Kadant Inc Q3 FY2021 Earnings Call

Thank you for joining us. Welcome to the Q3 2021 Kadant Inc. Earnings Conference Call. All participants are currently in listen-only mode. We will have a question-and-answer session later, and instructions will be provided then. I would now like to hand over the call to Mr. Michael McKenney, Executive Vice President and Chief Financial Officer. Please proceed.

Thank you, Grace. Good morning everyone and welcome to Kadant's Third Quarter Earnings Call. With me on the call today is Jeff Powell, our President and Chief Executive Officer. Before we begin, let me read our Safe Harbor statement. Various remarks that we may make today about Kadant's future plans and expectations, financial and operating results and prospects are forward-looking statements for the purposes of the Safe Harbor provisions under the Private Securities Litigation Reform Act of 1995. These forward-looking statements are subject to known and unknown risks and uncertainties that may cause our actual results to differ materially from these forward-looking statements as a result of various important factors, including those outlined at the beginning of our slide presentation and those discussed under the heading Risk Factors in our annual report on Form 10-K for the fiscal year ended January 2, 2021, and subsequent filings with the Securities and Exchange Commission. In addition, any forward-looking statements we make during this webcast represent our views and estimates only as of today. While we may elect to update forward-looking statements at some point in the future, we specifically disclaim any obligation to do so even if our views or estimates change. During this webcast, we will refer to some non-GAAP financial measures. These non-GAAP measures are not prepared in accordance with generally accepted accounting principles. A reconciliation of non-GAAP financial measures to the most directly comparable GAAP measures is contained in our third quarter earnings press release and the slides presented on the webcast and discussed in the conference call, which are available in the Investors section of our Website at www.kadant.com. Finally, I wanted to note that when we refer to GAAP earnings per share or EPS and adjusted EPS on this call, we are referring to each of these measures as calculated on a diluted basis. With that, I'll turn the call over to Jeff Powell, who will give you an update on Kadant's business and future prospects. Following Jeff's remarks, I'll give an overview of our financial results for the quarter. And we will then have a Q&A session. Jeff?

