Quanex Building Products Corp (NX) 2016 Q3 法說會逐字稿

Good day, ladies and gentlemen, and thank you for standing by. Welcome to the Quanex Building Products third-quarter 2016 conference call.

(Operator Instructions)

Now I would like to welcome and turn the call to Scott Zuehlke, Vice President of Investor Relations and Treasurer. Please go ahead.

Thanks for joining the call this afternoon. On the call with me today is Bill Griffiths, our Chairman, President, and CEO; and Brent Korb, our Senior Vice President of Finance and CFO.

This conference call will contain forward-looking statements and some discussion of non-GAAP measures. For a detailed description of our forward-looking statement disclaimer and a reconciliation of non-GAAP measures to the most directly comparable GAAP measures, please see our earnings release issued today and posted to our website. I will now turn the call over to Brent to discuss the financial results.

Thank you, Scott. I'll begin by providing comments on the previously announced debt refinancing, as well as leverage and cash flow. We were extremely pleased with the outcome of the debt refinancing.

To summarize, we entered into new senior secured facilities totaling $450 million, comprised of a $300 million revolving credit facility and $150 million term loan A. The new credit facilities give us ample flexibility and a capital structure that better supports our business requirements.

Borrowings under the new credit facilities bear a tiered interest rate based on our consolidated leverage ratio and has initially been set at LIBOR plus 200 basis points, or approximately 2.5%, reducing our credit spread by approximately 375 basis points. As of July 31, 2016, there were approximately $300 million of borrowings under the new credit facilities.

To put the lower spread into perspective, based on debt outstanding, the new capital structure reduces our future annual interest expense by approximately $13 million. That equates to more than a 60% reduction, or said another way, this debt refinancing is $0.25 accretive to earnings per share on an annual basis.

On a related note, we have consistently talked about our goal of achieving a leverage ratio between 2 and 2.5 times. We are proud to report that as of July 31, 2016, due to strong cash-flow generation year to date, we have achieved this goal as our net debt to pro forma adjusted EBITDA leverage ratio was 2.4 times. Having said that, we expect to continue to generate solid cash flow and to pay down debt during the fourth quarter, which should enable us to further improve our leverage ratio.

Turning to the income statement, consolidated net sales during the third quarter of 2016 increased 38% to $248.1 million, compared to the same period of 2015. As expected, the increase was driven by contributions from the HL Plastics and Woodcraft acquisitions.

We reported a net loss of $4 million for the quarter, compared to net income of $6.5 million in the third quarter of 2015. Adjusted net income from continuing operations was $10.5 million, or $0.30 per share during the third quarter of 2016, compared to $11.1 million, or $0.32 per share, in the third quarter of 2015, with the increased interest expense from our previous credit facility creating an $0.11 drag on adjusted EPS.

The adjustments being made for EPS are as follows: Acquisition-related transaction costs and purchase price inventory step-up recognition, write-off of deferred loan costs, unamortized original issuance discount, and prepayment call premium related to our debt refinancing, and foreign currency losses primarily related to an intercompany note with HL Plastics.

On a consolidated basis, EBITDA performance during the third quarter increased by 80% to $32.9 million, compared to the third quarter of 2015. After adjustments related to transaction costs and inventory step up, adjusted EBITDA increased by 32% and came in at $33.1 million compared to $25.1 million last year. Note that as of last quarter, we now include a selected segment data table in the earnings release to provide detail by segment. I will now turn the call over to Bill.

Thanks, Brent. During our last conference call and at our investor and Analyst Day in New York in late June, we reiterated our priorities for FY16. These were to continue improving margins, generate cash, and pay down debt to get our leverage ratio below 2.5 times by year end, and to ultimately refinance the debt with a more flexible and less expensive capital structure. We successfully accomplished all of these priorities in our fiscal third quarter.

Adjusted EBITDA margins expanded in each operating segment this quarter. In addition, this is the fourth consecutive quarter that margins improved in our legacy North American engineered components segment.

