Quanex Building Products CORP (NX) Q1 2020 Earnings Call Transcript

Ladies and gentlemen, thank you for standing by, and welcome to the Q1 2020 Quanex Building Products Corporation 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. As a reminder today’s conference is being recorded. I would now like to introduce your host for this conference call, Mr. Scott Zuehlke, Senior Vice President, Chief Financial Officer and Treasurer. You may begin.

Thanks for joining the call this morning. On the call with me today is George Wilson, our President and Chief Executive Officer. This conference call will contain forward-looking statements and some discussion of non-GAAP measures. Forward-looking statements and guidance discussed on this call and in our earnings release are based on current expectations. Actual results or events may differ materially from such statements and guidance, and Quanex undertakes no obligation to update or revise any forward-looking statement to reflect new information or events. For a more detailed description of our forward-looking statement disclaimer and a reconciliation of non-GAAP measures to the most directly comparable GAAP measures, please see our earnings release issued yesterday and posted on our website. I'll now discuss the financial results. On a consolidated basis, revenue was essentially flat year-over-year in a quarter where we expected to see mid-to-high single-digit declines, driven by the continued shift in the cabinet industry to stock cabinets. The reality is, we reported net sales of $196.6 million during the first quarter of 2020 compared to $196.8 million during the first quarter of 2019. More specifically, revenue was down by $3.8 million in our North American Cabinet Components segment. But $3.4 million of that decrease was attributable to a single customer who decided to exit the cabinet business altogether. Spot orders were strong during the quarter, and we are seeing early signs that the market shift from semi-custom to stock cabinets may be stabilizing. In fact, the latest KCMA data market showed that semi-custom cabinet sales were only down by 0.7% year-over-year. This is the lowest rate of decline we have seen in over a year. Revenue losses in our North American Cabinet Components segment were offset by above-market growth in our European Fenestration segment and growth in the low-single digits in our North American Fenestration segment. We reported net income of $10,000 or $0.00 per diluted share for the three months ended January 31, 2020 compared to a net loss of $3.6 million or $0.11 per diluted share during the three months ended January 31, 2019. We are pleased to say that this is the first time since the company's 2018 spin-off from Quanex Corporation that we have reported net income in the first quarter of our fiscal year. On an adjusted basis, net income was $1.2 million or $0.04 per diluted share during the first quarter of 2020 compared to a net loss of $2.3 million or $0.07 per diluted share during the first quarter of 2019. The adjustments being made to EPS are for restructuring charges, certain executive severance charges, accelerated D&A, foreign currency transaction impacts, transaction and advisory fees, and adjustments related to the Tax Cuts and Jobs Act. On an adjusted basis, EBITDA increased by 30% to $15.7 million in the first quarter of 2020. The increase in adjusted earnings was driven by an ongoing concentrated focus on controlling costs, improved operating leverage, operational efficiency gains and lower medical expenses. Moving on to cash flow and the balance sheet. Due to the seasonality of our business, we are typically a net borrower in the first quarter of each year. Having said that, we borrowed 50% less cash in the first quarter of 2020 than we did in the first quarter of 2019. As a result, free cash flow improved significantly during the quarter, and we repurchased $4.6 million of our stock at an average price of $17.19 per share. Our balance sheet remains strong and we exited the quarter with a leverage ratio of 1.4 times net debt to last 12 months adjusted EBITDA, which is a full turn better than where we were a year ago. I'll now turn the call over to George for his prepared remarks.

