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Norcraft Companies, Inc. (NYSE:NCFT)

Q2 2014 Earnings Call

August 13, 2014 10:00 am ET

Executives

Rodny Nacier - IR

Mark Buller - Chairman & CEO

Leigh Ginter - CFO

Analysts

David Goldberg - UBS

Desi DiPierro - RBC

Nishu Sood - Deutsche Bank

Will Randow - Citi

Trey Grooms - Stephens

Operator

Greetings and welcome to the Norcraft Companies Second Quarter 2014 Financial Results Conference Call. At this time, all participants are in a listen-only mode. A brief question-and-answer session will follow the formal presentation. (Operator Instructions). As a reminder, this conference is being recorded.

I would now like to turn the conference over to your host, Rodny Nacier, Investor Relations. Thank you, sir. Please go ahead.

Rodny Nacier

Good morning. We would like to thank you for joining us today for Norcraft Companies second quarter 2014 earnings conference call. This morning we distributed a press release detailing our second quarter financial results, which can be found in the Investor Relations section of our website at norcraftcompanies.com.

During our call today, management's remarks and answers to your questions may contain forward-looking statements as defined in the Private Securities Litigation Reform Act of 1995. Forward-looking statements address matters that are subject to risks and uncertainties that may cause actual results to differ from those discussed today. Examples of forward-looking statements include, statements regarding expected performance especially expectations with respect to revenue, gross margins, operating income and expenses, cash flow, and liquidity, as well as non-GAAP financial measures such as adjusted EBITDA.

These statements which may occur during our prepared remarks or during the question-and-answer session may be identified by words such as "expect," "should," "anticipate," "intent," "estimates," "believe," or similar expressions that are used in connection with any discussion of future financial and operating performance.

As a reminder, forward-looking statements represent management's current estimates and Norcraft assumes no obligation to update any forward-looking statements in the future. We encourage you review the company's past and future filings with the SEC, including without limitation the company's Form 10-K which indentifies specific factors that may cause actual results to differ materially from those described in these forward-looking statements.

This morning's conference call is hosted by Mark Buller, Norcraft Companies Chairman and Chief Executive Officer; and Leigh Ginter, the Company's Chief Financial Officer. They will make some prepared remarks and then we will open the call for your questions.

Now, I will turn the call over to Mark.

Mark Buller

Thank you, Rodny. Good morning and thank you everyone for joining us today to review our second quarter 2014 earnings results. I will provide a summary of our operating highlights for the second quarter. We will then discuss additional details on our financial results and our balance sheet. After our prepared remarks, we will open up the call for your questions.

Norcraft is a leading manufacturer of kitchen and bathroom cabinetry in the United States and Canada. Our strategy is focused in on servicing a dealer channel, with a single source for a broad range of high quality cabinetry, primarily in the semi-custom category. We have seven core brands, each with its own dedicated sales force and product offerings, which enables us to provide a customized level of service to each of our approximately 2,000 customers including 1700 cabinet dealers.

We achieved strong results in the second quarter and remain encouraged by the continued improvements across our business. Our customer oriented strategy and the ongoing shift to more premium products, are driving our top-line progression, while our lien operations allows to generate meaningful operating leverage on our growing sales.

We grew our profit metrics and cash flow at a strong pace in the quarter, allowing us to end the quarter with a strengthened balance sheet and capital position to reinvest on our strategy.

We are certainly pleased with these results for the quarter, in which we increased net sales 8.1% to $97.6 million and grew our adjusted EBITDA 18.2% to $14.9 million as compared to the prior year quarter. Our net income improved to $4.8 million, up $3 million from the prior year quarter, as a result of our improved operations, and the steps we have taken to reduce our interest expense by two-thirds. During the quarter we delivered on our plans to achieve mix and price gains in our core product lines, while carefully balancing our promotional activity to grow our sales.

