Quanex Building Products Corporation

Welcome to Q3 2021 Quinex Building Products Corporation Earnings Conference Call. At this time, all participants' lines are in a listen-only mode. To ask a question during this session, you will need to press star 1 on your telephone. And please be advised that today's conference is being recorded. If you require any further assistance, please press star 0. I would now like to hand the call over to your speaker today, Mr. Scott Vilke, Senior Vice President, Chief Financial Officer and Treasurer. Please go ahead, sir.

Thanks for joining the call this morning. On the call with me today is George Wilson, our President and CEO. This conference call will contain forward-looking statements and some discussion of non-GAAP measures. Forward-looking statements and guidance discussed on this call and in our earnings release are based on current expectations. Actual results or events may differ materially from such statements and guidance, and Quantix undertakes no obligation to update or revise any forward-looking statement to reflect new information or events. For a more detailed description of our forward-looking statement disclaimer and a reconciliation of non-GAAP measures to the most directly comparable GAAP measures, please see our earnings release issued yesterday and posted to our website. I'll now discuss the financial results. We reported net sales of $279.9 million during the third quarter of 2021, which represents an increase of 32% compared to $212.1 million during the third quarter of 2020. The increase was largely due to increased demand across all product lines and operating segments, combined with increased pricing, mostly related to pass-through of raw material cost inflation. More specifically, We posted net sales growth of 20.8% in our North American fenestration segment, 19.3% in our North American cabinet components segment, and 85.8% in our European fenestration segment, excluding the foreign exchange impact, and despite the challenges presented by flooding in Germany during the quarter. As a reminder, both of our manufacturing facilities in the UK were shut down in late March of 2020 and did not resume operations until mid to late May 2020. We reported net income of $13.7 million, or $0.41 per diluted share, for the three months ended July 31, 2021, compared to $10.8 million, or $0.33 per diluted share, for the three months ended July 31, 2020. The increase in net income was mostly due to higher volumes and improved operating leverage. However, this improvement was somewhat offset by higher taxes, inflationary pressures, and an increase in SG&A during the quarter, which was mostly attributable to more normalized medical costs combined with an increase in stock-based compensation expense. To add more color around the higher taxes, an increase in the UK tax rate was enacted on June 10th, 2021. The increase from 19% to 25% will not be effective until tax years beginning on or after April 1, 2023. However, companies are required to include the effects of changes in tax laws in the period in which they were enacted. Therefore, in Q3, we remeasured the deferred tax assets and liabilities that will reverse in 2023 at a new tax rate of 25%. So to account for this change, we now estimate our tax rate to be approximately 28% this year. On an adjusted basis, EBITDA for the quarter increased by 18.8% to $32.9 million, compared to $27.7 million during the same period of last year. The increase was again largely due to increased operating leverage from higher volumes. Moving on to cash flow in the balance sheet, Cash provided by operating activities was $18.5 million for the three months ended July 31, 2021, compared to $45.1 million for the three months ended July 31, 2020. Free cash flow came in at $12.3 million for the quarter, compared to $40.7 million in Q3 of last year. A higher inventory balance was the driver for the lower free cash flow during the quarter. This inventory growth is being driven by increases in raw material pricing and its related valuation, along with the strategic purchasing of some critical raw materials as they become available. The first item is self-explanatory, and it's just the proper valuation at lower of cost or market and the nature of first in, first out accounting for inventory. The building of raw materials is needed to compensate for ongoing supply uncertainty and significant increases in demand. Despite this pressure on inventory cost, we were still able to both repay $15 million in bank debt and repurchase approximately $1.8 million of our stock during the quarter. Year-to-date, as of July 31, 2021, cash provided by operating activities was $47.4 million compared to $47.6 million for the same period last year. Pre-cash flow year-to-date, as of July 31, 2021, was $31.4 million compared to $26.9 million during the same period of 2020. Our balance sheet is strong, our liquidity position continues to increase, and our leverage ratio of net debt to last 12 months adjusted EBITDA improved to 0.2 times as of July 31st, 2021. We will remain focused on managing working capital and generating cash in the near term. As George stated in our earnings release, We remain optimistic on the demand outlook for our products. However, we do expect inflation, labor costs, and supply chain challenges to continue pressuring margins throughout the fourth quarter of this year. We will continue to pass these incremental costs to our customers through index pricing, surcharges, and price increases. However, there are time lags in each case. In summary, on a consolidated basis, we are reaffirming net sales guidance of approximately 1.04 billion to $1.06 billion, and adjusted EBITDA of $125 million to $130 million in fiscal 2021. I'll now turn the call over to George for his prepared remarks.

