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Quanex Building Products (NYSE:NX)
Q2 2018 Earnings Conference Call
Jun. 5, 2018 11:00 a.m. ET

Contents:

  • Prepared Remarks
  • Questions and Answers
  • Call Participants

Prepared Remarks:

Operator

Good day, ladies and gentlemen, and welcome to the Quanex Building Products Corporation second-quarter 2018 earnings conference call. [Operator instructions] And as a reminder, this conference call is being recorded. I would now like to turn the conference over to Scott Zuehlke, vice president, investor relations, and treasurer. Please begin.

Scott Zuehlke -- Vice President of Investor Relations and Treasurer

Thanks for joining the call this morning. On the call with me today is Bill Griffiths, our chairman, president and chief executive officer; Brent Korb, our chief financial officer; and George Wilson, our chief operating officer. 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 Quanex undertakes no obligation to update or revise any forward-looking statements 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 turn the call over to Bill for his prepared remarks.

Bill Griffiths -- Chairman, President, and Chief Executive Officer

Thanks, Scott, and good morning, everyone. Like everyone else in the industry, the second quarter was characterized by a continuation of inflationary cost pressures. While we did not see any further cost increases in Q2, we did see the full impact of those imposed at the beginning of our fiscal year. By mid quarter, we were in a position to predict with some level of comfort the full-year inflationary impact on each of our product lines and prepare an appropriate pricing strategy.

Based on a level of visibility, we implemented selective price increases on most of our product lines, with effective dates of May 1, June 1 and July 1. After extensive engagement with our customers, most of the price increases have been accepted. Although due to timing, there was minimal benefit in the second quarter, we do expect to fully recognize the favorable impact of price increases in the second half of our fiscal year. Margin contraction did narrow during the quarter, primarily due to raw material pass-through provisions that went into effect after the contractual time lag.

This was particularly evident in our North American cabinet components segment. We believe the price increases will allow us to fully recover inflationary costs in the third quarter, with the expectation that aggregated segment margins will be similar to last year. In addition, we expect to return to margin expansion on an aggregated basis in the fourth quarter of this year. We also saw continued strength in our North American Engineered Components segment, which, after excluding eliminated products, achieved sales growth of 8.7% for the second quarter and 6.6% for the first half of 2018.

Underlying sales growth was mostly volume driven, but also included some price increases, and raw material index recovery, and surcharges. Similarly, in Europe, excluding eliminated products and foreign exchange impact, underlying sales growth was 8.7% for the second quarter and 7% for the first half. This growth was driven by market share gains and price increases. Excluding eliminated products, our North American cabinet components segment slowed, with an underlying sales growth rate of negative 1.7% for the quarter and negative 1.2% for the first half.

Our negative growth rate was primarily driven by the continued shift in product mix toward lower-priced cabinets, particularly in light of major increases in hardwood prices, with many of the most popular species up over 20% just this year. We continued to adjust our production capacities in line with these trends as we relayout factory floors in some of our cabinet component plants. As this work progresses, we are seeing productivity gains every month. These productivity gains in doors produced per labor hour, together with the recently implemented price increases, are expected to yield improved margins on a year-over-year basis in the second half of this year.

We continued to drive solid cash flow. And as we enter our seasonably stronger second half, we are on track to end the year with a further improved balance sheet and a leverage ratio of less than two times. But more on that shortly. I'll now let Brent discuss our financial results.

Brent Korb -- Chief Financial Officer

Thank you, Bill. I'll first touch on the income statement and then provide comments on cash flow and the balance sheet. We generated net sales of $214.2 million during the second quarter of 2018, compared to $209.1 million in the second quarter of 2017. The sales growth was mainly driven by market and new products growth, in addition to price increases largely related to raw material inflation recovery and a favorable foreign exchange impact.

