Caesarstone Ltd. Q2 FY2023 Earnings Call

Good day, and welcome to the Caesarstone Second Quarter 2023 Conference Call. All participants will be in listen-only mode. After today’s presentation, there will be an opportunity to ask questions. This event is being recorded. I would now like to turn the conference over to Mr. Brad Cray, Investor Relations. Please go ahead, sir.

Thank you, operator, and good morning to everyone on the line. I am joined by Yosef Shiran, Caesarstone's Chief Executive Officer; and Nahum Trost, Caesarstone's Chief Financial Officer. 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 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 SEC. In addition, on this call, the company will make reference to certain non-GAAP financial measures, including adjusted net income, adjusted net income per share, adjusted gross profit, adjusted EBITDA, and constant currency. The reconciliation of these non-GAAP measures to the most directly comparable GAAP measures can be found in the company's second quarter 2023 earnings release, which is posted on the company's Investor Relations website. Thank you, and I would now like to turn the call over to Yosef. Please go ahead.

Thank you, Brad. Good day, and thank you, everyone, for joining us to discuss our second quarter. I will discuss our business activity, and then Nahum will cover additional details regarding our financial results before we open the call for questions. Looking at our performance, we were pleased to produce a second straight quarter of strong operating cash flow and increased our net cash position, both of which remain significant focus areas for Caesarstone. We are working hard to restructure the business and reignite profitable growth with a goal to offset ongoing headwinds from challenging global economic conditions and the competitive landscape, which have resulted in lower demand. During the quarter, we devoted significant operational investments behind new products as well as reengineering existing collections using alternative and varying blends of materials aimed to address expected Australian regulations previously mentioned on recent calls. We are in the final stage of completing these costly projects to reengineer the full Australian portfolio in only a few months. Separately, in our core products, we are investing significantly in our R&D efforts to create an exciting array of innovative collections in the second half of 2023 to be launched next year. Additionally, we are focused on investing further in sales and marketing, which we believe, combined with improvements in our pricing strategy, will drive improved revenue performance in future periods, particularly in the U.S. We are moving swiftly with the implementation of our comprehensive restructuring plan and are taking many important steps as part of our strategic cost reduction efforts to improve our results, which we believe will become increasingly evident in the coming quarters. The closure of the Sdot-Yam manufacturing facility marked a pivotal step for Caesarstone, laying the groundwork for improved efficiencies and streamlined production within our manufacturing infrastructure. We are also working simultaneously to shift an increasing mix of production to our strategic network of third-party manufacturers in the Far East. This is expected to further reduce our costs and better align production to meet demand. Regarding other strategic cost-saving actions, we have enacted several changes within our organizational structure, including the consolidation of several senior management positions. We will also transition the work that was being done at our smaller samples and book plant to our network of third-party manufacturers in the Far East. These actions are expected to further improve our cost structure commencing in 2024. Looking ahead, we are on track to improve our financial position, including our cash flow, and we expect to significantly improve our profitability in Q3 and Q4 gradually. We are grateful for the hard work of all our team members who are executing our strategy to create a more agile, innovative, and profitable company as we strive to deliver growth in our top line and solid results for our shareholders as we move forward. Thank you, and I will now turn the call over to Nahum to walk through the details of our financial performance.

