Earnings Call Transcript - CSTE Q3 2020

Operator, Operator

Greetings and welcome to the Caesarstone's Second Quarter 2020 Earnings Conference Call. At this time, all participants are in a listen-only mode. A brief question-and-answer session will follow the formal presentation. As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Brad Cray of ICR. Thank you. You may begin.

Brad Cray, Host

Thank you, operator, and good morning to everyone. I am joined by Yuval Dagim, Caesarstone’s Chief Executive Officer, and Ophir Yakovian, 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, loss, and adjusted net income loss 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 third quarter 2020 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 Yuval. Please go ahead.

Yuval Dagim, CEO

Thank you, Brad, and good morning, everyone. The benefits of our team's collective efforts are emerging with visible progress evidenced in our third quarter results. During the quarter, we were encouraged with a sequential improvement in year-over-year sales trends compared to the second quarter of 2020. We also effectively controlled costs to accomplish our highest adjusted EBITDA and margin in over two years. Furthermore, we generated substantial cash flow from operations exceeding $28.2 million, further strengthening our available financial resources. Our strong working capital management has provided us with significant flexibility to continue executing against our strategic plan. In addition, following the improved performance of our business, we have resumed several initiatives that were postponed after the onset of the COVID-19 pandemic with a mission to be the first global brand of choice for countertops. Caesarstone's strategy includes three pillars: premium multi-material offering, customer experience and engagement, and global footprint expansion. These three strategic pillars are integral to unlocking Caesarstone's potential and are all managed under our global growth acceleration plan. The majority stake acquisition of Lioli, a producer of cutting-edge porcelain countertop slabs, represents a major milestone in our objective to become a leading global multi-material premium countertops brand of choice. Porcelain is one of the fastest-growing countertop categories, and this acquisition provides an attractive opportunity to complement Caesarstone's established presence in engineered stone surfaces. Lioli is located in the center of India's porcelain hub, equipped with top-of-the-line Italian manufacturing technology and a cost-effective vertically integrated operation to efficiently supply porcelain countertop products. Lioli is directly aligned with our strategy to leverage our brand distribution, sell on a global scale to efficiently enlarge our addressable market, and further advance Caesarstone as the brand of choice for countertops around the world. We will provide premium, multi-material countertop offerings as we move through 2021, with porcelain being marketed alongside quartz in all regions under our leading global Caesarstone brand. In addition, we are investing in technology and new engagement tools that we expect to launch in several markets in the coming months to significantly strengthen our sales and marketing capabilities, which we believe will enhance our customers' experience. Overall, our plan is progressing, our performance is improving. We have brilliant talent in place to further execute our strategy, and we remain confident in the prospect of our business as the recovery continues. With that, let me turn the call over to Ophir, who will provide details on our results and outlook.