Thanks, Scott. We are off to a solid start in fiscal 2020 as first quarter results continued to reflect our ongoing focus on operational excellence and cash flow generation. I will now provide some additional comments on each of our operating segments, starting with our North American Fenestration segment, where revenues were 1.3% higher than the prior year. On a more granular basis within this segment, revenues specific to fenestration in the US grew by 3.2% year-over-year, which compares favorably to Ducker's latest window shipment estimate of 2.5% growth for the three months ended December 31, 2019. On an adjusted basis, EBITDA in our North American Fenestration segment decreased by approximately 20 basis points versus the prior year. Labor inefficiencies were the primary driver of the slight margin decrease, as we built inventory ahead of a significant capital project. Our European Fenestration business delivered another good quarter as a result of solid demand in the UK market that was partially offset by the timing of spacer sales to Asia. Excluding the foreign exchange impact, this segment generated above-market revenue growth of 3.7% versus prior year, which was better than we expected. Adjusted EBITDA margin for our European Fenestration segment was approximately 100 basis points better than the prior year. Timing of price increases, stabilization of raw material costs, and productivity initiatives, all contributed to these favorable results. Revenue in our North American Cabinet Components segment decreased by $3.8 million or 7.1% year-over-year. As we mentioned in our fourth quarter earnings call, we had a customer who made a strategic decision to exit the manufacturing of cabinets. We stated the impact on our revenue as a result of this change would be a reduction of $10 million to $15 million on an annual basis. In the first quarter, this accounted for $3.4 million of the $3.8 million shortfall. The remaining decrease was driven by the ongoing but slowing shift in the market demand from semi-custom to stock cabinets, which was offset somewhat by an increase in spot business. As Scott mentioned, sales in the semi-custom cabinet market declined 0.7% year-over-year during our fiscal first quarter, which was the slowest rate of decline in more than a year. There appear to be signs that the cabinet market is beginning to stabilize. We will continue to monitor the market closely, but we can certainly say that the volume of quoting activity for spot buys has increased significantly, which we believe is a result of the tariffs and supply chain disruptions caused by the coronavirus. Despite the decrease in revenue for the North American Cabinet Components segment, we realized an improvement in adjusted EBITDA margin of approximately 70 basis points. This margin expansion has been driven by lower material costs, continued operational improvements, and our own efforts to reduce SG&A within this segment. Finally, when looking at unallocated corporate and other costs, we realized a year-over-year improvement of $2.8 million, which was primarily driven by lower medical costs, as we have experienced a significantly larger number of high-dollar claims in 2019 than we realized so far in 2020. Overall, we are very pleased with how our fiscal year started and we are optimistic looking ahead into the spring selling season. It is too early to increase our annual guidance at this time, but there is potential to do so later in the year if the results continue to exceed our expectations. As such, at this time, we are confident in reaffirming our guidance of between $865 million and $885 million in revenue with adjusted EBITDA between $102 million and $110 million. Going forward, our plan is to continue to use our strong cash flow to invest in high-return internal capital projects, while maintaining a strong balance sheet and opportunistically repurchasing our stock. We firmly believe that this strategy puts us in a strong position regardless of what the economy may do. And with that operator, we are now ready to take questions.

Our first question comes from Dan Moore with CJS Securities.

Good morning. This is Brendan on behalf of Dan. I wanted to ask a quick question. George, now that you have been in your role for a couple of months, could you provide us with an update on any strategic direction or focus changes or just a general update, including any subtle shifts compared to the direction that Bill took over the past year or two?

As we mentioned in the fourth quarter earnings call, since I was promoted from within to succeed Bill, there will be no major changes in our strategy moving forward. I participated in developing the existing strategy with the team, and we are very confident that it is the right plan going forward. Therefore, there are no strategic changes anticipated. We are very pleased with the transition, the team has adjusted well, and everyone remains focused on executing the plans we established under Bill, which we will continue to follow.

Okay. And then, following up on that, now with the leverage comfortably below 2, what are your top priorities, would you say, over the next few years with your strong cash flow? How do you look to allocate capital?

We're going to continue to focus on internal projects that generate high returns. We're going to continue to opportunistically buy back our shares. And we'll build cash to capitalize on projects as they come forward. So those are the three priorities: internal projects, share repurchasing, and building cash flow.

Are you noticing any changes or tangible effects from the EU Fenestration, especially regarding Brexit, or is everything still the same?

It's really still status quo. We've been very happy with the performance and the growth in our EU markets, and we see no changes and expect no changes.

Our next question comes from Reuben Garner with Benchmark Company.

Thanks. Good morning, everybody. Let’s start with the Cabinet business. You mentioned that you're observing stabilization in the semi-custom market. Can you provide more details about your outlook for that segment for the remainder of this year? Additionally, your margin performance in this quarter was quite impressive given the current environment. What contributed to that? Do you see potential for further improvement in the coming quarters?

