Earnings Call Transcript - KAI Q1 2021

Michael McKenney, Executive Vice President and CFO

Thank you, Ryan. Good morning, everyone, and welcome to Kadant’s First Quarter 2021 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 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’ll 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 Investors section of our website. 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?

Jeff Powell, President and Chief Executive Officer

Thanks, Mike. Hello, everyone. Thank you for joining us this morning to review our first quarter results and discuss our business outlook for 2021. I’ll begin by discussing our operational highlights and our first quarter financial performance. We had a great start to 2021 with high demand for our parts and consumables, which led to record bookings in the first quarter. Our business has executed well and generated strong cash flows, further improving our liquidity position. Capital project activity was robust, and this was especially true in our Industrial Processing 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 flows have us positioned well to capitalize on future growth opportunities. Q1 was an excellent quarter for us with one of the more notable highlights being our record bookings performance, beating the previous record set just last quarter. While we believe our first quarter bookings reflect some amount of pent-up demand, the record-setting start to the year is encouraging. Our Q1 bookings were up 16% compared to the same period last year to $204 million, led by our Industrial Processing segment. Strong demand led to an 11% sequential increase in parts and consumables bookings, which were a new record at $133 million in Q1. Revenue was up 8% compared to the first quarter of 2020, while parts revenue was up 12%. A favorable product mix and solid execution contributed to boosting our adjusted EBITDA margins to 18%, while our free cash flow was up nearly 4 times to $17 million compared to the same period last year. Overall, we benefited from strengthening industrial activity, especially in North America and Europe. Our business has executed well and our global workforce continued to safely meet our customers’ needs despite challenging circumstances in many areas of the world. All 3 of our operating segments experienced increased business activity and improved revenue performance sequentially and year-over-year. Flow Control segment had record bookings in the first quarter with a strong contribution from parts and consumables. Bookings and revenue were both up 12% compared to the same period last year, and parts made up 72% of total revenue in the first quarter. A favorable product mix, combined with improved operating leverage, led to a 21% increase in adjusted EBITDA compared to Q1 of 2020 and an adjusted EBITDA margin of 28%. The strong start to the year is expected to continue through the second quarter with demand moderating as the year progresses as our customers normalize their inventory. We continue to believe market conditions will strengthen as COVID-19 vaccines become more widely available and vaccination rates improve. Our Industrial Processing segment continued to experience strong demand for our wood processing equipment with bookings in this segment up 32% compared to the prior year. Strong end market demand for wood products, particularly OSB and dimensional lumber, continued throughout the quarter as U.S. housing starts surged 37% in March compared to March 2020 and is at the highest level since June of 2006. Revenue in this segment increased 7% to $69 million with parts and consumables leading the growth, up 19% compared to the same period last year. A favorable product mix and good execution led to 150 basis point improvement in our adjusted EBITDA margin. We are seeing increasing activity in the packaging markets. And shortly after the quarter closed, we booked an OCC system order in China for approximately $17 million. This, combined with the record backlog we had at the end of the first quarter, positions us well for the remainder of the year. Moving to our Material Handling segment, we continue to see relatively stable order activity. European markets are beginning to recover and activity in North America, particularly in the food sector, is improving. Altogether, this led to our third consecutive quarter bookings increase in Q1 to $42 million and just shy of beating our record bookings set in the first quarter of 2020. Revenue in the first quarter was up 6% to $40 million, and parts and consumables revenue made up 60% of total revenue. Capital bookings in our Material Handling segment were up slightly compared to the same period last year and are above pre-pandemic levels. Based on our business activity increasing over the last few quarters, we believe our Material Handling segment has solid potential in the secondary material handling and recycling sector, particularly in Europe and in pending infrastructure investments in the U.S. As we look ahead to the second quarter of 2021 and the full year, we are seeing signs of improved project activity and increased ability to visit our customers in certain regions. Our solid balance sheet, combined with strong cash flows, have us well positioned to capitalize on opportunities that may emerge with the improving global economy. We are encouraged to see our customers have learned a new way to conduct business as they deal with the challenges of the pandemic. That said, variability in vaccine distribution and accessibility, combined with surging infection rates in some areas, present a great amount of uncertainty in the global economic recovery and the timing of capital orders.

