Caesarstone's (CSTE) CEO Raanan Zilberman on Q3 2017 Results - Earnings Call Transcript

Caesarstone Ltd. (NASDAQ:CSTE) Q3 2017 Results Earnings Conference Call November 1, 2017 8:30 AM ET

Executives

Allison Cain - Investor Relations, Vice President of ICR

Raanan Zilberman - Chief Executive Officer

Yair Averbuch - Chief Financial Officer

Analysts

Michael Rehaut - JPMorgan

John Baugh - Stifel

Chris Counihan - Credit Suisse

Lena Rogovin - Chardan Capital

Operator

Good day and welcome to the Caesarstone third quarter 2017 earnings conference call. Today's conference is being recorded.

At this time, I would like to turn the conference call 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 third quarter 2017 earnings press release, which is posted on the company's Investor Relations website.

With that, I would like to now turn the call over to Raanan Zilberman, Chief Executive Officer of Caesarstone. Raanan, please go ahead.

Raanan Zilberman

Thank you Allison. Good day and welcome to our conference call to discuss our third quarter results and our business outlook for the rest of the year.

Third quarter revenue increased by 7.2% to a new record of $155 million. On a constant currency basis, growth was 4.6%. Gross margin was far below our expectation as a result of challenges related to our manufacturing performances. Our third quarter adjusted EBITDA was $26 million, a margin of 16.5%. This mainly reflects our gross margin's results. Our adjusted net income was $13 million and adjusted diluted EPS was $0.37. At last, our free cash flow generation in the quarter was $11 million.

Before I go through our regional performance, I would like to first discuss our manufacturing challenges and our gross margins in the quarter. In Israel, throughput and margins came under pressure in both of our manufacturing sites. The main reason for the reduced throughput is our product mix shift to premium and differentiated products. That continues and brings with it, at least for the moment, longer cycle time and longer setup time per model.

Again, I would like to mention that the shift of mix differentiated product enable us to maintain our premium position in the market and our prices. We of course think that those challenges are addressable and with the right management, the right focus and the right process and with time, our gross margin should improve.

In Richmond-Hill, after three quarters of consecutive improvement, this quarter we took a step backward in performance. As we discussed last quarter, this was partially expected given our decision to extend the range of production to higher-end products. Those products require longer cycle time to manufacture. The pressure was most significant than what we had expected and to make things more challenging, the plant was shut down for a full week as a result of Hurricane Irma.

Following the recent trends, I have decided to take several action items, few of which I would like to share with you now. So I have decided to appoint a new VP of Global Operation and we have already running a selection process. I have already placed a new leadership team in Richmond Hill, including a new plant manager, a new operation manager and few new department managers and a team of technical and manufacturing experts, all coming from Israel.

I can tell you that those changes have started beginning in October and already have positive impact in several dimensions. In the Israeli plants, I have taken several steps including the appointment of two new plant managers, actually rotating them and a new production manager to enhance the managerial structure and capacity of management. We are starting to implement a series of improvement process to shorten the cycle time and to minimize the idle time. Those improvement processes can take some time but if we will implement them correctly they will yield the expected results.

In addition, in order to better meet demand for our products, we have been utilizing some OEM production for basic SKUs under our strict specifications and our robust quality assurance process.

Now I would like to provide an update on each of our regions. In the United States, revenue was up by 6% to $61.9 million compared to $58.4 million. Our business in the United States was impacted slightly by Irma and Harvey and we believe that the activity is on an annual growth rate of around 9% to 10%. We as well believe that our current throughput is resulting in a miss of some opportunity to accelerate our revenue growth even further.

In Australia, sales in the third quarter were $37.1 million, up by 4.1% compared to $35.6 million last year. And on a constant currency basis, Australia was up by 0.1% in the third quarter. The stability in sales was achieved despite a continued weakness in the overall housing market as we reporting in the last two quarters.

Canada sales, which have consistently been a strong contributor to growth increased in the third quarter by 14.2% to $25.6 million compared to last year $22.4 million. And on a constant currency basis, growth in Canada was 9.8%.

Sales in Israel were $12 million for the quarter, up 6.1% compared to last year. And on a constant currency basis, sales were down 0.3% and this is reflecting a challenging market condition, again we have been [indiscernible] in the last quarter.

Revenue in the rest of the world during the quarter was down by $4.7 million to $9.2 million. And on a constant currency basis, revenue was down by 8.6%.

