Quanex Building Products CORP (NX) Q3 2020 Earnings Call Transcript

Thanks for joining the call this morning. On the call with me today is George Wilson, our President and CEO. 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 statements 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 to our website. I’ll now discuss the financial results. We reported revenue of $212.1 million during the third quarter of 2020, compared to $238.5 million during the third quarter of 2019. The decrease was primarily attributable to lower volume related to the COVID-19 pandemic. More specifically, our two manufacturing facilities in the UK were shut down in compliance with government orders on March 25, 2020, and manufacturing operations at those plants did not restart until mid to late May. However, volume across all segments increased significantly in June, and net sales in July exceeded prior year on a consolidated basis. We reported net income of $10.8 million, or $0.33 per diluted share for the three months ended July 31, 2020, compared to $11.8 million, or $0.36 per diluted share during the three months ended July 31, 2019. On an adjusted basis, net income was $11.1 million, or $0.34 per diluted share during the third quarter of 2020, compared to $13.7 million or $0.41 per diluted share during the third quarter of 2019. The adjustments made to EPS are for restructuring charges, impairment charges, certain executive severance charges, accelerated D&A, foreign currency transaction impacts, and transaction and advisory fees. On an adjusted basis, EBITDA for the quarter was $27.7 million compared to $32.8 million during the same period of last year. Moving on to cash flow and the balance sheet. Cash provided by operating activities was $45.1 million for the three months ended July 31, 2020, which represents an increase of 50.8%, compared to the three months ended July 31, 2019. Cash provided by operating activities was $47.6 million for the nine months ended July 31, 2020, representing an increase of 58.7% compared to the nine months ended July 31, 2019. Free cash flow improved significantly during the third quarter to $40.7 million, an increase of 57.1% compared to the third quarter of 2019. Year-to-date 2020, free cash flow more than doubled to $26.9 million compared to the same period of 2019. Our focus on managing working capital continues to provide benefits, but we realize most of the heavy lifting on this front has been accomplished. Our balance sheet is healthy, our liquidity position is strong and getting stronger, and our leverage ratio of net debt to last 12 months adjusted EBITDA improved to 1.1 times as of July 31, 2020, which is lower than where we exited fiscal 2019. We will continue to focus on generating cash and paying down debt in the fourth quarter, which should allow us to exit fiscal 2020 with a leverage ratio of net debt to last 12 months adjusted EBITDA at or below one-time. We will be opportunistic regarding repurchasing our stock. As previously disclosed, due to the uncertainty related to the ongoing pandemic, we withdrew full-year guidance and reduced our CapEx budget for fiscal 2020. Having said that, the recovery has been more robust than expected on all fronts, and we are now comfortable providing the following full-year 2020 guidance: net sales of $832 million to $837 million, adjusted EBITDA of $97 million to $102 million, CapEx of approximately $25 million, and free cash flow of approximately $50 million. It is important to note that although free cash flow increased significantly in the third quarter and year-to-date 2020 compared to 2019, much of that improvement came from systemic improvements in our management of working capital. Looking ahead, it will be more challenging to continue this rate of improvement in working capital. Additionally, we expect that a higher pension contribution and an increase in cash tax payments will make fourth-quarter comps more challenging. I'll now turn the call over to George for his prepared remarks.

