Earnings Call Transcript - KAI Q2 2022

Michael McKenney, Executive Vice President and Chief Financial Officer

Thank you, Kathryn. Good morning, everyone, and welcome to Kadant's second 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 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 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 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 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 will give an overview of our financial results for the quarter, and we will then have a Q&A session. Jeff?

Jeffrey Powell, President and Chief Executive Officer

Thanks Mike. Hello, everyone. Thank you for joining us this morning to review our second quarter results and discuss our business outlook for the second half of 2022. I’ll begin by reviewing our operational highlights for the second quarter. I'm pleased to report we had a solid quarter with strong demand and excellent execution across all our operating segments. This performance led to record adjusted EBITDA and strong earnings in the second quarter. While our aftermarket demand was very healthy, capital project activity was exceptionally strong, leading to bookings that would have been a new record if not for the negative impact from foreign currency translation associated with the strengthening dollar. Mike will discuss the impact of FX in more detail in his comments. Once again, I'd like to thank our operational teams around the globe for continuing to do a fantastic job in managing our businesses and ensuring that our products get to our customers when needed despite the supply chain disruptions. They've done a great job of meeting our customers' needs in a very challenging environment. Turning now to Slide 6, I'd like to review our Q2 financial performance. Our top line performance was supported by excellent aftermarket demand and capital order shipments, leading to revenue increase of 13% compared to the same period last year. Aftermarket parts revenue was up 17% and represented 66% of our Q2 revenue. Solid execution contributed to our adjusted EBITDA margin of 20.7% and adjusted EPS of $2.24, up 11% compared to Q2 of last year. We continue to benefit from strong demand in Q2, especially in North America and Europe. Bookings were up 25% to $266 million, with a solid contribution from our Material Handling segment, which benefited from our recent acquisition and robust demand for our bulk material handling products. As you know, we typically manufacture and sell in the same currency. This quarter, our bookings were significantly affected by currency translation and reduced our reported bookings by $10 million. Excluding acquisitions and the impact of FX, bookings were up 17% compared to the same period last year and reflect the ongoing demand from our customers. Next, I'd like to discuss our three operating segments, beginning with our Flow Control. Our Flow Control segment had excellent bookings and revenue in the second quarter, up 36% and 20% respectively, compared to the same period last year. Our aftermarket parts revenue was a record and made up 73% of total revenue in the second quarter. Improved operating leverage led to a record adjusted EBITDA and an adjusted EBITDA margin of 29.3%. Our Flow Control segment's record-setting bookings performance in the first half of the year is expected to moderate some in the second half. However, with our record backlog, we expect a strong second half of the year. Moving to our Industrial Processing segment, we continue to experience healthy demand with bookings in this segment up 8% to $110 million. Excluding the negative impact of FX, bookings were up 12%. New orders for our wood processing and recycled fiber systems in North America led the increase in bookings in the second quarter. Revenue in this segment increased 2% to $84 million and was affected by an unfavorable foreign currency translation. Excluding the impact of FX, revenue growth was 6% compared to the same period last year. Our adjusted EBITDA margin declined 320 basis points to 21.8% due largely to lower gross margins on capital sales in the second quarter, as anticipated, and the prior period including government assistance programs for COVID relief. Incremental price programs have offset inflationary costs and allowed us to maintain gross margin parity in our aftermarket parts business. We ended the quarter with another record backlog, and this positions us well for the remainder of the year. Like our Flow Control segment, we are expecting a slowdown in bookings in the back half of the year. In our Material Handling segment, we had record demand for aftermarket parts and solid top and bottom line contribution from our recent acquisition. Revenue in the second quarter was up 23% to $52 million and aftermarket parts revenue made up 56% of total revenue. Capital bookings in our Material Handling segment were up 93% compared to the same period last year due largely to contributions from our recent acquisition. Excluding acquisitions and the negative impact of FX, bookings were up 24%. Solid execution by our business in this segment helped boost adjusted EBITDA by 42% and adjusted EBITDA margin by 300 basis points. Capital project activity remains at a good level, yet we expect a moderation in demand, particularly in our European baler business as the second half of the year unfolds. As we look ahead to the second half of 2022, we continue to see good levels of project activity despite the ongoing macroeconomic challenges. Though as I mentioned, we do expect industrial demand to moderate to a more balanced level compared to the record levels we've experienced in the recent quarters as consumer demand slows in response to actions taken by central banks to control inflation. Our record backlog and ability to generate robust cash flow continue to have us well positioned to capitalize on opportunities that may emerge as the year unfolds, and we expect to deliver record financial performance again this year.

