Kadant Inc Q1 FY2022 Earnings Call

Good day. Thank you for being here. Welcome to the Q1 2022 Kadant Inc. Earnings Conference Call. Please note that today’s program may be recorded. I will now turn the call over to your first speaker today, Michael McKenney, Executive Vice President and Chief Financial Officer. Please go ahead.

Thank you, Peter. Good morning, everyone, and welcome to Kadant's first quarter 2022 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 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 1, 2022 and subsequent filings with the Securities and Exchange Commission. In addition, any forward-looking statements we made 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 refer to some non-GAAP financial measures. These non-GAAP measures are not prepared in accordance with generally accepted accounting principles. A reconciliation of the non-GAAP financial measures to the most directly comparable GAAP measures is contained in our first quarter earnings press release, and the slides presented on the webcast and discussed in the conference call, which are available in the investor 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 refer 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 will 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 first quarter results and discuss our business outlook for 2022. We had an excellent start to 2022 with high demand for our parts and robust capital project activity, which led to record bookings, revenue, and adjusted EBITDA in the first quarter. Business activity was strong in most regions of the world, and new order activity was driven by solid demand across all our operating segments. Capital project activity continued its momentum from last quarter, and this was especially true in our industrial processes segment, which had another great quarterly performance. I'll provide more details on that when I review our operating segments. Overall, our healthy balance sheet and strong cash flow have us positioned well to capitalize on growth opportunities. Before moving on to our Q1 financial performance, I want to comment on the global supply chain and how we are continuing to manage this complex situation. Ongoing constraints throughout the global supply chain have continued to push out expected deliveries of materials and components. These challenges have been further affected by the more recent shutdowns in China, with that country's busiest ports severely limited for an extended period. While our decentralized structure helps us to alleviate these temporary shutdowns and logistical delays, the interconnected global supply chain continues to be a challenge, creating significant work to keep our delivery promises to our customers. Operations teams are proactively managing these issues and working tirelessly to meet our customers’ needs. This resilience is reflected in our first quarter operating results and the solid execution by our businesses. Turning now to slide 6 and our Q1 financial performance. You can see we had a significant increase across these financial metrics compared to Q1 of last year. One of the more notable highlights was our record bookings performance, up 30% compared to last year. Q1 revenue was up 31% compared to the first quarter of 2021 to record $226 million, excluding acquisitions, and the unfavorable impact of FX, revenue was up 22% compared to the same period last year. Our aftermarket parts revenue was up 24% to a record $146 million and made up 65% of Q1 revenue. Improved operating performance led to our adjusted EBITDA margin of 20.2% and record adjusted EBITDA of $46 million. All our operating segments delivered excellent adjusted EBITDA margin performance despite inflationary pressures for materials and ongoing supply chain issues. We generated $3.53 of GAAP diluted EPS, which included a gain on the sale of a building, and our adjusted EPS was up 49% to $2.28. Cash flow in Q1, which is historically a weaker quarter, increased 24% compared to the same period last year to $24 million, while our free cash flow was $21 million. All three of our operating segments experienced increased business activity and delivered solid financial results. I'll review these segments next. Our Flow Control segment achieved its third consecutive increase in quarterly bookings and set a new bookings record at $100 million. This performance was led by strong contributions from aftermarket parts orders and our recent acquisition. Excluding our acquisition and the unfavorable impact of FX, bookings were up 80% compared to the same period last year. Q1 revenue was also a record, up 35% compared to the first quarter of last year, $86 million, while organic revenue, which excludes acquisitions and FX, is up 18%. Improved operating leverage led to a 33% increase in adjusted EBITDA compared to Q1 of 2021, with an adjusted EBITDA margin of 28%. Although we expect to deliver another record-setting performance this year in our flow control segment, the strong start to the year is expected to moderate as the year progresses for several reasons. The first one is seasonality, as the first quarter of the year is historically our strongest quarter in terms of bookings, as our customers prepare for annual spring maintenance shutdowns. Second, strengthening economic headwinds and the Russian-Ukraine conflict lead us to believe business activity in the latter part of the year could moderate. That said, we believe the fundamental drivers of our core end markets remain strong. Turning now to our Industrial Processing segment, we continue to experience strong demand for both capital and parts in the first quarter. Q1 bookings increased 23% compared to the prior year, with robust capital project activity in the recycled packaging and wood processing sectors leading the growth. Revenue in this segment increased 35% to $93 million as our customers continue to experience strong end market demand and maintain high operating rates to meet that demand. Good execution and improved operating leverage led to a 260 basis point improvement in our adjusted EBITDA margin. Our wood processing and packaging customers have been investing at an accelerated pace over the past 18 months to meet customer demand. As more capacity comes online later this year, capital project activity is expected to return to a more balanced level compared to the record-setting pace we've been experiencing. An area where we are seeing growing interest is the application of OSB as a substitute for medium-density fiberboard, also known as MDF, used in furniture. This is particularly evident in China, where a growing number of furniture manufacturers are exploring the use of OSB in furniture production. So far this year, we have booked orders for six stranding systems for producers in China and are in active discussions for several more projects. We currently have nine of our stranders operating in China. And once these six additional machines are up and running, we will have 15 OSB production lines operating in China. This emerging market segment has the potential to develop rapidly once the application has proven successful, and we are encouraged by the activity already this year. In our Material Handling segment, strong demand for our drillers and bulk material handling equipment led to record bookings of $60 million in the first quarter. While this increase benefited from our recent acquisition, organic bookings were up 23%. Demand for high-performance spellers was excellent as box plants and distribution centers continued to invest in their facilities. Revenue increased 20% to $48 million, and parts revenue in the first quarter made up 61% of total revenue. Excluding our acquisition and FX, Q1 revenue was up 4% compared to the relatively strong prior year quarter. Adjusted EBITDA margin increased 230 basis points and is expected to benefit from improved operating performance as the year progresses. As we look ahead to the second quarter of 2022 and the full year, ongoing project activity is healthy and we expect industrial production to maintain its momentum. Our record backlog and ability to generate robust cash flows has us well-positioned to capitalize on opportunities that may emerge as the year unfolds. We expect to deliver record financial performance again this year and are raising our full-year 2022 guidance. Mike will discuss this in more detail. And with that, I'll turn the call over to Mike.

