Quanex Building Products CORP (NX) Q4 2021 Earnings Call Transcript

Good day and thank you for standing by. Welcome to the Fourth Quarter and Full Year 2021 Quanex Building Products Corporation Earnings Conference Call. At this time, all participants' lines are in a listen-only mode. After the presentation, there will be a question-and-answer session. Please be advised that today's conference is being recorded. I'd now like to hand the conference over to your host today, Scott Zuehlke, SVP, CFO and Treasurer. Please go ahead. 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 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 to our website. I'll now discuss the financial results. Net sales increased by 14.2% and 25.9% during the fourth quarter and full year of 2021, respectively, record growth for both periods. As a reminder, both of our manufacturing facilities in the U.K. were shut down in late March of 2020 and did not resume operations until mid- to late May last year. The increases in revenue were mostly due to improved demand across all product lines and operating segments, combined with higher prices primarily related to the pass-through of raw material cost inflation. More specifically, for the fourth quarter and full year, we posted net sales growth of 10.1% and 19.6%, respectively, in our North American Fenestration segment, 15.9% and 17.1%, respectively, in our North American Cabinet Components segment and 17.6% and 45.6%, respectively, in our European Fenestration segment, excluding the foreign exchange impact. We reported net income of $20.9 million or $0.62 per diluted share for the three months ended October 31, 2021, compared to net income of $22.2 million or $0.67 per diluted share during the three months ended October 31, 2020. For fiscal 2021, we reported net income of $57 million or $1.70 per diluted share compared to net income of $38.5 million or $1.17 per diluted share for fiscal 2020. On an adjusted basis, net income was $20.8 million or $0.62 per diluted share during the fourth quarter of '21 compared to $22 million or $0.67 per diluted share during the fourth quarter of 2020. Adjusted net income was $58.6 million or $1.75 per diluted share for fiscal 2021 compared to $40.7 million or $1.24 per diluted share for fiscal 2020. The adjustments being made to EPS are for restructuring charges, certain executive severance charges, foreign currency transaction impacts and transaction and advisory fees. On an adjusted basis, EBITDA decreased by 5.3% to $37.3 million in the fourth quarter of 2021 compared to $39.4 million in the fourth quarter of last year. For the full year 2021, adjusted EBITDA increased by 21.3% to $126.8 million compared to $104.5 million in 2020. The decrease in earnings for the quarter was mainly due to inflationary pressures and supply chain challenges. The increase in earnings for the 12 months ended October 31, 2021, was largely due to higher volumes, improved operating leverage and better pricing. This increase was somewhat offset by higher raw material costs and an increase in selling, general and administrative expenses. I'll now move on to cash flow and the balance sheet. Cash provided by operating activities was $78.6 million for the 12 months ended October 31, 2021, compared to $100.8 million for the 12 months ended October 31, 2020. We generated free cash flow of $54.6 million in 2021 compared to $75.1 million in 2020. The decrease was primarily driven by an increase in working capital, more specifically the value of our inventory due to inflation. We were able to repurchase $11.2 million in stock and we repaid $65 million of bank debt during fiscal 2021, $20 million of which was repaid in the fourth quarter. Our balance sheet is strong. Our liquidity position is solid. And our leverage ratio of net debt to last 12 months adjusted EBITDA improved to 0.1x as of October 31, 2021, which is a half turn lower than where we exited fiscal 2020. As for 2022 and as noted in our outlook section in the earnings release, we have chosen not to issue guidance just yet. Demand remains strong, but ongoing supply chain disruptions continue to create uncertainty. With this backdrop, we believe it would be premature to give guidance at this time. We do believe that we should be able to realize margin expansion on a consolidated basis in fiscal 2022, but we also think that margin expansion will be second half loaded. As we sit here today and to set appropriate expectations for the first quarter of 2022, we currently expect mid-single-digit net sales growth for the first quarter, mostly due to price increases but margins will be pressured compared to the first quarter of 2021. We hope to provide an update on full year guidance when we report earnings for the first quarter of 2022. As a reminder, there is a fair amount of seasonality to our business. The first quarter of each year is typically the low watermark with the second half contributing most of our earnings and free cash flow. I'll now turn the call over to George for his prepared remarks.

