Good day, ladies and gentlemen and welcome to the Quanex Building Products Corporation Second Quarter 2018 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 follow at that time.

[Operator Instructions] And as a reminder, this conference call is being recorded. I would now like to turn the conference over to Scott Zuehlke, Vice President, Investor Relations and Treasurer. Please begin..

Thanks for joining the call this morning. On the call with me today is Bill Griffiths, our Chairman, President and Chief Executive Officer; Brent Korb, our Chief Financial Officer; and George Wilson, our Chief Operating Officer. This conference call will contain forward-looking statements and some discussion of non-GAAP measures.

Forward-looking statements and guidance discussed on this call and in our earnings release are based on current expectations. Actual results or events may differ materially from such statements and guidance and Quanex undertakes no obligation to update or revise any forward-looking statements to reflect new information of events.

For a more detailed description of our forward-looking statement disclaimer and a reconciliation of non-GAAP measures to the most directly comparable GAAP measures, please see our earnings release issued yesterday and posted to our website. I will now turn the call over to Bill for his prepared remarks..

Thanks, Philip and good morning everyone. Like everyone else in the industry, the second quarter was characterized by continuation of inflationary cost pressures. While we did not see any further cost increases in Q2, we did see the full impact of those imposed at the beginning of our fiscal year.

By mid-quarter, we were in a position to predict with some level of comfort, the full year inflationary impact on each of our product lines and prepare an appropriate pricing strategy. Based on our level of visibility, we implemented selective price increases on most of our product lines with effective dates of May 1, June 1 and July 1.

After extensive engagement with our customers, most of the price increases have been accepted. Although due to timing, there was minimal benefit in the second quarter. We do expect to fully recognize the favorable impact of price increases in the second half of our fiscal year.

Margin contraction did narrow during the quarter, primarily due to raw material pass-through provisions that went into effect after the contractual time lag. This was particularly evident in our North American cabinet components segment.

We believe the price increases will allow us to fully recover inflationary costs in the third quarter with the expectation that aggregated segment margins will be similar to last year. In addition, we expect to return to margin expansion on a aggregated basis in the fourth quarter of this year.

We also saw continued strength in our North American engineered components segment which after excluding eliminated products achieved sales growth of 8.7% for the second quarter and 6.6% for the first half of 2018. Underlying sales growth was mostly volume driven, but also included some price increases and raw material index recovery and surcharges.

Similarly in Europe, excluding eliminated products and foreign exchange impact, underlying sales growth was 8.7% for the second quarter and 7% for the first half. This growth was driven by market share gains and price increases.

Excluding eliminated products, our North American cabinet components segment sloped, with an underlying sales growth rate of negative 1.7% for the quarter and negative 1.2% for the first half.

Our negative growth rate was primarily driven by the continued shift in product mix towards the lower priced cabinets, particularly in light of major increases in hardwood prices with many of the most popular species, up over 20% just this year.

We continue to adjust our production capacities in line with these trends as we re-layout factory floors in some of our cabinet component plants. As this work progresses, we are seeing productivity gains every month.

These productivity gains in doors produced per labor hour together with the recently implemented price increases are expected to yield improved margins on a year-over-year basis in the second half of this year.

We continue to drive solid cash flow and as we enter our seasonably stronger second half, we are on track to end the year with a further improved balance sheet and our leverage ratio of less than 2x, but more on that shortly. I will now let Brent discuss our financial results..

acquisition-related transaction costs, purchase price inventory step-up recognition, restructuring charges related to the previously announced closure of several manufacturing plants, accelerated depreciation and amortization for equipment and intangible assets related to these facility consolidation as well as an accelerated depreciation for plant re-layouts in the North American cabinet components segment and foreign currency impacts primarily related to an intercompany note with HL Plastics in our European engineered components segment.

On an adjusted basis, EBITDA increased to $21.7 million in the second quarter of 2018 compared to $20.5 million in the second quarter last year. The increase in earnings was largely attributable to lower stock-based compensation expense and a lower effective tax rate as a result of the enactment of the Tax Cuts and Jobs Act.

