Mike McKenney – Senior Vice President and Chief Financial Officer Jon Painter – President and Chief Executive Officer.

Walter Liptak – Seaport Global.

Good day, ladies and gentlemen, and welcome to the Kadant Inc. Third Quarter 2017 Earnings Conference Call. At this time, all participants are in a listen-only mode. Later we will conduct a question-and-answer session, and instructions will be given at that time. [Operator Instructions] As a reminder this conference call is being recorded.

I would now like to turn the call over to Mr. Mike McKenney, Senior Vice President and Chief Financial Officer. Sir you may begin..

Thank you Andrew. Good morning, everyone, and welcome to Kadant’s third quarter 2017 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 annual report on Form 10-K for the fiscal year ended December 31, 2016 and subsequent filings with the Securities and Exchange Commission.

Our Form 10-K is on file with the SEC and is also available in the Investor section of our website at www.kadant.com, under the heading SEC Filings. In addition, any forward-looking statements we make during this webcast represent 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 today, which is available in the Investors section of our Web site 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'll give an overview of our financial results for the quarter, and we will then have a Q&A session.

Jon?.

Thanks, Mike. Happy Halloween everyone. And thanks for joining us on our third quarter call. If you’ve read the press release, I think, you agreed we have plenty treats to talk about today and tricks. I’d say you without question the third quarter was one of the best quarters in our history.

It was one of those quarters when everything that could go right went right and then some. Our results were driven primarily by a combination of excellent performance by our newly acquired Wood Processing business, as well as double digit internal growth and outstanding execution from our existing businesses.

Let me start with the financial highlights for the quarter. Q3 was a quarter of record for Kadant in fact, I think, we had a record number of records in the quarter. Bookings were a record up 43%, revenue was a record up 45%. Adjusted operating income was record up 91% or 16% of sales.

Adjusted EBITDA was a record $30 million, or 20% of revenue, which was also a record. GAAP diluted earnings per share was a record and up 43%. Our adjusted earnings per share, which excludes acquisition related costs, was also a record $1.49 up 84%.

As expected our gross margins at 42% was below our historical average due to the impact of purchase accounting and the high percentage of capital revenues during the quarter. Excluding purchase accounting expenses our gross margin was 45%.

Cash flow from operations of $7 million was also below or typical run rate due to the acquisition expenses we incurred during the quarter and the high level of capital shipments in the quarter. Mike will provide details on this during his remarks. Net debt at the end of the quarter was $187 million.

As you can see on Slide 6 acquisitions made a strong contribution to our revenues, bookings and adjusted earnings per share. In addition, the impact from the weaker dollar had a modest, favorable impact on our foreign currency translation.

While a big part of the story for the third quarter was the contributions from our Wood Processing acquisition, internal growth and excellent operating performance of our existing businesses played a big role as well. Our internal revenue growth excluding FX and acquisitions was up nearly 15%.

Internal growth in adjusted earnings per share was up 36%, while internal growth in bookings was up 19%. I'm also pleased to report our internal revenue growth for parts and consumables was up 13% while bookings were up 3%. On Slide 7 you can see a nice trended bookings over the last four quarters, culminating in bookings of $135 million.

Leading the strong bookings performance was our Fluid-Handling and stock product lines, which were up 39% and 37% respectively, compared to Q3 of last year. The recent acquisitions contributed $20 million to Q3 bookings. Q3 revenue was a record $153 million up 45%, compared to Q3 of 2016.

While our strong revenue up string was driven in large part by our acquisitions, most of our product lines were up double digits compared to Q3 of last year. A particular note was the revenue performance in Asia which was up 52% sequentially and 37%, compared to the third quarter of last year.

Parts and consumables revenue in the third quarter continued the momentum from the first half with revenue up 36% and bookings up 27%, compared to Q3 of 2016. Capital shipments were exceptionally strong in the third quarter and this reduced the portion of parts and consumables revenues to 55%.

Acquisitions were a major contributor to our parts and consumables growth in the third quarter, contributing $13 million and $14 million respectively to revenue and bookings During the third quarter, we completed the acquisition of the assets of Unaflex, a leading industrial supplier of expansion joints and flexible connectors used in industrial piping systems.

