Earnings Call Transcript - KAI Q3 2020

Operator, Operator

Ladies and gentlemen, thank you for standing by, and welcome to the Third Quarter 2020 Kadant Inc. Earnings Conference Call. At this time, all participants are in a listen-only mode. After the speakers’ presentation, there will be a question-and-answer session. Please follow the operator's instructions. I would now like to hand the conference over to your first speaker for today, Mr. Michael McKenney, Chief Financial Officer. Thank you. Please go ahead.

Michael McKenney, CFO

Thank you, Anne. Good morning, everyone, and welcome to Kadant’s third quarter earnings call. With me on the call today is Jeff Powell, our President and Chief Executive Officer. Before we begin, let me read our Safe Harbor statement. Various remarks that we may make today about Kadant’s future plans and expectations, financial and operating results, and prospects are forward-looking statements for 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 December 28, 2019, 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 third quarter earnings press release and the slides presented on the webcast and discussed in the conference call, which are available in the Investors section of our website. Finally, I want to note that when we refer to GAAP earnings per share or EPS or adjusted EPS on this call, we are referring to each of these measures as calculated on a diluted basis. With that, I will 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, CEO

Thanks, Mike. Hello, everyone. Thank you for joining us this morning to review our third quarter results and discuss our outlook for the remainder of the year. Since our last earnings call, the world has continued to be impacted by the COVID pandemic and the increasing number of cases in Europe and the U.S. has continued to create depressed economic activity and uncertainty around the world. I’ll begin by discussing how this impacted our operations and our third quarter financial results. The effects of the global pandemic made the third quarter another challenging quarter in terms of predicting demand and overall business levels. As we continue to work under advanced safety protocols, I remain proud of our dedicated employees around the world for the work they have done and continue to do to serve our customers. We had solid execution by our businesses in the third quarter along with various cost containment measures, which contributed to our strong margin performance. We also benefited from government employee retention assistance, which allowed us to maintain our talented workforce despite the lower business levels during the quarter. Our balance sheet remains healthy and our liquidity position is solid. Robust cash flows have always been the strength of Kadant, and we expect this will continue as economies begin to recover. Turning now to our Q3 performance, we had better-than-expected EPS results due to our Industrial Processing and Flow Control segments. This was further enhanced by government employee retention assistance, contributing to our solid adjusted EPS of $1.31 a share. Our adjusted EBITDA margin was excellent at 19.4%, and our cash flow was strong at $24 million. Our parts and consumable revenue made up 66% of the total revenue. On a sequential basis, parts revenue was up 6% to $103 million in the third quarter. As many of you know, growing our parts and consumable business is a key strategic focus. Overall, the quarter was better than expected, and I’m really pleased with how our employees performed to deliver these solid operating results. Next, I would like to review our performance in our three operating segments. While our Flow Control segment performed better than expected during the quarter, we continue to face a challenging market environment with industrial production weakening as the quarter progressed. Product mix, improved operating leverage, and solid execution led to a strong adjusted EBITDA margin of 27.5% for the third quarter, up 70 basis points from the same period last year. Although demand for aftermarket parts was solid and made up 69% of total revenue in the quarter, customer delays in capital project execution and the inability of our employees to engage face-to-face with customers and prospects due to the pandemic suppressed our bookings performance. Looking ahead to the fourth quarter, we expect Q4 to show improvement in terms of both capital project bookings and demand for parts and consumables. Turning now to our Industrial Processing segment. We experienced strong demand for our wood processing equipment, with bookings at their highest level since our record-setting 2018. This demand was driven by a robust U.S. housing market and continued strong demand for wood-based products. Revenue in this segment declined 16% to $62 million year-over-year and down 5% sequentially. This decline was largely due to a slowdown in capital business during the quarter in certain end markets, particularly in paper and packaging. Parts and consumables revenue, on the other hand, was solid and made up 68% of total revenue in the third quarter. Encouragingly, U.S. housing starts continue to show strength and were $1.4 million in September, up 11% compared to the same period last year, which benefits our customers producing OSB and dimensional lumber. We are experiencing an increase in capital project activity and expect capital bookings to strengthen significantly in the fourth quarter. Just last week, for example, we received a large order for a turnkey recycled stock preparation system from a container board producer in the U.S. with a value of approximately $11 million and expect to receive additional capital orders as the quarter progresses. In our Material Handling segment, we saw improved project activity and increased demand for aftermarket parts in Q3 versus Q2. Parts and consumables revenue in the third quarter made up 60% of total revenue, but it's still below historical run rates. Capital bookings in our Material Handling segment increased 34% sequentially, led by increased demand for our billers used in agricultural and waste processing applications. While this increase was coming from a weak prior quarter, we are encouraged to see our customers showing increased confidence in their economic outlook by awarding these larger capital purchases. As in our other segments, we’re seeing increased market activity, albeit still not on pace with prior years. Looking beyond 2020, we continue to believe this segment has upside potential in its aggregates and food end markets as economies continue to recover from the pandemic. As we look ahead to the final quarter of 2020, we are seeing signs of increased project activity in a number of end markets, particularly in our Industrial Processing segment with capital equipment expected to make up a larger portion of our product mix in Q4. We expect to show solid improvements in bookings compared to Q3. As was the case in the second and third quarters of this year, the uncertainty caused by the pandemic limits our ability to forecast the timing of orders. As a result, we will not be providing guidance for Q4. I would now like to pass the call over to Mike for a review of our Q3 performance. Mike?

