Quanex Building Products Corporation (NX) Q2 2016 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen, and welcome to the Second Quarter 2016 Quanex Building Products Corporation Earnings Conference Call. At this time, all participants are in a listen-only mode. Later we will conduct a question-and-answer session and instructions will be given at that time. [Operator Instructions] As a reminder, today's program is being recorded. I would now like to introduce your host for today’s program, Scott Zuehlke, Vice President of Investor Relations and Treasurer. Please go ahead Sir.

Thanks for joining the call this morning. On the call with me today is Bill Griffiths, our Chairman, President and CEO; and Brent Korb, our Senior Vice President of Finance and CFO. This conference call will contain forward-looking statements and some discussion of non-GAAP measures. For a detailed description of our forward-looking statement disclaimer and a reconciliation of non-GAAP to the most directly comparable GAAP measures, please see our earnings release issued yesterday afternoon and posted to our website. Before I turn the call over to Brent, I’d like to remind everybody that we'll host an Investor and Analyst Day in New York on June 29 at the New York Stock Exchange. Details about the event were distributed via a press release on May 16. So please remember to RSVP by June 17 if you plan to attend. I will now turn the call over to Brent to discuss the financial results.

Thanks, Scott. I'll start by touching on leverage and cash flow. As a reminder, our net debt to pro forma adjusted EBITDA leverage ratio was 2.9 times, immediately following the closing of the Woodcraft acquisition on November 2, 2015. Fast forward six months to April 30, 2016, and our pro forma leverage ratio now stands at 2.6 times, which is a strong improvement in only six months and is even more notable considering the seasonality of our business. To this point, we were able to generate enough free cash to pay off more than $10 million of debt in the second quarter and currently have no outstanding borrowings under our ABL. Our goal of achieving a leverage ratio between 2 and 2.5 times is very achievable by yearend. On a related note, we've been transparent about the possibility of refinancing our debt with a lower interest rate at some point and we believe the progress we’ve made on improving our leverage profile will ultimately prove beneficial when the time comes to move down that path. Year-to-date we generated cash provided by operating activities of $24.6 million, which represents an improvement of 643% compared to the same period of last year. Our cash generation story continues to be positive. Looking ahead to the second half of the year in the heart of the building season, cash flow generation historically picks up, which is expected to provide us with the ability to significantly improve our leverage profile further. Moving on to the income statement, consolidated net sales during the second quarter of 2016 increased 62% to $229.5 million compared to the same period of 2015. As expected, the increase was primarily driven by contributions from the HL Plastics and Woodcraft acquisition. In an effort to provide more topline transparency, we have included a sales bridge table with our earnings release for the first time that Bill will touch on later. We reported net income of $3.9 million for the quarter, which represents an increase of 72% compared to the second quarter of 2015. Adjusted income from continuing operations was $3.3 million or $0.10 per share during the second quarter of 2016, compared to $2.5 million or $0.07 per share in the second quarter of 2015. The adjustments being made for EPS are acquisition-related transaction cost, acquisition-related purchase price inventory step-up recognition and the impact of foreign currency losses, primarily related to an intercompany note with the HL Plastics. The year-over-year EPS improvement was driven by solid operational performance, especially in our legacy vinyl operation and the contribution from HL Plastics and Woodcraft, partially offset by the burden of higher interest expense. We believe the full contribution from the acquisition will more than offset added interest expense as we progress through the year. On a consolidated basis, EBITDA performance during the second quarter was solid and more than doubled to $24.4 million compared to the second quarter of 2015. After minor adjustments related to transaction cost and the inventory step up, adjusted EBITDA came in at $24.3 million compared to $11.6 million last year. We've also included a selected segment data table in the earnings release for the first time in this quarter to provide detail by segment. I'll now turn the call over to Bill.

