Caesarstone's (CSTE) CEO Yos Shiran on Q2 2016 Results - Earnings Call Transcript

| About: Caesarstone Ltd. (CSTE)

Caesarstone Ltd. (NASDAQ:CSTE)

Q2 2016 Earnings Conference Call

August 03, 2016 08:30 AM ET

Executives

Allison Cain - Investor Relations

Yair Averbuch - CFO

Yos Shiran - CEO

Analysts

Michael Rehaut - JPMorgan

George Staphos - Bank of America Merrill Lynch

Mike Dahl - Credit Suisse

Susan Maklari - UBS

John Baugh - Stifel

Operator

Good day and welcome to the Caesarstone Second Quarter 2016 Earnings Conference Call. Today’s conference is being recorded. At this time, I would like to turn the conference over to Allison Cain of ICR. You may begin.

Allison Cain

Thank you, operator, and good morning to everyone. Certain statements in today’s conference call and responses to various questions may constitute forward-looking statements. We caution you that such statements reflect only the company’s current expectations and that the actual events or results may differ materially. For more information, please refer to the Risk Factors contained in the company’s most recent Annual Report on Form 20-F and subsequent filings with the Securities and Exchange Commission.

In addition, the company will make reference to certain non-GAAP financial measures, including adjusted net income, adjusted net income per share, and adjusted EBITDA. The reconciliation of these non-GAAP measures to the most directly comparable GAAP measures can be found in the company’s second quarter earnings release, which is posted on the company’s website.

With that, I’d like to now turn the call over to Yos Shiran, Caesarstone’s Chief Executive Officer. Yos?

Yos Shiran

Thank you, Allison, good day, and thank you everyone for joining us to discuss our second quarter. Our second quarter was strong and our business is generally performing well. I would like to start with some highlights for the quarter. We grew sales by 11.6% to a newer record of $142.3 million. Without currency impact, growth would have been 13.4%. We extended our adjusted EBITDA to a new record of $39.8 million, margin of 27.9%, up over 1.5% compared to 26.3% in the second quarter last year. Adjusted net income was $25.4 million and our adjusted diluted EPS was $0.73 compared to $0.65 last year.

Now, I would like to give an update on each of our major markets for the second quarter. Second quarter sales in the United States were $59.9 million, representing 5% growth with core and IKEA business lower than expected. Core business growth was offset by year-over-year decline in IKEA. We believe our IKEA business would accelerate for the second half of the year and will support higher growth rates in this region in comparison to the first half.

I'm happy to notify that we have extended the agreements with IKEA for the US market until the end of 2017, which would allow us to further business for the benefit of both us and IKEA. We see this as a demonstration of the successful cooperation with IKEA. We expect the agreements with IKEA Canada to be soon extended as well. Our US team has been reinforced over the past quarter with new executives now on board. We continue to add talent and expand capabilities to better execute our global market strategy.

We have a devoted team that works hard and we believe that we will bear fruits going forward. We grow our sales in Australia to $33.5 million, up 24.9% compared to last year. On a constant-currency basis, Australia was up 29.5% in the second quarter. Housing conditions in Australia have been better than originally forecasted for 2016. Our Australian team is doing a great job and our business remains strong.

We grew sales in Canada to $24.3 million in the second quarter, a growth of 26.8% or 33.1% on a constant-currency basis. This was achieved despite weakening housing conditions. Our business in Canada is strong and our sales to IKEA continued ramp up.

Sales in Israel for the quarter were $11.1 million, up 16.3% compared to the second quarter last year. On a constant-currency basis, sales were up 14.2%. While it is a smaller market and generally mature, we are very pleased to see accelerated growth following strong execution.

Europe sales were up 1.6% to $6.9 million and 0.1% down on a constant-currency basis. As we noted, following 41% increase in the sales in the first quarter, this business is volatile due to timing of orders.

Revenue in the rest of the world was $6.7 million during the quarter, down 16.6% from last year and down 17.7% on a constant-currency basis. Like Europe, these tend to be smaller and more volatile individual markets.

Overall, our second quarter is also as strong and we are confident with our business. Thank you and I will turn the call over to Yair.