Despite the difficult third-quarter comp, margins in this segment improved by approximately 140 basis points and have improved by almost 300 basis points during the first nine months of our fiscal year. As anticipated, the rate of improvement is slowing, and that slower rate is expected to continue into the fourth quarter.

During the first half of our fiscal year in the North American engineered components segment, we experienced approximately 6% market volume growth, and previously indicated that due to the warm winter, there was a chance that orders have been pulled forward. For the quarter, this volume in this segment was more or less flat compared to last year, which appears to confirm this notion of a pull-forward.

For the first nine months of our fiscal year, our overall volume growth in this segment was approximately 3.7%, compared to Ducker's reported window shipment growth of 4.3% for the nine months ended June 30, 2016. July, which is accounted for in our numbers but not yet reflected in Ducker's, was particularly soft, with several customers reducing order rates as they adjusted their own inventory levels. August has improved slightly, but it appears that the fourth quarter could turn out to be similar to the third with little or minimal growth year over year.

Similarly, post Brexit, growth rates in our EU engineered components segment also slowed, although not to the same extent as in the United States. On a local currency basis, revenues grew 5.5% in the third quarter, compared to 9.6% in the first half. Interestingly, it was Germany that had a bigger drop than the UK, and more specifically, HL Plastics saw no slowdown at all in the third quarter, and, in fact, this business continues to add new customers.

Growth rates were also slower than anticipated in the cabinet components segment, where year-to-date revenues are essentially flat compared to 2015, with muted volume increases offset by material pass-through price reductions of approximately 3.5%. Notwithstanding this, we continue to be optimistic about the margin expansion opportunities in this segment.

Although the delivery of much of the equipment we ordered early in the year was delayed, we now have most of it operational, including our first return conveyor and a pick-and-place robot. Early trials of this simple automation are promising and endorse our initial expectations that a 200-basis-point margin improvement in this segment is, in fact, achievable. We were initially optimistic that we would see some of the benefits of implementing this simple automation this year, but due to the aforementioned equipment delivery delays, these benefits will be pushed into FY17.

In terms of our current expectations for the full year, it is now apparent that our original estimate of 5% to 6% growth, excluding any foreign exchange translation impact, could be closer to 3% to 4%, assuming we don't see a meaningful pick-up in the fourth quarter. If this in fact holds true, this would reduce the low end of our prior revenue guidance by approximately $20 million and adjusted EBITDA guidance by approximately $5 million. Note that this would be in addition to the expected foreign-exchange translation impact that we previously disclosed at the investor and Analyst Day.

The key take-away, however, is that despite softer revenues, we still expect a consolidated adjusted EBITDA margin of approximately 12% for the fiscal year, which remains unchanged versus any prior guidance. Also, as a result of slower growth, we have reduced our capital expenditures in the fourth quarter and now expect to spend approximately $40 million this year, as opposed to the original expectation of $45 million.

As a supplier to OEMs in an industry where the switching costs are generally high, it is a challenge to gain market share and grow faster than our overall markets. However, we can control our margin performance, which we have successfully demonstrated throughout the past year. And we will continue to focus on improving profitability through efficiency gains and using the cash we generate to further pay down debt and improve our leverage profile.

And with that, operator, we'd be happy to take questions.

Thank you.

(Operator Instructions)

Our first question is from the line of Scott Levine with Imperial Capital. Please go ahead, Scott.

Good afternoon, guys.

Good afternoon.

Good afternoon.

I was hoping for maybe a little bit more clarity with regard to the guidance bridge, if you will, from before to now. I think you mentioned $5 million reduction to EBITDA. That is not just versus the prior $117 million to $121 million, that factors in the FX sensitivity that you guys highlighted at the Analyst Day; is that correct? I just want to make sure I understand exactly what the number is.

