Quanex Building Products Corporation (NX) Q3 2018 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen and welcome to the Q3 2018 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 follow at that time. [Operator Instructions] As a reminder, today’s conference call is being recorded. I would now like to introduce you to your host for today's conference call, Mr. Scott Zuehlke, Vice President, Investor Relations and Treasurer. You may begin, sir.

Thanks for joining the call this morning. On the call with me today is Bill Griffiths, our Chairman, President, and Chief Executive Officer; Brent Korb, our Chief Financial Officer; and George Wilson, our Chief Operating Officer. This conference call will contain forward-looking statements and some discussion of non-GAAP measures. Forward-looking statements and guidance discussed on this call and in our earnings release are based on current expectations. Actual results or events may differ materially from such statements and guidance and Quanex undertakes no obligation to update or revise any forward-looking statements to reflect new information or events. For a more 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 Bill for his prepared remarks.

Thanks, Scott. Good morning and thanks for joining us on the call today. We are pleased to report yet another solid quarter in which we delivered results that were very much in line with our expectations. We also announced another important news yesterday related to the accelerated return of capital to shareholders through both an increased dividend and a new share repurchase program. I'll address those developments and the strong cash flow and balance sheet that make them possible later in the call. But first let me begin with a few highlights from the quarter. Excluding eliminated products, foreign exchange impact and price, underlying growth was a healthy 7% in our North American Engineered Components segment and 5.7% in our European Engineered Components segment. Pricing actions which include material pass-throughs accounted for an additional revenue growth of 2.2% in North America and 1.7% in Europe. Inflationary pressures continued in both segments during the quarter, which resulted in a margin contraction of 180 basis points in North America and 60 basis points in Europe. Moving on to our North American Cabinet Components segment, again excluding eliminated products and price, revenues actually shrank by 3.7% year-over-year. This is consistent with the ongoing shift in the marketplace to lower price point cabinets and lower price materials. Despite these dynamics, revenues overall in the segment actually increased by 6.3% due to price, the majority of which was driven by material pass-throughs as hardwood prices continued to escalate throughout the third quarter. This together with accelerating productivity gains more than offset inflationary pressures and drove margin expansion of 200 basis points year-over-year. Looking ahead into the fourth quarter, the expectation is for continued margin expansion in the North American Cabinet Components segment, flat to slightly higher margins in our North American Engineered Components segment, and flattish margins in our European Engineered Components segment. This should put us in the mid-to-upper range of our $890 million to $900 million revenue guidance and towards the low end of our $103 million to $108 million adjusted EBITDA guidance for the year. Cash flow and bank debt paydown was strong again during the third quarter, which allowed us to continue deleveraging the balance sheet. Our leverage ratio was 2x as of July 31, 2018 which was actually better than originally anticipated. Our strong balance sheet together with a high degree of confidence in our ability to generate strong free cash flow during the fourth quarter enables us to accelerate the return of capital to shareholders, with a doubling of the quarterly cash dividend to $0.08 per share and $60 million share repurchase program. More on the future strategy after Brent covers the third quarter results in more detail. Brent?