Thank you, Brent. As we entered our fiscal 2016 after consummating the acquisitions of HL Plastics and Woodcraft, we made it clear that our priorities for this year were to continue to improve our profitability, generate cash and pay down debt to put us in a position to potentially refinance later this year or early in 2017. As we closed the first half of our fiscal year, we have approximately $29 million in cash and no borrowings on our ABL Facility. Excluding transaction cost and purchase price accounting, EBITDA margins for the first half improved by more than 450 basis points, compared to the first half of last year. While the addition of HL Plastics and Woodcraft have clearly helped margins, the bulk of the margin expansion is being driven by operational improvements in our legacy window components business, particularly in our vinyl extrusion business. We expect margins to continue to improve during the second half of the year, but at a slower pace as the comps get more and more difficult. We continue to strive for greater transparency and clarity with respect to revenue growth. As such and as Brent mentioned, we’ve included a sales bridge with our earnings release. In that bridge, we detailed the primary items that affected each segment's overall quarterly and year-to-date topline as compared to last year. We hope that investors will be able to use this bridge in order to develop relevant and useful comparisons to available market data. Further sales bridge, market related volume grew by 6% in our North American Engineered Components segment during the first half of fiscal 2016. This compares favorably to Ducker’s latest estimate of 4.6% growth for U.S. window shipments for the six months ended March 31, 2016. The European Engineered Component segment now our most profitable grew approximately 10% on a local currency basis during the first half of the year. This includes a pro forma calculation for HL Plastics who are a big driver of the improvement as they continue to gain market share in the U.K. Moving on to the Cabinet Components business, on a pro forma basis and disregarding the impact of raw material pass-through deflation, our North American Cabinet Component segment grew generally in line with the market during the first half of our fiscal year. The most relevant market data comparison for this segment is semicustom cabinet shipments as published by KCMA. According to this source, semicustom cabinet shipments grew 4.6% during the six months ended March 31, 2016. We're investing heavily in this business as we continue to see opportunities for margin expansion and revenue growth as we enter 2017 and beyond. Despite the increase in the cost structure in the short term in order to become SOX compliant, improve the safety record and improve the manufacturing and engineering capability, this business will still finish the year with similar margins to last year. These incremental expenses combined with the capital investments we’ve made so far this year, will lead to improved productivity, quality and safety, which in turn will reduce cost and improve margins. We expect to see the benefits flow through the P&L in the latter part of this year and into 2017. In summary, our clear priority in 2016 is to continue to improve profitability and reduce our leverage ratio to under 2.5 times by year end. I think the numbers would suggest that we’re executing well on both of these priorities. Now that we are in the selling season, we also have more visibility into how the rest of our fiscal year should play out. Based on these factors and to be more consistent with our current expectations, we have increased our adjusted EBITDA guidance for the year to between $117 million and $121 million, compared to the original guidance of between $112 million and $120 million that we issued in December of 2015. We’ve also updated topline guidance for the impact of foreign exchange translation primarily related to the decrease in the Sterling-Dollar exchange rate since we issued guidance last December. In reality, the topline guidance has not changed. It is still 5% to 6% growth over 2015 on a pro forma basis but with the assumption that exchange rates will remain steady for the balance of the year. The read-through here is that we now expect higher consolidated adjusted EBITDA margin was said another way we expect to close the year with a more profitable outcome than prior guidance would suggest. And now we’re ready to take questions, operator.

[Operator Instructions] Our first question comes from the line of Ken Zener from KeyBanc. Your question please.

Good morning, gentlemen.

Good morning, Ken.

Good morning, Ken.

I do appreciate the transparency and the data that you're putting forth. I think it helps people understand your business. If we could look at the U.S. window, which is obviously improving [indiscernible] and you talked about the first half uplift being stronger than second half. Many companies in the first quarter talked about weather. Could you comment on how weather impacted your sales, if it was a specific region, if it was what you were expecting? And then related to that, if you could give us insight into what the channel was indicating in terms of either orders, backlogs and/or pricing related to the movements in oil.

Yes, Ken, clearly weather had a positive impact on an early start to the construction season. Clearly the window manufacturers and in fact others in the building product space with external products clearly were beneficiaries of that warm weather spell. Because of really two things, one, most window manufacturers tend to build some inventory through the winter months anyway and then the lag between a window actually being placed in an opening of a house compared to when we would get an order and ship the replacement component for that window, we really didn't see the same impact as our customers did, partly because they were able to balance through existing inventories in the channel. So we really didn't see a big difference or a spike as some of our customers did through that period of time. What we've seen is just very steady progress and steady growth through the first half of the year. In terms of future expectations, our customers are actually seeing a relative slowdown here in the early part of the summer, not a slowdown to be concerned about, but I think there was an expectation that given an early start they’d see another spike about now and that's clearly not happening, which may indicate that the warm weather just allowed them to pull through business as opposed to having a net increase in the year.

