Quanex Building Products CORP (NX) Q2 2023 Earnings Call Transcript

Good day, and thank you for standing by. Welcome to the Q2 2023 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. Please be advised that today's conference is being recorded. I would now like to hand the conference over to your speaker today, Scott Zuehlke, Senior Vice President, 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 turn the call over to George for his prepared remarks.

Thanks, Scott, and good morning to everyone joining the call. All things considered, and with a tough comp to Q2 of last year, we are pleased with our results for the second quarter of this year. As mentioned on our last earnings call, we believe we were starting to see a return to normal seasonality in our business during Q1 of this year, and our results for the second quarter further reinforce that belief. Solid operational performance during the second quarter was somewhat masked by index-related pricing pressure and continued customer inventory rebalancing in our Fenestration segments. Although volumes were down across all segments versus the prior year record levels, we did realize EBITDA margin expansion versus prior year on a consolidated basis. Our strong operational performance also resulted in improved free cash flow, which enabled us to repurchase $5.6 million of our common stock and repay $20 million of debt in the quarter. I will now provide some general comments on each of our reporting segments. In our North American Fenestration segment, revenues and earnings were down versus prior year due to lower volumes, driven by softer market conditions, weather-related softness in West Coast markets, customer inventory rebalancing for our spacer products and pricing pressures on lower raw material costs related to index pricing mechanisms. Operational performance remained strong in this segment, and we did a good job of controlling costs despite the lower volumes. Looking at the LMI acquisition we completed in November, I am pleased to announce that we have realized our announced synergy goal. This business continues to perform very well and we are evaluating growth opportunities. Moving on to our North American Cabinet Components segment. The decrease in revenues year-over-year was primarily a result of lower market demand and the rollback of hardwood-related index pricing. We were able to realize solid margin expansion in this segment despite volume and index pricing pressures. Continued focus on cost controls, combined with capitalizing on the timing of lower cost hardwood purchases, helped minimize volume impacts. In our European Fenestration segment, results were impacted by market softness, customer inventory rebalancing in our spacer business and foreign exchange impact, which more than offset the share gains in our U.K. vinyl extrusion product line. Continued improvements in operational metrics, combined with sourcing initiatives and pricing carryover, all contributed to realizing margin expansion in this segment. Having said that, challenges related to higher energy costs, higher transportation costs, and general inflation are ongoing in this market, and we continue to work with our customers regarding go-forward pricing expectations. In summary, we continue to execute on our strategic and operational initiatives, and we are controlling what we can control. Near-term inflationary headwinds and index-related pricing pressures present challenges for revenue, but the Quanex team continues to perform, and we remain confident in our ability to meet the net sales and adjusted EBITDA guidance ranges for this year. Optimizing return on invested capital and working capital remain top priorities for improved cash flow generation, which will support our growth initiatives and align well with our road to $2 billion strategy. Although macro headwinds still exist for the entire Building Products segment, we feel we are very well positioned to execute on our strategy and create value for our shareholders. I will now turn the call over to Scott, who will discuss our financial results in more detail.

