probably in the 3 million to 4 million tons. So, I don't know exactly how this is all going to play out, but if China is serious that they are going to ban all waste paper by 2020, that way they're going to have to figure some stuff out in terms of how to get pulp in. And of course if they process the – the restrictions are because the waste paper has these contaminants in it, by pulping it outside of China, you get around that, because you essentially are removing the contaminants in Vietnam or Thailand or wherever they do that and then they send relatively clean pulp into China.

Okay. Alright great. Well, it's not like the sector in Asia will be very strong for…

We don't – we can see Q3 looks pretty good. I can tell you that. And I would say this is kind of unchartered territory for how this is going to go, but if China is serious about this, that will force of investment.

Okay. If I could just switch gears but stay around the same line, thinking about the sector, you mentioned North American packaging is healthy for the medium term, so, I wondered if you could just clarify what do you mean by medium term, is it this year, is it into next year, and I guess I'm thinking about what do you think about North America packaging in 2019. Are there still project that are building in the – in your funnel? Do you expect steady growth in 2019?

Right. And I – when I talk about the medium and short-term, I am not saying in any way the long-term is worst. As I've talked about before, I absolutely think this structural change with the e-commerce and Amazon impact and what that drives to boxing is got, that's a long-term structural change, so I am totally optimistic in long, medium, short and long-term. I can tell you that the analysts were forecasting capacity additions in North America are talking 3.5% increases for the next couple of years.

Thank you. And our next question comes from Chris Howe from Barrington Research

Good morning, gentlemen. Good quarter.

Hi Chris, how are you doing?

Hi, Chris.

I am going great. I just wanted to see if there is been any update as in regard to the acquisition environment. Are you still seeing kind of the same things that you've echoed before as far as things being a little bit expensive or just kind of what you are seeing there in the quarter and right now I guess?

Sure. So I am actually very happy. We have a business development person whose is doing an excellent job and we are seeing a lot of stuff. That said, it's been a little on the expensive side. So we found a number of things we actually like quite a bit, but we just couldn't get there and price. So I would say it's active, but a little on the pricey side for our taste at this point.

Okay. Then another thing, previously you mentioned a five year goal while back of 2% to 3% organic revenue growth. And is there going to be an Investor Day coming up or is that something that's a little bit archived right now?

Well, so another good question, Chris. With that I am almost a little embarrassed about that forecast for 2021 because we are basically kind of bumping against it in 2018. So yes, we need to re-do. We are going to have another Investor Day towards the end of this year or possibly the beginning of next year and we'll probably update that. We had our internal revenue growth of 2% to 3%. Last year we did around 6%, this year we are probably going to do around 10%. So, we are well ahead of that. That said, I don't think this is a five year growth rate. So, we'll have to come up with something that's maybe not as conservative as we were before, but certainly not as aggressive as we are experiencing right now. And we'll update the acquisition model and so forth. I wouldn't be surprised if we have a little more on the internal side and little less on the acquisition side, but we have to work all that through.

I think you mentioned before the oriented strand board and how that's a growth opportunity moving forward in Asia? How should we think about that? How material could that be within the next 12 months or so?

Let's start with – it's a very big opportunity, right. A lot of furniture built in China. I have heard and these are not – I am going to caution, these are not sort of my estimates, but the people who we work with in that area say that, if this thing really takes off over the next sort of 5 to 10 years, you could be looking at another 50-60 OSB mills. So, that would be a lot. My guess is with missionary, this is a missionary product, it will probably take longer, but to put it in perspective, we've booked so far two OSB mills that we have some optimism, we'll book some more in Q3. Prior to that there were was only really three western OSB mills in the whole country. So, this is a big influx of a new product line. So we kind of see a pausing, I would say not stopping, but pausing as they work to introduce this product and then if it's successful you should see a sort of pick up again at some point.

Thank you. And our next question comes from Bill Hyler from WDH Capital. Your line is now open.

Hi. Good morning guys.

Hi Bill, how are you?

I'd like to delve a little more into this containerboard expansions. First in North America, it looks like there is another round of significant expansions that have been announced this year. A lot of them are expansions, a lot of them are conversions from paper plants to containerboard. Can you walk us through your relative exposure to a paper plant versus the OCC recycle containerboard plant? And what the relative – given your exposure would be between the two type of plants because you'll probably lose a little bit on the paper side as these other plants are built out?

