Caesarstone Ltd (CSTE) 2017 Q3 法說會逐字稿

Good day and welcome to the Caesarstone Third Quarter 2017 Earnings Conference Call. Today's conference is being recorded. At this time, I'd like to turn the conference call over to Allison Cain of ICR. You may begin.

Thank you, operator, and good morning to everyone. Certain statements in today's conference call and responses to various questions may constitute forward-looking statements. We caution you that such statements reflect only the company's current expectations and that the actual events or results may differ materially. For more information, please refer to the risk factors contained in the company's most recent annual report on Form 20-F and subsequent filings with the Securities and Exchange Commission. In addition, the company will make reference to certain non-GAAP financial measures, including adjusted net income, adjusted net income per share and adjusted EBITDA. The reconciliation of these non-GAAP measures to the most directly comparable GAAP measures can be found in the company's third quarter 2017 earnings press release, which is posted on the company's Investor Relations website.

With that, I'd like to now turn the call over to Raanan Zilberman, Chief Executive Officer of Caesarstone. Raanan, please go ahead.

Thank you, Allison. Good day and welcome to our conference call to discuss our third quarter results and our business outlook for the rest of the year. Third quarter revenue increased by 7.2% to a new record of $155 million. On a constant currency basis, growth was 4.6%. Gross margin was far below our expectation as a result of challenges related to our manufacturing performances. Our third quarter adjusted EBITDA was $26 million, a margin of 16.5%. This mainly reflects our gross margin results. Our adjusted net income was $13 million and adjusted diluted EPS was $0.37. At last our free cash flow generation in the quarter was $11 million.

Before I go through our regional performance, I would like first to discuss a our manufacturing challenges and our gross margins in the quarter. In Israel, throughput and margins came under pressure in both of our manufacturing sites. The main reason for the reduced throughput is our product mix shift to premium and differentiated products. That continue and brings with it at least for the moment, longer cycle time and the longer setup time [pill model]. Again, I would like to mention that the shift of mix differentiated premium products enable us to maintain our premium position in the market and our prices.

We are confident that those challenges are addressable and with the right management, the right focus and the right process and [with time] our gross margin should improve. In Richmond-Hill after after 3 quarters of consecutive improvement, this quarter we took a step backward in performance. As we discussed last quarter, this was partially expected given our decision to expand the range of production to higher-end products. Those products require longer cycle time to manufacture. The pressure was more significant than what we had expected, and to make things more challenging, the plant was shut down for a full week as a result of Hurricane Irma.

Following the recent trends, I've decided to take several election items, a few of which I would like to share with you now. So I've decided to appoint a new VP of Global Operation and we are already running the selection process. I've already placed a new leadership team in Richmond-Hill, including a new plant manager, a new operation manager and few new department managers and a team of technical and manufacturing experts, all coming from Israel. I can you that those changes have started beginning in October and already have a positive impact in several dimensions.

In these early plans, I've taken several steps including the appointment of 2 new plant managers, actually [rotating] them and a new production manager to enhance the managerial structure and capacity of management. We are starting to implement a series of improvement process to shorten the cycle time and to minimize the idle time. Those improvement processes can take some time, but if we implement them correctly, they will yield the expected results. In addition, in order to better meet demand for our products, we have been utilizing some OEM production for basic SKUs under our [strict] specification and our robust quality assurance process.

Now I would like to provide an update on each of our regions. In the United States, revenue was up by 6% to $61.9 million compared to $58.4 million of [last year]. Our business in the United States was impacted slightly by Irma and Harvey and we believe that the activity is on an annual growth rate of around 9% to 10%. We as well believe that our current throughput is resulting in a [midst] of some opportunity to accelerate our revenue growth even further.

In Australia, sales in the third quarter were $37.1 million, up by 4.1% compared to $35.6 million last year. And on a constant currency basis, Australia was up by 0.1% in the third quarter. The stability in sales was achieved despite the continued weakness in the overall housing market, as we reported in the last 2 quarter.

Canada sales, which have consistently been a strong contributor to growth, increased in the third quarter by 14.2% to $25.6 million compared to last year $22.4 million. And on a constant basis, growth in Canada was 9.8%.