Thank you, Bill. I'll start with the income statement and wrap up with comments on cash flow and the balance sheet. We reported net sales of $239.8 million during the third quarter of 2018 compared to $229.4 million in the third quarter of 2017. Similar to the first half of 2018, the increase was mainly driven by market growth in addition to price increases, largely related to raw material, inflation recovery, and a favorable foreign exchange impact. Net income was $10.8 million or $0.31 per diluted share for the three months ended July 31, 2018, compared to $10.2 million or $0.29 per diluted share during the three months ended July 31, 2017. On an adjusted basis, net income was $11.6 million or $0.33 per diluted share during the third quarter of 2018, compared to $11.5 million or $0.33 per diluted share during the third quarter of 2017. The increases were primarily driven by a lower effective tax rate and lower depreciation and amortization. The adjustments being made per earnings per share are as follows; purchase price inventory step-up recognition, restructuring charges related to the previously announced closure of several manufacturing plants, accelerated depreciation and amortization for equipment and intangible assets related to these facility consolidations, accelerated depreciation for plant re-layout in the North American Cabinet Components segment, foreign currency impacts primarily related to an intercompany note with HL Plastics in our European Engineered Components segment, and transaction and advisory fees. On an adjusted basis, EBITDA decreased slightly to $30.8 million in the third quarter of 2018 compared to $32.2 million in the third quarter of last year. The decrease was mainly due to the negative impact of inflationary pressures coupled with an increase in selling, general, and administrative expense. SG&A was up year-over-year primarily due to the fact that third quarter 2017 results included a $2 million benefit related to the legal expense reimbursement from one of our insurance carriers. Cash provided by operating activities was $26.8 million and $48.5 million for the three and nine months ended July 31, 2018 respectively, compared to $29.7 million and $46.5 million for the same periods of 2017. We generated free cash flow of $21 million during the third quarter of 2018 versus $20.2 million during the third quarter of 2017. Year-to-date, as of July 31, 2018, we generated free cash flow of $27.4 million, which is $8 million higher than the same period of 2017. We were able to repay $16.8 million of bank debt during the third quarter and have repaid $29.3 million of bank debt this year as of July 31. As a result of our strong free cash flow generation and bank debt paydown, our leverage ratio as of July 31, 2018 dropped to 2.0 times. This lower leverage ratio also means that the interest spread we are now paying on our outstanding debt balance is 25 basis points lower at LIBOR plus 175 basis points. We remain focused on generating cash, but now have a renewed focus on returning capital to shareholders. I will now turn the call back over to Bill for some closing comments.

Thanks, Brent. As you know for the past two years, our focus has been on margin improvement, cash flow generation, and deleveraging the balance sheet. Recently, our Board with the support of outside advisors conducted a comprehensive exploration of strategic options for Quanex to maximize shareholder value. This work, over the last several months, included a detailed exploration of potential acquisition candidates, potential merger candidates, and also the potential sale of the Company. It also included a third-party validation of our five-year strategic plan. Ultimately, after a thorough process, the Board unanimously concluded last week that the best path forward for shareholder value creation is to continue to execute our business plan to drive continued margin expansion and cash flow generation while maintaining a strong balance sheet. We have a good business that is performing well and generates attractive annual cash flow, which provides the opportunity to return capital to shareholders while maintaining a low leverage ratio. Accordingly, we announced yesterday a doubling of our quarterly cash dividend to $0.08 per share, which results in a yield close to 2% based on the current stock price. The Board also authorized a $60 million share repurchase program to be executed in open market transactions over the coming quarters. In summary, we are pleased with our continued strong performance this quarter, particularly in our North American Cabinet Components segment and we are confident that Quanex is well positioned for continued steady growth, performance improvement, and value creation. We now would be happy to take your questions. Operator?

[Operator Instructions] Our first question comes from Kathryn Thompson with Thompson Research Group.

Good morning. This is Steven Ramsey on for Kathryn. I wanted to first focus on gross margins and inflation. You had discussed on the last quarterly call, I believe that you were highly confident in getting pricing to offset inflation and the price cost gap closing maybe next quarter. Are you getting price to the extent you thought you would and has inflation played out in the way that you expected it to when you put in those price increases?

So generally speaking, I think it's fair to say that the inflationary costs are kind of in line with what we expected at the early part of the year. They're not getting worse, but they're not really getting better either. Pricing is always a difficult thing to get and we've had different levels of success in different parts of the business. Hence, one segment still having some margin contraction and another with some significant margin expansion. Not all of that is directly related to price trying to cover inflationary costs. I think we've been pretty clear that in the Cabinet Components segment, the opportunity for productivity improvements is significantly better than it is in the segments that we've had for some time and margins are at a much better level. So that explains some of it. I think we'll see continued improvement in the fourth quarter, but we're not necessarily going to see significant margin expansion in Europe and the North American Fenestration Components segment.

