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Quanex Building Products Corp (NYSE:NX)
Q3 2019 Earnings Call
Sep 6, 2019, 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 Third Quarter 2019 Quanex Building Products Corporation Earnings Conference Call. [Operator Instructions] As a reminder, this conference call is being recorded.

I would now like to introduce your host for today's conference, Mr. Scott Zuehlke, VP, Investor Relations and Treasurer and Interim CFO. Sir, you may begin.

Scott Zuehlke -- Vice President, Investor Relations and Treasurer, Interim CFO

Thanks for joining the call this morning. On the call with me today is Bill Griffiths, our Chairman, President and Chief Executive 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 statement to reflect new information or events. For 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 will now discuss the financial results. We generated net sales of $238.5 million during the three months ended July 31, 2019, compared to $239.8 million for the three months ended July 31, 2018. The decrease was primarily attributable to a weaker demand environment, mainly in our North American Cabinet Components segment and inclement weather in the US.

However, our European and North American Fenestration segments continued to generate net sales growth above that of their respective markets, largely due to price increases related to raw material inflation recovery. We reported net income of 11.8% million or $0.36 per diluted share for the third quarter of 2019, compared to net income of $10.8 million or $0.31 per diluted share during the same period of 2018.

On an adjusted basis, net income increased by 18% to $13.7 million or $0.41 per diluted share during the third quarter of 2019, compared to $11.6 million or $0.33 per diluted share during the third quarter of 2018. The adjustments being made to EPS are for restructuring charges, certain executive severance charges, non-cash asset impairment charges, foreign currency transaction impacts, transaction and advisory fees and adjustments related to the Tax Cuts and Jobs Act.

On an adjusted basis, EBITDA for the quarter increased by 8% to $32.8 million, compared to $30.5 million in the third quarter of last year. The year-over-year increase in adjusted earnings was largely due to the successful implementation of pricing initiatives combined with operational efficiency gains.

Moving on to cash flow and the balance sheet. Cash provided by operating activities was $29.9 million for the three months ended July 31, 2019, compared to cash provided by operating activities of $26.8 million for the three months ended July 31, 2018. Free cash flow generation was strong during the quarter. As such, we generated free cash flow of $25.9 million in the third quarter of 2019, compared to the $21 million we generated during the same period of 2018.

This allowed us to repay $32.5 million in bank debt during the quarter and repurchase approximately 1.6 million of common stock. As of July 31, 2019 we had approximately $21.6 million remaining under our existing share repurchase program. Our leverage ratio of net debt to adjusted EBITDA decreased to 2 times. As a result of this decrease, the applicable margin we will pay on our outstanding revolver balance decreased by 25 basis points, which means the interest rate we are now paying is LIBOR plus a margin of 150 basis point. The next 25 basis point step down in margin would be when our leverage ratio is less than or equal to 1.5 times.

I'll now turn the call over to George to provide his prepared remarks on operational performance.

George Wilson -- Vice President, Chief Operating Officer

Thanks, Scott. Despite softer than expected revenues, we achieve another quarter of strong operational performance, which resulted in consolidated margin expansion of approximately 100 basis points versus prior year third quarter. Our European Fenestration segment again led the way with revenue growth of 9.3% for the quarter, excluding foreign exchange impact. And we realized margin expansion of approximately 180 basis points.

Results for the segment continued to be driven by above market growth, price increases implemented late last year and improvements in silicone cost for our spacer products. Sales in both of our North American segments continue to face headwinds, despite the weaker demand, our North American Fenestration segment still outperform the market with revenue growth of 2.2%, compared to Ducker's latest calendar second quarter window shipment estimate of a negative 2.3%. Ducker has recently reduced their full year calendar 2019 window shipment growth estimate to negative 1.2%, down from a positive 0.7%.

During the first nine months of our fiscal year, our North American Fenestration segment reported sales growth of 3%. We also realized 180 basis points of margin expansion in the third quarter. This improvement was driven by price increases implemented early in the year, along with our continued reductions in SG&A.

Now, moving onto our North American Cabinet Components segment. A semi-custom portion of the cabinet industry continues to lose share to the stock portion, and we expect that this trend will continue. Revenue declined $6.4 million or approximately 10% year-over-year. As Bill mentioned in our last quarterly call, mainly due to a tough comp we expected and realized margin degradation in this segment during the third quarter. This was primarily driven by the timing of certain accruals, along with lower volumes. Operational improvements in this segment continued to be realized and are helping us offset the impact of a softer top line.

I will now turn the call over to Bill for his commentary on our outlook and strategy going forward.