In Europe, sales in the third quarter were 49 million and they were up by 28.2% compared to last year. And on a constant currency basis, sales in Europe were up by 25.4%. This increase was primarily related to our performance in the United Kingdom.

I would like to reserve some final thoughts after Yair comments on the financial. Yair, please go ahead.

Yair Averbuch

Thank you Raanan and good morning to everyone. Global sales in the third quarter increased by 7.2% to a new record for any quarter of $154.7 million compared to $144.3 million in the third quarter of last year. On a constant currency basis, sales grew by 4.6%. Gross margin in the quarter was 32.1% compared to 40.5% last year. The primary factors of the decrease in margin were, higher portion of total production coming from Richmond hill where we are still incurring higher production costs, lower throughput in Israel for the reasons discussed before, higher material cost related mainly to polyester prices, the impact of the hurricanes in the U.S. during the quarter and increased compliment of fabrication and installation revenue, which comes with lower margin related to our growth with IKEA.

Operating expenses in the third quarter were $38.7 million or 25% of sales versus $30.3 million last year which was 21% of sales. I would like to note that legal settlement and loss contingency expenses this quarter were $5.7 million compared to $1 million in the same quarter of last year. Recently, we have seen an influx of subrogation claims filed by the Israeli National Insurance Institute, NII, providing for reimbursement of its payment related to damages paid or that will be paid to plaintiff if we are found liable for the plaintiff damages.

Given that recent development, we have made a one-time $4.3 million adjustment to the net liability exposure for all claims outstanding as of June 30, 2017 under a new assumption that each of the individual claims filed against us would be followed by a future NII subrogation claim. Excluding legal settlement and loss contingency related to silicosis, operating expenses in the third quarter were $33 million, 21.3% of sales compared with $29.3 million or 20.3% of sales last year. This increase was primarily due to increased strategic investments, specifically marketing and sales in the United States and the shift to direct distribution in the United Kingdom.

Third quarter operating income was $11 million, down from $28.2 million in the third quarter of last year. Adjusted EBITDA in the quarter which eliminates share-based compensation and legal settlement and loss contingency expenses was $25.6 million, a margin of 16.5% compared to $37.5 million, a margin of 26% last year. These reflect the changes in gross margin and SG&A items just discussed.

Finance expenses in the third quarter were $1.6 million, up from $1.1 million last year. Finance expenses related to exchange risk fluctuation increased by $0.8 million offset by an increase of $0.3 million in interest income from bank deposits.

Taxes in the third quarter were $2 million, 20.9% of income before taxes compared to 15.8% tax rate last year. This effective tax rate increase is related to a bigger portion of taxable income generated outside of Israel where tax rates are higher.

Adjusted net income attributable to controlling interest in the third quarter was $12:7 million, compared to $24.3 million last year. Adjusted diluted earnings per share in the quarter were $0.37 compared to $0.70 last year, both relates to 34.5 million shares.

Turning to our September 30 balance sheet. We had cash, cash equivalent and short-term bank deposits of $136.5 million. This compares to $129.4 million at the end of the second quarter with $10.6 million in free cash flow generated during the quarter.

With respect to our 2017 guidance. Given our year-to-date results, our manufacturing throughput position and the cost related challenges, we are updating our guidance as follows. We are narrowing our revenue guidance from a previous range of $580 million to $595 million to a range of $580 million to $590 million. Our expected range of adjusted EBITDA for the year is $100 million to $105 million, down from our previous guidance of the lower part of the range of $119 million to $126 million.

Thank you. And I will switch back to Raanan for a quick summary.

Raanan Zilberman

Thank you Yair. Indeed, our revenue for the quarter has set a new record and we are somewhat pleased with it. However, it is clear that the challenges in manufacturing have yielded margins that are below our expectations. As I mentioned, we believe that we have already identified the main challenges and that they are all addressable. As shared with you before, we have commenced implementing countermeasures and we expect gradual margin improvement to follow soon.

While focusing short term on increasing the throughput of our production, we are continuing to leverage on our key strong assets that never change, the differentiated and creative product line, the brand that is the top of mind in the industry and our very strong grip in the channels to the market. Looking ahead, I can say that the basic fundamentals are positive for us as the demand for quality is still growing and our products and brands are top position globally.

Thank you and we are now ready to open the call for questions.

Question-and-Answer Session

Operator

[Operator Instructions]. Our first question comes from the line of Michael Rehaut with JPMorgan. Please go ahead with your question.

