Quanex Building Products Corporation (NX) Q4 2018 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen, and welcome to the Quanex Building Products Corporation's Fourth Quarter and Full Fiscal Year 2018 Earnings Conference Call. [Operator Instructions] As a reminder, this conference call is being recorded. I'd now like to turn the conference over to Scott Zuehlke, Vice President, Investor Relations and Treasurer. Sir, you may begin.

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 discussions 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'll now turn the call over to Brent, to discuss the financial results.

Thank you, Scott. I will begin with a review of the income statement and finish with comments on cash flow, the balance sheet, and 2019 guidance. I will then hand the call over to Bill who will provide additional color around our performance as well as our strategy and expectations going forward. Net sales increased 4.8% for the fourth quarter to $244.1 million and 2.7% for the full fiscal year to $889.8 million compared to the same period of 2017. The increases were primarily driven by market growth as well as price increases mainly related to raw material inflation recovery and for the full year a favorable foreign exchange impact. We reported net income of $6.5 million or $0.19 per diluted share for the three months ended October 31, 2018 compared to $10.7 million or $0.31 per diluted share during the three months ended October 31, 2017. For fiscal 2018, net income increased to $26.3 million or $0.75 per diluted share compared to $18.7 million or $0.54 per diluted share for fiscal 2017. On an adjusted basis, net income was $7.6 million or $0.22 per diluted share during the fourth quarter of 2018 compared to $13.1 million or $0.37 per diluted share during the fourth quarter of 2017. Adjusted net income was $22.7 million or $0.65 per diluted share for fiscal 2018 compared to $27 million or $0.77 per diluted share for fiscal 2017. The adjustments being made for earnings per share are as follows: LIFO inventory reserve adjustment, 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 transaction impacts, the net tax benefit related to the Tax Cuts and Jobs Act, and transaction and advisory fees. On an adjusted basis, EBITDA decreased to $25.2 million in the fourth quarter of 2018 compared to $33.3 million in the fourth quarter of last year. For the full-year 2018, adjusted EBITDA was $90.9 million compared to $99 million in 2017. The decreases in adjusted earnings are mostly due to the negative impact of inflationary pressures throughout the year and an increase in selling, general and administrative expenses. The increase in SG&A expense was driven by an elevated medical cost, higher annual incentive accruals and a year-over-year increase in insurance-related legal expenses. Insurance-related legal expenses for the fourth quarter and full fiscal year of 2017 included a benefit of $2 million and $4 million respectively related to legal expense reimbursement from one of our insurance carriers. Before I move on to cash flow and the balance sheet, I want to remind everybody that we recently amended and extended our credit facility. This underscores the progress we've made over the past two years improving our leverage profile and it provides a number of benefits including the maturity date on our outstanding debt was extended by more than two years. The new terms in covenant are less restrictive and give us more flexibility with respect to returning capital to shareholders and the new pricing grid is more favorable by 25 basis point across all tiers. Now on to the cash flow and the balance sheet. Cash provided by operating and activities was $104.6 million in 2018 compared to $79.8 million in 2017. We generated free cash flow of $78.1 million in 2018 which represents an increase of 73% year-over-year, largely driven by a focused effort to streamline working capital. As a result of our strong cash flow and consistent with our commitment to continue to reduce our leverage while returning capital to shareholders, we repurchased $32 million in stock in the fourth quarter and repaid $28 million of bank debt during fiscal 2018. We also achieved our targeted end-of-year leverage ratio of 2x net debt to last 12 months adjusted EBITDA as of October 31, 2018, even after the $32 million stock repurchase. As noted in the outlook section of our earnings release, we're forecasting revenue growth of 4% to 6% in 2019. Adjusted EBITDA guidance of $97 million to $107 million represents year-over-year margin expansion of approximately 70 basis points at the midpoint. From a capital expenditure standpoint, we expect to spend approximately $25 million to $30 million in 2019. For modeling purposes, it is appropriate to make the following assumptions for 2019. Depreciation of approximately $36 million, amortization of approximately $15 million, SG&A of $105 million to $110 million, interest expense of approximately $11 million, and a tax rate of 24%. I'll now turn the call over to Bill for his prepared remarks.