Michael McKenney, CFO

Thank you, Jeff. I’ll start with some key financial metrics from our third quarter. Our GAAP diluted EPS was $1.28 in the third quarter, down 9% compared to $1.41 in the third quarter of 2019. Our GAAP diluted EPS in the third quarter includes $0.03 of restructuring costs, $0.03 from a discrete tax benefit, $0.02 of acquired backlog amortization, and $0.01 of acquisition costs. In addition, our third quarter results included pretax income of $2.7 million or $0.18 net of tax attributable to government employee retention assistance programs related to the pandemic. These government assistance benefits were received by many of our subsidiaries around the world and enabled us to retain employees during the past two quarters. As our business continues to strengthen, we expect this benefit to decrease significantly in the fourth quarter. Consolidated gross margins were 44.2% in the third quarter of 2020, up 140 basis points compared to 42.8% in the third quarter of 2019. Approximately 110 basis points of this increase was due to the receipt of government assistance benefits related to the pandemic. The remaining 30 basis points improvement is principally due to better product mix related to a higher percentage of parts and consumables. Parts and consumables as a percentage of revenue increased to 66% in the third quarter of 2020, compared to 61% last year. SG&A expenses were $43.9 million or 28.4% of revenue in the third quarter of 2020 compared to $47.1 million or 27.1% of revenue in the third quarter of 2019. The $3.2 million decrease in SG&A expense was principally due to reduced selling and travel-related expenses and a $1 million benefit from government assistance programs. Adjusted EBITDA decreased to $30 million or 19.4% of revenue compared to $32.3 million or 18.6% of revenue in the third quarter of 2019. On a sequential basis, adjusted EBITDA increased 13%, due to increased profitability in our Flow Control and Industrial Processing segments. Operating cash flows were $24.4 million in the third quarter of 2020, which included a modest negative impact of $0.8 million from working capital compared to operating cash flows of $25.7 million in the third quarter of 2019. On a sequential basis, operating cash flows increased 11%. We had several notable non-operating uses of cash in the third quarter of 2020. We repaid $25.5 million of debt, paid a $2.8 million dividend on our common stock, and paid $1.8 million for capital expenditures. Free cash flow increased 7% sequentially to $22.6 million in the third quarter of 2020. Free cash flow decreased 4% compared to $23.6 million in the third quarter of 2019. Let me turn next to our EPS results for the quarter. In the third quarter of 2020 GAAP diluted EPS was $1.28 and our adjusted diluted EPS was $1.31. In comparison, in the third quarter of 2019, our GAAP diluted EPS was $1.41 and our adjusted diluted EPS was $1.38, which included a $0.02 discrete tax benefit. The decrease of $0.07 in adjusted diluted EPS in the third quarter of 2020 compared to the third quarter of 2019 consists of the following: $0.55 due to lower revenue, $0.01 due to higher weighted average shares outstanding. These decreases were partially offset by $0.18 due to government assistance programs, $0.17 due to lower operating costs, $0.10 due to lower interest expense, $0.02 due to higher gross margin percentages, and $0.02 from an acquisition. Collectively, included in all the categories I just mentioned was a $0.01 favorable foreign currency translation effect in the third quarter of 2020 compared to the third quarter of last year, due to the weakening of the U.S. dollar. Looking at our liquidity metrics, our cash conversion days, which we calculate by taking days in receivables plus days in inventory and subtracting days in accounts payable, was 140 at the end of the third quarter of 2020 compared to 128 at the end of the second quarter of 2020 and 122 at the end of the third quarter of 2019. The increase in cash conversion days was driven by a higher number of days in