Michael McKenney, Executive Vice President and Chief Financial Officer

Thank you, Jeff. I'll start with some key financial metrics from our second quarter. Consolidated gross margins were 43.3% in the second quarter of 2022 compared to 43.6% in the same quarter of 2021, which included COVID government assistance benefits of 30 basis points. Parts and consumables revenue accounted for 66% of total revenue in the second quarter of '22, up from 64% in the previous year. SG&A expenses totaled $55.3 million in the second quarter of '22, an increase of $6 million from $49.3 million in the second quarter of '21. The SG&A in the second quarter of 2022 included $5 million from our acquisitions and a $2.1 million favorable effect from foreign currency translation. SG&A in the second quarter of '21 was $1 million lower due to government assistance programs. As a percentage of revenue, SG&A expenses decreased to 25% in the second quarter of '22 from 25.2% in the same period last year. Our diluted EPS was $2.24 in the second quarter compared to $1.96 in the second quarter of '21. The diluted EPS for the second quarter of '21 included $0.05 in acquisition costs. The second quarter '22 diluted EPS surpassed the upper end of our guidance by $0.28 due to higher revenues, improved gross margins, and lower SG&A than anticipated. Adjusted EBITDA rose 11% to a record $46 million compared to $41.3 million in the second quarter of '21 because of strong performance in our Flow Control and Material Handling segments. Adjusted EBITDA as a percentage of revenue was 20.7%, down from 21.1% in the second quarter of '21. Operating cash flow was $18.8 million in the second quarter of '22 versus $44.4 million in the second quarter of '21. Free cash flow was $11.9 million in the second quarter of '22 compared to $42.3 million in the second quarter of '21. The declines in operating and free cash flow were primarily due to a $17.7 million increase in working capital in the second quarter of '22 compared to an $11.8 million decrease in the same period last year, representing a change of $29.5 million. The increase in working capital was mainly driven by higher inventory levels to support sales in the second half of '22 and increased accounts receivable. We had several significant nonoperating uses of cash in the second quarter of '22, including $15.3 million paid down on debt, $6.9 million for capital expenditures, and a $3 million dividend on our common stock. I would note that $3.1 million of the $6.9 million in capital expenditures was related to the facility project in China that we announced at the beginning of the year and discussed on the last call. As I previously mentioned regarding this project, proceeds from selling the old facility to the local government will cover the costs of the new facility. Now, turning to our EPS results for the quarter, both our GAAP and adjusted diluted earnings per share in the second quarter of '22 were $2.24. In the second quarter of '21, GAAP diluted earnings per share were $1.96, and after adding back $0.05 for acquisition costs, adjusted diluted EPS was $2.01. The $0.23 increase in adjusted diluted EPS in the second quarter of '22 compared to the same quarter of '21 can be broken down into: $0.20 from acquisitions, net of interest expenses on acquisition borrowings; $0.16 due to higher revenue; and $0.02 from lower interest expenses. These were partially offset by $0.10 due to government assistance in the prior year, $0.04 from higher operating costs, and $0.01 from a lower gross margin percentage. Overall, there was an unfavorable foreign currency translation effect of $0.11 in the second quarter '22 compared to the same quarter last year as a result of the strengthening of the U.S. dollar. Reviewing our liquidity metrics, our cash conversion days, calculated as days in receivables plus days in inventory minus days in accounts payable, was 123 at the end of the second quarter of '22 compared to 109 at the end of the second quarter of '21. Working capital as a percentage of revenue was 12.4% in the second quarter of '22 versus 12.7% in the prior year. Our net debt, defined as debt less cash, decreased by $9 million or 5% sequentially to $150 million. Our leverage ratio, calculated according to our credit agreement, was 1.05 at the end of the second quarter of '22, down from 1.16 at the end of the first quarter of '22. Now moving to our guidance for '22, we are raising the lower end of our full year revenue guidance to $890 million to $905 million, revised from $885 million to $905 million. We are maintaining our adjusted diluted EPS guidance for the full year at $8.80 to $9. I should note that we could have raised our guidance for the year but for the significant strengthening of the U.S. dollar, especially against the euro, during the second quarter. The adjusted diluted EPS guidance excludes the $1.30 gain on the sale of the facility in China and the related $0.01 impairment charge, as well as $0.04 in acquisition-related costs. Our revenue guidance for the third quarter of '22 is $211 million to $218 million, and our EPS guidance is $1.99 to $2.09. I want to caution that there could be variability in our quarterly results due to several factors, including fluctuations in order flow and the timing of capital shipments. Additionally, risks that could impact our guidance include supply chain challenges, a stronger U.S. dollar, geopolitical tensions, inflation, and China's Zero-COVID policy. The continued strengthening of the U.S. dollar in the second quarter significantly affected our forecasts. The '22 guidance includes a negative foreign currency translation impact of approximately $45 million on revenue compared to 2021, which is an additional decrease of $31 million compared to our April forecast. Our adjusted diluted EPS guidance takes into account a negative foreign currency translation effect of $0.49 compared to 2021, which represents an added decrease of $0.35 compared to our April estimate. With the mix shifting more towards capital in the latter half of the year, we now expect full year '22 gross margins to be in the range of 42.5% to 43%. This suggests gross margins in the third and fourth quarters will be approximately 100 to 200 basis points lower than in the first half of the year. Consequently, as a percentage of revenue, we now anticipate SG&A will be around 24.5% to 25%, reduced from our earlier guidance of 25% to 25.5%. We also expect R&D expenses to be about 1.5% of revenue. Our tax rate for the remaining quarters is projected to be around 28%. Lastly, we now anticipate depreciation and amortization to be about $34 million to $35 million for '22. That concludes my review of the financials, and I will now turn the call back over to the operator for our Q&A session.

