Quanex Building Products CORP (NX) Q4 2020 Earnings Call Transcript

Ladies and gentlemen, thank you for standing by, and welcome to the Fourth Quarter and Full Year 2020 Quanex Building Products Corporation Earnings Conference Call. At this time, all participants are in a listen-only mode. After the speaker presentation, there will be a question-and-answer session. As a reminder, today's program is being recorded. And now I'd like to introduce your host for today's program, Scott Zuehlke, Senior Vice President, CFO and Treasurer. Please, go ahead, sir.

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.

Thanks Scott. We are extremely pleased with our fourth quarter and full year 2020 results, especially considering the uncertainty that has existed since the beginning of the pandemic. The full year 2020 results were like a roller coaster ride. The year started very strong before COVID began to impact operations during our second quarter. The pandemic caused uncertainty at all levels of our business, slowdowns across all of our product lines, and temporary plant closures in the U.K. Then, volumes rebounded swiftly midway through the third quarter, which has continued through year end. We ended 2020 with record order and sales levels in October. As Scott mentioned, we generated net sales of $851.6 million in 2020, which was 4.7% lower than 2019. However, even with the lower volume in sales in 2020, we were able to increase adjusted EBITDA on a consolidated basis. The increase was driven by our continued focus on operational improvements, along with SG&A reductions. Also, in a renewed effort to improve our return on invested capital metric over time, we have implemented various processes designed to improve capital efficiency, reduce costs, and really scrub the expected returns on our capital projects. In fact, over the course of the last three years, we have significantly improved ROIC, and we plan to stay the course and expect further improvement in this metric in the coming years. Before I move on to discuss market and segment performance, I would like to take a moment to thank the entire Quanex team for their continued commitment and dedication to keeping each other safe, maintaining a high level of supply and quality performance for our customers, and for giving their time and resources to help the communities in which they live. It has been a challenging year for everybody and I am very proud of what the Quanex team has accomplished. From a macro perspective, the markets we operate in are all showing robust activity, despite the ongoing challenges presented by COVID. Pre-pandemic, we strongly believe that the U.S. housing market was under-built. Fast forward to today, and you can see a growing migration from urban to suburban living, low existing housing inventory, low mortgage rates, and what appears to be a pickup in millennial household purchases. Given all these factors, we believe the stage is set for what should translate into continued high demand for building products for the foreseeable future.

Certainly. Our first question comes from the line of Daniel Moore from CJS Securities. Your question, please.

George and Scott, good morning. Thanks for taking the question.

Hey, good morning.

Starting with Europe, exceptional strength, obviously in Q4 and carrying forward, how much of that in Q4 would you attribute to kind of catch-up for manufacturing shutdowns earlier in the year and are we now through that process? In other words, going forward, is it more sort of a one-to-one end market demand versus your production?

Dan, this is George. So, to answer your question, we feel like that it isn't a catch-up that the demand is actually there. And the reason why we take that position is really the nature of product, especially on the vinyl profile. The size of the product and the bulkiness of it doesn't really allow for building of inventory. So, it is a one-for-one shipment to the job site, and we do not see any slowdowns in the near-term, and we expect that this will continue throughout 2021.

Helpful. And you gave estimates of growth for each of the segments in fiscal 2021. You're experiencing relatively similar growth in fiscal Q1? Are you doing a little bit better perhaps to start the year in Europe? And maybe just a little bit of cadence around that guide would be really helpful.

Hey, Dan, this is Scott. I can handle that one. So far, this first quarter is unlike any other in recent history where it's much stronger already. And I think from a cadence standpoint, on the revenue side of things, I would be modeling around 20%, maybe a little more than that for the as a percentage of full year revenue in the first quarter. Typically, I think that's been closer to 15% prior year.

Overall, correct? Not just Europe?

Correct. That's overall.

Got it.

Yes.

Understood. Okay. Really helpful. And then, the guide for the full year implies a range admittedly, but relatively flat EBITDA margins despite pretty significant growth. So, is it tougher comps with raw materials, higher SG&A, conservatism, a combination of all three?

