Kadant Inc. (KAI) Q2 2021 Earnings Report, Transcript and Summary

Good day, and thank you for standing by. Welcome to the Q2, 2021 Kadant Inc. Earnings Conference Call. At this time, all participants are in a listen-only mode. After the speakers’ presentation, there will be a question-and-answer session. [Operator Instructions] I would now like to hand the conference over to your speaker today. Michael McKenney, Executive Vice President and Chief Financial Officer. Please go ahead.

Thank you, Misty. Good morning, everyone, and welcome to Kadant's Second Quarter 2021 Earnings Call. With me on the call today is Jeff Powell, 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 plans and expectations, financial and operating results and prospects are forward-looking statements for the 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 January 2, 2021, and subsequent filings with the Securities and Exchange Commission. In addition, any forward-looking statements we make during this webcast represent our views and estimates 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 views or estimates change. 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 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. Finally, I wanted to note that when we refer to GAAP earnings per share or EPS and adjusted EPS on this call, we are referring to each of these measures as calculated on a diluted basis. With that, I'll turn the call over to Jeff Powell, who will give you an update on Kadant's business and future prospects. Following Jeff's remarks, I'll give an overview of our financial results for the quarter, and we will then have a Q&A session. Jeff?

Thanks, Mike. Hello, everyone, and thank you for joining us this morning to review our second quarter results and discuss our business outlook for the second-half of 2021. I'll begin by reviewing our operational highlights for the second quarter, and I'm pleased to report that we had our best quarter ever, with strong demand and excellent execution across all of our operating segments. Widespread business reopenings and pent-up demand led to a high level of economic activity and our record financial performance in the second quarter. Our aftermarket parts and consumables business was exceptional in the second quarter, and capital project activity was also moving at a record-setting pace. Our new order activity was driven by strong demand for our stock preparation and wood processing product lines, both of which are included in our Industrial Processing segment. And this led to another great quarterly performance for this segment. I'll provide more details on this when I review our operating segments. I'd like to thank our operations teams around the globe for doing a fantastic job in managing the flow of our materials and ensuring our products get to our customers when needed, despite the supply chain challenges. They've done a superb job. Before moving on to review our second quarter financial performance, I wanted to update you on the progress of our recent acquisition of Clouth that was announced in June. I am pleased to tell you that last week, we completed the acquisition of Clouth and most of its related companies and are moving forward with integrating this business into Kadant. Clouth's first class management team has built a solid reputation in its core markets. And their quality products complement and extend our doctor blade offerings. I'm delighted to welcome Clouth's employees to the Kadant family, and I look forward to the contributions they will make to Kadant. Turning now to Slide 6 and our Q2 financial performance, you can see we had significant increases across all of these financial metrics compared to Q2 of last year. Our bookings were up 60% compared to Q2 2020, and were a new record for the third consecutive quarter. Q2 revenue was up 28% compared to the second quarter of 2020 and up 14% sequentially and to a record $196 million. Our aftermarket parts and consumables revenue was also up 28% compared to the same period last year, and up 6% sequentially to a record $125 million in Q2. The consistently high operating rates of our customers, combined with lower store room inventory, a part contributed to this record aftermarket performance. Solid execution contributed to boosting our adjusted EBITDA margin to 21% which led to a record operating cash flows of $44 million in Q2. We continue to benefit from strengthening industrial activity in Q2, especially in North America and Europe. Our businesses executed well and our global workforce continue to safely meet our customers' needs, despite challenging circumstances in many areas of the world. All three of our operating segments experienced an improved adjusted EBITDA margin performance, despite the growing inflationary pressures for materials and supply chain constraints. Next, I'd like to discuss our three operating segments, beginning with our Flow Control segment. Our Flow Control segment had record revenue and strong bookings in the second quarter with a solid revenue contribution in the capital projects. Bookings and revenue were up 45% and 38%, respectively, compared to the same period last year and parts made up 65% of total revenue in the second quarter. Improved operating leverage led to a record adjusted EBITDA and an adjusted EBITDA margin of nearly 30%. Our Flow Control segment's strong start to the first-half of the year is expected to moderate somewhat in the second-half. However, the record backlog and strong bookings heading into Q3, we still expect a strong second-half of the year. Our recent acquisition of Clouth will further add to our overall performance and will be included in this segment going forward. Our Industrial Processing segment continued to experience strong demand with bookings in this segment up 92% to a record $102 million. New orders for our fiber processing systems in China led this increase in bookings in the second quarter. Strong end market demand for wood products continued throughout the quarter, as U.S. housing starts increased 23% in June 2021 compared to June 2020. Although housing starts were down 5% from May to June of this year, overall demand for housing and wood products is high and is expected to remain strong throughout the second-half of 2021. Revenue in this segment increased 26% to $83 million with parts and consumables leading to growth, up 32% compared to the same period last year and 11% sequentially. A favorable product mix and good execution led to a 340 basis point improvement in our adjusted EBITDA margin. We ended the quarter with another record backlog and this positions us well for the remainder of the year. In our Material Handling segment, we had strong demand for aftermarket parts and saw a strong uptick in orders for our high performance balers that prepare materials for secondary processing and transport. European markets led the way to our record revenue performance in Q2. Revenue in the second quarter was up 18% to $42 million and parts and consumables revenue was strong, making up 60% of total revenue. Capital bookings in our Material Handling segment were up compared to the same period last year and are back to pre-pandemic levels. Although not a record, total bookings were up 29% at the top end of our historical bookings. Solid execution by our businesses in this segment helped boost our EBITDA by 30% and adjusted EBITDA margin by 180 basis points to its highest level since Q4 of 2019. Capital project activity remains at a good level, and we expect capital projects in the second-half of 2021 to be similar to the strong performance in the first-half of the year. As we look ahead to the second-half of 2021, we continue to see signs of healthy project activity and an optimism in our customers as the economic recovery takes hold. As more regions of the world begin to experience an improved economic outlook, we expect to see strong demand for our products and technologies. With the extent of the spread of COVID-19 Delta variant still a big unknown, our record backlog has us well-positioned as we look ahead to the second-half of the year. I'd like to pass the call now over to Mike to review our Q2 performance.