Thanks, Mike. Hello, everyone. Thank you for joining us this morning to review our third quarter results and discuss our outlook for the remainder of the year. We had another quarter of record revenue and bookings, along with strong EBITDA margin performance and free cash flow, positioning us well for a strong finish to the year. I'd like to begin by reviewing our operational highlights for the third quarter. The robust demand for aftermarket parts and a high level of capital project activity in the third quarter led to an all-time high for revenue and bookings. Our aftermarket parts and consumable business was exceptionally strong in most regions of the world, and new order activity was driven by solid demand across all of our operating segments. In the third quarter, we announced the closing of two acquisitions, one in our Flow Control segment and another in our Material Handling segment. The integration of these businesses is going well and their financial results contributed to our third quarter performance. Just after the third quarter closed, we completed an acquisition of a small manufacturing business in India. It is a well-established manufacturer of engineered stock preparation and equipment used to process recycled and virgin fiber for paper packaging and tissue production. Our acquisition of this business will create a new manufacturing base for us in India, where we have a leading market position and have been active for more than 20 years. It also provides a strategic platform to accelerate new business opportunities in the fast-growing Indian packaging and tissue markets. Before moving on to our Q3 financial performance, I want to comment on the global supply chain and how we are managing in this complex environment. The headwinds found within the global supply chain continued to be a challenge, pushing out expected deliveries and materials and creating a significant amount of work to keep our delivery promises to our customers. I'm pleased to say it is a challenge that our operations teams around the globe are managing successfully. Our employees are doing a great job in navigating through a highly dynamic and uncertain environment that looks to be with us for some time. While there is little expectation for a sudden return to normalcy, I am confident we will work through these immediate supply chain challenges and continue to meet our customers' needs. Turning now to Slide 6, and our Q3 financial performance. You can see we had significant increases across all of these financial metrics compared to Q3 of last year. Q3 revenue was up 29% compared to the third quarter of 2020 to a record 200 million. Excluding acquisitions and the favorable impact of FX, revenue was up 18% compared to the same period last year. Our aftermarket parts consumables revenue was up 28% to a record 131 million in Q3. The consistently high operating rates of our customers and strong end-market demand contributed to our record aftermarket performance. Solid execution contributed to boosting our adjusted EBITDA margin to 20.5%, which led to our excellent operating cash flow of 38 million in Q3. All of our operating segments delivered excellent adjusted EBITDA margin performance despite the continuing inflationary pressures for materials and the ongoing supply chain constraints. Bookings were exceptional in the quarter, up 71% to a record 245 million. Excluding acquisitions and FX, bookings were up 57% with contributions from all three of our operating segments. I'll review the performance of these segments next, beginning with our Flow Control Group. The Flow Control segment achieved its fifth consecutive increase in quarterly revenue, reaching a record 76 million in the third quarter, up 34% compared to Q3 of last year. Aftermarket parts revenue was exceptionally strong and made up 72% of total Q3 revenue. Bookings were also a record at 77 million, up 55% compared to last year. Organic bookings, which exclude acquisitions and FX, were up 32% compared to the same period. Strong performance in Europe and North America led our bookings growth in Q3. Improved operating leverage led to record adjusted EBITDA, and our adjusted EBITDA margin of 29.1%. While our recent acquisition at Clouth contributed to our overall performance, organic growth within our Flow Control Group continued to demonstrate the strength of this segment. Our Industrial Processing segment continued to experience strong demand with bookings nearly doubling from the same period last year to a record 119 million. New orders for our fiber processing systems in the U.S. and Europe led this increase in the third quarter. Overall demand for housing and wood products remained high, and our wood processing product line capitalized on strong end market demand. Revenue in this segment increased 31% to 82 million with strong performance in aftermarket parts and capital business. Adjusted EBITDA was up 24%, while adjusted EBITDA margin declined compared to Q3 of last year when we received employee retention benefits related to the pandemic. As you may have read in the press, China is experiencing power supply issues. This has created a challenge for us with production schedules, and it is uncertain how long this will impact our operations. We are also seeing an increasing number of requests from our customers to delay shipments as they manage supply chain constraints. In spite of these headwinds, we entered the quarter with another record backlog that positions us well for the remainder of the year. Moving to our Material Handling segment, we experienced healthy demand for our capital equipment and aftermarket parts. Revenue was up 17% to 42 million with parts revenue making up 59% of total revenue in the quarter. Bookings in this segment were up compared to the same period last year to a record 49 million in Q3. We saw increased order activity and strong demand for our high-performance balers, which contributed to our record bookings in the third quarter. Our recent acquisition, Balemaster, is also experiencing record demand and the integration of that business and the cadence is proceeding well. Solid execution of our baling businesses, including our recent acquisition, helped boost adjusted EBITDA by 26% and adjusted EBITDA margin by 120 basis points compared to the same period last year. Despite the supply chain issues I mentioned earlier, we remain optimistic for an improved capital investment environment as infrastructure spending and industrial demand for raw bulk materials grow. As we look ahead to the remainder of 2021, we continue to see signs of healthy project activity. Our decentralized structure continues to serve us well during these rapidly evolving times, allowing us to respond quickly to local and regional developments. Our record backlog has us well positioned for the remainder of the year. However, delays in shipments and the timing of orders have shifted some expected revenue bookings from Q4 into 2022, which Mike will comment on in his remarks. With that, I'd like to pass the call over to Mike to review our Q3 performance.