Thanks Scott. Overall, we are very pleased with the results we delivered in a quarter that again presented many unprecedented challenges. As we began our third quarter, there were still many unknowns related to COVID-19 and its impact on our company and the worldwide economy. As Scott mentioned, our facilities in the U.K. were closed by government mandate through mid to late May. In North America, we still had many employees on furloughed status for the first few weeks of the quarter. Fortunately, those headwinds changed directions very quickly, and demand rebounded swiftly as we entered June. All facilities are now operating at pre-pandemic run rates, and consolidated revenue in July actually exceeded prior year. As discussed on prior earnings calls, our cost structure is highly variable and allowed us to anticipate this change and effectively meet a rapid run-up in demand. I'd like to take a moment to thank my Quanex teammates for their continued hard work and dedication to meeting our customers' needs during this changing and uncertain time. I'll now spend a moment discussing results from each of our segments, beginning with North American Fenestration. Revenue in this segment was $122.4 million, down 10.2% from prior year third quarter. This shortfall was primarily driven by the pandemic's negative impact on demand, especially during the month of May. Adjusted EBITDA of $17.8 million was $4.8 million less than prior year third quarter. Volume-related impacts and higher overtime costs in June and July combined with pandemic-related delays to the upgrade project in our vinyl extrusion business in North America, all negatively impacted the results. We generated revenue of $38.3 million in our European Fenestration segment, which was 13.7% less than prior year or down 12.9% after excluding the foreign exchange impact. As mentioned earlier, our U.K. plants were shut down through mid- to late May and effectively had very little revenue during that month. However, volumes rebounded quickly, and revenue in June and July was actually stronger than prior year levels. In Continental Europe, spacer volumes remained steady, with strong demand continuing in Germany, Austria, Switzerland, and Scandinavia. Despite low volume in May, this segment was able to realize adjusted EBITDA of $7.7 million in the quarter, which represents margin improvement of approximately 290 basis points over prior year. This margin expansion was driven by favorable material costs, efficient ramp-up, and productivity gains. Our North American Cabinet Components segment reported revenue of $51.9 million, which was 11.5% less than prior year. However, revenue was only down 7.5% when adjusted for the customer that exited the Cabinet Manufacturing business in late 2019. We saw a significant increase in demand in June and July, driven by opportunities created by supply chain disruptions in the cabinet component import markets. Adjusted EBITDA for the segment was $3.1 million, down $1.7 million from prior year third quarter. It is important to note though, that EBITDA was negatively impacted by a $1.7 million accrual for writing off the final amount of customer-specific inventory associated with that customer that exited the cabinet business. Absent this write-off, we would have realized margin expansion of approximately 90 basis points in this segment as well. Finally, unallocated corporate and SG&A costs were $1.4 million better than prior year third quarter. The primary drivers of this improvement were lower executive compensation costs and a favorable medical cost true-up for the quarter. As Scott also mentioned in his commentary, we have focused on generating cash flow, and those efforts have allowed us to continue deleveraging our already strong balance sheet. While the potential to benefit from a further improvement in working capital will be limited on a go-forward basis, the increased demand we are seeing provides us with confidence in our ability to maintain a healthy balance sheet, generate cash, and opportunistically repurchase stock. Market fundamentals and demand for our products, combined with our ongoing focus on operational efficiency gains, give us further confidence in our ability to meet the full-year 2020 guidance. All that said, there's still much uncertainty for the mid- to long-term. COVID-19 continues to be a problem around the world, and the timing and successful distribution of a potential vaccine is questionable. In addition, the U.S. presidential election is right around the corner, and the result could have long-lasting economic and societal impacts, regardless of who the winner is. With these things in mind, we feel our current strategy of focusing on operational excellence, maintaining a healthy balance sheet, generating cash, and opportunistically repurchasing shares remains our best near-term strategy. We have demonstrated our ability to execute on this strategy, and we feel that our efforts have positioned us well to capitalize on opportunities when and if they arise. And with that, operator, we are now ready to take questions.

Thank you, sir. I show our first question comes from the line of Daniel Moore from CJS Securities. Please go ahead.

George, Scott, good morning and congrats on the nice results, and thanks for taking the questions. I'll start with EU Fenestration recovering much quicker than certainly we had expected or maybe feared. How much of that increase do you think in July and August was catch-up from being shut down earlier in the year? And what do order patterns look like as we enter September?

So, great question and I wish we had complete visibility into that answer, Dan. We think it's a balance of both. There is a piece of that that we do believe is catch-up. However, with that being said, August and September orders look relatively strong. So, we're confident. The big question mark with the EU is how does that play into the next year? So, we're pretty confident we'll see a strong remainder of our fiscal year, but how that plays into 2021 is still a little unknown.

