Michael McKenney - Executive Vice President and Chief Financial Officer.

Good day and thank you for standing by. Welcome to the Q1 2022 Kadant Inc. Earnings Conference Call. At this time, all participants are in a listen-only mode. After the speakers’ presentation there will be a question-and-answer session. [Operator Instructions] Please be advised that today's conference is being recorded.

I would now like to turn the conference over to your speaker today, Michael McKenney, Executive Vice President and Chief Financial Officer. Please go ahead..

Thank you, Kathryn. Good morning, everyone, and welcome to Kadant's second quarter 2022 earnings call. With me on the call today is Jeff Powell, 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 plans and expectations, financial and operating results and prospects are forward-looking statements for purposes of the Safe Harbor provisions under the Private Securities Litigation Reform Act of 1995.

These forward-looking statements are subject to known and unknown risks and uncertainties that may cause our actual results to 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 January 1, 2022 and subsequent filings with the Securities and Exchange Commission.

In addition, any forward-looking statements we make during this webcast represent our views and estimates 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 views or estimates change.

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, and the slides presented on the webcast and discussed in the conference call, which are available in the investor section of our website@www.kadant.com.

Finally, I wanted to note that when we refer to GAAP earnings per share, or EPS and adjusted EPS on this call, we are referring to each of these measures as calculated on a diluted basis. With that, I'll turn the call over to Jeff Powell, who will give you an update on Kadant’s business and future prospects.

Following Jeff’s remarks, I will give an overview of our financial results for the quarter, and we will then have a Q&A session.

Jeff?.

Thanks Mike. Hello, everyone. Thank you for joining us this morning to review our second quarter results and discuss our business outlook for the second half of 2022. I’ll begin by reviewing our operational highlights for the second quarter.

I'm pleased to report we had a solid quarter with strong demand and excellent execution across all our operating segments. This performance led to record adjusted EBITDA and strong earnings in the second quarter.

While our aftermarket demand was very healthy, capital project activity was exceptionally strong, leading to bookings that would have been a new record if not for the negative impact from foreign currency translation associated with the strengthening dollar. Mike will discuss the impact of FX in more detail in his comments.

Once again, I'd like to thank our operational teams around the globe for continuing to do a fantastic job in managing our businesses and ensuring that our products get to our customers when needed despite the supply chain disruptions. They've done a great job of meeting our customers' needs in a very challenging environment.

Turning now to Slide 6, I'd like to review our Q2 financial performance. Our top line performance was supported by excellent aftermarket demand and capital order shipments, leading to revenue increase of 13% compared to the same period last year. Aftermarket parts revenue was up 17% and represented 66% of our Q2 revenue.

Solid execution contributed to our adjusted EBITDA margin of 20.7% and adjusted EPS of $2.24, up 11% compared to Q2 of last year. We continue to benefit from strong demand in Q2, especially in North America and Europe.

Bookings were up 25% to $266 million, with a solid contribution from our Material Handling segment, which benefited from our recent acquisition and robust demand for our bulk material handling products. As you know, we typically manufacture and sell in the same currency.

This quarter, our bookings were significantly affected by currency translation and reduced our reported bookings by $10 million. Excluding acquisitions and the impact of FX, bookings were up 17% compared to the same period last year and reflect the ongoing demand from our customers.

Next, I'd like to discuss our three operating segments, beginning with our Flow Control. Our Flow Control segment had excellent bookings and revenue in the second quarter, up 36% and 20% respectively, compared to the same period last year. Our aftermarket parts revenue was a record and made up 73% of total revenue in the second quarter.

Improved operating leverage led to a record adjusted EBITDA and an adjusted EBITDA margin of 29.3%. Our Flow Control segment's record-setting bookings performance in the first half of the year is expected to moderate some in the second half. However, with our record backlog, we expect a strong second half of the year.

Moving to our Industrial Processing segment, we continue to experience healthy demand with bookings in this segment up 8% to $110 million. Excluding the negative impact of FX, bookings were up 12%. New orders for our wood processing and recycled fiber systems in North America led the increase in bookings in the second quarter.

Revenue in this segment increased 2% to $84 million and was affected by an unfavorable foreign currency translation. Excluding the impact of FX, revenue growth was 6% compared to the same period last year.

Our adjusted EBITDA margin declined 320 basis points to 21.8% due largely to lower gross margins on capital sales in the second quarter, as anticipated, and the prior period including government assistance programs for COVID relief.