Thanks, George. Before I get started, I want to reiterate that we reported record results in the second quarter of last year. So we did have a tough comp. However, business did improve in the second quarter of this year versus the first quarter of this year. On a consolidated basis, we generated net sales of $273.5 million during the second quarter of 2023, which represents a decrease of 15.3% compared to $322.9 million during the second quarter of 2022. The decrease was largely due to softer demand caused in part by customer inventory rebalancing, lower pricing in North America, and foreign exchange translation impact. Overall, our 2Q results further reinforce our belief that we are seeing a return to normal seasonality in our business. Net income decreased to $21.5 million or $0.65 per diluted share for the three months ended April 30, 2023, compared to $26.5 million or $0.80 per diluted share for the three months ended April 30, 2022. After adjusting for one-time losses on damage to a couple of our manufacturing facilities due to inclement weather, coupled with one-time transaction and advisory fees, net income decreased to $21.7 million or $0.66 per diluted share for the quarter compared to $26.5 million or $0.80 per diluted share for the same period of last year. On an adjusted basis, EBITDA for the quarter decreased to $39.9 million compared to $45.2 million during the same period of last year. The decrease in earnings for the second quarter of 2023 was mostly attributable to lower volumes, decreased pricing, mainly due to surcharge rollbacks and raw material index pricing mechanisms in North America, foreign currency translation, and higher interest expense. Now for results by operating segment. We generated net sales of $157 million in our North American Fenestration segment for the second quarter of 2023, a decline of 11.8% compared to $177.9 million in the second quarter of 2022, driven by a decrease in volumes due to softer market demand, customer inventory rebalancing in our spacer business, and lower pricing. We estimate that volumes in this segment declined by approximately 9% year-over-year, with the remainder of the revenue decline versus Q2 of 2022 due to a decrease in price. Excluding the contribution from LMI, revenue would have been down 21.8% year-over-year in this segment. Adjusted EBITDA was $20.4 million in this segment or about 22% lower than prior year. We generated net sales of $53.5 million in our North American Cabinet Components segment during the quarter, which was 26.6% lower than prior year. This decrease was driven by lower volumes and lower index pricing for hardwood. We estimate the volumes declined by approximately 25% in this segment year-over-year, and the remainder of the revenue decline versus Q2 of 2022 was due to a decrease in price. Adjusted EBITDA was $4 million for the quarter compared to $4.5 million in the second quarter of 2022. We did a good job of controlling costs in Q2 of this year, and we realized adjusted EBITDA margin expansion of 130 basis points in this segment compared to the second quarter of 2022. Our European Fenestration segment generated revenue of $63.8 million in the second quarter, which represents a decrease of 13.2% year-over-year, driven by lower volumes due in part to customer inventory rebalancing in our spacer business and foreign exchange translation. We estimate that volumes declined by approximately 10% year-over-year in this segment, with pricing up by approximately 4% and negative foreign exchange translation impact of about 7%. Adjusted EBITDA came in at $14.9 million for the quarter compared to $15.1 million in the second quarter of 2022. From an operational standpoint, this segment continues to perform well, and we realized adjusted EBITDA margin expansion of 270 basis points year-over-year. Moving on to cash flow and the balance sheet. Cash provided by operating activities improved to $35.3 million for the second quarter of 2023, which represents an increase of 78% compared to $19.8 million for the second quarter of 2022. We did a very good job managing working capital, and the value of our inventory decreased during the quarter due to easing raw material inflationary pressures, which had a positive impact on working capital. Free cash flow was $27.8 million for the quarter, which was more than double the $13.4 million we generated in the second quarter of last year. Our balance sheet continues to be strong, our liquidity keeps improving, and our leverage ratio of net debt to last 12 months adjusted EBITDA was 0.6 times as of April 30, 2023. Excluding real estate leases that are considered finance leases under U.S. GAAP, our leverage ratio, net debt to last 12 months adjusted EBITDA was 0.3 times. As George mentioned, we were able to repay $20 million of debt and we repurchased $5.6 million of our common stock in the second quarter because of our free cash flow position. We will remain focused on generating cash, paying down debt, and opportunistically repurchasing our stock. We will also maintain our focus on growing the company through organic, inorganic, and innovative growth opportunities as they arise while continuing to preserve our healthy balance sheet. The goal is always to create shareholder value. As stated in our earnings release, we continue to be cautiously optimistic for the second half of our fiscal year, and we believe the long-term underlying fundamentals for the residential housing market remain positive. Based on year-to-date results, conversations with our customers, and recent demand trends, we are reaffirming our guidance for fiscal 2023, which is as follows: net sales of $1.12 billion to $1.16 billion, although we are now more comfortable with the lower end of this range, and adjusted EBITDA of $130 million to $142 million, although we are now more comfortable with the mid- to upper end of this range. We previously guided to free cash flow of $50 million to $55 million for fiscal 2023. But based on year-to-date results and the fact that we have done a good job managing working capital, we are increasing our free cash flow guidance to a range of $60 million to $65 million. From a cadence perspective, for the third quarter of this year versus the third quarter of last year, we expect revenue to be down 10% to 12% on a consolidated basis. By segment for the third quarter of this year compared to the third quarter of last year, we expect revenue to be down 5% to 7% in our North American Fenestration segment, down 30% to 32% in our North American Cabinet Components segment, and down 2% to 4% in our European Fenestration segment. On a consolidated basis, adjusted EBITDA margin is expected to be flat to up 25 basis points in the third quarter of 2023, again, compared to the third quarter of last year.

Thank you. Our first question comes from the line of Reuben Garner from The Benchmark Company, LLC.

Thanks. Good morning, everybody. Congrats on the strong quarter.

Thank you, Reuben. Thank you.