Thank you, Jeff. I'll start with some key financial metrics from our second quarter. Consolidated gross margins were 43.6% in the second quarter of 2021 compared to 43.5% in the second quarter of 2020. Our parts and consumables revenue represented 64% of revenue in both periods. SG&A expenses were $49.3 million and 25.2% of revenue in the second quarter of 2021, compared to $45.1 million and 29.5% of revenue in the second quarter 2020. The $4.2 million increase in SG&A expenses includes a $2.6 million unfavorable foreign currency translation effect and increases in incentive compensation outside labor and travel-related costs due to improved business conditions. We received $1 million from the government assistance programs in the second quarter of 2021 compared to $0.8 million in the second quarter of 2020. I would like to note for guidance purposes, that we do not expect to receive any meaningful government assistance payments going forward. Our GAAP diluted EPS was a record $1.96 in the second quarter, up 96% compared to $1 in the second quarter of 2020. Adjusted EBITDA increased 56% to $41.3 million or 21.1% of revenue compared to $26.6 million or 17.4% of revenue in the second quarter of 2020, due to strong performance in our Flow Control and Industrial Processing segments. I would like to note that both adjusted EBITDA of $41.3 million and the 21.1% of revenue were records. Adjusted EBITDA is an important metric for us as we assess the returns achieved on our business initiatives. Operating cash flow increased 101% to a record $44.4 million in the second quarter of 2021, compared to $22 million in the second quarter of 2020. Free cash flow was also a record at $42.3 million in the second quarter of 2021 compared to $21.1 million in the second quarter of 2020. During the quarter, we were able to utilize our strong cash flows to pay down our existing debt by $27 million. We had several other notable non-operating sources and uses of cash in the second quarter of 2021. We borrowed $78.7 million at the end of the second quarter to fund the third quarter acquisition of Clouth. We also paid $2.1 million for capital expenditures, and paid a $2.9 million dividend on our common stock. Let me turn to our EPS results for the quarter. In the second quarter of 2021, our GAAP diluted EPS was $1.96, and after adding back acquisition costs of $0.05 our adjusted diluted EPS was $2.01. In the second quarter of 2020, our GAAP diluted EPS was $1, and our adjusted diluted EPS was $1.06. The $0.06 difference includes restructuring costs of $0.03 and acquisition costs of $0.03. As shown in the chart, the increase of $0.95 in adjusted diluted EPS in the second quarter of 2021 compared to the second quarter of 2020 consists of the following: a $1.15 due to higher revenue, $0.08 due to higher gross margin percentage and $0.05 due to lower interest expense. These increases were partially offset by $0.27 due to higher operating expenses, $0.04 due to a decrease in the amounts received from government assistance programs and $0.02 due to higher weighted average shares outstanding. Collectively, included in all the categories I just mentioned, was a favorable foreign currency translation effect of $0.16 in the second quarter of 2021, compared to the second quarter of last year due to the weakening of the U.S. dollar. Looking at our liquidity metrics on Slide 15, our cash conversion days, which we calculate by taking days in receivables plus days in inventory subtracting days in accounts payable decreased to 109 at the end of the second quarter of 2021, compared to 128 at the end of the second quarter of 2020. This decrease was primarily driven by a lower number of days in inventory. Working capital as a percentage of revenue was 12.7% in the second quarter of 2021 compared to 14.8% in the second quarter of 2020. Our net debt that is debt less cash, decreased $40 million or 26% sequentially to $116 million at the end of the second quarter 2021. We paid down $27 million of our debt in the quarter. And as previously mentioned, we also borrowed $79 million of debt at the end of the second quarter to fund our acquisition of Clouth, which was largely completed in mid-July. The closing in mid-July relates to the majority of the Clouth's entities that we are acquiring. We borrowed an additional $4 million at the end of July associated with the acquisition of the remaining legal entity, which we expect will be completed in mid-August. Our leverage ratio calculated in accordance with our credit agreement increased to 1.71% at the end of the second quarter of 2021, compared to 1.5% at the end of the first quarter of '21. Our net interest expense decreased $0.9 million or 47% to $1 million in the second quarter of 2021, compared to $1.9 million in the second quarter of 2020. At the end of the second quarter of 