Incremental price programs have offset inflationary costs and allowed us to maintain gross margin parity in our aftermarket parts business. We ended the quarter with another record backlog, and this positions us well for the remainder of the year. Like our Flow Control segment, we are expecting a slowdown in bookings in the back half of the year.

In our Material Handling segment, we had record demand for aftermarket parts and solid top and bottom line contribution from our recent acquisition. Revenue in the second quarter was up 23% to $52 million and aftermarket parts revenue made up 56% of total revenue.

Capital bookings in our Material Handling segment were up 93% compared to the same period last year due largely to contributions from our recent acquisition. Excluding acquisitions and the negative impact of FX, bookings were up 24%.

Solid execution by our business in this segment helped boost adjusted EBITDA by 42% and adjusted EBITDA margin by 300 basis points. Capital project activity remains at a good level, yet we expect a moderation in demand, particularly in our European baler business as the second half of the year unfolds.

As we look ahead to the second half of 2022, we continue to see good levels of project activity despite the ongoing macroeconomic challenges.

Though as I mentioned, we do expect industrial demand to moderate to a more balanced level compared to the record levels we've experienced in the recent quarters as consumer demand slows in response to actions taken by central banks to control inflation.

Our record backlog and ability to generate robust cash flow continue to have us well positioned to capitalize on opportunities that may emerge as the year unfolds, and we expect to deliver record financial performance again this year.

With that, I'll turn the call over to Mike for a review of our financial performance in Q2 and our guidance outlook for the remainder of the year.

Mike?.

Supply chain challenges, strengthening of the U.S. dollar, geopolitical tensions, inflation and China's Zero-COVID policy. The continued strengthening of the U.S. dollar during the second quarter had a significant impact on our forecasts.

The '22 guidance includes a negative foreign currency translation impact of approximately $45 million on revenue compared to 2021, which represents an incremental decrease of $31 million compared to our April forecast.

Our adjusted diluted EPS guidance includes a negative foreign currency translation effect of $0.49 compared to 2021, which represents an incremental decrease of $0.35 compared to our April forecast. With mix moving more towards capital in the back half of the year, we now anticipate gross margins for full year '22 will be 42.5% to 43%.

That implies gross margins in the third quarter and fourth quarter will be approximately 100 to 200 basis points lower than the first half of the year. As a result -- as a percentage of revenue, we now anticipate SG&A will be approximately 24.5% to 25%, down from our previous guidance of 25% to 25.5%.

And we continue to anticipate R&D expense will be approximately 1.5% of revenue. We expect our tax rate for the remaining quarters will be approximately 28%. And we now anticipate depreciation and amortization will be approximately $34 million to $35 million in '22.

That concludes my review of the financials, and I will now turn the call back over to the operator for our Q&A session..

[Operator Instructions] Our first question comes from Chris Howe with Barrington Research. Your line is open..

Good morning, Jeff, good morning Mike..

Good morning Chris..

Good morning. Thanks for taking my questions. First one here for Mike, as we look at the revenue guidance taking up the lower end of guidance in the $211 million to $218 million for the third quarter, I think at the midpoint, that would imply about $235 million in the fourth quarter for revenue.

Can you just talk about the revenue dynamics here in the second half? I think we were all expecting a little bit more revenue in the third quarter than the $211 million to $218 million, so more has pushed to the fourth quarter..

Well, Chris, one of the things I'd mention to you is what I said at the very end of my discussion here on the call. We -- from the April iteration to the July iteration, we lost $31 million in revenue due to translation and a significant part of that is in the third and fourth quarter. So we're taking a haircut just on translation.

And I think that's probably the piece you're missing..

Okay. That makes sense. And then if we look at parts and consumables, I think it was mentioned on the last call, or it's been known, but greater ability to pass through price here just given the shorter-cycle nature.

Can you refresh us on the difference between price -- parts and consumable margin versus capital equipment as it stands today? And how you see each portion, parts and consumables and capital equipment, versus the inflation headwind? I know you're essentially caught up on the parts and consumables side, but how is capital equipment faring today?.

Well, Chris, so as you know, we don't give out directly the two parts and consumables and capital. But what I often will tell folks is, if you look at our gross margin profile, so say the 43.3% in the first half of the year, if you do a bell curve around that, 15 points to both sides, that would capture essentially most of our transactions.

And capital will tend to fall to the lower side of that bell curve. So that's the kind of the picture I paint for folks on gross margin. And in regards to the discussion on where we are, parts and consumables and capital, yes you're right. As we mentioned, we've been able to adjust on parts and consumables. We can react more quickly to that.

