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NCI Building Systems (NYSE:NCS)
Q2 2018 Earnings Conference Call
Jun. 6, 2018 9:00 a.m. ET

Contents:

  • Prepared Remarks
  • Questions and Answers
  • Call Participants

Prepared Remarks:

Operator

Greetings, and welcome to the NCI Building Systems second-quarter earnings conference call. At this time, all participants are in a listen-only mode. A brief question-and-answer session will follow the formal presentation [Operator instructions]. As a reminder, this conference is being recorded.It is now my pleasure to introduce your host, Darcey Matthews, vice president of investor relations for NCI Building Systems.

Thank you, Ms. Matthews. You may begin.

Darcey Matthews -- Vice President, Investor Relations

Good morning, and thank you for your interest in NCI Building Systems. Joining me today for the call are Don Riley, our CEO, and Mark Johnson, our CFO. Please be reminded that comments regarding the company's results and projections may include forward-looking statements that are subject to risks and uncertainties. These risks are described in detail in the company's SEC filings, earnings release, and supplemental slide presentation.

The company's actual results may differ materially from the anticipated performance or results expressed or implied by these forward-looking statements.In addition, management will refer to certain non-GAAP financial measures. You will find a reconciliation of these non-GAAP financial measures and other related information in the earnings release and our supplemental presentation located on our website. Our first-quarter 2018 earnings were released last night. A copy of both the release and our supporting supplemental presentation can be found in the Investors section of our website. This morning, Don will make a few comments about the quarter and some of our initiatives and then turn the call over to Mark for more specific financial commentary before we open the call up to take your questions. And now, I'd like to turn the call over to Don.

Donald R. Riley -- Chief Executive Officer

Thanks, Darcey. Good morning, everyone. Thank you for joining us today to review our 2018 second-quarter results. I am proud of the NCI team and our customers' performance in Q2.

It is through their efforts and support we achieved solid results in a period of macroeconomic headwinds. Year over year for Q2, NCI revenues and adjusted EBITDA were as 9% and 7% respectively, and adjusted earnings per share were at 56%. We successfully increased pricing to offset the recent inflation in material and labor costs. We had gross margin percent expansion in our billings and components businesses versus prior year, and sequentially for NCI as a whole. And our total backlog was up 11%, reaching historic levels.

This solid performance has positioned us well for Q3. As we stated last quarter, we expect low-rise non-residential construction starts will continue to grow mid-single digits, with the addressable markets for our legacy businesses growing 2% to 4%. IMP, based upon increasing market penetration, should continue to grow at low double-digit rates. Our current backlog and incoming order rates for billings and IMP continue to support these base assumptions.In the second quarter, the NCI team maintained a strong focus on managing costs, driving operating efficiency, and ensuring commercial discipline.

Based on these areas of focus, we were able to successfully manage through this period of expanding inflation. We are currently expecting a strong third quarter. It is anticipated some of his strength will be due to portions of work advancing into Q3 from Q4 with customers trying to get ahead of inflationary prices.As noted on our Q1 call and as demonstrated in our Q2 performance, we have dealt with these periods of rising inflationary costs before and are confident in our ability to manage through that. We anticipate that this may create a less pronounced seasonal step-up between the third and fourth quarter, but when evaluated as first half, second half, we continue to have the view that 2018 will be a meaningfully better year than 2017 for NCI.As we have discussed, the three key areas of our long-term strategy are, first, the implementation of advanced manufacturing where investments in automation and process innovation will further drive down our operating costs, improve margin quality and service, and enhance our long-term operational flexibility.

A key element of this initiative is the implementation of an automated frame line for the buildings business.The frame line is in place and operational per our plan and will be fully up to speed by the end of Q3. We gave our board a tour of the line last month, and the board and the entire NCI team are excited about the potential this project holds for us. This has been our largest investment to date in automation, and I am pleased that the team has accomplished this key initiative on time and ahead of schedule. It will greatly add to the company's flexibility in terms of scaling up for peak seasons.Second, we are making strides with our continues improvement initiative where we're taking advantage of the great work that has been done in manufacturing to deliver cost reductions with lean and six sigma initiatives across our entire business.