2021, we had $141 million of borrowing capacity available on our revolving credit facility which matures in December of 2023. Our record bookings activity in the second quarter of 2021 has resulted in an increase in our revenue expectations for the year. While we have had record booking results over the last three quarters, we remain cautious about the future potential impact on our business of increasing COVID cases in certain regions of the world and supply chain disruptions, which could impact the timing of delivery on projects. Travel and visitation restrictions have continued to impact our ability to timely execute some projects in certain parts of the world, especially where COVID travel restrictions are still in place. In addition to an increase in our revenue expectation due to continued strength in the market and the record bookings in the second quarter, our 2021 estimates now include the acquisition of Clouth. As a result, we are updating our revenue range for the year to an increase over 2020 of approximately 23% to 25% and or $783 million to $793 million, up from our previous estimated range of $710 million to $730 million. The majority of this increase is organic with approximately one-third of the revenue range increase related to the addition of Clouth. We anticipate that revenue in the fourth quarter will be the strongest for the year due to both strong capital project activity and our recent acquisition. For the third quarter, we anticipate revenue between $195 million to $200 million and for the fourth quarter revenue of $220 million to $225 million. For the third quarter, if we exclude the additional revenue from Clouth, we anticipate revenue will be down compared to the second quarter of 2021, due to the projected timing of revenue recognition on capital projects. As mentioned earlier, this guidance is, of course, predicated on the pandemic and supply chain issues having little impact on our customers' activities or the delivery of shipments to them. We now anticipate gross margins for the year will come in at approximately 42.5%, down from our prior estimate of 43%, principally, as a result of including the amortization of the acquired profit and inventory related to our Clouth acquisition. As I have noted on the last two calls, the mix will be more weighted toward capital in the second-half of the year, especially in the fourth quarter. As a result, we anticipate gross margins will be 42% in the second-half of the year, which includes the impact of amortization of the acquired profit and inventory. Our current estimate for the inventory write-up is approximately $3.5 million with $1.4 million or $0.09 turning in the third quarter and the remaining $2.1 million or $0.12 turning in the fourth quarter. We anticipate SG&A expenses will be a little over $54 million per quarter in the third and fourth quarter. We now anticipate that SG&A expenses as a percentage of revenue will be lower than we projected at the beginning of the year and will be approximately 26% of revenue for the full year 2021. This includes backlog amortization expense of approximately $400,000 or $0.03 in the third quarter. Our interest expense will be approximately $1.3 million per quarter in the second-half of 2021 due to the incremental borrowings related to our recent acquisition. We anticipate the tax rate for the year will be approximately 28% in the third and fourth quarter of '21, approximately 28.5% to 29%. We anticipate that our adjusted EPS will be lower in the third quarter compared to the second quarter of 2021 due to several factors, including a lower anticipated gross margin percentage versus the second quarter, and the lack of payments received from government programs that contributed $0.10 to the second quarter results. I hope these directional comments will help provide insight into how we see our current business environment. Before concluding my remarks, I wanted to comment on our first quarter 2021 results. We have recast our first quarter 2021 non-GAAP financial metrics to reflect that our SG&A expense included $1.3 million of acquisition costs related to our acquisition of Clouth, which was announced in June. We reported diluted EPS of $1.43 in the first quarter of 2021. With these acquisition costs added back, our adjusted diluted EPS was $1.53 in the first quarter of 2021. Also, we reported adjusted EBITDA of $31.1 million or 18% of revenue in the first quarter of 2021. With the addition of these acquisition costs, our adjusted EBITDA was $32.4 million or 18.8% of revenue. This recasted information is shown in the appendix to this presentation and is included in the information presented for the six months of 2021 in our earnings release. That concludes my review of the financials, and I will now turn the call back over to our operator for our Q&A session. Operator?

