Quanex Building Products Corporation (NX) Q2 2017 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen. And welcome to the Q2, 2017 Quanex Building Products Corporation's Earnings Conference Call. At this time, all participants are in a listen-only mode. [Operator Instructions] As a reminder, this conference is being recorded. I would like to introduce your host for today's conference Mr. Scott Zuehlke, Vice President of Investor Relations and Treasurer. Sir, please begin.

Good morning. Thanks for joining the call. 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 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 measures to the most directly comparable GAAP measures, please see our earnings release issued yesterday and posted to our website. I will now turn the call over to Brent to discuss the financial results.

Thanks Scott. I will start with the income statement and finish with comments on our balance sheet and cash flow. We reported net sales of $209.1 million during the second quarter of 2017, a decrease of 9% compared to the same period of last year. Similar to last quarter, the decrease was primarily attributable to our previously disclosed decision to walk away from less profitable business in an effort to increase longer-term returns and drive margin improvement both near-term and long-term. Net income decreased to $1.9 million for the three months ended April 30, 2017, while adjusted net income increased to $3.8 million, or $0.11 per share during the second quarter of 2017 compared to $3.3 million or $0.10 per share in the second quarter of 2016. The adjustments we made for 2017 and 2016 earnings per share are as follows. Acquisition related transaction costs, purchase price inventory step-up recognition, a one-time pre-acquisition employee benefit adjustment, restructuring charges related to the previous closure of the three manufacturing plants, gain on the sale of fixed assets related to the closure of the plant in Mexico, accelerated depreciation and amortization for equipment and intangible assets related to the facility consolidations, and foreign currency impacts primarily related to an inter company note with HL Plastics. As disclosed in the earnings release and as expected, we recorded additional restructuring charges in Q2 related to the closing of the two U.S. vinyl extrusion facilities and the Mexican cabinet components facility in late 2016 and early 2017. We will continue to incur operating lease expense until the two vinyl extrusion facility leases end, as well as other employee related costs. EBITDA came in at $19 million for the second quarter of 2017 compared to $24.4 million last year. On an adjusted basis, EBITDA for the second quarter of 2017 was $20.5 million compared to $24.3 million last year. The decrease was largely due to lower volumes as we continue to transition away from less profitable business combined with elevated legal expenses. It is worth noting that we were able to realize adjusted EBITDA margin expansion in our cabinet component and European engineered component segments even with lower revenues. Moving on to the balance sheet, our leverage ratio ticked up to 2.7x as of April 30, 2017, mainly as a result of adding approximately $16 million in debt resulting from a capital lease for a new warehouse service in our UK vinyl profiles business. We remained focused on generating free cash flow to pay down debt and anticipate a significant improvement in our leverage ratio by year end 2017. As a reminder, our long-term leverage ratio target is 2x to 2.5x. We expect to be well within this range by the end of the fiscal year. Cash provided by operating activities decreased to $15.7 million for the six months ended April 30, 2017 compared to $24.6 million for the same period of 2016. The biggest driver of the year-over-year reduction relates to the timing of payments to suppliers. This issue will naturally correct itself. We continue to expect an increase in the year-over-year free cash flow of approximately $10 million. Keep in mind that we generate most of our cash in the second half of each year due to the seasonality of our business. For example, in 2016 we generated 82% of our free cash flow in the second half and to take it a step further, we generated 52% of total free cash flow in the fourth quarter alone. I'll now turn the call over to Bill.