Just to be clear, we started out with guidance of $965 million to $975 million and EBITDA of $117 million to $121 million. As we've been saying, because of the exchange rates translation only reduces that guidance to $950 million to $960 million and $115 million to $119 million, which is a $15 million hit to the top line just through translation and about a $2 million hit to EBITDA, again, simply through translation.

And what we're saying now is if the revenue trend continues, and it's not certain, but I have to say it's likely at this point, there's a further risk to the top line of $20 million, which would take it to $930 million to $940 million and that translates to about a $5 million EBITDA impact, which would drop EBITDA to $110 million to $114 million.

Okay. Got it. And maybe a little bit more clarity as to how much of that -- is that almost all North America? It sounds like it is, but a little bit more clarity on the segment impact.

It is. So having gone through probably the worst quarter in Europe with respect to Brexit, because our quarter bridged the lead up to the vote, and then, of course, the subsequent crash after the vote, the reality is while growth rates dropped, they're still stronger than anything else we're seeing, 5.5% for the quarter. We were running along at around 10%.

The star of the show continues to be HL. They're running at around 10% consistently. Germany dropped to a little more than we expected, a little better in August. But I think all of that relates simply to the economic turmoil, if you like, whether real or perceived in mainland Europe and the UK. And I don't expect to see much of a change there during the fourth quarter.

In North America, we're seeing two things happen. In the legacy window components segment, window shipments are coming in lower than was originally anticipated at the beginning of the year. Ducker just reduced their expectation for the full year. We are still growing at about market in the window components business, because I think when Ducker gets a look at July and into what is the third calendar quarter, I think they will see a similar slowdown that we did.

We've said many times before that our revenue is really determined by our customers' success and failure in the marketplace. And as we saw softer revenues as the quarter developed, we reached out to customers to find out what was going on, and consistently found that a number of them, not all, I might add, but a number of them, were getting concerned that they were sitting on higher inventories and the cycle wasn't as strong in the late summer as they had originally anticipated and started adjusting their inventory levels accordingly. But I think the take-away is even though those low to mid single-digit growth rates are disappointing, I think we're on top of the market in that segment.

In the cabinet segment, as most of you know because you follow some of the cabinet suppliers, there's been a fair amount of market share shift amongst the cabinet manufacturers themselves. We clearly have been on the wrong end of that particular set of circumstances. And while we serve everybody, those that have lost the market share have had a bigger impact on our numbers than those that have gained, hence the relatively flat revenues. And that's offset by falling lumber prices and, therefore, a reduced dollar amount on similar volumes.

Volumes were actually up around 2%, 2.5%. But the semi-custom segment overall, according to KCMI, for the first half of the year is up 6%. So we're falling short of the market there, but that's clearly because our customers are shifting share, as most of you are well aware of. Hopefully that gives enough color, Scott.

Yes, it does. It does, thanks. One last one, if I may. The tax rate came in a little bit lower than we were expecting. Anything unusual there and what should we be using going forward?

No, the tax rate was mostly affected by the refinancing and the expenses that were incurred in the quarter. It will have a similar effect on a year-to-date number as we look into the fourth quarter. So it came in at like 20%. I think third quarter year to date in that same standpoint for fourth quarter. As we look into the future, we'll get back to our 34%, but the real driver is we took a $16.7 million expense in the third quarter.

Got it. Great.

And our next question is from the line of Ken Zener with KeyBanc. Please go ahead.

Good afternoon, gentlemen.

Good afternoon, Ken.

Good afternoon.

Cabinets. Bill, you just talked about this volume differential between you guys and the market. But in the second quarter, I'm just trying to understand again, so third quarter the margins were lighter than we would have expected. You obviously talked about that volume on the top line. But I'm just -- in the second quarter, the margins came in lighter because you guys had some SOX in it, some costs, as well as investment in the business. And then I'd ask you and you said for the full year, even with the increased cost base, the margins are going to come out pretty much on top of were for the full year when you acquired them.