Michael Rehaut

So I guess there are a few moving pieces hurting gross margin. Can you maybe breakout some of the components? And then I guess build on how they are trending most recently? And then with all the initiatives and changes, what do you see as the [indiscernible] on this one or two years knowing that some like polyester prices are out of your control, also you if you could some touch here with the differentiated products just a little bit better?

Raanan Zilberman

Mike, we are sure whether the quality of your line. It was almost impossible to hear you. But I understood the questions to be quantifying the different drivers in gross margin. So that's what I will do and there was something else that we missed. You are welcome to ask it further. So with regard to gross margin drivers, I would [indiscernible] temporarily external issues, raw material prices basically polyester which has had an impact of 150 basis points negative on the gross margin. Also the U.S. weather with the different hurricanes impacted our results to Around 50 basis points. Then we have other temporary items that we should resolve. Richmond Hill performance, which is still a lot more costly than the Israel performance and because Richmond will become a big portion of our performance, it had an impact of 300 basis points to our gross margin. Israel throughput 250 basis points negative, again due to increased portion of differentiated product with longer production cycle time and setup time. And then the one thing that continues to carryover for us which we see it very positively but in gross margin it is some what taking it down. So in operating margin, it's a neutral impact. It's the increase of fabrication and installation portion of revenue which impacted our margin, our gross margin by 50 basis points.

Operator

Thank you. Our apologies for the poor audio quality. We will move on to our next question from the line of John Baugh with Stifel. Please go ahead with your question.

John Baugh

Thank you. Good morning. Could you discuss, I heard sort of two different stages, I am talking about the Richmond Hill production and then Israel, it is sounded like you have made a bunch of managerial changes in the United States and you alluded to some favorable impact already. I guess I am kind of curious as to what metrics or commentary you can give us that gives us of a frame of reference to improvement, if any, in the U.S. plant from the third quarter through October? And then the same kind of commentary in Israel where it sounds like the changes there will take longer to implement. And I was curious there whether there will be worse performance gross margin wise in 4Q from 3Q in the Israel production? Thank you.

Raanan Zilberman

Thank you John. Let's take it one by one. Let's start the Richmond Hill plant. Few months ago when I joined the company and I looked at the performance at Richmond Hill, I shared with you that there were six, seven months of consecutive improvement in the plants. When we say improvements, we talk maybe about the two parameters, the quantity, the throughput and the quantities, the yield. And basically those two parameters are resulting in the ultimate power meter which is the cost of slab that we manufacture and later on impacting the gross margins.

So I was very positive. But it looks like it was not sustainable and definitely the hit that we are getting know in Q3 was because the performance went backwards especially in September. I decided that we need a Plan B and as mentioned before I have implemented a Plan B already, just to give it some life, the problem in Savannah in Richmond Hill is definitely not the equipment. As I mentioned before, it's top of the line. It's a Rolls-Royce equipment. There is no issue with the equipment of the plant. The production of quartz is pretty challenging technical expertise and unique know how and the American team that was there couldn't cope with the gaps of the know how and I had to decide a tough call to move an Israeli team with already existing know how to replace the leadership team because it needs to be an immediate reaction.

So I am talking about additional seven people from the management team and probably another seven technical engineers to support them and they are running plant right now. When I mentioned that we see improvements in results and significant improvement, I mention again to those two power meters, the throughput and the yield, the quality. It's not because they are better manager. It's all about know how. And I believe that we are in the right direction.

I don't want to make big promises because it's the first month, but I have good feeling be these are very experienced people that run the operational overview and I prefer not to look at the last two years. I prefer to look ahead. I feel that we are living right now the right plan with the right people and I am very positive about how Richmond is going to look like in the in the coming periods.

Now with regards to Israel, let's take things in proportion because when talking about challenges in the operational processes in Israel and the manufacturing, you have to appreciate that we know the entire industry. We are visiting our competitor. We see other plants. We are considering to buy others. We don't know any of our competitors that is producing in the throughput of Caesarstone. I can assure you that the throughput is higher in the industry. We don't know of any competitor that is able to produce between $90 million to $100 million from a production line.