Thank you, Jeff. I'll start with some key financial metrics for our first quarter. Consolidated gross margins were 43.4% in the first quarter of 2022, down 50 basis points compared to 43.9% in the first quarter of 2021. This decrease was due to a lower overall percentage of parts and consumables revenue, which represented 65% of revenue in the first quarter of 2022 compared to 68% in the prior year, partially offset by higher gross margin profile from our acquisitions. SG&A expenses were $59.2 million in the first quarter of 2022, an increase of $9.8 million compared to $49.4 million in the first quarter of 2021. The first quarter of 2022 SG&A includes $6.1 million in SG&A from our acquisitions, $1.3 million of non-recurring non-cash acquisition-related costs, and a $0.9 million favorable effect from foreign currency translation. The remaining increase in SG&A is primarily associated with increased compensation expense related to wages and additional headcount and increased selling costs associated with improved business conditions compared to the first quarter of 2021. As a percentage of revenue, SG&A expenses decreased to 26.1% in the first quarter of 2022 compared to 28.7% in the prior year period. Our diluted EPS was $3.53 in the first quarter, compared to $1.43 in the first quarter of 2021. Our diluted EPS in the first quarter of 2022 includes a $1.30 gain on the sale of one of our Chinese facilities related to a relocation project, $0.04 in acquisition-related costs, and a $0.01 impairment charge. As we outlined in our February earnings call, we reached an agreement with the local government in China to buy our existing facility that supports our stock preparation product line. Over the next two years, we will build and move to a new facility. The final down payment related to the sale of the facility was received from the government, and this agreement became effective in the first quarter, resulting in a $20.2 million pretax gain on sale, or $1.30 per diluted share after tax. We have received a 31% down payment, and the remaining proceeds from the sale of the facility will be due at the earlier of when the government sells the property or within two years of the effective date of the agreement. We currently estimate the CapEx for this project to be approximately $20 million, with most of the CapEx costs being incurred over the next 18 months. The proceeds from selling the facility will pay for the new facility and the relocation costs that will be incurred. Our adjusted diluted EPS was $2.28 in the first quarter of 2022, and exceeded the high end of our guidance range by $0.18 due to higher revenue and a lower tax rate than forecast. The tax rate in the first quarter was 24.4% and included approximately $0.07 of tax benefits related to the divesting of equity awards, and a change in tax reserves associated with uncertain tax positions. In addition, the tax provision included a $0.6 million benefit from the reversal of a tax reserve, which is offset by a corresponding expense in SG&A related to the reversal of an indemnification asset. Excluding these items, our tax rate would have been 27%. Adjusted EBITDA increased 41% to a record $45.8 million compared to $32.4 million in the first quarter of 2021 due to strong performance in all our segments. As a percentage of revenue, adjusted EBITDA increased to 20.2% compared to 18.8% in the first quarter of '21 due to improved performance in our industrial processing and material handling segments. Operating cash flow increased 24% to $23.8 million in the first quarter of 2022 compared to $19.1 million in the first quarter of '21. Historically, the first quarter has been a weak quarter for operating cash flows. This represents a strong start for 2022 with both operating and free cash flow being our highest first-quarter performance. We had several notable non-operating uses of cash in the first quarter of 2022. We paid down debt by $19.2 million, paid $2.9 million for capital expenditures, paid a $2.9 million dividend on our common stock, and paid $4.6 million in tax withholding payments related to divesting of stock awards. Free cash flow increased 24% to $20.9 million in the first quarter of 2022 compared to $16.8 million in the first quarter of '21. Let me turn next to our EPS results for the quarter. In