The Unaflex product line consists of high impact components that fill a critical need in piping systems used in process industries. Unaflex is well-positioned in the power generation, chemical and water treatment segments and serves a number of other industrial segments, as well. It is the leading supplier in the U.S. of rubber expansion joints.

Because of its strong market position, the critical nature of its product and the high percentage of spare parts revenue, the business is very profitable with normalized EBITDA margins between 15 and 20 – I'm sorry between 20% and 25%. The addition of this business expands our product portfolio and fits nicely with our Fluid-Handling product line.

Unaflex high impact products, history of stable earnings, large parts and consumables business and strong market position makes this an attractive business for us. We paid about $31 million for the business or approximately seven times EBITDA.

Since our closing in mid-August we're making excellent progress on the business integration and the management team is doing a great job working through all the challenges associated with being acquired by a public company. I’m pleased with the accomplishments the team has already made during their short time with us.

While we're talking about acquisitions I should note the integration of NII is proceeding nicely. And as we mentioned on our last earnings call, we forecasted an unusually strong quarter for NII do the timing of capital shipments. They succeeded even our heightened forecast which is a nice start for them.

That said, Q3 was unusually good and we do not expect them to perform at this level every quarter. Our recent acquisitions have significantly changed our customer base from our traditional pulp and paper end markets. The chart on Slide 10 shows the breakdown of our business by end markets for the third quarter alone.

As you can see nearly half of our revenue in Q3 was outside of the traditional pulp and paper market and the trouble grades of printing, writing and newsprint represented only 10% of our business.

The two largest end markets for us, packaging and wood processing, which represent over 60% of our revenue in Q3 had good growth prospects due to strong demand for housing and rapidly growing e-commerce related packaging. I think we're well-positioned as a company to enjoy some nice internal revenue growth in our end markets going forward.

Next I'd like to review our performance in the major geographic regions where we operate. Let me start with North America. The pulp and paper market in North America remains quite healthy. Prices are being sustained or increased across many grades and operating rates for U.S. container board machines are in the upper 90s while inventories remain low.

The packaging industry is starting to see a meaningful impact for e-commerce which now represents about 9% of retail sales and is growing at 10% to 15% per year. This is a driver of packaging growth as goods shipped to households consume three to eight times more cardboard per unit than good sold through our traditional brick-and-mortar stores big.

The continued strength in the U.S. housing market has led to strong growth in our Wood Processing product lines. As I noted in our last earnings call, housing starts remain at the highest level since 2007 and the increasing home ownership rate by millennials bodes well for demand for single-family housing.

Industry analysts are projecting housing starts to grow by 8% per year for the next three years, which supports our assumption of 3% growth in lumber demand in North America. As you can see in Slide 11, increases for the – revenue increase for the fourth consecutive quarter to a record $68 million, up 45%, compared to Q3 of last year.

Excluding the impact from our acquisitions and FX, revenue was up 8%, compared to the same period last year. Bookings in North America were $60 [ph] million, up 28%, compared to Q3 last year.

Increases in bookings for our Wood Processing, Fluid-Handling and Stock-Prep product line were partially offset by reductions in our Doctoring, Cleaning & Filtration product line.

Overall we believe the North American market will continue to be a major contributor to our business and we're well-positioned to capitalize on the positive economic trends and favorable market conditions. Slide 12 shows our revenue and bookings performance in Europe, which were both records.

After years of relatively weak market conditions, Europe has continued to show strength this year. In general our operations in Europe are seeing solid market conditions in the lumber, industrial and packaging segments.

Third quarter revenue was up 47% to a record $46 million from Q3 of last year and up 37% sequentially due largely to our acquisition of the NII business. We also saw strong performance in our stock-prep product line in Europe, which was up 12% over the third quarter last year. Excluding acquisitions and FX, revenue was up 17% in Europe.

Bookings in Europe were flat sequentially from the record 2Q performance and up 29% compared to the third quarter of last year. During the quarter we booked three large OEM orders for Fluid-Handling equipment for a combined value of nearly $2 million and had very strong machinery order activity for our pulp bales and related equipment.

