Earnings Call Transcript - UFI Q3 2022

Operator, Operator

Ladies and gentlemen, thank you for standing by, and welcome to Unifi Third Quarter Fiscal 2022 earnings conference call. At this time, all participants' lines 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, A.J. Eaker, Vice President of Finance. Thank you. Please go ahead.

A.J. Eaker, Vice President of Finance

Thank you, R.J, and good morning, everyone. On the call today is Albert P. Carey, Executive Chairman, Edmund Ingle, Chief Executive Officer, and Craig A. Creaturo, Chief Financial Officer. During this call, management will be referencing a webcast presentation that can be found in the Investor Relations section of our website at unifi.com. Management advises you that certain statements included in today's call will be forward-looking statements within the meaning of the federal securities laws. Management cautions that these statements are based on current expectations, estimates, and projections about the markets in which Unifi operates. These statements are not guarantees of future performance and involve certain risks that are difficult to predict. Actual outcomes and results may differ materially from what is expressed, forecasted, or implied by these statements. You are directed to the disclosures filed with the SEC on Unifi's Forms 10-Q and 10-K regarding various factors that may impact these results. Also, please be advised that certain non-GAAP financial measures, such as adjusted EBITDA, adjusted EPS, adjusted working capital, and net debt may be discussed on this call. I will now turn it over to Albert P. Carey.

Albert P. Carey, Executive Chairman

Thanks, A.J. Good morning, everybody, and thanks for joining Unifi's third quarter conference call. After a few comments about the state of the business, I'll then turn it over to Edmund Ingle and Craig A. Creaturo, who will fill you in on the Q3 performance for the company, and then we'll move to our usual Q&A session. I'd say most of us on this call are operating in some of the most turbulent times that I can remember and experiencing some of these macro headwinds such as the pandemic, inflation, and labor shortages. And now there's a whole new round of challenges such as the war in Ukraine and the COVID lockdown in China. But I would say despite all of this, our team at Unifi remained agile and is trying to work around these challenges. That's why I'm happy to see that our Q3 revenue is right on our forecast of $201 million and our adjusted EBITDA of $12.2 million is also a little better than forecasted. We had to offset some new costs that came in over the course of the quarter. The $201 million in Q3 revenues are going to allow us to deliver the full year of over $800 million in revenues, and that's a significant milestone for us at Unifi. You'll recall back in Q3 that we were working on two significant challenges in North America: one was getting pricing to offset the raw material cost and then the second challenge was the labor shortage that we had in North America. While both challenges still remain, we've seen improvement in Q3, and going forward into Q4, we'll see more improvement as well. These lockdowns in China began to be a headwind at the end of the third quarter and will continue to impact us in the fourth quarter. But the underlying mid- and long-term demand trends are very strong for our Asia business, so we feel positive about that when the lockdowns finally end. In Brazil, while we're seeing some margin normalization that we spoke about last quarter, we're really happy with the current performance in the region. We expect strong demand and market growth opportunities and REPREVE begins to become more of a factor in Brazil, which it hasn't been in the past. On REPREVE, it continues its growth. We were at 36% of our mix in the quarter; we're at 38% year-to-date. I think this is driven by the increased attention to sustainability and recycled products from our customers. Many of our customers now see us as a very good partner to help them meet their sustainability targets, with many of those targets that are due in 2025. So this trend is not only going to continue but I think it is likely to accelerate in the upcoming quarters. As I look out over the next quarter, yes, we do have our work cut out for us with the China COVID lockdowns. But we have a lot to look forward to in Unifi. Our labor situation in North America is improving. We've been able to pass along pricing. Our REPREVE momentum is good. And despite the Asia lockdowns, that market has very strong demand, and we think that's going to rebound fairly quickly. All of this makes us feel confident about our future. And as we take a look at our goals that we outlined during Investor Day, we continue to be very optimistic about that. So I would say we are beginning to see some positive momentum building. With all that, let me turn this over to Edmund, who will now take you through some of the details of our quarterly performance.