Yair Averbuch

Thank you, Yos, and good morning to everyone. I will start with our income statement for the second quarter. Sales in the second quarter increased by 11.6% to $142.3 million compared to $127.5 million in the second quarter of last year. On a constant-currency basis, sales increased by 13.4%. We drove gross margin improvement in the quarter to 42.1% compared to 41.3% last year. This margin improvement was driven mainly by favorable product mix and economies of scales, and to a lesser extent, lower raw material cost and lower manufacturing cost in Israel. Those were partially offset by inefficiency related to the US manufacturing facility and negative exchange rate fluctuations.

Operating expenses in the second quarter were $28.7 million or 20.2% of sales versus $24.3 million last year, which was 19.1% of sales. This increase in the expenses was primarily due to increase in marketing and sales efforts, mainly in the United States, as well as legal settlement and loss contingency expenses that were not incurred in the prior year’s second quarter.

Operating income was $31.3 million compared to $28.3 million in the second quarter of last year. Our operating margin was 22.0% compared to 22.2% last year. Adjusted EBITDA in the second quarter which eliminates share-based compensation and legal settlement and loss contingencies expenses reached a new record of $39.8 million. This was a margin of 27.9% versus 26.3% last year. This year-over-year margin improvement reflects the improved gross margin I just mentioned.

Finance expenses in the second quarter were $1.4 million compared to $0.4 million in the prior year. The increase was primarily due to $0.5 million net loss related to currency exchange rate fluctuations in the second quarter this year compared to net gain of $0.4 million in the second quarter of 2015.

Our taxes in the second quarter were $3.6 million or 11.9% of income before taxes, compared to a 16.6% tax rate last year. Excluding the one-time favorable tax adjustment of $1.2 million related to tax audit of the years 2012 through 2014 carried by the Israeli tax authorities, our effective tax rate would have been 15.8% this quarter. Adjusted net income attributable to controlling interest, which eliminates share-based compensation, legal settlement and loss contingencies expenses as well as non-recurring tax credit increased in the second quarter by 9.9% to $25.4 million, up from $23.2 million last year.

Adjusted diluted earnings per share in the quarter were $0.73 on 34.9 million shares. Adjusted diluted earnings per share last year were $0.65 on 35.5 million shares. This year’s increase mainly reflects the improved performance. Since our share repurchase authorization was put in place, we have used $29.8 million to buy back approximately 829,000 shares through the end of the second quarter.

Turning to our June 30th balance sheet, we have cash, cash equivalent and short-term bank deposit of $55.7 million. Our net cash position from the end of 2015 went down by $9.9 million entirely as a result of our use of cash to repurchase shares. Our free cash flow was $21.9 million in the first half of 2016.

With respect to 2016 guidance, we are reiterating our full-year guidance for both revenue and adjusted EBITDA. Revenue guidance for the year remains at $550 million to $565 million and our adjusted EBITDA guidance for the year remains at $138 million to $145 million. Before we take questions, on behalf of our entire organization, employee within the board, I would like to thank you all. Yos has been a good friend and a great leader for all of us for the past seven and a half years and led the company to great achievements. Under his management, Q2 annualized adjusted EBITDA is almost equal to the company annualized revenue when he was joined. We will miss Yos, and we wish you best successes in the future.

As we published on May 23rd, Yos’s last day in office is August 21st. The board believes that the new CEO will be appointed by the end of September. Our Chairman, Yonathan Melamed will act as an Interim CEO for any period in-between. Thank you and we are now ready to open the call for questions.

Question-and-Answer Session

Operator

[Operator Instructions] We’ll go first to Michael Rehaut of JPMorgan.

Michael Rehaut

Thanks. Good morning and best of luck, Yos.

Yos Shiran

Thank you.

Michael Rehaut

First question I had was on sales growth, and in particular, the US, you mentioned in your prepared remarks that the IKEA business was down year-over-year, and I think that’s contrary to your expectations - yeah, I was hoping to get a little bit more detail in terms of why you have confidence that that business will increase? Obviously, it’s kind of been a little bit of a wild card over the last several quarters and we were expecting a turn in that business this quarter. And then, just more broadly, if that business had turned, maybe just a comment on the broader strength of the core businesses you referred to.

Yos Shiran

Yes. I will answer it in few words and maybe try to better explain the situation there. So, first of all, our revenue from IKEA was below the projection and we believe it was mostly due to gradual implementation of the promotional events. We expect IKEA business to grow sequentially and we see auto spike increasing. Although we believe that the outlook for IKEA is very positive and we - as I said, we just signed an extension to the contract with IKEA US and soon we expect to sign the same soon with IKEA Canada, an extension of one year through 2017. So, this is for IKEA. It was lower than we expected for Q2, but we think - just we needed to be a little bit patient and it will start to grow again compared to last year, of course, and then further.