The market in Asia, which is dominated by China, continues to be extremely strong for capital, as well as parts and consumables. The government continues to shutdown smaller inefficient mills and the large wells are running at good operating rates with high levels of profitability.

Our revenue in Asia was up 37% from last year due largely to shipments of large capital orders booked in the previous two quarters. While not a record revenue performance it's one of the highest in our history and was driven by our stock prep and doctoring, and cleaning and filtration product lines.

Acquisitions had minimal impact on revenue and bookings in Asia in Q3. The high level of capital bookings we had in the prior two quarters continued in the third quarter with bookings more than doubling from a week Q3 of 2016. All of our major product lines had double or triple digit growth in bookings in Q3.

During the quarter we booked a number of large capital projects in our stock-prep product line, including four large OCC systems with combined value of more than $8 million.

And in our doctoring, cleaning and filtration product line we booked in order for doctoring and showering products for our four tissue machines with a value of approximately $1 million.

Although we know the capital equipment market in China is at elevated levels, we continue to have an active pipeline of projects which looks promising for the remainder of 2017 and into 2018. Finally, a few comments on the rest of the world results. As you can tell from my remarks we're seeing very good market conditions in most regions of the world.

With the exception of South America and in particular Brazil, our revenues in the rest of the world saw a nice jump to $13 in Q3, up 52% compared to Q3 of 2016, due entirely to contributions from our Wood Processing acquisition. Excluding acquisitions and FX, revenue decreased 7%.

Likewise bookings were up sequentially year-over-year due largely to our Wood Processing acquisition. South America and in particular Brazil, continues to face economic headwinds.

I was in Brazil earlier this month visiting our operations outside São Paulo and although the current economic conditions are weak, there is a growing optimism by our local management team and in the market about a brighter outlook for 2018. Let me conclude my remarks with a few comments on our guidance for Q4 and the full year 2017.

We're very encouraged by the booking trends we've seen through the first three quarters of the year. Based on our better than expected Q2 results and the inclusion of our newest acquisition, we're raising our full year revenue and earnings per share guidance.

For 2017, we expect to achieve GAAP diluted earnings per share of $3.56 to $3.60 on revenues of $509 million to $512 million. We now expect our adjusted diluted earnings per share, which excludes the transaction expenses and purchase accounting adjustments associated with the recent acquisitions to be $437 to $441.

Our revenue and earnings per share guidance is the result of both strong performance of our existing business in North America, Europe and Asia, as well as the positive impact of the inclusion of our acquisitions.

For the fourth quarter of 2017 we expect to achieve GAAP diluted earnings per share of $0.81 and $0.91 on revenue of $143 million to $146 million. On an adjusted basis we expect diluted earnings per share of $1.2 to $1.6. I’ll now pass the call over to Mike for some additional details on our finance performance in Q3.

Mike?.

$0.53 due to higher revenue, $0.35 from the operating results of our acquisitions, excluding borrowing and acquisition related costs and $0.01 due to a lower effective tax rate.

These increases were partially offset by $0.12 due to higher operating expenses, $0.06 due to higher interest expense, $0.02 due to higher weighted average shares outstanding and $0.01 due to lower gross margin percentages.

Collectively, included in all the categories I just mentioned, was a favorable foreign currency translation effect of $0.04 in the third quarter of 2017, compared to last year's quarter due to the weakening of the U.S. dollar.

Given the magnitude of our EPS beat this quarter, I would take a moment to compare our adjusted diluted EPS results in the third quarter to the guidance we issued during our August 2017 earnings call. Our adjusted diluted EPS guidance for the third quarter of 2017 with a $1.12 to $1.16.

We reported adjusted diluted earnings per share of a $1.49 in third quarter of 2017, which was $0.33 over the high end of our guidance range. This was principally the result of higher revenues and better gross profit margins driven by stronger performances in our DCF and Fluid-Handling product lines in Europe and our stock-prep product line in China.

The higher revenue was a result of higher than expected capital shipments including some shipments that were expected to occur in the fourth quarter that ended up shipping in the third quarter. The higher than expected gross profit was a result of a better mix of capital shipments.