Our success is due to a continued shift in product mix to mid and higher price point products mainly in the semi-custom category, where competition has been less intense compared to lower price in-stock categories.

We have extensive experience operating in the higher price segments of the cabinet market, which puts us in a firm position to execute our upper migration strategy in our mix. The combination of our end market focus, wide product offering, and stable customer base, also provides for less volatility in our business.

Combined, our mix and price gains more than offset lower volumes, which is entirely a result of our decision in 2013 to reduce our exposure to some lower margin business, which impacted our sales growth by 230 basis points in the second quarter of 2014. This decision is consistent with the strategic realignment, our business to exit less profitable relationships in competitive categories to improve our mix. Excluding the impact of this lower margin business, our volume increased in the low-single-digits compared to the prior year quarter.

Our adjusted EBITDA of $14.9 million in the second quarter improved from $12.6 million in the prior year quarter on higher sales resulting in over 30% operating leverage on our lien and actively managed cost base.

We remain confident in the embedded operating leverage in our business, which is supported by our ability to meet incremental 30% to 40% increase in demand without having to add capacity to our U.S. manufacturing base.

Our core cabinet dealer channel remains intact as we continue to benefit from our ongoing investment to expand our network, service our existing customers, and introduce new products to develop and strengthen long-term relationships in all of our markets.

Our dedicated and highly specialized sales force continues to build relationships in our markets and contract new business, while providing our design teams with feedback to further enhance our custom and semi-custom product offerings. This helps us built brand loyalty and solidifying multi-year relationships with our local level dealers, who typically source products from an (inaudible) of three to five manufactures.

Our new construction and R&R markets both edged higher during the second quarter, with higher project activity in most of our markets. We remain positive on the long-term recovery in new and existing residential activity based on encouraging signs we've seen in our markets and overall positive sentiment from our dealer network. Furthermore, based on our past experiences, we believe that demand for high-end quality cabinetry is resilient and with our focused strategy in place we believe we are well positioned to capture a rising share of the gradual improvements in demand, as we continue to enhance our mix.

We realize low-single-digit pricing during the quarter, which offset higher raw material prices, mainly hardwood, which persisted from the past several quarters. Our promotional environment was relatively flat for the second consecutive quarter compared to a year ago, which gives us confidence that the competitive landscape has improved. We are actively fine tuning our pricing, promotional activities and costs in order to continue building on the progress we have been making.

In summary, we are pleased with our growth and accomplishments during the second quarter of 2014. We believe we have the right strategy and positioning in the industry to continue to win business and strengthen our market presence. Our upward mix strategy is long-term in nature based on the characteristics of our market dynamics. This provides us with a long tailwind of opportunities to both grow our business, while also driving improvements to our bottom line and generating returns for shareholders over the next several years.

I will now turn the call over to Leigh to provide additional details on our financial results. Leigh?

Leigh Ginter

Thank you, Mark and good morning everyone. During the second quarter we grew our sales and improved our profitability, while also generating cash flow and strengthening our balance sheet.

In the second quarter, our net sales increased 8.1% to $97.6 million from $90.3 million in the prior period quarter. Sales grew in nearly all of our divisions driven largely by improvements in our product mix across various price points, combined with our focus on on-time deliveries and a high level of customer service.

Our income from operations increased 23.1% during the second quarter to $11.2 million, compared to $9.1 million in the second quarter of 2013. This improvement was led by an increase in our gross profit to $27 million compared to $24.2 million in the same quarter last year. Gross margin increased to 27.7% compared to 26.8% in the second quarter of 2013, as higher sales on the company's fixed manufacturing cost based and labor efficiencies more than offset marginally higher material cost which continued from last year. The impact of promotional activity was flat across both periods.

Our SG&A expenses increased to $15.8 million in the second quarter, compared to $15.1 million in the same quarter in 2013. As a percent of sales, SG&A was 16.3% in the second quarter; compared to 16.8% a year earlier, a 50 basis point improvement was a result of favorable leverage on higher sales, which offset marketing expenses to generate new customers and introduce new products and also offset $0.5 million in incentive stock compensation expense issued in connection with our IPO.