Michael McKenney, Executive Vice President and CFO

Thank you, Jeff. I’ll start with some key financial metrics from our first quarter. Consolidated gross margins were 43.9% in the first quarter of 2021, up 100 basis points compared to 42.9% in the first quarter of 2020. This increase was due to a higher overall percentage of parts and consumables revenue, which represented 68% of revenue in the first quarter of 2021 compared to 66% in the prior year and higher margins achieved on capital projects. We also had a modest contribution of 20 basis points from government assistance programs. SG&A expenses were $49.4 million in the first quarter of 2021 compared to $45.6 million in the first quarter of 2020 and represented 28.7% of revenue in both periods. There was an unfavorable foreign currency translation effect, which increased SG&A expenses by $1.7 million in the first quarter of 2021; and transactional currency gains, which lowered SG&A expenses by $1.3 million in the first quarter of 2020. Our diluted EPS was $1.43 in the first quarter, up 31% compared to $1.09 in the first quarter of 2020. Adjusted EBITDA increased 14% to $31.1 million or 18% of revenue compared to $27.3 million or 17.1% of revenue in the first quarter of 2020 due to strong performance in our Flow Control segment. Operating cash flow was $19.1 million in the first quarter of 2021 compared to $6.2 million in the first quarter of 2020. Historically, the first quarter has been a weak quarter for operating cash flows. This represents a strong start for 2021 with both operating and free cash flow being our highest first quarter performance. We had several notable nonoperating uses of cash in the first quarter of 2021. Most importantly, despite the first quarter typically being the weakest of the year, we were able to pay down debt by $9.1 million. We also paid $2.3 million for capital expenditures, paid a $2.8 million dividend on our common stock and paid $3.4 million in tax withholding payments related to the vesting of stock awards. Free cash flow was $16.8 million in the first quarter of 2021 compared to $3.5 million in the first quarter of 2020. Let me turn next to our EPS results for the quarter. Both our GAAP and adjusted diluted EPS were $1.43 in the first quarter of 2021 compared to $1.09 in the first quarter of 2020.

Jeff Powell, President and Chief Executive Officer

When we examine our capital, we've noted previously that we have shorter production cycles for some unit capital and longer cycles for the more complex systems. Many of the items booked in the first quarter of this year are expected to be built and shipped within this year. While it will likely happen in the second half of the year, some may get pushed into next year, as is often the case. However, a significant portion of what is booked early in the year typically gets shipped during the calendar year.

Michael McKenney, Executive Vice President and CFO

And I would add to that, Kurt, that's why I expect the fourth quarter to be quite strong.

Jeff Powell, President and Chief Executive Officer

As far as the sustainability, I mean, I think there obviously was very little that happened during most of last year, although we did see a recovery in the fourth quarter of last year, and that’s continued now. I think that there’s a little bit of pent-up demand. There are projects that were going to occur last year that did not happen, which will likely still happen. And then there’s just the normal kind of yearly activity level. So I think this year could be a pretty good year for us on capital projects as they try to recover from the kind of the slow activity level of last year.

Michael McKenney, Executive Vice President and CFO

Yes, I would say that the Flow control segment significantly benefited from the parts and consumables aspect in terms of bookings.

Jeff Powell, President and Chief Executive Officer

Yes. I think a couple of things have happened. Obviously, a lot of our customers ran their inventories down some last year. So you will have some rebuilding of that. But most of our parts and consumables tend to be a function of the operating rates. So as the economies recover around the world and the operating rates start to improve, we would expect to see a kind of return to normal levels of use that tends to go hand-in-hand with the operating rates.

Michael McKenney, Executive Vice President and CFO

Yes, you’re exactly right, Kurt. It’s more of a gross margin challenge. Our operating margins will actually improve. So you’re correct in that assumption. As we progress through the year, we expect to see improvement in our EBITDA margins.

Jeff Powell, President and Chief Executive Officer

We mentioned in the last quarter call that business activity and deal flow have significantly increased. The situation remains similar to before; many deals that were set to go to market last year did not occur, creating a backlog of deals alongside the usual annual deal flow. Our business development team is very active. You are correct that valuations are high and have been for some time, largely due to an abundance of available capital, which has driven valuations upwards. Nevertheless, we have a strong track record of successfully acquiring privately owned companies, where we build relationships that demonstrate our value as custodians of their businesses. We have consistently managed to acquire high-quality companies at fair valuations, and we will continue to pursue this strategy.

Chris Howe, Analyst

Starting off with the guidance, very encouraged by that. You increased it to $710 million to $730 million, perhaps outside potential to get beyond that should a recovery accelerate ahead of expectations. Can you talk about that potential to go above this guidance range? And what are the puts and takes that underlie your confidence in increasing that revenue guidance? More specifically, following up on that, the Material Handling segment, what kind of assumptions or what are you seeing for that business in the current quarter and for the balance of the year?