Sales in Israel were $12 million for the quarter, up 6.1% compared to last year. And on a constant basis, sales were down 0.3% and this is reflecting the challenging market condition again we've been (technical difficulty) in the last quarter. Revenue in the rest of the world during the quarter was down by 4.7% to $9.2 million, and on a constant currency basis, revenue was down by 8.6%.

In Europe, sales in the third quarter were $9 million and it was up by 28.2% compared to last year, and on a constant currency basis, sales in Europe were up by 25.4%. This increase was primarily related to our performance in the United Kingdom. I'd like to reserve some final [source] after Yair comments on the financial. Yair, please go ahead.

Thank you, Raanan, and good morning to everyone. Global sales in the third quarter increased by 7.2% to a new record for any quarter of $154.7 million compared to $144.3 million in the third quarter of last year. On a constant currency basis, sales grew by 4.6%. Gross margin in the quarter was 32.1% compared to 40.5% last year. The primary factors of the decrease in margin were higher portion of total production coming from Richmond-Hill where we are still incurring higher production costs, lower throughput in Israel for the reasons discussed before, higher material costs related mainly to polyester prices, the impact of the hurricanes in the U.S. during the quarter and increased component of fabrication and installation revenue, which comes with lower margin related to our growth with IKEA.

Operating expenses in the third quarter were $38.7 million or 25% of sales versus $30.3 million last year, which was 21% of sales. I would like to note that legal settlement and loss contingency expenses this quarter were $5.7 million compared to $1 million in the same quarter of last year. Recently, we have seen an influx of subrogation claims filed by the Israel National Insurance Institute (NII) providing for reimbursement of its payments related to damages paid or that will be paid to plaintiff if we are found liable for the plaintiff damages. Given that recent development, we have made a one-time $4.3 million adjustment to the net liability exposure for all claims outstanding as of June 30, 2017, until a new assumption that each of the individual claims filed against us will be followed by future NII subrogation claim. Excluding legal settlements and loss contingencies related to silicosis, operating expenses in the this quarter were $33 million, 21.3% of sales, compared with $29.3 million or 20.3% of sales last year. This increase was primarily due to increased strategic investments, specifically marketing and sales in the United States and the shift to direct distribution in the United Kingdom.

Third quarter operating income was $11 million, down from $28.2 million in the third quarter of last year. Adjusted EBITDA in the third quarter, which eliminate share-based compensation and legal settlement and loss contingency expenses, was $25.6 million, a margin of 16.5% compared to $37.5 million, a margin of 26% last year. These reflect the changes in gross margin and SG&A items just discussed.

Finance expenses in the third quarter were $1.6 million up from $1.1 million last year. Finance expenses related to exchange rate fluctuation increased by $0.8 million offset by an increase of $0.3 million in interest income from bank deposits.

Taxes in the third quarter were $2 million, 20.9% of income before taxes, compared to a 15.8% tax rate last year. This effective tax rate increase is related to a bigger portion of taxable income generated outside of Israel where tax rates are higher.

Adjusted net income attributable to controlling interest in the third quarter was $12.7 million compared to $24.3 million last year. Adjusted diluted earnings per share in the quarter were $0.37 compared to $0.70 last year, both relates to 34.5 million shares.

Turning to our September 30 balance sheet. We had cash, cash equivalents and short-term bank deposits of $136.5 million. This compares to $129.4 million at the end of the second quarter with $10.6 million in free cash flow generated during the quarter.

With respect to our 2017 guidance. Given our year-to-date results, our manufacturing throughput position and the cost-related challenges, we are updating our guidance as follows. We are narrowing our revenue guidance from a previous range of $580 million to $595 million to a range of $580 million to $590 million. Our expected range of adjusted EBITDA for the year is $100 million to $105 million, down from our previous guidance of the lower part of the range of $119 million to $126 million. Thank you. And I will switch back to Raanan for a quick summary.

Thank you, Yair Averbuch. Indeed our revenue for the quarter (inaudible) and we are somewhat pleased with it. However, it is clear that the challenges in manufacturing have yielded margin that are below our expectations. As I mentioned, we believe that we have already identified the main challenges and that they are all addressable. As I shared with you before, we have commenced implementing countermeasures and we expect gradual margin improvement to follow soon.