The phenomenon that we are talking about is a phenomenon of few percentage. From this high peak, we went back a few percentage. A few percentage, by the way, it's a lot of money. And the direct reason and the immediate reason is not because somebody was not doing what he needs to do. It was mainly because we introduced in the last year around 24% new products. The way to survive in this competitive environment of the market nowadays is to keep on introducing new products again and again and again, like the rugged concrete, like all these new products that we have launched last year and I can tell you and I can assure you, more supplies will come in 2018.

Now that comes with a toll, absolutely with a toll. To be unique, to be special, you have to complicate it because otherwise everybody knows to do it and that takes longer cycle time, longer setup, more complicated equipment and that brought a regression in the throughput.

Now you ask me, if I am happy? Certainly not. You ask me if it is addressable? Yes. I think that we have seen it in the past that when you introduce a mass throughput of new products, you go backward and now you need to back to the basic of manufacturing, lean manufacturing, improvements of team, working on the shop floor, employee's, technical people and management and try to cut it back again.

This is the challenge that we will try to mitigate in the near the future. By the way, I have no problem with the local management. The changes that I did was mainly to energize and to mainly rotate people, mainly to energize and to bring new vivid into the battle. But it's a good team, actually a world-class team and I am sure that the numbers will be at the right place in the future.

John Baugh

Thank you for that detail. So the changes, first of all, you took, it sounds like, 14 people from the Israeli production over to the United States. Will that have some kind of an impact on the Israeli facility? It just sounds to me like the fourth quarter margin compression in Israel production will continue.

Raanan Zilberman

It's two for comments. For the first one, I will say, I believe that we have enough redundancy and enough depth in a managerial structure. And a matter of fact is that actually after the changes, I can tell you again that October performance on the two plants in Israel were much better than any months of the last quarter. So no immediate impact. I believe that we have the right team.

However, as you mentioned, it's not a push of a button. I can tell you that with the change of the management and with the changes that we do in Israel, it is a very quick result operation. In Richmond Hill, there is no issue. I believe the curve will be faster.

In Israel, as somebody that grew up from the shop floor, I can tell you it is a manufacturing battle with hundreds of KPIs with Kaizen's team and this work needs to be done. It won't be a overnight. But again, I am telling you, we haven't seen in the past anyone, any other manufacturer that no two manufacturers quality is better than Caesarstone. So at the end of the day, it will come back to where it needs to be. I believe, to be honest, it's not pleasant to be with such a report and with such a margin, but these are internal problems that should be solved by managerial. The real constraint is always the market and this is where we should focus at the end of the day.

John Baugh

And if I could ask one more question and focus on U.S. revenue. You mentioned a 9% to 10% rate. I assume that is adjusting for what you think was a hurricane impact or maybe some anything else unusual that didn't happen in Q3. But I guess my question is, when I look at the comparisons to the prior year, Q3 was your easiest comparison in terms of U.S. revenue growth. What channels of distribution or customers or what gives you the confidence that you are looking at this 9% to 10% rate is sustainable out, say, the next two to four quarters? Thank you.

Raanan Zilberman

First of all, let's take it into proportion. We grew this quarter 6%. So you can calculate, again, the impact of Irma and Harvey was relatively small, okay, as compared to the 9%, 8%, 9% or 9%, 10% that we mentioned. So the number for the quarter is 6%. Drilling down into the channel, I would say that the big news of this year is definitely our improved throughput with IKEA. We are doing better. But I think that in terms of managing the channels, I feel a little bit more comfortable nowadays with what we are trying to do with the channels more than what we are already doing but with what we are trying to do. And I think we talked about it a little bit in the past and I am ready to say a few words now.

First, with the kitchen and bath channel, which is the bread and butter of the company, I think it's a simple game. We are trying to increase the proximity. This is where we are very strong. This is where we make our money. It's true that there is a lot of competition there. But we have already identified a series of actions that are already undergoing. And at the end of the day, if we do them correctly, again kitchen and bath should remain the backbone of what we do.

In the contractor and builder channel, we have some new cards to play and I believe that we will evolve our strategy and go beyond of what we have done in the past. Generally speaking, without too many details, I think that we need to sell to the contractors and builder more than just the slab and we need to give them a full solution and we need to have a stronger grip on the entire value chain. This is a competitive market. So you better sell product and service and not just a product. Otherwise you are between the hard and the rock. So here we are working on that and I believe that with time we will continue to improve the position. By the way, it was a market for us this year. It grew nicely.