Excellent. And then in this kind of inflationary, tariff-driven environment, has competitor responses to these different pressures? Has that also changed your outlook on the ability to drive margin improvement?

Not really. For the most part, our business and this is very similar to our competitors, is a just-in-time manufacturing environment rather than a build-to-stock environment. And as such, we've never really seen any significant offshore competition, and so the tariff issue hasn't really shown up yet for us. I mean some commodity costs clearly, but for the most part it has not changed the competitive environment.

Excellent. And then last question. Kind of stepping back not even thinking specific company guidance here, but is there anything that you see with customers, partners, that would give you concern about the steady market growth in 2018 or even into calendar 2019?

No, I think it's going to be steady as she goes. So I mean, we've said consistently, sort of mid-single-digit growth. We're just beginning our operating planning process for 2019, and we don't see anything out there that would cause us to think differently at this point. Obviously, we're watching closely the recent consolidation moves in the window industry, and because of our knowledge of those particular companies, we do not expect any material change in our business as a result of that.

Great. Thanks.

Our next question comes from Daniel Moore with CJS Securities.

Bill, Brent, good morning. Thanks for taking the questions.

Good morning.

Hi Dan.

So cabinet margins, obviously as you described saw nice uplift, a little over, tweaking over 10%. I know this is a seasonally strong part of the year for you. Is that a good kind of run rate to go forward? How much additional upside potential is there as we look out beyond the current initiatives over the next year or two?

So I think the general answer is yes. The current run rate looks very much as though it's sustainable. As we've said repeatedly, we still believe there is upside to that. Clearly, it's taken us longer than we all wanted to get to this run rate. And so I'm still a little bit cautious as to how to guide going forward, but we see no reason at this point that we shouldn't at least be able to sustain the run rate we saw in Q3.

Very helpful. Capital allocation, greatly appreciate the color. And having – assuming you were able to complete the first or full $60 million in terms of share repurchase even with the higher dividends, looking out a year from now, you would still probably be in the low 2s as far as leverage. So do we think about this as sort of round one of share repurchases, is the intention to complete this and then reassess? How should we think about it beyond what's been announced today?

Yes. Clearly, I don't want to commit to something that may be a year or 18 months in the future. That would be premature. I do think at the end of this exercise, the conclusion was pretty straight forward that we could generate greater shareholder value with the business continuing to improve, continuing to spin-off the kind of cash flow we've seen. We clearly can afford the dividend increase. And as you point out, because of the low liquidity and the rules regarding stock buybacks, it's going to take a while to eat up that $60 million, and we will be another year deeper into the cycle. And I think our view at this point is while we're still confident, there are legs in this cycle. There is clearly more investor skepticism around latter innings here, and we feel it is prudent to maintain a low leverage ratio, which as you say should be no greater than low 2s or bracketing two times and still return cash to shareholders and be very well positioned, if in fact, the cycle does turn down. And if it doesn't, we're in an even better position, so I think this is clearly a prudent approach at this time and certainly will generate increased shareholder value here.

Very good. Lastly, a sort of a part B to that would be, obviously, your intention is very clearly articulated here. Smaller tuck-ins or would you still entertain those types of opportunities in and around your core current business?

We would. I think it's fair to say that we arrived at this conclusion because there isn’t a lot out there that’s attractive to us that could generate the kind of returns that buying back our own stock at its current low levels does. So you never want to study never, but I don't see a whole lot out there anytime soon with zero visibility on anything right now.

Got it. Thank you again for the color.

Our next question comes from Ken Zener with KeyBanc.

Good morning, everybody.

Hi, Ken.

Good morning.