[Operator Instructions] The first question comes from the line of Chris Howe with Barrington Research.

Good morning Jeff. Good morning, Mike. Thanks for taking my question. Good morning. As we think about the common topic, it seems across all conference calls related to the supply chain constraints. Can you provide some context around the pressures or challenges in the environment as it pertains to the quarter, how that may have impacted the end of the quarter and kind of how you see yourself navigating this environment?

Well, I would say, Chris, I think our decentralized structure really becomes a strength for us here. As our business leaders are able to see what's coming and react quickly and stay in front of material price increases. In addition, I'd note the fact that over 60% of our business is parts and consumables, that also helps as it's easier to adjust for inflationary pressures on parts and consumables since they're so short cycle. There's no doubt there's going to be some impact. I would say, most notably, of course, on capital orders that were taken prior to the inflationary pressures rising. However, overall, I don't think there's really going to be a big impact for us on our gross margins. As you know, as I just said, if I exclude the inventory write-up associated with Clouth, we're still going to come in near that 43%. And I've been saying that from the get-go from the beginning of the year. But I would say tailing onto that, that in addition to the inflationary issue, we are concerned about supply chain issues, in particular, shipping both in regards to cost increases and the timing of when shipped items are delivered. And I noted that also in the call. So you're hearing a lot about that also, I'm sure, for many of the others.

Okay. And then just following-up on that. We know Kadant's strong market position across each of the segments. As we take that market position in consideration of this current environment along with the price increases to help offset some of this environment, is there an opportunity here for Kadant to work its way up on price? I would assume that customers know Kadant's value proposition and their integral piece that they provide to their equipment and that a small incremental raise in price may be permanent.

Yeah, Chris. So we're always working hard to create more value for our customers. And we focus very hard on the total cost of ownership, extending the life and the performance of our products, while we also have, as you know, several internal initiatives to lower our costs. There's always tremendous pressure to lower your pricing or to keep pricing levels the same. And so our guys get up every day and focus hard on how to deliver more value to our customers. And so there are certainly instances where costs have gone up, and you don't have any option other than to pass those costs on to our clients, just like our clients are doing that with their customers. Our customers have announced price increases as their costs have gone up. But we work very hard to increase the overall value we deliver to our customers so that they get a better return on that investment. And that's the case in these kind of uncertain times as in more traditional times. So that's always a focus of ours. We work hard to help contain costs for our customers so that they prosper and do better and reward us accordingly with more work.

Okay. And then, one last question, if I may about the Material Handling segment. You did very well on a geographic basis as specifically as it pertains to the demand you saw in Europe leading to that record revenue. How about other geographic regions as it pertains to material handling we've mentioned briefly in the past, it's hard to size, but the infrastructure impact that could happen with material handling. And as we look at the second-half outlook, kind of what are your thoughts on a geographic basis versus the first-half? Thanks.