Understood, that's helpful. In North American cabinets, are you seeing any pressure from rising input commodity costs? And can you give us an updated view of where EBITDA margins in that segment can get to over the next, say, maybe two to three years?

Yeah. Sure. So, there's been a lot of discussion on the talk around wood pricing. We primarily deal in the hardware markets. And for us, we have not seen a significant amount of inflationary pressure. What you're hearing in the news is a lot on the softwood, in the softer species, which we don't have a lot of exposure to. So, we're not seeing a significant amount of pressure on our input costs at this point. Looking ahead, on your question as it relates to the EBITDA expectations, we're very confident through what we're doing on the sales side as well as our operational projects that we've had in place now for two to three years that we're starting to see the results of that. We can get low-double-digit EBITDA margins over the next couple of years, and we're very confident in our ability to do that.

Perfect. I'll sneak one more. In terms of working capital, you have clearly been putting in a lot of effort on that front. Looking ahead, will it be more of a challenge moving forward, or are the gains you’ve made just less beneficial? I understand it may be difficult to keep generating more, but are the improvements you've made sustainable?

Yeah. Dan, it's Scott. I'll take this one. I think, going forward, the focus will continue to be on working capital management. I think our message here is that any gains or benefits on that front going forward are going to be challenging to get to. I think, we don't think it's going to be a headwind by any means, but it's going to be hard to improve going forward.

I think to add to that, Dan, what we mentioned in our script and what we've done over the last couple of years and we're seeing, they've been systematic changes. So these – we've effectively changed the way we've done business and very much put the whole working capital project as any other manufacturer. It's a process, and we've optimized that and we've done a very good job of that. So that's what you're seeing right now.

Okay. And as I hand it over, it sounds like buybacks are now potentially back on the table opportunistically, as I heard you, is that correct?

Yes. Opportunistically, you are correct.

Thank you. Our next question comes from Reuben Garner from Benchmark. Please go ahead.

Thank you. Good morning, everybody and congrats on the quarter.

Good morning, Reuben.

Maybe I had some connection issues at the beginning. So if you already answered this, I apologize. I think I heard you say that your sales were up year-over-year. In July, did I hear that correctly? Can you tell us how August trended across the three businesses?

So you did hear that correctly. On a consolidated basis, July was up year-over-year. Keep in mind that Europe exceeded expectations across all fronts. So that really helped July. We're still closing August books, but August was another strong month and that gave us confidence in putting out the guidance that we included in the release.

Okay. Regarding your implied margins for the fourth quarter, it seems they are roughly even year-over-year at the EBITDA level. Can you discuss the breakdown between gross margin and SG&A? I know you made some cuts to SG&A earlier in the year. Should we anticipate those coming back, and are you starting to see improvements in gross margins that might offset that?

Yes. I think the way you're looking at that is correct. In terms of our operational improvements at that gross margin level, there are some projects that we're working on. We've talked about our North American vinyl process improvement and the technology upgrade. We're starting to see benefits from that project, which we would have expected, and so your view on that is accurate.

Okay. I heard you mention increased overtime during the quarter in June and July. It seems running at full capacity is more challenging now compared to last year due to the current environment. Given that demand is improving, is there any chance you could consider raising prices in any of your businesses to offset the elevated labor costs and other COVID-related expenses?

That's a great question, Reuben. I'll address the overtime first, then discuss pricing. The ramp-up has been quick, and we anticipated this. The primary reason for utilizing overtime is the swift recovery and the challenges in the marketplace. We're not alone in this; we're hiring across almost all our plants, and the effects of the CARES Act make it tough to attract people from unemployment to fill our open roles. This recruiting challenge is a short-term issue many companies are facing, which is why we relied heavily on overtime. However, our structure enabled this, and we managed to meet demand effectively and take advantage of incoming orders. Regarding pricing, that's more complex. We'll pursue pricing adjustments based on the specifics of each product line and the unique challenges in various regions. Where feasible, we will and have gone after price increases.