A lot of stuff implied in the press release. If I could obviously kind of focus on some of your business results to keep it a little more channeled. UK, you had a – [indiscernible] has got some UK business over there, so your window business did quite well. Could you – obviously not commenting on their business, but could you comment on kind of the demand trends because they've highlighted some deceleration over there, but it seems as though you are not necessarily seeing that type of slowdown, and the implications for next year, if you could kind of just [indiscernible] October year end, like what you're seeing right now in terms of that market? Is your business model that's so distinctive or what? Thank you.

I think that the general answer to that is, we have seen a deceleration. In fact this time last year, our underlying growth rates in Europe were actually double-digits. So I think what we're seeing now, we sort of more in line, and the issue with margins there are our UK spacer business in particular has faced a very, very significant price increases in base silicon. Yes, to the extent that it's very difficult to pass that price on. There is a lot of price inflation in the window business in the UK because glass prices are also extremely high there right now because there is a shortage of glass. But generally speaking, we're pleased. I think we'll continue to see next year growth rates in Europe in that mid single-digit range.

Thank you for that commentary. And then, for our cabinets, which you said, taking you longer to get here and you’re headed in the right direction. Could you perhaps put your business as an OEM supplier? You have obviously some price inflation in your wood products. But could you put it in context of the broader shift we're seeing in cabinets, which is that there’s been some large cabinet manufacturers that are focused on mix, shifting down as opposed to the mid market kind of moving out. Are you – how is that impacting your business in terms of units versus mix? Because we've seen that downward mix shift away from that kind of that mid-tier category. Could you just kind of expand on what your business is seeing for that mix?

That is the biggest single reason that it's taken us this long to get margins where we were close to where we wanted them. The mix shift has been very, very significant. And there is no question, I think that that is going to continue. We've been adjusting our business accordingly and frankly adjusting our pricing strategy accordingly because as you're well aware that entry price point stock cabinet business that was never our core business. And our core is in semi custom, which remains still reasonably strong. But the shifts getting accelerated by some dramatic increases in the typical materials that go into that namely, Cherry, Hard Maple, I mean they’ve seen 25% to 30% price increases year-over-year which I think exacerbated that shift downward. So we're continuing to adjust our business model. But that's one of the biggest reasons that margin improvement has been slow to come by. We're doing two things at the same time. We are putting in some significant productivity improvements, but having to shift products we produced at the same time. So it's been difficult.

Is there anything given your position in the supply channel? Is there anything to suggest you can kind of see an end game? What's happening there? You mentioned significant cost increase in Cherry and some other materials. Is that what you think might be leading to the mix shift? Or is it more judged perhaps a style? Some cleaner lines that can in fact be met by lower-end prefab cabinets? Any comments there would be useful? Thank you.

Yes, no question. I think stylistically that shift already started. I think it accelerated because the spread between the price of a hardwood cherry cabinet and an engineered wood with clean lines that just made that shift happen much quicker. Let me just add a final comment though. As you know there's been a lot of consolidation in the Cabinet business, a lot of market share shift. We still fundamentally believe that the Cabinet business is a good space to be in. We honestly believe here that the Repair and Remodel segment is going to come back stronger and stronger as it becomes more and more expensive and difficult to get entry level new homes. I think we'll see more and more people remodeling their homes. So we think, over the next several years the cabinet space is a good place to be.

Thank you.

Our next question comes from Julio Romero with Sidoti & Company.

Hey, good morning. Thanks for my questions.

Good morning, Julio.

So just a follow-up on the prior conversation on the mix shift and cabinets. I know you had almost a 16% gross margin in that segment this quarter, given the industry mix shift. How does that affect your long-term goal on the gross margin side? How much headroom would you say you have on the gross margins in that segment?

Yes. We still believe that the level of improvement we originally talked about is still achievable. So no change in our expectations there. As I said, it's been slower, exacerbated by this shift. I still believe we can get there. It's not going to happen overnight because there's a lot of product changes, a lot of manufacturing process changes, and pricing strategy changes yet to come.