We reported net income of $4.1 million or $0.12 per diluted share for the three-months ended April 30, 2018, compared to $1.5 million or $0.04 per diluted share during the three-months ended April 30, 2017. On an adjusted basis, net income was $4.8 million or $0.14 per diluted share during the second quarter of 2018, compared to $3.8 million or $0.11 per diluted share during the second quarter of 2017. The adjustments being made for EPS are as follows: acquisition-related transaction costs; purchase price inventory step-up recognition; restructuring charges related to the previously announced closure of several manufacturing plants; accelerated depreciation and amortization for equipment and intangible assets related to these facility consolidations; as well as an accelerated depreciation for plant relayouts in the North American cabinet components segment; and foreign currency impacts, primarily related to an intercompany note with HL Plastics in our European Engineered Components segment. On an adjusted basis, EBITDA increased to $21.7 million in the second quarter of 2018 compared to $20.5 million in the second quarter of last year.

The increase in earnings was largely attributable to lower stock-based compensation expense and a lower effective tax rate as the result of the enactment of the Tax Cuts & Jobs Act. The lower stock-based compensation expense was mostly the result of taking the long-term incentive accrual, relative total shareholder return down to 0 for the expected 2018 vesting, coupled with a lower stock price. Unlike the first half of the year, we do not expect any benefit to stock-based compensation expense in the second half of the year and continued to estimate approximately $105 million in SG&A for the full year. Cash provided by operating activities was $21.6 million for the 3-months ended April 30, 2018, compared to $16.7 million for the same period of 2017.

We generated free cash flow of $6 million during the second quarter of 2018 versus $4.2 million during the second quarter of 2017. Year to date, our free cash flow improved by approximately $7.2 million versus 2017. We were able to repay $8.25 million of bank debt during the second quarter due to solid free cash flow generation and the repatriation of roughly $2.5 million of foreign cash. As a reminder, due to the typical seasonality of our business, we generate most of our free cash flow during the second half of the year.

As a result of our solid free cash flow generation and bank debt paydown, our leverage ratio as of April 30, 2018, improved to 2.2 times. We remain focused on generating cash and further deleveraging the balance sheet. We continue to expect to end fiscal 2018 with the leverage ratio below two times. I will now turn the call back over to Bill for some closing comments.

Bill Griffiths -- Chairman, President, and Chief Executive Officer

Thanks, Brent. As you have just heard, we expect to exit fiscal 2018 with a leverage ratio comfortably below two times, which begs the question, "what are our capital allocation priorities in 2019 and beyond?" Before looking at the future though, I thought it would be worthwhile taking a look back at our journey over the past few years. In 2013, our revenues were $953 million, only 50% of which were driven by the sale of components to OEMs. Our adjusted EBITDA was $44 million, with a margin of 4.6% and free cash flow of $5.6 million.

At the end of 2013, we embarked upon a strategy of transforming Quanex into a pure-play supplier of components to OEMs in the building products industry. This strategy included portfolio rationalization, acquisitions, divestitures, and extensive operational improvements, all of which resulted in margin expansion and increased cash flow. Now let's take a look at where we stand today and how much better positioned we are. At the midpoint of our 2018 guidance which we just reaffirmed, our full-year revenue would be approximately $895 million, almost all of which is earned from selling components to OEMs.

Our adjusted EBITDA would be just over $105 million, which equates to a margin of approximately 11.8%. And we have guided to free cash flow of $50 million to $55 million. These are significant improvements through a five-year transformation of the business. As we move forward through the second half of 2018 and enter 2019, we consider ourselves well positioned to further enhance margins, improve free cash flow, and grow shareholder value.

Clearly though, as we have evolved over the past five years, some expectations have changed. Most notably, our overall rate of growth. We have concluded that the opportunity to grow through bolt-on acquisitions is much more limited than we thought several years ago. As such, this is not likely to be a meaningful part of our strategy going forward.

It is also clear that organic growth expectations across our industry are now lower than our original expectations five years ago. The silver lining is that the cycle is likely to last longer than originally expected, albeit at a slower growth rate. We are confident in our financial position and our ability to further improve on it over the next several years, particularly as it relates to cash-flow generation, which gives us the flexibility to evaluate our options with respect to returning cash to shareholders, while at the same time, maintaining a healthy balance sheet in the unlikely event that the cycle winds down faster than expected. And with that, operator, we'll now take questions.

Questions and Answers:

Operator

Thank you. [Operator instructions] And the first question will come from Jay McCanless of Wedbush. Your line is open.

