Thomas O’Brien - Chief Financial Officer Jon Painter - President and CEO.

Rudy Hokanson - Barrington Research Walter Liptak - Global Hunter.

Good day, ladies and gentlemen and welcome to the Q2 2014 Kadant Inc. Earnings Conference Call. My name is Mark and I will be your operator for today. At this time, all participants are in listen-only mode. Later, we will conduct a question-and-answer session. (Operator Instructions).

I would now like to turn the [conference] over to Thomas O’Brien, Chief Financial Officer. Please proceed, sir..

Thank you, Mark. Good morning everyone and welcome to Kadant's second quarter 2014 earnings call. With me on the call today is Jon Painter, our President and Chief Executive Officer. Before we begin, let me read our Safe Harbor statement.

Various remarks that we may make today about Kadant’s future expectations, plans and prospects are forward-looking statements, for purposes of the Safe Harbor provisions under the Private Securities Litigation Reform Act of 1995.

Our actual results may differ materially from these forward-looking statements as a result of various important factors, including those outlined at the beginning of our slide presentation and those discussed under the heading Risk Factors in our report on Form 10-Q for the fiscal quarter ended March 29, 2014.

Our Form 10-Q is on file with the SEC which is also available in the Investors section of our website at www.kadant.com under the heading SEC filings. In addition, any forward-looking statements we make during this webcast represents our views only as of today.

While we may elect to update forward-looking statements at some point in the future, we specifically disclaim any obligation to do so even if our estimates change and you should not rely on these forward-looking statements as representing our views on any date after today. During this webcast, we will refer to some non-GAAP financial measures.

These non-GAAP measures are not prepared in accordance with Generally Accepted Accounting Principles.

A reconciliation of the non-GAAP financial measures to the most directly comparable GAAP measures is contained in our second quarter earnings press release issued yesterday, which is available in the Investors section of our website at www.kadant.com under the heading Investor News.

With that, I will turn the call over to Jon Painter, who will give you an update on Kadant’s business and future prospects. Following Jon’s remarks, I will give an overview of our financial results for the quarter and we will then have a Q&A session.

Jon?.

Thank Tom. Hello everyone. It's my pleasure to brief you on our second quarter results as well as our outlook for the remainder of the year. We had a fantastic quarter with a record number of records including revenue, bookings, backlog, adjusted operating income, adjusted EBITDA and adjusted earnings per share.

I hope you would like the word record because you're going to hear it a lot today. I'll begin today's business review with the financial highlights of the quarter. We finished the second quarter setting a new record for revenues at 105 million which was up 28% compared to the second quarter of 2013 driven by both internal growth and acquisitions.

Gross margins in the second quarter was strong at 43%. Adjusted operating income was up 47% to a record 13 million representing 12% of revenue. Our operating leverage improved leading to an adjusted operating income margin of 12% even with a drop of gross margin.

Our adjusted EBITDA was a new record at $15 million or 15% of sales, up 39% compared to Q2 of last year. Our GAAP diluted earnings per share of $0.70 in the second quarter included $0.04 of expense related to acquire profit and inventory and backlog associated with businesses acquired in 2013.

The adjusted earnings per share was also $0.70 and this was also a new record. We also repurchased over 255,000 shares of common stock during the quarter for $9 million. And finally, our bookings increased 32% over Q2 of last year to a record a $115 million and we ended the quarter with a record backlog of $129 million.

Turning to our revenue performance in the second quarter, you can see that all of our product lines are up. The strong growth in revenue was led by our stock-prep and fluid-handling product lines which increased 27% and 19% respectively compared to the same period last year.

As we discussed on previous calls, we put a lot of effort into internal growth and I am pleased to report that these efforts combined with improved market conditions are paying off.

The biggest contributor to our revenue increase this quarter was internal growth in our existing businesses, which is up 15% and 7% for the quarter and year-to-date respectively. The other big contributor to our revenue growth was our acquisitions, which contributed $10 million to Q2 revenue.

When we acquired Carmanah in November of last year, we said we expected 2014 revenue of $35 million to $40 million. The management team at Carmanah has done an excellent job and we now expect that they will have revenue of over $40 million this year and even higher bookings.