Thanks, Scott. We are extremely pleased to announce that 2021 was a record year for Quanex despite numerous challenges. We reported record revenue and earnings and return on invested capital continued to improve. In addition, we reported another year with solid free cash flow. In fact, cumulative free cash flow over the past five years is approximately $325 million. Also, as Scott mentioned, we were able to pay down $65 million of debt and return $11.2 million to shareholders through share repurchases during the year. While we are very pleased with these results, we're not surprised. In an environment with strong demand, the operational improvements we've made in our manufacturing facilities over the past four years, combined with the systemic and permanent changes we've made to our working capital management, continued to yield strong results. I am very proud of the entire Quanex team for the energy, effort and performance they continue to deliver to our customers, communities and shareholders. Before providing comments on segment results, I will give some additional color on our view of the events of 2021, the markets we serve and the macroeconomic environment we currently face. As we enter 2021, there was optimism and hope that the COVID pandemic would soon be under control and that operating environment would return to some level of normalcy. As different variants spread and vaccine uptake proved lower than expected, the optimism was soon replaced by the reality that the battle against COVID is far from over and that measures to contain or minimize the spread of the virus will continue around the world. The year also ushered in a new and, in some respects, more significant challenge: supply chain stress and disruption. With the infusion of COVID relief payments into our economy, demand for goods in the Building Products segment increased at record rates. At the same time, the supply chain's ability to ramp up was continually impeded by labor constraints, plant shutdowns or slowdowns, freight issues and significant weather events. As a result, backlogs for finished goods dramatically increased over the year to record levels, and suppliers have been unable to close the gap. All these factors have worked together to add an unprecedented amount of stress to the entire chain. And as a result, everyone around the world is now seeing high levels of inflation, sporadic deliveries and unexpected back orders or stock-outs with little or no notice. This last piece limited visibility on the delivery of goods is currently our biggest challenge. All told, the planning and operational environment we see today is significantly more challenging than in 2020, when our primary concern was the labor disruption caused by the pandemic. When looking at the markets we serve, demand continues to be strong across all segments. Low existing housing inventory and low mortgage rates continue to support strong housing demand and R&R remains healthy due to high levels of back orders and continued strong consumer confidence. Although we continue to watch for a pullback in demand due to inflationary pressures, we are not seeing signs of this at this time. I will now discuss segment results. Our North American Fenestration segment reported revenue of $156.3 million in the fourth quarter, which was 10.1% better than prior year fourth quarter. Solid demand across all product lines, combined with higher index pricing, additional surcharges and permanent price increases accounted for the stronger revenue performance. Adjusted EBITDA of $20.2 million in this segment was 15% less than prior year fourth quarter. Volume-related benefits were more than offset by increases in material costs, normalized medical costs and higher SG&A driven by incentive compensation. As a reminder, approximately 80% of our North American Fenestration business has contractual raw material pricing index mechanisms. The timing lag of these indices are typically 60 and 90 days, and therefore, we are in arrears and chasing price until the rate of inflation flattens or reverses. At such time, we would expect to see a period of margin improvement or catch-up. For the full year, this segment had revenue of $578.3 million and adjusted EBITDA of $75.4 million, which represents a 20 basis point margin decrease from prior year in a very challenging inflationary environment. We generated revenue of $69.7 million in our European Fenestration segment in Q4, which was $12.9 million or 22.7% higher than prior year or up 17.6% after excluding the foreign exchange impact. Strong demand in the U.K. and Continental Europe, combined with price increases, resulted in record revenue levels for the segment. Adjusted EBITDA of $12 million in the quarter was 10.1% less than prior year Q4. The drop in margin percentage for the quarter was driven by material inflation, normalization of SG&A expenses, and increases for incentives. On a full year basis, this segment had revenue of $251.6 million and adjusted EBITDA of $50 million, which equates to margin expansion of 160 basis points versus prior year. Our North American Cabinet Components segment reported net sales of $66.6 million in Q4, which was 15.9% better than prior year. Strong demand combined with higher index pricing and additional permanent price increases were the drivers for higher performance. Adjusted EBITDA for the segment was $5.4 million, which represents an increase of 16.3% compared to prior year fourth quarter. Volume benefits, combined with pricing actions, improved wood yields and normalized expenses all contributed to the favorable performance by largely neutralizing inflationary pressures during the quarter. For the full year, this segment had revenue of $246.1 million and adjusted EBITDA of $14.2 million, which was an improvement of 17.1% and 22.5%, respectively. We were able to realize margin expansion of approximately 30 basis points in this segment even though we chase price all year. And as a reminder, 100% of our cabinet business has contractual raw material pricing index mechanisms. Finally, unallocated corporate and SG&A costs were $2.1 million lower than the prior year fourth quarter. The primary drivers of the lower expenses were true-ups for stock-based compensation expense and lower-than-planned medical expenses in the quarter. For the full year, unallocated corporate and SG&A costs were $12.8 million, which returned to normalized levels versus 2020, which was a year impacted by COVID. As Scott mentioned in his financial commentary, cash flow generation remains solid despite a significant increase in the value of our inventory due to inflation, and our balance sheet is strong. Our Board of Directors recently authorized a new $75 million share repurchase program, and we will continue to utilize this authority in the open market and on an opportunistic basis. We have positioned ourselves well, and we will continue to evaluate all opportunities to create value for our shareholders. As we look forward into 2022, we remain very optimistic on the demand environment. Our customers are reporting record levels of backlogs and this, combined with current favorable housing and R&R markets, should translate into continued strong demand. Operationally, we feel we have made progress on our hiring needs by raising starting wages by an average of $1.80 per hour in our manufacturing facilities. Outside of the index pricing and the associated time lags, we have been able to implement surcharges and permanent price increases to help offset inflation. The major challenge we currently face is supply chain and freight uncertainty, and it is for this reason alone that we have decided not to provide specific financial guidance for 2022 at this time. Due to continuing supply chain disruptions, we have very little, if any, visibility into our short-term delivery schedules. In this environment, it is extremely difficult to predict the cadence for shipments over the next few months or the potential costs associated with sudden changes in schedules. And therefore, we think it is prudent to not provide guidance until such time as we can gain some forward visibility. In summary, we continue to execute on our strategy and are proud to have delivered a record year in a very challenging environment. Demand remains strong, and if the global supply chain stabilizes and our businesses continue their excellent operational performance, then we believe it will translate into revenue and earnings growth in another solid year in 2022. We will continue to stay focused on executing on our strategic plan, and we look forward to reaching a point where we can give more definitive guidance. And with that, operator, we are now ready to take questions.