We continue to ahead of our implementation plans for 2018, having trained over 350 employees in lean and six sigma principles and are working on tripling the number of continuous improvement projects compared to 2017. I am proud of the commitment the NCI team has made to these efforts, and it is also positive to see the results showing up in our ESG&A numbers and product line gross margins.Third, NCI solutions, our growth strategy around insulated metal panels and our ability to drive adjacent products across our legacy distribution channels are progressing in line with our expectations. IMP grew 10% year over year in Q2, where the prior year was an incredibly strong quarter with an unusually high architectural mix. For Q2, IMP represented 33% of NCI's consolidated EBITDA.As we've noted, the impact of these three elements by 2020 will be $40 million to $50 million, yielding margins and EBITDA expansion and a reduction in our overall ESG&A.

We continue to remain confident in these ranges and have a direct line of sight for hitting these targets. The team is focused on these three critical areas, and I believe there are more opportunities for further cost reductions and operational efficiencies at NCI as we increase our competencies and advance manufacturing and continuous improvement.Our overwriting objective remains to establish a business platform that enables NCI to outperform our addressable market within the low-rise non-residential market while allowing expansion of our operating margins. We entered the second half of 2018 positioned well, with a focus on commercial discipline and operational excellence while staying true to our long-term growth strategies around IMP, stores, and product adjacencies.We're confident 2018 will be a better year than 2017. We finished Half 1 strong, with EBITDA of 15% ahead of prior year and on our way to a positive start perhaps to with our backlog up 11%.

I want to close again with thanking the NCI team and our customers, and I look forward to answering your questions at the end of the call.I will now turn the call over to Mark to comment on our second-quarter financial results and third-quarter guidance.

Mark E. Johnson -- Chief Financial Officer

Thank you, Don. As in past earnings announcements, we have provided both a press release discussing our results and additional analysis and supplemental information posted on our website. I will, therefore, streamline my comments and add some additional color on our financial results for the quarter.Our consolidated revenues were up 8.7% year over year as result of gains in both pricing and volume. Commercial discipline was the foremost driver behind our improvement this quarter, as we achieved broad-based price increases in all four of our business segments.

In fact, of the $37 million year-over-year increase in our revenue, roughly $27 million of the increase was attributable to the successful management of higher raw material costs, which positively impacted both our revenues and gross profit.We have been able to proactively stay ahead in the midst of an inflationary environment in which we've seen many of our input costs rise. These include not only raw material costs, such as steel, chemicals, and paint but also transportation costs and labor costs. We have more work to do with transportation costs in the IMP business and are focused on continuing to drive commercial discipline as certain costs continue to rise in the second half of 2018. In terms of volume growth, external gains primarily came from the components and IMP segment, which continued the trend seen in Q1. In the components business, volume gains were achieved across most commercial products and were particularly strong in overhead roll-up doors.

While insulated metal panel volumes saw solid gains, product mix was less favorable than a year ago and cold storage and commercial and industrial sales made up a larger proportion relative to the higher margin architectural products. In contrast, last year's second quarter had an unusually large proportion of architectural panel sales, which made for a difficult comparison at the margin line this quarter. Gross margins at 22.8% were just above the midpoint of our guidance and increased 100 basis points sequentially. Nevertheless, we are comping to an unusually strong margin period in the second quarter of 2017, and as expected, saw a year-over-year gross margin decline. The decline is reconciled in our supplemental information and relates to the product mix shift within IMP, combined with lower manufacturing utilization in buildings and coaters and higher transportation costs in IMP. Looking at our adjusted operating margins, we saw roughly 40 basis points of improvement over last year's second quarter.

The increase in our operating margins was mostly driven by controlling and leveraging our ESG&A costs, which has been a focus in our cost reduction efforts. Before turning to our outlook, I'll comment on our cash flow and working capital. During the second quarter, we generated nearly $47 million in cash flow from operations with just under $9 million of capex spend. On a year-to-date basis, our operating cash flow grew from less than $8 million last year to nearly $40 million this year. This improvement was achieved despite the inflation and material costs due to better year-over-year working capital metrics and lower tax and interest rates.