Jeff Powell, President and Chief Executive Officer

Yes, Chris, this has certainly been a challenging time for forecasting. We have a global presence, and while North America, especially the U.S., is making a good recovery from the pandemic, other regions are still struggling and lagging behind. Our international footprint makes it tough to understand market dynamics for accurate forecasts. Our conservative approach means we are cautious about overpromising. That said, we have raised our expectations following a second quarter of record bookings. Ultimately, our outlook will depend on the strength of economies in the second half of the year. Many economists predict robust growth, particularly if other regions catch up on vaccinations and begin reopening. There is global potential for better business, but currently, there is an unusual amount of uncertainty. While there could be opportunities for growth if economies strengthen, forecasting remains difficult. We’re assessing our current position and applying our usual expectations. Regarding Material Handling, it was significantly affected by shutdowns, as many clients in this sector faced closures and are slowly reopening. We've seen consistent growth in bookings over the last three quarters. As the economy stabilizes and the housing market, a key driver for this segment, remains strong, we expect to benefit. There’s also the possibility of an infrastructure package, which would be advantageous, although the scope and direction of such a package is still uncertain. Overall, we believe this business will remain stable and hopefully grow steadily. Our customers are performing exceptionally well. If you look at their earnings releases, they are earning more than ever before. It's impressive what they are achieving. There is always some variability, as they might place large capital orders in one quarter and then take some time to use that capacity. However, we have a substantial parts and consumables business in that sector, which tends to correlate with operating rates. Currently, operating rates are very high, and they are expected to remain so for the foreseeable future. Therefore, we anticipate that our recurring revenue from that segment, which is quite substantial, will persist. We aim to ensure our customers are successful, as their resources enable them to reinvest in their businesses for improvement, and we are collaborating with them in this effort. We believe we will benefit from this partnership. Ultimately, the primary factor driving us is the operating rates and the associated business. We monitor these factors daily and review them weekly as a management team. Our top priority is ensuring our people are safe and can continue conducting business. We strive to support our clients in the best way possible, although it's challenging due to restrictions in many countries. This morning, I read that India, which is currently facing significant difficulties, may be turning a corner, which was encouraging news. The vaccination rate in Europe is also improving. We’ve been impressed with how economies and our customers are adapting to these challenges and finding new ways to operate. Overall, our bookings are strong, even amid ongoing difficulties in certain regions. Each region presents different circumstances, and we are adjusting our operations accordingly. We anticipate that vaccination rates will increase in most major markets as the year progresses, leading to gradual improvements. However, some areas, particularly India, remain quite challenged. While India is not our largest market, it is important and has significant growth potential for us.

Walter Liptak, Analyst

I wanted to just ask a couple of follow-ups. First, on the discussion about the fourth quarter being the strongest. I wonder if you could go into a little bit more detail about why that is. And knowing that the fourth quarter could be stronger, is there a way of pulling some of the orders into the third quarter, increasing production levels in the third?

Michael McKenney, Executive Vice President and CFO

Yes, I think it really depends on our booking situation. We had strong capital bookings in both the fourth and first quarters, and those will be shipping in the third and fourth quarters, though there's a heavier emphasis on the fourth quarter. Each quarter brings its own dynamics, so it's possible that some orders might be moved into the third quarter or pushed into the first quarter of 2022.

Walter Liptak, Analyst

Okay. All right. Great. And then a follow-up on the gross margin. I wanted to make sure I understood the reason that the gross margin had headwinds. Was that inflation-related?

Jeff Powell, President and Chief Executive Officer

No. No, it’s strictly a function of the mix of the business and where in the first half of the year, the mix is going to be favorable towards parts and consumables; and in the second half, it will be more heavily weighted towards capital. So just a function of mix.

Walter Liptak, Analyst

And I don’t think I heard any discussion about some of the topical things like the inflationary pressures and supply chain. I wonder if your operations are getting hit by some of those issues.

Jeff Powell, President and Chief Executive Officer

Yes. I mean I think everybody is starting to see that, and we’re watching that closely. Of course, with our project activity, we kind of build up our cost project-by-project basis. So you kind of take into account any changes that may be occurring in the materials at the time that you’re quoting the project. On our parts and consumables, which is more of our Flow business, that’s something we watch closely. We work hard to try to contain those, that inflationary impact. And there are times when we have to go back to our customers and say, 'Look, the cost has gone up.' Stainless steel has gone up one-third in the last 12 months. So there are some cost and inflation components that you have to go talk to your customers about. But it’s something that we definitely watch closely and monitor.

