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Select Interior Concepts, Inc (NASDAQ:SIC)
Q3 2019 Earnings Call
Nov 5, 2019, 9:00 a.m. ET

Contents:

  • Prepared Remarks
  • Questions and Answers
  • Call Participants

Prepared Remarks:

Operator

Greetings and welcome to the Select Interior Concepts 2019 Third Quarter Results Conference Call. [Operator Instructions] I would like to turn the conference over to your host, Mr. Nadeem Moiz, CFO. Thank you and you may begin Mr. Moiz.

Nadeem Moiz -- Chief Financial Officer

Thank you, operator. Good morning everyone and welcome to our third quarter 2019 financial results conference call. Joining me on the call today is Ty Johnson, our Chief Executive Officer. During our discussion today, we will be referring to our earnings presentation which is available on the Investors section of our website. I will start with Slide 2, where I'd like to remind everyone that any forward-looking statements contained in this presentation or commented on today are subject to the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995. Actual results could differ materially because of issues and unknowns that need to be considered in evaluating our financial outlook and operating performance.

Please see our recent SEC filings which identify the principal risks and unknowns that could affect future performance. We assume no obligation to update publicly any forward-looking statements. Specific conditions issues and unknown factors that may represent forward-looking statements are noted in the detail on the slide. In addition, we'll be discussing or providing certain non-GAAP financial measures today, including adjusted EBITDA and adjusted EBITDA margins. Please see the appendix for a reconciliation of these non-GAAP measures to their most directly comparable GAAP measure.

I would now like to turn the call over to Ty Johnson, our CEO.

Tyrone Johnson -- Chief Executive Officer

Thanks Nadeem. Good morning everyone and thank you for joining us today. I will begin with a brief business update. Nadeem will follow with a review of our financials. During the quarter we continued to execute our strategy to grow faster than our markets, cross sell products and integrate acquired businesses. Those efforts paid off in most markets we operate helping to increase sales by 25% year-over-year and to grow adjusted EBITDA to $17 million. Partly offsetting this positive momentum, we continued to experience softness in Southern California market and incurred increased costs related to changes in our global supply chain, which I will address in more detail shortly. We were pleased to convert a more significant amount of adjusted EBITDA into operating cash flow, which totaled $11.5 million for the quarter and $20.3 million year-to-date. Lean initiatives and working capital management are among our top priorities and help to drive this improvement. We ended the quarter with a strong balance sheet to continue building our position as a key player in both US slab distribution and residential interior design services. We are in the early stages of a very attractive market opportunity and remain confident in our ability to continue to drive improvements within our business.

Turning to Slide 4, during the quarter, we grew sales in both our installation and distribution businesses. At Residential Design Services or RDS we design and install flooring, counters, cabinets and other high-end products. We grew RDS sales 42% year-over-year primarily through the geographic diversification of this business into several new regions over the past year. Organic sales were up modestly during the quarter with stronger volume overall and in nearly all-served markets, particularly in Northern California, Phoenix and Virginia. We are winning customers through new product line penetration and adjusting our product offerings to capture the growing share of new communities that target entry level and mid-priced homes.

Cross selling activities are also contributing more favorably to results. These factors are helping us outperform in our collective markets and maintain healthy backlog levels. While Southern California continues to represent a smaller mix of our expanded footprint, the expected pickup in starts in construction pace in that region has not yet materialized. As one of our higher end markets, the unfavorable impact of Southern California has been more pronounced on RDS price mix, including the shift by some builders from design center consultations to packaged selections. Although we cannot control the market environment, we are taking additional cost actions reallocating resources and pursuing cost savings in other areas of the business to mitigate margin headwinds.

Through our Architectural Surfaces Group or ASG segment we are a leading nationwide distributor of natural and engineered stone and related products. During the third quarter, we grew sales in this segment by 5% year-over-year. Sales benefited from higher volume, a receptive pricing environment for quartz products and a positive contribution from greenfield locations. In October, the U.S. International Trade Commission announced preliminary countervailing tariffs on quartz countertops imported from Turkey and India, two countries where we source products. A ruling on anti-dumping tariffs for Turkey and India is still pending. In recent months, we have taken significant actions to rapidly expand our global quartz sourcing network. The meaningful ramp-up in additional global suppliers and the introduction of new products resulted in some initial inefficiencies. This resulted in higher costs for freight and labor as we made the conscious decision to maintain our share and provide a high level of service to customers. As we work to streamline our expanded supply chain we expect our operations and costs to normalize.