With the big box, this is our biggest potential. I mentioned it in the past. We talked about it. I can't report on any breakthrough and I think it will take time, but from the moment that I stepped in the company, I targeted it as something that we need to do. I believe in it. And we are taking action items. It takes time but I believe that at the end of day, we will crack it. So it's not a theory. It's something that we are trying to execute.

And at last, even the stone supplier, we have identified some potential in their channel. So to cut a long story short, if you ask me, I feel that we haven't exhausted those channels. Actually there are more opportunities that if we will be sophisticated and good in the execution, that can give us a differentiation to the Chinese players. They are very competitive with the price. We need to be competitive with the brand, with the service, with the channel and with the customer experience. This is something that it will be very hard for them to compete with.

John Baugh

Thank you.

Operator

Our next question is from the line of Susan Maklari with Credit Suisse. Please go ahead with your question.

Chris Counihan

Hi. This is Chris Counihan, on for Susan. I just wanted to drill in a little deeper on that competitive landscape. Are you seeing any change in the pressure from imports and domestic competitors?

Raanan Zilberman

It's a good question. I will tell you why. We do see increase in the landscape. There is more competition. But if you want the other side of the moon for the reduce in performance in the operation and the story about the differentiated products, is the fact that we did not erode price so far. Now this is not a place for the future. It might happen. It is a very competitive market. But as I mentioned before, one of the way to keep your position is try and to be sophisticated and with USP on the product and that's what we are trying to be. Unfortunately, it came with the toll that it came.

So to answer to your question, yes, there is a tough competition, yes, it is increasing and the reason are very simple. Quality is accepted by the mid and the low segments of the consumer segments. And there will be always demand for low-cost solution. At Caesarstone, we will have to live with it serving the top-end, probably the mid-end and some selective projects, et cetera, et cetera. We will have to live with this environment. However, the good news., the market is growing. The market is growing.

Chris Counihan

Okay. Thanks for that. And then I was hoping you could provide some color on some of the demand you are seeing for new product. So as you guys work through these production issues, do you see that these new products are being accepted by the marketplace?

Raanan Zilberman

The product that we launched in 2017, absolutely. You know it's been for a while that Caesarstone is a trendsetter. So normally we come with new products and the phenomenon that we see or the questions that we see is how fast other will imitate it, okay. So we never look at others, never. And we know this, people are imitating. Imitating the product look-alike, sometimes the name, the look of the websites, even look-alike names. This hasn't been changed. So yes to your question, the product has been accepted very well. And as I mentioned before, we are working on some new things in the pipeline to maintain the current leadership and even and maybe beyond this to touch even some attributes of the slabs.

Operator

[Operator Instructions]. The next question is from the line of Lena Rogovin with Chardan Capital. Please proceed with your question.

Lena Rogovin

Thank you. I have a couple of questions. The first question is about production volumes. Could you just provide a breakdown for Israel and for Richmond Hill as a percent of total production? And my second question is about the margins. Do you believe that it is still early to get back to the previous levels of margins? I am mostly talking about the gross margin. And when should we expect to start seeing some margin improvement? Thank you.

Yair Averbuch

Okay. So while we are not providing a throughput breakdown between the plants, Richmond Hill this year improved itself compared to last year significantly. However, it's still far below Israel. But it's a much bigger portion of our production today relative to last year.

With regards to margin, as Raanan said, we implemented many steps here in the company. We see some very encouraging results in October and we believe that we will see a gradual margin improvement. Too early to say to what level.

Raanan Zilberman

But I think if we do the sale, we have provided guidance. So I think you can, it's very easy to make a derivative product for the Q4 because you have all the information. So we have been very cautious and I think for good reason because as I mentioned again, it's not a push of a button. These are industrial processes. They will take time. But if you ask me, Raanan, are you confident that you can bring it to where it should be? Then I say, the answer is yes. Should we expect to see it in Q4? My answer is no, okay. We see improvements, but you can do a very easy exercise to see what we guided for Q4.

Lena Rogovin

Fair enough. Thank you.

Operator

Thank you. At this time, I will turn the floor back to management for closing remarks. Thank you. The floor is yours for closing remarks.

Raanan Zilberman

Yes. Thank you very much. And thank you for the attention and interest in the company to-date. We appreciate it. I think that we now have a lot of work to do in-house and we look forward to updating you on the continuing progress in the next quarter here. So again, thank you very much for your support. Have a good day and we will talk to you soon again.

Operator

Thank you. This concludes today's conference. You may disconnect your lines at this time. Thank you for your participation.