Thank you, Jeff. I'll start with some key financial metrics from our third quarter. Consolidated gross margins were 41.9% in the third quarter of 2021 compared to 44.2% in the third quarter of 2020. Our consolidated gross margins in the third quarter of 2021 were negatively affected by the amortization of acquired profit and inventory related to the Clouth and Balemaster acquisitions, which lowered consolidated gross margins by 110 basis points. In the third quarter of 2020, government assistance benefits increased consolidated gross margins by 110 basis points. Excluding the impact from both of these, consolidated gross margins were approximately 43% in both periods. Our parts and consumable revenue represented 66% of revenue in both periods. SG&A expenses were 52.3 million in the third quarter of 2021, an increase of 8.5 million compared to 43.9 million in the third quarter 2020. The third quarter of 2021 SG&A includes 3.4 million in SG&A from our acquisitions. There was an unfavorable foreign currency translation effect of 0.9 million in the quarter and a reduction in government assistance benefits of 0.7 million. We also incurred acquisition-related costs of 1.3 million in the third quarter of 2021 compared to 0.4 million in the third quarter of 2020. The remaining increase in SG&A expenses is primarily associated with increased incentive compensation and travel-related costs due to improved business conditions. As a percentage of revenue, SG&A expenses decreased to 26.2% in the third quarter of 2021 compared to 28.4% in the prior year period. Our effective tax rate was 24.6% in the third quarter of 2021, lower than we anticipated, primarily due to tax benefits from acquisition-related expenses, employee equity awards, and the reversal of tax reserves associated with uncertain tax positions. Our GAAP diluted EPS was $1.75 in the third quarter, up 37% compared to $1.28 in the third quarter of 2020, and our adjusted diluted EPS increased 50% to $1.97. Adjusted EBITDA increased 36% to 40.9 million or 20.5% of revenue compared to 30 million or 19.4% of revenue in the third quarter of 2020, due to strong performance in our Flow Control segment, which was up 42% with a large portion attributable to organic growth. This is the second quarter in a row that our consolidated adjusted EBITDA as a percentage of revenue has exceeded 20%, and we expect to also achieve this for full year 2021. Operating cash flow increased 56% to 37.9 million in the third quarter of 2021 compared to 24.4 million in the third quarter of 2020. Free cash flow increased 53% to 34.6 million in the third quarter of 2021 compared to 22.6 million in the third quarter of 2020. We had several notable non-operating sources and uses of cash in the third quarter of 2021. We paid 141.4 million for the acquisitions of Clouth and Balemaster, and we borrowed 63.1 million related to these acquisitions. Despite the significant acquisition activity in the quarter, we were able to utilize our strong cash flows to pay down our debt by 26 million. We also paid 3.4 million for capital expenditures and paid a 2.9 million dividend on our common stock. Let me turn next to our EPS results for the quarter. In the third quarter of 2021, our GAAP diluted EPS was $1.75. And after adding back acquisition-related costs of $0.22, our adjusted diluted EPS was $1.97. In the third quarter of 2020, our GAAP diluted EPS was $1.28 and our adjusted diluted EPS was $1.31. As shown in the chart, the increase of $0.66 in adjusted diluted EPS in the third quarter of 2021 compared to the third quarter of 2020 consists of the following: $0.90 due to higher revenue; $0.09 from acquisitions, net of interest expense and acquisition borrowings; and $0.05 due to lower interest expense. These increases were partially offset by $0.21 due to higher operating expenses, $0.15 due to a decrease in the amounts received from government assistance programs, $0.01 from higher non-controlling interest expense, and $0.01 due to higher weighted average shares outstanding. Collectively, included in all the categories I just mentioned was a favorable foreign currency translation effect of $0.07 in the third quarter of 2021 compared to the third quarter of last year due to the weakening of the U.S. dollar. Looking at our liquidity metrics on Slide 15: our cash conversion days, which we calculate by taking days in receivables plus days in inventory and subtracting days in accounts payable, decreased to 113 at the end of the third quarter of 2021 compared to 140 at the end of the third quarter of 2020. This decrease was primarily driven by a lower number of days in inventory. Working capital as a percentage of revenue was 13.5% in the third quarter of 2021 compared to 15.6% in the third quarter of 2020. Our net debt, that is debt less cash, increased 115 million sequentially to 231 million at the end of the third quarter of 2021. We borrowed 63 million in the quarter to fund our acquisitions and we were able to pay down 26 million of debt in the quarter. Our leverage ratio, calculated in accordance with our credit agreement, was 1.69 at the end of the third quarter of 2021 compared to 1.71 at the end of the second quarter of 2021. Our net interest expense decreased 0.3 million to 1.3 million in the third quarter of 2021 compared to 1.6 million in the third quarter of 2020. At the end of the third quarter of 2021, we had 105 million of borrowing capacity available under our revolving credit facility, which matures in December of 2023. I would like to update our revenue range for the fourth quarter and full year 2021. Although we had record bookings of 245 million in the third quarter, which is the fourth record quarter in a row, we ended the third quarter with a record backlog of 299 million. The current headwinds from supply chain and logistical constraints have caused us to reduce our revenue expectations for the fourth quarter. We now anticipate revenue of 210 million to 215 million, down from 220 million to 225 million that we noted in the July call. For the full year 2021, we now anticipate revenue of 778 million to 783 million revised from 783 million to 793 million. This change in the revenue range includes 13 million of revenue that has been moved into 2022 as a result of supply chain issues or customer requested changes to the shipping dates. In addition, the timing of capital orders also had an impact. As Jeff mentioned, the China power supply issue, which came to light during September, has also had an impact on our production schedule. The Chinese government has imposed varying power restrictions from time to time, which are outside of our control. Our current revenue expectation is based on the current power use guidelines we have been given holding throughout the quarter. Our guideline and gross margins essentially remain the same. We anticipate fourth quarter gross margins will be 42%, which includes the impact of amortizing the acquired profit and inventory. Our current estimate for the amortization of acquired profit and inventory in the fourth quarter is 2.1 million or $0.13. We anticipate SG&A expenses will be approximately 55 million to 56 million and R&D will be a little over 3 million in the fourth quarter. The SG&A expense includes backlog amortization of approximately 600,000 or $0.04. We anticipate our net interest expense will be approximately 1.4 million in the fourth quarter of 2021, and we anticipate the tax rate for the quarter will be 27% to 28%. We hope these directional comments are helpful. That concludes my review of the financials. And I will now turn the call back over to the operator for our Q&A session.