I would say it's a combination of all three, but really the thing that we've hedged a little bit on the margins is that we are seeing some pressures for the first time on some raw material inflation, as well as we're still dealing with labor-related COVID impacts. So, over time it tends to be a little higher in certain spots as people are still quarantining and testing positive. And so, until we get the vaccine and that shows some effectiveness, we anticipate that labor will continue to be tight for not only us, but our suppliers and our customers.

Yes. And then, the way that we forecast for medical expenses is, we're expecting somewhat of a reversion to what had been normalized prior to 2020. Medical costs in 2020 were much lower than expected.

Got it, okay. And then capital allocation, obviously, balance sheet is in the best shape, it’s been in quite some time generating plenty of cash. You bought back a little bit more stock. Maybe just update us on your priorities and willingness to be a little bit more aggressive from here?

The situation is obviously fluid and as opportunities present themselves, we'll continue to look at everything. How I would answer that is, we have a very aggressive but achievable five-year strategy plan that we use as our roadmap. That strategy plan, in our mind, creates significant value for our shareholders, so that gives us a good baseline on where we're going to fund our growth. As opportunities arise, if they exceed that threshold, we'll obviously take a look at them or if they present maybe a different growth profile, we're not going to not look at it, but we have a defined plan. We will continue to pay down debt and that will be our priority, and we'll often opportunistically buy stock when we can. But, we're very comfortable with our strategic plan, and it provides growth and value to our shareholders. And the good thing about this is, our balance sheet is in a position that when opportunities do arise, we're in a position to be able to jump on them very fast. And so, that's why I answered the fact that it's a pretty fluid situation, but we're in a very good spot.

Indeed. Lastly for me, Scott, my pencil wasn't fast enough. Can you run through, I heard depreciation, $33 million, just the other pieces of the guide for fiscal 2021?

Yes. Let me find it here.

Sorry, about that.

Depreciation, $33 million; amortization, $14 million; SG&A, $95 million to $100 million; interest expense, $3.5 million to $4.5 million; and then tax rate of about 26%.

Perfect. And the CapEx guide embedded in that $60 million-ish rough free cash flow?

Roughly $30 million.

Perfect. Thank you. I’ll jump back with any follow-ups.

Sure.

Thanks, Dan.

Thank you. Your next question comes from the line of Julio Romero from Sidoti & Company. Your question, please.

Hey, good morning, George and Scott.

Good morning.

Good morning.

Hey. I wanted to ask about pricing across the three segments. Really appreciate you giving by segment, your outlook for revenue there. But can you just talk about – is there any kind of pricing gains embedded in any of the three?

We're looking at pricing opportunities where they exist. As you know, in North America, most of our products are on index for raw material pass-throughs. So, the opportunities will be obviously evaluated on a case-by-case basis for non-material related increases. We're seeing inflationary pressures. So, we'll obviously try to pass along those where we can or parlay those into growth opportunities to pair back. In Europe, because things are not on an index, yes, we'll be a little more aggressive with price, and that will be dictated by the market.

Got it. So, I guess right now, the top line guidance, no real price embedded in it at the moment?

I would say limited price other than what we expect for index.

And more rifle shot approach.

Got it. Could you discuss the $30 million you're allocating for CapEx in 2021? Considering your balance sheet and expected cash flow, is there a chance to invest more than $30 million in internal initiatives this year?

I understand that my business leaders would prefer to exceed $30 million. However, we have a limited number of engineers and can only manage so many projects at a time. Therefore, we will be strategic in how we launch and implement capital expenditures. Our focus will be on generating returns and ensuring that we complete projects successfully and to our expectations, rather than just spending for the sake of spending. We are very methodical in our approach. If we can integrate projects quickly enough, there may be a chance to invest more than $30 million, particularly in initiatives that enhance margins or improve the company's profile while exceeding our cost of capital. Our priority is to be diligent in achieving the results we expect from the projects we undertake.

Got it. You mentioned that your top priority for cash is paying down debt, followed by opportunistic share repurchases. Given your free cash flow guidance, do you expect to reach a net cash position fairly soon?

Should be in by 2023.

Excellent. Thanks for taking the questions.

Sure. Thank you, Julio.

Thank you. Our next question comes from the line of Reuben Garner from Benchmark Company. Your question, please.

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

Thanks.

Thanks, Reuben.