Yeah. So I would say that our Material Handling business is predominantly focused on North America and Europe. And as you just indicated, we've had some strong demand in Europe, particularly for our building side of the business. Our aggregate side of the business, bulk handing material side of the business has been -- it was hit harder by the pandemic than any of our other businesses, we actually had customers that were forced to shut down. They were the only customers that were forced down during the pandemic. And they've been slower to come back up. So I would say that's probably been one of the -- one of the business has been fairly flat over the last many quarters, up a little bit certainly in Europe, but flat in America. We expect this infrastructure package if it received final approval to help some. Obviously, there's going to be -- they're talking about spending more money in roads, bridges, infrastructure, which our customers supply directly to. And so that will translate into -- over time, should translate into more demand for our technology and products as they ramp up their production, their supply. But it has been probably the slower one to recover, and we're expecting and hoping that the growth we've seen in Europe will continue, but also that we'll see some increase in demand in America and the U.S., in particular, as this infrastructure bill hopefully gets rolled out. It hasn't been hit severely, but it's been, I would say, flatter than our other segments for some time.

Okay. Thank you.

Your next question is from John Franzreb with Sidoti & Company.

Good morning, guys. Thanks for taking my questions.

Good morning, John.

I want to discuss the backlog. How long has it been extended compared to historic norms? And is any particular segment seeing backlog extended well beyond into next year that normally wouldn't be the case?

Well, of course, we're midyear now. And backlog is a little over $240 million. So there's no question that there's a chunk of it that's going to be delivered in 2022 at this point. I would say that would -- in terms of looking at that by the segments, it's probably most notably in Industrial Processing, where we have capital projects are really going to be 2021 revenue.

2022.

Oh, I’m sorry, 2022.

Yep.

Okay. And do you expect that to be filled in the first-half of 2022? Or, it would be a year on?

I think the majority of it will be in the first-half of 2022 but we do have some orders that will go to the second-half. But the majority will be in the first-half.

Okay. And then since we’re satisfying pent-up demand that was pushed to the right during the pandemic, what’s your sense from your customer base, how long it would take to satisfy that demand? Just a two year process to reach equilibrium? Or, are they trying to get their orders up in there first, so they can get up there and get that their equipment when they want it?

Yeah. John, I think there is clearly some pent-up demand. In particular, I think they ran down their stores or inventory levels on parts and consumables, and they will start to build those up. But if you look at the biggest, strongest market we had, which is on the Industrial Processing side, the stock prep and the wood processing, those are really being driven by market growth. There’s been a shift. If you look at packaging, of course, there’s been a shift that was occurring but really was accelerated by the pandemic and at home deliveries, which, as you know, requires more packaging. And then there’s been a growing demand gap versus supply of new housing. And that’s really being driven by many things, again, accelerated a little bit by the pandemic and people working at home, but also just since the ‘08, ‘09 crash, the demand has grown faster than supply. So that supply deficit has continued to widen. And then you’ve got the -- you have the millennials that are really now starting to enter the house buying market in a big way. And so when you look at the industry forecast for those, they are expected to be strong for the next several years. Housing is always goes up and down relative to the economy. But overall, they’re projecting that this housing demand in this, if you will, the supply gap will be there for many years. And so there will probably be some moderating as the pent-up demand is alleviated. There’s underlying fundamentals in our two biggest core markets that I think are going to continue to support our business for the years ahead.

Great. Great news. And just on Clouth. It sounds like that you expect to do better in the fourth quarter than the third? Or, I just didn’t hear that properly? Or is that the case or not?

Yeah, John, what I was trying to convey there was just simply we didn’t close the transaction until mid-July. So we don’t have – we’re not going to have a full quarter of revenue.

Okay. I just wanted to check to see if there is something seasonal I should be aware. Okay. Thanks for taking my questions guys. Good quarter, great quarter, actually. Thank you.

Thank you.

Our next question is from Kurt Yinger with D.A. Davidson.

Great. Thanks, and good morning Jeff and Mike.

Good morning, Kurt.

Good morning. Just wanted to start on the capital equipment side. I’m just curious whether you have any thoughts or indications from your customers around how sustainable these elevated levels of bookings can be or whether perhaps we should expect kind of a bit of a normalization here in the back half or early 2022, as you work through some of this potentially pent-up demand after the softness last year.