inventory due to a number of factors, including delays in capital project deliveries, weakness in capital project activity, and delays in maintenance spending by our customers. Our subsidiaries manage their inventory supply to ensure that critical components are available for customers as needed, and the timing of these purchases has been difficult to predict in this environment. Working capital as a percentage of revenue was 15.6% in the third quarter of 2020 compared to 14.8% in the second quarter of 2020 and 14.6% in the third quarter of 2019. Our net debt, that is debt less cash, decreased $18 million or 8% to $204 million at the end of the third quarter of 2020 compared to $222 million at the end of the second quarter of 2020. We repaid $25.5 million of debt in the third quarter and have repaid $41.9 million in debt in the first nine months of 2020. During the quarter, we repaid our real estate loan, which had a remaining principal balance of $18.9 million by borrowing from our revolving credit facility. This effectively swapped debt with an annual interest rate of 4.45% under the real estate loan for U.S. revolver debt currently at 1.65%, which at current rates would reduce interest expense by over $500,000 on an annual basis. In addition, our leverage ratio calculated in accordance with our credit facility decreased to 1.88 at the end of the third quarter of 2020 compared to 2.03 at the end of 2019. As a result of being below 2, the applicable margin on our revolver debt will decrease by 25 basis points, which at current debt levels would reduce our interest expense by roughly $600,000 on an annual basis. Regarding guidance, the current environment continues to make forecasting difficult. We have noticed an increase in demand for our parts and consumables products. And on the capital side, we anticipate a sequential increase in bookings in the fourth quarter. Given the current uncertainty, we will not be providing guidance for the fourth quarter of 2020. We will reevaluate providing guidance next quarter. While we are not providing guidance, I would like to provide a few directional comments on our outlook for the remainder of the year. We currently anticipate a modest sequential increase in revenue for the fourth quarter. I should caution here that if countries start locking down, that could impact the timing of when projects are delivered. We also anticipate the fourth quarter product mix will be weighted more towards capital than the third quarter. Last quarter on our call, I gave a few directional comments indicating our revenue for the year could decrease roughly 11% to 14% compared to 2019. Our current view is that the revenue decrease compared to 2019 would be closer to the lower end of that range. We anticipate that we will remain eligible for some government assistance programs, however, as our business strengthens, the benefits from these programs in the fourth quarter will be significantly less than amounts received in the second and third quarters. We recognized $0.5 million in the third quarter and $0.9 million on a year-to-date basis of restructuring costs related to the reduction of employees across our businesses. In aggregate, we expect these year-to-date restructuring activities will reduce our cost structure by approximately $4.1 million annually. We may incur additional restructuring costs in future periods as we continue to monitor the impact of the pandemic and the resulting global economic downturn on our businesses. Given the current uncertainties regarding what the future holds across our end markets and geographies, it’s difficult to provide firm guidance at the moment. However, we’ve given these directional comments to help provide insight into how we see our current business environment. That concludes my review of the financials. And I will now turn the call back over to the operator for our Q&A session.

Operator, Operator

Thank you. Our first question comes from Chris Howe from Barrington Research. Your line is now open.

Chris Howe, Analyst

Good morning, Jeff and Mike.

