Kadant Inc (KAI) Q2 2023 Earnings Call Transcript

Thank you, Abigail. Good morning, everyone, and welcome to Kadant's Second Quarter 2023 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 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 December 31, 2022, 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. Reconciliation of the non-GAAP financial measures to the most directly comparable GAAP measures is contained in our second 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, and thank you for joining us this morning to review our second quarter results and discuss our business outlook for the second half of 2023. I'll begin by reviewing our operational highlights for the second quarter. I'm pleased to report, we had another well-executed quarter with solid aftermarket demand for parts, combined with strong capital business, leading to record revenue, record adjusted EBITDA and record adjusted EPS. Our operations teams around the globe continued to deliver exceptional value for our customers and perform at a high level as shown by our strong financial performance. They have done a great job of meeting our customers' needs in a challenging environment, and I want to thank them for their outstanding work and the results they generated. Turning next to Slide 6. I'd like to review our Q2 financial performance. We achieved a number of new financial records in the second quarter driven by large capital shipments along with strong contribution from aftermarket parts. Revenue increased 11% to a record $245 million with solid growth across all regions and all operating segments. Strong execution contributed to a record adjusted EBITDA of $52 million, up 12% compared to last year and representing 21% of revenue in the second quarter. Our adjusted EPS was also a record at $2.54 a share. As economic headwinds strengthen, second quarter bookings declined from the record set in the first quarter of this year. Capital project activity remains healthy, but as the scope of these projects is refined, the execution timeline has, in some cases, been pushed out to a later date. While the general slowdown in industrial activity over the past few months is reflected in our second quarter new order activity, we have a strong backlog and expect bookings in the second half of 2023 to be similar to the second half of last year. I'll provide more details on that when I review our operating segments. Next, I'd like to discuss our three operating segments, beginning with Flow Control. As you can see on Slide 7, our Flow Control segment had solid bookings coming off of a record first quarter in 2023. Revenue in the second quarter increased 12% to a record $96 million with a strong contribution from capital projects. Our aftermarket parts revenue remained robust in the second quarter and made up 68% of total revenue. Excellent operating performance led to record adjusted EBITDA and an adjusted EBITDA margin of 29.3%. Our Flow Control segment's bookings performance in the first half of 2023 provided a good start to the year. We expect business to moderate in the second half, reflecting the overall softening in industrial production. That said, the fundamentals of our end markets remain healthy, and we are well-positioned to capitalize on new projects and opportunities. Our Industrial Processing segment revenue in the second quarter grew 7% compared to the same period last year. Relative to our other operating segments, our Industrial Processing segment was more impacted by foreign currency translation in the second quarter. And when excluding the impact of FX, our revenue was up 9%. Strong operating leverage boosted EBITDA margin 40 basis points to 22.2%. As you can see on Slide 8, our year-over-year bookings comparison is challenging for the second quarter as we had historic demand in the prior year period. The decline in capital business was largely in our wood processing product line, while demand for parts in this segment was comparable to the same period last year. In our Material Handling segment, we achieved our best revenue performance since creating this segment with strong contributions from our bulk material handling equipment, leading to record revenue of $59 million in the quarter. Aftermarket parts demand for our high-performance billing systems, particularly in Europe, was also notable. Bookings in our Material Handling segment were down 19% compared to the same period last year, largely due to reduced capital project activity in our billing product line. The record-setting revenue volume combined with solid execution by our businesses in this segment helped boost adjusted EBITDA margin to a record 22.9% in the quarter. We are encouraged by the number of infrastructure projects already underway and the additional projects being planned since the passage of the infrastructure bill in the U.S. Inquiries for our material handling equipment continue to increase as infrastructure projects gain traction, and we are well-positioned to take advantage of this growing demand. As we look ahead to the second half of 2023, the ongoing economic challenges lead us to believe demand for our products will be similar to that of the second half of last year. Our operations teams around the globe are executing well on their strategic initiatives and making positive strides to create and capture more value. Our robust backlog and ability to generate strong cash flows continue to have 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 2023 revenue and EPS guidance. With that, I'll turn the call over to Mike for a review of our financial performance in Q2 and our guidance outlook for the remainder of the year.