Sales organization in the US should be larger and better managed to accommodate our current scale of operation and our additional growth opportunities. And we believe that the step we take in reorganizing our sales and operations in the US will lead to more robust and focused performance and to better achievements gradually in our core business. So, this is situation between IKEA and the core, I hope it explains it. Yeah?

Michael Rehaut

Just so I heard it correctly, you said from IKEA, we use the words a more gradual implementation of the promotional events, is that right?

Yos Shiran

The promotional events are back, but the growth rate - so IKEA in Q2, it grew, but it was still below the absolute number of IKEA last year. So, there was a decline in IKEA, both in-between Q2 ‘16 to Q2 ‘15. So we expect that - going forward that IKEA will get stronger with the events. So, of course, in absolute numbers, it will change and also we expect to see of course a positive growth rate for IKEA.

Michael Rehaut

And then, Yos, are you able to describe a little bit more in terms of some of the changes in the US team, you mentioned new executives and new people in place just to get a better sense of what you’re doing either through new people or new strategy? You said to kind of better capitalize and organize the efforts.

Yos Shiran

So, again, from a wide angle, of course, that’s a comment I think maybe to emphasize that we view the current growth rates in the States is temporary and we believe that the US market represent a strong growth opportunity for us. What we do there - so we believe that we can leverage the sales by improving our performance and adjusting it to the current scale of the business, and maybe to illustrate within our activities, we recruited new executives teams and increased our sales force and we’re launching new products which we believe will be appreciated by the American consumer and in general we are trying to make sure that the way manage the sales organization is adequate to the size and the opportunity. I think it’s excellent, but longer than we expected, but we are confident that we are taking the right steps and we will see the fruits going forward as I said.

Operator

We’ll take our next question from George Staphos of Bank of America Merrill Lynch.

George Staphos

Good morning or good day, and Yos, good luck to you as well. I guess first question I have, piggybacking on Mike, so in the third quarter, should we expect IKEA US to be up year-on-year? You said it would grow sequentially, but should we be having positive comparisons year-on-year?

Yos Shiran

So, we wouldn’t like to get into first of all regions guidance and of course not to stop to break it down the core and IKEA, but overall we expect the second half in the States to be stronger than the first half and we believe that IKEA business will accelerate gradually through the second half of the year and will support the higher growth rate in this region in comparison as I said in the first half.

So, again, I cannot get into specific quarters, but IKEA is - what I can say is that we see a healthy pipeline but getting stronger, and we see IKEA coming back and now with the extension for additional year, we see this as a positive trend and we believe that it would be a good business for both IKEA and Caesarstone.

George Staphos

Okay. Yos, just on the US and maybe one other question on IKEA, in the past - maybe taking the last one first, have you discussed how far out you wanted to re-extend with IKEA or is it always a one year extension that you had in mind? And then, in the US, the slowdown in growth, would you attribute any of it at all to increased competition or you really don’t see any change in the run rate there?

Yos Shiran

So, the IKEA contract was for two year, now we extended it to additional - even more than two years and now we extended it for further one year. It, of course, also matters in decision of IKEA and we try to accommodate and meet the ideas of both sides, IKEA and us. So, as of now, it is extended through 2017.

Now, as to the rest of the business, we still have a lot of work to do and we believe as I said that we can grow - that we growth potential in the States is much bigger and we believe that it will come but it will take some time.

George Staphos

Okay. My last question, I’ll turn it over. Two part, one, the investment in marketing and sales and G&A, is that reflective of the changes that you’ve already made in the organization or reflective of growth related spending that you’re doing looking after the future? And then, have you seen any effect at all from BREXIT in terms of consumers, purchasing patterns, any kind of trend and volume early in the quarter? Thank you.

Yos Shiran

So, I think the first question, the answer is both I think to - as to BREXIT we don’t feel it. We don’t see any effect currently on our business.

George Staphos

Okay. Thank you.

Yos Shiran

Thanks.

Operator

We’ll go next to Mike Dahl of Credit Suisse.