Thanks Brent. In our U.S. vinyl profiles business, the anticipated annual revenue reduction of $65 million continued on pace with a $17 million reduction in Q2, after an $11 million reduction in Q1. We expect that the balance of $37 million will be split relatively evenly between Q3 and Q4. And as we've said previously, this has been factored into our full year guidance. The consolidation of this business is now essentially complete. Through the first half of this year, we successfully closed two facilities, relocated 13 extrusion lines, retired 23 lines, and transferred 228 active tools to our remaining three facilities, all without any service disruptions. We'll spend the balance of this year fine tuning and optimizing the shop floor layout in each of the three remaining facilities in order to drive greater efficiencies to further improve margins. In the rest of the businesses that make up the balance of our North American engineered component segment, revenues, EBITDA, and margins were all flat year-over-year, impacted by particularly soft April mainly due to weather, heavy rains on the West Coast and the storm in the North East. Despite the slow start, there is a great deal of optimism throughout our customer base for a strong summer selling season. In our cabinet components segment, margins improved slightly year-over-year on flat revenues even though we continue to face strong operational headwinds. We were able to negotiate acceptable price increases on about half of the $20 million of margin dilutive business we previously identified, and we agreed to walk away from the other half. This has also been factored into our full year guidance. While this will have a positive impact on our results in the second half, it was still a headwind in the second quarter as most of the price increases did not go into effect until late April and we continued to work excessive over time for customers building safety stocks for products that we are in the process of transitioning to other suppliers. This resourcing effort took much longer than anticipated but was finally completed as Q2 closed and therefore should have no ongoing negative impact in Q3. We believe that these actions along with productivity improvements from some of our automation projections will drive margin expansion of approximately 200 basis points in the second half of this year on what is expected to be relatively flat revenue levels. In our European engineered component segment, we realized 4% revenue growth on a local currency basis during the quarter, which was lower than the double digit growth rate we've seen over the past year but really not a surprise given the political turmoil throughout the quarter in Europe. Brexit was officially triggered. There was a contentious election in France, and there is still a surprisingly uncertain pending election in UK. Despite all these moving parts, the European engineered components segment continues to be most profitable, and margin improved by further 30 basis points year-over-year in this second quarter. We still expect solid mid-single digit revenue growth for the remainder of the year in this segment. As Brent mentioned just now, our leverage ratio increased slightly this quarter to 2.7x as a result of the new HL Plastics capital lease. As a reminder, most of our free cash flow is generated in the second half of our fiscal year. Last year, we generated approximately $42 million of free cash flow during the second half, and we remain confident that we will surpass that number in the second half of this year. This cash will be used to pay down debt, as it is very unlikely that we will close on any acquisitions during the balance of this year. Thus we should end the year with a leverage ratio close to 2x. In summary, we came into this year expecting materially lower revenue but with improved margins and stronger free cash flow. In order to achieve this we needed to do two things. One, rapidly restructure our U.S. vinyl profiles business and two, stop the profit leak in our cabinet components business and reposition it for profitable, sustainable growth over the next several years. Through the first half of this year we've successfully completed the consolidation in our U.S. vinyl profiles business and turned the corner in our cabinet component segment, thus setting is up for a strong second half. As such we are confident in reaffirming our prior guidance of $880 million to $900 million in revenue and $105 million to $112 million in adjusted EBITDA with the leverage ratio closer to 2x. And with that operator, we are now ready for questions.

[Operator Instructions] Our first question is from Daniel Moore of CJS Securities. Your line is open.

Good morning, Bill and Brent. Thanks for taking the questions. You touched on this still little bit but may be little bit -- just a little bit more color in North American engineered products, organically roughly flat so far this year adjusting for eliminated products. Just talk about what gives you the confidence that underlying growth is likely to tick higher, accelerate toward the mid-single digits for the remainder of the year.

Yes. So as far as comps go, if you recall the first half of last year, it was pretty strong mostly for the -- because of the warm winter, so with flat at this point year-over-year, I'd have expected at this point perhaps to be a little ahead of that. And so, we spent a significant amount of time in conversations with our customers, and in April I think there has been several reports indicating soft April in construction all around because of weather. We certainly saw that which sort of dragged the quarter down a little bit. But our customers are extremely confident of a strong summer here. So frankly our forecasting, our planning and expectations is really based on what our customers are telling us and we have many of our larger customers saying. Don’t be lull to sleep here, get ready the volumes are coming.” So that's where our confidence level is coming from. And last year if you recall July which is the last month of our third quarter was exceptionally weak and a bit of surprise to everybody. So I think the comps by the time we get to the end of this quarter should get a little easier. Although we are almost through May here and May is tracking about where we expected it to a little ahead of last year but not significantly so, but again the confidence is really coming from conversations with our customer base.