William C. Griffiths -- Chairman, President and Chief Executive Officer

Thank you, George. Looking forward, even with the optimism surrounding lower interest rates, we expect the soft demand trend to continue through the fourth quarter. In Europe, despite the continued uncertainty surrounding Brexit, we still anticipate above market growth, excluding foreign exchange impact as we continue to gain share in the UK and expand our international sales capabilities out of our German spacer facility. We also expect above market growth in our North American Fenestration segment in the fourth quarter, largely fueled by increased customer outsourcing of screens and increased volumes in our vinyl extrusion operation as new incremental business enters full production.

Unfortunately, most of this above market growth in Fenestration will be offset by a continued decline in our North American Cabinet Components segment as the market continues to shift from semi-custom to shelf cabinets. As a result, we now expect consolidated full year revenues to be flat year-over-year. Even with the weaker demand environment, however, we still anticipate further margin expansion in our European and North American Fenestration segments in the fourth quarter and for the full year.

We also expect margin expansion in our North American Cabinet Components segment in Q4, which should equate to flat margins for the full year. Consequently, even with softer revenues, we are maintaining the midpoint of our adjusted EBITDA guidance at $102.5 million, but narrowing the range to between $100 million and $105 million. Based on the seasonality of our business, the fourth quarter has historically been our strongest from a cash flow perspective, and we anticipate that this year will be no different.

Our objective will be to use this cash to continue paying down debt so that we exit the year with a leverage ratio closer to 1.5 times, while also continuing to be opportunistic with respect to buying back our stock. We expect to enter fiscal 2020 with a strong balance sheet and a demonstrated ability to generate more than $50 million of free cash flow per year, while also adequately funding the capital requirements of the enterprise.

As we think about capital deployment in 2020, depending on the macro economic environment, options we are considering include further deleveraging of the balance sheet, completing stock repurchases and possibly making additional strategic capital investments to support future growth. We are currently evaluating capacity extent -- expansion projects in the three fastest growing portions of our business, namely our screens business in North America, our vinyl extrusion business in the UK and our spacer business in Germany. We are also evaluating potential investments in new technology to improve the competitiveness and capabilities of our US vinyl extrusion business and our stock cabinet components business.

We believe that our strong free cash flow profile will allow us to fund all of these capital investments, while still opportunistically buying back more stock and also continuing to deleverage our already healthy balance sheet. We will, of course, have greater clarity on our future capital deployment strategy when we report our fourth quarter and full year results in December.

And with that, we're now happy to take questions.

Questions and Answers:

Operator

[Operator Instructions] And our first question comes from Dan Moore with CJS Securities. Your line is now open.

Peter Lukas -- CJS Securities -- Analyst

Hi. Good morning. It's Pete Lucas for Dan. Just starting off with a quick question on the cabinets. You mentioned the shift from semi-custom to stock, but have you seen any volume improvement in July and August as the weather has improved?

William C. Griffiths -- Chairman, President and Chief Executive Officer

July and August really carried the same sort of trend that we've been seeing all year. Clearly the weather got better. And, yeah, we did see an improvement, but as the comps get tougher later in the summer, it's pretty clear to us now that the trend is going to be pretty much as I just said. We'll see a continued decline in the cabinet business in Q4. I think in line with the market, generally speaking. We have strong expectations that we will do better in both North American and European Fenestration relative to the market, although the market there clearly is softening as well.

Peter Lukas -- CJS Securities -- Analyst

Got you. Next with relation to EU Fenestration. You mentioned the growth there above the market due to price increases and silicon costs. Are you seeing any market share gains? And if so, do you think those are sustainable?

William C. Griffiths -- Chairman, President and Chief Executive Officer

Yes, absolutely. So the price increases took place late last year as part of the recovery for not only silicon, but resin price increases. But we are continuing to gain share in the UK vinyl segment and we are continuing to expand our international sales opportunities, particularly out of the German spacer facility, hence evaluating whether we should look at capacity expansion in both of those operations in 2020.

Peter Lukas -- CJS Securities -- Analyst

Got you. And last one from me. With Brexit looming and the pound falling, what type of impact do you expect from each of these two factors on EU Fenestration revenue and margins over the next couple of quarters?

William C. Griffiths -- Chairman, President and Chief Executive Officer

It's really just translation effects. The real impact will be the relationship between the pound and the euro, which could have a direct impact on raw material input costs.

Peter Lukas -- CJS Securities -- Analyst

Very helpful. Thanks. I'll jump back in the queue.