Mike Dahl

Hi, thanks for taking my questions, and Yos, best of luck. Just to follow on to last couple of lines of questioning around the US, guess one other question I have is you’re in a lot of markets that are much further developed as far as adoption rates for quartz, and yet you’re still seeing substantial growth in some of these markets. So, is there anything you see structurally about the US or anything else you can kind of help us understand outside of some of the company specific issues you’ve discussed that are kind of making this growth ramp more gradual than you initially thought? And then, also how much of it is potentially just also product launches that haven’t yet hit the US versus some of these other regions if there is any more color you can give us on those things that might be helpful?

Yos Shiran

So, basically - just for me to understand that I am answering your question precisely, you’re asking in essence how do compare the execution in Canada and Australia for instance compared to the States, is this what you’re asking or…?

Mike Dahl

Right, yes. Effectively part is how you compare the execution of Caesarstone and the US versus those markets, but part is also a market question in that, is there something different about the structure whether it’s distribution or something else in the US that’s making those growth ramp more difficult to sustain and in some of those markets?

Yos Shiran

So, I think basically the United States is much bigger than Australia and Canada, I mean there is a tougher challenge to control on one hand, on the other hand, the market is very healthy, we don’t have numbers, we don’t have exact quantification of the core’s lost rate but we feel that the core segment continues to grow and it’s really a matter of our execution. Of course, with the market growth, the competition is growing as well, but it’s not new to us and we are also competing in Canada, in Australia and Israel, everywhere, so we’re used to competition.

So, I think it’s more - get adopted to the size of the states, we grew very faster, almost four times in the last few years and we need to adjust the organization to the new scale and to make it ready for future growth. So, it’s a bit more complicated than Canada and Australia. In addition to that, in Canada and Australia, we are number one in terms of brand and size and it’s not the case in the States, of course we’re striving to get there, but we still need to work hard for that.

So, I hope this helps.

Operator

We’ll go next to Susan Maklari of UBS.

Susan Maklari

Thank you. Good morning. Can you talk a little bit about the US plant here and how that has progressed? And maybe how you’re thinking about it coming further online through the back half of 2016?

Yos Shiran

Hi, are you asking about the progress in the plant in Richmond Hill?

Susan Maklari

Yes.

Yos Shiran

So, again, as you know, this factory is important strategically. So far we see just a burden financial wise, but of course we expect that in the future it will help us to deliver better results. It was definitely negatively significant in Q4 last year and Q1 and I am happy to say that in Q2, we managed to control it better and we expect it to get better gradually with the time and with the people gaining more experiences and more control over the processes. There is huge potential, as I said. So far, we just see the negative impact but I am confident that the positive impact will also arrive in the future.

Susan Maklari

Okay. So, do you expect it to basically come - be much further aligned by the end of this year? Are you shipping products?

Yos Shiran

No. We ship products from the States. Of course, we optimize our production locations between the States and Israel. And as I said, gradually we see the plant in the States getting more and more efficient.

Susan Maklari

Okay. And then, Yos, congrats on doing such a great job there, but can you just give us a little bit more details on this CEO search and perhaps for that spend I know that you mentioned you expect someone there by the end of September, but any further information on that?

Yos Shiran

I think the board appointed a committee that deals with its - to my opinion, very professional and I am sure they will - or expect that they will find an adequate new CEO soon, hopefully sooner than later. And they’re looking for somebody that can manage global company with eye growth; so hopefully, they will be able to present somebody soon.

Susan Maklari

Okay. Thank you.

Yos Shiran

Thanks.

Operator

We’ll go next to John Baugh of Stifel.

John Baugh

Thank you, and Yos, best of luck in your future. I enjoyed working with you. I was wondering if you could give us the FX headwind to EBITDA in second quarter and what it is now year-to-date and what’s the outlook for that is for ‘16?

Yos Shiran

Yes. Hi, John. So, FX was around 100 basis points direct for the second quarter relative to 2015. And you know we looked at the quadrant exchange rate and took them in consideration when we directed our guidance.

John Baugh

Thank you for that. And maybe back to the plant and the drag, it sounds like you’re making progress, and I’m curious is that progress due to increased production and absorption of fixed cost or are you also seeing less scrap and better unit production cost or any more granularity there? Thank you.

Yos Shiran

So, the plant performance is progressing there, and we’ve succeeded to establish control over spending and process in the plant. And we’re slowly ramping it up as demand accelerates and focus on further improvement quality wise. And so, I was jumped on to get specifically into either we produce more but we certainly improved the philosophies and the performance there.

John Baugh

And then, I was curious on the new product launches, are those - I think you were saying was specific to the US, any color on the timing and what types of products we’re going to see?