Jay McCanless -- Wedbush Securities -- Analyst

Hey, good morning, everyone. Thanks for taking my questions. Just the first one I had, in terms of the price increases across the various segments. Can you talk about how far along you are with that? Is there going to be any more price increases, especially given what you said about hardwood prices moving up and potentially affecting the cabinet part of the business?

Bill Griffiths -- Chairman, President, and Chief Executive Officer

So most of the increases have been implemented and accepted. There are a few increases that are still being negotiated as we speak, but it's essentially done. And we are confident that what's been implemented and accepted thus far will deliver the results that we really just reaffirmed here in the earnings release and the prepared remarks. We have not seen further increases since the beginning of the year outside of the raw materials that are covered with escalators anyway.

Should there be unexpected increases as we enter the second half, we'll deal with that accordingly. But the takeaway is, we were very thoughtful after we saw the inflationary impact. They've been implemented for the most part, accepted for the most part. And we should be in good shape for the second half of the year.

The only issue will be if things like hardwood or resin continue to escalate at a rapid rate, there is still a time lag associated with a number of those contracts.

Jay McCanless -- Wedbush Securities -- Analyst

OK. Thank you for that. And then the second question I had is -- and I don't want to be -- and I don't want to put words in your mouth, but with the cabinet business, it sounds like you guys are not only worried about volume, I mean, about price, but potentially the loss of volume as people start to move toward those lower-priced cabinets. Is there anything you guys can do to offset that or maybe to change up your product mix a little bit to be more relevant with what customers are buying now?

Bill Griffiths -- Chairman, President and Chief Executive Officer

Yes. We clearly -- as we have really got our arms around this business now, the first order of -- on our list of priorities was to get the margins back to where we needed them to be. We are clearly looking at what the trend lines are and adjusting the product portfolio accordingly. There's clearly a trend toward more Engineered Products, and it's no surprise that the bulk of our operational excellence work is going into our Engineered Components facilities.

So we are actively working on that.

Jay McCanless -- Wedbush Securities -- Analyst

OK. Great. Thank you for taking my questions.

Operator

Thank you. The next question is from Daniel Moore of CJS Securities.

Daniel Moore -- CJS Securities -- Analyst

Good morning.

Bill Griffiths -- Chairman, President, and Chief Executive Officer

Good morning, Dan.

Daniel Moore -- CJS Securities -- Analyst

Bill and Brent, thanks for the color and particularly around how things have evolved over the last few years. I thought it was very helpful to put that in context, and you gave color around SG&A. Just remind us what a sort of normalized corporate G&A run rate looks like, either on a quarterly or annual basis.

Brent Korb -- Chief Financial Officer

On an overall corporate?

Daniel Moore -- CJS Securities -- Analyst

Correct.

Brent Korb -- Chief Financial Officer

I mean $105 million is what we're projecting for the year. But you're saying on an annual run rate just on the corporate office, the unallocated corporate?

Daniel Moore -- CJS Securities -- Analyst

Yes. That's right.

Brent Korb -- Chief Financial Officer

So we've had -- we've been effectively zero for an unallocated pieces for the first half of the year. I would expect that to be closer to $2.5 million, $3 million on a quarterly basis going forward.

Daniel Moore -- CJS Securities -- Analyst

Perfect. And then given that and given, as you mentioned, Bill, M&A opportunities perhaps not being as plentiful as you have been looked, have you had any additional or more conversations from a partnership perspective looking at different ways to maybe leverage that corporate line over a larger revenue base over time?

Bill Griffiths -- Chairman, President, and Chief Executive Officer

We have had some discussions. It's not necessarily easy. I think I would reiterate the default position. It's still -- we are a nicely profitable just under $1 billion revenue business, in great financial shape, strong cash flow generation.

And clearly, as we get through this year, we'll be at an inflection point where returning cash to shareholders is a real option in front of us. And I think we can do that meaningfully, and at the same time, maintain a balance sheet that if, in fact, as some economists are predicting, perhaps two or three years out, there could be a soft recession or at least a slowdown. In the event that happens, we'll have a balance sheet to enable us to get through that with ease given the strength of our cash flow.

Daniel Moore -- CJS Securities -- Analyst

Very helpful. And one more, shifting gears. You reiterated guidance, $35 million CapEx still around the right number, and how should we think about that as we look out to fiscal '19 just in terms of the cadence for cash? Thanks again.