Edmund Ingle, Chief Executive Officer

Thanks, Al. And good morning, everyone. Our third quarter results were in line with our expectations, and we are pleased with the strength of our results despite some of the persisting challenges we're facing in today's operating environment. I want to thank all of our employees for their ongoing hard work and commitment. During the quarter, we produced strong sales and profitability figures and saw a sequential margin recovery in several pockets of the business. The underlying demand paired with our continuous improvements on the U.S. labor front gives us confidence going forward, and I'm excited for what lies ahead. Moving into the slide presentation, we will begin on Slide 3 with an overview of the quarter. For the second consecutive quarter, we achieved sales of over $200 million, an increase of 12.3% on a year-over-year basis resulting from strong demand and proactive pricing initiatives. This figure could have been another 1% to 2% higher if we were not still somewhat labor constrained in the U.S. While some production inefficiencies remain because our improving labor metrics have not yet been fully realized, our recent actions have generated noticeable improvement in our yields, which is evident in our sequential margin profile. We will continue to strive towards optimizing the situation to satisfy the needs of the market and, of course, our customers. We remain optimistic in our ability to do so going forward. As we communicated in our last earnings call, the inflationary environment's impact on domestic margin performance and pricing levels continued. Raw material costs and inflation continue to present headwinds. We have further price increases scheduled for the fourth fiscal quarter in response to the cost pressures that we experienced in Q3. While impacts from COVID-19 have subsided domestically, unfortunately, we cannot say the same for Asia. As we are all aware, China's zero-COVID policy has impacted the economy and supply chain in the Shanghai region, impacting our sales and profitability in that segment for the fourth quarter. However, I want to be clear that the demand has not faded and is waiting to be filled as many industries are similarly impacted. Our team in Asia is very resilient, and I'm encouraged by their optimism that the business environment will quickly open up once lifting restrictions. While the Russia and Ukraine conflict is creating volatility in major markets, we have had no direct impact on our operations due to these geopolitical events. In Brazil, we maintain a strong market position, though we are seeing some of the expected margin normalization from the exceptionally strong environment in the prior-year period. The business remains strong, and we are looking forward to seeing volumes grow as we move through the next few quarters. Our new texturing technology, both implemented and forthcoming, will serve as the volume growth driver. Now I'd like to move on to Slide 4 to discuss REPREVE. Revenues from REPREVE products represented 36% of net sales during the quarter, compared to 34% a year ago. We kicked off a busy quarter with a strong REPREVE presence at the WM Phoenix Open golf tournament again. The activation was accompanied by a national television ad featuring WM's 30-second commercials, which showcased the REPREVE process. Loosened COVID-19 restrictions allowed us to increase REPREVE mobile tour stops, and we focused on increasing brand partnerships across our digital and social media channels. Our continuing co-branding and customer engagement gives me confidence, just like our recent indicators of business momentum. Now I'll pass the call over to Craig A. Creaturo, our CFO. Craig?

Craig A. Creaturo, Chief Financial Officer

Thank you, Edmund, and good morning, everyone. To echo some of the sentiments from Al and Edmund, I'm pleased with our sales and profitability performance, which is consistent with our expectations, especially in an environment with several moving pieces all around the globe. Demand for our products continues to grow, and our management team is keenly focused on achieving a healthy balance of both short-term and long-term goals. As we look at the quarter from a high level, we accomplished our short-term sales and profitability goals for Q3, maintaining the underlying business momentum as we implemented responsive selling price adjustments and made positive step changes against our recent U.S. labor challenges. In Brazil, you may recall that in the fourth quarter of fiscal 2021, we recognized an estimated benefit from expected recovery of non-income taxes in Brazil of $9.7 million. During the just completed quarter, we reduced the estimate due to additional clarity and review, which resulted in $815,000 included in our reconciliations of adjusted EBITDA and adjusted EPS. As we look below the pretax income line, the headwinds that Edmund outlined for Q3 and Q4 have impacted our effective tax rate due to decreased overall U.S.-based earnings. This brought our effective tax rate slightly above the expected range for Q3, which will extend into Q4. Let's turn to Slide 5 of the webcast presentation. Consolidated net sales increased 12.3% from $178.9 million to $200.8 million, primarily driven by responsive selling price adjustments, partially offset by volume shortfalls. For the Polyester segment, performance was muted by U.S. labor pool challenges. Price and mix changes demonstrate the selling price adjustments made over the last several months in response to rising input costs, although we are still working to fully normalize the portfolio for today's cost levels. In Asia, sales volume was challenged during March 2022 due to COVID lockdowns in China. While inflation in Asia has been calmer than in the U.S., sales prices are still increasing accordingly. In Brazil, year-over-year price levels followed market dynamics, driving a price-mix benefit of 19.1%, though lower volumes resulted from a comparatively strong quarter in the prior year. Nylon exhibited stability, with higher sales following the increase in raw material costs. Moving on to Slide 6, the Polyester segment experienced a decline in gross profit due to U.S. labor and input cost headwinds mentioned in our last conference call. The Asia segment maintained a strong gross margin profile, though volume shortfalls in March 2022 due to COVID-related lockdowns are expected to impact profitability more substantially in Q4. Brazil remains the segment with the highest gross margin as a percentage of sales and continues to significantly contribute to Unifi's success. We are proud of the progress made sequentially in the Polyester and Nylon segments from December. Moving on to Slide 8, we ended Q3 with $18.5 million borrowed against our ABL Revolver, with $65 million available as of March 27, 2022. Under our balanced approach to capital allocation, we expect to continue investing in the business to drive innovation and organic growth, maintaining a strong balance sheet while being opportunistic with share repurchases and/or M&A opportunities.