So your comment there about through summer, does that -- does that commentary stop at the quarter physical reporting date? Or are you making a comment into a period that is now in the third quarter?

Yes, the month of May was the same trajectory as we've seen in the early part of the selling season or the latter part of our second quarter. So the trajectory continues on that 5% to 6% pace, but I think there was initially an expectation that when we get into May, June and July, we'd see a much higher sales rate than that, but we're on track for, A, our expectations, and, B, where we're guiding to at this point.

Great. And obviously I think your comments are not to be misunderstood that it is worst, but I guess in the cabinet, you guys talked about investments that you're making at the business, which I think is -- it's going to be –[indiscernible] all the quarterly number flow out. You talked about the investments being a drag, but have been very helpful in the second half and then in the first half of '17. Could you quantify those investments throughout in terms of dollars or basis points that you accepted obviously there to be like longer term profitability in that segment?

Yeah, we're not going to get that granular particularly at this stage. The message I really want to convey is, we knew going into this in both acquisitions we would have to potentially increase the cost base simply the burden of SOX compliance is pretty significant. We also knew in the case of the cabinet business in particular that in order to really improve the margins there, which are good to start with. We knew we would have to invest in manufacturing and engineering capability both people and capital. And so I really just wanted to put up those investments have really been made in the first half of the year. Yes, we've increased the cost base. If you look at the margin profile in the first half of the year, it's not as high as I think most people in the investment community would have expected given the announcement we made of their margins when we acquired them. But my message is, we'll see some of those benefits flow through in the second half net-net for the full year even with the increased cost base, the margins are going to come out pretty much on top of where they were for the full year when we acquired them. And then they're going to clearly start delivering better margins as we go through 2017 and the analogy is we put a lot of investment into our Vinyl Profile business a year and half ago, where we're seeing the benefits now and I think we’ll see a similar profile out of the cabinet business as we get into 2017.

Understood. And one last question, if you had to identify one factor that led to your roughly 5% midpoint move, what would that be in terms of your fiscal '16 guidance? Thank you very much.

It is continued confidence that the topline is going to come in pretty much where we expected it to be and more confidence that our operational improvements really are being delivered and we're seeing them show up in the P&L.

Thank you.

Thank you. Our next question comes from the line of Nich Coppola from Thompson Research. Your question please.

Hi, this is Steven on for Nich Coppola. Looking at the strong year-over-year EBITDA margin improvement, how should we think about the drivers? Can you may be expand a little further on that, as far as contributions from Woodcraft and H&L versus vinyl upgrades in general operational improvements?

I think in order of priority you should think about it like this. The bulk of the 450 basis point improvement at the half year comes from the vinyl extrusion business, which really is a result of the investments we’ve made over the last 18 months to two years and is in line with our expectations that we outlined at the time we were upgrading the equipment. I think secondly, the rest of our businesses and the rest of our product lines also continue to improve their margins as a result of internal operating efficiencies and then thirdly, the incremental improvement from the two acquisitions, so, in that order of priority. Now clearly particularly when it comes to the vinyl extrusion business, as we move each quarter, then the comps to prior year get more and more difficult because we started to see these improvements already in the second half of last year. So what will happen as we go forward into 2017, the operational improvements related to vinyl will slow down and the comps will become much more equivalent and we'll start to see in 2017 Woodcraft take their place as the investments we're making now start to pay off in margin improvement in 2017.

Great. Thanks. And then looking at the EU engineered products, when you exclude HL Plastics, you're left with the performance of the European Spacer business when excluding FX sales being up just a little over 1%, can you help us think about a more normalized growth rate in that business?