the first quarter of 2022, GAAP diluted earnings per share was $3.53 and adjusted diluted EPS was $2.28. In the first quarter of 2021, GAAP diluted earnings per share was $1.43, and after adding back $0.10 of acquisition costs, adjusted diluted EPS was $1.53. As shown in the chart, the increase of $0.75 and adjusted diluted EPS in the first quarter of 2022 compared to the first quarter of '21 consists of the following: $0.96 due to higher revenue, $0.16 from acquisitions net of interest expense on acquisition borrowings, $0.02 due to lower interest expense, and $0.01 from lower recurring tax rate. These increases were partially offset by $0.26 due to higher operating costs; $0.09 due to a lower gross margin percentage and $0.04 due to government assistance programs in the prior period and $0.01 due to higher weighted average shares outstanding. Collectively included in all the categories I just mentioned was an unfavorable foreign currency translation effect of $0.04 in the first quarter of ‘22 compared to the first quarter of last year due to the strengthening of the US 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 104 at the end of the first quarter 2022 compared to 123 at the end of the first quarter of '21. This decrease was driven by a higher number of days in accounts payable. Working capital as a percentage of revenue was 10.8% in the first quarter of '22, compared to 15.1% in the first quarter of '21. Our net debt, that is debt less cash, decreased $16 million, or 9% sequentially, to $159 million at the end of the first quarter of '22. In the first quarter, we continued our pattern of paying down our debt, and we're able to further lower our leverage ratio calculated in accordance with our credit agreement to 1.16 at the end of the first quarter of '22 compared to 1.34 at the end of '21 and 1.5 at the end of the first quarter of '21. At the end of the first quarter of 2022, we had $170 million of borrowing capacity available under our revolving credit facility, which matures in December of '23. Now let's review our updated guidance for 2022. As a result of our strong start to the year, we are increasing our full-year revenue guidance to $885 million to $905 million from $870 million to $890 million, and we are increasing our adjusted diluted EPS guidance for the full year to $8.80 to $9 from $8.55 to $8.75. The adjusted diluted EPS guidance excludes the $1.30 gain on the sale from the facility in China and the associated $0.01 impairment charge as well as the $0.04 of acquisition-related costs. Our revenue guidance for the second quarter of '22 is $215 million to $220 million and our EPS guidance is $1.86 to $1.96. As always, I will caution here that there could be some choppiness and variability in our quarterly results due to several factors, including the variability of order flow and the timing of capital shipments. In addition, other risks that could impact our guidance include supply chain challenges, strengthening of the US dollar, geopolitical tensions, inflation, and China's zero COVID policy. The 2022 guidance includes an unfavorable foreign currency translation impact of approximately $14 million on revenue and $0.14 on adjusted diluted EPS due to the strengthening of the US dollar. As a result of the increase in revenue guidance, and with the mix moving a little more towards capital, we now anticipate gross margins for 2022 will be close to 43.0%. In addition, as I've mentioned during the Q&A on our last call, we anticipate second-quarter gross margins will be approximately 42.5% as a result of capital gross margins and forecasted revenue in the quarter. As a percentage of revenue, we still anticipate SG&A will be approximately 25% to 25.5% and R&D expense will be approximately 1.5% of revenue. We expect our tax rate for the remaining quarters will be approximately 28% in '22. We continue to expect depreciation and amortization will be approximately $36 million to $37 million. We continue to anticipate regular CapEx spending in 2022 to be approximately 2% of revenue. In addition to that amount, we estimate CapEx related to the China facility relocation project will be approximately $12 million in 2022. That concludes my review of the financials and I will now turn the call back over to the operator for our Q&A session.