Some lower margin capital projects that were originally scheduled to ship in the third quarter were deferred in the fourth quarter and some higher margin shipments to be expected in the fourth quarter ended up shipping in the third quarter. Also contributing to better than expected performance was our recently acquired Wood Processing business.

As you may remember in our last call, we expected that NII would have a strong third quarter and they ended up doing significantly better than we had forecasted. To be honest part of this was because we are intentionally conservative in our forecasting because they are new to us.

Now let's turn to our cash flows and working capital metrics starting on Slide 20. Cash flow from operations was $7 million in the third quarter of 2017, down from $15.4 million in the third quarter of 2016.

The decrease was primarily due to a $15.7 million increase in accounts receivable driven by strong revenue growth in the quarter, especially from our stock-prep product line.

In addition, our operating cash flows were impacted by the payment of $6.6 million of acquisition related costs in the third quarter of 2017, including $2.7 million of costs, which were reimbursed by the seller after quarter end. We had several notable non-operating usage of cash in the third quarter of 2017.

We paid a total of $304 million for the acquisitions of NII and Unaflex, net of cash required, $5.3 million for capital expenditures and $3.3 million for our quarterly dividend. We also borrowed $20.5 million during the quarter, primarily to fund the recent acquisitions. Let's now look at our key working capital metrics on Slide 21.

Days in receivables decrease to 59 days from 62 days at the end of the second quarter of 2017. Inventory days were down 79 from 97 in second quarter of 2017, and our days in payable were 36 at the end of the quarter. The decrease in inventory days is due to our recent acquisitions.

If we adjust the calculation and include the opening balance sheet inventory related to the acquisitions, the adjusted inventory days for the third quarter is 93.

Looking at our overall working capital position, our cash conversion days measure calculated by taking days in receivables plus days in inventory and subtracting days and accounts payable was 102 at the end of third quarter of 2017, down from 113 days in the second quarter of 20167.

If we use the adjusted inventory days the cash conversion days would be 116. Working capital as a percentage of revenue increased to 18% in the third quarter of 2017, compared to 11.6% in the second quarter of 2017 and third quarter of 2016.

The sequential and year-over-year increase was due to our recent acquisitions which are only contributing a partial year of revenue, and the increase in working capital and also the increase in working capital driven by the accounts receivable increase related to strong shipments in the quarter.

Net debt that is debt less cash at the end of the third quarter of 2017 was $187.4 million, compared to net cash of $22.2 million in the second quarter of 2017. We borrowed approximately $179 in connection with our acquisition of NII, this was a mixture of Canadian, Euro and U.S. dollar denominated debt.

We bought approximately $31 million related to our acquisition of the assets of the Unaflex. Our interest expense increased to $1.3 million in the third quarter of 2017, compared to $0.3 million in the third quarter of 2016.

And we forecast our net interest expense for the fourth quarter to be approximately $1.6 million, with forecasted weighted average interest rates of approximately 2.2% for the fourth quarter.

As you can see on Slide 24, our leverage ratio calculated as defined in our credit facility increased as a result of our recent borrowings to 2.45 at the end of the third quarter of 2017. Under the credit facility this ratio must be less than 3.5. A few comments on increase in our revenue and adjusted diluted EPS guidance for 2017.

We increased our revenue guidance range to $509 million to $512 million, from our previous guidance range of $488 million to $494 million. Approximately $7 million of the increase is related to our acquisition of Unaflex, the remainder of the increase is due to the third quarter revenue beat.

Regarding our EPS guidance, we increased our adjusted diluted EPS guidance to $4.37 to $4.41 from our previous guidance of the $3.99 to $4.07. The $0.34 increase to the top end of our guidance range is almost entirely due to our third quarter beat.

We expect the acquisition of Unaflex – the Unaflex business to be essentially breakeven on a GAAP diluted EPS basis and modestly accretive on adjusted diluted EPS basis for 2017. A few comments on our fourth quarter guidance. Our fourth quarter adjusted diluted EPS guidance remains consistent with the guidance we gave in August.