While focusing short term on increasing the throughput of our production, we are continuing to leverage on our key strong assets that never change, the differentiated and the creative product line, the brand that is the top of mind in the industry and our very strong grip in channels to the market. Looking ahead, I can say that the basic fundamentals are positive for us, as the demand for quartz is still going and our products and brands are top position globally. Thank you, and we are now ready to open the call for the questions.

(Operator Instructions) Our first question comes from the line of Michael Rehaut with JPMorgan.

(technical difficulty) So I guess a few moving pieces regarding gross margin. Can you maybe breakout some of the components and then I guess a bit on how they are turning most recently? And then [you had all the indicators and plant changes], did you see a kind of the potential recovery back in the next 1or 2 years, knowing that's from like prior surprises that are out of your control although you had some (inaudible) with differentiated products [just a little bit there]?

Mike -- we're not sure about the quality of your line; it was almost impossible to hear you, but I understood the question, to be quantifying the different drivers in gross margin. So that's what I will do and if there was something out that we missed, welcome to ask it further. So with regards to the gross margin drivers, we have [technical difficulty] temporary external issues; all material prices, basically polyester, which has had an impact of 150 basis points negative on the gross margin. Also, the U.S. [vessel] with the different hurricanes our results to around 50 basis points. Then we have other mid-term temporary items that we should resolve. Richmond-Hill performance, which is still a lot more costly than the Israel performance and because Richmond-Hill becomes a bigger portion of our performance, it had an impact of 300 basis points to our gross margin. Israel throughout was 250 basis points negative again due to increased portion of differentiated product with longer production cycle time and setup time. And then the one thing that continues to carry over for us which we see it very positively, but in gross margin it is somewhat taking it down, so in operating margin, it's a neutral impact. It's the increase of fabrication and installation portion of revenue, which impacted our margin, our gross margin by 50 basis.

We'll move on to our next question from the line of John Baugh with Stifel.

Could you discuss -- I heard sort of 2 different stages, I'm talking about the Richmond-Hill production and then Israel. It sounded like you've made a bunch of managerial changes in the United States, and you alluded to some favorable impact already. I guess, I am kind of curious as to what metrics or commentary you can give us that gives us a frame of reference to improvement, if any, in the U.S. plant from the third quarter through October? And then the same kind of commentary in the Israel, where it sounds like the changes there will take longer to implement, and I was curious there whether there will be worst performance gross margin wise in 4Q from 3Q in the Israel production.

Let's take it one by one. Let's start with the Richmond-Hill plant. Few months ago when I joined the company and I looked at the performance at Richmond-Hill, I shared with you that there were 6 months, 7 months of consecutive improvements in the plants. When we say improvements, we talk mainly about 2 parameters, the quantity, the throughput and the qualities, the yield. And basically those 2 parameters are resulting in the ultimate parameter which is the cost per slab that we manufacture and later on impacting the gross margins. So I was very positive, but it looks like it was not sustainable and definitely the hit that we are getting now in Q3 was because the performance went backwards in August and especially in September. I've decided that we need plan B and as mentioned before, I've implemented a plan B already. Just to give it some more light, the problem in Savannah in Richmond-Hill is definitely not the equipment; as I mentioned before, it's top of the line, it's the [world-class] equipment. There is no issue with the equipment or the plant. The production of quartz is pretty challenging technical expertise and you need know-how and the American team that was there couldn't cope with the gaps of the know-how and I had to decide a tough a call to move an Israeli team with already existing know-how to replace the leadership team because it needs to be an immediate reaction. So I'm talking about additional 7 people from the management team and probably another 7 technical engineers to support them and they are running the plant right now.

When I mentioned that we see an improvement in result and significant improvement, I mention again to those 2 parameters, the throughput and the yield, the quality. It's not because they are better managers, it's all about know-how and I believe that we are in the right direction. I don't want to make big promises because it's first month, but I have a good feeling because these are very experienced people to hand the operation overview, and you know I prefer not to look at the last 2 years, I prefer to look ahead. I feel that we are having right now the right plan with the right people and I am very positive about how Richmond-Hill is going to look like in the coming periods.