Thank you, Brent. As we announced at the end of our third quarter, our strategy for the foreseeable future is to maintain a healthy balance sheet and return excess capital to shareholders. As a result, we had an even greater emphasis on working capital management and cash flow generation during the fourth quarter. As Brent just mentioned, this led to exceptional free cash flow of approximately $78 million in fiscal 2018 including approximately $51 million in the fourth quarter alone. To put this into perspective, the $78 million of free cash flow for fiscal 2018 equates to $2.23 per diluted share and a strong free cash flow yield both of which compare very favorably to the current consensus averages for our peers. Our strong free cash flow generation enabled us to fund a doubling of the dividend, the repurchase of 1.9 million shares for approximately $32 million while still maintaining the leverage ratio of 2x, a level we're comfortable with. Our full-year adjusted EBITDA of $91 million was about $12 million shy of the low end of our guidance. This shortfall was primarily driven by increased incentive payments as a result of our strong free cash flow performance along with an unforeseen increase in medical expenses. To provide some context, we generated approximately $33 million more in free cash in 2018 than we did in 2017, while incentives in 2018 were about $11 million higher and medical expenses were almost $4 million higher than the prior year. Consistent with industry peers, we experienced softer than expected sales in August and September. Despite this softness, we continued to outperform the market in all segments from an underlying growth perspective. This is primarily due to greater weighting to R&R versus new construction During the fourth quarter, our North American Engineered Components segment achieved underlying growth of 5.1%, and in Europe, despite all the turmoil surrounding Brexit, underlying growth was 5.9%. The North American Cabinet Components segment had a strong quarter all round with underlying growth of 8.2% and gross margin expansion of 225 basis points compared to last year. This marks the second consecutive quarter of significant gross margin expansion in this segment. We are pleased with our progress here and will continue to focus on operational excellence to further enhance productivity and derive margin expansion. So while there is currently some pessimism within the building products sector, our current view isn't as negative. We believe we will see 4% to 6% revenue growth in 2019 compared to the 6% underlying growth we realized in 2018. In addition, while we expect inflation to continue in 2019, particularly with respect to logistics, benefits and healthcare costs, we are confident that we can pass these costs on through pricing initiatives. As such, we expect a slight improvement in 2019 in adjusted EBITDA margins in our North American Engineered Components segment with flat to slightly declining margins in our European Engineered Components segment and continued meaningful margin expansion in our North American Cabinet Components segment based on the expectation for further productivity improvements. Accordingly, as Brent said, we expect adjusted EBITDA of between $97 million and $107 million in fiscal 2019. CapEx was a little lower than planned in 2018 due to delays in a couple of major projects which have been pushed into this year. Even with this carryover, we anticipate spending $25 million to $30 million in fiscal 2019. We remain laser focused on generating cash flow and we will continue to aggressively manage working capital. The exceptional working capital performance in the fourth quarter is clearly a one-time benefit. However, we are confident that this level of working capital as a percentage of sales is sustainable. And as a result, free cash flow in 2019 should be between $50 million and $55 million. We will continue to de-lever and opportunistically buy back stock. In summary, we agree that new residential construction has slowed. But we're more weighted to repair and remodel than new construction and we believe that the R&R market will continue to strengthen. In addition, we see a favorable trend with our customers outsourcing more component business as a result of labor constraints and we're also winning back some of the business we lost over the past few years. All-in-all, we entered 2019 with more optimism than pessimism. We remain committed to a disciplined approach to capital allocation by maintaining the strong balance sheet and returning capital to shareholders. Our Board and management team are confident in the fundamental strength of our business and our ability to draw the efficiencies and deliver sustainable growth and shareholder value creation in the coming years. And with that, operator, we'll now take questions.

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

Bill, I told –[indiscernible] I'm going to ask a question that I know you tried to answer in detail already, but in terms of the outlook for next year for fiscal '19, 4% to 6% top line growth, just talk about you know maybe expand on what gives you confidence there and specifically - and what are you looking at in terms of price versus volume? You mentioned starting to win back some business that you lost, any more detail or specifics you can give there? And what kind of FX impact are we looking at based on rates right now? That's a mouthful, but I'll start with that.