Well, the capital buying cycles have always been there. So there is some volatility in that over the years, if you followed us over the years. And I think we are seeing a little bit of pent-up demand there, no question for things that were kind of -- we hit the pause button last year. So there is a little bit of that. As I just mentioned, when we we’re talking to John, though, there is clearly kind of increased demand in some areas, which also our customers are going to have to address by adding additional supply. So I don’t know exactly how long this buying cycle will last. What we typically see is when the customers are doing really well, they’re having strong free cash flow, after a period of time they start to invest in new technology to increase their competitive position, increase their supply capabilities. And we have customers that are making near record profits in some of our markets. And so we would expect them to reinvest some of that back in to further strengthen their businesses. But it’s a little difficult, unfortunately, Kurt, to know exactly how long that may go. Obviously, as you know, this is a somewhat unprecedented event that were still somewhat experiencing here. So I don’t know that we know for sure other than we know our customers are doing very well, and they tend to reinvest in their business when they’re doing very well.

Right. Okay. No, I appreciate that. And just on the gross margin guidance, it didn’t really change versus the prior outlook. Obviously, the revenue outlook has moved higher. Curious how we should be thinking about potential mix impact from capital equipment and any cost inflation impact here in the back-half. And as you look at the capital equipment bookings you’re kind of taking in right now. Do you feel like you’re appropriately pricing those to offset the higher level of cost that you’re seeing in the business?

So, I would say, Kurt, to your last question on current pricing, yes, I think our pricing now reflects the state of the market in terms of the material cost increases. So it’s really kind of the things that we -- orders we booked prior to these inflationary pressures arising, but those will work their way through the backlog. And on a go forward basis, as I indicated, I really don’t – I’m not anticipating much of an issue. As it relates to the margins, in the second-half from the get-go here, I’ve been saying second half of the year is going to be stronger on the capital side, and that will impact the margins. So the guidance I gave was for 42% margins in the second half of the year. That’s really relatively consistent with where we’ve been all along. And that 42% includes the inventory write-up associated with the Clouth transaction. But still, even when you back that off, you’ll be able to calculate and note that, okay, margins in the second-half are lower. And the reason they’re lower is because of the mix of capital.

Right. Okay. That’s helpful. And just lastly, it seems like over the last couple of quarters, you’ve had some real nice momentum in terms of fiber processing systems for customers in China. Just curious whether you think that’s indicative of kind of a sustainable pickup as customers finalize strategies in response to the fiber restrictions? Or, any other thoughts you had on that topic?

Well, China traditionally goes through these buying cycles. We’ve seen these for – we’ve been there for nearly 30 years, and we’ve seen these results. They’ll have a two or three year buying cycle and then they’ll take time to absorb that new capacity rationalize it and they go on to the next one. And I mentioned before that we’re constantly amazed at their ability to continue to grow the business and to bring on new capacity and for demand to be there for it. And so it’s always difficult to predict exactly how long these things will last. But there’s a fair amount of, I would say, project discussions that have been taking place this year in China. And as we mentioned, we had a very strong quarter, bookings quarter there. So we’re pleased with that, and we’re pleased with the level of discussions and the activity that’s occurring now. No guarantee those will convert to orders. But I would say that its – there’s a good activity level in discussions going on right now for projects there. And they continue to grow. I mean their economy, if you look at the economy, even though its down, they’re still growing whatever, 6.5%, something like that. So I mean there’s still good growth there.

Right. Okay. Appreciate all the color, and good luck here in the back-half guys.

Thanks, Kurt.

The next question is from Walt Liptak with Seaport Research.

Hi. Thanks. Good morning, guys.

Hi, Walt.

Good morning, Walt.

I wanted to ask, I guess, a follow-on about the adjustments or the third quarter gross margin. When you put out your results for the third quarter, will you do adjusted numbers like adjusted EPS where you back out that Clouth inventory step up or adjusted EPS or gross margin?

Yes, Walt. We standardly adjust those out there onetime nonrecurring items. So far and away and right now, that $3.5 million split, $1.4 million and $2.1 million between the third and fourth. That’s a marker that we had, and it’s not finalized but I wanted to get it out there so that people were aware of it. And then yes, we will adjust that out. We also have the backlog write-up, if you will. It’s not anywhere near the level of the inventory write-up, but I mentioned that it’s about $400,000. Again, that’s our marker for it currently, and that will be roughly $0.03. But both those items will be called out and then excluded from our adjusted EPS in the quarter.

Okay. Great. Okay. And just to clarify, so the 42% gross margin, that’s going to be the GAAP number and the non-GAAP or the adjusted number is going to be closer to 43.

