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CSW Industrials, Inc.  (NASDAQ:CSWI)
Q3 2019 Earnings Conference Call
Feb. 05, 2019, 10:00 a.m. ET

Contents:

  • Prepared Remarks
  • Questions and Answers
  • Call Participants

Prepared Remarks:

Operator

Greetings, and welcome to the CSW Industrials Third Quarter 2019 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, Tom Cook. Thank you, sir. You may begin.

Thomas Cook -- Investor Relations

Thank you, Christine. Good morning, everyone, and welcome to CSW Industrials' Fiscal Third Quarter 2019 Earnings Call. Joining me today are Joseph Armes, Chief Executive Officer of CSW Industrials; and Gregg Branning, Chief Financial Officer. If you have not received the earnings release, it is available on our website at www.cswindustrials.com. This call is being recorded. A replay of today's call will be available and details on how to access the replay are in the earnings release.

During this call, we will be making forward-looking statements. These statements are based on current expectations and assumptions that are subject to various risks and uncertainties. Actual results could materially differ because of factors discussed in today's earnings release and the comments made during this call and the Risk Factors section of our annual report on Form 10-K and other filings with the SEC. We do not undertake any duty to update any forward-looking statements.

This call will also include an analysis of adjusted operating income, net income and earnings per share, which are non-GAAP financial measures of performance. These non-GAAP measures should be used as a supplement to and not a substitute for operating income, net income and earnings per share computed in accordance with GAAP. For a more complete discussion include an analysis of adjusted operating income, net income and earnings per share, see our earnings release.

I would now like to turn the call over to our Chairman and Chief Executive Officer, Joe Armes. Joe?

Joseph B. Armes -- Chairman and Chief Executive Officer

Thank you, Tom. Good morning, and thank you for joining our fiscal third quarter conference call. We're going to begin today with a brief recap of our results for the quarter. Next, I will provide some segment highlights and a review of each of our end markets. Then I'll hand the call off to Gregg for a closer review of our financials.

I'm pleased to report that we had an exceptionally strong third quarter, highlighted by consolidated revenue growth of 12.3%, all of which was organic and a 44% increase in adjusted diluted earnings per share to $0.46, which was driven by higher revenue, effective cost controls and operating leverage. Higher revenue resulted from growth in both of our Industrial Products and Specialty Chemicals segment and was led by stronger sales in HVAC, architecturally specified building products and general industrial end markets. GAAP earnings per share increased to $0.39 per share compared to the prior year period of $0.17 per share.

In our Industrial Products segment, sales were up over 15% to $43.7 million, as we experienced continued strength and demand for our HVAC products and a strong contribution from architecturally specified building products. Segment level operating margins remained at a healthy 18.5%, although that was down 80 basis points compared to the prior year as a result of higher performance-related compensation expense on stronger results and spending on an ERP upgrade. We are very pleased by this result and looking forward, we expect to continue to grow at a pace in excess of our end markets as we bring new innovative products to the market and capture incremental share as demonstrated by our 6.6% organic revenue growth rate on a year-to-date basis.

As we've said in the past, we do experience volatility quarter-to-quarter as a result of customer order patterns and weather. The third quarter was no exception, as the pace of our growth benefited from an easier comparison as we lap some cold weather that occurred in fiscal third quarter of 2018. Therefore, we would expect to see some moderation in our growth rate over the next few quarters, as compared to the growth rate we experienced in the third quarter. We would expect our future growth trend to be more in line with our year-to-date growth rate.

Anecdotally, during the quarter, I had the opportunity to attend the AHR Expo in Atlanta, which is the largest global HVAC trade show. At the event, our team launched two new products, which generated substantial and immediate interest. These product launches included a surge protector for heating and cooling units, as well as triple guard, which is an innovative water leak monitoring system designed to protect the home from water damage.

Turning to our Specialty Chemicals segment. Sales grew almost 9% to $33.8 million, with growth stemming from general industrial end markets and higher volume in architecturally specified building products. Operating margins improved 100 basis points to 13.5%, as our restructuring activities and improved sales leverage bolstered our profitability.