Walter Liptak, Analyst

Okay. All right. But it sounds like there’s not going to be any sort of an impact on your gross margin related to inflation or timing of projects related to availability of parts?

Jeff Powell, President and Chief Executive Officer

I don’t think availability will be an issue. We are monitoring costs closely, and our largest expense is metal, which has peaked at the moment. We expect prices to decrease for the rest of the year, but we are keeping a close watch on the situation. While we are observing some increases, our divisions are managing the situation based on their observations. Yes. We currently have a total of six divisions that have either implemented 80/20 or are in the process of implementing it. So far, we are about one-third of the way through the company. We have plans for the next four divisions, with some set to start in the second half of the year. We are working to speed up the implementation, and our senior management is key to this process as they go through the program, apply it in their areas, and then assist with implementation in other divisions. This initiative is gaining momentum, and we are pleased with our progress. We experienced significant early successes, and the new businesses are enthusiastic, leading us to believe we will see favorable outcomes. We are already observing some positive results, and we are committed to taking this initiative globally. Our current focus is on accelerating the implementation process because it is making a meaningful impact, and we are witnessing encouraging results. You’re correct. We don’t have a significant presence in semiconductors. We do utilize PLCs and control systems to manage our equipment, but the expenditure in that area is minimal relative to our overall material purchases. This doesn’t mean we won’t face challenges; we might have to procure items sooner than desired or particular products for certain divisions. However, as of now, I have not received any reports of issues concerning our control systems. As for M&A activity, we're consistently exploring and engaging in discussions with various companies across all sectors. We have a strong interest in the Flow Control sector, and our financials indicate that it is our most profitable area. We're eager to expand our business there. Overall, across all three of our segments, there are promising opportunities we are evaluating. The key challenge lies in acquiring these businesses at sensible valuations. We need to ensure we can add value to our acquisitions. Thus, we continuously assess various businesses to determine how we could enhance their value if they became part of Kadant. Our search spans all areas. We are always engaged in discussions and have been throughout the pandemic. Our business development team is consistently exploring opportunities, which means something could arise at any time. Regarding the lumber business, if you examine our products and technologies, we aim to develop unique technologies that significantly benefit larger operations. For example, we are unlikely to become a turnkey supplier for an entire mill, which involves substantial construction and installation. That does not align with our business model. Instead, we focus on key, high-tech products that enhance the quality and production of a business while also reducing input costs. Ideally, these products also include consumables and spare parts that enhance ongoing support. This approach tends to define our focus. It's an interesting situation. When we look at lumber, it's quite relevant, especially since it reached record prices again yesterday. As you've probably heard from the homebuilding sector, they are significantly impacted by the rising cost of lumber. This situation partly stems from the housing crash of 2008 and 2009. Demand has returned to levels similar to 2006, which were nearly at all-time highs, while production is about 16% lower than it was in 2006. This creates an imbalance, with demand at near-record levels and production capacity significantly behind. Therefore, it's not surprising that demand vastly outpaces supply, causing prices to reach these unprecedented heights. One of two outcomes will likely occur: either demand will decrease, or supply will increase, and I believe we will see both happen. Demand may slightly moderate, and we can expect more production capacity to come online. I recently saw a report forecasting that global oriented strand board (OSB) demand will grow by over 4% annually for the next five years, indicating robust demand for OSB in the coming years. Most housing demand estimates suggest there will also be healthy demand for dimensional lumber. While it may not reach the record levels or prices we're witnessing now, the outlook should remain solid, providing our customers with very profitable opportunities. In some areas, there is certainly a shortage of fiber. Demand for packaging is high, particularly due to the surge in home delivery during the pandemic, which has significantly increased the need for specific packaging types. As a result, prices have adjusted accordingly. I have previously mentioned that the boost in home delivery caused by the pandemic will likely persist in some form because once people become accustomed to home deliveries and set up accounts, they find it convenient and cost-effective. Experts largely agree that this trend will continue after the pandemic, and we are witnessing a lot of activity in packaging to address these requirements. Before wrapping up the call today, I just want to leave you with a few takeaways. First, the health and well-being of our employees remains our top priority as we work through the pandemic. Like our customers, we have learned to work in new ways. As we look ahead and beyond the immediate health crisis, we will continue our focus on meeting our customers’ needs as we seek to accelerate revenue growth in our core markets. Our financial health is excellent, and our liquidity position is stronger today than when the crisis began. Our ability to generate strong free cash flow remains a cornerstone of our business model. And we expect the continuing improvement of the economies around the world, and we look forward to a much stronger 2021. And with that, I want to thank you for joining the call today, and please stay safe.