Thank you, Jeff. I'll start with some key financial metrics from our second quarter. Consolidated gross margins were 43.5% in the second quarter of 2023, up 20 basis points compared to 43.3% in the second quarter of 2022. This increase was principally due to higher margins achieved on capital projects, especially in our Industrial Processing segment, offset in part by a lower proportion of parts and consumables revenue, which represented 62% of revenue in the second quarter of 2023 compared to 66% in the prior year. SG&A expenses increased $4.7 million to $60 million in the second quarter of 2023 compared to $55.3 million in the second quarter of 2022 due to wage increases and incremental costs related to trade shows and travel. As a percentage of revenue, SG&A expense decreased to 24.5% in the second quarter 2023 compared to 25% in the prior year period. Our GAAP EPS increased 13% to $2.54 in the second quarter compared to $2.24 in the second quarter of 2022, principally due to higher revenues. Our adjusted EPS was a record $2.54 in the second quarter 2023, exceeding the prior record of $2.40 achieved in the first quarter of 2023. The second quarter 2023 adjusted EPS exceeded the high end of our guidance range by $0.39 due to higher revenue and better gross margins than forecasted. We had record revenue in the second quarter of 2023 driven by our highest quarterly parts and consumable revenue. Both our Material Handling and Industrial Processing segments exceeded their parts and consumables revenue forecast due in part to fulfilling additional orders from backlog. Adjusted EBITDA increased 12% to a record $51.6 million compared to $46 million in the second quarter of 2022 due to strong performance in our Flow Control and Material Handling segments. As a percentage of revenue, adjusted EBITDA was 21% compared to 20.7% in the second quarter 2022. Operating cash flow increased 20% to $22.5 million in the second quarter 2023 compared to $18.8 million in the second quarter of 2022. Free cash flow was up 16% to $13.7 million in the second quarter of 2023 compared to $11.9 million in the second quarter of 2022. We had several notable non-operating uses of cash in the second quarter of 2023. Paid down debt by $25.1 million, paid $8.8 million for capital expenditures and paid a $3.4 million dividend on our common stock. I would also note that $3.1 million of the $8.8 million capital expenditure amount related to the facility project in China. The facility move has started and is expected to be completed in the third quarter, with the remaining capital expenditure of approximately $5 million to be paid over the next two quarters. Let me turn next to our EPS results for the quarter. Our GAAP and adjusted earnings per share were $2.54 in the second quarter of 2023 compared to $2.24 in the second quarter 2022. As shown in the chart, the increase of $0.30 in adjusted EPS in the second quarter 2023 compared to the second quarter 2022 consists of the following: $0.63 due to higher revenue, $0.02 due to a higher gross margin percentage, and $0.01 due to a lower tax rate. These increases were partially offset by $0.30 due to higher operating expenses, $0.05 due to higher interest expense, and $0.01 due to higher weighted average shares outstanding. Collectively, included in all the categories I just mentioned, there was an unfavorable foreign currency translation effect of $0.06 in the second quarter 2023 compared to the second quarter of last year due to the strengthening 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, was 138 at the end of the second quarter 2023 compared to 136 last year. Working capital as a percentage of revenue was 16.7% in the second quarter of 2023 compared to 15.6% last quarter. Our net debt, that is debt less cash, decreased $10 million or 10% sequentially to $87 million. This is the lowest net debt position we've had since 2017. We were able to pay down $25 million revolving credit facility debt in the second quarter of 2023. And as a result, our leverage ratio, calculated in accordance with our credit agreement decreased to 0.51 at the end of the second quarter 2023 from 0.64 at the end of the first quarter of 2023. We have a strong balance sheet and are well-positioned to take advantage of investment opportunities with our current net debt position, current borrowing capacity of $257 million available under our revolving credit facility, and an additional $200 million of uncommitted borrowing capacity. Now I'll update our guidance for 2023. We are increasing our full year revenue guidance to $925 million to $940 million from $910 million to $935 million, and we are increasing our adjusted EPS guidance for the full year to $9.15 to $9.35 from $8.90 to $9.15. The adjusted EPS guidance excludes $0.04 in estimated relocation costs associated with one of our facilities in China. Our revenue guidance for the third quarter of 2023 is $229 million to $236 million, and our adjusted EPS guidance is $2.19 to $2.29, which excludes $0.04 of estimated relocation costs. As always, I'll caution here that there could be some variability in our quarterly results due to several factors including the variability of order flow and the timing of capital shipments. We now anticipate gross margins for 2023 will be 43% to 43.5%. This implies gross margins in the remaining quarters will be slightly below 43% as the mix is expected to be more weighted towards capital in the second half of 2023. As a percentage of revenue, we now anticipate SG&A will be approximately 25%. We continue to anticipate our tax rate for the remaining quarters of 2023 will be approximately 27%, and we now anticipate CapEx spending in 2023 will be approximately $38 million to $40 million, up from $32 million to $34 million as we were able to accelerate some investments originally planned for 2024. Our CapEx, for 2023, CapEx spending includes approximately $9 million related to our facility project in China. That concludes my review of the financials. And I'll now turn the call back over to Abigail for our Q&A session.