Ophir Yakovian, CFO

Thank you, Yuval, and good morning, everyone. I will start by discussing our third quarter results. For the third quarter of 2020, global revenue was $123.9 million, compared to $142.8 million in the third quarter of last year. On a constant currency basis, third quarter revenue was lower by 14.4% compared to the same period last year. The majority of the adverse revenue impact was primarily due to business disruption related to COVID-19 in our Americas region, which I will detail shortly. However, we are encouraged to see business activity improving in the third quarter compared to the second quarter and expect further improvement in the year-over-year trend in the fourth quarter. Looking at other markets; in the Americas, our largest region, inconsistent state and local shelter-in-place guidelines continue to impact business activity. In the US and Canada, the closure of IKEA stores for the majority of the second quarter significantly reduced our order backlog, which naturally had an unfavorable impact and accounted for approximately half of our North American sales decline in the quarter. This impact to our big box channel was partially offset by increased activity at US Home Depot stores where we have an expanding presence. Core sales were down due to shelter-in-place guidelines and social distancing practices limiting installation at some residential job sites. In the APAC region, Australia accounts for most of our sales, and performance has been better than our expectations. That said, the soft market conditions that existed prior to the pandemic continued to impact that market. In the EMEA region, both our indirect and direct sales were affected by the aftermath of the first lockdown. Recent government restrictions are also reemerging in certain parts of Europe and may slow the recovery. In Israel, a second pandemic shelter-in-place order was issued in the second half of September, resulting in a slight year-over-year decline in revenues. This order was partially lifted during the second half of October, but is expected to impact Q4 performance. Looking at our third quarter P&L performance; our improved third quarter margin performance and bottom-line results benefited from our focused execution of initiatives to improve efficiencies across our business. Adjusted gross margin was 31.4% compared to 29.9% in the prior quarter. The higher year-over-year adjusted gross margin mainly reflects improved product mix, lower raw material costs, and improved efficiency, partially offset by the impact of lower sales volume, lower selling prices, and less favorable regional mix. We continue to evaluate our level of production capacity to meet the expected demand. To date, we are pleased with our ability to flex capacity and control inventory, which has helped us to manage our working capital carefully. However, it is important to note that the effective capacity utilization of our plants is currently running at less than 70%. As we ramp up production in future quarters, this will likely have a favorable impact on our gross margins. With that point, we expect our fourth quarter gross margin to be lower quarter-over-quarter, but slightly higher year-over-year. Excluding legal settlements and loss contingencies, operating expenses for the quarter were 18.8% and benefited primarily from previous efforts of our global growth acceleration plan to improve efficiencies, combined with tight cost control from our business continuity measures, driving lower marketing and sales expenses, as well as lower general and administrative expenses. As we see an improved business environment, we expect to increase our sales and marketing expenses to support our brand and future growth. Adjusted EBITDA in the third quarter was $23.7 million, representing a margin of 19.1% compared to $22.5 million, a margin of 15.8% in the prior quarter. This performance primarily reflects the higher gross margin compared to last year, in addition to lower operating expenses, excluding legal settlements and loss contingencies. Adjusted diluted earnings per share in the quarter were $0.41 compared to $0.29 in the same period last year, on a similar share count. Looking at our balance sheet; our prudent effort to control costs, manage our production capacity, and working capital, and improve our operational efficiency has collectively allowed us to generate strong cash flow from operations and preserve a substantial cash position. These include cash, cash equivalents, and short-term bank deposits, as well as short and long-term marketable securities of $155.7 million. At the end of the third quarter, we had no debt from financial institutions. According to the company's dividend policy, and based on our net income performance during the third quarter and first nine months of 2020, our Board declared a dividend of $0.14 per share with a record date of November 18, and payment date of December 9, 2020. As we move forward, we remain confident that the strength of our balance sheet provides us with sufficient flexibility to continue executing against our strategic plan. With that, let me turn the call back to Yuval for closing comments.

Yuval Dagim, CEO

Thank you, Ophir. In closing, we remain encouraged by the ongoing disciplined execution of our global growth acceleration plan. And we are excited by the tremendous potential of our business. I am grateful for the significant contributions of all our team members across the globe and appreciate their dedication during these unique times. Looking ahead, as we integrate Lioli and make additional progress on other initiatives under our strategy, we are confident that we are on the right path to improve the long-term trajectory of the business. I look forward to updating you further on our progress next quarter. Thank you. And we are now ready to open the call for questions.

Operator, Operator

Our first question is from Reuben Garner with Benchmark Company.

Reuben Garner, Analyst

Thank you. Good morning, or I guess excuse me, good afternoon, guys. Maybe we could start with the top-line trend. You mentioned an expectation that it would continue to improve in Q4; I know there's a lot of puts and takes with different countries having COVID shutdowns and that sort of thing. Maybe could you help walk through the month-by-month progression in Q3? How did the year-over-year declines improve through the quarter and what you saw in October? And in the first part of the fourth quarter so far.

Yuval Dagim, CEO

Yes, hi, Reuben. Good morning. Indeed, we are quite pleased with the sequential improvement of our sales from quarter to quarter. Although global sales are improving, indeed, the change varies between the regions, but all regions are improving from the bottom level since April 2020 this year. We do see the improvements from quarter to quarter and from month to month, and this includes the fourth quarter we just started.

Reuben Garner, Analyst

And is there any way to quantify that? I mean, your costs have declined by more than half from Q2 to Q3. Can we expect a similar trajectory in Q4; maybe you're down mid-single digits as we approach 2021? And then potentially next year, you can return to growth.