Thank you, Yosef, and good morning, everyone. Looking at our second quarter results, global revenue in the second quarter was $143.7 million compared to $180.3 million in the second quarter of last year, a decrease of 20.3%. On a constant currency basis, second quarter revenue was down 18.4%, mainly due to lower volume partially offset by the benefit of previously enacted pricing actions. The 1.9% difference between U.S. dollar revenue and constant currency revenues reflects the impact of the stronger U.S. dollar against our generated revenues in all markets outside of the U.S. I will note that our second quarter 2023 revenues reflect two factors. One is the impact of the challenging prior year comparisons during which we realized a number of price increases in a period of strong market activity. The other factor is the impact of the residential sales activity, which slowed down starting in the second half of 2022. The result of that slowdown is now more pronounced in our results. Therefore, second quarter revenues were impacted by softer global market conditions and the competitive landscape of our products. Market pressure was more severe in the residential renovation and remodeling channels in North America and with destocking activity at many third-party distributors. In the U.S., sales were down 25.4%, mainly tied to softer residential end markets, particularly through third-party distributors. Higher sales with big box customers and better performance in our commercial business were positive for the quarter. In our other large markets, Canada sales were off about 15.3% on a constant currency basis, experiencing similar dynamics as the U.S. Australia fared relatively better with sales down roughly 5.3% on a constant currency basis, owing to less severe market pressure. Looking at our second quarter P&L performance, I will start with gross margin, where we saw a significant drop-off in the second quarter, largely related to several factors, many of which are temporary, as I will discuss. Our gross margin was 8.3% for the quarter. Adjusted gross margin rose to 9.6% compared to 26.4% in the prior year quarter and 19.7% in the first quarter of 2023. While lower revenues were certainly a pain point in our margin for the quarter, when factoring out a number of other atypical and we believe transitory impacts during the quarter, we estimate our gross margin was around 15%. As reported, the year-over-year difference in gross margin reflects several factors. The first factor is the activity at our plant, including those mentioned by us, accounting for roughly 510 basis points for the margin decline. We experienced lower fixed cost absorption, resulting in higher manufacturing unit costs. Lower productivity related to the closing of the Sdot-Yam plant was also a factor. In addition, as Yosef also mentioned, we invested heavily in reengineering existing collections, which consumed a significant amount of resources and resulted in our throughput and margins coming under pressure in Israel. Our teams worked tirelessly to develop, engineer, test, refine, and attain the capability to manufacture those products previously produced in this Sdot-Yam plant as well as those aimed to meet evolving Australian regulations at our Bar-Lev facility in Israel. We saw reduced throughput and higher manufacturing unit costs due to this mix shift. The second factor concerns inventories. We were impacted on two fronts. First, a large portion of the units sold during the quarter were from our higher cost inventory on hand at the beginning of the year, combined with an inventory write-down during the quarter. These two factors represented 11% of the gross margin difference. These factors were partially offset by previously enacted pricing actions and the benefit from lower shipping costs. We are confident that many of these margin challenges are addressable, and our gross margin should improve during the second half of 2023 as we gain additional efficiencies from our restructuring efforts and the wind down of higher cost inventory. We also expect to benefit from lower raw material and sea freight expenses compared to last year. Operating expenses in the second quarter were $58.8 million, compared to $41.2 million in the prior year quarter and included an impairment and restructuring expense of $23.6 million related to the Dorian plant closure. Excluding the legal settlements and loss contingencies and the expenses related to the planned closure, adjusted operating expenses were 24.3% of revenue compared to 22.1% in the prior year quarter. Adjusted EBITDA in the second quarter was a loss of $13.4 million compared to adjusted EBITDA of $17.1 million in the prior year quarter. The difference primarily reflects lower operating income. Turning to our balance sheet, Caesarstone's balance sheet as of June 30, 2023, included cash, cash equivalents, short-term bank deposits, and short-term marketable securities of $57.3 million with a total debt to financial institutions of $8.3 million. We generated positive cash flow from operations of $17.2 million during the quarter, mainly driven by our inventory reduction efforts. This compared to cash used in the amount of $4.5 million in the second quarter of 2022. During the quarter, we paid down our lines of credit from Israeli banks and ended the quarter with full availability on our lines of credit. Our net cash position as of June 30, 2023, was $49 million compared to $33.3 million as of March 31, 2023, and $28.2 million as of December 31, 2022. Before turning to our outlook, the Sdot-Yam plant closure has gone as planned overall. The plant closed in May and costs associated with the closure totaled $23.6 million during the quarter. The majority of that was related to the write-down on a long-term noncancelable lease agreement related to the facility with a term ending in 2032. We also incurred cash costs of $2.6 million. We now expect the total cash cost related to operations to come within a narrower band of $5 million to $7 million, which we estimate to incur by mid-2024. As a result of the facility closure, as mentioned also in the previous call, we expect to realize annualized savings of approximately $10 million to $15 million. Above and beyond those savings, we are in the process of accepting bids to sublet portions of the noncancelable lease agreement that I've mentioned earlier. The one-time write-down on the lease is in part based on our estimates of our ability to sublet part of the facility. We expect that the remaining costs associated with the lease will be increasingly offset by subleases over time. I will mention again that cash received from executing subleases would represent cash savings above and beyond our anticipated $10 million to $15 million of annualized cost savings. Regarding our outlook, we are reiterating our outlook for the full year of 2023 to generate positive cash flow from operations and to end the year with an improved net cash position. This is based on inventory reductions and other working capital improvements along with cost optimization efforts. Additionally, we anticipate significant improvement in adjusted EBITDA in the second half of 2023 compared to the first half of the year. Adjusted EBITDA should step up sequentially through year-end, resulting in third quarter performance better than the second quarter and the fourth quarter adjusted EBITDA showing additional improvements. While revenues are likely to remain pressured through year-end, we base our assumption for significant sequential improvement in the second half adjusted EBITDA and adjusted EBITDA margin on several factors. We have already sold through most of our higher cost inventory. The operational investments that we have made to develop and reengineer products are largely behind us. The closure of the Sdot-Yam facility in May will give us a full quarter of higher asset utilization on remaining assets. An increasing portion of our products will be produced at our third-party manufacturers in the Far East. And finally, we will start benefiting from lower shipping costs and raw material prices that have eased over the last few months, expected to have a positive impact in the third quarter and more evident in the fourth quarter of 2023. In summary, we are prioritizing our focus on taking actions that will make Caesarstone a more regional company that produces stronger cash flow as we look to drive long-term value for our shareholders. With that, we are now ready to open the call for questions.

We will now begin the question-and-answer session. Our first question comes from Reuben Garner, The Benchmark Company.

To start, Nahum, you provided some insights on the gross margin, but could you explain the sequential bridge from Q1 to Q2? Revenue decreased by about $7 million, and gross profit dropped by roughly $16 million. There are several factors you mentioned. Can you specify how much of this is due to competitive pricing dynamics, the inefficiencies from the plant closure, and any other reasons behind the write-down? Additionally, what factors contributed to the 10-point decline we observed?