Our interest expense decreased to $2.2 million in the second quarter, compared to $6.5 million in the prior period with a 66% reduction reflecting our refinancing and reduction of higher cost debt in December 2013.

Net income of $4.8 million in the second quarter improved compared to a net income of $1.8 million in the prior period quarter as a result of our higher sales and improvements across our operations and capital structure.

Our adjusted EBITDA, which we view as the more meaningful metric to gauge our profit performance, increased 18.2% to $14.9 million in the second quarter compared to $12.6 million in the same quarter of 2013.

Moving on to our balance sheet and liquidity, for the six months ended June 30, 2014, we generated cash flow from operations of $12.4 million and invested $4.4 million in CapEx and customer cabinet displays. This compares to $6.3 million of operating cash flow and $4.1 million in CapEx and customer cabinet displays during the first half of last year. We are pleased with our cash flow metrics and as we generate free cash flow, we remain focused on further reducing our leverage while maintaining adequate liquidity to support our growth initiatives.

At June 30, 2014, we had cash of $46.5 million and total long-term of debt of $149.6 million which compares to cash of $39.1 million and total long-term of $150 million at December 31, 2013. Following a recapitalization of our balance sheet in late December of 2013, our entire long-term debt consists of one senior secured term loan facility which matures in 2020 and currently has a floating interest rate of 5.25% based on LIBOR plus an applicable margin.

At the end of the second quarter of 2014, we had no borrowings outstanding on our $25 million revolving credit facility. Our net debt to adjusted EBITDA ratio was 2.3 times on an LTM basis, an improvement from 2.6 times at the end of last quarter, and at the end of 2013.

Into the second half of 2014 we believe our balance sheet strength and available liquidity supports the ongoing growth of our business while enhancing our cash generation. We are confident that continued execution of our strategy and the ongoing recovery in residential activity will drive further financial improvement for our company.

I'll now turn the call back to Mark.

Mark Buller

Thank you, Leigh. We are pleased with the success of our business strategy and operating momentum year-to-date. In the second half of 2014, we're excited to continue accomplishing our goal to service our customers, expand our dealer network, and enhance our product offering of higher end cabinetry to grow our business. Combined with our disciplined cost structure, we have an established foundation to meaningfully improve our profits and cash flow as we continue to execute our goals.

Thank you for joining us today. Operator, we are now ready to open up the line for questions.

Question-and-Answer Session

Operator

(Operator Instructions).

And our first question comes from the line of David Goldberg with UBS. Please proceed with your question.

David Goldberg - UBS

I wanted to ask a bit of a theoretical question to kind of start things off, but you guys have really had success in kind of moving customers' up-market, getting them to spend a little more on the cabinet, a little bit higher end, semi-custom. But I'm wondering that there's kind of an end game when you think about mix shift. I mean, is there some point where you think you have the right price point in this kind of positive mix shift benefit flows down or is it just kind of consistent process that you go through where you think people will just be willing to pay more and more overall dollars, ex-inflation I guess on real dollars for the cabinetries that they put in their kitchen?

Mark Buller

Yes, that's a good question, David. If you look at 10 years here at Norcraft, starting in 2003, we've been able to literally play that game for 10, 11 years. So we expect that to continue indefinitely for the foreseeable future. So we're very comfortable with where we're at and where we're going in that way.

David Goldberg - UBS

That's helpful. My other question, Mark, I think you gave some really good commentary on the competitive environment and the promotional activity but we've heard from some other cabinet makers that are trying to get a little more compete in this and they started to kind of follow a similar strategy as you guys offer promotions to get people to trade up where your net margins are still higher but you maybe offer more promotions on a higher price point. We're heard other cabinet manufacturers' kind of thinking a similar strategy or implementing following you guys where you've been. Are you seeing that now? Are you seeing some more pressure from that, from some of the other cabinet manufacturers and how does that impact your strategy?