Bill Griffiths -- Chairman, President, and Chief Executive Officer

That is about the right number. It could possibly be a little lower than that as we get into '19. As we have said, we have been reinvesting in the business and expect that to start tapering off as we go through '19 through 2021.

Daniel Moore -- CJS Securities -- Analyst

Perfect. Thank you again.

Operator

Thank you. The next question is from Ken Zener of KeyBanc. Your line is open.

Ken Zener -- KeyBanc Capital Markets -- Analyst

Good morning, gentlemen.

Bill Griffiths -- Chairman, President, and Chief Executive Officer

Good morning, Ken.

Ken Zener -- KeyBanc Capital Markets -- Analyst

The 3Q margins, if you could just restate what you said. I think, in total, you said it'd be flat. I just -- I know there's been restatements. Could you be explicit in terms of that EBIT margin that you're looking for? And then restate what you talked about cabinet margins in the second half.

I wasn't sure if that was a third or fourth-quarter comment. Thank you.

Bill Griffiths -- Chairman, President, and Chief Executive Officer

So the divisional EBITDA margin, so excluding any corporate, the expectation is that, on an aggregated basis, so all of the segments added together, the third-quarter margin would be similar to what it was last year as a result of the full impact of the prices across the board that we just implemented.

Ken Zener -- KeyBanc Capital Markets -- Analyst

Was that about 8.5%? Is that the right number, Brent?

Brent Korb -- Chief Financial Officer

It's in that order of magnitude, Ken.

Ken Zener -- KeyBanc Capital Markets -- Analyst

OK.

Bill Griffiths -- Chairman, President, and Chief Executive Officer

And then as it --

Ken Zener -- KeyBanc Capital Markets -- Analyst

[Inaudible] there, Bill, on the cabinet, yes.

Bill Griffiths -- Chairman, President, and Chief Executive Officer

Yes. OK As it pertains to cabinets specifically, the expectation is that, in the second half of the year in the cabinet components segment, we will see year-over-year margin expansion.

Ken Zener -- KeyBanc Capital Markets -- Analyst

In total for the second half. Does that mean 3Q or is it more 4Q geared?

Bill Griffiths -- Chairman, President, and Chief Executive Officer

It's certainly be greater in 4Q. We should see expansion, however, in 3Q as well.

Ken Zener -- KeyBanc Capital Markets -- Analyst

Very good. And then I guess I just have two more questions, but I'll combine them just to pretend like it's one.

Brent Korb -- Chief Financial Officer

Ken, just real quick, I want to make sure there's clarification. You asked about that sort of 8.5%, that's EBIT, not EBITDA.

Ken Zener -- KeyBanc Capital Markets -- Analyst

Right.

Brent Korb -- Chief Financial Officer

That's EBIT.

Ken Zener -- KeyBanc Capital Markets -- Analyst

Correct, correct.

Brent Korb -- Chief Financial Officer

OK. making sure.

Ken Zener -- KeyBanc Capital Markets -- Analyst

I do appreciate that. Well, I'll just break these two questions up then. So George, could you update us on kind of the warm edge spacer adoption, because that's been such a growth area, and I know that's obviously where you were involved in the past. Can you talk about how that adoption rate is working in terms of existing clients, as well as what the outlook might be based on third-party equipment that supports your share gains?

George Wilson -- Chief Operating Officer

Sure. As it relates to the high-speed automation, growth continues to exist. I would say the only thing that I would put as the caveat is that growth rate is limited by the ability of the equipment makers to produce those machines. So lead times on all equipment have extensively grown.

So you'll see lead time from all equipment makers now pushing out to nine to 12 months. So that's changed since it originally started, but the growth rate is still there. It's just we're dependent upon the equipment makers to make the machines.

Ken Zener -- KeyBanc Capital Markets -- Analyst

And is that due to higher demand this year? Obviously, there's more than one manufacturer. But is that just the matter of a smaller CAPEX supplier being overwhelmed by rising demand? Or is there something unique that we should understand is happening?

George L. Wilson -- Chief Operating Officer

No. It more relates to the equipment makers tend to be small, so their ability to grow is limited. They're small family owned companies. In most cases, there are three or four owned globally that make the IG, the equipment makers, and they typically make three to four lines per year.