Got it. And if I could just ask a couple on capital allocation? Do you have a target level of cash flow you maybe aiming to return? Maybe if you can point us in the direction of percentage-wise that we can think about in terms of cash flow of operations or maybe free cash flow and a target level you would want to return?

No, we really don't. I mean, I think the premise is simply this, the current level of cash flow generation is likely to improve as we get into 2019 and 2020. We would expect and I've said before CapEx should start to come down a little. Obviously, with lower debt levels, our interest cost will come down slightly. And our expectation is we will continue to improve the business, including in some cases working capital. So I think the current levels should get incrementally better. And as I said earlier, when we use up that first $60 million, we'll reassess and look at it then.

Sure. And the last time you guys had a repurchase I believe in 2014 or 2015. You're pretty aggressive in deploying that capital for that 12- to 15-month period. Would that be kind of a fair run rate to assume from a modeling perspective on our end?

Well, the difference this time is – so last time, we did $75 million. It was under a 10b5-1. This is going to be discretionary at market. And look, we can only purchase a maximum of 25% of the average daily volume. So it's going to take several quarters into next year even if we're very aggressive. And obviously, it's going to depend a lot on what happens to the stock price.

Got it. That's helpful. Yes, thank you for taking my questions guys.

Thanks.

Our next question comes from Bill Baldwin with Baldwin Anthony Securities.

Yes. Good morning.

Good morning, Bill.

Couple of questions. On the spacer initiatives that you’ve come up with here in the last few years for the large – for your large window companies, I know there's been issues with getting the equipment in and so forth to get that product up and running like you like for it. Can you, kind of bring us up to date with where you are in that program now and kind of how you see them, folding out over the next 12 to 24 months in terms of more lines coming on?

Yes. There's really no change, Bill. We have four manufacturers now that are producing lines. They are capacity constrained. They're also building other equipment as well. And that's the governor on this. And so we've seen three to four new lines a year as the installation rate. We don't expect that to change as we get into 2019, so more of the same. Not as fast as we would like, but beyond our control.

I understand. So how many lines do you have running right now, Bill?

I don't have that in front of me. And I don't want to give you a bad number, Bill. So we'll follow-up with you on that. I just don't have it in front of me.

Okay. Also, Bill, can you bring us up to date with your latest thinking as far as what your thoughts are long-term strategically on the vinyl profile business? How you see that fitting into the Quanex strategies?

Well, there is no question. That’s one of the more competitive parts of our business. We continue to strive for improved margins and productivity in that business as well. And yes, keep in mind that really only applies to the U.S. Our European vinyl business is an outstanding business. We're very, very pleased with that. So we continue to work very hard in the U.S., and obviously watching very carefully the recent moves in the vinyl window space as well.

Is there still an opportunity that you think, Bill, to bring on new business in that product line?

Yes. There is no question and we're encouraged by some recent discussions we've had with the current customers about perhaps gaining some additional business as we enter 2019. A little premature to talk about it now, but we have high expectations for next year.

If you were to be successful, would it be kind of – I mean, will it move the needle on the business? Would it be important to the trend line growth of the business or the growth for vinyl profile and for your North American components business?

It will clearly be positive in every respect. I think when you look at total Quanex, it's not going to make a major difference to the topline or the bottom line, but we'll take every little incremental dollar improvement we can.

I understand, Bill. Thank you very much and congratulations on the hard work you guys put in over the last several years.

Thanks Bill. End of Q&A

And I'm not showing any further questions at this time. I’d like to turn the call back over to Bill Griffiths for closing remarks.

Thanks everyone for listening in and we look forward to speaking to some of you as we get out on the road here in the coming weeks, and we'll speak again in early December. Thanks everyone, and bye now.

Ladies and gentlemen, this does conclude today's presentation. You may now disconnect and have a wonderful day.