Mark Buller

Yes, right now our promotional activity has been more or less consistent over the last two quarters. So in our case, we are very happy with where we're at and we're having a lot of success with it. So we keep fine-tuning them from quarter-to-quarter but in general we're seeing a pretty stable market from our perspective.

Operator

Thank you. And our next question comes from the line of Robert Wetenhall with RBC. Please proceed with your question.

Desi DiPierro - RBC

Hi, guys. This is actually Desi filling in for Bob. Thank you for taking my questions.

Mark Buller

Good morning, Desi.

Desi DiPierro - RBC

Good morning. You guys generated a lot of cash in the quarter brought net leverage down to 2.3 times. So now as you look at the company with a strong balance sheet favorable outlook for free cash flow in the future. I want to maybe get your thoughts around capital allocation and what's the acquisition environment is like the in terms of quantity and types of company that you're seeing?

Mark Buller

Yes, first of all we want to continue paying down debt and we're going to do that for indefinite amount of the time along with that we're going to continue investing in new operations and eventually we're going to do an addition of better plant in Canada. And along with that we are looking for acquisitions. At this point in time, we haven't seen anything. But we're definitely interested in pursuing that.

Desi DiPierro - RBC

All right. And then on the material side, you highlighted hardwood as being the largest driver for higher material costs. Are there any other material that are giving you may be cause for concern and have you -- you've generally been -- have you been successful in raising prices to offset those this higher cost?

Leigh Ginter

This is Leigh, Desi. Yes, we have been successful in increasing our costs through price increases to our customers more than offset the hardwood inflation this year so we hinted about that. But that is primarily where we've seen increases this year in hardwood. And as Mark mentioned, earlier it's been somewhat stable now or is stable life a little bit but we continue to watch that and think that will continue to have some pressure there especially as the market continues to recover.

Operator

Thank you. And our next question comes from the line of Nishu Sood with Deutsche Bank. Please proceed with your question.

Nishu Sood - Deutsche Bank

Thanks and good morning. Mark I wanted to ask you about your comments that the remodeling demand environment that you're seeing has continued to be positive. And I think that that stands out in contract but the general comments we've heard about the repair and remodeling market so far this year as having weakened somewhat. So I wanted to kind of dig into that a little bit. What are your thoughts on -- what's driving the difference? Do you think it's a category issue that may be perhaps cabinet are performing outperforming other ticket items or perhaps it might be with your having migrated upwards in terms of price point it may be a higher-end, price point higher-end consumer versus lower-end consumer. So what do you think is driving the outperformance in what you're seeing versus the overall repair and remodeling market?

Mark Buller

Yes that's a very good question. So if you look back at the last five or six years, there has been very, very little R&R especially in the cabinet space. So I think if you look back I think at the history you might think, you probably have never seen this much pent-up demand on the R&R side as you see right now.

So along with that interest rates are great, unemployment is moving in the right direction, the banks are starting to lend, and along with that we're continuing to gain share through new product development, excellent salesmanship, and so forth. So we expect the R&R market to continue improving and definitely we think we're just at the beginning of the R&R market. So we're feeling really good about it, we're seeing it, we're excited about it.

Nishu Sood - Deutsche Bank

And then with the exiting of lower margin, lower price points business last year and your general strategy care of shipping upwards in terms of price points. What impacts or how is that dynamics going to play out in the movement of your gross margin? And I see you had good trends in your gross margin line. Would you be able to get back to peak gross margin level or perhaps revisit peak gross margin levels quicker because you have migrated upwards in terms of price points? In other words does it raise the ceiling on your gross margin potential because you have shifted upwards in terms of price points?