Great. Congrats, again, and good luck navigating through the rest of the year.

Thank you.

Thank you. Our next question comes from Julio Romero from Sidoti & Company. Please, go ahead.

Hey, good morning. I hope you all are well.

Thanks.

I wanted to start with North American Fenestration. If you could talk about what particular product lines have the strongest demand coming out of July. I think you've talked in the past about the screens leading your growth there and less so from Mikron and Spacer. Can you maybe just talk about what you're seeing today in regards to which product lines are driving demand?

In the quarter, there was strong demand across all the product lines. However, if I were to rank them based on opportunities and the potential for faster revenue growth, the market is currently more favorable in the screens area compared to the other product lines. Nonetheless, we experienced consistent strong demand across all three product lines.

Okay. And on the cabinet side, I guess, your cabinet sales adjusting for that one customer who exited, outperformed the KCMA data for the last three months. And I think I saw for the July data for KCMA, semi-custom actually outperformed stock, which was surprising. Can you maybe just talk to what you're seeing there, in regards to semi-custom and value and what you're hearing from customers?

No. You're exactly right. We observed a spike in demand, and we're taking advantage of some opportunistic business as well as new sales prospects that have emerged for us. We've been very active in all of our cabinet plans. So, it was a pleasant surprise to see the KCM data, and based on the order patterns we observe, that data is accurate. For the first time in a long while, semi-custom has outperformed stock. I believe that as the effects of anti-dumping and tariffs continue, along with the stabilization of hardwood pricing, the market is starting to balance itself out. We're noticing similar trends in our order patterns as well.

Got it. And then, just last one for me is, you touched on it earlier, your balance sheet is in a much better position than it has been in the past and you paid down some debt in the quarter. As we approach 2021, can you maybe talk about what capital projects are maybe top of mind for you?

In terms of capital expenditures for operational projects, we have a variety of initiatives that we plan to start in our U.K. vinyl business. There's also the potential for a second phase of our vinyl extrusion efforts, as the results from the initial project are quite promising. This progress could pave the way for further development, and the remaining capital expenditures will focus on supporting our growth. We've recently launched a new screen plant in the northeast and are assessing other locations in the country for potential expansion. Therefore, these operational projects will be our priority as we enter 2021.

I think, for modeling purposes for next year, you should assume that capital budget is higher than this year, so this year we just guided to do about $25 million something higher than that. I don't think that you're going to see us go much more than $30 million to $35 million, but we're going through our budgeting process now and we'll come out with official 2020 guidance in December.

Got it. Yes. That makes sense. That's for me. Thanks very much guys.

Thank you.

Thank you. Our next question comes from the line of Steven Ramsey from Thompson Research. Please go ahead.

Hey, good morning. This is actually Brian Biros on for Steven. Thank you for taking my questions. I guess on the guidance range you guys provided, what would you call out as the biggest drivers to reaching the higher low end of that range?

For the higher end of the range, we would expect to see some continued volume and favorable seasonality during the extended build season. Wet weather could influence this positively or negatively. An early hard fall could push us towards the lower end of the range, but aside from that, it's mainly about the timing of customer orders, and we feel confident we will be right in that range.

I think Europe continuing to perform as it has over the last couple of months will play a role in, ultimately, where we fall within that guidance. But as we sit here today, we're comfortable.

And obviously, I have to put out the disclaimer. Anything that happens unknowingly as COVID and some sort of secondary shutdown, but that goes for everyone, I suppose.

Yes, understood. Following up on the CapEx commentary you provided, what level of investment are you considering for the German spacers unit in Q4 and into 2021?

I think for our European spacer business, I mean, the investment will continue to be very similar to where we're at. So, we don't break out our CapEx to that level of detail between the two product lines in Europe. But we continue to be very happy with what we're seeing in terms of our spacer growth in European and international markets. So, we'll continue to invest in that growth and some capacity expansion.