Thank you. Your first question comes from Kurt Yinger from D.A. Davidson. Your line is open.

Great. Thanks and good morning, Jeff and Mike.

Good morning, Kurt.

Just wanted to start off on the supply chain. With orders being pushed out, do you expect that's really a Q4 type phenomenon as you get into next year? Can you kind of get back on track and continue to grow sequentially, or do you expect that's going to remain a challenge in terms of delivering the plan and the backlog?

As Mike mentioned, we had a significant amount of revenue that was delayed from the fourth quarter into next year. Currently, we believe that in the first half of next year, we will still face shipping challenges primarily due to logistics, which is one of our main hurdles. However, experts suggest that these issues should be resolved by the summertime. Our expectation is that this will be a situation affecting the first half of the year. We anticipate that by the latter half of the year, conditions will begin to normalize. Since this is a new experience for us, there are no certainties, but we feel things will improve in the first one or two quarters of next year.

Got it. And when you think about just the capacity of your system and the flexibility that you might have, is the supply chain a limiting factor to kind of revenue growth from here or is it more just based on more of a headwind in terms of delivering to kind of scheduled out timelines?

Yes. I believe it's primarily a delivery issue rather than a revenue concern. I don't anticipate any significant loss in revenue due to this situation. It’s simply taking longer to deliver than we had expected.

Okay, that's helpful. All right. And then just on the margin front, can you just talk directionally about how you're thinking about the potential kind of impact as capital presumably increases as a proportion of revenue in 2022? Is that something with overall volume levels being higher, do you think you can kind of hold in that 42 to 43 gross margin range you've kind of achieved here in the second half, or could that drag be a real needle mover?

I don't know if it will be a real needle mover, Kurt, but there's no question that that mix of capital and parts and consumables plays a part in the gross margin performance. I always say when we're heavier in capital, that will create some pressure on gross margins. But the good news side of that is we get operating leverage on it. So our operating margins will be better.

Got it. Okay. All right. That's helpful. And then just last one for me. As you look across your segments, your different customer sets and geographies, it seems like over the last quarter or two here, things have been universally strong. But as you look ahead to Q4, any notable pockets of acceleration or deceleration or any trends you're kind of thinking about heading into 2022 that are different from what you've seen over the last couple of months?

I would say no, not right now. I think our customers continue to operate at a fairly high operating rate, as you know. Two-thirds of our business recently has been parts and consumables, and they tend to go as the operating rates go. Most of our customers around the globe are operating at very high rates. Demand is pretty high still. And so right now, we've had kind of broad growth across all three of our segments, and we don't see any significant variation from one segment to the other. I think everybody seems to be operating at a pretty high rate right now. Demand is pretty high.

Got it. Okay. That’s good to hear. Well, I appreciate all the color and good luck here in Q4.

Thanks.

Thank you. Next, we have Walt Liptak from Seaport Research. Your line is open.

Hi. Good morning, guys.

Hi, Walt.

Hi, Walt.

Hi. I wanted to ask, just to go back to that last question about the shipping and if you could just go into a little bit more detail. We've all heard about what's going on, on the West Coast ports. Is it that you're having trouble getting component parts in through the ports or is there something else going on with shipping about getting products out from your factory someplace else?