Now we got to Israel, let's take things in proportion, because when talking about challenges in the operational processes in Israel and the manufacturing, we have to appreciate that we know the entire industry. We are visiting our competitor, we see other plants, we are considering to buy others. We don't know any of our competitors that is producing in the throughput of Caesarstone. I can assure you that this throughput is the higher in the industry. We don't know of any competitor that is able to produce between $90 million to $100 million from a production line. The phenomena that we are talking about is a phenomena of few percentage from this high tick we went back few percentage -- few percentage, by the way, it's a lot of money, and the direct reason and the immediate reason is not because somebody was not doing what he needs to do, it was mainly because we introduced in the last year around 24% new products. The way to survive in this competitive environment of the market nowadays is to keep on introducing new products again and again and again, like the Rugged Concrete, like all these new products that we've launched last year and I can tell you and I can assure more supplies to come in 2018. Now that comes with a toll, absolutely with a toll. To be unique, to be special, you have to complicate it, because otherwise everybody knows to do it and that takes longer cycle time, longer setup, most complicated equipment and that brought a regression in the throughput. Now you ask me, if I'm happy, certainly not. You ask me if it's addressable, yes. I think we've seen it in the past that when you introduced a mass throughput of new products, you go backwards and now you need to go back to the basic of lean manufacturing, improvements of [things] working on the shop floor, employees, technical people and management and to do the do to try and to cut it back again and this is the challenge that we will try to mitigate in the near future. By the way, I have no problem with the local management; the changes that I did was mainly to energize and to mainly rotate people, mainly to energize and to bring new vivid into the battle. But it's a good team, actually a world-class team and I'm sure that the numbers will be at the right place in the future.

The changes, first of all, you took, it sounds like, 14 people from Israeli production over to the United States. Will that have some kind of an impact on the Israeli facilities? It just sounds to me or like is the fourth quarter margin in compression [for] Israeli production will continue?

It's 2 fair comments. For the first one, I would say, I believe that we have enough redundancy and enough depth in the managerial structure. And a matter of fact is that actually after the changes, I can tell you again, that October performance on the 2 plants in Israel were much better than any months of the last quarter, so no immediate impact. I believe that we have the right team. However, as you mentioned, it's not a push of button. I can tell you that with the change of the management and with the changes that we do in Israel, it's a very quick result operation. In Richmond-Hill, there is a [know] issue, I believe the curve will be faster. In Israel, if somebody did go up from the shop floor, I can tell you, it is a manufacturing battle with 100s of KPIs with [Kaizen's] team and this work needs to be done, it won't be overnight. But again, I'm telling you, we haven't seen in the past anyone, any other manufactures, that no 2 manufacturers quartz better than Caesarstone. So at the end of the day, it will come back to where it needs to be. I believe to be honest, it's not pleasant to be with such report and with such a margin, but these are internal problem that should be solved managerial. The real constraint is always the market and this is where we should focus at the end of the day.

And if I could ask 1 more question and focus on U.S. revenue. You mentioned 9% to 10% rate, I assume that is adjusting for what you think was the hurricane impact or maybe some -- anything else unusual that didn't happen in Q3. But I guess my question is, when I look at the comparisons to the prior year, Q3 was your easiest comparison in terms of U.S. revenue growth. What channels of distribution or customers or what gives you the confidence that you're looking at that this 9% to 10% rate is sustainable out say in the next 2 to 4 quarters? Thank you.

Yes, first of all, let's take it into a proportion, [that now we grew] this quarter is 6%. So you can calculate again the impact of Irma and Harvey was relatively small as compared to the 9% -- 8%, 9% or 9%, 10% that we mentioned. So the number for the quarter is 6%. Drilling down into the channel, I would say that the big news of this year is definitely our improved throughput with IKEA. We are doing better, but I think that in terms of managing the channels, I feel a little bit more comfortable nowadays what we are trying to do with the channels more than what we are already doing, but what we are trying to do. And I think we talked about it a little bit in the past and I'm ready to say a few words now. First with the kitchen and bath channel, which is the bread and butter of of the company, I think it's a simple game. We are trying to increase the proximity. This is where we are very strong. This is where we make our money. It's true that there is a lot of competition there, but we have already identified a [series of action] that are already undergoing. And at the end of the day, if we'll do them correctly, again, kitchen and bath should remain the backbone of what we do.

In the contractor and the builder channel, here I believe that we have some new cards to play and I believe that we will evolve our strategy and go beyond of what we have done in the past. Generally speaking, without too many details, I think that we need to sell to the contractors and builder more than just the slab, and we need to give them a full solution and we need to have stronger grip on the entire value chain. This is a competitive market, so you better sell product and the service, and not just a product, otherwise you are between the (inaudible). So here we are working on that, and I believe that with time we will continue to improve the position. By the way, it was a good market for us this year which grew nicely.