Right. So I would say that, let's talk about, when there is a conversion, right, that's often, they are modifying a paper machine. They are often adding new Stock-Prep and significant modifications to the paper machine. So, we do quite well in that kind of set up. The area we probably do a little less well is a greenfield paper mill, where they are actually building the whole thing including the paper machine, because our competitors in the Stock-Prep side and frankly in the – the stuff that goes on the paper machine, they make the whole paper machine and they'll bundle that. So, I would say when we come to expansions, our favorite is conversions. We also like that they do a lot of debottlenecking that kind of stuff. We like that. And of course, even when there is a greenfield mill, we fight quite hard to get the customer, they insist on our stuff.

Right. Okay. I guess to say, that's true with virgin plants too, you don't make as much. You don't have as much exposure to a…..

We don't have much exposure to virgin, right. I mean one of the things that's happening, right, so adding virgin capacity in North America because they can increase a little, but we haven't had a new virgin mill in North America in like 30 years probably, it's a long time. It's very difficult to add – truly add a plant that tends to go in South America. But when they do these sorts of small capital improvements, we will get some of that. The other thing I would say is, with the other side of the paper shortage that's created in China with these restrictions on imports is that OCC prices have plunged here. So, there is a lot of favoritism to doing recycle, which we also like.

Right. The economics I think are now favoring that in a big way. Let me just – also I have a question on China. I've been reading some of these expansions they've announced pulp plant in Vietnam I think is an area they've been targeting. So what you are saying is, what they'll do is you'll process the waste paper say in Vietnam, produce clean pulp, and then ship that back to the OCC plant in China.

That's exactly right.

To produce the containerboard. Now, have the OCC plant in China been idle. Have many been idle or running at lower capacity than they normally would be because of this problem?

Absolutely. As I said in my remarks that 40 mills have announced downtime in July and August and these are big players, you know Nine Dragon, people like this. So yeah, it's a real problem I would say.

So, there should be a double of positive effect for you I guess long-term here, you'll do some business in Vietnam but also the traditional Chinese plant should start ramping up again in the next five years.

I think it's going to shift, right. So we are doing quite well I would say capturing market share in this build out in Southeast Asia in particular. But a cleaner pulp will be going to China than just a regular waste paper. So, I think – I expect it will have a slight or maybe some modest negative impact on our parts business in China because they're going to be processing already semi-cleaned pulp, right. So it won't be as much wear and tear. And I don't know – we don't know exactly know how this is all going to fall. They are even talking about doing some build outs in North America where the waste paper is, in that case they have to dry it, because you can't ship pretty wet. When it's in Vietnam, they'll ship what they call wet lap, so they don't spend a lot of energy drying it and they just put it back in the pulper, but if you are shipping it from North America, you really got a fully dry it because it's on a boat for a month.

Okay. All right. I'll appreciate it. Thank you.

Thank you.

[Operator Instructions] And our next question comes from Dan Jacome with Sidoti. Your line is now open.

Just a quick housekeeping question. I couldn't find it in the K, how – what of your COGS, production cost, how much is comprised of just stainless steel and I guess aluminum and what else is into the chest maybe ductile iron?

No. You won't really find that there.

Just maybe like a high level thought on that, I mean…

I'll give you the broadest comment. It is easily our largest cost. It's hard to say it's this much because you know sometimes you buy raw steel and we process it, sometimes you buy a casting made of steel, you are – your steel, the price of steel impact that casting, but there is a lot of labor into the thing you bought. So, it's kind of little bit kind of hard to quantify. But you know it's far away our largest 30%-ish, would you say?

Material

Okay. There is a number, alright, that's kind of what I was going at 30% to 40%. Just well, maybe one more on the, you said that containerboard capacity expansions during the next couple of years they are pretty solid. I agree, I've seen similar things in my reading, but what – all of that's going to be recycled linerboard do you think? Is that what you are saying about the conversions and the lack of virgin?

It depends on what region you know the – when production – when box usage ticks up, you need to add more fiber into the system. So, somewhere in the world, virgin capacity has to be added, because you – there is loss every time you recycle right, so you got to add fiber, so that will mean, somewhere in the world – my guess is, it won't be so much in North America.

Okay.

It will be in Russia – Russia and Brazil will be my two leading candidates for that.

Thank you. I'm showing no further question at this time. I would now like to turn the call back to Jonathan Painter for closing remarks.

Thanks Nicole. Before I let you go, I'd like to summarize what I think are the key takeaways for the quarter. First, we have a solid performance in Q2, with strong internal growth of 10% and 11% in revenue and bookings respectively. Second, China's recovered paper import restrictions have created a big opportunity for us as producers scramble to build pulping capacity in Southeast Asia. Third, cash flow from operations is a healthy $28 million and finally despite the negative impact of FX and the tariffs, we're expecting to have a record 2018 with revenue and earnings per share. Thanks for joining us on the call today. And I look forward to updating you next quarter.

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