Hi, good morning, Mike and Jeff. As a new analyst following the company, could we discuss some of the factors affecting the year-over-year bookings? They seem to have declined quite significantly. Is this mainly due to an economic slowdown, or was last year exceptional in terms of bookings because of a catch-up from the pandemic?

Yes. I believe it's really a mix of two factors. Last year, our bookings reached a record of $266 million, which was impressive, and this year's first quarter saw an increase to $275 million, setting a new record. When analyzing our bookings, some of what we anticipated for the second quarter actually came in during the first quarter, resulting in that strong $275 million figure. However, there is definitely an industrial slowdown occurring. The overall economy shows that the service sector is performing well, while the industrial side is experiencing some decline. Comparing it to last year's record, the outstanding first quarter combined with a slight deceleration in industrial production plays a role. Typically, capital equipment tends to fluctuate, while parts sales are fairly stable and consistent. Therefore, the variations in capital expenditures from one quarter to the next, alongside this slowdown, are significant. It seems that people are adopting a more cautious approach, waiting to see how the Federal Reserve will act. Interest rates have risen, naturally increasing borrowing costs, and these factors all contribute to the overall situation.

Thanks and good morning, Jeff and Mike. As a follow-up on the orders question, could you provide some insight into how much worse orders were compared to your expectations for the quarter? Additionally, what gives you confidence that the second half bookings will meet the levels you mentioned? Do you have a solid pipeline, ongoing conversations, and good visibility on that? That's the first part.

Yes, Larry. The orders aligned with our forecast for the quarter, so there were no disappointments. This was in line with our expectations. As Jeff mentioned, we had an exceptionally strong bookings performance in the first quarter, and we also noted that the second quarter of last year had bookings of $266 million. Additionally, we highlighted that it was a remarkably strong ordering quarter for us, particularly in both periods regarding capital.

Okay. And then the pipeline into the second half that gives you that confidence?

Yes. I think as Jeff said, our parts and consumables business is very stable. We are seeing some softness in the capital bookings front, and that's what people have forecast.

Okay. Now we begin to consider the long term again as we move into the second half, and we're experiencing some low order levels currently. Could you share some high-level insights on what this might indicate for 2024? Is this expected to be a low point, and do you anticipate starting off slowly based on the orders before seeing a resurgence in industrial demand due to initiatives like IIJA and others? Or is it possible to foresee an increase in margin earnings next year because of the 80:20 dynamic and positive pricing? Any overarching considerations on how we might frame next year based on the current order situation would be very helpful.

Yes. As we conclude the second quarter, it is challenging to predict what will occur next year, especially with the Federal Reserve actively trying to control inflation. However, we are encouraged by improved demand in our wood group, as builders are seeing positive trends. Many forest product companies have released strong earnings and express optimism, hoping the sector will recover next year. On our Material Handling side, particularly in bulk equipment handling, we are seeing growth spurred by the infrastructure bill, which is only starting to be implemented. It generally takes time for the government to begin spending. Our customers are anticipating this and making investments in preparation for when the funding starts flowing, but that impact has not yet been felt in the market. Experts suggest the first half of the year may be slow, with a potential uptick in the second half. Some even speculate there could be rate cuts later in the year. While it's uncertain, we believe there will be improvements as the year progresses. For now, we expect a stable finish to this year, likely beginning next year on a flat note, before seeing investments increase as our customers gain more clarity on interest rates and Fed actions. These are unpredictable times due to varying stances of central banks globally, with China focusing on stimulating demand amid disinflation concerns, while Europe sees minimal growth. Overall, we believe conditions should become better as next year unfolds.