Got it. Thanks so much.

Thanks.

Thank you. I show our next question comes from the line of Ken Zener from KeyBanc. Please go ahead.

Good morning, George and Scott.

Good morning, Ken. How are you?

I'm doing well. Very nice quarter in terms of your operational stability and the cash flow. So, windows, screens are doing better as they outsource spacers and extrusion, on the other side. Can you talk about what you're seeing or hearing from customers, or really the end-user preference for having someone come into their house? Because I think one of the big issues or trends we saw in Q2 was smaller ticket items just going to Home Depot. And, say, picking up a gallon of paint, Windows are very different, because it involves the contractor. And what I'm trying to understand is how much demand might be building up for this product once people get comfortable allowing contractors to come into the house, because that could be a real tailwind for, I think, higher-priced items that involve contractors next year. Could you expand on that to the degree you feel comfortable?

Sure. And we've spent a lot of time talking to our customers about this. I think what we've seen that's evolved, when you replace a window, there's – although there's contractors in the home, there's able to be separation. It's not like redoing and painting the entire inside of your home. So there is an ability to separate yourself a little bit. What has changed, and I think where our customers have evolved, is actually the selling process. So they've – a lot of our customers have done a phenomenal job of creating online sales tools, virtual selling tools that have replaced that experience where a guy goes in and measures all your windows and does this and that. And so there's new tools that have come out to help facilitate that. And what we're hearing is that demand for the windows, and we had the same concern initially, Ken, about what that means. And they have not skipped a beat. Demand has remained very strong. And our customers continue to be optimistic, even going into next year. So we've been thrilled at what that has done. But really the most significant change is in their selling process.

Interesting. Staying on that segment or that business line, the extrusion, could you just expand upon the, you talk about delay for the domestic extrusion improvements. Could you clarify that? I’m just a little foggy on that, as well as your comments about Phase 2 if that applies to the U.S. as well. And just restate the context that has made that business worthy of incremental investments. Why the supply or competition has improved for you on that extrusion? Thank you very much.

Well, in terms of the delay of the project, the main reason why it is the supplier of the equipment is from Austria. So obviously, there's travel restrictions and the ability to send a lot of their technical teams over to launch has forced us to be able to do things different. So installation via Zoom, and it was – the process was a little clunky and slow at first. But now, what it has done is our team has learned an enormous amount, and the technology that we're using to be able to launch with our own asset resources has really picked up speed. So, it delayed it initially, but we have recovered and are happy with the progress. In terms of the vinyl market itself, there's just – as we continue to learn what we're good at, what we're learning in the process. You know, we know from that experience and what we've done operationally that we can be competitive; we can win in this market. So, it's more learning about ourselves internally over the course of the last four years of our process and then with new technology and what that's been able to generate for us in terms of benefits. The other thing that we're doing in terms of vinyl extrusion is we're beginning to extrude in some off markets, so filling up capacity in areas that may not be traditionally just window profiles, but utilizing our extrusion assets as a contract manufacturer has helped our profitability. So, that's why you see a little bit of a change in direction, and it's more because of our operational improvements.

Great. And then Scott, you said 1.7 million in cabinets was a charge in this quarter, is that correct?

Correct. And there was actually a similar charge in Q2. So almost 3.4 million, and nothing's left there. So view adjust cabinet results for that inventory write-down, you can really see that the cabinet business is doing very well, much better than it has for us in a long time.

And it's fair to assume prospectively meaning Q2 and Q3, and next year, we should assume the margin base would be adjusted for those charges, correct, as a reasonable comp?

Easier comps, next year. Correct, for Q2 and Q3.

Thank you very much, gentlemen. Bye-bye.

Thank you.

Thanks.

Thank you. I show no further questions in the queue. At this time, I'd like to turn the call over to Mr. George Wilson, CEO for closing comments.

Great. Thanks. We'd like to thank everyone for joining, and we look forward to providing you all an update on our next earnings call, which will be in December. Thank you.

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