Mr. Thanks, Scott. Not unlike others in the building product space, our fiscal third quarter was affected by significant inflationary pressures and material shortages that impacted manufacturing schedules and taxed our operations. Late in the quarter, The growth of the COVID Delta variant led to a resurgence of illnesses and required quarantines, which further impacted the already tight labor market. In addition, our plant in Heinsberg, Germany, flooded in late July during the devastating rainfall that fell over Western Europe. Despite these demanding challenges, we are pleased that we are able to announce another strong quarter of financial results and reaffirm our full-year guidance for fiscal 2021. Before discussing our results, I would like to take a moment to thank our team in Heinzburg, Germany, for their amazing efforts after the flood. Within just 14 days of the storms, the facility was back up and operating at full capacity, and not one customer was shut down because of this weather event. The team there worked long, hard hours to make sure our customers were supported, and they did a tremendous job under unbelievably difficult circumstances. Now, looking at the macro environment in North America, demand for windows and doors remains very strong. Supply chain pressures remain the constraint and have resulted in extended backlogs for our customers and longer lead times for end consumers. Demand for cabinet components also continues to be strong, and according to KCMA, the number of average backlog days within the industry has risen to 66.9 days versus prior year levels of 37.7 days. Although the summer months in Europe usually bring a slight drop off in demand due to holiday travel, current demand for our products in the UK and Europe remains consistently strong. We mentioned on a Q2 call that the glass shortages were beginning to limit output for window manufacturers in Europe and the UK. This trend continued into the third quarter, and we expect the same through the end of our fiscal year. From a supply perspective, material shortages continue to present a major operational headwind throughout the quarter. The biggest challenges remain in most chemical feedstock products and aluminum, and we are seeing allocations and short shipments of orders on a regular basis. While it is still too soon to tell, these shortages could be exasperated by the impact from Hurricane Ida. The rapid rate of material inflation continues to be the largest financial headwind we face. As a reminder, for the most part, we have contractual pass-throughs for the major raw materials we use in North America, but there is often a contractual lag that can generally be anywhere from 30 to 90 days long. These pricing mechanisms are working, but will not be fully realized until we see a flattening or decrease in pricing that allows for the catch-up period. We anticipate that we will begin to see prices peak and possibly begin to drop toward the end of the calendar year. At the time when index pricing does turn, there will be pressure on our revenue. However, we do expect to see improved profitability at that time. The labor market continues to be tight in every market we serve. During the quarter, we made progress in our recruiting efforts, but in North America, we are still looking to fill over 400 open positions. To improve both retention and employee acquisition, we have increased wages in almost all of our domestic plants. On an annual basis, we have raised wages in North America by approximately $5.1 million, which is being covered largely by price increases that have been passed on to our customers. We believe these increases will offset this structural change in the labor market and allow us to remain margin neutral. We are confident that the wage increases will continue to relieve pressure in this area. With that said, the growth of the COVID Delta variant and related spike in U.S. COVID cases has certainly added pressure, both because of ongoing positive cases and required quarantines for employees. I will now provide my comments on performance by segment for our fiscal third quarter. Our North American fenestration segment generated revenue of $147.8 million, which was approximately 21% higher than prior year Q3, and compares favorably to Ducker window shipments growth of 14.2% for the calendar quarter ending June 30th, 2021. Strong demand across all product lines, share gains in our screens business, increased capacity utilization on our vinyl extrusion assets, and an increase in index and surcharge pricing all contributed to the above-market performance. Adjusted EBITDA of $18.3 million in this segment was approximately 2.4% higher than prior year Q3. Volume-related operating leverage, the implementation of annual pricing adjustments, operational improvements, and lower SG&A all contributed to the improved performance year over year. These items were offset by timing lags for index pricing and higher levels of overtime utilization. For the first nine months of fiscal 2021, this segment had revenue of $422.1 million and adjusted EBITDA of $55.2 million, which represents year-over-year growth of 23.6% and 38.1% respectively. This also represents adjusted EBITDA margin expansion of approximately 340 basis points when compared to the first nine months of fiscal 2020. Our European fenestration segment generated revenue of 71.1 million in the third quarter, which is 32.8 million, or approximately 86% higher than prior year. Excluding foreign exchange impact, this would equate to an increase of approximately 68%. As a reminder, our European facilities were shut down for part of last May. Robust demand for our products continues in both vinyl extrusion and spacers as the repair and remodel markets in the UK and continental Europe remain strong. Adjusted EBITDA of $14.4 million for the quarter was $6.7 million better than prior year. This improvement was driven by prior year COVID impact along with volume-related operating leverage and pricing actions which helped to offset inflationary pressures. On a year-to-date basis, revenue of $181.9 million and adjusted EBITDA of $38 million resulted in margin expansion of approximately 540 basis points as compared to the first nine months of last year. And our North American Cabinet components segment reported net sales of $61.9 million in Q3, which was $10 million were approximately 19 percent better than prior year. Favorable index pricing and high order demand contributed to solid revenue growth in the quarter. Adjusted EBIT in this segment was 2.5 million, which was 0.6 million less than prior year. As discussed earlier, the timing lag of our contractual pricing index has added significant pressure on margin percentage for this segment. Although we are being impacted by this timing lag on hardwood, the inflation impact versus prior year Q3 was somewhat minimized by operating leverage from higher volume along with incremental price increases on certain products. Year-to-date, this timing lag has impacted adjusted EBITDA by 6.4 million. But if we adjust for this inflation, we would have realized approximately 400 basis points of margin expansion in this segment on a year-to-date basis. Operational improvements and volume-related leverage gains have helped offset the timing-related material impacts. And when hardwood prices flatten or drop, we can expect to realize margin expansion at that time. Unallocated corporate and other costs were $2.2 million for the quarter, which is $1.3 million higher than prior year. The primary drivers of this increase were stock-based compensation expense, operating incentive accruals, and more normalized medical expenses as compared to 2020. As Scott discussed, our balance sheet continues to improve. Our operational teams continue to focus on metrics they can control, and our cash flow profile remains attractive. Our management team and board are actively engaged in evaluating our capital allocation strategy for fiscal 2022, but in the short term, Our top priorities are to continue paying down debt and accumulating cash. There appears to be growing confidence that the current cycle within the building product sector will extend for several years, and we are seeing more and more M&A opportunities across our desk. Given the strength of our balance sheet, we will evaluate potential acquisitions that are both strategic and accretive to our growth and margin profile. So despite the near-term supply and inflationary pressures, we continue to outpace 2020 for both quarterly and year-to-date revenue, net income, adjusted EBITDA, and EPS. We have executed on our plan, and we have put the company in a position to capitalize on various paths to create shareholder value. We remain very optimistic on the future. And operator, we are now ready to take questions.