Yeah, the growth rate in the European Spacer business was in the high single digits; HL the low double digits therefore on aggregate when you combine them, it was about 10% and that's all in local currency. So as you can see the translation effect of FX has been a big drag on the revenue line, which again is one of the reasons we try to be a little more transparent as to what that impact is and it is mostly the sterling-dollar exchange rate as you probably are aware that Dollar-Euro exchange rate is actually starting to turn and is now slightly favorable.

Excellent. Then one last question and a follow-up there, is that growth in the Spacer Business is that taking market share, is that growth in line with the market? Thank you.

It’s actually in both cases it is taking market share. As we said before, we’re relatively new in that market with new technology and we continue to slowly gain share. So in both cases, we’re outpaced in the market.

Thank you.

Thank you. Our next question comes from the line of Scott Levine from Imperial Capital. Your question please.

Hey good morning, guys.

Good morning, Scott.

Good morning.

So firstly on pricing, it looks like the price change were to the negative in both North America and EU components. A little bit more color there and maybe is that really just the opposite of lower commodity prices or maybe a little bit more color as to pricing conditions or whether we can expect any improvement either on our gross or net basis in the second half?

Yes, so the pricing story is a double-edged sword. The good news is we’re getting good margin expansion in a year, where we're not getting price from our customers. The bad news is we’re not getting price and in some cases as the numbers would show, we’re actually making some minor price concessions in some areas. Now my belief is that we will start getting price in 2017. Typically we start negotiating prices on a calendar year basis not our fiscal year and we start doing that in final calendar quarter of the current year. So we've known all along and I think we’ve been clear to lay down expectations that while we'll get volume growth, we'll get margin expansion, we will not get price in 2016. That’s exactly the way the year is turning out. We'll be going into price negotiations with many of our larger customers in the last calendar quarter of this year and my expectation is we will get price, but in the low single digit range in 2017 and that because we’re at the far end of the food chain and everybody else in the chain has been able to get price in 2016. We continue to see strong data that house prices are increasing. Our customers we know have gotten price increases almost across the Board. It hasn’t trickled down to us yet. Next year is the year for that.

Got it, fair enough. We will wait on the commentary in the fourth quarter. And then one more follow-up on the U.K., is the uncertainly around Brexit or any of the housing data in the first half of the year suggesting any either hesitation heading into the back half? You indicated I think HL was growing low double-digit and it seems like it’s miming your expectations, but any signs of any underlying slowing in the U.K. demand environment based on what you’re seeing recently or not?

Not really. As you can see, 10% growth in the aggregate here and low double-digits or HL specifically would indicate business is still pretty strong there. I think the economist would say there has been some slowdown in capital investments, some slowdown in new construction, but not significant and of course new construction is not a big part of the U.K. window business. So I think the reality is we have not seen any material slowdown or hesitation at this point and of course three weeks from now, we'll have the answer anyway.

Got it. Thank you. One last one if I may, does the upside to your guidance or EBITDA, is this primarily a reflection of upside versus your expectations for the first half of the year or is the second half coming in any better than you expected and maybe a little bit more color on thoughts behind the guidance provision?

Yes it definitely is because the first half of the year was a little stronger than our expectations. As you know Scott, we typically have a significantly stronger second half than the first half and we've planned to budget it that way. So most of this expectation really is because the first half came in a little stronger than expected and mostly on the margin improvement side.

Got it. Great. Thanks Bill.

Thank you. Our next question comes from the line of Daniel Moore from CJS Securities. Your question please.

Good morning. Thank you. I wanted to focus a little bit more on European operations but on margin side. Blended EBITDA margins in mid-teens, what is your current capacity utilization across the different businesses and how much upside to margins do we have from here?

At HL specifically, we still have some room to move in terms of capacity there. We added some capacity early this year that was already in the works when we acquired them. So we're in pretty decent shape there. Our European operation is getting close to the level where we may need to think about an expansion there as we get into 2017. Still very early, but not an issue right now, but relative to the U.S., capacity utilization in all three operations there is significantly higher.

Got it. And I realize that Woodcraft will be the driver of margins in '17 as you described. So maybe just talk about incremental margins and upside and opportunity in those businesses?