Capital, we do have the risk of it sitting in our backlog for 3 months, 6 months, 9 months or even a year. What the units are doing is -- so I would say overall, capital is our biggest exposure on the gross margin. And what our folks are doing, they're trying to, where they can, negotiate surcharges for materials.

We're shortening the amount of time that quotes are valid. They're of course looking at projections on commodities and building that into their pricing when they're quoting things. So I think our -- really, our units have actually, I think on capital, have done an excellent job at trying to maintain our margin profile. So I think so far, so good..

Okay. And then actually led me to another question, as far as the mix of backlog on capital equipment, you're having some success in peeling away the portion of capital that's been sitting in backlog for a longer period.

Or kind of how do you stand on getting more towards newer pricing?.

Well, the components that are -- the orders that are in backlog currently, of course, that's -- other than the ones that have surcharges, those are the pricing is fixed. So it's really more the people looking forward at what commodities are going to cost, and building that in..

Okay thanks for taking my questions..

Thank you. Our next question comes from Kurt Yinger with D.A. Davidson. Your line is open..

Good morning Kurt..

Can you hear me okay? Good.

Yes, we can hear you..

Perfect. So based on your commentary, I mean, it sounds like you expect some softer booking activities in the second half.

But I guess, relative to the conversations you're having with your customers, is your sense that you're just kind of seeing some moderation from a very strong two years or has there been kind of a noticeable pullback in plans around capital -- I guess, capital activity based on the evolving macro we've seen over the last couple of months?.

Yes. So Kurt, I think as you pointed out, we've had the last two quarters, of course, but really for 4 quarters, we've had exceptionally strong bookings. And so what we typically see with our customers is, when you're on a really strong buying cycle like that, they have to install that equipment and get it up and optimized.

And so there tends to be a little cyclicality to these buying cycles associated with that. And we've just been on such an amazing run for the last few quarters. All said, our activity level discussions, things are still quite strong.

But I think we are factoring in that -- I mean, we can't lose sight of the fact that the Fed is on record saying they're going to slow things down. And so we tend to always try to be pretty conservative, and we believe them when they say they're going to try to slow down economic activity.

So we've kind of factored that into our planning and our forecasting. But generally speaking, if we talk to our divisions, things are still -- they're still quite active and quite busy.

But experience tells us that, when you're running at a $266 million level, and of course, it was effectively a $276 million quarter if not for the currency issue, that's a very, very strong kind of demand. And so history would tell us that there will be a little bit of moderation as they start to take delivery of that and install it..

Right, okay. And I mean, that comment kind of gets to my next question. And as you discussed, I mean, since the financial crisis, there's been kind of this rinse-and-repeat pattern of two years of elevated organic growth and then kind of a digestion phase.

But I guess as you look at the markets you serve, and you've done several acquisitions, and some of the different drivers there between e-commerce and packaging and just the underbuilt nature of the housing market, is there anything different, looking forward, that might help smooth some of that cyclicality notwithstanding the macro environment?.

Well, we've worked over the last -- if you look at kind of the growth and diversification over, say, the last 10 years or so, we've worked pretty hard to diversify geographically as well as markets we serve. And it certainly -- and it definitely has helped us some from where we were, say, 10 years ago.

So for instance, right now, our bulk material handling business, we mentioned, had record bookings. There's this infrastructure bill that hasn't -- they really aren't spending it yet, but our customers are getting geared up and prepared for that activity. So as -- so that helps.

Clearly, if there's a slowdown and possibly some slowdown in one sector, that you've got another sector that is seeing increased demand as they prepare to meet the new customer demands associated with that. So yes, I think we have -- and also geographically, it's a funny thing. Right now.

Our bookings in China actually -- and our activity level in China is quite strong. And so it's -- we do have, I think, good diversification geographically, which, unless we go into a kind of a global slowdown, serves us well, as well as some distinct markets we have.

So I mean, we're -- and the general underlying fundamentals of the migration to kind of sustainable materials, I think, is -- we're quite pleased that we're in the markets we're in. From a packages standpoint, from a wood processing standpoint, there's just an underlying trend globally that's going to serve us.

It doesn't mean there aren't going to be some cyclicality to it associated with economic activity, but the longer-term trends are quite supportive..

Got it. Okay, that's helpful. And then just my last question, I mean, at a high level and when you put it all together, it sounds like things are still pretty good from a demand perspective.