Turning now to our end markets, and beginning with HVAC and plumbing, we continue to see robust demand for our products and we expect that we will outpace end market growth over the long term. New housing starts are moderating, which presents a modest headwind to us, although, we would remind stakeholders, that we are relatively insulated to the cyclicality, as our products are used in repair and replacement applications, as well as new construction.

In our architecturally specified building products to-date, we have not seen a slowdown in commercial construction and our bidding and backlog activity remains strong. Our products in this category are typically installed near the completion of a project, so we have good visibility through calendar 2019. Importantly, we are still a small player in this category and have strengthened our breadth of products and geographic reach through the acquisition of Greco combined with our legacy businesses of Smoke Guard and Balco. And as a result, we believe our ability to execute, as the more impactful factor, relative to the effects of macro trends in this end market.

Our Rail business, which primarily consist of track side applicators and lubricants and generally follows rail traffic was up mid-single digits during the third quarter, which was in line with overall track volume. As we have noted in the past, this is a GDP growth type business and based on macro forecast, we would anticipate modest growth throughout 2019.

Turning to energy. We experienced incremental growth during the quarter, despite relatively flat North American rig count, with increasing volatility and commodity prices, particularly in Canada. We will continue to monitor these dynamics and their effect on our ability to serve this end market.

Finally, in our general industrial end markets, demand was very strong in the third quarter, particularly for lubricants that extend the useful life of heavy machinery.

So to conclude, we are very pleased with our performance in the third quarter, our end markets remain largely healthy, we continue to capture incremental share across the business and we are seeing the tangible benefits from our cost reduction activities that we implemented last year. We continue to focus on our strategic capital deployment plan, which is designed to maximize shareholder value. This plan includes investing in organic growth initiatives, strategic bolt-on acquisitions and the return of cash to shareholders. To that end, during the quarter, we returned $9.9 million to shareholders through share repurchases, bringing the year-to-date total to $40.7 million. We will continue to direct capital to the opportunities providing the highest risk adjusted return and we look forward to providing additional updates on the execution of this strategy.

Now, I'll turn the call over to Gregg for a closer look at the numbers. Gregg?

Greggory W. Branning -- Executive Vice President and Chief Financial Officer

Thanks, Joe, and good morning, everyone. Consolidated revenue during the third quarter of 2019 increased 12.3% to $77.5 million. Higher revenue was driven by increased sales across both our segments, primarily in the HVAC, architecturally specified building products and general industrial end markets. Looking at our segment level revenue and operating income, Industrial Products segment revenue increased to $43.7 million, a 15.3% increase over the prior year.

This increase was driven by higher sales volumes in the HVAC, plumbing and general industrial end markets. GAAP segment operating income increased to $8.1 million, a 10.1% increase over the prior year. The increase in operating income was driven by higher sales, partially offset by increased performance-based compensation expenses and spending and upgrading our ERP systems. As a percentage of sales, third quarter GAAP operating margin decreased 80 basis points to 18.5% compared to the prior year period of 19.3% due to the spending on our ERP upgrade.

To Specialty Chemicals segment revenue increased to $33.8 million, an 8.7% increase over the prior year. Increased sales were driven by higher volumes in general industrial end markets and to a lesser extent architecturally specified building products. Our GAAP segment operating income increased to $4.6 million, a 17.9% increase over the prior year. The increase was due to savings from prior restructuring and realignment activities and leverage from increased sales, partially offset by performance-based compensation expenses.

As a percentage of sales, our third quarter GAAP operating margin increased 100 basis points to 13.5% compared to the prior year period of 12.5%.

Now turning back to our consolidated results. Our gross profit increased to $34.2 million compared to $30.2 million in the prior year period. Our gross margin increased 40 basis points to 44.2% compared to 43.8% in the prior year period, driven by the sales leverage. Consolidated operating expenses in the quarter were $24.8 million or 32% of sales, representing a 30 basis point decrease from the prior year level of $22.3 million or 32.3% of sales. The increase in operating expense was a result of increased performance-based compensation due to the stronger operating results. And in addition, we incurred approximately $400,000 in cost related to an ERP upgrade in our Industrial Product segment. The decrease in operating expense, as a percentage of sales was due to the increased sales.