Overall we delivered meaningful growth including organic expansion in each quarter of 2019 through the execution of our product, channel and geographic diversification strategy. We are committed to generating improvements across all areas of our growing business, rationalizing our cost structure and accelerating the integration of prior acquisitions onto our platform. In both businesses we have taken aggressive cost actions including tightened SG&A controls and headcount reductions to improve margin performance. We will continue to focus on delivering best-in-class service to our customers while generating strong financial results.

Our acquisition strategy is aligned with that goal. We are disciplined in our pursuit of high quality add-ons and remain very active in seeking accretive complementary acquisition opportunities. We operate in a highly fragmented industry and will continue to execute our consolidation strategy and solidify our premier market positions, while generating attractive returns for our shareholders.

Once again, thank you for joining and with that I will turn the call over to Nadeem.

Nadeem Moiz -- Chief Financial Officer

Thank you, Ty and good morning everyone. Overall, in the third quarter, we grew our market share, grew adjusted EBITDA and cash flow. We ended the quarter with a strong balance sheet to continue executing our growth and M&A objectives. Now moving to Slide 5 with a review of net sales. Net sales increased $31.8 million or 25% to $159.4 million compared to the prior year. During the quarter we expanded share in new geographies, increased product offerings and continued ramping up greenfield sites. Acquisitions added $29.2 million or 22.9% to sales growth. Organic efforts added $2.7 million or 2.1% to the top line and growth in both segments.

Looking at our segments, in our RDS segment sales growth of 42% was driven primarily by acquisitions. Our efforts to rapidly diversify our RDS footprint over the past year added to modest organic growth. We experienced overall positive volume trends through new project wins and share gains in key markets. That said, Southern California market conditions remained challenging, partially offsetting volume growth in other markets and representing costs most of our consolidated price mix pressure for the quarter. We look forward to our expanded geographic diversity being increasingly represented in organic performance as we move into 2020.

In ASG sales growth was driven by favorable volume and price mix along with greenfields and a marginal contribution from acquisitions. Moving to Slide 6, in the third quarter reported EBITDA increased $14.3 million from $8.7 million in the prior-year quarter. Adjusted EBITDA rose 12.9% to $17 million compared to the prior-year quarter. Acquisitions were margin accretive and added $4.3 million to adjusted EBITDA. The $800,000 decline in organic volume and price mix primarily reflects the headwinds in Southern California. The volume decline in larger higher end homes that we typically serve in Southern California, were more than offset by higher volumes in other markets, that mainly cater to more entry-level market lease size homes. Increase in cost of $1.6 million in the quarter were primarily due to higher freight and labor costs in ASG supply chain. While we have not been meaningfully impacted by US tariffs and imports from China or other markets, we have expanded our sourcing network to lock in more suppliers to support our long-term growth and inventory optimization.

The global disruption in long-standing supplier relationships created near term logistical challenges as processes and systems are aligned. Corporate and public company infrastructure costs were slightly lower than prior-year quarter. For the quarter our GAAP net income was $2.5 million. This included other income of $2 million, primarily driven by change in fair value of future earn-out payments for completed acquisitions. This change is a result of mark-to-market adjustments of earnouts on our balance sheet which are performed each quarter by a third party for accounting purposes and recorded in other income on our P&L. Accordingly, changes in fair value may occur from period to period, which will be reflected in reported net income. GAAP net income also included, among other non-core items, a pre-tax expense of $958,000 related to our ongoing strategic alternatives review.

Moving to Slide 7, year-to-date cash flow from operations of $20.3 million increased significantly compared to $2.8 million in the prior-year period. We converted just under half of our adjusted EBITDA into cash flow from operations. We remain committed to improving our working capital efficiency to generate additional cash flow. We ended the quarter with a solid capital position consisting of total liquidity of $74 million and net debt of $180 million. Our net debt-to-LTM pro forma adjusted EBITDA ratio was 2.8 times, keeping us at a fairly conservative leverage profile with significant capital resources to allocate effectively.

Moving to Slide 8, with the dedication of our team, we're executing our strategy to deliver a meaningful sales growth while taking steps to generate stronger EBITDA and improved cash flow. We expect that collective benefit of completed acquisitions and share gains to contribute favorably to our fourth quarter. That said, market softness in Southern California and changes to supply chain dynamics will likely impact us for the balance of the year.