Yeah look, as we continue -- if we can continue the growth rates that we've seen throughout Europe, I think we'll continue to see some margin expansion because of leverage in those operations because we're getting into a level of capacity utilization where leverage could start becoming meaningful. So I do think we'll see improvements in Europe as we go through 2017.

And lastly on that topic, do your comments around pricing for '17 apply to Europe as well or is that a different dynamic?

It is a different dynamic. We have had price increases there, not this year, but in prior years and a little too soon to talk about what may happen in Europe in 2017. It’s really the U.S. we're focused on in terms of price.

Okay. And maybe for Brent switching gears to the balance sheet. You mentioned the opportunity for refinancing, is that something you're looking at in this calendar year, talk about timing, and then just more generally as you get down to your 2 to 2.5 leverage ratio target, remind us to your priorities for investing in free cash and your appetite for perhaps additional acquisitions?

Yeah, so when we -- at the time of the acquisition, we had targeted end of this fiscal year or early part of next fiscal year for a potential refinancing. That being said, we're always active in looking to see if we can do something sooner. So we're definitely looking at that now. As it relates to priorities, clearly focused on paying down the debt. It does not by any stretch have us on the sidelines related to acquisitions. That being the case, if we were to do something in the near term, more than likely would be a smaller bolt-on to an existing business ideally something with some cost take out but really stay laser focused with paying down the debt.

Very helpful. Look forward to seeing at the Analyst Day and again the conference in July.

Yep.

Thank you. Our next question comes from the line of Al Kaschalk from Wedbush Securities. Your question please.

Good morning, guys.

Good morning, Al.

I want to focus a little bit further and maybe look at the European side a different angle, understanding that your focus is on North America pricing. So can you maybe provide and maybe on the fairest question, but let's go for it. Over the last couple years, how has pricing dynamics worked in other words what is the market, has it been price increases put out and then not realized? Has the end market demand been more of a dictator of what pricing has done specifically? Just to give us a little bit of color of maybe what we could be looking for in the next to 12 to 18 months given the macro backdrop?

Yeah, typically in Europe, the dynamic of putting through a price increase and not getting it to stick, that’s not as common there at all and because keep in mind we have two product lines there that are still growing market share in the early stages of their evolution. We have not been particularly aggressive from a pricing standpoint and I still believe that’s the correct strategy/ We're still actively trying to get war made space to be used on a more frequent basis in Europe, hence outgrowing the market and in many respects a similar story at HL. That’s an old business that’s new again and they continue to grow their market share and if you recall their growth rate prior to us acquiring them was extremely large. I think 50% over the prior three years again because they're reentering a market and that’s not the time to try and put through price increases, in addition to which as you can see from the information we've given on the segment, margins are pretty decent there anyway. We don’t have to raise prices. We’re kind of happy with the margin profile as it is.

All right. Very helpful. And I guess with the capacity situation the incrementals are obviously pretty strong. Just turning off -- most of my other questions have been answered, but one question just more on a broader market, where are we in the -- and you can answer about North America and/or Europe, but on the energy efficiency side, replacement, legislation, regulatory, where are we in the product cycle there?

In North America, legislation continues to move at a snail’s pace in that direction, but not aggressively so. In Europe, because energy costs are so much higher than they are in the U.S., legislation there continues to strongly favor our current product lines. Hence the disproportionate growth rates to what you would consider general economic conditions in Europe. So legislation unquestionably continues to drive more energy efficient windows in Europe and we’re benefiting from that. We are not seeing that any significance in North America.

Great. Okay. Thank you very much. Good luck.

Thank you.

Thank you. And this does conclude the question-and-answer session of today's program. I would like to hand the program back to Bill Griffiths for any further remarks.

Thanks again everyone for joining the call and just to sum up, we clearly had a very good first half. The stage is set for a strong finish to our fiscal year and we expect to continue executing on all of our operational initiatives and based on the current outlook as you’ve seen, we've increased guidance for 2016. Next hope to see you all at our June 29 Investor Meeting at the New York Stock Exchange. Thanks for joining us.

Thank you ladies and gentlemen for your participation in today's conference. This does conclude the program. You may now disconnect. Good day.