Consolidated operating income for the third quarter increased 19% to $9.4 million or 12.2% of sales compared to $7.9 million or 11.5% of sales from the prior year. Our effective tax rate on continuing operations for the third quarter ended December 31, 2018 was 36.7%, which was higher than normal, due to a return to provision adjustment to our accruals related to the tax law enacted in fiscal 2018 following the filing of our 2018 tax return. We continue to expect our 2019 effective rate to be in the range of 25% to 27%.

Consolidated earnings from continuing operations increased to $6 million or $0.39 per share -- per diluted share compared to $2.6 million or $0.17 per diluted share in the prior year period. Adjusted to apply a normalized tax rate, adjusted net income from continuing operations in the fiscal third quarter of 2019 was $7 million or $0.46 per diluted share compared to adjusted income from continuing operations of $5.1 million or $0.32 per diluted share in the prior year period.

Finishing our total debt at quarter end was $11.6 million and we closed the quarter with $14.6 million of cash on our balance sheet. This yielded a net cash position of $3 million even with the $40.7 million, return to shareholders through share repurchases, driven by our strong generation of cash through the end of the third quarter of $58.3 million.

We had $250 million of borrowing capacity on our revolving credit facility, an additional $50 million an accordion as we generate ample cash in the quarter to pay our revolving credit facility balance down to zero. This provides ample flexibility to fund our growth and acquisition strategy.

Now, I'll turn the call back to Joe.

Joseph B. Armes -- Chairman and Chief Executive Officer

Thanks, Gregg. We only have two months left in our fiscal year, but we're very pleased with the strong execution across our operating units in the third quarter, we're also pleased with momentum in our business. I believe we're well positioned to conclude a successful fiscal 2019, we're poised for incremental progress and value creation in the year ahead.

Let me take this opportunity to thank all of my colleagues at CSW Industrials, who are doing such a fantastic job, as we continue to serve our customers and steward well the capital entrusted to us by our shareholders. Thank you for your interest in CSW Industrials.

Operator, we're now ready to take questions.

Questions and Answers:

Operator

Thank you. We will now be conducting a question-and-answer session. (Operator Instructions) Our first question comes from the line of Jon Tanwanteng with CJS Securities. Please proceed with your question.

Pete Lucas -- CJS Securities -- Analyst

Hi, good morning. It's Pete Lucas for Jon. You touched on it in your comments. I just want to make sure for why margins were down despite higher revenue and industrials, was that just the ERP upgrade, or was that, anything to do with mixed input costs or something else there?

Greggory W. Branning -- Executive Vice President and Chief Financial Officer

Yes, this is Gregg. It was primarily due to the ERP upgrade. We did have, as I mentioned, the higher compensation based -- our performance-based compensation expense. But if you were to take out just the ERP and ignore the compensation-based, performance-based compensation, we would have actually been up 20 basis points. And then further clarity on the ERP, we're in the midst of a four-year period to move all of our industrial businesses into one general platform and being -- this being the front end, the way the accounting rules work there are -- you have to expense some costs on the front end, the majority of this will roll through our normal CapEx. And so we don't expect it to be an ongoing expense, which is also why we didn't call it out as a onetime.

Pete Lucas -- CJS Securities -- Analyst

Helpful. Thanks. And any update on the price of metals for architectural products?

Greggory W. Branning -- Executive Vice President and Chief Financial Officer

Yes, this is Gregg again. I would say that we've seen that moderate it. But more importantly, where we did see the increases early in the year, we put price increases in place for tariffs and metals in general. And so, as you saw with our gross profit margin were up year-over-year. And so we've been able to cover the price of commodities in general.

Pete Lucas -- CJS Securities -- Analyst

And then last one from me, just as far as what the M&A environment looks like in terms of valuations you're seeing out there, number of deals, just general tone of the market?

Joseph B. Armes -- Chairman and Chief Executive Officer

Yes, the tone of the market remains pretty strong. However, we are seeing some very interesting opportunities on some product line extension, smaller acquisitions that would be strategically important to us, but not large in size. But I would say valuations are still high. We continue to have a disciplined approach, but we are seeing some interesting opportunities in small product line extension opportunities.

Pete Lucas -- CJS Securities -- Analyst

Very helpful, thanks. I'll jump back in queue.