But are there any specific customer sets or geographies that you've grown kind of increasingly cautious on over the last couple of months?.

I think you can see it in the bookings of the different segments. They were all up. So I mean, we're experiencing good demand everywhere. The issue -- the concern you would have is if you would have some particular event.

The most obvious would be if you had a big COVID outbreak in China and they decided to shut down a region of China for a period of time that could impact us.

That's probably one of the bigger risks that we could envision, is that you get -- in the towns we're in, you get a big outbreak of COVID and the government adhering to their Zero-COVID policy, locks down the town for two weeks or four weeks, something like that, that would be a significant event to us.

But really, all of our businesses are experiencing kind of good demand really around the world right now..

Got it. Okay, well I appreciate all the color and I’ll turn it over, thank you..

Our next question comes from Walter Liptak with Seaport Global..

Hi, thanks, good morning guys..

Hey, Walter..

Good morning, Walter..

Hey, I wanted maybe do a follow-on to that last one, but maybe think more specifically about the industrial process, and maybe that's where there's the most risk to monetary policy changes.

So when you're talking about orders slowing in the back half, is there a reference to some of those wood products-related companies that build -- that produce lumber and other things, or OSB, for the housing market?.

Sure. So I think the -- certainly, the housing market, which was running 1.8 million starts or so for the first several months of this year, it's moderated now. It's kind of the last two months, it's been like 1.55 million 1.6 million, which is still a good healthy level.

Our customers will be quite busy, I think, and quite happy at 1.6 million start level. But they were really cooking at 1.8 million. And they've made a lot of investments to upgrade their facilities and to bring new facilities online.

And at some point, the organization's resources and focus starts to be, okay, we've got to get these facilities up and running, and running optimally. And so because of that, we think that there could be a little bit of a slowdown in the buying cycle.

Also, of course, as interest rates go up, mortgage rates go up and the Fed works to slow the economy down, housing typically feels that. But overall, the underlying demand for housing is still very strong. The demand gap, the demand versus starts, is still growing, is still broadening.

And so again, we like the underlying fundamentals, but we do think, for the next couple of quarters, that we might see some moderation there because of all of those variables..

Okay, great. I was thinking about the pricing and what you guys were talking about earlier. The industrial metals prices, some of them have started coming down. And I don't know if that flows through to you guys, if it's a second half benefit or if there could be a benefit from lower materials costs in 2023..

Well, certainly metals, in particular, stainless is one of our single biggest costs and we track that weekly and you're right, it has come down the last few months. I would point out, though, that it's exactly twice the price it was this time in 2020.

So 24 months ago in August, stainless steel 316 was about $1.50 and now it's a little -- it's like $3 and change. Well, it's still twice the price than it was 24 months ago. So I think it has quite a ways to continue coming down.

But it's definitely -- all the commodities are definitely starting to decline in price, and that is helpful for us and will help us going forward for sure..

Okay. That sounds great. And you talked about China, and it sounded to me like China is reopening after the COVID lockdowns. Is that correct? Because there's also mixed things in the news, too, that COVID is starting to spike again. There have been some other shutdowns.

What's been your experience?.

Yes. So China is continuing to adhere to the Zero-COVID policy. And the experts believe that they will stay with that at least until November, when they have their governmental conference, and President Xi is expected to be reappointed for a third term. So I think they're not going to take the chance of having any serious outbreak before that.

We're hoping that possibly they will change things a little bit after the conference at the end of the year. But right now, when they get an outbreak in a region, they lock that region down. Now we've been -- our subcontractors, our suppliers of raw materials have been impacted by that. But our plants to date haven't been severely impacted by that.

But any time they see an outbreak in a region, they tend to come in and lock that region down for two to four weeks, depending on the severity of the outbreak.

And it's always a worry of ours, that if Jining, which is where one of our facilities, or Wuxi, where another of or facilities are, if there was going to be an outbreak there, they could come in and lock it down for a few weeks and that would -- we'd feel that for sure..

Okay. All right, great. Yes, and maybe along those lines, Mike, when you were doing your end of your prepared remarks, you talked -- you put some disclaimers in there, timing of capital shipments can move around because of Zero-COVID, and supply chain or things like that.

Was that always in your guidance remarks or are you telling us that there could be some timing issues with some of the bigger shipments in the back half of the year?.

Both, Walt. No, that's always there. So that's a repeat of a standard caution, so it's not new..