Yos Shiran

Yeah. Most of the launches this year happened around June, July, and in the States, specifically, this will be a line of more traditional colors with more granite inspired but also marble inspired. So there will be an extension basically of traditional colors with the partial add of what is called transitional, so between modern and traditional colors. So it’s just a start, we don’t have indication yet of the reception in the market, but according to initial responses that we get at least probably seems promising, we’ll have to wait and we’ll be happy to report about it later.

John Baugh

And Yos, what are the price for - of those super natural, above or below, where are we price-point margin wise on those?

Yos Shiran

Most of the granite look are priced in the classical range and the regular range, but part of it which are very unique, will be priced at the supernatural area.

John Baugh

Okay. And then, my last question, any development on silicosis, any new cases or claims, et cetera? Thank you.

Yos Shiran

To silicosis, we continue to deal with the lawsuits in Israel, including the lawsuits that were found this year and in the quarter as reported. Also, we have one claim in Australia in which there was no significant development. And, in general, the big picture remains the same.

John Baugh

Thank you. Good luck.

Yos Shiran

Thanks

Operator

[Operator Instructions] We’ll go next to Michael Rehaut of JPMorgan.

Michael Rehaut

Thanks. Want to focus on what I’d feel as one of the real bright spots of the quarter, it hasn’t been talked about as much yet, the gross margin had very strong sequential improvement and basically after three quarters of very sizable year-over-year declines, you had a positive - versus a year ago, you had a positive margin. So just wanted to get a sense of year, I think you highlighted that fx currency was 100 basis points drag, but what’s some of the other positive - if you’re able to quantify, what’s some of the other positive drivers were from a basis point standpoint? And also how to think about the back half of the year if we should be expecting something above 40% as well or if there is anything that should drive it back below 40%

Yos Shiran

Okay, Mike. So, maybe up, it’s from the point of previous quarter, so maybe I don’t know if you want them sequentially or year-over-year, but let me maybe start sequentially, we saw a major gross margin improvement related to in both mix of our product, regional mix or it also got better with Canada and Australia going so much. And that along with volume was almost 600 basis points. Then there was 460 basis points related to, sorry, and then there was 160 basis points improvement related to Richmond Hill. The Richmond Hill was better than last quarter and it’s relative to its drag on the margin and this was offset with a couple of other small factors. FX wasn’t much of a big deal between those two quarters.

If you look at it year-over-year, then for that mix and volume contributed 350 basis points to margin. Material cost and lower manufacturing cost in Israel was each around 50 basis points and those two factors are offset with Richmond Hill drag that was approximately 250 basis points relative to last year and FX was a drag of 100 basis points.

Michael Rehaut

And you said year-over-year materials and lower…

Yos Shiran

Lower manufacturing cost in Israel.

Michael Rehaut

50 basis points each?

Yos Shiran

Yes.

Michael Rehaut

Okay. And so, then how do you think about the back half of the year, I mean again, substantial improvement sequentially, do you think that 42% is a reasonable number and obviously overtime the inefficiencies from Richmond Hill should continue to abate, so how should we think about the back half?

Yos Shiran

We don’t really provide guidance by line items and every - low expectation abate into our guidance. One thing I want to mention though, we took into consideration an expected increase in SG&A mainly related to our investment in the US market. That was one factor of course of many, but that’s what I can say about the second half of the year.

Michael Rehaut

Alright, thank you.

Operator

We’ll go next to Mike Dahl of Credit Suisse.

Mike Dahl

Hi, thanks. I think you just addressed my question around gross margins with the answer to Mike’s questions. Thank you.

Operator

At this time, we have no further questions in the queue.

Yos Shiran

Okay. Just some closing remarks on my end, so I’d like to thank everyone, it’s been an honor to be part of the Caesarstone success story, and to have had the opportunity to lead its transformation to become strong innovative global company, with a worldwide known premium brand, cutting edge technology and winning strategy.

Our people will work together to create a solid globally recognized leadership position and significant opportunities for the future. I would like to express my thanks and appreciation and Caesarstone’s current and past directors and employees worldwide. Without them, this great journey wouldn’t have been successful and meaningful. It has also been my pleasure over the past few years to engage with our investors and analysts.

I am grateful that you shared our vision and success and thankful for your support and confidence. I wish all of Caesarstone’s investors, management, and employees lots of success in the promising future ahead. Thank you again.

Operator

That does conclude out conference for today. We thank you for your participation.

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