With the [Big Box], this is our biggest potential, I mentioned it in the past, we talked about it. I can't report on any breakthrough and I think it will take time, but from the moment that I stepped in the company, I target it as something that we need to do, I believe in it, and we are taking action items, it takes time, but I believe that at the end of the day, we will crack it. So it's not the theory, it's something that we are trying to execute. And at last, even the stone supplier, we have identified some potential in their channel. So to cut the long story short, if you ask me, I think that we haven't exhausted those channels. Actually, there are more opportunity that if we will be sophisticated and good in execution that can give us a differentiation to the Chinese player. They are very competitive with the price. We need to be competitive with the brand, with the service, with the channel and with the customer experience. This is something that it would be very hard for them to compete with.

Our next question is from the line of Susan Maklari with Credit Suisse.

Hi, this is [Chris Scott] on for Susan. I saw the drilling will be from a competitive -- in the competitive landscape. Are you seeing any changes in the pressure from imports and domestic competitors?

It's a good question. I'll tell you why. We do see increase in the landscape. There is more competition. But if you want the other side of the moon for the reduced in performance in the operation and the story about the differentiated products, is the fact that we did not evolve bright so far. Now this is not the pledge for the future, it might happen. It is a very competitive market. But as I mentioned before, one of the ways to keep your position is to try and will be sophisticated than with [just beyond] the product, and that's what we are trying to be. Unfortunately, it came with the toll that it came. So to answer to your question, yes, there is a tough competition, yes, it's increasing and the reasons are very simple. Quality is accepted by the mid and the low segments of the consumer segments, and there will be always demand for low-cost solution, and Caesarstone we will have to live with it, serving the top-end, probably the mid-end and some selective projects and [setup] et cetera. We will have to live with this environment. However, the good news, the market is growing -- the market is growing.

And then also I think you provided some color on some demand you're seeing for new products, so as you guys work through these production issues, do you think -- do you see that these new products are being accepted by the marketplace?

The product that we launched in 2017, absolutely. It's been for a while that Caesarstone is a trendsetter. So normally we come with new products and the phenomena that we see or the question that we see is how fast other will imitate it. So we never look at others, never. And we know that people are imitating, imitating the product look like sometimes the name, the look of the website, even look like names. These haven't been changed. So, yes, to your question, the products have been accepted very well, and as I mentioned before, we are working on some new things in the pipeline to maintain the [color] leadership and even maybe beyond this to touch even some attributes of the slabs.

(Operator Instructions) The next question is from the line of Lena Rogovina with Chardan Capital.

I have couple of questions. And my first question is about production volumes. Could you just provide the breakdown for Israel and for Richmond-Hill percentage of total production? And my second question is about the margins. Do you believe that it is still [early] to get back to the previous levels of margins, I'm also talking about the gross margin. And when should we expect start seeing some margins improvement? Thank you.

So while we are not providing throughput breakdown between the plants, Richmond-Hill this year improved itself as compared to last year significantly, however, it's still far below Israel, but it's a much bigger portion of our production today relative to last year. With regards to margin, as Raanan said, we implemented many steps here in the company. We see some very encouraging results in October, and we believe that we will see a gradual margin improvement, too early to say to what level.

But I think it will be fair to say, we have provided guidance. So I think you can -- it's very easy to make a derivative for the Q4, because you have all the information. So we've been very cautions, and I think, for good reason, because as I mentioned, again, it's not the push of a botton, these are industrial process, they will take time. But if you ask me, Raanan, are you confident that you can bring it to where it should be, then I say, the answer is yes. Should we expect it to see it in Q4, my answer is no. We see improvements, but you can do a very exercise to see what we guided for Q4.

At this time, I'll turn the floor back to management for closing remarks.

Yes. Thank you very much. I thank you for the attention and the interest in the company today, we appreciate it. I think that we now have a lot of work to do in-house and we look forward to updating you on the continued progress in the next quarter, [yes] . So again, thank you very much for your support. Have a good day and we'll talk to soon again.

Thank you. This concludes today's conference. You may disconnect your lines at this time. Thank you for your participation.