Could you give us an understanding why the margins did not accelerate post SOX? Did you guys have investments that were more than you would have expected or did SOX continue? That can obviously be a complicated and expensive consulting process.

It is. And I think the biggest effect is it's taken a little longer than we had originally planned. It's fair to say we're probably a full quarter behind our original schedule. So, yes, we have increased their costs. That rolled through into the third quarter. We continue to invest in the business. And unfortunately, the offset in savings, partly because of equipment delays and partly because the whole program is, as I said, about a quarter behind schedule, that's the reason that it appears weaker than it is.

I am not concerned at all. I'm not concerned about what's happening to the top line. We're heavily focused on margin improvement. It's taken a little longer than I would have liked to get there. We are still very, very confident we are going to see those improvements in 2017.

So, and I'm going to stick with this one, Bill, because it's obviously been a recent acquisition. The delay in the quarter, you're referring to SOX implementation or your CapEx.

Everything. Everything. So we had late deliveries of equipment, hence, we did not get any savings to offset some of the increased costs. The SOX compliance and operational margin improvements are running slightly behind schedule as well. And therefore, ran into the third quarter without any off saving benefits on the improvement side. Just a delay.

I'm just trying to understand though, because even -- the margins rather than the 10.5% that we had last year, which three months ago was our thought process and I believe yours as well, it seems like that's going to have a 6 or 7 handle on it now, the margin, even with the strong fourth quarter.

Is that something that syncs with what you're thinking? Because the fourth quarter could -- if you do another 3% or 4% or 5% even, it's going to be less than 5%. Just trying to get a range here so we don't perhaps have a misunderstanding as we're entering 2017 on this business.

We are going to fall short of our original expectation for the full year. I do not expect that to run into 2017.

I heard the volume, there was a lot of conversation it seemed around windows, and obviously, some of the market share in cabinets. But using the math that we're talking about just for this segment, it seems like that would actually account for all of the EBITDA shortfall. Is that correct? Because you guys are having more success by the window margins?

I'm just trying to think about how the visibility here in terms of how you're looking at it right now in terms of that revenue shortfall and the potential EBIT exposure associated with that. That seems to be the new guidance, the 930.

The revenue shortfall is a little bit of both, but a lot of it is in the window segment coming in much softer than was anticipated in the second half of the year.

Okay. But conversely, where the EBIT leverage is, is in cabinets, almost by definition here, since that margin's going to be --

Right.

Thank you.

And our next question is from the line of Daniel Moore with CJS Securities. Please go ahead.

Thanks for taking the questions. Obviously covered a lot of ground already. Maybe you can give us a little bit of an update in terms of some of the equipment initiatives that you've been looking at in terms of installing new equipment into your customers' new lines. What the uptake has been and what the outlook looks like for FY17.

Yes, that relates specifically to the spacer business, and those programs continue to gain momentum. One customer in particular, the one that was the first adopter, has already ordered an additional four lines, some of which are in the installation phase now. As you know, we broke ground on an expansion of the IG facility to allow us to keep up with that.

But again, the caution there is while that's still very successful, the gating item there is the ability of the equipment manufacturers to produce these lines as fast as customers are starting to gain interest in them. And our expectation is that that's at least a three-year program with a steady ramp-up in volume.

So you won't see it move the needle this year. We'll see steady progress next year and then into 2018, but continues to go very well.

Okay. And then just taking a step back in terms of the macro North American fenestration business, obviously going to be a little lighter, disappointing this year, maybe 2% to 3% growth. Talk about your three- to five-year outlook. We've talked about mid single-digit growth expectation. What does this year -- what do you think are the biggest factors holding back growth in that market and what does that do to the midterm outlook?

Again, I think this revolves -- this slowdown revolves more around new construction than anything else. I think, clearly, the recent data would say we're likely to struggle to get to 1.2 million starts this year and the original thought at the beginning of the year, we would surpass that easily.