Yes. So Q2 reflected several temporary items that we recorded during this quarter. You said it accurately, one of them is the inventory items. So during the second quarter, we recorded a slow-moving provision on our inventory items. That had an impact of almost 600 basis points, a negative impact of almost 600 basis points. In addition, as we mentioned, Q2 reflected a significant investment in reengineering a large portion of our portfolio. This reduced the utilization in our plants, resulting in additional expenses which increased the overhead. Those factors contributed a negative impact of around 500 basis points. So if you take those two main factors into consideration, you have around 11% of decline, which is the main item from the 19.7% gross margin that we generated in Q1.

So those items should not recur in the back half of the year. So does that mean that if your volume or revenue is in the kind of mid-40s range, that your actual baseline for gross profit is north of 20%? Any improvements in efficiencies or volume growth from there would take you above 20.

You're right in part; Q3 will still reflect some investments, especially in July and August, with the last portion of our project to reengineer products. So there will still be an impact on Q3 results. In addition to that, our higher cost of product is expected to be completed and washed out again during the beginning of Q3. So taking those two factors into consideration, I think our Q3 should look much more like the first quarter.

Q3 should look more like the first quarter, so closer to 20%.

Yes. There are positive indicators, like a reduction in the sea freight expenses that we are paying, and we will start benefiting from lower raw material prices. This will become more evident as we progress in the second half of 2023.

Are there any potential savings in general and administrative expenses resulting from the restructuring? It seems like general and administrative expenses decreased slightly from Q2 to Q3, but they're still near their highest levels. Will we see this number decrease to help counteract some of the challenges in revenue?

We do expect our restructuring is not only related to the Sdot-Yam closure. Our restructuring is a much wider plan that includes several factors. Some of them also relate to G&A, for example, the consolidation of several positions in management. So yes, we do expect G&A to slightly come down in the second half.

Reuben, I would like to explain a bit about the reengineering. This work is tied to regulations in Australia and is specifically related to the Australian collection. We expect changes in the regulation in Australia, which has necessitated adjustments to the raw materials used in the product. Transforming the Australian collection is a costly process, and we are still uncertain about the outcome of the Australian decision. We are proceeding based on our best estimates and have chosen to incur these costs to better position ourselves for future developments in Australia. It's also important to mention the restructuring plan, which is partly a strategic move with multiple dimensions. It's not just about closing Sdot-Yam, but also includes improvements in marketing and sales, as well as savings largely due to our shift to strategic partners in the Far East. These are a few clarifications.

Our next question comes from Mr. Stanley Elliott, Stifel.

You talked about improved profitability as the year progresses. Just kind of help to frame it out kind of given the starting point where we are in the first half. You did about roughly maybe, let's call it, a 5% sort of margin last year in the second half. Do you think that you will be above that or below that?

I think we should look at starting the second half, as I mentioned earlier, and you should look at our first quarter margin as a more indicative number, as this quarter reflects several temporary items. During the second half, we expect to see a gradual improvement in our gross margin from several factors: the restructuring plan, the lower raw material prices, and the lower shipping costs that will become more significant over the course of Q3 and even stronger during Q4. We expect a gradual improvement there as well.

So it sounds like probably negative or kind of flattish sort of EBITDA for '23, and then kind of really focus more on '24 with some of the restructuring and some of the other initiatives that you have underway to return to profitability?

We are looking at it from quarter to quarter because we are in the middle of a very big restructuring plan and we are starting to see the benefits of what we have already done, and there is a lot more to do. We expect a gradual improvement, as we said, between Q3 and Q4, and we will have to refine the internal projection. Of course, the external projection during the call on Q4, but we definitely see a gradual improvement. As Nahum said, bear in mind that we have been suffering for a long period due to the high inventory levels that were produced during last year with very high raw material prices and shipping prices. So this is almost washed out. We'll definitely see an improvement in Q3, in addition to the other improvements that we will start benefiting from, including the significant cost-cutting we are doing.

And with the inventory worked down, is there a way to kind of size what we should think about from a dollar basis through the balance on a year-over-year basis reduction in inventory? Or any ballpark on cash flow targets in either the second half or all of '23?

Yes, as you said, the cash flow from operating and the net cash position is still our focus for this year. As we mentioned in the outlook, we expect to continue to generate positive cash flow from operating, not only on the basis of lower inventory, which came down nicely during the first half from almost 180 days to the current level of 120 days. We expect to continue and reduce the days of inventory as the year progresses and as we continue with our restructuring plan. But not only that, not only on the back of lower inventory, but also on tighter cost control and better prices on our raw material and shipping cost. So we expect to continue to generate positive cash flow also in the second half.

This concludes our question-and-answer session. I would like to turn the conference back over to Mr. Yosef Shiran for any closing remarks.

Thank you for your attention this morning, and we look forward to updating you on our progress next quarter. Goodbye.

This conference has now concluded. Thank you for attending today's presentation. You may now disconnect. Thank you.