So, as you're aware, the comps this year versus '17 included some lost business in '17. If you take that out, the underlying growth numbers which are the ones I just quoted for the full year are around 6%, and so we won't have those negative comps in 2019. So the expectation is, we'll see perhaps some softening as the home builders slow down, but we've demonstrated underlying growth of that magnitude now for the past few quarters. In addition, to compensate for some of the softness in new construction, we do believe that R&R will continue to strengthen. We have a very healthy pipeline of business that's under quotation and negotiation right now to the order of some $30 million of customers that are considering outsourcing more product. That's not to say that we'll get awarded all that business or those decisions will be made positively. But it's the biggest pipeline of new potential business we've had in several years. We've recently been awarded a couple of contracts that actually are business that we lost over the last few years, not all of it by any means, but in the range of $10 million to $15 million worth of business. So collectively, I mean, we are pretty optimistic even though we recognize the new construction part of this is likely to soften through at least the first half of next year. And then the gross margin level is, we kind of ended the year about where we expected it to be. Obviously, the big miss was a couple of large one-time items that fall mostly into SG&A. We demonstrated it last year, albeit somewhat late in the year, our ability to pass on price for some of the inflationary concerns. We are currently working on pricing initiatives for early in 2019 and clearly we expect to be able to pass those through. So when you put all that together, we are very confident of the outlook we just laid out.

And you gave a little bit of detail on EBITDA expectations by segment. Could you break out or perhaps is it maybe rank order, growth expectations on the top line by segment next year?

I think we're going to continue to see some strong growth in cabinets and in North American Fenestration, assuming some of the projects we're working on come to fruition. I think with all the turmoil in Europe, our expectation is that growth there will probably be the slowest in 2019. And margins probably will be tougher to expand in Europe as well. There is clearly a great deal of uncertainty. We're obviously very pleased with the way we ended the year, given everything that's going on, but we're probably a little more pessimistic about Europe than we are in North America at this point.

And lastly from me on the SG&A front. You're guiding to relatively flat - slight increase obviously versus a kind of spike in Q4. What are the expectations for incentive compensation in terms of what you're accruing for next year versus this year and what are we - what are the key drivers? And in terms of medical, what drove that spike in Q4? And is that very much of a one-time or sustained, how should we think about that?

So on incentives, we always accrue at target at the beginning of the year and then we adjust as we go through the year based on the - on performance. Clearly, we had a renewed focus after the strategic review and the announcement at the end of the third quarter on generating cash in Q4. That drove some exceptional performance, which we believe is sustainable and that in turn drove higher than target incentives in Q4. The medical was primarily a result of a number of bad or excessive claims that obviously we can't talk about. But all unique because we're self-insured, is a heart transplant, a premature baby et cetera, et cetera, and that's what drove those costs up. Now by the same token, we've also seen elevated benefits and healthcare costs anyway, so what's factored into 2019 is an increase in general medical costs, but a heart attack or a premature baby is completely unpredictable and that's really what drove the bulk of that $4 million.

Our next question comes from Kathryn Thompson with Thompson Research. Your line is open.

This is Brian Biros on for Kathryn, thanks for taking my questions. I wanted to start off with the softening you mentioned in August and September. If you could maybe expand on that at all. If there is any buckets that falls into as a cause or impact on a segment basis, it would be helpful.

Yes, so the short, succinct answer there is as you're well aware, because the home builders for the most part reported pretty soft end to the summer and September was the end of the fiscal quarter for a number of our customers. So many of our window customers slowed their order intake pretty significantly in August and September, I think because the home builders had seen a slowdown. After their fiscal quarter closed, orders picked up again in October and October was actually a very strong month for us. So some level of recovery in the month of October, and frankly one of the reasons we're optimistic is, we're in the process of closing our November, which also looked pretty strong as well relative to last year.

On the share repurchase, $60 million in the program you guys spent, I think $32 million of it in the quarter, so over - just over half of the entire buyback program, private placement, was that kind of a one-off opportunity or does that kind of signal a desire to get through that $60 million and move on to whatever is next on the pipeline or how do we think about that because I think the previous commentary was that $60 million would be spent over like multiple quarters, are we ready to half of this?

Yes, so that was one-time opportunity, not part of a - an ongoing strategy to burn through the $60 million quickly. As we said, the share repurchase is based on an at-market, opportunistic, it's not a 10b5-1 plan. Therefore, we have a limited number of days that we can trade and we have obviously a limited number of shares because of the relatively low float that we can buy at any one point in time. And we're obviously cognizant of the balance between keeping the leverage ratio around 2x and the share price. I think it's probably safe to assume that once we get through today's call, Brent and I will be spending some significant time planning moves for next week when the window opens for us. So I still expect the balance of $28 million to take some time to consume as we go through 2019.

Our next question comes from Kenneth Zener with KeyBanc Capital Markets. Your line is open.

This is [Brandon] on for Ken, actually. You touched a little on this before, but just trying to understand what can create the low end and high end of your margin guidance? Is it sales tied to volume or is it pricing? What happens if you can't get price, can you still hit that target?