Regarding Cabinet revenue and the current market conditions, we believe the trends we are observing are due to the tariffs and supply chain disruptions caused by the coronavirus. These issues have been ongoing and were evident at the end of our last fiscal year. We anticipate that this environment will persist, and our customers are reassessing their supply chains to mitigate risk, which has created opportunities for us. I do not expect any changes moving forward. The short-term disruptions from the coronavirus are prompting our customers to reconsider the risks associated with a global supply chain and seek alternative sourcing and backup plans. We plan to take advantage of this. In terms of margin expansion, we see all our projects progressing as anticipated, and we have no reason to believe we won't meet our guidance on an annual basis. We are pleased with the progress we are making at this time.

Great. Thanks, George. Can you provide an update on your capital expenditures, including last quarter's descriptions and planned investments? What benefits are you observing so far, if any? I know you are working to expand your screens business into new areas. Can you discuss the growth opportunities you foresee for that segment beyond just the housing market?

Regarding the capital projects we highlighted at the end of our last fiscal year, I can share that all our projects are on schedule and progressing as anticipated. We are very satisfied with the progress made, and believe that the benefits and returns we predicted from these projects will materialize. Everything is proceeding as planned, including the screen expansion, which is also on track. As we mentioned, we anticipate entering the Northeast market operationally by the end of our fiscal Q3. We are optimistic about our progress and believe that the market will continue to seek opportunities to outsource certain components due to tight labor conditions in various regions. We will assess our capabilities against the outsourcing opportunities that arise.

Great, thanks. Congrats on the quarter and good luck for the rest of the year.

Thanks, Reuben.

Our next question comes from Steven Ramsey with Thompson Research Group.

Good morning. I have a handful of questions on German spacers. I guess, to start with, where are we at, again, on the new line or lines coming online? And if they're already in place, how fast do you expect that to ramp up?

The equipment is ready and is being launched as planned. Our ongoing efforts to generate revenue from this capacity are progressing well. We do not provide detailed revenue figures for specific lines, but we anticipate growth in revenue, consistent with our expectations, and we are meeting all the targets outlined in our forecasts.

Excellent. And I guess, on the margin impact, just given EU margins are very strong and yet you're still investing heavily in German spacer growth, I guess, is this diluting margins to a significant degree? And just any commentary around the current margin impact and maybe once this investment kind of matures, how it impacts margins.

The spacer that we produce in Germany fits a very specific high-end market. So we see very good growth opportunities for the spacer market. And the fact that it serves a relatively specific niche and high-end types of projects, we don't expect nor anticipate any sort of degradation in margins.

But as it hits a more mature phase and sales staff have ramped up and products are delivered to customers, I guess, ultimately, it would be a positive for margins over time.

As we continue to grow that segment, it could have a favorable impact on our margins, and that's our plan.

Excellent. Thank you.

Thank you.

Our next question comes from Julio Romero with Sidoti & Company.

Hey, good morning, everyone. I wanted to ask about your cost control initiatives. You saw essentially no corporate costs in the quarter. Can you just talk about what you're doing there, what's driving that and if this quarter changes your full-year SG&A expectation at all?

As we've transitioned to a new leadership team and reassessed our approach, we've identified some synergies and cost advantages from these changes. However, the main factor this quarter has been the medical costs. In 2019, we experienced a significant number of large one-time medical claims, which we have not encountered at that level this year. Consequently, we have seen a substantial decrease in medical costs from one quarter to the next.

And then, Julio, as you know, it's almost impossible to be able to accurately forecast what those medical claims may or may not do going forward.

Got it. I wanted to switch over to the Cabinet segment. One thing you guys had talked about a couple of quarters ago was potential conversion of capabilities in the Cabinet business to potentially service some other price points within the market. Can you give us maybe an update on any progress there and any takeaways from whether a conversion of those capabilities maybe makes sense for Quanex?

We've launched a new process on a small scale to test out operational capabilities. But really, before we make a decision in terms of investing heavily in that segment going for a lower price point, we really feel that we're being prudent by allowing the market to settle and not making rash decisions in a volatile time. So we're preparing in both steps. We're operationally testing our capabilities and then we're preparing and monitoring the market to determine when we'll make that final decision on how much to invest.