Our bookings of $115 million in Q2 were up 32% compared to Q2 of last year with acquisitions contributing $14 million. As is the case with revenue, we had strong internal growth in our existing businesses. Excluding the impact from our acquisitions, our bookings were up 16% and 13% for the quarter and year-to-date respectively.

The strong internal growth was primarily due to our China stock-prep business, which was up significantly compared to the last few quarters where bookings were relatively sluggish. Our fluid-handling and doctor cleaning and filtration product lines have modest decreases in bookings due to lower capital bookings.

It was a solid bookings quarter for both capital and spare parts. Very strong capital bookings and our stock-prep product lines in China and North America contributed to 41% increase in global capital bookings in Q2. Overall, I’m very encouraged by the start we had in 2014 and the continued activity level we’re seeing in Q3.

The bookings and revenue trend chart on slide eight, shows our quarterly revenue which is the red line and our bookings, which are the blue bars. Q2 revenue was up 28% from Q2 of last year, boosted by strong internal growth and contributions from our recent acquisitions.

Sequential bookings were up slightly in Q2 setting a new record for the second consecutive quarter. The record bookings in Q2 were positively impacted by several large capital orders as well as contributions from our recent acquisitions. We've now had two consecutive quarters with book-to-bill ratios of 1.1 or better.

Our revenue for parts and consumables were a record $62 million in the second quarter of 2014 and made up 60% of our Q2 revenues. Acquisitions were a major contributor to these record results, contributing three quarters of the increase. Excluding acquisitions, our parts and consumables revenue was up 4%.

Revenue was up 4% sequentially and 19% over Q2 of last year with particularly strong performance in our fluid handling product line which is up 14% compared to the same period last year. We also had record parts to consumables bookings which were up 26% over Q2 of last year and 1% sequentially.

Excluding acquisitions our parts and consumables bookings were up 8% over Q2 of last year. I would like to take the next few minutes to provide a brief review of business activity in each of the major geographic regions of the world. Let me start with North America. North America had strong performance in both bookings and revenues.

Our revenue in North America was up 32% compared to the second quarter of 2013 to 53 million or down 1% sequentially from a very strong Q1 acquisitions were our major contributor to revenue growth in Q2. In addition our fluid handing product line led our internal growth up 15% compared to Q2 of last year.

Bookings in North America were 52 million up 43% compared with the same period last year but down 26% sequentially compared to our record selling Q1. You may recall that we booked an $11 million stock prep system for a customer in Mexico in Q1.

While we have seen a step down from the extremely strong activity level we had in Q1 the overall market conditions for both capital and spare parts in North America is still quite good we have seen a lot of activity from our Virgin pulp customers in the second quarter, including $5 million order for a chemical pulping system with similar potential projects in the works.

Turning to Europe, we had another solid quarter and we are seeing business activity continue to strengthen as the macro economy slowly improves. We have a higher percentage of non-paper industrial customers in Europe compared to the other regions and those customers are experiencing higher growth than pulp and paper customers.

Our Q2 revenue in Europe was $27 million, up 64% over Q2 of last year and 33% sequentially. Revenue from the sale of a large stock-prep system for a printing and writing producer in France contributed to the strong revenue growth. Q2 bookings of $22 million were up 18% compared to Q2 of last year, but were down 12% sequentially.

Like others, we are closely watching developments in Russia. However our backlog for Russia remains rather modest at $1.5 million. Next let's take a look at China.

After a relatively weak demand and production situation in 2013 across most paper grades, 2014 appears to be on a better trajectory with industrial production of 9% in the first six months of 2014.

In addition, the government recently announced an update to its planned mill closures totaling 3.7 million tons of capacity to be removed by the end of this year. We view this capacity contaminant favorably as these mills being closed are inefficient, polluting operations that in most places do not ease our equipment.

In this environment, paper producers seem increasingly optimistic about sustainable demand growth and are beginning to invest in new capacity. As you may recall, we've been talking about increased project activity for the last several quarters and we're announcing this activity is being converted into bookings.

Our Q2 revenues in China were $14 million, up 10% compared to Q2 of last year and more than doubled first quarter of this year. This increase in revenues was led by a stock-prep product lines which shifts several large stock-preps during the quarter.