Got it. That's helpful. And I want to drill down on the Mikron business and we went through some of this last quarter. I apologize for the multipart question but remind us how much revenue you have left with that largest customer that you’ve divested quite a bit. And then the annual run rate revenue of Mikron kind of pro forma as well as the margin profile and just your confidence around maintaining your -- or growing that revenue as we lookout to fiscal 2018.

Yes. So -- I am not sure that we actually disclosed the amount that we have left. It's no longer material. They would no longer at Mikron fall into our top five customers, although of course we sell them other products elsewhere. We are now in a position where as a result of the consolidation and the loss of that business, that we have a pretty stable footprint where we can start re-growing the business. Frankly, the restructuring went better than we anticipate and as a result perversely we actually increased capacity even though we have two fewer plants and 23 fewer lines, our actual realized capacity went up somewhat, so through the second half we are going to be doing a combination of two things. We are obviously actively out pursuing other business and I am not going to talk about the specifics of that because there are some ongoing negotiations, but we are confident we can start re-growing this business with the better profitability going forward. But more importantly, as we start getting efficiencies up with the existing footprint, we are doing a fair amount of fine tuning to make sure that we are fully utilizing our most productive equipment, and it is possible as we go through the second half of the year that we will end up retiring more extrusion lines to further reduce our capacity more in line with our production expectation.

Thank you. Our next question is from Ken Zener of KeyBanc. Your line is open.

Good morning, gentlemen. Doing very well. In cabinet doors, you talked about pre buy a little bit. Could you put in context kind of the -- because there are so many different styles right in doors what is the kind of visibility that they might pre order for in. I don't know -- I've always assumed there is kind of a three week lead time. If you could kind of talk about that price increases in context for us.

Yes. So generally speaking, pre buys are unusual because most of the product line is highly customized. This was very specific to product that we expected to exit the building much, much sooner, but one particular customer had a lot more difficulty than anticipated in getting the business resourced, so we ended up in a spot where we were tight on labor and we worked excessive over time. In fact, in the second quarter alone, the over time premium compared to the second quarter of the previous year was $0.5 million greater, so absent that and the majority of that over time was really working for customers whose product we really didn't want or need and it was certainly dilutive to margin. But absent that the margin improvement would have been probably closer to 80 basis points better. So I wouldn't take that to mean that pre ordering is something that is common, and we are not going to speak to specifics on the individual price increases for obvious reasons, but suffice to say that with the exit of some of the other business and the productivity improvements, it gives us confidence that in the second half we should see about 200 basis points margin improvement in that business.

Okay. Hey, you are nicer than I thought there, Bill. I wondered if on the engineered component side specifically warm-edge spacers, I know that there has been increased adoption with some mechanize Asian which is enabling you have to have a greater market share in that category. Can you talk to how that is being adopted and that's better, faster with OEMs you provide that mechanization or better or their product that you adopted better. Thank you very much.

So the short answer is it's been adopted slowly. And slowly because of the inability of the equipment manufacturers to produce enough lines fast enough. That's really the choke point on that project. The customer on the West Coast that had the first line installed very, very successfully had subsequently ordered two more. The customer on the East Coast, that's moved a little slower has one working very successfully about to take delivery of a second with a third pending order. And we have a number of other customers that are actively looking at the project. The short version of the value proposition is for the first time ever we can now on automated line using flexible warm-edge spacer produce insulated glass unit at about the same production rate as the metal bar spacer. But we do so with significantly less labor. Typically the metal bar lines mostly because they are old now run with 8 to 9 people and super spacer line will run typically with three people. So net-net even though the cost of the spacer component itself is more expensive, the total cost of the insulated glass unit for the customer is about the same with significantly better quality and labor as we all know is difficult to come by so they can utilize their existing labor much more efficiently. So hopefully that answers the questions with enough color.