Edmund Ingle, Chief Executive Officer

Thank you, Craig. Following today's call, I'd like to finish with Slide 9 of the presentation and discuss our outlook and expectations for the remainder of fiscal 2022. Our revenue numbers have exceeded expectations, leading us to increase our previous top-line outlook for fiscal 2022. Still, we must continue to work through all global uncertainties, including ongoing labor pool constraints in our U.S. operations, inflation, and COVID-19 lockdown impacts in Asia. For the full year Fiscal 2022, we expect sales to reach $810 million or more, representing an increase of 21% or more from Fiscal 2021 revenues. We are lowering our outlook on adjusted EBITDA to range between $54 million and $57 million, due to recent and ongoing COVID-related lockdowns in Asia and renewed global volatility. Our CapEx outlook should fall between $40 million and $42 million. Lastly, during our Investor Day in February, we issued longer-term targets, and I want to highlight that we remain on track to achieve our previously stated $1.1 billion or more revenue target by 2025, comprised of 6% REPREVE fiber sales. We remain confident about the momentum and growth outlook for the REPREVE brand, enhancing our margins and profitability, and helping us achieve $110 million or more in adjusted EBITDA by fiscal 2025. Sustainability sets us apart from our competitors and is the driver of growth. Our segments are expanding in their recycled competition and demand continues to be strong for recycled products. With these growing markets and our current initiatives aimed at increasing margins and operations, Unifi is poised to close 2022 on a positive note while setting up the company for long-term success. We will now open the line for questions. Thank you.

Operator, Operator

As a reminder to ask a question, please standby while we compile the Q&A roster. The first question comes from the line of Christopher McGinnis from Sidoti & Company, LLC. Your line is open.

Christopher McGinnis, Analyst

Good morning. Thanks for taking my question. Just in relation to the impact of Asia, how do you quantify that impact in revenue? Is there a way to assess how much it's going to affect us given the stronger trends there? And also, are there any discussions about shifting supply chains that could benefit you if it goes to Central America or another region? Thanks.

Edmund Ingle, Chief Executive Officer

Thanks, Christopher, for joining us today. There is uncertainty around how much it's going to impact us. Much of our business in our Asia segment is actually outside of China. We are expecting a significant shortfall in revenues in April, but do see this improving as we move through May and June of this fiscal quarter. It's hard to determine exactly how much. Regarding your question about shifting supply chains, we are in conversations with several major brands about moving some volume to Central America, which will help long-term in that region. We're also observing how quickly the zero-COVID policy in China will impact supply chains. With the geopolitical noise going on, everyone is rethinking their approach to moving products away from concentrated business in China into other regions, but it will take time. Thank you.

Christopher McGinnis, Analyst

I appreciate that. And then, do you need more investment in Central America, or how are your assets positioned for potential stronger growth in that region?

Edmund Ingle, Chief Executive Officer

Yes. We announced in our Investor Day in February that we are investing in all regions of the Americas, including Central America. We are well positioned with the ongoing investments to capture greater market share and volumes in that region.

Christopher McGinnis, Analyst

Great. I appreciate it. Thanks for taking my questions, and good luck in Q4.

Craig A. Creaturo, Chief Financial Officer

Thank you.

Edmund Ingle, Chief Executive Officer

Thanks, Christopher.

Operator, Operator

Your next question comes from the line of Daniel Moore from CJS Securities, Inc. Your line is open.