As we stated during our first-quarter call, we anticipate generating meaningful operating cash flow, enhanced by lower interest costs and lower effective tax rates for fiscal 2018.Turning now to our outlook. The consolidated backlog is up 10.8% year over year to $632 million. Based on key leading indicators and incoming order rates across our businesses, we continue to expect our combined buildings and components businesses to track in the range of 2% to 4% volume growth for the addressable portion of low rise starts for fiscal 2018. And for our IMP product line, we expect revenue to continue to grow at low double-digit rates.

Thanks to greater market penetration and our ability to accelerate sales of these products through our buildings and components channel.We continue to anticipate net capital expenditures in the range of $45 million to $55 million for the year to be funded from operating cash flow. Of this amount, almost half represents growth or productivity investments. We expect to see the usual seasonal pattern of stronger construction activity in the second half, driving volume, plant utilization and earnings during that period.The rising cost environment is motivating certain customers to take delivery as soon as possible to avoid further price increases when available. This is true during the second quarter and we expect it will continue in the third quarter, which, depending on pricing activity, may result in a less pronounced step up in activity levels from the third quarter to the fourth.

With these considerations in mind, we currently estimate consolidated revenue for the third quarter will range between $525 million and $545 million, with adjusted EBITDA ranging between $56 million and $66 million. As a reminder, we have provided additional guidance for the third quarter in the supplemental presentation posted on our website.And now, we'll open the call for your questions.

Questions and Answers:

Operator

Thank you. We will now be conducting a question-and-answer session [Operator instructions]. Our first question is from Lee Jagoda with CJS Securities. Please proceed.

Lee Jagoda -- CJS Securities -- Analyst

So just focus on the leading indicators that have been forecasting this low single-digit low-rise non-res gain for some time. The buildings volume has been declining on a third-party basis for you for the last several quarters. And is there some mix issue or some other thing that's causing the volumes in buildings to be lower than what the leading indicators would suggest?

Mark E. Johnson -- Chief Financial Officer

The buildings group is very, very focused more, I would say than they ever have, on being a leader in the pricing environment as raw material costs have been increasing so dramatically. Normally, at this time in a cycle like this, while for the whole company we may get ahead of cost increases, the buildings group may be lagging. They're actually ahead along with our other divisions during this period, so very aggressive pricing and favoring project profitability over volume.And the other comment I would add is that in the second quarter of last year, we had very, very strong volume growth in the buildings segment. We had over 13% volume growth year over year.

And so you're comping against a much stronger volume period with strong growth in it.

Donald R. Riley -- Chief Executive Officer

And I would echo Mark's comments around the commercial discipline, as well as we're really pleased with where the backlog is for buildings right now and the quality of that backlog.

Lee Jagoda -- CJS Securities -- Analyst

And then just as a follow-up, the IMP backlog within engineered building products was up 21% year over year. Can you comment on how far that backlog looks out and the mix of that backlog in terms of high value versus low value compared to what you shipped this quarter?

Donald R. Riley -- Chief Executive Officer

So I would say that it's very representative of the product that we shipped this quarter. Products that go to the buildings group tend to be in that mid-range, ICI type of product, very satisfied with the margins on that product. And the timeline for those, typically we'll ship anywhere in the 90-to-120-day range.

Operator

Our next question is from Matt McCall with Seaport Global Securities. Please proceed.

Reuben Garner -- Seaport Global Securities -- Analyst

It's actually Reuben on for Matt. You guys mentioned some pull forward in the Q3 guide. Can you quantify how much and maybe which are the segments we expect to see near-term boosts from?

Mark E. Johnson -- Chief Financial Officer

It's really difficult to quantify that. It's just a behavioral element of what occurred when you see rapid price increases like this. We've seen similar events in the past. If you go back to the fourth quarter of 2016, there was a somewhat similar environment, maybe not quite as dramatic but you saw a much flatter seasonality between Q3 and Q4.