Looking ahead to 2020, we're optimistic about increased activity for our Company as housing trends and builder sentiment improve. We look forward to build on our progress as a leading installer and distributor of high-end interior products in coming years.

Operator, we would now like to open up for Q&A.

Questions and Answers:

Operator

Thank you. [Operator Instructions] And our first question will come from Alex Rygiel of B Riley FBR. Please go ahead.

Alex Rygiel -- B Riley FBR -- Analyst

Thank you. Good morning, gentlemen.

Tyrone Johnson -- Chief Executive Officer

Good morning, Alex.

Nadeem Moiz -- Chief Financial Officer

Good morning, Alex.

Alex Rygiel -- B Riley FBR -- Analyst

Tyrone, Nadeem could you quantify the weakness in California and discuss where we are relative to sort of the bottom and if we have inflected a higher yet or when you might see an inflection higher in your business?

Nadeem Moiz -- Chief Financial Officer

Yeah, absolutely. So look, if you look at RDS sales year-over-year in the quarter, the sales increase is predominantly related to acquisitions and we sort of called that out here. And when you think about the growth in RDS year-over-year in the quarter was fairly flat. And so that represents the softness in Southern California, offset by stronger markets in Northern California and cabinet expansion in Phoenix.

The Southern California exposure in RDS is roughly 25% or so in the quarter. And historically, if you go back couple of years ago, it was at a much higher rate than that. And so we're trying to point out the continued geographic diversification that we've been very actively pursuing.

Tyrone Johnson -- Chief Executive Officer

And what I would add to that, Alex, this is Ty, is that as we talk to our builder customers in that region and as we look at our order book, we think the softness may persist through the fourth quarter. As Nadeem mentioned and as I mentioned in our prepared remarks, we are encouraged with respect to 2020 in terms of some leading indicators, but over the short term we think Southern California will continue to present some headwinds for the business.

Alex Rygiel -- B Riley FBR -- Analyst

And turning to backlog within the RDS segment, could you characterize what our backlog is today in that segment relative to maybe 2Q and 1Q and has total Company backlog in RDS sort of reached that bottom and when might that influx higher?

Tyrone Johnson -- Chief Executive Officer

Yeah, so the way to think about backlog, Alex, is it's actually been pretty stable all year. So what's wrote off has been replenished. So there have been certain delays in certain projects but in the round the backlog level has remained stable.

Alex Rygiel -- B Riley FBR -- Analyst

And is [Indecipherable] still your largest customer in RDS segment?

Tyrone Johnson -- Chief Executive Officer

They are.

Alex Rygiel -- B Riley FBR -- Analyst

And turning to ASG, can you comment on pricing in the industry, particularly as it relates to quartz?

Tyrone Johnson -- Chief Executive Officer

Yes. So we've been able to continue to be aggressive with respect to price on quartz given our dedicated supply chain and our focus on medium to higher-priced products. There is more hand to hand combat at the lower end, much more competitive in terms of some of those products, but we've been able to be price takers in the marketplace and we expect that to continue.

Alex Rygiel -- B Riley FBR -- Analyst

And as it relates to the increased costs associated with the supply chain, can you quantify that and how should we think about that in the fourth quarter and sort of early next year? Do we recapture all of that incremental expense in this third quarter in some sort of period of time?

Nadeem Moiz -- Chief Financial Officer

Yeah, I can help you with that, Alex. If you go back to the EBITDA bridge that we have on Page 6, we call that out that negative 1.6, that's predominantly the supply chain impacts along with some increases we've seen on the facility lease expense we called that out on here. And we would expect some of that to continue into the fourth quarter as I highlighted in the script. And certainly it starts to get normalize as we look forward beyond the next few months. And we're obviously working very diligently and quickly to, A, service our customers in the most efficient manner and, B, to right size the supply chain and get that aligned with respect to the right product in the right location. So we don't expect the disruptions that we saw to continue on a long-term basis.

Alex Rygiel -- B Riley FBR -- Analyst

And lastly, one more question, as it relates to sort of your outlook for gross margins in the fourth quarter, should we think about -- how should we think about that relative to 3Q and the first half?

Nadeem Moiz -- Chief Financial Officer

Yes, the first half was -- it was sort of in that 28% range, Q1, Q2 in both businesses. I think Q3 is sort of sitting in that 26% inching toward about 27%. We are -- there are two things that we highlighted in fourth quarter, the continued softness in Southern California and the supply chain dynamics. So we would expect fourth quarter to be similar to third quarter.