The lower stock-based compensation expense was mostly the result of taking the long-term incentive accrual for relative total shareholder return down to zero for the expected 2018 vesting coupled with a lower stock price.

Unlike the first half of the year, we do not expect any benefit to stock-based compensation expense in the second half of the year and continue to estimate approximately $105 million in SG&A for the full year.

Cash provided by operating activities was $21.6 million for the 3 months ended April 30, 2018 compared to $16.7 million for the same period of 2017. We generated free cash flow of $6 million during the second quarter of 2018 versus $4.2 million during the second quarter of 2017.

Year-to-date, our free cash flow improved by approximately $7.2 million versus 2017. We were able to repay $8.25 million of bank debt during the second quarter due to solid free cash flow generation and the repatriation of roughly $2.5 million of foreign cash.

As a reminder, due to the typical seasonality of our business, we generate most of our free cash flow during the second half of the year. As a result of our solid free cash flow generation and bank debt pay-down, our leverage ratio as of April 30, 2018 improved to 2.2x. We remain focused on generating cash in further de-leveraging the balance sheet.

We continue to expect to end fiscal 2018 with the leverage ratio of below 2x. I will now turn the call back over to Bill for some closing comments..

Thanks, Brent. As you have just heard, we expect to exit fiscal 2018 the leverage ratio comfortably below 2x which makes the question what are our capital allocation priorities in 2019 and beyond. Before looking at the future though, I thought it will be worthwhile taking a look back at our journey over the past few years.

In 2013, our revenues were $953 million, only 50% of which were driven by the sale of components to OEMs. Our adjusted EBITDA was $44 million, with a margin of 4.6% and free cash flow of $5.6 million.

At the end of 2013, we embarked upon a strategy of transforming Quanex into a pure-play supplier of components to OEMs in the building products industry. This strategy included portfolio rationalization, acquisitions, divestitures and extensive operational improvements, all of which resulted in margin expansion and increased cash flow.

Now, let’s take a look at where we stand today and how much better positioned we are. At the midpoint of our 2018 guidance which we just reaffirmed, our full year revenue would be approximately $895 million, almost all of which is done from selling components to the OEMs.

Our adjusted EBITDA will be just over $105 million, which equates to a margin of approximately 11.8% and we have guided to free cash flow of $50 million to $55 million. These are significant improvements through a 5-year transformation of the business.

As we move forward through the second half of 2018 and into 2019, we consider ourselves well-positioned to further enhance margins, improve free cash flow and grow shareholder value. Clearly though as we have evolved over the past 5 years, some expectations have changed, most notably, our overall rate of growth.

We have concluded that the opportunity to grow through bolt-on acquisitions is much more limited than we thought several years ago. As such this is not likely to be a meaningful part of our strategy going forward. It is also clear that organic growth expectations across our industry are now lower than our original expectations 5 years ago.

The silver lining is that the cycle is likely to last longer than originally expected albeit at a slower growth rate.

We are confident in our financial position and our ability to further improve on it over the next several years particularly as it relates to cash flow generation, which gives us the flexibility to evaluate our options with respect to returning cash to shareholders while at the same time maintaining a healthy balance sheet in the unlikely event that the cycle winds down faster than expected.

And with that operator, we will now take questions..

Thank you. [Operator Instructions] And the first question will come from Jay McCanless of Wedbush. Your line is open..

Hi, good morning everyone. Thanks for taking my questions.

Just the first one I had in terms of the price increases across the various segments, can you talk about how far along you are with that? Is there going to be anymore price increases, especially given what you said about hardwood prices moving up and potentially affecting the cabinet part of the business?.

So most of the increases have been implemented and accepted. There are a few increases that are still being negotiated as we speak, but it’s essentially done and we are confident that what’s being implemented and accepted thus far will deliver the results that we really just reaffirmed here in the earnings release and the prepared remarks.

We have not seen further increases since the beginning of the year outside of the raw materials that are covered with escalators anyway.