So I think it's really the trickle-down effect, that housing starts are coming in lower than originally expected. Therefore, window shipments, same thing, and we're seeing the effect of that.

I still believe that there is still an opportunity for the R&R market to come back a little faster, particularly if new starts continue to be depressed and the sale of existing homes continues to improve. That may help the R&R market. And I'll be honest with you, I'm not sure at this point whether our future growth rates to the mid-cycle are in jeopardy on a year-over-year basis.

I would say that if it continues at this pace, instead of reaching mid-cycle in 2020, maybe it's 2021 or 2022. I think it just delays the final outcome; I don't think the final outcome changes.

Okay. That's helpful. And lastly, with the re-fi out of the way, have you already begun to start to spend a little bit more time on M&A? Maybe talk about the pipelines and areas where you're seeing the most opportunity there.

In reality, clearly, we were very busy during the third quarter with the re-fi. We still had the opportunity to look at a handful of bolt-on acquisitions, none of which got fully through our filter or climbed over our hurdles.

So right now, even though I think it's fair to say the overall M&A market is still pretty robust, the things we've been looking at specifically are sort of slow, which is why, again, I'll reiterate the focus is going to be -- and look, even on the revenue side, much of that we can't control, but we can control our margins. We're going to focus on that, continue to generate cash, continue to consistently pare down the debt level and improve the leverage ratio, which, if something exciting comes along, will put us in a good position. If nothing exciting comes along, we'll figure out what the next step's going to be.

Okay. Thank you.

Our next question is from the line of Nick Coppola with Thompson Research Group. Please go ahead.

Hi. Good morning. Or good after -- good evening.

Good afternoon, Nick.

So in North American engineered components, price was a modest drag again. Can you talk more about the price environment there, particularly heading into 2017 and what opportunities there might be there?

Yes, good question. The pricing pressure I'm sure is no surprise to you, is primarily in the vinyl extrusion side of the business. And we're just starting and embarking upon a number of sensitive price negotiations, particularly in that segment of the business. And it is not going to be easy, and I think I'll perhaps leave it at that.

Okay. Fair enough. And shifting gears here, you talked about no slowdown in HL Plastics to date. Looking out a little bit further, what are your thoughts about that business and the macro environment, given Brexit? What are your customers telling you?

It will probably slow down from 10% to maybe mid to high single-digit growth as we go forward here, and we expected that all along. Nobody we've talked to is predicting a doom-and-gloom scenario at the grassroots level in the UK.

And I think one of the things we've seen here at the macro level in the US is the whole Brexit discussion is now becoming a little calmer, a lot more realization that this is going to take two years, three years, maybe longer. So there's a lot of second guessing going on, and I think the markets took the volatility out of the way. But when we talk to people on the ground, it's business as usual.

What is going to have an impact that has yet to be determined is we are starting to see, and I don't mean we, just HL Plastics, but we in general in the industry in the UK are starting to see price increases as a result of the Euro/UK exchange rate.

And those are getting passed through without too much difficulty because everybody gets why. But by the time they all get passed through by the end of this year and hit the consumer, you wonder then is that going to have an impact in 2017.

And as yet to be decided, some companies are using the exchange rate as a surcharge, as opposed to a price increase. So that if exchange rates reverse, the surcharge actually comes off. We've elected not to do that, but we'll see. So far no storm clouds on the horizon and cautiously optimistic of a continued decent future there.

Okay. Thanks for taking my questions.

And our next question is from the line of Al Kaschalk with Wedbush Securities. Please go ahead.

Good afternoon, everybody.

Good afternoon, Al.

Good afternoon.

Just try to put some finer points around a couple of the comments, because clearly, we've tackled a few of these issues. But Bill, could you maybe restate or clarify why Germany was softer than the UK or at least softer than maybe your expectations? I think that's what I heard, but I didn't grasp.