Our Q2 bookings in China were one of the highest in our history at 29 million nearly doubled the prior year. The timing of capital orders benefited us in Q2 as we booked five large orders for stock-prep recycling systems with the combined value of 15 million.

In addition our wood processing business booked two orders for stranded systems totaling 4 million as I mentioned in our Q1 call. As I commented on previously, the capital business in China can be quite lumpy due to the timing of capital projects as well as market conditions.

That said while we don’t expect a repeat of the booking performance we had in Q2 we do expect we'll have the solid bookings performance in Q3 as we have already booked 4.5 million in capital orders so far this quarter. Turning to South America, our smallest region.

You can see the second quarter of 2014 was down significantly from the second quarter of 2013. With improvements in market conditions in China and Europe and continued softness in South America, I think it's fair to say South America is our weakest market.

Some of the weakness is due to temporary factors such as the distraction of the world cup and the uncertainty regarding the outcome of the presidential elections in Brazil to be held later this year. The primary factor however is the continued sluggishness of the global commodities market and constrained consumer spending in Brazil.

Despite these set backs we believe the medium and long-term outlook for Brazil is good driven by growing middle class and rising standard of living. Our revenue in South America was $6 million in Q2 down 22% compared to the same period last year and 12% sequentially.

Bookings in Q2 were relatively soft at $5 million compared to an exceptionally strong Q2 of last year. I’d like to close my remarks with a few comments on our guidance for Q3 and the remainder of the year.

As we noted in both our February and April earnings calls we expected strong bookings in the first half of the year and that those bookings would drive significant revenue and earnings increases in the second half of the year.

While with the first half of the year behind us the good news is we were able to secure the bookings we had forecast and in fact we feel pretty good about our booking prospects for the second half of the year. The bad news is some of the first half bookings we hope would make their way into the revenue this year will likely slip into 2015.

These project delays will also cause a shifted revenue from Q3 to Q4 resulting in a weaker Q3 followed by a very and Q4. The anticipated revenue that was delayed is from capital projects, some of which were in China where we do not use [percent] complete accounting. Consequently we do not recognize revenue in these projects until they are shipped.

In the third quarter we expect to generate $0.52 to $0.54 of GAAP diluted earnings per share and revenues of $94 million to $96 million. For the full year we’re lowering our GAAP diluted earnings per share guidance to $2.50 to $2.60 and revenues of $400 million to $410 million.

As a reminder, these results include $0.17 of purchase accounting charges related to the profit and acquired inventory and the backlog associated with the businesses we acquired last year and $0.03 of restructuring charges.

Finally, although we’re lowering our guidance for 2014, we’re still expecting 2014 will be by far the best year in our history with record bookings, revenue, adjusted EBITDA, and adjusted earnings per share. I’ll now pass the call over to Tom for additional details on our financial performance in Q2.

Tom?.

Increases of $0.38 from higher revenues; $0.12 from the combined effect of the operating results of the acquisitions and lower acquisition transaction expenses and $0.02 due to lower operating expenses. These increases were partially offset by decreases of $0.29 due to lower gross margin percentages and $0.04 from a higher effective tax rate.

Collectively included in all the categories I just mentioned was a favorable foreign exchange translation effect of $0.01 in the second quarter of 2014 compared to last year’s second quarter. Now let’s turn to our cash flows, working capital and debt leverage starting on slide 20.

Operating cash flows from continuing operations were $9 million in the second quarter of 2014, down from $11.1 million in the second quarter of 2013, partly due to the timing of customer deposits.

Free cash flow defined here as cash flows from continuing operations less CapEx was $8.1 million in the second quarter of 2014, down from last year's $9.7 million. We did several notable non-operating uses of cash during the second quarter of 2014, the most significant of which was $15.5 million for repayment of debt.

We also purchased $9.3 million of our common stock, paid a dividend of $1.7 million and expanded $900,000 in CapEx. The stock repurchases in the quarter represented slightly more than 255,000 shares at an average price of $36.58 per share.

Over the past 12 months, we have returned $19.8 million of capital to our shareholders, $13.9 million from share repurchases and $5.9 million from dividends. This represents approximately 78% of our net income during that period.