So a couple of questions about the seasonality. I guess starting with the top line. I think the low end of the range would still imply a little pickup sequentially over the next two quarters, which I think is seasonally normal. Is there any risk to that? What would the risks be to that? Is it further inventory reductions or just general market declines? I mean what's kind of implied in the market, I guess, to get to those levels is probably a better way to ask it?

I'll take this. I'll start here, Reuben. From a consolidated level, I would say we're very confident in hitting that low range of the guidance. If there were concerns, it would be macro driven. I think we have some pretty good clarity now from our customer base. The order patterns and inventory levels seem to be stabilized across the supply chain and with our customers. So if there were a miss or upside either, I think it's going to be mainly driven by macro conditions.

Okay. It seems like you're suggesting that the margins are expected to be significantly lower sequentially compared to Q2, which was a strong quarter. What could be the cause for this expected decline? Historically, we typically see an increase in revenue during the latter half of the year.

I believe there may have been a misunderstanding. What we are indicating is that third quarter margins are expected to be flat or increase by 25 basis points compared to the previous quarter.

Would that imply a significant reduction in the fourth quarter to meet the full year guidance?

No, if we're guiding to the lower end of revenue but the upper end of EBITDA, that's actually better profitability.

I will work on that and get back to you later. So, maybe one last question from me. I'll sneak in what I consider to be my best question. The gross margin performance in the second quarter in both Europe and cabinet was quite strong. Was there anything one-time associated with that? Are you finally past the issues related to price and cost, or could you provide any details on those two segments in particular?

Yeah. I'll give you some color, and we'll break it down between the two. In terms of the cabinet performance, it was really as expected, very much index driven. Last year, as we talked about almost every quarter, we were chasing the profitability because of the 90-day lag. And as pricing was going up, we were paying faster than we were able to pass it along. Well, it's the complete inverse as it's going down. So it's exactly what we anticipated as the hardwood pricing is coming down. We're able to buy hardwood at lower prices faster than the index triggers. So we should be harvesting margins on the way down, and we've kind of alluded to that in past calls. So that's really what's driving that. I mean, the market itself is very defined in terms of pricing. So it's index related. In Europe, it's a combination. Operational performance has been very, very strong, and we're doing some good things from both the sourcing team and the operational teams, and then the other piece of it is some carryover pricing that we're starting to realize as the inflation levels in certain areas have kind of panned out. There are still pressures in Europe as it relates to inflation. So there's going to be some continued conversations with our customers because the European inflation levels, at least at this point because of energy cost and some of the higher levels of freight and logistics costs, are just ahead of what we're seeing in North America. So we think price will still be an important factor over in Europe, and we'll see what happens there.

Okay. Great. Thanks, congrats and good luck going forward.

Yeah.

Thank you. One moment for our next question. Our next question comes from the line of Steven Ramsey from the Thompson Research Group.

Good morning. This is Brian Biros filling in for Steven. Thank you for taking my question. To start with pricing, could you elaborate on some givebacks mainly due to the indexing? Are there specific materials to highlight regarding the extent of the declines, and are there any increases to mention as well? Additionally, what pricing expectations are reflected in your guidance for the remainder of the year?

So as a reminder, the indexes are primarily in North America. We'll start with our North American Fenestration; the main commodities typically on index are vinyl PVC resins, aluminum, and steel in our screen products, along with an oil-based index for our butyl-based spacers. These have experienced downward pressures across the board. As we progress through the year, we're starting to see that the pricing on many of these commodities is stabilizing and flattening out, with a few potentially showing signs of rising again. However, they're still quite volatile. We believe that the indexes will protect our margins and are fair to both us and our customers. In the Quanex custom cabinet components group, the main woods involved are hardwoods, soft maple, hard maple, cherry, red oak, and a couple of other minor species. We are observing a similar trend there, where the prices of these hardwood species have decreased significantly over the past year, but we are now witnessing that the pace of decline is flattening and, for some species, beginning to rise slightly. Thus, we expect the rate of price reductions related to the index to begin slowing down. In Europe, pricing is negotiated and closely tied to the commodities, and we are continuing discussions with our customers about when we will reduce prices. Additionally, there are still substantial inflationary pressures in other areas. Therefore, Europe tends to involve more complex and specific negotiations with customers.