Ophir Yakovian, CFO

We don't provide guidance for Q4; we just say that we are improving this. We do see an improvement in the trend. As you mentioned, there's still one strategy active in many parts of the global footprint. If you take Europe, we see softer shutdowns in many major countries; we mentioned Israel, which has been in lockdown since mid-September, and we still -- it is not fully lifted. So we're going to be cautious about providing guidance in this uncertain environment at the moment, but we do expect to see improvement in the trend year-over-year.

Yuval Dagim, CEO

And also, Reuben, in line with this improvement in our strong financial results, we also resumed investment in some projects and resources to boost revenues even further for next year.

Reuben Garner, Analyst

Okay, I understood, and I want to ask a question about that before I get there. The margin turnaround in the third quarter was pretty remarkable. Can you help us with a bridge from where you were in Q2 from a margin standpoint to Q3? Or is it better to look at it on a year-over-year basis? You showed margin improvement year-over-year with a 13% revenue decline; just help us walk through what the different pieces are to get there, and how to think about those as we move forward.

Ophir Yakovian, CFO

Yes, I mean, we look at it compared to last year on a year-over-year basis. First, we are very pleased with the performance and cumulative gross margin improvement. It can be attributed to three main components. One is we had a better product mix; we sold more premium products where we command a higher premium and better margins. That was the main component here. There were better raw material prices coming from better sourcing and lower prices. We've also seen improved efficiency in our operations. These are the positive aspects, while the burden on gross margin is coming from lower sales volume with higher logistics costs per unit due to lower volume and less favorable regional mix. I would also mention here that we are still operating under 70% capacity utilization in our factories, which also negatively affects our gross margin. These are the main contributors to the improvement in our EBITDA. Looking at Q4, we expect gross margin to be lower than what we've seen this quarter but slightly better than the performance we had in Q3 last year. In terms of EBITDA margin, we expect more normalized levels of sales and marketing and G&A as we prepare for growth.

Yuval Dagim, CEO

Reuben, if I may add another dimension to our answer. If you remember, I mentioned prior performance indicators in Q1 this year being relatively healthy compared to the second quarter of the previous year. Leaders across the globe have acted with speed and discipline to mitigate costs in response to the current demand, and I think this was reflected in our results in Q3.

Reuben Garner, Analyst

Got it. That makes sense; it's helpful. Let's talk about those investments to drive growth. Can you elaborate on the amount of the investment? What exactly are you investing in? Is it more salespeople? Is it just marketing in general? And then what do you expect to be the outcome? I mean, is it Europe and the US increasing penetration primarily that you're focusing on? Just help us understand what the investments are, maybe quantify, if you could, and then what benefits you expect from them?

Yuval Dagim, CEO

Sure, so maybe three areas of investment focus on adding resources to boost growth and revenues. First, we just completed our deal with Lioli Ceramica, adding another category to our business and addressing a bigger market by offering porcelain and quartz to our customers in the coming years. In addition, we are continuing to invest behind our sales team in the US as we expand our presence in various markets, which we started at the beginning of the year. Lastly, we are engaging in several projects under our global growth acceleration plan, some of which are around new technologies we plan to launch in the coming months to improve customer engagement.

Reuben Garner, Analyst

Okay, great. And then I'm going to sneak one more in, if that's all right. You just closed on that deal. Talk to me about what the pipeline looks like from an M&A perspective. Do you anticipate more deals? What's a reasonable expectation for others in the future? Is this part of the playbook to acquire similar-sized different materials and integrate them into your distribution network?

Yuval Dagim, CEO

Yes, I may start with our mission, which is for the Caesarstone brand to become the first brand of choice in countertops globally. Under this mission, we have our strategy with three main pillars: having a multi-material offering in premium countertops, improving consumer and customer engagement and experience, and expanding our global footprint to go direct in other markets. Our M&A efforts are primarily focused on multi-material offering, which we completed with the addition of porcelain. Our future focus will remain on tapping into global regions where we can establish a direct presence instead of relying on distributors.

Operator, Operator

Next question is from Asaf Chandali from Oppenheimer.