There are few significant factors contributing to the sequential decrease in adjusted diluted EPS between the third quarter results and the fourth quarter forecast. One is as expected the newly acquired Wood Processing businesses fourth quarter is substantially below their spectacular third quarter results.

The second is the cadence existing business revenues also exceeded expectations in the quarter, in part due to capital shipments. And as a result there will be a sequential decrease in capital shipments when compared to the fourth quarter.

And finally, gross margins for capital revenue in the fourth quarter is forecast to be lower than the third quarter results.

We knew we had some lower margin job shipping in the second half of 2017 and we expect that the majority of these lower margin capital projects would ship in the third quarter as it turns out mostly these lower margin capital projects will now ship in the fourth quarter.

In regards to SG&A with the inclusion of Unaflex, we expect the SG&A spending for the full year of 2017 as a percentage of revenue will be approximately 31%. I would note that this includes the transaction costs and backlog amortization related to both NII and Unaflex. Excluding these items, SG&A spending would be approximately 30% of revenue.

Regarding our tax rate, we continue to expect our effective tax rate will be approximately 26% in 2017, compared to our 2016 tax rate that came in slightly over 27%. We now expect depreciation and amortization will be approximately $19 million in 2017, which includes approximately $3 million from the recently acquired NII and Unaflex businesses.

Excluding onetime items, the quarterly D&A run rate will be approximately $6 million. That concludes my view of the financials. And I will now turn the call back over to the operator for our question-and-answer session.

Operator?.

Thank you. [Operator Instructions] Our first question comes from Walter Liptak with Seaport Global. Your line is now open..

Hi good morning guys..

Hey Walt..

Hi Walt..

Hi congratulations on all the records.

I want to ask first for 2017 you’re looking forward to a record for the full year too?.

Yes..

I think if we restock them now we might record..

Alright. Well let me ask maybe first just about some of the amortization costs that are running through your SG&A.

For example, the back log amortization of $1 million does that run off after this quarter or next quarter or is that a an ongoing expense?.

That’s both in inventory well and the back log are run off in the short term. So the back log will re-anticipate will run off in the fourth quarter here..

Okay and yes. And I want to ask you about that inventory that’s in the gross margin too..

Yes..

How much was that in millions of dollars?.

It was about $3.4 million in the third and we’re looking at about $1.8 million in the fourth. And then we should be at the end of it. It might trickle into 2018 a little bit but we should….

[Indiscernible].

Yes not much left on that..

Okay. We had great EPS this quarter, but it sound like if you exclude those two things it would been even significantly higher. So it will be an easy comp this year..

So that’s what we’re doing to get you to the adjusted, right. So the GAAP numbers include those costs and the adjusted numbers we exclude those..

Okay. It’s alright..

Yes..

The purchase accounting amortization, the stuff that's transient, I would say, it's going to be over within a couple of quarters in our last quarter end before..

So if you are looking at the third quarter loss those were quite large, where two of those combined that process inventory, amortization to backlog amortization, those two combined were about $0.28..

Okay. Alright I thought the 42.3% was part of the adjusted – what’s the adjusted number so that it looks to me like it also included some inventories..

Yes, so the 42.3% is all in, so you have the inventory in there and that I noted in my comments that the impact was 220 basis points related to amortizing the acquired profit in inventory. So you can add that back to the 42.3%. And then we come up to about 44.5%..

Okay, then the 44.5% is what gets you to the $1.49 part of the number in the dollar?.

You can kind of think 42.3% as a GAAP type gross margin of 44.5% is more adjusted..

Okay..

I think the point is both of those, the acquired profit inventory and backlog, those get amortized very quickly and they'll be behind us here, going into 2018..

Okay, great. Thanks for that clarification. I wanted to ask you about the NII growth rate and the out performance.

Was there an out performance of the housing market? Was it a market share gain or was it just sort of an in-line based on what you saw from the marketplace?.

So this a couple of things, so overall the market particularly in North American is extremely strong.

But as Mike kind of alluded to there was an element of it that they came in and gave us kind of a blockbuster third quarter number that we, I would say, were a little concerned about just passing that on to the investment community and we were somewhat conservative in what we did with that.