Donald R. Riley -- Chief Executive Officer

And it would be across, especially the single skin and buildings businesses. And then you would also see some within IMP but probably not quite as much.

Reuben Garner -- Seaport Global Securities -- Analyst

And then maybe following up on one last question, the buildings backlog growth of 14%, the last several quarters, it's been tracking well above revenue growth. And I think you said the visibility that the backlog provides. Can you talk about the differences between the backlog growth we've seen over the last year and the revenue growth, and what gives you confidence that maybe you'll see an acceleration in buildings segments moving into the back half and into the next year?

Mark E. Johnson -- Chief Financial Officer

The backlog has been growing at a faster rate than revenue for somewhat last several quarters. And what that relates to is the type of projects that are incoming and the amount of site work that needs to get done before those products are ready to be delivered. And so we've seen a predominance of that type of project coming into the backlog right up until this most recent quarter. And then in the most recent quarter, we saw a reversal of that to where projects that are ready for immediate or fairly rapid delivery are the predominant items in the buildings backlog now.

Reuben Garner -- Seaport Global Securities -- Analyst

And then if I could sneak one more. Can you quantify the volume versus the price breakdown in the backlog, whether its buildings or consolidated?

Mark E. Johnson -- Chief Financial Officer

On a consolidated basis, there's not a precise measurement of the underlying volume but approximately somewhere around 7% to 8% underlying volume growth.

Operator

Our next question is from Scott Schrier with Citigroup. Please proceed with your question.

Scott Schrier -- Citi -- Analyst

Mark, I wanted to clarify the comment about the less pronounced seasonal step up from 3Q to 4Q. So just to be clear, you are still expecting a step-up from 4Q versus 3Q?

Mark E. Johnson -- Chief Financial Officer

Generally speaking, we have almost always been a step up in the third quarter to the fourth quarter. The only period of time where that's not been a case is when the economy, in general, has been decelerating. So just based on that historical pattern, yes but how pronounced it would be and how notable it will be, we'll be able to provide guidance on that we're a little bit closer to it.

Scott Schrier -- Citi -- Analyst

And based on some of your conversations with some of this pull forward in demand, trying to get in front of these steel cost. At this point, is there any potential for a slowdown in 19, because a lot of this is just all pushed into '18?

Mark E. Johnson -- Chief Financial Officer

Right now, based on our leading indicators, we don't see a slowdown in '19. As you know, we have 90 to 180 days in buildings and six to nine-month in IMP view. So our current indicators don't show a slowdown in the horizon we have visibility to.

Donald R. Riley -- Chief Executive Officer

And in that horizon, he is referring to as our internal indicators. The excellent indicators we look at give us more a nine- to 14-month view and those do not show a slowing indication, either.

Scott Schrier -- Citi -- Analyst

So cash flow works good, you improve your cap structure this quarter. We noticed that you had a little bit of an increase in some business expenses in the quarter. So if you could talk about how you're thinking about acquisitions, or potentially where some of those targets might be? And what you're seeing in terms of seller expectations?

Donald R. Riley -- Chief Executive Officer

So as we consistently shared, our priorities for capital allocation have been our internal projects initiatives where we see a high rate of return. And we have a demonstrated history of delivering on the results associated with that. A prime example is the one I referenced today around advanced manufacturing, getting that line in place and operational. We then see, as a second priority, is the debt pay down and managing our debt to the ratios we anticipate.And then as I have shared, we see that there is an 18-month horizon where we are very strongly focused on our internal initiatives, and the impact those are going to have.

And we see being more aggressive after that 18-month horizon on looking at adjacencies. So other aspects associated with the envelope. And as we've also said that doesn't mean that if there are opportunistic items that come into play in that period, we would absolutely look at those assuming that they fit in the portfolio and are accretive for us.

Operator

[Operator instructions] Our next question is from Brent Thielman with D.A. Davidson. Please proceed with your question.

Brent Thielman -- D.A. Davidson -- Analyst

Don, the comments on the building segment and focus on price over volumes to some degree. Has competition been slower to respond to the cost environment than you would have expected? And if that's the case, is that starting to change?