And your first question will come from Chris Howe with Barrington Research.

Good morning, Jeff. Good morning, Mike. As it relates to the business outlook for fiscal year ‘22, whether qualitative or quantitative, could you discuss again the different challenges that we're seeing in this environment as it relates to order flow, and the timing of capital shipments, supply chain constraints, foreign currency, geopolitical, and then lastly, the zero COVID policy? Leading off with the zero COVID policy, can you describe what your thoughts are in the region? And what you're hearing from on the ground? Is potential for worsening there as it relates to China in the zero COVID Policy? Or what's the latest on that?

Yes, I know it's very interesting, Chris, because we have, as you know, a very large employee base over there. I don't know what this count is now, but probably over 400 employees. And to our knowledge, we've not had a single employee get COVID. Of course, we're here in the US; the rest may be 60% of the population has contracted COVID. So they have really adhered to pretty strict protocols over there that as soon as an individual tests positive, they get isolated. It's common for them to isolate the town in the region if they have a bit of an outbreak. So it's a challenge. If you think about our supply chain, we may have suppliers that are in a region that is under quarantine for a period of time, which is slowing down the delivery of materials that we need, also affecting workers, be they our workers or workers of our suppliers. If there's an outbreak in your apartment complex, you're quarantined for two to four weeks, they don't leave the complex. So it's fairly draconian relative to the rest of the world. I guess it's been effective if your goal is to have zero COVID infections; well within our employee base, they've achieved that, but you do it at some cost, which is slowing and interruptions within the economy. It's something that is a challenge for us. Our employees so far have done a great job in finding alternative suppliers and working around and through this, trying to stay ahead of our material needs from an inventory management standpoint. But it's just so uncertain; you just don't know where and if an outbreak is going to occur and how that might impact you going forward. So it's probably one of our biggest uncertainties I would say around the world right now is the China COVID policy.

That's very helpful. And then staying along general themes. You mentioned in the industrial processing segment, the transition from OSB to OSB from MDF, as it relates to furniture. You mentioned six stranding systems being put in place, nine existing for a total of 15. How should I rightly think about this long-term opportunity for furniture?