Thank you for that information. For my second follow-up, could you elaborate on what you're hearing from end markets and customers? You mentioned that demand is improving sequentially and that orders have returned to their normal seasonal patterns. We've also heard that overall sentiment is better than anticipated, particularly when compared to the beginning of the year. I'm trying to understand if this improvement is simply due to seasonal changes and inventory adjustments, or if there are actual positive developments from the customer's perspective. Thank you.

I think what we're seeing and what we've been impacted by is definitely more of a macro environment. The affordability of housing becomes an issue. If you can imagine in our fenestration businesses, as we're looking at new starts, that's an important metric. But also, the size of homes, the affordability piece comes into play. Then people are either building or buying smaller homes, which has smaller openings and less windows. I think those have been more of an impact over purely customer demand. So the affordability piece in the market becomes an issue. And then for cabinets and then what we're seeing in Europe, it's really the discretionary income piece. Those tend to be a little more discretionary whether you redo your kitchen or your bathroom cabinets versus replacing a window and door. So I think that's why we're seeing volume hit a little more. In terms of overall expectations, I think the market is exactly where we anticipated it would be, and we've talked about that for the last couple of quarters. I think we'll see some normal seasonality. Again, it will be dependent upon macro conditions, what the Fed does, and different things of that nature will have more impact, but for us, we've been pretty pleased that the year is panning out exactly the way we forecasted and saw it to come out, at least at this point.

Got it. Thank you.

Thank you. One moment for our next question. Our next question comes from the line of Julio Romero from Sidoti & Company, LLC.

Thanks. Hey. Good morning, George and Scott.

Good morning.

Hey. Good morning. Maybe to continue on price for a little bit, can you talk about price aside from anything on an index or anything surcharge related? Maybe speak to the efforts to maintain price across the three segments, and has that gotten any more or less challenging than maybe three months ago?

We put in a lot of effort to be a fair supplier to all our customers. We maintain open and transparent discussions with them. In areas not tied to an index, the main impacts often come from freight and packaging supplies. We continue to seek price increases where possible, while also being mindful of our responsibility to support our customers in the market. Looking at North America, and indeed on a global scale, there is currently more pressure to either reverse price increases or keep prices steady. Customers are beginning to resist any further price hikes. So, to answer your question, it’s definitely more challenging now than it was six months ago. However, our commitment to transparency and working together with our customers has benefited us both.

Got it. That's helpful. And then maybe just turning to the cost side. You guys obviously did a good job controlling costs in the quarter. And you talked about some of the things that helped you were some favorable purchases while the index figures hadn't happened yet. Were there other levers you were able to pull on the cost side within the quarter? And would those levers on the cost side be able to benefit you in the back half of the year?

Yeah, absolutely. Great question. And the answer to that is yes, there are other triggers that we pulled. And I think it highlights what we've said all along that our cost structure is built in such a way that when we do go up or down, we have the ability to be ahead of the game, probably more than most. And I think so for example, in cabinets, I would tell you, they're not easy discussions. But when volume starts dropping, the team was ahead of it and controlled our labor cost, controlled our supply cost, and really focused on managing their inventory levels. We have those kinds of things in place in all the divisions. So we have triggers that we pull. We test our different models: if volume were to do this, here's what you do. And they were prepared, and all the groups reacted very well. So it's really the cost structure across the board that we're managing.

Got it. And then maybe turning to the LMI integration. It sounds like that's going well. Maybe just talk about that, if you could, and would there be a potential of maybe additional synergies beyond the target?

We are very pleased with the acquisition of that business. From a cultural standpoint, it has integrated seamlessly, and the teams are collaborating effectively. This acquisition has opened up new markets for us. We're not only servicing the fenestration markets through vertical integration but also making inroads into the automotive sector and wire cable. Additionally, they provide materials for products like dog toys. This has given us insight into a variety of areas. We are very satisfied with their performance and continue to be. Regarding growth and further synergies, I believe there are opportunities to utilize other materials we already produce. For instance, in our spacer business, we could expand their sales team to include offerings in silicone and butyl rubbers, positioning them as a full-service compound provider beyond their current focus on EPDM. I see cost synergies as well as new sales opportunities, which will enhance the utilization of our existing assets. We can pursue some of these initiatives without needing to increase our capital expenditures. Overall, we are excited about the potential within this business.

Got it. Well, thanks very much for taking the questions and good luck on the back half of the year.

Thanks, Julio.

Thank you. I would now like to turn the conference back over to George Wilson for closing remarks.

We'd like to thank you all for joining, and we look forward to providing you an update on our next earnings call in September. Have a great day.

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