Greggory W. Branning -- Executive Vice President and Chief Financial Officer

Thank you.

Joseph B. Armes -- Chairman and Chief Executive Officer

Thanks, Pete.

Operator

Our next question comes from the line of Joe Mondillo with Sidoti. Please proceed with your question.

Joseph Mondillo -- Sidoti & Company, LLC -- Analyst

Hi. Good morning, guys.

Joseph B. Armes -- Chairman and Chief Executive Officer

Hi, Joe.

Joseph Mondillo -- Sidoti & Company, LLC -- Analyst

So just a follow-up on the margin question at Industrial segment. Going forward, what kind of incremental margins do you sort of think about considering sort of the ERP costs and I'm not sure how sort of this incentive-based comp sort of plays out. But I think historically, you've talked about around maybe 30% incremental margins this quarter, we were I think below 20%. So how do you sort of -- how should we sort of think about that going forward?

Greggory W. Branning -- Executive Vice President and Chief Financial Officer

Yes, Joe. This is Gregg. I think, again, we still believe the fall through should be in the 30% based on normal mix this quarter from a year-to-year, fall through, certainly, the impact of the ERP drove that fall through as you mentioned below 20%, if it hadn't been for that, we would have been well above the 20%. And then the other thing is we -- if you recall, looking at proxies and information in the past, we have been underperforming on performance-based compensation. And so that's quite honestly bolstered some of the margins in the past. And then this year, we're doing better, and so you see an effect going both directions as a result of that. But more importantly again to your underlying question, the 30% is still a good number.

Joseph Mondillo -- Sidoti & Company, LLC -- Analyst

Okay. Is this $400,000 expense on ERP, that's an ongoing expense, right? And is that -- is this the first quarter that we've seen that? So in other words, if the next three quarters going to be sort of a headwind related to that, that would weigh on margins?

Greggory W. Branning -- Executive Vice President and Chief Financial Officer

No. Where -- my earlier comments is, the way the accounting rules work is without getting into the technical aspects, the beginning of a project does not get capitalized, if you will. There's a lot more technicalities than that, but -- so that gets expenses. And then going forward, the majority of the cost will end up in capital, which will be put us more at the top end of our capital range that we've talked about in the past. So we don't expect this to be any large ongoing headwind from an expense perspective, might be small moderation but nothing like we saw here in the first quarter.

Joseph Mondillo -- Sidoti & Company, LLC -- Analyst

Okay. And then just in terms of the performance-based comp, is this sort of an inflection to where the next couple of quarters maybe a little bit of a headwind? Or is that sort of reset after this quarter, so going forward like you said, incremental should be sort of back to normal?

Greggory W. Branning -- Executive Vice President and Chief Financial Officer

Yes, yes. I think that we'll see a minor headwind for both segments, but nothing like we saw this quarter.

Joseph Mondillo -- Sidoti & Company, LLC -- Analyst

Okay. At the HVAC part of the business. Could you talk about that piece of the business. I was -- and I'm a little surprised that it is so strong, specifically, given sort of the housing data. I mean, existing home sales continue to weaken, I would think that kind of performance in that market would affect your growth rates a little bit, but it doesn't seem like it has. So could you talk about why you think you're seeing such strong growth? And I know you mentioned that this quarter did see a good comp in terms of maybe weather, but could you just talk about sort of the overall trends that you're seeing there?

Joseph B. Armes -- Chairman and Chief Executive Officer

Yes, this is Joe. We did have an easier comp for the quarter due to weather last year, but we really think this is -- as I said in my prepared remarks, I mean, we've got repair and replacement. It is a large part of our business and it's not totally dependent upon housing starts. I would say that the installed base is really important for us. And as the installed base has grown dramatically over the last few years, then that's good for our business. We also have innovative products, the ductless mini-split is an innovation here in the US, has been popular in other parts of the world, but that's primarily a refurb or remodel product that people, if you add a room and your kind of central system is unable to be balanced properly or just isn't getting -- if you finish out an addict or something like that, it's just not getting the kind of airflow that it needs, the ductless mini-split it's a perfect solution to that problem. And so I think it's a number of those factors. And then again, the innovation of this -- in this end market is really a big driver, efficiency, safety, environmental concerns as all provide opportunities for innovation and we are creating kind of new product categories, as an industry, not just us, but as an industry, creating new product categories and new product lines that really it's an adoption issue. For instance, the new surge protectors that we introduced at the trade show, I mean theoretically every air conditioning unit, every furnace and every home and commercial building in America or in the world have one of those or at least, yes, each unit should have one. And as we know homes, oftentimes have multiple units. So that's going to be an innovation effort for us, an adoption effort for us in the industry. It's not that there is just 3% growth in an existing market and we're fight -- killing each other for share, there is a big greenfield opportunity there.