Well front of the gun they did better than even they said that they would do. So that element is just to do really with the timing of capital orders, it's not a sort of steady state growth rate. When we talked about at the time we bought them we said that globally you can expect that their markets will grow like 2.5%, a little higher in North America.

We were just at a conference a couple weeks ago and it was very upbeat on North American housing but it still comes down to about maybe 3% growth in North America for lumber, which isn't about what we had..

Okay, great. Okay. And then just from a high level just looking at your organic growth on the paper and packaging side it looks like outsized organic growth compared to what this industry does long-term. What do you attribute the you call that e-commerce and a few other things.

I guess what do you attribute the strength and the organic revenue on the paper and packaging side?.

Sure, so part of it when no question is driven by the very strong growth in China right now. So globally that’s a big part of it but I kind of went through the other markets it's pretty strong everywhere. I will say that packaging for us which is by far the biggest part of our pulp and paper revenue is definitely getting a kick from this e-commerce.

I mean as you think about it, you go to Wal-Mart and buy a toaster, that box is shipped to Wal-Mart with 87 other toasters and you maybe used up a half a foot of cardboard, but you have a toaster shipped to your individual house and you use five feet of cardboard. So it's an order of magnitude difference as e-commerce grows as a percentage of retail.

So now we're talking about growth rates for the packaging in the developed world of Europe and North America, more in the 3% range, which is that's significantly better than what I've been talking about in the past..

Okay, alright, great. And I feel great about that. To me that's a permanent kind of structural tailwind if you will that we’ll enjoy for awhile. And I wonder if I can just ask the last one about cash flow.

We understand about the weaker cash flow in the third quarter, but I wondered if – is there a question with some of those receivables in the fourth, were you expecting from cash flow in the fourth quarter?.

Yes I would expect that we'll see a good portion of those receivables come in as cash in the fourth. As is sometimes the case for us our back end of our quarter had meaningful capital shipments. So hence we end up with those still in receivables. And as I noted it was a little over 15.9, 15.7 in receivable grow. But yes that'll come back to this cash..

Okay great. Alright, thank you..

Thanks Wal..

[Operator Instructions] One moment for questions. I'm showing no further questions – we do have a follow-up from Walter Liptak with Seaport Global. Your line is now open..

Hey Walt..

Okay guys I'm back. I like to ask a lot about Unaflex. In expansion joints, I think, for awhile you had an initiative to grow that part of your business organically.

I wonder if that is what led to this acquisition and what you see kind of with your core expansion joint business and how Unaflex will be around maybe find some synergies with them?.

So the real fit is with our rotary joint business. So they're both in a way joints. But what we loved about Unaflex is they're the leading provider of these rubber expansion joints. So they have a very strong market position that's kind of hard to grow into in these conservative process industries.

When you have a critical component – it's hard to increase your market share organically. When you're not, you're not the number one player. So it's definitely a case of it's better to buy the number one player than try to grow there organically.

So it's a nice little – it's a nice – it's a nice sort of little-to-medium size business that was a good fit for that..

Okay.

Are there synergies with rotary joint as their channel strategy?.

Yes, there are synergies with rotary joint for sure. It's kind of a natural extension of the product portfolio, it's really another kind of joint for cases where there's thermal expansion or vibration all that kind of stuff..

Okay. Alright great, thank you. I’ll take the reset of the questions offline..

Okay..

I'm showing no further questions. I would now like to turn the call back to Jonathan Painter for any further remarks..

Okay, thank you, Andrew. Before I let everyone go this morning, let me just summarize what I think of the key takeaways from the quarter. Number one, we had a fantastic quarter with record earnings per share, adjusted earnings per share $1.49. Number two, we had strong internal revenue and bookings growth of 15% and 19% respectively.

Number three, we completed the acquisitions of the NII and Unaflex businesses, and the integrations are going well. And finally, for the third time this year we're raising our full year revenue and earnings per share guidance and we expect a record year in 2017. I look forward to updating you next quarter. Thanks very much..

Ladies and gentleman thank you for participating in today's conference. This concludes the program. You may all disconnect. Everyone have a great day..