To begin, can you discuss the growth in North American fenestration compared to cabinets in the near term? It's encouraging to see that cabinet growth has returned. Has the anticipated increase in new housing from the summer not yet impacted the full quarter? Scott, you mentioned the strong outlook for Q1; is that where we might start to see the advantages of the North American fenestration growth?

Yes and no. I mean, I think, we're seeing strength across all product lines, cabinets included right now. What we're still challenged within the cabinet business is just this shift from semi-custom to stock. And we've been pretty successful in navigating that shift over the past probably six to nine months, and we expect to continue to be successful there. But we're still battling that and we expect to continue battling that for the foreseeable future, at least this year. However, what I can say on that front is, if you follow KCMA data, that shift has slowed significantly, which will benefit us and has benefited us moving forward. But a lot of the growth, as indicated in the release will be coming from the North American Fenestration segment. Screens are still doing really well.

Got it. Okay. You talked about the guidance for the margins and the factors affecting them for the upcoming year. If we maintain this level of growth over the next few years, which seems reasonable, what margin targets do you believe are achievable for either the consolidated results or by segment three years from now?

Yes, that's a little tougher of a question. I think from a consolidated standpoint, let's just take it segment-by-segment just to give our bogey the opportunity there. So, top of the list there would be our cabinet business or the North American Cabinet Components segment. We still think that the margin expansion opportunity is real, and could exceed probably a couple of hundred basis points over the next two to three years. There's still some left in the North American Fenestration segment. So, you should expect some margin expansion there, albeit smaller than cabinets. And in Europe, quite frankly, the margins are so good there and so healthy that we're just trying to protect and maintain margins there.

We are currently highly focused on return on invested capital and reviewing past projects. Our operational execution has been diligent and has exceeded expectations over the last few years. We have several projects lined up for the short to mid-term and are excited about opportunities for margin expansion while remaining diligent in this area.

Okay. In terms of the new administration, are there any risks related to the potential elimination of tariffs or opportunities arising from possible code changes in the U.S. aimed at enhancing energy efficiency in homes? If these changes were to materialize, would you have an advantage over your competitors, or would it benefit everyone similarly?

Yes, I'll run with that one. I think, we have identified both risks and opportunities associated with the new administration, and we've talked about that for a period of time. On the risk side, we have benefited by some of the tariffs on the cabinet side as well as our customers. I'm not sure that those will be repealed to a level where it's just completely open. And I think there's been enough changes in the supply base that it's not a catastrophic risk, but it's a risk nonetheless that could put pressure on margins down the road. But we feel pretty good about our plans to weather that risk. It is an opportunity in terms of energy efficiency codes. As you can see in Europe, where those codes and standards are very much in place, they're probably 10 years ahead of the U.S. in terms of their requirements for passive house and electrical usage. And you're right; our product lines absolutely meet those standards and add to better performing products in the fenestration industry. So that would be an opportunity for us. Energy Star was there at one point. And that's why we saw some of the drive in some of our products, something like that reinstituted. We believe, would have a benefit for us.

Great. Congrats again on the quarter. And you guys have a Merry Christmas and a Happy New Year.

You too.

Thanks.

Reuben, thank you.

Thank you. Our next question comes from the line of Steven Ramsey from Thompson Research. Your question please.

Hey, good morning guys.

Morning.

Good morning.

I would like to discuss the CapEx outlook, which has increased from the $25 million spent over the last two years. Can you explain what projects are contributing to this increase and the proportion of this year's CapEx that is focused on growth versus enhancing margins? Additionally, if possible, could you provide some details by segment?

Sure. I will give you a general overview. We probably would have spent more in 2020 if we could have. Some of our projects were restricted due to equipment sourcing from overseas or across borders. We faced challenges in getting people to install the equipment because of travel and quarantine restrictions. That was the main limitation in 2020; it wasn’t a matter of us trying to limit projects or reduce cash flow. It was really about logistics and getting equipment into the pipeline. Looking ahead, most of our investments will focus on growth and capacity expansion in specific areas, particularly to support our growth in Europe as we gain market share. We will invest in our mixing capabilities and some of our spacer capacity as well. In North America, expect to see continued investment in technology improvements and cabinets as we implement new methods for processing wood that enhance margins. This is why there is a significant opportunity for margin improvement in the Cabinet segment through technology advancements. In North American fenestration, our focus will be more on growth. We made a substantial investment in upgrading vinyl profile technology, and we are already seeing positive results sooner than expected. If all goes well, we may proceed to the next phase of that project. We are also continuing to expand our screen business and will look to add capacity based on volume and sales opportunities. This is the approach we will take regarding our CapEx over the next one to three years.