Joseph Mondillo -- Sidoti & Company, LLC -- Analyst

Okay, great. And then on the architectural building product side, could you just talk about the backlog of projects that you have there? And sort of how does the outlook for the next few quarters sort of compare to what you've seen over the last year or so?

Greggory W. Branning -- Executive Vice President and Chief Financial Officer

Yes. This is Gregg, again, Joe. Our backlog remains strong. We're up significantly from the end of last fiscal year. And so, we're well positioned. As you know, that is more of a backlog based business and so it really comes down to execution. And then to a certain extent weather and availability of labor by the trades, but we're in good shape. You may recall, last quarter, we mentioned a couple of nice projects that we won that will ship out or start -- we'll start recognizing revenue, if you will, in fiscal -- at the end of -- in Q4 of this year and then next fiscal year and so that bodes well for us.

Joseph Mondillo -- Sidoti & Company, LLC -- Analyst

Okay. And just overall, Industrial segment, could you talk a little bit about pricing, and how that's trended over the last few quarters? Looking forward, I know some commodity prices have come back a little bit, does that spread between pricing and cost. Is that a benefit or does that affect you at all? So just talk about like pricing versus volume that kind of thing?

Joseph B. Armes -- Chairman and Chief Executive Officer

Well, Joe, this is Joe. I'll start and Gregg can follow up. But I think we've been pretty aggressive on price increases to protect our margins and generally speaking in the tariffs, as the tariffs and some of the raw material costs have go -- have moved up, our competitors have been in a similar situation. So that's made it a situation where we could raise prices, we just need everybody to be disciplined in that regard. But we feel like we've stayed ahead of the curve on that effectively, and we're pleased with the operating teams and how they've done that. I think that -- as some of these raw material costs fall, we do not necessarily have to give all that back. And so that will be the next kind of level of work for us and will be diligent in trying to maintain these margins and it's important for us to do. Gregg?

Greggory W. Branning -- Executive Vice President and Chief Financial Officer

Yes. I would also add, Joe, this is Gregg, that when you look at -- to your question on the volume and price, certainly we saw volume too. It wasn't all price, otherwise, we would have seen our gross margin tick up a lot more than it was than it did. So we've seen the cost primarily in the form of tariffs as those have come through. But our price increases that we put through earlier this year and we -- in some cases, we put through more than one price increase to make sure we protect our margins as we committed to our investors at the end of last year is that it's our job to protect our margins. So we've been fairly strategic in looking at our price increases and trying to pay attention to what's happening within the general markets. The demand for our products, value selling our product et cetera. And so, as Joe said, I think as we're hopeful tariffs will go away at some point and then it's our opportunity and our job to try and mitigate any decrease in price at that point and capture more higher margins, but that will -- we'll cross that bridge when we come to it. But we've been very effective in pushing price in the face of increased cost through tariffs.

Joseph Mondillo -- Sidoti & Company, LLC -- Analyst

Okay. Would you say at least at the Industrial segment, a good portion of the growth over 50% is on price?

Joseph B. Armes -- Chairman and Chief Executive Officer

I wouldn't, no.

Joseph Mondillo -- Sidoti & Company, LLC -- Analyst

Okay.

Joseph B. Armes -- Chairman and Chief Executive Officer

Again the pricing is strategic. And so in some cases, we've been able to push more price through than others. And then the other thing I would say is, if you think back some prior conversations, I believe we've is that on the building product side, because it is a backlog based business that -- those projects are bid well in advance. And so their price doesn't really affect those projects until future bidding. And so that's the other reason I would say that it's not over 50% as price related.