Operator

Thank you. And our next question comes from Steven Ramsey with Thompson Research Group. Your line is now open.

Steven Ramsey -- Thompson Research Group -- Analyst

Good morning. I wanted to hit on a couple of the growth product categories. I guess, starting with the spacer business in Germany. Can you talk more to the sales and growth and margin aspirations in this business. Maybe kind of ballpark timeline, if it's near term or long term and then kind of the investment needed to get to where you're hoping to go?

William C. Griffiths -- Chairman, President and Chief Executive Officer

Yeah. So one of the things that we've been doing somewhat quietly as we've gone through this year is, we transferred more and more of the international sales responsibility for our spacer business out of North America into Germany. Firstly, we have stronger capabilities there, and more importantly, on a global basis it's actually more beneficial to trade out of mainland Europe than it is out of North America.

So we're starting to see increased opportunities. And if you recall, the spacer is really the only one of our products that we can manufacture and ship pretty much anywhere in the world. The rest of our products have a very limited radius. So we've had an active program for some time now to develop that international business where we're seeing some benefit. As you've seen in the results, throughout this year, hence the consideration if we want to continue to grow that business as we go into 2020 and 2021, it looks as though capacity expansion in Germany would be a smart thing to do.

Secondly, the other fast growing portion of our business, again, as you see in Europe is our UK vinyl profile business. We've been taking share as some of our competitors have struggled a little bit in that environment. And again, we may consider capacity expansion there in 2020 going into 2021. And then in North America, we have talked before about -- as our customers in the window business run up against capacity constraints. One of the easiest product lines to outsource is screens. It's labor intensive and takes a lot of floor space. And we've been seeing increased opportunities to take additional screen business that may require some selected expansion in regions of the country where we're currently underserved. And that's under evaluation.

And I think to tie a ribbon around the whole thing, it's pretty clear from a macro economic environment right now, 2020 is likely to be overall relatively slow growth in the residential segment. At least that's the indications we're seeing right now. But there are bright spots that we want to take advantage of. And our focus through this year and certainly going into next year is going to be on the things we can control. So the segments of our business where we do see growth, we will make investments there and anticipate sort of following the market with the rest of our product lines.

And in terms of cost, if we funded every one of these growth projects to the full, our capex of normalized around $25 million could reach $40 million, but no higher than that. And it's not likely that we will do that all at once. That might get spread out over the next two years. A lengthy answer, but hopefully that covers what you asked.

Steven Ramsey -- Thompson Research Group -- Analyst

Yes. Very helpful. Thank you. And I'm sorry if I missed this, but I wanted to get a little more clarity on the pricing front, more in the cabinets business with the shift in product categories. How are you approaching pricing and given the shift in end-market dynamics and the shift in your own capabilities to serve?

William C. Griffiths -- Chairman, President and Chief Executive Officer

We put through price increases last year, late in the year and some in the early part of this year in our cabinet business because of all the dynamics that are going on in cabinets now, consolidation and the shift we have not pushed for price increases for the balance of this year. And quite frankly, I'm not sure we'd be very successful at getting price as we enter 2020.

So, again, we're focusing on what we can control and go into work on our cost structure and capabilities, particularly so that we can be more competitive in the stock cabinet segment, which is a relatively small portion of our business right now.

Steven Ramsey -- Thompson Research Group -- Analyst

Great. Thank you.

Operator

Thank you. [Operator Instructions] Our next question comes from Julio Romero with Sidoti. Your line is now open.

Julio Romero -- Sidoti -- Analyst

Hey, good morning, everyone.

Scott Zuehlke -- Vice President, Investor Relations and Treasurer, Interim CFO

Good morning.

William C. Griffiths -- Chairman, President and Chief Executive Officer

Good morning, Julio.

Julio Romero -- Sidoti -- Analyst

Just on that last point, Bill, you had talked about evaluating options for 2020 and potentially for the stock cabinets segment. Could you possibly convert some existing manufacturing to service that stock cabinetry or does it take a greater undertaking for a new facility or something along those lines?

William C. Griffiths -- Chairman, President and Chief Executive Officer

It wouldn't be a new facility. We're looking at some technological investments in existing facilities. And you're right, some potential conversion of capabilities elsewhere. Still in the early stages of evaluation, but at least wanted to get it out there. We recognize this trend, looks as though it's going to continue. And, clearly, a high priority for us strategically is to figure out a way to make that an integral part of our business at similar levels of profitability and enjoy the growth prospects.