Excellent. And thinking about the guidance for North America Fenestration mid-single to high single-digit, can you talk about some of the factors there that might swing you to the low-end or the high-end? And how much of this is impacted by longer lead times, maybe in certain end markets, maybe driving strength early in calendar 2021 or mid-calendar 2021? Any factors on the North American Fenestration sales range?

The factors that could lead us to the low end of the range are primarily market dynamics. If our customers struggle to find labor for window installations, this limitation could dampen demand not only for Quanex but for the entire industry, likely pushing us toward the lower end of the range. On the positive side, if they can redirect their labor to window or door installations and continue to outsource some components, this could present us with opportunities. For instance, if a company that typically manufactures on-site decides to outsource to a supplier to better allocate their labor, and if that trend persists, we may experience growth rates that are closer to the upper end of the range.

Got you. And then last quick one for me. Maybe thinking for Q4 results and then what's embedded in the outlook for expenses, how much have expenses that were pulled back tightly as COVID hit in the spring? How much of those have come back to-date? How much of those are coming back in 2021; T&E being one of those items, but whatever other cost items are coming back or staying reduced?

Well, the T&E piece is really the one item that I would say is still being held back really just based on travel restrictions and quarantines and the uptick in cases here recently. But we suspect that as the year progresses in 2021 that we'll get back to a more normalized T&E level, probably not back to where we were in 2019, but slowly progressing for so the spend for that item will go up over time.

I believe there are several areas to consider. For instance, when evaluating SG&A, we will examine what insights we gained during this virtual period, including aspects like trade shows that can be quite costly. We need to determine if there's a different approach that provides us value. While I expect some return to normalcy, I think we have adapted and some things may change permanently. Therefore, I'm not entirely sure that everything will revert to the way it was before the pandemic.

Great. Thanks for the color.

Sure.

Thank you. Our next question comes from the line of Ken Zener from KeyBanc. Your question please.

Good morning, everybody.

Good morning.

Hi, Ken.

Impressive quarter. A lot of details. I wonder because I just looked at the press release, George, this is about a year for you being CEO, correct?

That is correct. We're a year in January 1.

Good. It's been a long year, so I had to double check that. This year, considering your success, I have individual questions, but I wonder if you could provide some perspective. Bill has faced various challenges, and I know you shifted from the spacers business to operations. Despite strong efforts, the industry presented many unexpected challenges. Ironically, one of the biggest was COVID, yet you've delivered very solid results. My first question is, if we could take a step back, how has your view of the company changed now that it's been a year since you became CEO, particularly with COVID happening? What's different about the company's opportunities now? I just wanted to understand, especially since this has been a very strong quarter, if it's indicative of even better things to come.

That's a great question. When I took a moment to reflect, I realized that while I would like to attribute the results to my role as CEO, that wouldn't be accurate. Being the internal successor has certainly made the transition smoother since I was involved with strategy before assuming this role, and we have maintained our strategic focus throughout. Under Bill's leadership, we have established a strong operational framework to achieve our goals, and we have not strayed from that path. We have assembled a new team, and my fresh perspective has encouraged us to collaborate in new ways. Additionally, COVID has prompted us to rethink our approach, which can be beneficial. I've come to understand that our five-year strategic plan is robust, and our emphasis on operational excellence has positioned us well. Over the past year, I’ve discovered more about the opportunities ahead than anything else. I initially thought COVID would drastically alter everything, but it hasn't, which speaks to the strength of our current setup. We have a clear plan and a solid risk management process in place. So it's not a matter of panic, but rather executing our plan effectively. In that sense, I’m downplaying my contribution, but that reflects the reality.