Joseph Mondillo -- Sidoti & Company, LLC -- Analyst

Okay. I wanted to ask about the seasonality, at least on the margin side of the Specialty Chem segment. I just want to verify last fourth quarter in 2018, you saw a fairly weak quarter relative to the rest of the year, but I believe there were some issues there. And so I just wanted to make sure sort of how to think about that on a comp basis this year. Is that correct that fourth quarter last year was sort of an anomaly and after you did certain, I mean, you made some consolidated couple of plans in Europe and there has been changes since then. So how do I think about fourth quarter relative to the rest of the year sort of going forward?

Greggory W. Branning -- Executive Vice President and Chief Financial Officer

Yes, this is Gregg again, Joe. You're right, there were some anomalies. We have consolidated some facilities in Europe. We have finished -- effectively finished the small fill line. You may recall, we've talked about that. And so what we said, as we exited Q4 and had our call at the end of last fiscal year, we believe that was the low water mark, if you will, for our margins in that business and that we would trend this year up to a mid-teens margin, which we've been doing. Clearly where we do see seasonality is more in fiscal Q3 from a sequential standpoint, the margins in that segment were down from 16.7% in fiscal Q2 to the 13.5% in fiscal Q3 and volume makes a big difference there, just as it does in our Industrial Products segment, as we are seasonal with HVAC and plumbing products that go through both segments.

Joseph Mondillo -- Sidoti & Company, LLC -- Analyst

Okay, perfect. And then last question for me. I don't know if you mentioned this in your prepared remarks. But could you update us on sort of -- what you're thinking about CapEx for this year and if you have any comments for next year? And then also anything -- I know you've been working on sort of ways to increase your inventory returns and I'm just wondering sort of on working capital, what your thoughts are for that?

Greggory W. Branning -- Executive Vice President and Chief Financial Officer

Yes. CapEx, we continue to be in the 1.5% to 2% range of sales and we expect that to finish this year somewhere near that. As we go into fiscal 2020 and beyond with the ERP project, we'll probably be on the higher end of that range and maybe a tick over, we'll give more a better general range as we finish the fiscal year and we complete our budgeting cycle. But I would say as we go forward, we'll tick up a little bit because of the ERP project. And I forgot your second part of the question.

Joseph Mondillo -- Sidoti & Company, LLC -- Analyst

So just working capital, how you're thinking about like use of cash for that?

Greggory W. Branning -- Executive Vice President and Chief Financial Officer

Yes. So working capital continues to be a focus for us. We did see -- you'll see in the cash flows, a nice improvement in our receivables. Our receivables are down roughly, our DSO is down about five days from the end of last fiscal year, fiscal 2018. And so, we've made a concerted effort there. Our DPO has remained flat and our inventory returns have remained flat. Part of the reason the inventory returns have remain flat is twofold; one, you may recall in our comments at the end of fiscal Q2, that we did take on some additional inventory to try and protect ourselves from tariffs, some of that inventory is still on hand. And then as we build for our fiscal Q4 coming out of our low seasonality of Q3 that drives inventory up. But it remains a very high priority for all of us here at CSWI.

Joseph Mondillo -- Sidoti & Company, LLC -- Analyst

Okay, great. Thanks a lot. I appreciate it.

Greggory W. Branning -- Executive Vice President and Chief Financial Officer

Thank you, Joe.

Operator

Thank you. We have reached the end of the question-and-answer session. I would now like to turn the floor back over to management for closing comments.

Joseph B. Armes -- Chairman and Chief Executive Officer

Great. We just want to say thank you to everyone for joining us. Appreciate your support, your interest in CSWI and we look forward to speaking to you at the end of our fiscal 2019 year-end. So thank you.

Operator

Ladies and gentlemen, this does conclude today's teleconference. You may disconnect your lines at this time. Thank you for your participation, and have a wonderful day.

Duration: 32 minutes

Call participants:

Thomas Cook -- Investor Relations

Joseph B. Armes -- Chairman and Chief Executive Officer

Greggory W. Branning -- Executive Vice President and Chief Financial Officer

Pete Lucas -- CJS Securities -- Analyst

Joseph Mondillo -- Sidoti & Company, LLC -- Analyst

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