Our working capital performance was quite encouraging during the second quarter of 2014 with significant improvements in both days in inventory and days in receivables. Days in inventory were 92 in the second quarter of 2014 compared to 103 in the second quarter of 2013 and 110 in the first quarter of 2014.

Additionally, our days and receivables measure improved to 61 days in the second quarter of 2014, one of our best performances ever and compares to 70 days in the second quarter of 2013 and 68 days in the first quarter of 2014.

I should note here that our measure of 61 days in receivables for a multinational company such as Kadant with operations in many countries with different payment practices is quite an extraordinary performance.

Slightly offsetting these improvements in days and inventory and days in receivables was a decrease that is deterioration in our AP days measure both on a sequential basis and compared to last year.

Looking at the overall working capital position, our cash conversion days calculated by taking days in receivables plus days in inventory and subtracting days in accounts payable improved significantly to 109 at the end of the second quarter of 2014, down 23 days and eight days from the first quarter of 2014 and the second quarter of 2013 respectively.

Our net cash position decreased by $4.8 million in the second quarter of 2014 compared to the first quarter of 2014, largely due to the stock repurchase and dividend payments which I noted earlier.

Net cash that is cash less debt, at the end of the second quarter of 2014 was $9.5 million compared to $14.3 million in the first quarter of 2014 and $48.5 million in the second quarter of 2013.

Finally, as you can see on slide 24, our leverage ratio calculated is defined in our credit facility was 0.42 at the end of the second quarter of 2014, down from 0.66 in the first quarter of 2014, mainly due to the repayment of approximately $19 million of debt in Canada which was associated with the Carmanaha acquisition.

Under our credit facility, this ratio must be less than 3.5. That concludes our review of the financials. And I will now turn the call back to the operator for our Q&A session.

Operator?.

(Operator Instructions). Your first question comes from line of Rudy Hokanson from Barrington Research. Please proceed..

Good morning.

Could you maybe speak more about what you’re finding with Carmanah in terms of their penetration of markets and also up on discussion in the first quarter call, a little bit about the sales opportunities that you’re seeing in China?.

Sure. So, kind of as I said in my earlier remarks Carmanah has exceeded our expectations, really a terrific management team, and have terrific opportunities both in North America and abroad. The main benefit in North America is really these idle oriented strand board operations that are starting up which kind of kicks up spare parts business for us.

The other thing that do as they’ve got kind of good innovation with a disposable knives.

Traditionally, the stranding operations would have knives and they would grind them by hand kind of every eight hours and they have a dedicated grinding shop, which has a lot of manpower, time consuming but it also was a bit dangerous because these things have big heavy sharp knives.

So Carmanah has introduced these disposable light weight knives that are easier to change, but it's a nice, now that's a spares business to us and they've done nice, job particularly in North America increasing the number of customers to use that those disposable blades inside of the traditional blades are drive.

So that's been a nice source of spare parts grow for Carmanah. Internationally China I would think, I would say is the big story for them.

Internationally, you wonder where the trees are, and where there is wood, housing and things like that or other needs for panels its China and Russia, Russians obviously a little slower for all the reasons that we all know about.

But China is a nice opportunity and basically they've got those two orders that they got in China earlier this year, we'll probably be the capital orders for all of China in 2014. So you can do much better than that before that goes.

So those systems will kind of the delivered towards the end of this year early next year, and then we'll see where goes from there. As I can said in my early remarks that is a new product in that market. So those are customers that will have a little bit of year in work to introduce OSB as a alternative supplier..

Okay. And on general consumable soft in terms of you legacy business.

Could you talk about what you're seeing in terms of utilization in the paper industry on the equipment right now, it's their way of tracking with what's happening with your consumables relative to perhaps the activity level in the paper industry that might give us some kind of front line over the last couple of quarters?.

Sure I mean I would tell you Rudy one of the statistics and I think you can see that we had a superb quarter.

We have record after record but frankly one of the numbers that I am the most proud of is that we had an 8% internal bookings growth for parts and consumables and that really speaks well kind of hard work that our various subsidiaries are doing. The production and operating rates in North America and Europe are pretty stable and haven’t changed much.