Right. No, I think that's understood. Well, I appreciate that. Look, I do have some questions. I do think you guys should think about hosting at the Analyst Day as well, just to reacquaint, it's been a while since you guys have done that. That's something I would suggest, just to add more to your plate. All right. Some specific questions. Your margin improvement was pronounced, it was greatest in Europe Fenestration from a margin and EBIT contribution perspective. And your gross margins went up substantially. Is that really the gross margin lift and the EBIT expansion we saw in European Fenestration? Isn't that the same thing that high growth drove a lot of that margin, or is there something else like, lower input costs that we should be aware of?

For last year, I mean, it's a combination of those. The majority of it was volume-driven. And because they're extrusion operations, when you can lever up and effectively run efficient at high full capacity. You should see margin expansion. So, there was no surprise there. When you're at full volume, we're going to do very, very well. And that was the case in both spaces and the vinyl extrusion. We did see a period of time early in the quarter where we had some lower-than-anticipated raw material costs, which has since started to creep back. And as you know, the European products are not on index. So, when the raw material inputs are a little bit lower, we're going to see higher gross margins. And that's exactly what we saw.

Now switching to U.S. windows, which is a category, new construction, R&R, that's actually been called out by many industry participants as having bottlenecks. Could you from your perspective as a supplier for both the extrusion, the edge spacers, and screens. Can you talk to, what is different based upon what you're seeing right now as opposed to history? Is it the fact that, crews can't be so close together? Is it that they can't scale up? Why is that industry on such a bottleneck right now given your perspective?

I believe the main issue is labor. It's difficult to grasp because there are reports of 10%, 12%, and even higher unemployment rates nationwide, yet we struggle to find workers for our plants. From our discussions with customers, we understand that installing our products requires significant labor. If someone were to attempt to build a new house or undertake any project now, they would face lead times of at least two months, which has become the norm. From what I see and hear, this is fundamentally a labor bottleneck.

Could you describe both in factories as well as in the field, correct, George?

Yes.

Now as that relates to your Warm Edge Spacer, which the last time I think publicly, you guys talked about it a lot at your Analyst Day. Warm Edge Spacer’s, reflect lower volume customers historically, because they have to do it manually. However, there are some new machines that some of the larger window manufacturers, the higher volume machines get close to 1,500 units to ship, that actually use less labor. Can you talk to how market share has gone for you in that category related to customers buying those $1.5 million machines to cut their production, their labor intensity down by half?

Yes, it continues to progress at a slow and steady pace. The only reason for the slow progress is the limited number of equipment manufacturers worldwide, with only four or five suppliers available. In the U.S., there are really only one or two manufacturers. During the COVID year, the situation was challenging as two of the major suppliers are based in Europe and were unable to send personnel to install equipment, causing delays in implementations. However, the demand to reduce labor through automation is strong, and there is a robust pipeline of equipment orders that will benefit us. The equipment manufacturers are sold out for probably the next two years, so the bottleneck lies in getting the equipment deployed in the field.

Can you publicly state how the equipment reduces the number of people needed per line shift in production? I believe it goes from about seven or eight people for 1,500 units down to two or three. Is that correct?

It's 400. Eight or nine people down to three people.

Right. That's eight or nine on a manual. Yeah. Okay.

Yes.

Last question, cabinets are improving. The market is performing better, providing a tailwind. Can you quantify the lost customer exposure for fiscal 2020 in total, particularly in the fourth quarter? Also, while conditions are improving, the margin isn't exceptional. EBITDA has shown improvement, but can you discuss the potential margin? You mentioned a couple of hundred basis points, Scott. When you acquired the business, it was around 200 to 300 basis points at the EBIT level. I'm surprised that the target is just a couple of hundred basis points from zero EBIT. Is that correct or could you clarify?

A couple of hundred basis points on EBITDA margin expansion over the next two to three years, yes, what I said. On the customer that exited the cabinet business, that on an annualized basis, that was roughly $11 million to $12 million.

Thank you very much, gentlemen.

Thanks Ken.

All right. Thanks.

Thank you. This does conclude the question-and-answer session. I'd like to now hand the program back to George Wilson, CEO for any further remarks.

Yes, I'd like to thank you all for joining and we look forward to providing you all an update on our next earnings call. I'd like to take this opportunity to wish you all a very happy holiday. Be safe. Thank you.

Thank you, ladies and gentlemen, for your participation in today's conference. This does conclude the program. You may now disconnect. Good day.