Okay, that makes sense, and I appreciate it. It’s clearly challenging to make those decisions at this moment. For my last question, you mentioned the M&A capacity in the balance sheet. At any point, have you considered share repurchases? Are we nearing a stage where we can take actionable steps in M&A, or is it still just a promising pipeline while we wait for the right opportunities to align?

So I would say, Larry, on the share repurchase, yes, we have a $50 million authorization outstanding. We always have an authorization available to utilize. So that is always in the mix for capital deployment. And I would also say, for us currently right now, there is a lot of activity on the M&A front. We're seeing a lot of companies come out. So that is certainly always in play for us also.

Yes. I would say our deal flow, supported by our corporate development group, was unexpectedly weak last year, but it has recovered well this year. There is a significant amount of activity, many discussions, and numerous companies interested in being acquired. Our team is currently very busy seeking out companies that are good strategic fits for us at the right value.

Okay. Thank you very much and good luck.

Hey, good morning, everyone. And filling in for Kurt Yinger today. And just a couple of quick questions for me. So could you give us more color on the backlog? And like how would you characterize it? When does it extend out into the cancellation rate or anything else we should know about it?

We ended the quarter with a backlog of $363 million. This is down from the record backlog of $393 million we had at the end of the first quarter. However, $363 million is still a very high backlog for us, marking our third highest, only surpassed by the first quarter of 2024 and the second quarter of 2022. We have a strong backlog, and regarding cancellations, they are quite rare for us. While they do occur occasionally, a significant portion of our backlog, around 70%, consists of capital projects. Once our customers commit to these projects, they usually do not back away from them. So while cancellations can happen, they are infrequent.

Got it. Got it. Yes, that makes sense. And then you talked about your wood clients. And so when it comes to mill taking downtime over the quarter, how did that trend? And how do you expect that to be going forward, maybe for the full year? Also, if you could talk about it more broadly?

Yes. The first quarter, the mills on the wood side were slow and demand was down, but it surprisingly picked up quite a bit in the second quarter. Prices firmed up. And our parts business was quite strong, which tends to be an indicator of operating rates. So I would say on the wood side, things seem to be improving. Now it's very much a function of interest rates. And I think everybody is trying to adjust to the new rates. But there's almost no kind of used inventory coming on the market. Everybody's locked into these very low-interest-rate loans. They don't want to trade out a 3% mortgage for 7%. And so almost all of the home purchases now are new construction because of that. And so of course, that drives a lot of our customers' demand. So I think if you look at the underlying fundamentals of demand in the housing sector, you look at the millennials, which are going to peak around 2030 as far as prime house buying. And then also, the average age of homes on the 20 to 40 year, which is when major remodeling takes place, that's at a quite high rate, too. So the underlying fundamentals for wood were actually quite good for the next several years. And I think there's been this momentary challenge with the Fed raising rates to try to crush inflation. But as rates start to come down, whether it's middle of next year or the end of next year, I think you're going to see the wood sector come back very strongly because there's just so much underlying demand. And these millennials aren't going to live in their parent's basement forever. They want to get out. And so there's just a lot of demand, and we've underbuilt for 10 years now or more. So I think you're starting to see some improvements now, and we expect that will absolutely continue and will accelerate as soon as rates top out and start to come down some.

Great. Thank you for that. And then just going back to capital allocation from your comments, is it fair to say you're leaning more towards like sticking with the dividend and increasing the dividend relative to M&A?

I would say no, that wouldn't be true. We have a dividend, and although we can't promise, our goal is always to strive to try to increase it every year. So in all likelihood, we'll be continuing with the dividend. However, that really is not impacting our decisions regarding M&A at all.

Okay. Got it. Thank you so much and good luck for the next quarter.

Thank you, Abigail. And before wrapping up the call today, I just want to leave you with a few takeaways. Despite the slowing economies, the second quarter was another record-setting quarter, and our operations teams deserve a lot of credit for producing these results. We have strong market positions and expect stable demand during the second half of the year. And finally, our balance sheet continues to strengthen, and we are actively pursuing new growth opportunities. And with that, I want to thank you for joining the call today, and we look forward to updating you next quarter.

Thank you for your participation in today's conference. This does conclude the program. You may now disconnect.