Donald R. Riley -- Chief Executive Officer

I think in the buildings segment, I would say we've had a reasoned environment, especially among the top players. And I would say if we've seen aggression, it's more in the smaller and smaller regional players. Probably very dependent upon where their steel positions were, what inventory costs were and how they were managing through that. So I would say we are seeing general positive pricing discipline across the top of the big three players that have about 73% to 75% share and more competition at the lower level.

Brent Thielman -- D.A. Davidson -- Analyst

And I know you reiterated in the mid-single-digit growth for the low rise but is there anything you see out there or at least beginning to develop that might suggest that pace is accelerating?

Donald R. Riley -- Chief Executive Officer

I think the areas that we continue to see as hot are mini storage. It continues to run very well for us. The other areas that are very strong for us is cold storage, and our FDA regulations out there that are starting to come into play that people, again, in the end of the life cycle where they have to comply with but then you also have the local fresh food phenomenon where you require local distribution in order to meet those food services that same day delivery. So we see very strong growth on that front.We have seen very strong growth on the ICI front in that world and some of the smaller regional players which we view as very private.

And the slower front continues to be the AG front for us.

Operator

Our next question is from Matthew Bouley with Barclays. Please proceed with your question.

Matthew Bouley -- Barclays -- Analyst

The Q3 guidance for gross margins, you're calling for effectively flat year over year to an improvement versus Q2. Can you break out I guess what the pieces of that you have the most visibility into, whether that's IMP mix or better manufacturing utilization? And then what factors may be less in your control. So I guess, what are just the wild cards that could drive that margin to the upper or lower end of the range? Thank you.

Donald R. Riley -- Chief Executive Officer

So the visibility we have into the third quarter really comes from what we can see in our backlog and the near-term schedules that we have. The phenomenon we saw in the IMP product mix was very pronounced in the second quarter. We still expect to see less-favorable year-over-year mix in the products based on what's in backlog right now relative to the insulated metal panel business. So that's a restraining impact on our margins.If you note, at the midpoint of our guidance, we're just below where prior-year margins came in.

And the primary driver for lower margins is that mix of business in the IMP world. We have additional cost increases that we're continuing to pass through. In our price increases, we've taken into account how we price work going into the backlog. We expect to continue to be ahead of the material input costs in the third quarter and relatively excited about where we see margins going from here for the last half of the year.

Matthew Bouley -- Barclays -- Analyst

The second question specifically in the buildings segment, strong year-over-year margin performance, improving sequentially, sounds like you're attributing that to pricing and ESG&A. And correct me if I'm wrong here but then I guess just how sustainable would you say is that type of margin improvement as we look to the second half of the year, again, focusing on the things that are in your control, particularly ESG&A. Thank you.

Donald R. Riley -- Chief Executive Officer

I would say, at a macro level, we feel that we're positioned very well. As Mark has said, we've been able to pass on inflation and continue to expect to be able to do that. And we expect sequentially to have improvement quarter to quarter in our gross margins. And we expect to have sequential improvement in our ESG&A and we attribute that not only to the commercial discipline but also to the initiatives continuing to come into play across all the organization.

Operator

Ladies and gentlemen, there are no further questions. I would like to turn the conference back over to Darcy Matthews for closing comments.

Darcey Matthews -- Vice President, Investor Relations

Sure, thank you. On behalf of Don, Mark and I, we appreciate your interest in NCI. And we look forward to speaking with everyone soon. Have a nice day.

Operator

[Operator signoff]

Duration: 30 minutes

Call Participants:

Darcey Matthews -- Vice President, Investor Relations

Donald R. Riley -- Chief Executive Officer

Mark E. Johnson -- Chief Financial Officer

Lee Jagoda -- CJS Securities -- Analyst

Reuben Garner -- Seaport Global Securities -- Analyst

Scott Schrier -- Citi -- Analyst

Brent Thielman -- D.A. Davidson -- Analyst

Matthew Bouley -- Barclays -- Analyst

More NCS analysis

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