Julio Romero -- Sidoti -- Analyst

Okay. Very good. And I wanted to ask about how tariffs are affecting the industry and consequently Quanex. I would assume that tariffs on cabinet components coming out of China would be driving some increased quoting your way. Can you talk about -- if that's happening and how that should flow through your P&L in the coming quarters?

William C. Griffiths -- Chairman, President and Chief Executive Officer

We are seeing increased quoting activity, but in all fairness, I think it's driving the business to other low cost countries outside of China. So a lot of it is really going to move, I think, to Mexico to existing cabinet manufacturers facilities. A lot of it is moving toward Vietnam and Indonesia. So as of yet, we have not been successful in being awarded any of that business. And frankly, right now, I think it's unlikely as this goes to other low cost countries.

Julio Romero -- Sidoti -- Analyst

Understood. I appreciate the detail there. And best of luck in the rest of 2019.

William C. Griffiths -- Chairman, President and Chief Executive Officer

Thank you.

Operator

Thank you. And our next question comes from Ken Zener with KeyBanc. Your line is now open.

Ken Zener -- KeyBanc -- Analyst

Good morning, everybody.

Scott Zuehlke -- Vice President, Investor Relations and Treasurer, Interim CFO

Good morning.

William C. Griffiths -- Chairman, President and Chief Executive Officer

Hi, Ken.

Ken Zener -- KeyBanc -- Analyst

[Indecipherable] more dynamic calls, I think, not only because your businesses are performing well, perhaps better than expected on certain levels. But you're also talking about reinvesting. So, if I could just take a broad picture. I mean, what hesitations do you have given the slowdown in housing growth. Obviously, our view is that, it I'll be kind of flat modestly, both new and R&R. But what concerns do you have given your experience last cycle with investing at this point of the cycle. I mean, are you basically saying with your German expansion, UK extrusion that you're running at 100% or just about? And how do you balance those incremental sales that you want with what would be perhaps more of an incremental margin drag as you add capacity and fill it out?

William C. Griffiths -- Chairman, President and Chief Executive Officer

Yeah. So, I'm trying to take this piece by piece. It's been very clear, I think, through this year that Europe in general has been a positive surprise all around. I mean, given the political chaos, the fact that that business continues to perform. And I think it's going to continue to be insulated from many of the things we see in the US. We've talked in the past about if there were acquisition opportunities, that's a jurisdiction we will probably look at. Our view now is that, investment in expanding capacity there is a better way of continuing to grow those market. We're not talking about bricks and mortar, we're talking about -- and we're not bumping up against 100% capacity at this point.

Yes. This is a forward looking view. We feel Europe is going to settle down and we think all the pieces are in place for us to continue to get growth there. We just want to be ready for it in terms of production capability. In the US is it more the same thing applies. Any potential acquisitions to fuel our growth in North America are few and far between and as we look at the horizon, it actually makes more sense for us to increase capacity in those segments where we know we can get growth. The labor issue isn't going to go away, so I think we can continue to enjoy increased screen business. That will require setting up at least one, if not two, and possibly even a third screen manufacturing plant. The capital investment there is minimal. It's a few hundred thousand dollars in a leased facility. We may utilize the existing facilities to do that, but there's opportunities for growth there.

The harder ones are investments in technology to better position our vinyl extrusion business, which as you know, is one of our more competitive product lines and the stock cabinet business, and we will monitor the potential investment against what's likely to happen in the residential markets in 2020. We concur with your view that we think stocks will be flat or flattish next year. We're not convinced that there's a downturn on the way. And when you put all the pieces together, it's not a bad time to invest in the business and really take advantage if things continue to slow down.

Ken Zener -- KeyBanc -- Analyst

Thanks for the answer. I appreciate that. Could you -- within that outlook, is there a way -- now that we have '19 guidance pretty much done by quarter. Is there a way we should think about growth relative to incremental margins in each of your segments. I mean, usually companies offer 20% or 30% incrementals as you -- has your [0:01:19] business stabilized enough that we could hear from you some type of guidance in that regard?

William C. Griffiths -- Chairman, President and Chief Executive Officer

Yeah. I think as we -- that will be more appropriate, I think on our December calls. As we've talked about before, the reason it becomes difficult is, the business product lines, as you know, are completely different. And as we've said, the screen business, which is where we are seeing growth kind of has the lowest drop through rates. Clearly, we've been awarded some new business in our vinyl business that will change that a little bit. So we will attempt to do a better job at clarifying that as we guide toward 2020 in December.

Ken Zener -- KeyBanc -- Analyst

Thank you very much.