Should there be unexpected increases as we enter the second half we will deal with that accordingly, but the takeaway is we were very thoughtful after we saw the inflationary impact being implemented for the most part, accepted for the most part and we should be in good shape for the second half of the year.

The only issue will be if things like hardwood or resin continue to escalate at a rapid rate, there is still a time lag associated with a number of those contracts..

Okay, thank you for that. And then the second question I had it’s – and I don’t want to be and I don’t want to put words in your mouth, but with the cabinet business, it sounds like you guys are not only worried about volume, I mean, about price, but potentially the loss of volume as people start to move towards those lower priced cabinets.

Is there anything you guys can do to offset that or maybe to change up your product mix to be more relevant with what customers are buying now?.

Yes. We clearly as we have really got our arms around this business now the first order on our list of priorities was to get the margins back to where we needed them to be.

We are clearly looking at what the trend lines are and adjusting the product portfolio accordingly is clearly a trend towards more engineered products and it’s no surprise that the bulk of our operational excellence work is going into our engineered components facilities. So, we are actively working on that..

Okay, great. Thank you for taking my questions..

Thank you. The next question is from Daniel Moore of CJS Securities. Your line is now open..

Good morning..

Good morning, Dan..

Bill and Brent, thanks for the color particularly around how things have evolved over the last few years, I thought it was very helpful in context and you gave color on SG&A, just remind us what the sort of normalized corporate G&A run-rate looks like either on a quarterly or annual basis?.

On an overall corporate, I mean, $305 million is what we are projecting for the year, but you are saying on an annual run-rate just on the corporate office, the unallocated corporate..

That’s right..

So we have been effectively zero on the unallocated pieces for the first half of the year. I would expect that to be closer to $2.5 million, $3 million on a quarterly basis going forward..

Perfect.

And then given that and given that as you have mentioned Bill, M&A opportunities perhaps not being as plentiful as you had looked, have you had any additional or more conversations from a partnership perspective looking at different ways to maybe leverage that corporate line over a larger revenue base over time?.

We have had some discussions. It’s not necessarily easy. I think I would reiterate the default position, they still – we are a nicely profitable just under $1 billion revenue business in great financial shape, strong cash flow generation.

And clearly as we get through this year, we will be at an inflection point where returning cash to shareholders is a real option in front of us.

And I think we can do that meaningfully and at the same time maintain a balance sheet that if in fact as some economists are predicting perhaps 2 or 3 years out, there could be a soft recession or at least a slowdown in the event that happens we will have a balance sheet to enable us to get through that with ease given the strength of our cash flow..

Very helpful. And one more shifting gears you reiterated guidance $35 million CapEx still around the right number and how should we think about that as we look out to fiscal ‘19 just in terms of the cadence of free cash? Thanks again..

That is about the right number. It could possibly be a little lower than that as we get into ‘19. As we have said we have been reinvesting in the business and expect that to start tapering off as we go through ‘19 through 2021..

Perfect. Thank you, again..

Thank you. The next question is from Ken Zener of KeyBanc. Your line is open..

Good morning, gentlemen..

Good morning Ken..

For 3Q margins, if you could just restate what you said I think in total you said it will be flat, I know there has been restatements, could you be explicit in terms of that EBIT margin that you are looking for and then restate what you talked about cabinet margins in the second half or I wasn’t sure if that was a third or fourth quarter comment? Thank you..

So, the divisional EBITDA margin, so excluding any corporate, the expectation is that on an aggregated basis, so all of the segments added together, the third quarter margin would be similar to what it was last year as a result the full impact of the prices across the board that we have just implemented..

That’s about 8.5%, is that the right number, Brent?.

It’s in that order of magnitude, Ken..

Okay. And then you made good job there, Bill, on the cabinet..

Yes, okay. As it pertains to cabinets specifically, the expectation is that in the second half of the year in the cabinet components segment we will see year-over-year margin expansion..

In total for the second half, does that mean 3Q or is it more 4Q geared?.

It’s certainly be greater in 4Q. We should see expansion however in 3Q as well..