Our first question comes from Daniel Moore with CJS Securities.

I wanted to start with maybe just kind of price versus quantity in Q4. Is it possible to give us a sense of how much of the revenue growth and in the case of Europe, ex-currency revenue growth came from price adjustments versus quantity?

I don't have a specific breakdown. However, unlike previous quarters, I can state that the price increase was the main factor driving growth more than volume, although volume also increased.

Across all three, for the most part, at least.

Yes. That's correct.

That's helpful. And even more difficult question, but if we had to guesstimate kind of true underlying demand for each segment relative to quantity, in other words, how much faster revenue could have grown in the quarter had not been for supply chain and logistics. Any color or sense there and maybe order of magnitude for rank order each one where the biggest challenges are, if you will.

Dan, you're right. It is a very difficult question. Our current order patterns indicate that demand remains extremely strong across all product lines. However, in some areas, customers are choosing to adjust their schedules to provide their workforce with breaks. This makes it challenging to assess how much additional volume could have passed through the system, since our customers are making decisions to scale back. Therefore, I hesitate to provide a specific number for what the volume might be if everyone were operating at full capacity. All these factors are interconnected. Currently, we have a mix of uncertain deliveries influencing the situation, along with customers deciding to give their labor force some time off. As a result, it's tough to provide an accurate answer.

Understood. Just trying to get a flavor of the relative size of kind of underlying demand, but I appreciate that.

What I can tell you, Dan, is in almost every case, our customers are seeing significant growth in their back orders. So as you go out and look at other companies that report publicly, you'll be able to get a good feel for what they're seeing. And there's still significant pent-up demand.