Jeff Powell, CEO

Hi, Chris.

Michael McKenney, CFO

Good morning, Chris.

Chris Howe, Analyst

First off, I wanted to follow-up on some previous comments that you’ve made surrounding the Material Handling segments, given all the politics that are in the environment now. Can you talk about what type of benefit, whether it be qualitative or quantitative you might see from infrastructure spending to this segment?

Jeff Powell, CEO

Yes, it would have to be, obviously, qualitative at this point, but that business is very sensitive to infrastructure development and infrastructure spending. In prior periods, when there has been a federally sponsored infrastructure spending bill, that particular business has benefited greatly from that. It’s interesting during the pandemic, many of our customers in that market were not deemed essential, and so they were shut down. One of the reasons why I think we’ve seen a more moderate booking level in that business this year is because many of our customers have just started back up or are trying to repair their balance sheet, because they were forced to shut down for an extended period. But going forward, once the pandemic is behind us, any increased infrastructure spending will we expect to see benefit them in a meaningful way.

Chris Howe, Analyst

Great. That’s helpful. And following up on that question with leverage at 1.9 turns, understanding a lot is in flux as we step outside our door here in this environment. But is it possible that opportunities could become available to allocate your capital towards acquisitions in this segment of the tuck-in variety as we look into the fourth quarter or next calendar year?

Jeff Powell, CEO

Yes, I think I might’ve mentioned this a little bit on the last call, but during the deeper part of this pandemic, there just wasn’t a lot of activity, a lot of discussions. You couldn’t travel, you couldn’t meet with people. So there clearly is pent-up opportunities from sellers that had planned to sell their business this year and were not able to, from private equity funds that had planned to sell some of their portfolio companies and were not able to. And then there are also, I think, some questions around what the capital gains tax rate may look like in the future, depending on our election outcomes. Our business development group is seeing quite a bit more activity level going on right now as we get towards the end of the year. As we’ve said, we didn’t really slow down; we continued to pursue strategic opportunities. There just weren’t a lot of them to share because of the pandemic. But I think everybody in the investment banking community would confirm that the activity levels picked up quite a bit here in the last couple of months.

Chris Howe, Analyst

Okay. Lastly, for the Industrial Processing segment, a great quarter showing strong demand based on U.S. housing. Perhaps, you can comment on these trends continuing. Do you think there is a long tail, and perhaps with us still being entrenched at home that this demand trend could continue through the first half of next year?

Jeff Powell, CEO

The industry analysts that focus on pricing lumber pricing, which is probably the best indication of demand, actually are forecasting that these prices are going to remain at an elevated level for the next potentially two to three years. They’re talking about a fairly robust market for the foreseeable future.

Chris Howe, Analyst

Great. That’s all I have. I’ll hop back in the queue.

Operator, Operator

Thank you. Our next question comes from the line of Kurt Yinger from D.A. Davidson. Your line is now open.

Kurt Yinger, Analyst

Yes. Good morning, Jeff and Mike.

Jeff Powell, CEO

Hi, Kurt.

Michael McKenney, CFO

Good morning, Kurt.

Kurt Yinger, Analyst

I just wanted to start off on the capital equipment side. It seems like every day, the list of containerboard projects gets a little bit longer. Obviously, you touched on the strength in wood products and even on the box board side, there are some big projects upcoming. So I just wanted to see from an end market perspective, there’s a lot of momentum heading into 2021. Just curious if there are any markets or regions that you still have real reservations about looking ahead.

Jeff Powell, CEO

Well, as you know, we just mentioned this new conversion project we just received an order for, and there are others out there. I think the North American market has some activity. Asia and China, in particular, are still in a state of flux because of the waste import ban, which goes into full effect at the end of this year. Our Asian customers are quite active and busy, but they’re really trying to sort out exactly where they’re going to make future investments. Excuse me. India is the fastest growing market right now, although it’s starting at a small base, but it’s one of the faster growing markets. We think there are opportunities there. I would tell you that right now, Europe is probably one of the more challenging markets. You probably have seen in the headlines in the last few days that their new infection rates are really spiking. There’s talk about, I guess, putting curfews in place; there are some discussions about lockdowns, although nobody’s done that yet. But I would say probably Europe looks like Western Europe is really struggling with the pandemic right now. We would expect that will probably result in them recovering more slowly than in the rest of the world.