I would say production rates in China are improving a little bit. I’ve talked earlier about how we are often partnering with our customers in China to help them operate more efficiently and that often entails using more of our parts coincidently. So I hope that kind of answers your question on that..

Okay, fine. Thank you very much..

Thank you..

Your next question comes from the line of Walter Liptak of Global Hunter. Please proceed sir..

Hey Walt.

Walt?.

Walter, please make sure that your phone is not mute..

Hi, good morning everyone. I wanted to ask about Carmanah sales.

If we could break out what the sales bookings were in the quarter?.

We do have that in our press release, no we don’t actually..

Yes we have the Carmanah sales in the press release so you can see in the wood processing segment there it’s 9.8 million of revenues in the second quarter..

Okay, okay.

Sorry about that, was bookings and backlog in there as well?.

That’s right below the paper making systems segment number there..

Okay, great..

But my point is right around [you]..

Okay, great. Wanted to ask about China and these, the nice bookings that you took-in in the quarter. Is that sustainable, do you think? And it sounded like you took in an order for $4 million.

I thought I heard you say post the end of the quarter, is that right?.

I would say the short answer Walt is $29 million that isn't, that's hardly the new normal. That's not really a sustainable everyday kind of thing. So that timing of capital orders absolutely benefited us Q2, not only we did, we have this $15 million of stock-prep systems, we had $4 million of those two stranding systems I talked about.

So, the short answer is the $29 million is a bit unusual. But as I kind of said in my remarks, in Q3, while we're not going to do $29 million, we're going to have a very respectable quarter, because we've already booked $4.5 million of capital.

So, I expect not to repeat the $29 million we did in Q2, but to still have a pretty decent and higher than average let's say booking quarter in Q3..

Okay, got it..

And Q4 is now looking terrible either. You never know the capital on China we hate predicting, as we hate predicting revenue. Because the orders are so big that if one flips out, suddenly you missed your number completely..

Right. So just to get a little bit more color on these, the stock-prep orders and the strander orders.

Were those all one customer or was it just coincidental that you took in multiple orders from different customers?.

I'll tell you actually how we -- the short answer is not all one customer. The way we defined in order as we might have three orders for one line on one paper machine we are convinced as we'll call that one order because that's basically for one stock-prep line.

But we also might have a customer who is ordering two lines or three lines and we'll call that three orders. That's kind of when I say there is five orders, that I mean for five lines. Five fiber processing lines for five paper machines..

Okay. So I guess…..

(Inaudible) more orders technically speaking separate CEO, but I think that's a short hand way to think about..

Okay, makes sense.

So as you look into the second half are there other projects out there like what percentage of your pipeline do these orders represent?.

Well it's there is still an active pipeline absolutely as I mentioned in Q3, we have already booked around 4.5 million. So that's a pretty good for half way through the quarter, that's not so bad. You can never tell when of these things fall, but we don't expect another quarter like Q2 for the rest of the year..

Okay. Got that.

So the project that pushed out that was just a push from the shipment from the third until the fourth is that right?.

There was, yes, there was. And let me start by saying, this happens all the time, projects get shift routinely because typically especially in China because it's not just they're building a building, they are putting a paper machine, there is a million different things going on.

It's not someone ordering equipment for an existing milling you just sent it and it goes. There is kind of a lot of moving parts with the Greenfield mill. So delays are not at all unusual particularly in China. Frankly we had some stuff shipping from three to four and four into 2015.

It’s just and a little bit we’re guessing on – we’ll go buy the facility and see how the building is coming along and kind of use a little bit of our own judgment as to when that customer will actually be able to take that.

And of course, the other thing I’d add is one of the issues in China is we don’t ship typically till they make the final payment and they really don’t make the final payment till they’re good and ready and they need equipment. I mean that’s just the way life works in China..

Okay.

How does the pricing look on these orders in China and what are you expecting for the gross margin when they do ship?.

We don’t give into gross margins by product line or by region but I think we’ve said in the past that our margins including our capital margins in China are quite respectable. It’s not like a lot of companies; they almost lose money in China. I would not say that’s the case with us.

We have, I would say the pricing is lower than the rest of the world but the costs are lower than the rest of the world and we have very respectable margins there..