Yes, that’s very consistent. Perhaps another question. If, based on the price increases we implemented in fiscal '21, we didn’t raise prices again from this point and volumes remained flat, what kind of revenue growth would that roughly translate to in fiscal '22?

Yes. I mean if you're talking about flat volume just from a price standpoint, you're probably low single-digit growth.

Got it. Just on what's gone through already, not additional price increases?

Yes. Timing impact of the price increases because, obviously, they've been staggered throughout the year.

Exactly. That's helpful. Do you have an outlook for the overall windows market in North America and/or Europe as we consider fiscal or calendar '22?

That's part of the uncertainty here. But what we have referenced in the past is for North America anyway, Ducker is a third party we use. And last update they showed for '22 versus '21 on window shipments was low single-digit growth and around the two-plus percent range.

And in Europe, I would say what our customers are predicting, again, with very little and limited visibility is relatively flat year-over-year on volume.

Coming from a high base.

That's been a heck of a run, no question. Maybe shifting gears, one more just CapEx expectations for fiscal '22. And then in terms of buybacks, the prior repurchase authorization executed over two to three years. Do you anticipate a similar timeline or maybe being more accelerating that given where we are with the balance sheet? And thanks for all the color.

So on the CapEx front, if you recall, our guidance for 2021 for CapEx was, I think, $30 million to $35 million. I think we're comfortable staying around the same amount for 2022 guidance for CapEx. We underspent that budget last year, and it wasn't because we were pulling back on any projects. It's just lead times for equipment are such that everything is moving to the right. On the buyback question, really, there's not an answer I can give or clarity there. It's on an opportunistic basis. If we continue to feel that our stock is undervalued versus our peers, which obviously, we feel that way today, we could ramp that up over the next several years. I mean $75 million is actually considerably more in the open market than we had last time because if you recall, the $60 million, half of that was purchased by one firm. So essentially, we sold $30 million in the open market over a three-year period. So I would think that we could ramp that up.

Our next question comes from Reuben Garner with Benchmark Company.

Let's see. So I think Dan asked about the price versus volume in the fourth quarter. Scott, what about the full year in your fiscal '21? Can you give us like a ballpark how much of the 26% revenue growth was price versus volume?

For the full year, it was more volume than price on a full year basis. Out of that 26% growth, I would say, 15%, 20% is probably volume.

Okay. That's helpful. Are you finding that your supply chain issues are affecting you less than your competitors when it comes to getting products out the door? Are there any notable differences in pricing strategies among your peers? Do any of them have advantages or disadvantages compared to your situation?

In terms of our competition, much of it depends on size and scale. We stand out in our sector as we are larger, and I believe we are performing as well as or better than our competitors in sourcing raw materials. Currently, in the market, no one is significantly increasing prices or causing pressure on volumes. Everyone is facing substantial inflation and supply challenges, and right now, the focus for all is on maintaining their customer base and meeting their needs. There isn’t much aggressive market share competition at this point; we're all somewhat entrenched due to the limitations on what can be sourced. It’s really a situation resembling trench warfare at the moment.

Okay. And then a couple of questions on capacity. So two sides of the question here. The first is, do you have any plans for increases in areas where you're either low or looking to expand like the screens operation or cabinets? And then on the flip side, any updates on maybe the areas where you are underutilizing your assets and you guys have been working on trying to offer other products or services? Any progress there that you can talk about?

So on your first question in terms of capacity expansion, I think, we continue to go forward. We talked about adding some mixing and blending capacity in the U.K. for our vinyl extrusion business. That will continue. And that project is in process. Again, as Scott mentioned, the timing of such is impacted because of lead times to get equipment and it's extended, but we're looking to add capacity there. We continue to evaluate the screen markets in areas where we're underserved. We will look to expand our geographical footprint, but that's also going to be predicated on not being able to get enough raw materials to be able to support it. We also have a project in our spacer business in Germany that we're adding additional capacity for our rubber extrusion for those spacers in Germany, and that continues. So in certain pockets, we are going forward and investing and spending in the business. The second piece of your question, on any parts of our business that are underutilizing our assets. The best example of that and it has been a win is on our vinyl extrusion business in North America. We talked a lot about focusing on return on net assets, return on invested capital. We continue to expand our capabilities in producing light parts primarily in fence posts and fencing, vinyl fencing components. And I think we've proven that we're a very reliable supplier in supporting that industry and that continues. It's had a positive impact on our vinyl extrusion business in North America.