Yes. It's a little bit of everything, but the bigger issue for us is getting containers and ships out of China. That's a significant part of it. As you know, a large percentage of our business in China is sold and remains in China, but they still manufacture components for some of their sister divisions around the globe. Right now, shipping is very challenging. The costs have risen substantially. We've managed that aspect, but the timing and schedules are somewhat beyond our control. That's what we're currently dealing with. I think most experts believe that it will start to improve over the next several months in the spring and early summer. That’s our hope and expectation. Essentially, it's about getting our equipment shifted to customers.

Okay. I wonder if you can give us some more detail about the types of products, which segment some of the delayed shipments are in?

Yes, I would say, Walt, it’s primarily focused on Industrial Processing. Of the $13 million revenue shift I mentioned, 80% of that is related to Industrial Processing. When we break down that $13 million among the product offerings in Industrial Processing, half of it comes from the stock product line and 30% from the wood product line. So it’s largely centered in Industrial Processing.

Okay, got it. Okay, great. And maybe to segue into another question is in Industrial Process, great orders there. It's been really strong tied to the residential builds. How is the funnel looking for projects? Do you get visibility on some of those projects? Do you think the order activity will continue into 2022?

I believe demand remains quite robust. After the quarter ended, we received an order in the wood processing segment.

$8 million

We booked an $8 million order last week for new stranders in the OSB market, which is one of the largest orders in the company's history. Demand remains very strong. Lumber prices have declined from their peak, currently around $575, which is still significantly above the historical average of about $375. While prices have dropped, companies remain very profitable, demand is high, and they are reinvesting in their businesses to meet that demand.

Thank you for that. I have one last question: could you help us understand the M&A you completed, including which segments they involve and how they fit with Kadant?

Clouth, based in Germany and part of the Flow Control Group, was one of our oldest businesses alongside the doctoring blade business, where they were a major competitor. Together, we now combine the two leading blade suppliers in the world, creating significant opportunities for product development, market penetration, and sharing best practices. They had advanced manufacturing operations in Europe that we can utilize. I previously mentioned that this acquisition was our top target for 30 years, making it an excellent addition. Balemaster, part of our Material Handling segment, has been on our radar for about five years. They are a leading baler supplier in the U.S. with record demand, primarily serving the containerboard markets. Their focus is on recycling OCC and pre-consumer cardboard from box plants and board mills, aligning well with our position as the largest supplier of balers globally. They've experienced near record demand for several quarters, especially as the global economy increasingly shifts towards renewable materials like fiber cellulose, which drives recycling needs. E-commerce has risen by 14% compared to the third quarter of last year, while containerboard is expected to grow by approximately 4.7% annually over the next five years, outpacing GDP as more sales-based packaging is adopted. These trends are fueling demand for our businesses. Lastly, we recently completed the acquisition in India after the quarter ended. This is a company we have sought to acquire for many years to establish a manufacturing presence in a fast-growing market. Though the market isn’t large for us, we have been active there for some time and aimed to deepen our market presence while gaining insight into local manufacturing costs, skills, and competencies. This acquisition serves dual purposes: enhancing our market position and providing a manufacturing base in the region where we can explore further opportunities. Overall, we've made acquisitions in all three sectors, with Clouth being the largest, followed by Balemaster and the smaller operation in India.

Okay, great. Thank you very much. Congratulations on those deals and I appreciate you running through them for us.

Sure. Thanks, Walt.

Thank you. Presenters, I see there are no further questions at this time. I would now like to turn the conference back to Mr. Jeff Powell, President and Chief Executive Officer, for any closing remarks.

Thanks, Grace. Before wrapping up the call today, I just want to leave you with a few takeaways. 2021 is shaping up to be the best year in our history across a wide range of metrics. We made solid progress this year on our efforts to accelerate revenue growth and the acquisitions we completed in the second half of the year will further contribute to this growth and our long-term sustainability. Our year-to-date free cash flow is at a record level and our ability to generate free cash flow remains a cornerstone of our business model. We look forward to a strong finish in 2021. With that, we want to thank you for joining us today, and please stay safe.

Thank you, presenters. Ladies and gentlemen, this concludes today’s conference call. Thank you all for joining. You may now disconnect.