Alex Rygiel -- B Riley FBR -- Analyst

Thank you. Thank you very much.

Operator

Our next question will come from Matt McCall of Seaport Global Securities. Please go ahead.

Matt McCall -- Seaport Global Securities -- Analyst

Thank you. Good morning, everybody.

Tyrone Johnson -- Chief Executive Officer

Hey, good morning Matt.

Nadeem Moiz -- Chief Financial Officer

Good morning, Matt.

Matt McCall -- Seaport Global Securities -- Analyst

So back to the ASG and the supply chain comments you made. The quantification was helpful. So you talked about freight and labor and some new -- or efforts to expand the sourcing network. Were the elevated costs surprising and what's really different about these new sources? Why did they cost more and I guess why is it not more of a permanent cost increase?

Nadeem Moiz -- Chief Financial Officer

Yeah, absolutely. Matt, I can help you with that. So most of the costs really came in sort of in the middle to latter part of third quarter and really what happens is as you're changing supply chain and you are sourcing from multitudes of countries and getting factories ramped up in other countries, you expect your suppliers to behave in a particular way and follow a certain level of releases. And what we experienced in third quarter, which is not unusual for global distributor supply chain in particular when you're changing sourcing is you've got suppliers sending you product and containers at on their schedule. And so what we experienced in the third quarter was definitely an aberration with respect to receiving excess containers and your experience cost like demurrage and some excess freight to move things around, a little bit of more warehouse space, some contract labor to kind of get the inventory process because really the ultimate goal here is to make sure that we're servicing our customers and we're delivering on our product and maintaining a level of service. And obviously it's very important to us with respect to market share and the pricing on a go-forward basis. So in doing so, we experienced a bit of aberration in third quarter. And again the disruption is sort of felt across the space and in the slab distribution space in particular Company sourcing out of India and Turkey and those kinds of places and Far East.

Matt McCall -- Seaport Global Securities -- Analyst

Okay, thank, Nadeem. That's helpful. The other question I had was, you talked about SoCal. I don't think this was asked earlier, but you mentioned some cost actions that you're taking, I think it was you Ty. Can you talk about maybe any expenses that are associated, the expected savings, what exactly you're doing in Southern California to kind of combat the market softness?

Tyrone Johnson -- Chief Executive Officer

Yeah, absolutely. Let me just kind of start and then I'll ask Nadeem to give you some of the particulars, Matt. So we've always maintained that we have a highly variable cost structure in this business and when and if necessary we right-size the organization. So we've done a number of things across the cost structure to make sure that we're aligning up the overall support with the level of revenue. And with that, I can turn it over to Nadeem to give you a little bit more color.

Nadeem Moiz -- Chief Financial Officer

Yeah, absolutely. So certainly our focus is very much on the operating expense side and including COGS but certainly the operating expense side, and we continue to make progress on that in RDS and including ASG and SIC corporate in all three areas. And in particular on the RDS side where we focus on, where we see softness in certain areas is things like project coordinators and transactional people. They really help support a lot of the project work that we're doing and as you know we have multitude of communities in Southern California that we're working on at any point in time. And there is an aspect of management coordination on the back end. And so we were very decisive in the third quarter, we started taking that out, that's going to continue in the fourth quarter. Along with you will obviously have some reduction in commission and sales commission as a result of drop in sales. So that's going to flow through that as well. And then we look at the business holistically and if you look at the gross margin change, it's about 200 basis points quarter-over-quarter. Yet the EBITDA margin changed about 100 basis points. So obviously we've taken SG&A reductions. You can see that's coming through here. And so, including other back-end support staff in ASG and SIC we've taken some decisive actions. So we expect that to continue into fourth quarter and as we continue to manage cost very, very, very tightly.

Matt McCall -- Seaport Global Securities -- Analyst

Okay, perfect. Thank you.

Operator

This concludes our question-and-answer session. I would like to turn the conference back over to CEO, Tyrone Johnson for any closing remarks. Please go ahead, sir.

Tyrone Johnson -- Chief Executive Officer

Thank you everyone for joining us today. We appreciate your support of Select Interior Concepts and look forward to updating you on our progress next quarter.

Operator

[Operator Closing Remarks]

Duration: 25 minutes

Call participants:

Nadeem Moiz -- Chief Financial Officer

Tyrone Johnson -- Chief Executive Officer

Alex Rygiel -- B Riley FBR -- Analyst

Matt McCall -- Seaport Global Securities -- Analyst

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