Any comments on how big of an industry or opportunity that is for you guys?

We're pretty early into this, Reuben. So as we continue to develop it, we'll try to give a little more guidance in the future. I don't want to come out and give targets or guidance at this time on the size. We're relatively new into this space.

I mean I can add a little bit there. I think the main difference between the fencing sector of the industry versus the window profile sector of the industry for vinyl extrusion is that the fencing sector is bumping up against capacity. So, they're looking to add capacity where that's where we can come in and help whereas on the windows side, there's a lot of spare capacity. So, it's just about getting our assets up and running. We are an expert at extruding vinyl. It doesn't really matter what the product is.

Congrats on the quarter. I know it's a tough time. Happy holidays.

Thanks, you too.

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

Can you talk about supply chain and freight in Europe and how that differs from your U.S. operations?

Yes. So, the products that we have in Europe, the supply chain is very similar, although the logistics piece of it is a little more complicated in Europe. So, we utilize for our spacer business in Europe and in North America the exact same supply base. So, they'll face the same challenges as it relates to demand and pricing. We've seen anything that's being shipped internationally, it has added some additional stress, as you can imagine, with trying to get containers that are shipped or anything that's put on a boat. I'm not going to rehash that story. Everyone's seen it. That's the biggest difference between what we see. Luckily in Europe, our largest silicon supplier is located in Continental Europe. So that has added some stability, but very, very similar when we compare the two, Julio.

Okay. So similar challenges, whether you're in Europe or the U.S. Okay. And I guess piggybacking on an earlier question. You talked about your supply chain issues relative to your competition. But how about relative to customers, just given your business model, your customers are oftentimes your competitor as well? So are you seeing greater or less supply chain challenges than your customers?

We have developed strong and lasting relationships with most of our partners. We have collaborated with many of them to enhance our buying power together. This has fostered a cooperative environment where we both seek to assist one another in addressing the supply chain challenges we face. However, communication around labor issues remains crucial, as labor shortages continue to hinder companies from bringing services in-house. Despite our efforts in tackling the labor market issues, the competitiveness still limits their ability to in-source to a level that could pose a risk.

Our next question comes from Ken Zener with KeyBanc.

So not your average quarter. The earlier question about fence post and like products wasn't really where I was going to go, but your extrusion plants had real issues in the past. There's capacity. There still is, the windows. But one of the big things obviously in extrusion is just having long cycle runs, right, where you don't have to change out the profiles, et cetera, et cetera. It seems to me, I'm not an expert in this, but defense poster is really just wrapping around. It's just a 4x4-inch run. So you not only have the growth potential of your fixed asset, but it seems to me that it's essentially the same run constantly because it's a white, gray or black fence post, where you don't have to change out profiles. Is that correct?

I would say, generally, you're absolutely right. The window profiles that we do are very complex and each customer has something different. So the level of complexity on that extrusion is pretty significant. The fence posts, although not identical, are fairly close. And yes, they tend to be much longer runs with recycled material or more favorable to what you would think on a continuous extrusion process. So, if I were to ask the guys in the plant, they would love loading up on fence posts, yes.

And just a point of clarification, George was referring to our vinyl business here in North America and in the U.K. It's not completely different. Yes.

Can you elaborate on the distribution channel requirements? I understand it's still developing for you, George. I know you prefer not to share specific numbers, but this seems like an important aspect for asset utilization. Vinyl siding is a good example because it has long production runs and a tight distribution network. Are there particular distribution challenges you encounter compared to window manufacturing? For instance, is there a significantly higher selling, general, and administrative expense? Is it costly to establish those relationships despite achieving favorable gross margins? What dynamics are at play here?