Okay, that's fair. I appreciate the information. My last question is about the North American Fenestration segment. You mentioned some inefficiencies in labor. Were those concentrated in a specific geographic area? Also, do you still view that segment as having the most potential for margin expansion in fiscal '20?

It was concentrated within one specific line, being driven by one very specific capital project. So it wasn't geographical. It was project-related. In terms of margin expansion, we still think, as we said, that the NAF segment will hit their operational performance that we forecasted on a go-forward basis. So we think it will recover and provide the expected margins that we anticipated at the beginning of the year and we've guided to.

Got it. Appreciate the color. Thanks very much and best of luck in fiscal '20.

Our next question comes from Ken Zener with KeyBanc.

Good morning. Regarding the cabinet bidding process as customers aim to reduce supply chains and risks, could you provide more insight on where this is originating? Is it coming from builders or manufacturers? What is your perspective on this? Are customers looking for components that you've already prepared, or are they interested in more extensive discussions? Also, what kind of lead times do you anticipate they are considering?

So what we're seeing, obviously, the information is coming from our customer, which is the OEM. We feel like there has been no significant change, and there's actually demand on the builder side of the business. Our customer supply chain, which can be heavily weighted to overseas suppliers is just at risk. And so, we see a lot of opportunity, both from our existing customer base and some new ones, about trying to minimize that risk and looking at internalizing and bringing in their supply base to a domestic more convenient supply. As you know, Ken, and we've talked about openly, our route to market is very short lead times, enabling our customer to carry low inventories and have significantly less risk in terms of carrying inventory. And that's what we do and that's what we're focused on and selling on.

We've noticed a significant amount of volatility in the market, particularly affecting certain stocks, as concerns arise about potential supply chain disruptions from China. This situation seems to have made your customers increasingly anxious about availability, especially given the short lead times crucial for their operations. Have you observed a growing level of concern among your customers regarding their orders? It appears their inventory could deplete rapidly without your services, which is why I'm interested in this discussion.

No, I understand the question. And again, I can't speak with certainty... I don't have visibility into that, Ken. All I can say is that the rate at which we're seeing different opportunities on a spot basis have increased. So for me to make presumptions on why that is the case, I would be guessing.

Fair enough, George. Who would have thought that post-Brexit Europe would turn out to be such a high margin business? For the UK, can you discuss the current state of the business now that Brexit has been finalized? How is the UK market performing? Is it simply continuing to operate steadily, and has pricing adjusted to account for the depreciation of the pound? How have things been overall in the UK?

The market itself has been very steady. What we see in the product that we serve in terms of vinyl profile and to the extent spacers, they go into obviously windows and residential homes. The majority of the market is R&R there because the infrastructure is old. There is a constant demand to replace old windows. As windows fail, they have to replace it. So it's a relatively stable market. And we've done a very good job, I think, capitalizing operationally on delivering and servicing our customers in a market that will continue to be very stable for those reasons. It's an under-built and under-served market that we like being in.

And then, Ken, I can add a little to that on the top line side, which obviously we're converting well. We're selling more products to existing customers, but we've also been successful last year, which is paying dividends this year, in acquiring new customers, specifically in our vinyl profile business in the UK. So that's translating well for us.

Thank you, Scott. One last question. George, you mentioned that you are not updating your guidance for the year, and I think that's the right call. Is your commentary based on the first quarter showing a positive net income? Specifically, where do you see the potential for upside? Is your confidence for an increase mainly in Cabinets, considering margins and possible demand trends, or do you see it more with Fenestration North America?

So, Ken, this is Scott. I'll take this one. So obviously, the first quarter being a good quarter gives us some optimism going into the spring selling season. Conversations with our customers add to that optimism. We're sitting here in early March, and we can say that February gives us some optimism. And I think the upside, if there are, is upside to our guidance later in the year. First, it would probably translate to the top line as we're seeing some good spot business in Cabinets. And then on the bottom line, it will translate but not to the extent that we're seeing revenue growth above that of our original forecast.

And I'm not showing any further questions at this time. I'd like to turn the call back over to George.

Thank you, everyone, for joining. And we look forward to providing an update on our next earnings call in June.

Ladies and gentlemen, that concludes today’s presentation. You may now disconnect, and have a wonderful day.