Kurt Yinger, Analyst

Okay. That’s helpful. And looking back, bookings activity on the capital side seems to correlate pretty well with revenue two or three quarters out. Without trying to pin you down to a specific quarter or anything like that, when would we need to see real momentum there to get back to capital being a positive revenue growth contributor? Is that something that just given the weakness here in 2020 is maybe more relegated to the second half of next year at best?

Jeff Powell, CEO

Yes, that’s a challenging question, Kurt, because this pandemic is unprecedented. Trying to understand when our customers are comfortable enough with the recovery to start making big investments in new capital is very challenging to forecast right now. We have some customers that are so busy and profitable that they don’t want to shutdown to do any upgrades of equipment; that could be the same for certain packaging suppliers. Others, of course, are operating at reduced rates. Usually, you see a couple of quarters later because of the build cycle for the bigger capital equipment. But I just don’t know that we have confidence right now in when we’re going to see that uptick. As we mentioned, we do think there’ll be some strengthening in Q4. Since the close of the quarter, we’ve started to see some nice orders come in. But it’s very difficult to forecast what 2021 is going to look like at this time.

Kurt Yinger, Analyst

Right, right. Okay, that’s helpful and fair. And then just switching to parts and consumables, the backdrop seems a lot better than it did a couple of months ago. Mike talked about the directional guidance for the fourth quarter, but it just seems like that part side could really come back, especially with the destocking dynamic you’ve seen. So I’m just wondering what might be holding that back here in the near-term from really recovering more strongly.

Jeff Powell, CEO

I think there’s a couple of things. One is, I think customers are still being pretty cautious on their inventory levels. The other is that in many cases, we’re still unable to get people in to do audits and service calls and the kind of things that normally lead to parts sales. So we’ve got kind of two challenges that we’re dealing with: the continued caution of our customers, which is somewhat understandable, and then just the challenge of getting our service people into the mills.

Kurt Yinger, Analyst

Okay, okay. And then just lastly, a two-parter on gross margins. Could you breakout the exact dollar amount over the last two quarters from the government relief programs? And at a high level looking to 2021 seems like there’s a little bit of inflation on steel, maybe capital strengthens and some mix impact there. Just curious how you’re thinking about the positives and negatives on gross margin looking ahead.

Michael McKenney, CFO

Sure, Kurt. Well, I’ll give you the absolute numbers included in the gross margins. For the second quarter, it was $1.3 million and for the third quarter, $1.6 million. I gave the impact in the call there was a 110 basis point impact in the third quarter. Looking forward on the commodity price increases, generally, I’d say we’d hope to be able to pass that on. So if that occurs, we’ll hopefully not see much of an impact on our gross margins as a result of that.

Kurt Yinger, Analyst

Got it.

Michael McKenney, CFO

So I think I would say looking forward on the commodity price increases, generally, I’d say we’d hope to be able to pass that on. So if that does occur, we’ll hopefully not see much of an impact on our gross margins as a result of that.

Kurt Yinger, Analyst

Okay, okay. That’s awesome and very helpful. Good luck in the fourth quarter, guys.

Jeff Powell, CEO

Thank you.

Michael McKenney, CFO

Thank you.

Operator, Operator

Thank you. And now I would like to turn the call back to Mr. Jeff Powell for closing comments.

Jeff Powell, CEO

Thank you. Before wrapping up the call today, I wanted to just leave you with a few takeaways from the quarter. The health and wellbeing of our employees has been and continues to be our top priority. I’m proud of our employees working to serve our customer’s needs through these uncertain times. Financial health is excellent, and our liquidity position is stronger today than when the crisis began earlier in the year, as evidenced by our improved debt leverage ratio of 1.88. Our ability to generate strong free cash flow remains solid and is a cornerstone of our business model. I want to thank you for joining the call today, and we look forward to talking to you next quarter.

Operator, Operator

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