Christopher Howe, Analyst

Good morning, Jeff, good morning Mike.

Jeffrey Powell, President and Chief Executive Officer

Good morning Chris.

Christopher Howe, Analyst

Good morning. Thanks for taking my questions. First one here for Mike, as we look at the revenue guidance taking up the lower end of guidance in the $211 million to $218 million for the third quarter, I think at the midpoint, that would imply about $235 million in the fourth quarter for revenue. Can you just talk about the revenue dynamics here in the second half? I think we were all expecting a little bit more revenue in the third quarter than the $211 million to $218 million, so more has pushed to the fourth quarter.

Michael McKenney, Executive Vice President and Chief Financial Officer

Well, Chris, one thing I want to highlight is what I mentioned at the end of my discussion. From the April iteration to the July iteration, we experienced a loss of $31 million in revenue due to translation, with a significant portion occurring in the third and fourth quarters. So we're taking a hit solely from translation, and I believe that's the aspect you might be overlooking.

Christopher Howe, Analyst

Okay. That makes sense. If we look at parts and consumables, it's been acknowledged that there is a greater ability to pass through price due to the shorter-cycle nature. Can you clarify the difference in margin between parts and consumables versus capital equipment as it currently stands? Additionally, how do you see both segments, parts and consumables and capital equipment, in relation to inflation pressures? I understand that you're mostly caught up on the parts and consumables side, but how is capital equipment performing today?