Asaf Chandali, Analyst

Hey, guys, first of all, congratulations on a great quarter despite the difficult conditions. I guess it also depends on the margin front. Gross margins for the quarter were the highest since about Q2 2018. With these depressed revenue levels and you mentioning some headwinds, pricing, or unfavorable geographic mix, do you think that the better product mix this quarter was totally one-time? Because maybe mixed signals are evident since you're guiding for a lower margin sequentially, which is still solid, I guess around 26.5 for Q4. But how should we be thinking about a normalized run rate? Where should we be thinking about the company's goals for 2021 and 2022? When sales normalize, is a high 20s, near-term, above 30 medium-term?

Ophir Yakovian, CFO

That's a good question. I think that it's quite a hectic period that is changing things. The product mix we're seeing now is difficult to predict for the coming quarters. Our estimate is that these factors will normalize, leading to a more reasonable and normalized mix. However, we haven’t changed our long-term goals; I believe that once we reach normal sales volume again, we can aim for the 32% to 35% gross margin target, which is visible and achievable. What we observed in this quarter were several operational KPI improvements stemming from our global growth acceleration plan, which we believe contributed to improve our gross margin. Hence, we feel that we are on the right track to achieve our goals, but higher sales volume will be key as the economy recovers.

Yuval Dagim, CEO

Just to support that, Asaf, with another perspective. The latest addition to our portfolio, porcelain, is accretive to both gross margin and EBITDA margin, which will contribute to our growth moving forward.

Asaf Chandali, Analyst

Okay, great. And I know that, yes, I guess we could just move toward the old economy. It kind of naturally interfaces here. We can start on the financials. It's a couple of percentage points of the top line now, if I recall correctly. Where do you guys want to get that? How should we be thinking about you growing the Lioli business? Should I be looking forward to the next year? Will I get any segmentation breakdown between porcelain and quartz? Any color that would be helpful?

Yuval Dagim, CEO

Yes, sure. It's a bit premature to provide detailed breakdowns for this new category in our business. The porcelain category is expected to grow 10% in the coming years, meaning we are joining a growing segment at the right time. We will utilize our current assets to access a larger market size, namely our logistics and distribution network. Safe to say, the porcelain offering will start next year, and it will be easier to provide growth projections and details as we integrate it into our business.

Asaf Chandali, Analyst

Okay, any specific reason you chose porcelain? Was that just a good target, or is it your first in a multi-material approach?

Yuval Dagim, CEO

The multi-material approach is focusing on stone. In the stone area, we include quartz, porcelain, and natural stone. Porcelain is a natural fit for our business given the manufacturing process associated with stone. That allows us to broaden our material offering in the coming years.

Asaf Chandali, Analyst

Okay, great. And just one last question here regarding the sales trends on a constant currency basis. For example, in Australia; the Q3 number is showing not much of a difference relative to where you guys were pre-COVID. Even on a year-over-year basis, is this sustainable? Are you experiencing any potential benefits from reduced competition from China? I see Australia is only down 7%, which is a much smaller decline compared to levels we were even seeing in 2019. Any color that would be helpful.

Yuval Dagim, CEO

Two dimensions to my answer. First, indeed we are in a stronger competitive position this year than last year in markets like Australia, Canada, and Israel by leveraging our OEM supply. We see this as a solid competitive advantage. At the same time, the business environment during COVID-19 varies country by country. For early parts of this year, Israel and Australia were affected less, generating stronger revenue. Then, with the long lockdown in Victoria, we felt a greater impact there. The varying market activity in each country will dictate demand and volume in the short term.

Asaf Chandali, Analyst

If I could just ask about the cadence of revenues throughout the quarter. How did July, August, and September look? Was there a gradual improvement? How do you see things through now, effectively the beginning of November?

Yuval Dagim, CEO

We indicated earlier that we see a gradual improvement from month to month and obviously from quarter to quarter. We expect this trend to continue.

Operator, Operator

We have reached the end of the question-and-answer session. I will now turn the call over to Yuval Dagim, CEO, for closing remarks.

Yuval Dagim, CEO

Thank you for your attention this morning. We look forward to updating you on our progress next quarter.

Operator, Operator

We have reached the end of our conference. You may disconnect your line at this time. Thank you and have a good day.