Operator

[Operator Instructions] Our next question comes from Reuben Garner with Seaport Global Securities. Your line is now open.

Reuben Garner -- Seaport Global Securities -- Analyst

Thanks. Good morning, guys.

Scott Zuehlke -- Vice President, Investor Relations and Treasurer, Interim CFO

Good morning.

William C. Griffiths -- Chairman, President and Chief Executive Officer

Good morning, Reuben.

Reuben Garner -- Seaport Global Securities -- Analyst

So, I had some technical difficulties, so excuse me if this was already asked. But I just want to try to understand your top line guidance a little bit. What changed for you guys from your last guide, was it predominantly the pressures -- the secular pressures in cabinets or are you seeing a softer consumer and housing outlook. Is it a combination of the two? What really was the difference between what you guided a few months and what's you guidance today?

William C. Griffiths -- Chairman, President and Chief Executive Officer

I think the biggest change is that in the Fenestration segment that -- there we have not seen the bounce back in mid to late summer that was originally anticipated, particularly by our customer base. And I think the housing sentiment has clearly sort of weakened as summer has gone on here. So the benchmark we use, Ducker forecasts window shipments at the start of the year, that marketing group forecasted window shipment growth in the low single digits and it's now forecasting the full year to be negative year-over-year.

So we are seeing that. The good news is, because of the things I just talked about, we're actually doing much better than the market in that case. In case of cabinets the KCMA numbers continue to show about a 5% decline in semi-custom compared to a 5% increase in stock cabinets. So we're seeing a continuation of that. But really that change since our last guidance is the continued softness in primarily the North American Fenestration segment, which, of course, is our biggest.

Reuben Garner -- Seaport Global Securities -- Analyst

And so in the Fenestration settlement, forgive me for not knowing this, but is it possible that your customers built up some inventory in anticipation of demand being better and that's leading to them not necessarily ordering as quickly as they otherwise would have?

William C. Griffiths -- Chairman, President and Chief Executive Officer

I don't think so. I think the channel remains as it always has. I think overall demand is there. And if you recall, we talked earlier in the year that really the constraint on whether we would see a pickup in the second half to recover from the weather in the first half was really going to be labor. And I think that's what we're seeing now. There's just not enough labor even for renovation projects, as well as new construction to pick up the business that was lost earlier in the year.

Reuben Garner -- Seaport Global Securities -- Analyst

And last one from me. This past quarter we heard some good order commentary from some of the builders. I mean, has anything changed in the last month that you would think that wouldn't ultimately flow through. Can you guys -- I mean, mortgage rates have come in. I know that there's broader macro concerns, but the consumer seems to be doing OK. Is there anything that would lead you to believe that trend may not continue or eventually lead to business for you guys as we look into your next fiscal year?

William C. Griffiths -- Chairman, President and Chief Executive Officer

All I think we can say is, these numbers we just reported are as of the end of July. We're in the process of closing our month of August. And the trend we saw in June and July continued into the month of August. And right now, the expectation is, we'll see that trend continue into September as well. So the answer is, no, we're not seeing it, despite -- and that's why I said on the remarks here, there's a lot of optimism around interest rates and mortgage rates continue to fall to an all time low driving a lot of refinancing, but it does not seem to be driving an increase in new construction, at least not yet.

Reuben Garner -- Seaport Global Securities -- Analyst

All right. Thank you, guys.

William C. Griffiths -- Chairman, President and Chief Executive Officer

Thanks.

Operator

Thank you. And I'm not showing any further questions at this time. I would now like to turn the call back over to Bill Griffiths for any closing remarks.

William C. Griffiths -- Chairman, President and Chief Executive Officer

Thanks, everyone, for joining us on the call today. We look forward to updating you in early December. We expect a strong close to the year as we continue to focus on the things that we have direct control over. So, once again, thanks and we'll see some of you as we hit the road here in the next few weeks. Thanks, everyone.

Operator

Ladies and gentlemen, thank you for participating in today's conference. This does conclude today's program and you may all disconnect. Everyone have a wonderful day.

Duration: 34 minutes

Call participants:

Scott Zuehlke -- Vice President, Investor Relations and Treasurer, Interim CFO

George Wilson -- Vice President, Chief Operating Officer

William C. Griffiths -- Chairman, President and Chief Executive Officer

Peter Lukas -- CJS Securities -- Analyst

Steven Ramsey -- Thompson Research Group -- Analyst

Julio Romero -- Sidoti -- Analyst

Ken Zener -- KeyBanc -- Analyst

Reuben Garner -- Seaport Global Securities -- Analyst

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