Michael McKenney, Executive Vice President and Chief Financial Officer

Well, Chris, as you know, we don't disclose the specific figures for parts and consumables versus capital. However, I often explain to people that if you examine our gross margin profile, like the 43.3% recorded in the first half of the year, plotting a bell curve around that with a 15-point range on either side would encompass most of our transactions. Typically, capital tends to fall on the lower end of that range. That's the picture I try to convey regarding gross margin. Regarding our position on parts, consumables, and capital, you're correct. We've been able to make adjustments in parts and consumables more swiftly. Capital carries the risk of remaining in our backlog for extended periods—be it 3 months, 6 months, 9 months, or even a year. Overall, capital represents our most significant exposure in gross margin. Our team is working to negotiate material surcharges and is reducing the validity period for quotes. They are also taking commodity projections into account when pricing. I believe our team has performed exceptionally well in maintaining our margin profile concerning capital. So far, things are looking good.

Christopher Howe, Analyst

Okay. And then actually led me to another question, as far as the mix of backlog on capital equipment, you're having some success in peeling away the portion of capital that's been sitting in backlog for a longer period. Or kind of how do you stand on getting more towards newer pricing?

Michael McKenney, Executive Vice President and Chief Financial Officer

The orders currently in backlog, apart from those with surcharges, have fixed pricing. The focus now is on anticipating future commodity costs and factoring that into decisions.

Kurt Yinger, Analyst

Good morning Kurt.

Jeffrey Powell, President and Chief Executive Officer

Yes, we can hear you.

Kurt Yinger, Analyst

It sounds like you anticipate some decline in booking activities for the second half. Based on your discussions with customers, do you think this is just a natural moderation after two strong years, or have you noticed a significant reduction in plans regarding capital activity due to the recent changes in the macro environment?

Jeffrey Powell, President and Chief Executive Officer

Yes, Kurt, as you mentioned, we’ve experienced exceptionally strong bookings over the last four quarters. Typically, during such strong buying cycles, customers need to install the equipment and optimize it, which introduces some cyclicality to these cycles. We've had an incredible run recently. Overall, our discussions indicate that activity levels remain robust. However, we must acknowledge that the Federal Reserve has indicated plans to slow things down. We tend to approach this with caution and take their statements seriously regarding intentions to dampen economic activity, which we've incorporated into our planning and forecasts. Generally speaking, when we communicate with our divisions, activity remains busy. Yet past experience suggests that with demand at $266 million—effectively $276 million if not for currency issues—we can expect a slight moderation as customers begin to take delivery and install the equipment.

Kurt Yinger, Analyst

Right, okay. And I mean, that comment kind of gets to my next question. And as you discussed, I mean, since the financial crisis, there's been kind of this rinse-and-repeat pattern of two years of elevated organic growth and then kind of a digestion phase. But I guess as you look at the markets you serve, and you've done several acquisitions, and some of the different drivers there between e-commerce and packaging and just the underbuilt nature of the housing market, is there anything different, looking forward, that might help smooth some of that cyclicality notwithstanding the macro environment?

Jeffrey Powell, President and Chief Executive Officer

We have put in significant effort over the past decade to enhance our geographic reach and the variety of markets we serve, which has certainly benefited us compared to ten years ago. For example, our bulk material handling business has recently seen record bookings. Although the infrastructure bill is not yet being fully utilized, our customers are preparing for expected activity related to it. This preparation helps us mitigate the impact of a potential slowdown in one sector by having another sector with rising demand ready to meet new customer needs. Our bookings and activity levels in China are currently strong, reflecting good geographical diversification, which will serve us well unless we face a global downturn. Additionally, we are in advantageous markets, and the ongoing shift towards sustainable materials is encouraging for us. Overall, while there may be some cyclicality linked to economic conditions, the long-term trends remain very favorable.

Kurt Yinger, Analyst

Got it. Okay, that's helpful. And then just my last question, I mean, at a high level and when you put it all together, it sounds like things are still pretty good from a demand perspective. But are there any specific customer sets or geographies that you've grown kind of increasingly cautious on over the last couple of months?