Very good.

And then I guess I have got two more questions, but I will combine them just to pretend like it’s the one?.

Ken, just real quick I want to make sure there is clarification. You asked about that sort of 8.5%, that’s EBIT, not EBITDA..

Right, correct, correct. I do appreciate that. Well, I will just break these two questions up then. So, George, could you update us on kind of the warm edge spacer adoptions, because that’s been such a growth area and I know that’s obviously where you were involved in the past.

Can you talk about how that adoption rates working in terms of existing clients as well as what the outlook might be based on third-party equipment that supports your share gains?.

Sure. As it relates to the high-speed automation, growth continues to exist. I would say the only thing that I will put as the caveat is that growth rate is limited by the ability of the equipment makers to produce those machines.

So lead times on all equipment have extensively grown, so you will see lead time from all equipment makers now pushing up to 9 to 12 months, so that’s changed since it originally started, but the growth rate is still there since we are dependent upon the equipment makers to make machines..

And is that due to higher demand this year, obviously there is more than one manufacturer, but is that just a matter of smaller CapEx supplier being overwhelmed by rising demand or is there something unique that we should understand is happening?.

No, it’s – it more relates to the equipment makers tend to be small, so their ability for growth is limited, they are small family-owned companies in most cases, there is 3 or 4 of them globally that make the IG, the equipment makers and they typically make 3 to 4 lines per year..

That’s it. Interesting.

Bill, broader question not about businesses within engineered components, but given some of the consolidation that we have seen in the broad window industry, JELD-WEN, can you talk about any impacts or thoughts that might be not impacting this year if you obviously have guidance, but what might be impacting the landscape as you look to FY ‘19 and ‘20 in terms of your business in terms of what that consolidation might mean? Thank you..

Yes.

At this point, obviously, we are in dialogue with the some of the players that you are referring to and clearly for the next year we have been told its business as usual, we don’t see on the horizon at this point any negative impacts to our business, but we don’t particularly see any positive impact to our business either, but obviously we are monitoring that very carefully and any potential future consolidation that might occur..

Thank you very much..

Thank you. The next question is from Julio Romero of Sidoti & Company. Your line is open..

Hi, good morning everyone..

Good morning Julio..

Hey, just a couple of quick ones here.

How much headroom do you guys see to raise prices in the European engineered segment given the amount of price increases you kind of have already kind of put into date?.

We are reaching the limits right now and we have had two not insignificant increases, one towards the end of last year one in the early part of this year. I think it’s unlikely we will see any further increases as we exit this year.

The only thing that’s still questionable particularly in Europe is silicon in the spacer that continues to be in short supply and prices do seem to be continuing to escalate. We are holding our price at this time, but if it continues to increase significantly we may have to do something..

Got it. And do you guys have any contractual pass-throughs in Europe at all or is it just kind of completely opposite as in the U.S.

and there is no contractual pass-throughs there?.

Generally speaking the answer is no, it’s the opposite of the U.S. There are almost no contractual pass-throughs..

Got it.

And then just one last one if you could give us any update on any quantifiable improvement you guys have done in woodcraft kind of year-to-date?.

Sorry, could you repeat that, Julio, I didn’t catch it..

Sure.

Just any just talk about the improvements you guys have made in the woodcraft segments in terms of the automation you have put in kind of year-to-date?.

Yes. Year-to-date, we are in the – there are really two parts to the business, the rough mills, which produced the blanks to make into cabinet doors and the rough mills are where we have put in a significant amount of automation.

Year-over-year at this point, productivity is up by 11% and in cabinet door production we measure cabinet doors produced per labor hour and productivity there is up 5%..

Excellent. Thanks for taking my question, guys..

Thank you. There are no further questions at this time. I will turn the call back over to Mr. Griffiths for closing remarks..

Thanks for joining us everyone and we look forward to updating you early in September as we close out at the quarter. Thank you..

Thank you. Ladies and gentlemen, this concludes the program. You may now disconnect. Everyone have a great day..