Yes, the answer is I'm really not smart enough to know, because it actually took us by surprise. We certainly anticipated a little bit of a slowdown in the UK, but Germany just almost ground to a halt. Honestly, I really don't know why. It's picked up a little in the month of August, but clearly was more impacted for whatever reason than what the UK was directly. It was a bit of a head scratcher, frankly.

But the majority of revenue in HL is UK based?

Yes.

Okay.

Two-thirds of the segment is UK-based.

Okay. Second, on the cabinet side, what you're messaging here is focus on the margin and the marginal dollar that comes in, you're doing a good job on that. But the question that I have is, is the growth rate or the growth in that business a function of more stock-oriented product?

I know you mentioned market share changes, but is it -- is it an end market that's not as strong in the semi-custom side? And going forward, what are the factors that may help your side of the fence in terms of delivering where you thought you could be?

Well, I think first of all, the picture is actually a little bit murky, right, because you have the big cabinet manufacturers who have different positions in each of the sectors, stock, semi-custom and custom. You have some of the bigger customers changing their strategies and shifting market share, sometimes up in one category and down in another, so that muddies the water a little more.

But when we reached out and talked to our customers, it was very clear that we had more that were affected negatively by market-share shifts than those that were affected positively. Remember, almost all of our volume is in the semi-custom segment in the middle.

To put it in perspective, KCMA, their numbers for semi-custom were around 6% growth for the first half of the year, and we were a little under half of that. The reason I'm not concerned about it is that will eventually settle down and steady out. And right now, I have that team focused more intensely on internal matters that's directly under their control.

And as we get the margin improvement through 2017, we'll start to focus in a lot more on what we can do with the top line. So right now it's definitely a secondary priority. But to reiterate, I'm not losing sleep over what's happening on the revenue line.

Finally, just for Brent, in terms of one clarification, is there a way, in terms of interest expense on the P&L, how we should think about that? I know it's a modeling question, but what should we be thinking about that, not necessarily for the rest of FY16 but going forward?

Just going forward? Think of it as -- it's as simple as today at the end of July, $300 million had 2.5% interest, which is going to get you to about $2 million per quarter. And then in terms of deferred financing costs, we had just north of $2.5 million, like $2.75 million that gets amortized over five years. That's what's going to drive your interest expense. So to the extent we pay down debt or there's a change in LIBOR, that's how you'll model that out.

Okay, guys. Thank you. Okay.

And our next question is from the line of Michael Conti with Sidoti. Please go ahead.

Hey, good afternoon.

Good afternoon.

Good afternoon, Mike.

Just most of my questions were answered, but on the Woodcraft side, can you just help us bridge how much of the sequential increase in lumber impacted the sequential margin?

We can give you that data offline. The overall year-to-date impact is negative 3.5%.

Okay. Got it. And then just last one, the benefits from the margin perspective on the investment that you're making there, if that's supposed to be more back-end weighted as we look out to FY17 and maybe just we should see a bigger lift in the second half of next year.

Yes, you should; that's the way to model it. We've got the first pieces of all of this automation in place working. It's working up to expectations. It was delayed significantly because of equipment manufacturers.

The next wave now is to place more orders and scale that up throughout the organization. So just getting that capital and deploying it is going to take a while. So the second half should be stronger than the first half next year.

Perfect. Thank you.

And ladies and gentlemen, this concludes our Q&A session. I would like to turn the call to the CEO, Bill Griffiths, for final remarks.

Thank you. Just to wrap up, as I've said, despite the softness in revenues, which I'm not overly concerned about, margin expansion is going to continue to be our number-one priority and the result in cash-flow generation should allow us to continue to improve our leverage profile. The debt refinancing, as Brent explained, was a huge win for us and we now have a capital structure that's more affordable and better suited to our business now and in the future.

Thanks again for joining the call and we look forward to talking to you, either while on the road marketing or in an industry sell side conference between now and our next earnings call in December. Thanks, everyone.

Ladies and gentlemen, thank you for participating in today's conference. This concludes the program and you may all disconnect. Have a wonderful day, everyone.