I call that the McKenney Safe Harbor that he always puts in his comments..

All right, so I’m curious, it’s always good to be safe, thanks..

Our next question comes from Bobby Eubank with Chevy Chase Trust..

Good morning, guys. Following up on Kurt's question, particularly around U.S.

housing and the Industrial Processing segment, you are not going to give longer-term guidance, but maybe if you just think about the market and existing OSB equipment that's out there debarking, where do you feel like you are in kind of maybe a total addressable market, age of the fleet, things like that? Is equipment from the prior housing cycle, is that coming up on replacement? How do you just think about longer-term, how much structural demand in that segment? And I have a follow-up, thank you..

Yes. So there's several variables really that affect that market, Bobby. One is, of course as you pointed out, the age of the equipment. And our guys recently did some analysis work and said, "Hey, a lot of this equipment is getting quite old." So we think kind of -- there's clearly going to be a good replacement demand for the equipment.

In addition to that, you're seeing the wood used in more and more construction. And I've talked about this before, that -- and particularly in Europe as they try to meet their climate initiatives. They traditionally built homes out of block, out of concrete block. And that's one of the biggest greenhouse gas emitters of all industrial processes.

And so you're seeing more and more construction start to transition over to more wood-based materials. In North America, of course, we build them -- a predominant building material is lumber, is wood. But in Europe, that's not -- traditionally has not been the case. So we're seeing that change take place.

And then you have just the general demand being driven in part by in America by the millennials that are all entering the house buy. I have a 30 year old daughter who just closed on a house last Friday and a 33 year old daughter who built on a year ago. So -- and I know Mike's got three kids doing the same.

So many people are seeing their children, who most of them are in this -- many of them are in this millennial generation, are entering their prime house buying. And so that's really also driving demand up, too. And then of course you've got the fact that more and more people are working from home.

And they find that their home, their current home, doesn't exactly meet their needs now that they're working from home. And so there's a percentage of people that are changing their housing requirements to address their work from home -- new work from home process that we're seeing take over, really not only in the U.S., but really around the world.

So there are several things that are driving it. So if you look at the housing industry, of course, has great metrics, and there's a lot of consultants out there that follow it. And they talk about, for the next 10 years, the demand is going to continue, and we've been underbuilding really since the '08, '09 crash.

And so that demand gap just continues to grow and is being exasperated by the millennials entering their prime house-buying. So there's a lot of variables out there, age of equipment, kind of transition to the material use and then just increased demand based on demographics, that all, we think, are favorable to the industry..

Thanks and hopefully, your daughter was able to get a rate lock or something like that. You put in the presentation....

Her rate lock is her father. That was her rate lock..

There you go. You put in the presentation high energy prices and CO2 reduction targets in Europe are driving capital project activity in the region. I thought that was kind of an interesting comment, a little bit qualitative -- more qualitative than sometimes you put in the presentation.

Can you kind of double-click on that and expand on what exactly you're seeing and maybe durability there?.

Sure. So as you know, the world has seen a significant increase in the cost of energy in Europe in particular that's it's very acute because, of course, there -- many countries are very dependent on Russia. And with the current Russia-Ukraine conflict, those supplies are at risk.

And so between the cost and availability, what we're seeing in Europe is there is a much, much better payback to install more efficient processing equipment. And so we're benefiting from that.

Countries that are paying twice as much for energy and are actually concerned that they may not have as much energy as they need going forward are working hard to reduce their dependence on it. And that benefits us because most of our technology, one of the big kind of value propositions of our technology, is more output with less input.

So we reduce their electricity consumption or their steam consumption or natural gas consumption for the same output. And so that's -- projects are just easier to justify. There's a better payback for them because of the higher energy prices..

Thanks, good luck in the second half..

Thank you. Thank you, Bobby..

There are no other questions in the queue. I'd like to turn the call back to management for any closing remarks..

Thank you, Kathryn. Before wrapping up the call today, I just want to leave you with a few takeaways. Second quarter was, in many ways, a continuation of our first quarter, where we saw strong demand for our products and technologies and robust capital project activity.

While consumers, industry and governments are dealing with high inflation, our end markets remain well positioned to weather an economic slowdown, and our business fundamentals remain strong.

We'll continue to focus on solutions that drive sustainable industrial processing, and we look forward to delivering exceptional value to our stakeholders again in 2022. With that, I want to thank you for joining us today, and we look forward to updating you again next quarter..

This concludes today's conference call. Thank you for participating. You may now disconnect..