Ken Zener -- KeyBanc Capital Markets -- Analyst

That's it, huh? Interesting. Bill, a broader question, not about businesses within Engineered Components. But given some of the consolidation that we've seen in the broad window industry, JELD-WEN, can you talk about any impacts or thoughts that might be -- not impacting this year, because you obviously have guidance, but what might be impacting the landscape as you look to FY '19 and '20 in terms of your business and in terms of what that consolidation might mean? Thank you.

Bill Griffiths -- Chairman, President, and Chief Executive Officer

Yes. At this point, obviously, we're in dialogue with some of the players that you're referring to. And clearly, for the next year, we've been told it's business as usual. We don't see on the horizon at this point any negative impacts to our business, but we don't particularly see any positive impacts to our business either.

But obviously, we're monitoring that very carefully and any potential future consolidation that might occur.

Ken Zener -- KeyBanc Capital Markets -- Analyst

Thank you very much.

Operator

Thank you. The next question is from Julio Romero of Sidoti & Company. Your line is open.

Julio Romero -- Sidoti & Company -- Analyst

Hey, good morning, everyone.

Bill Griffiths -- Chairman, President, and Chief Executive Officer

Good morning, Julio.

Julio Romero -- Sidoti & Company -- Analyst

Hey, just a couple of quick ones here. How much headroom do you guys, say, the raised prices in the European Engineered segment given the amount of price increases you kind of have already kind of put in to date?

Bill Griffiths -- Chairman, President, and Chief Executive Officer

We're reaching the limits right now, and we've had two not insignificant increases, one toward the end of last year, one in the early part of this year. I think it's unlikely we'll see any further increases as we exit this year. The only thing that's still questionable, particularly in Europe, is silicon in the spacer. That continues to be in short supply, and prices do seem to be continuing to escalate.

We're holding our price at this time. But if it continues to increase significantly, we may have to do something.

Julio Romero -- Sidoti & Company -- Analyst

Got it. And do you guys have any contractual pass-throughs in Europe at all? Or is it just kind of completely opposite as in the U.S. and there's no contractual pass-throughs [Inaudible]

Bill Griffiths -- Chairman, President, and Chief Executive Officer

Generally thinking, the answer is no. It's the opposite of the U.S. There are almost no contractual pass-throughs.

Julio Romero -- Sidoti & Company -- Analyst

Got it. And then just one last one. If you could give us any update on any quantifiable improvement you guys have done in Woodcraft kind of year to date.

Bill Griffiths -- Chairman, President, and Chief Executive Officer

Sorry. Could you repeat that? Julio, I didn't catch it.

Julio Romero -- Sidoti & Company -- Analyst

Sure. Just any -- just talk about the improvements you guys have made on the Woodcraft segments in terms of the automation you've put in kind of year to date.

Bill Griffiths -- Chairman, President, and Chief Executive Officer

Yes. Year to date, we are in the -- there are really two parts to the business. The rough mills, which produce the blanks that make into cabinet doors, and the rough mills are where we've put in a significant amount of automation. Year over year, at this point, productivity is up by 11%.

And in cabinet door production, we measure cabinet doors produced per labor hour, and productivity there is up 5%.

Julio Romero -- Sidoti & Company -- Analyst

Excellent. Thanks. Thanks for taking my questions, guys.

Operator

Thank you. There are no further questions at this time. I'll turn the call back over to Mr. Griffiths for closing remarks.

Bill Griffiths -- Chairman, President, and Chief Executive Officer

Thanks for joining us, everyone, and we look forward to updating you early in September as we close out our third quarter. Thank you.

Operator

[Operator signoff]

Duration: 29 minutes

Call Participants:

Scott Zuehlke -- Vice President of Investor Relations and Treasurer

Bill Griffiths -- Chairman, President, and Chief Executive Officer

Brent Korb -- Chief Financial Officer

Jay McCanless -- Wedbush Securities -- Analyst

Daniel Moore -- CJS Securities -- Analyst

Ken Zener -- KeyBanc Capital Markets -- Analyst

George Wilson -- Chief Operating Officer

Julio Romero -- Sidoti & Company -- Analyst

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