So I would say we're in the somewhat early stages of them evaluating this. We sold our first systems there, I think, around 2013. We've got some subsequent orders from that customer, and now it seems to be getting started again. There was a lot of activity before COVID; then when COVID hit, things got quiet for I would say two years, and then all of a sudden, they started back up again. As is often the case in China, when things get moving, they can go quite quickly. So all of a sudden, the activity level has been quite high with these orders; the six systems that we've booked so far this year came quickly, and some of them actually weren't even in our pipeline; they weren't on our radar. Once the decision is made in China, because they have such a massive manufacturing base, the order flow can potentially be significant. We're encouraged by this activity, and we do think OSB is a better product than MDF. It's wider and steadier, with a lot of advantages. If they were to fully embrace it, and really start to convert a lot over, it could be a fairly significant new market for us.

And my last question, before I hop back into the queue. Mike, you mentioned the Q2 gross margin pressure just based on higher capital orders. There was a change to the revenue guidance to the upside. As we look at the last nine months of the year, any change to the commentary you previously stated on the last conference call as it relates to revenue? First, you mentioned an even split between the first half and the second half, with the strongest quarters being Q2 and Q3 in combination, as well as better operating leverage in the second half. Is that still consistent?

Good question, Chris. Yes, I would say the update on that is now that the second half of the year has really firmed up. When we gave the guidance in February, it was relatively evenly split. But now the second half of the year is stronger. The operating margins, as a result of the better operating leverage, have also improved. So the back half of the year will be stronger than the front half.

Your next question will come from Bobby Eubank with Chevy Chase Trust.

Good morning, guys. Congrats on solid execution in a very challenged environment. I appreciate the conservatism in your commentary. Look, you've talked in the past about your 80:20 pricing; can you walk through what type of inflationary inputs you're seeing and your ability to continue to pass through these extreme raw material increases? Thanks, guys.

Yes, thanks, Bobby. As you know, the 80:20 program looks at your profitability by product and by customer, and you take some pricing action as a result of that. But what we've experienced, what you're alluding to, is that we're in an unusual period for the last 30 or 40 years, where we're seeing significant cost increases on our raw materials. We've always worked hard to try to minimize the cost that we have to pass on to our customers; that's part of our value proposition. Because we manufacture everything from basic raw materials, we don't buy or assemble sub-assemblies, we primarily manufacture. We have a little more control over that than you might have if you're selling a lot of your manufacturing out to others. That being said, we certainly have experienced cost increases and, in many cases, we've had to pass those on to our customers. Our customers are experiencing that across the board. It's a general environment where inflationary pressures are increasing pricing throughout the supply chain. We work hard to minimize the impact of that, but they understand there are instances where the costs have gone up considerably, and we have no other alternative but to pass those costs on to them.

Could you give some high-level commentary around expectations for the material handling segment in the second half of the year and maybe into 2023? We have the infrastructure bill here in the US; of course, the recycling components of that have been very strong, but what about the mining and aggregate side and the outlook there?

Yes. We had a very strong first quarter on that side of the business regarding mining and aggregate. The general sentiment from our operating team there is that there's a sense of optimism. There is the new infrastructure bill, and a lot of money has not been spent yet, but people are preparing for that. They are starting to make investments in their operations to meet the demand when that does occur. With the Russia-Ukraine conflict, a lot of raw materials come from that region, and with the sanctions, we see customers beginning to invest and ramp up production to replace that lost supply chain. Things like potash are raw materials that Russia and Ukraine are major exporters of. As that supply diminishes, the rest of the market has to ramp up production to replace that loss. We're starting to see customers make investments, and we're discussing projects that result from that conflict. So there's a sense of optimism regarding increases in demand over the next few years.

The acquisition pipeline remains healthy; any near-term things we should be expecting?