Yes, you can -- however you’re doing your model, you now have a number to go from that 42%, you can take the $1.4 million out of it to get to the kind of recurring.

Okay. Got it. And then your comments, I think when you’re talking about the fourth quarter, I apologize, you were clear, I just didn’t hear it. I think you said that on a core basis, your revenue was going to be down. Did I hear that correct? I wonder, if you can provide some more details.

So just to clarify for you since you brought up fourth quarter. For the fourth quarter, we’re guiding to revenue of $220 million to $225 million. But the question you’re asking, what you heard, Walt, was for the third quarter, we’re guiding to $195 million to $200 million, and that includes the Clouth revenue. Now it wasn’t a full quarter, but includes a partial quarter for Clouth. And if you back that off, that would be down in comparison to the second quarter. And then I noted, really, the reason for that is just the timing on capital shipment deliveries, which are heavy to the fourth quarter.

Okay. Got it. All right. That’s clear. Thank you very much. And then the last one for me is I’m just wondering about your 80/20 programs that you’ve talked about in the past, obviously, it’s helping a lot, it seems like it’s helping a lot in the leverage and the profits. What inning are you in now? How many operations are working on 80/20?

Yes. So as you know, I like to talk about innings, I guess baseball was the game I played growing up. And as it turns out, it worked out well for us. But I would say -- so we have kind of six companies that are in various stages of implementing it. Some of them are, I would say, a true 80/20 companies, others are on their way there. And we have kind of four more teed up, and well start some of those here in the back-half of the year. So I would say right now that we’re kind of in the third inning and are trying to rush hard to get to the fourth inning. But that’s in the number of companies. If you look at it from a revenue standpoint, it’s a little further along because we’re focusing on some of our bigger operations. As it turns out, you might think that 80/20 you would use on your companies that are underperforming or, let’s say, on the bottom half of your performance. But in fact, you get a better return out of going after your biggest and most profitable companies. So that’s what we’re doing. So we’re right now doing that we’re -- in some of our bigger companies and have plans for the next group to be some of our top performers. And you’re right, we are seeing some good results from that. And we expect to see significantly more as we get the entire organization 80/20 over the next couple of years.

Okay. Great. And just to get the number. So when you look at your business, you got six that are implementing 80/20. What’s your total number of companies?

We kind of talked about the business being somewhere in the neighborhood of 20 depending on how -- it could be in 19 or 21, depending on how you look at it, but approximately 20 companies, I think.

Okay. All right. Great. And then the last one for me is, congratulations on the Clouth deal. I wonder if you could talk about the pipeline and your appetite for more deals, do you have the capacity to get more deals done and do the integration given Clouth already kind of in the back.

Yeah. So I mentioned most of this year, the prior call that activity level is very robust. And I’d say our deal team is seeing as many opportunities as we have in a very long time. We continue to be very active. We didn’t slow down during the pandemic, although certainly, things slowed down because of the ability to travel. So we’re continuing at full speed ahead in discussions and looking at opportunities, thinking strategically about what makes sense for us. And it’s a good strong market out there. From a capacity standpoint, we’ve got plenty of capacity with our existing line, with our accordion, with our other debt instruments that are out there. So I don’t think that financing is going to be an issue. And from an integration standpoint and a resource standpoint, again, our decentralized structure really helps us. And so that’s not really a constraint either. So if we find a good strategic opportunity, we’ve got the financing, and we have the kind of the organizational capability to bring that on, and we will.

Okay. Great. Thank you.

Your next question is from Will Hyler with WDH Capital. And Bill your line is open, please make sure it’s not muted.

Hello, can you hear me?

Yeah.

Hi, Bill.

Hey, guys. Appreciate the call. Good morning. I had a quick follow-up on the Asian question, which sounds like Asia is recovering. I know between 2018 and 2020, your Asian revenues had been on a steady decline. But when you look at Asia now, are you starting to see revenues outside China? Because I know there’s been expansion, pulp expansion in countries like Vietnam, Indonesia maybe a little color on where the revenues in Asia could be coming from over the next year or two.