Jeffrey Powell, President and Chief Executive Officer

You can see the bookings across different segments have increased, indicating strong demand everywhere. The primary concern would be a specific event, like a significant COVID outbreak in China leading to regional shutdowns, which could impact us. That scenario represents a major risk if towns where we operate face a sizable COVID outbreak and the government enforces their Zero-COVID policy with lockdowns lasting two to four weeks. However, overall, our businesses are experiencing solid demand globally at this time.

Kurt Yinger, Analyst

Got it. Okay, well I appreciate all the color and I’ll turn it over, thank you.

Walter Liptak, Analyst

Hi, thanks, good morning guys.

Jeffrey Powell, President and Chief Executive Officer

Hey, Walter.

Michael McKenney, Executive Vice President and Chief Financial Officer

Good morning, Walter.

Walter Liptak, Analyst

I wanted to follow up on the previous question, focusing specifically on the industrial process, as that may be where the greatest risk lies regarding changes in monetary policy. When discussing the slowdown in orders for the latter half of the year, are you referring to some of the companies related to wood products, such as those producing lumber and OSB for the housing market?

Jeffrey Powell, President and Chief Executive Officer

Certainly. The housing market, which had around 1.8 million starts in the first few months of this year, has now moderated to approximately 1.55 million to 1.6 million in the last couple of months, which is still a healthy level. Our customers are likely to stay very busy and satisfied at the 1.6 million start level, though they were operating at a higher capacity of 1.8 million. They have invested significantly in upgrading their facilities and bringing new ones online. At some point, their focus shifts to ensuring these facilities are operational and efficient. This could contribute to a slight slowdown in the buying cycle. Additionally, as interest rates and mortgage rates rise, and the Federal Reserve attempts to slow the economy, the housing market often feels the impact. However, the underlying demand for housing remains very strong, and the gap between demand and starts is still widening. While we appreciate the fundamentals, we anticipate some moderation in the next couple of quarters due to these factors.

Walter Liptak, Analyst

Okay, great. I was thinking about the pricing and what you guys were talking about earlier. The industrial metals prices, some of them have started coming down. And I don't know if that flows through to you guys, if it's a second half benefit or if there could be a benefit from lower materials costs in 2023.

Jeffrey Powell, President and Chief Executive Officer

Certainly, metals, especially stainless steel, represent one of our largest costs, and we monitor that on a weekly basis. It has indeed decreased over the past few months. However, I want to emphasize that it is currently twice the price it was in August 2020 when stainless steel 316 was approximately $1.50 and now it's around $3. While we do expect prices to continue to decline, it's important to note that all commodities are beginning to decrease in price, which is advantageous for us and will provide benefits moving forward.

Walter Liptak, Analyst

Okay. That sounds great. And you talked about China, and it sounded to me like China is reopening after the COVID lockdowns. Is that correct? Because there's also mixed things in the news, too, that COVID is starting to spike again. There have been some other shutdowns. What's been your experience?

Jeffrey Powell, President and Chief Executive Officer

China is still following the Zero-COVID policy, and experts anticipate it will remain in place at least until November, coinciding with their governmental conference where President Xi is expected to be re-elected for a third term. They seem unlikely to risk a significant outbreak prior to that. We hope there may be some adjustments after the conference later this year. Currently, whenever an outbreak occurs in a region, they implement a lockdown in that area. Our subcontractors and suppliers have felt the effects of this, but our plants have not experienced severe disruptions so far. However, when outbreaks occur, regions may be locked down for two to four weeks based on the outbreak's severity. We remain concerned that if an outbreak were to happen near our facilities in Jining or Wuxi, there could be a temporary lockdown that would impact us.

Walter Liptak, Analyst

Okay, great. Mike, during your prepared remarks, you mentioned some disclaimers about the timing of capital shipments potentially being affected by Zero-COVID and supply chain issues. Was this always part of your guidance, or are you indicating that there could be timing challenges with some of the larger shipments in the latter half of the year?