Thank you. Our next question is from Nick Coppola of Thompson Research. You line is open.

Hey, good morning. So in North American engineered products you had flat margin despite the revenue decline. And I think last quarter you talked about expenses related to the relocation of equipment being a drag. So how big of a drag was that and then may be just talk about some of the ways you are able to hold margins by the lower top line.

Yes. Look, the biggest issue really was a lack of margin improvement in the vinyl profiles business. As we sort of closed that out their margin sort of held I'd expect to see some improvement here as we go into the second half and certainly next year awful lot of moving pieces in that business. So it's sort of difficult to pin down here the detail of any one or single set of component. Suffice to say I think given all the moves that took place, given that there was a very soft weather related April coming out of the second quarter flat, we considered a victory and we now have a stable platform to build on for the second half of the year.

Okay. That makes sense. And then transitioning to cabinets, but also on margins. You talked about 200 basis points improvement for the year. We can certainly come out without a blast next couple of quarters. But can you just talk more about what the drivers are? How do you get there? Is it all automation initiatives? Are there some other things that we should be thinking about?

Well, no, there really it's three things that we talked about really through the first half of this year. One, that the margin dilutive business will be corrected. Half of it will go out of the door which will be a benefit. Half of it we got price increases that were acceptable to us, which clearly will be a benefit. Neither of those two factors had any positive impact in the second quarter because it really took us all of the second quarter to get both of those things accomplished satisfactorily. And then the automation projects that have been initiated through the course of the last year, some of those are really kicking-in as expected. So we'll see three things, better margins through price, better margin because some dilutive business will exit the building and three productivity improvements are actually starting to take hold. So those are really the three components that will drive the expansion in the second half.

All right. That's some helpful context. And then just last question here. I wanted to drill on EU volume. So it was up mid-single digit but it was a step down from the prior quarter. I think in your opening comments you already talked about Brexit and something like that. Just any additional commentary about the trajectory of the business in the EU.

Yes. I mean we basically halved the growth rate. I mean we were running in the low double digit quarter-over-quarter, year-over-year through last year and through the first quarter and clearly the level of uncertainty is having an impact but we grow 4% on a local currency basis and the expectation is that will be the growth rate here as we go forward. There is a surprising amount of uncertainty regarding next week's election. It's gone from-- the poll saying a landslide victory to a Reuters report today that actually said she could lose her majority and of course based on recent experience in election who knows what the polls really mean but it creates a level of uncertainty that certainly slowing investment. But certainly not to the point of panic here. So I think it will still continue to move in mid-single digit.

Thank you. Our next question is from Bill Baldwin of Baldwin Anthony Securities. Your line is open.

Hi, good morning. Couple of questions here. Are there any longer-term thoughts Bill about bringing some of HL Plastics broader product lines over to the North American market? Just final profile.

No. We will towards the end of this year start looking more aggressively at some of their very specific product lines that we feel may have a niche position in the U.S. market. And we may in fact start test marketing some of those products with a view that if it's successful we'll actually start manufacturing them here in our vinyl profile operation. But still very much in the early stages and frankly that would be a relatively long slow process. I'd expect to see any benefits from that until certainly the second half of 2018. But given that we've sort of cleared the decks of a lot of other issues here, that's now starting to become a higher priority.

Secondly, Bill is there any initiatives ongoing to increase your exposure to the non-residential construction markets?

There are and there are a couple of new products that are being introduced in our vinyl profiles business that are appropriate for low rises, storefronts and light commercial and that's an active part of their growth initiative to rebuild the volumes in that business. So yes there are active programs underway.

And lastly would you describe your growth in your European market as fairly evenly divided between the legacy spacer business and your recently acquired vinyl business?

It's a little bit higher in the vinyl business than in the spacer business but not significantly so.

Thank you. At this time, I'd like to turn the call back to Mr. Bill Griffiths for closing remarks.

Thanks everyone for joining the call. And we look forward to updating you at the end of the third quarter hope with a much stronger performance as we look forward to a very strong close for the year this year. Thanks.

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