Sure. So obviously, you mentioned kind of what occurred from 18 to 20. There were two events that occurred there. One was the China government decided to stop importing all waste paper and that really just created a complete chaos and havoc in the market for a while. And then, of course, it was compounded by COVID pandemics. So it has been a very chaotic time over there. But they are starting to come out of it. Obviously, they kind of opened there, although the last week or so, obviously, the COVID cases now are really starting to increase there again, which is a little scary. But they were coming out of it, the economy is recovering, and they also we’re kind of sorting out the fiber supply issues that was created by the ban, the import ban. But we’ve always been active outside of China. China just, of course, kind of is a dominant player. But over the last couple of years, we’ve secured several orders for system work in Southeast Asia, and then particularly in India, which we report as part of our Asian business. And we’ve been very strong in India. India is actually the fastest growing market right now, for paper. It’s actually growing faster than China. It’s just a very small base that you’re starting from. But we’re heavily invested in India and have been for a long time, and we think it’s going to continue to be one of the faster growing. So we are busy outside of China. But again, China’s share size makes a movement there, quite noticeable. But as I mentioned a few minutes ago, our project activity level, our discussions over there have been quite strong this year.

Great. I guess and just one follow-up question on maybe the big picture out there that you guys are seeing in OCC containerboard pulp. You’ve been a big beneficiary of the expansion in these markets, particularly OCC, I assume recycling the past five, six years. I mean, any color where you think we may be, what inning? I mean you still see a fairly optimistic outlook for the next three, four, five years.

So there’s a fair amount of new capacity coming online, but the demand is strong. If you look at OCC prices, they’re up close to $100 a ton, so they’re back up. The demand is strong for it. And I think what’s really going to drive this market over the longer run is this migration away from plastics and kind of high carbon footprint materials. And that’s just going to continue. I mean that’s just going to continue for a long time. So you’ve got this kind of, I would say, tailwind that is going to continue to drive this market as people ban plastics and other nonrenewable, non-biodegradable materials. And you have seen it everywhere. They’ve announced -- every week, you see an announcement where we’re trying a new cellulose-based product to replace plastic being beverage containers and things like that. So I think this is going to – it’s not going to grow at 10% a year for the next 10 years, we’re not saying that. But I think that you’re going to see a slow, steady increase in the demand as more and more packaging and more and more materials migrate to cellulose because it's renewable, it's biodegradable. And so that’s why we’re in the business, and that’s why we’re excited about the business because we think that is the perfect raw material of the future. And so it goes -- of course, it somewhat goes up and down as economic cycles do. But over the long run, we think we have a tailwind there that’s going to continue for the foreseeable future.

Okay. And you mentioned plastic recycling, I mean, it’s not your traditional pulp paper, wood area. But is there potential opportunities to use your any of your businesses in getting a bigger foothold in plastic recycling and which seems to be also growing dramatically in the next few years.

So, we’re playing that business a little bit in that our balers, we manufacture, they bale up the plastic for recycling. The challenge for plastic, of course, has always been what do you do with it? That’s I mean you’ve got the PET, which, of course, it’s a food grade that is strong. And that gets – there’s a market for that, there’s a commodity market for that, and it gets back into fibers and things of carpets and things like that. But there’s always been a challenge on finding in-market products for recycled plastic. And China was taking a very large share of that and stopped, of course, over the last couple of years, which created some challenges for that. We’ve not looked too much at that business. I mean, it’s a market that we traditionally not played in. It isn’t really renewable or biodegradable. And so it’s not one that is a big focus of ours. I think there’s going to be continual pressure and challenges in that market as countries around the world continue to ban the use of it in products. And so it’s not one that we are heavily invested in.

Yep. Okay. I’m good. I appreciate the insights. Great quarter. Thanks.

Thank you.

Thank you.

[Operator Instructions] There are no further questions. I will turn the call back over to the speakers for closing remarks.

Thanks, Misty. Before wrapping up the call, I just wanted to leave you with a few takeaways. Our customer-centric focus to deliver maximum value has always been and remains a key differentiator for us at Kadant. As we look ahead and beyond the immediate health crisis and the broad economic recovery, we will continue to focus on meeting our customers’ needs, as we seek to accelerate revenue growth in our core markets. Our financial health is excellent and our ability to generate strong free cash flow remains a cornerstone of our business model. We do expect continuing improvements to the economy around the world, and we look forward to a strong half of 2021. Thank you for joining the call today, and please stay safe.

This concludes today’s conference call. You may now disconnect.