Well, we're always, as you know, our corporate development team is always very busy looking and talking to as many as sometimes tracking a couple of hundred companies to find ones that are a good strategic fit. We have two fairly high hurdles: one, it has to be a good strategic fit for us, and second, it must be an acquisition that we think we can create value with through the combination of the price we pay and the improvements we might be able to make in the business. These are fairly high hurdles. So a couple of hundred companies quickly funnel down to a much smaller number. That said, our balance sheet is in good shape; we're generating a lot of free cash, and there's a healthy pipeline of opportunities. During the pandemic, things were slow for a year and a half. Some deals came to market that were just sitting there waiting for things to recover. Some companies operate at a high level and want to take advantage of their good performance to sell the business. There's a healthy activity level out there. The challenge for us is always finding something that's a good fit at a reasonable price, but we're working hard on it. We never really slow down that effort; it's a continuous effort.

Makes a lot of sense. Lastly, you mentioned the challenges of operating factories worldwide. Is there any trend between you and your customers regarding evaluating supply chains or near-shoring?

Well, when you get into environments like this, everyone is searching for supplies everywhere in the world, so you get quite flexible in where you're going to get things. Our customers' principal concern right now is ensuring we can meet deliveries. In some cases, we will run higher inventory levels to assure them of supply. In other cases, they're running higher inventory levels themselves to have more parts and consumables available when needed. So, yes, I'd say there's a lot of discussion and activity between us and our customers in environments like this.

Your next question will come from Walter Liptak with Seaport.

Hey, good morning, guys. Great quarter. Let me try a couple of follow-ups. On pricing, it seems like price costs, the inflation, you guys are doing a great job with it. How are you doing your price increases? Because in the industrial landscape, we see all kinds of things, surcharges, annual price increases, periodic or related to projects. I wonder if you could give us some insight into how you're doing it because you're making it look easier than what we've seen from some other companies.

Thanks Wal. We're doing some of the things you mentioned. Our teams are very connected to their input costs. They monitor that closely and are making adjustments accordingly, including the things you just noted: putting in place surcharges, trying to contractually limit the time quotes are available, and putting in place surcharges that will adhere. For us, our parts and consumables turn quite quickly, so they don't sit in backlog very long. The area where we have the most exposure is in capital where we take an order and, even though we've limited the time that the quote is open for, if that order isn't in our backlog for six to nine months, we haven't secured all the components, and we do have some exposure. But our folks are working all the levers. It's quite a dynamic environment, so they are monitoring it closely, continuously.

Yes. And Wal, I might add also that this is where our decentralized structure really helps us. Supply chain issues and inflationary issues differ greatly around the world—South America versus Asia, Europe, and North America. With our decentralized structure, we have all our divisions focusing on this every day based on the local conditions they're experiencing on the ground. So, it's like a force multiplier; a large number of people around the world are focusing on this every day, which makes it more manageable for us.

Okay, great. Thanks for that. Just the last one on those OSB projects out in China, can you give us a ballpark of what the value of one OSB mine would be?

They obviously, as you might imagine, depend on everything they buy with them, but they can often buy two strands at a time. Normally, our orders tend to fall between $2 million and $4 million per OSB order, which tends to be the case. Sometimes it's a little less, depending on the options they're picking up with it.

And I'm showing no further questions at this time. I will now hand it back over to Jeff Powell for closing remarks.

Thanks, Peter. Before wrapping up the call, I just wanted to leave you with a few takeaways. The first quarter was an excellent start to 2022 with high demand for our parts and robust capital project activity which led to record bookings and revenue. Although there are increasing economic and geopolitical headwinds, our employees around the globe continue to focus on meeting our customers’ needs with innovative technologies and solutions that drive sustainable industrial processing and deliver long-term value to our stakeholders. Our financial health is excellent, and our ability to generate strong free cash flow remains a cornerstone of our business model. We look forward to delivering exceptional value for all our stakeholders again in 2022. We want to thank you for joining the call today and please stay safe.

This concludes today's conference call. Thank you for participating. You may now disconnect.