It's very similar for us at this point in time. We are an OE supplier to not only the window manufacturers, but now we're an OE supplier of the fencing. They have a combination of manufacturing and distributing, and we are also selling to guys that just distribute fence posts. But at this point in time, we're 100% OE supplier to those guys and have no end distribution to the consumer.

And regional distribution constraints given that you're already out of Kentucky? Is that into Texas and that's kind of the end of your market? Or is there something...

No, we're selling to guys all over the country right now. So, I would say what we see is that the fencing market tends to be regional with the competitors that we're selling to, but we're selling a product that would cover national geographies.

Good. It's great to hear from you all. Now let's move on to the more complex aspects. I appreciate your guidance for the first quarter. It seems like you're providing us with clarity on that. You mentioned that margins would improve, but you're not specifying numbers for the entire year. Please proceed.

On the revenue side, we're saying we should see some revenue growth mid-single digits in the first quarter. Margins will be pressured in the first quarter, not up.

In the first half? Yes, in the first quarter?

Yes.

Yes. No, no, I got that. Exactly. Sorry if I misspoke. So I do appreciate that near-term guidance, realizing you're holding off on the year. But you did say margins up for the year was your expectations, correct?

Right, for the full year.

Yes. Assuming no disasters in the supply chain, we would expect solid...

Understood. Can we discuss the transportation issue you mentioned? It seems you're experiencing increased raw material costs that are indexed and lagging, but transportation costs are soaring. Is the problem related to transportation access, such as not being able to get trucks or your customers struggling to get trucks? I was a bit unclear on that.

I think the answer is yes and yes. There are moments when inflationary pressures on freight are evident, whether through fuel surcharges or actual increases in freight prices. This is the current situation and is likely to continue moving forward. However, part of the reason we're not providing specific guidance right now is that we could find ourselves at the end of a month or quarter with $2 million or $3 million worth of shipments that the trucker simply doesn't show up for that day, which can happen regularly. So, it's a bit of both.

Yes. Now as a component supplier, you have to wait for your customer, who might or might not, right? Do you think because your extrusions are coming out of Kentucky need to go somewhere, your screens are more or less adjacent to your customers, is that a fair statement? Obviously, your space is that Ohio.

That is a fair statement. Screens tend to be a very defined shipment. And we usually control our own freight and have a small fleet of our own for screens. That's the least impact for freight availabilities.

Right. Is it the amazing part? Or is this both the edgers and the extrusion that we're seeing as transportation issue arise?

Primarily, yes. It's definitely more focused on spacers and vinyl extrusions, as well as the changes in freight.

Well, yes. So cost neutrality depends on the pricing lag. If you experience $10 of inflation, you recover $10 of inflation. Is that typically around a six-month lag due to the cost indexes? How does it usually work for you? If there is a specific timeframe, is it three months or six months?

It's usually 60 to 90 days are typically the range we see. I don't think we have any indexes that are six months in length, but 60 to 90 days is pretty standard.

Longest lag is in the cabinet business.

Thank you for answering these questions. It seems like you're managing the business effectively, and I don't want to assume you're not improving. If you have these cost recoveries on the index as you described, how do you view that in terms of maintaining margin neutrality to address the changes in ratios? Is this something you've considered? I understand the cost aspect, but we are particularly focused on margins. How should we interpret that?

I mean that's a difficult question to ask. I mean when we look at how the pricing has impacted us, raw material pricing, specifically over the last six to nine months, what we've found is that even when we think we're going to catch up with the rate of inflation where it's been heading, there have been times, and we didn't catch up enough. So, we're at a point in time where we need to try to be more proactive and forward-looking and try to at least become margin neutral.

Your comments on margins suggest that your confidence for fiscal year '22 is strong.

Yes. I mean I think for margins to be up like we think, we expect at some point, probably more towards the half of the second half of the year that inflationary environment will at least somewhat stabilize, so we can catch up.

I'm showing no further questions in queue at this time. I'd like to turn the call back to George Wilson for closing remarks.

I'd like to thank everyone for joining today, and we look forward to providing an update on our next earnings call. Have a very safe, happy and joyous holiday.

This concludes today's conference call. Thank you for participating. You may now disconnect.