Yes. I mean obviously, leverage through volume is important. But clearly, pricing, we're very confident we can get it through, but I think there is some sentiment now with the home builders at least. They maybe have reached a price threshold and will have difficulty passing the higher home prices on to consumers in this environment. That eventually trickles down, but we're at the lower end of the food chain and I don't think we will see as much push back as the home builders will see. So, we're confident, but the hedge is there in terms of margin guidance. Clearly, in an inflationary environment, it is more difficult to get margin expansion.

Our next question comes from Julio Romero with Sidoti & Company. Your line is open.

So, I wanted to start out with the cabinet segment. Can you just comment on that, the gross margins there, I saw 16.8% might be the strongest since 1Q of '16 I believe. So can you just talk about what's driving that and what should gross margins look like for 2019?

Yes, look as we've said all along, we've invested an awful lot of time, money and resources into productivity improvements in that business, while at the same time shifting the product mix to be more in line with what's been happening in the marketplace. It's been slow in common, but I think finally we're seeing the results of those productivity improvements flowing through. We've had two strong quarters of margin improvement there. Our expectation is that we will continue to see a similar level of improvement as we go through 2019, and the corollary to that too as you know we've explained before, part of these productivity improvements automatically cause a reduction in inventory and a good portion of the working capital improvement through inventory reduction came out of the wood craft operation in the fourth quarter. So the two are tied together and again gives us confidence that the sustainability of the working capital levels as a percentage of sales.

And you laid out an expectation for a slight margin improvement in the North American Engineered Components segment. Can you just bridge out the driver of that expected improvement. Is that kind of just based on the volume leverage or is there another key component there that's going to drive that?

No, it'll be mostly volume, leverage with the underlying assumption that inflationary costs are passed through in price.

And then just on CapEx. You had full year of about $26 million. I think that came a little bit lower than what you guys had mentioned earlier in the year of $35 million, you mentioned some delayed projects. Does that imply that only maybe $2 million or $3 million of the $10 million of growth CapEx you initially targeted was deployed? Just hoping you can kind of reconcile that for us.

Yes. So initially we guided towards $35 million of CapEx. As we went through the year, I think we reduced that guidance to close to the $30 million because clearly we could see that we did not need to put that extra $5 million into the business. The $4 million shortfall was really two projects that are delayed and are now already commencing in 2019. And as I say - and I think we've said pretty consistently that after three years of $35 million a year investment and $26 million this past year, the ongoing run rate of $25 million to $30 million is about right on a non-recessionary - in a non-recessionary environment.

And so I guess for this year the $25 million to $30 million, does that imply $5 million in growth CapEx or is it a little more than that implied in the guidance?

Yes, that's about right.

And then just last one for me here. $78 million of cash flow was very strong and you've good free cash expected for next year, but just as I think about your cash usage, given the $28 million left on the share repurchase, is it prudent to maybe expect a debt pay-down in the back half if the repurchase is deployed and you have some good free cash coming into the financial statement in the back half?

That's exactly the right way to think about it, as you know, the first half of the year, we're often cash consumer and we expect to be this year. But we will continue the share buybacks, but you're right, our expectation is, we will in fact continue to de-lever as well as use up most if not all of that $28 million in the authorization by the end of the year, but a lot of it could be back-end loaded, because as you know that's when we generate our cash.

Our next question is a follow-up from Daniel Moore with CJS Securities. Your line is open.

I know you don't want to get into quarterly guide, but just you gave interesting color around October kind of bouncing back. How do we think about the cadence of growth and any comments on margins, kind of first quarter or first half starting out the year relative to your full-year guide?

So, we were - as I said, October was strong. I think some of that was recovering from the shortfall in August and September. November was pretty decent actually. And, now we're into holidays and the beginning of winter. I would not read too much into high levels of growth in the first half compared to next year, particularly with the uncertainty around the new construction. I mean, it certainly looks as though the winter and early spring are going to be slow for new construction. I do think we'll make that up in terms of R&R. But I wouldn't get too aggressive on the first half of the year.

But it doesn't sound like the first quarter at least is coming out negative relative to your positive growth expectations.

At this point, I would be shocked if it's negative.

Thank you. And I'm showing no further questions at this time. I'd like to now turn the call back over to the CEO, Bill Griffiths for closing remarks.

Thanks everyone for joining us today. Happy holidays to everybody and we look forward to talking to you in March. Thank you.

Ladies and gentlemen, this concludes today's conference. Thank you for your participation. Have a wonderful day.