Stefanos Crist, Analyst

This is Stefanos Crist, calling in for Daniel. How are you?

Edmund Ingle, Chief Executive Officer

Hi, Stefanos.

Stefanos Crist, Analyst

First, what are the gross margin levels implied in both Asia and Brazil in your revised Q4 guidance? When do you expect those to start to improve, particularly in Asia?

Craig A. Creaturo, Chief Financial Officer

I would say the gross margin levels implied for Q4 in Brazil are very close to where we are at for Q3, and that business peaked in Q3 of last year. We think Q3 is a pretty representative gross margin for what we should see in Q4. In Asia, our expectations for the gross margin percentage are close but lower than what we just completed in this quarter. While this fiscal year is slower, we still expect it to be profitable. Thankfully, our business operations are structured in a way that mitigates significant losses in gross margin. We'll have a good margin profile but not quite as good as if we had full sales without the COVID lockdown.

Stefanos Crist, Analyst

Got it. Thanks. Can you also provide an update on the labor shortages that have impacted margins in the polyester segment? What steps have you taken to alleviate that, and what is the expected cadence for margin improvements in poly moving forward?

Edmund Ingle, Chief Executive Officer

Yes. We are still experiencing labor challenges, but not to the same extent as in Q2. We've hired more trainers, changed our onboarding process, and adopted a team approach to focus on group efficiencies rather than individual contributions. We have engaged with labor to understand their needs, and we saw an impact in productivity during Q3, but it wasn't as severe as in Q2. We're seeing improvements in April compared to March. It's a long journey, and we need to continue investing time and resources, but we're not in the same situation we were in fiscal Q2.

Craig A. Creaturo, Chief Financial Officer

I think we lost 10 points of volume growth in North America in Q2. It looks like about 5% improvement in Q3.

Stefanos Crist, Analyst

I appreciate the color. Thank you.

Edmund Ingle, Chief Executive Officer

You're welcome.

Operator, Operator

Your next question comes from the line of Marco Rodriguez from Stonegate Capital Markets. Your line is open.

Marco Rodriguez, Analyst

Yes. Good morning, everybody. Thank you for taking my questions. Could you follow up on some of the earlier questions focused on Asia? From a percentage standpoint, how much of that business over there is China? How are the revenue and volume impacts from China? Are they completely shut down, or are there shipments going out?

Edmund Ingle, Chief Executive Officer

I'll take this call. Thank you, Marco. The whole country of China is not shut down, though there are many restrictions beyond Shanghai. The challenge for us in Shanghai is getting some of our export containers out. Most of the textile production facilities are in other regions like Suzhou, where our commercial operations are. When Shanghai locked down late March and early April, other regions started creating restrictions to avoid the same situation, so it is tough to determine exactly how much the quarter's going to be impacted. However, it will be significant.

Marco Rodriguez, Analyst

Very helpful. Is there any consideration to shift the supply to different ports that are less impacted than Shanghai?

Edmund Ingle, Chief Executive Officer

Yes, we are. Ningbo is a port that's not fully locked down, and we're using alternate methods to move containers to get our products out the door. Our team in China is doing an amazing job working around these restrictions. While there's no supply issue, we are struggling to send products to customers due to these challenges.

Marco Rodriguez, Analyst

Thank you for the detailed answers. Can you discuss your labor issues and expected improvements for the next quarter and how you see it playing out into FY'23?

Edmund Ingle, Chief Executive Officer

I don't have a crystal ball, but our efforts around onboarding and employee engagement, along with new technology implementation, are helping us see improvements. We expect to see meaningful improvements in productivity and employee retention rates by the end of our second quarter in fiscal '23, around December. We'll have to wait and see if that fully materializes as expected.

Marco Rodriguez, Analyst

Great. Thank you for your time, I really appreciate it.

Craig A. Creaturo, Chief Financial Officer

Thank you.

Edmund Ingle, Chief Executive Officer

Thanks, Marco.

Operator, Operator

There are no further questions at this time. I would now like to turn the call back to our speakers for their closing remarks.

Edmund Ingle, Chief Executive Officer

Thanks, everyone for participating today. Our next earnings release for the fourth fiscal quarter ending July 3, 2022, is tentatively scheduled for Wednesday, August 10th, after the close of the market, with the conference call to follow on Thursday, August 11th, at 8:30 a.m. Eastern Time. Thanks again for joining the call.

Operator, Operator

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