Okay. Got it..

Both capital and [others]?.

Okay. And then Tom, this is just one for you; I guess kind of at high level and you addressed some of the gross margin. Was it a surprise at all to you where the gross margin came in for the quarter? I guess the way that I am looking at it is that the gross margin was lower than I expected but you offset that with lower SG&A cost, lower overhead..

Yes..

Was it gross margin what you expected and then….

I would say pretty much this kind of an inverse relationship between the level of revenues and the gross margin percentages, because typically when we have more revenues it’s going to carry -- it’s going to be a result of more projects, more stock-prep orders et cetera, which have a lower gross margin percentage, it’s good gross margin dollars, but lower percentages.

So that certainly was within our range. I think the other two factors which I mentioned was we saw a decrease in margins of about half a point, so 50 basis points due to the amortization of the step-up in inventory from Carmanaha. And as I just mentioned, it was almost a point or 94 basis points for the effective mix..

So basically add those, the 43 or 45ish which is about where we physically are..

Yes. So we said back in our earnings call in February that we thought margins would be 44% to 45% for the year and we're still tracking to that. There will be variability quarter-to-quarter. As I said generally, the higher the revenue, the lower the margin percent, because generally the higher the revenue means the more capital we have in that mix..

Okay, got it. Okay..

On a slightly different. Well, I'm actually kind of pleased that we have this 12% adjusted operating income margin with for us relatively on the lower end of the scale gross margins. So that actually makes me kind of feel good about the future..

Yes.

And I guess it's kind of where I was going with the question is on the overhead cost, the SG&A was lower and I’m wondering is that something that you reacted to or that’s just from ongoing cost control at that administrative level?.

Yes. I think we have good cost control, but I think if you look at the overall level which has slightly down sequentially the SG&A. So it was pretty close, I don’t know if we can go back to that slide, but if we could, you can see that the level of SG&A was pretty close sequentially in the second versus first down a little bit.

But the leverage we got was obviously with the higher revenues the percentage of SG&A to revenues went to 30% from whatever the previous quarter was the 34% or so. So had good as Jon mentioned we had good operating leverage which led to good operating margins in the quarter..

Yes, okay. All right, sounds good. Then just the last couple of things.

What are you expecting for tax rate in the back half?.

The tax rate for the year we are saying will be about 33% to 34%, and there could be variability again by quarter, but for the year we are still in that 33% to 34% range..

Okay. Okay.

The cash flow continues to be impressive and I guess we would continue to see share repurchase at the current level?.

The cash flows were I would say good they weren’t the record setting like many of the other records but I still think we will have a very good year for cash flows in 2014.

If you take our net income implied with the guidance it’s about 29 million, add D&A back to that of 11 we have some equity compensation in the range of 6 so you can easily get up to say $45 million $46 million and then say 8 million or so for CapEx so we will have free cash flow in the high 30s assuming the guidance and all those other factors that goes on to it.

So that will be a very strong free cash flow performance for us so that’s just a good second half in cash flows and that's certainly what we're hoping for..

Okay, and the primary use of cash at this point is that share repurchase?.

Yes. I mean we paid $15 million down in debt, we may continue to do that. And our share repurchases have been more opportunistic, we saw good opportunities in the second quarter and we took advantage of those to the effective $9 million or $9 million in the second quarter..

Alright, okay. Okay, sounds good. Thanks..

Okay, great. Thanks Walt..

(Operator Instructions). That appears to be no further questions. I would now like to turn the call over Jonathan Painter for closing remarks..

Thanks Mark. Let me conclude today's call with a way, I think several key takeaway points. First, we had an outstanding quarter with new records for revenue, adjusted EBITDA, adjusted earnings per share, bookings and backlog with solid contributions from our acquisitions as well as from our existing business.

Second, we're seeing improving market conditions in China and Europe. And finally although we're lowering our revenue and earnings per share guidance for 2014, the reason for this is timing of capital orders and decidedly not weakening market conditions. I look forward to updating you next quarter on our progress. Thanks for your attention. Bye, bye..

Thank you very much. This concludes today’s conference. Thank you for your participation. You may now disconnect and have a great day..