Mark Buller

Yes I'd say so. It's going to take time, it's a journey. But we're very pleased with our margins in Q2 and we see continued improvement in that area. So we're happy with the way we're managing the business and it was the right thing to do to exit that lower no margin business about 12 to 18 months ago, and it's starting to show up in a very positive way in Q2 and we expect that to continue indefinitely. So we feel really feel good about like I said where we're at in Q2 and what the decisions that we made beforehand so we expect to continue.

Operator

And our next question comes from the line of Will Randow with Citi. Please proceed with your question.

Will Randow - Citi

Just had a question when Leigh mentioned low-single-digit price increases, if I heard it correct, maybe I missed it, that would imply that new volume growth is kind of accelerated giving that you're working off negative comp let's call it 5 percentage points, so may be your real organics growth is 10 percentage points. Am I thinking about that right?

Leigh Ginter

Little bit less than that. Well our unit volume was down for the quarter about 5%.

Will Randow - Citi

Got it.

Leigh Ginter

But -- yes, we're getting a lot in price and mix. But if you factor out that business that we walked away from our unit volume would have been about 3%. So a lot of units but very little or no profitability on those units we walked away from so.

DOC 12

That kind of information from customer base, yes, anecdotes from here and there. In general, well, we know that the banks are lending more today than they were yesterday. And people are feeling better about the economy. People are feeling great about the equity that's suddenly appearing in their homes.

So we think, as I mentioned before, things are going to move in the right direction here for a longtime and we're at the early innings of an R&R. So it's not just one thing that's driving; it's many, many different things. As I mentioned, we're continuing to gain share in all of our markets and we'll continue to do that. So we feel great, like I said, about that market.

Operator

Thank you. And our next question comes from the line of Trey Grooms with Stephens. Please go ahead with your question.

Trey Grooms - Stephens

First question, Mark, you mentioned that order book has strengthened significantly since the last time we spoke. Can you talk about kind of where you're seeing relative strength and weaknesses geographically throughout your footprint?

Mark Buller

Yes, the southwest is pretty good -- actually very good. The southeast is pretty good and then northeast and the northwest would be behind those markets so. But right now all the markets are doing pretty good but particular strength in the southeast and the southwest.

Trey Grooms - Stephens

Okay, perfect. That's helpful. Second one I guess would be for Leigh. On the 30% operating leverage, is that a sustainable kind of run rate at least for the near-term or given the strengthening you're seeing in end markets with your order book and the product mix should this creep up a little bit as we look to the near-term?

Leigh Ginter

Yes. Our stated objective is generally to have about 20% to 25% drop-through to the bottom-line. We had a good quarter. We were able to leverage our fixed overhead despite the sales we walked away from which obviously indicates that the mix played a key contributor. We also were able to get some labor efficiencies in the second quarter. If you remember the first quarter was a tough quarter on labor efficiencies for us because of the weather and all of that. So that straightened out.

And so going forward that's certainly our goal is to be above 20% to 25%, and we think it's certainly came together nicely in the second quarter. And, as Mark said, we had to really -- to use Mark's word, a wicked third quarter, a wicked July. So we're very happy with our operating leverage at this point.

Trey Grooms - Stephens

Wicked July? That sounds pretty encouraging. Last question, I guess for Leigh, on SG&A as a percent of sales they're continuing to come down. How should we think about that metric I guess over the long-term? Do you see additional leverage there as we move over the next year or two years?

Leigh Ginter

Well, we are in the low 16s right now, 16.3% and we hit on a high sales quarter. I would say for modeling purposes if you're in the 16% to 16.4% on an annual basis that's a fair run rate. Eventually we will have to add some cost there. We're not there yet but that's kind of our goal is to stay in that 16% range. And that's where we were several years when we were at the peak of our revenue.

Operator

Thank you. And it seems that we have no further questions at this time. I'd like to turn the floor back to management for closing remarks.

Mark Buller

Thank you for your questions and we look forward to updating you on our future quarterly calls. Good morning.

Operator

This concludes today's teleconference. You may disconnect your lines at this time and thank you for your participation.

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