Michael McKenney, Executive Vice President and Chief Financial Officer

Both, Walt. No, that's always there. So that's a repeat of a standard caution, so it's not new.

Jeffrey Powell, President and Chief Executive Officer

I call that the McKenney Safe Harbor that he always puts in his comments.

Bobby Eubank, Analyst

Good morning, guys. Following up on Kurt's question, particularly around U.S. housing and the Industrial Processing segment, you are not going to give longer-term guidance, but maybe if you just think about the market and existing OSB equipment that's out there debarking, where do you feel like you are in kind of maybe a total addressable market, age of the fleet, things like that? Is equipment from the prior housing cycle, is that coming up on replacement? How do you just think about longer-term, how much structural demand in that segment? And I have a follow-up, thank you.

Jeffrey Powell, President and Chief Executive Officer

Yes, there are several factors that influence that market. One key factor is the age of the equipment, which our team analyzed and found to be quite old. This indicates that there will likely be a strong demand for equipment replacement. Additionally, we're seeing an increase in the use of wood in construction, particularly in Europe as they work towards their climate goals. Traditionally, homes were built using concrete blocks, which are significant greenhouse gas emitters. However, construction is gradually shifting towards more wood-based materials. In North America, wood has always been a primary building material, but this shift is notable in Europe. Furthermore, the demand is being fueled by millennials, who are now entering the housing market. I have two daughters, one who just bought a house and another who built one the previous year, and many parents like me are witnessing their children in this generation starting to buy homes. The trend of more people working from home is also affecting housing demands. Many individuals are finding that their current homes no longer meet their needs due to this shift. As a result, a portion of the population is reevaluating their housing requirements to adapt to the new work-from-home reality, which is not just happening in the U.S., but globally as well. Overall, the housing industry shows strong metrics, and numerous consultants predict continued demand for the next decade, especially since we have been underbuilding since the 2008-2009 crisis. This ongoing demand gap is further intensified by millennials entering the housing market. So, we believe that the age of equipment, the transition in materials used, and increased demand driven by demographics are all positive indicators for the industry.

Bobby Eubank, Analyst

Thanks, and I hope your daughter was able to secure a rate lock. You mentioned in the presentation that high energy prices and CO2 reduction targets in Europe are driving capital project activity in the region. I found that comment quite interesting, as it seems a bit more qualitative than what you usually include in the presentation. Could you elaborate on that and share what you're observing, as well as any thoughts on its durability?

Jeffrey Powell, President and Chief Executive Officer

Sure. As you know, energy costs have risen significantly in Europe, particularly due to many countries' reliance on Russia. The ongoing Russia-Ukraine conflict has put those supplies at risk. Consequently, the cost and availability of energy have led to a greater incentive to install more efficient processing equipment. We're seeing that countries facing energy prices that are double what they used to pay and concerns about future energy availability are actively working to lessen their dependency on it. This situation is advantageous for us since most of our technology offers higher output with lower input. This means we help reduce their consumption of electricity, steam, or natural gas while maintaining the same output. Therefore, projects are easier to justify, and there's a greater return on investment given the elevated energy prices.

Bobby Eubank, Analyst

Thanks, good luck in the second half.

Jeffrey Powell, President and Chief Executive Officer

Thank you. Thank you, Bobby.

Michael McKenney, Executive Vice President and Chief Financial Officer

Thank you, operator.

Jeffrey Powell, President and Chief Executive Officer

Before wrapping up the call today, I just want to leave you with a few takeaways. Second quarter was, in many ways, a continuation of our first quarter, where we saw strong demand for our products and technologies and robust capital project activity. While consumers, industry and governments are dealing with high inflation, our end markets remain well positioned to weather an economic slowdown, and our business fundamentals remain strong. We'll continue to focus on solutions that drive sustainable industrial processing, and we look forward to delivering exceptional value to our stakeholders again in 2022. With that, I want to thank you for joining us today, and we look forward to updating you again next quarter.

Operator, Operator

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