Hardwoods Distribution Inc

TSX:HDI

Earnings Call Transcript 2020-Q1

[Operator]

Good afternoon. My name is Colin, and I'll be your conference operator today. At this time, I would like to welcome everyone to the HDI Q1 2020 Results Conference Call. [Operator Instructions]Thank you. Mr. Brown, you may begin your conference.

[Robert J. Brown, President, CEO & Director]

Thanks, Colin, and good morning. And welcome, everyone. Thanks for joining us. These are extraordinary times, and I'm sure the COVID-19 pandemic is top of mind for many people on the call today. I will speak about the pandemic and its impact on our business in a few moments. However, I wanted to start today's call with some comments related to our first quarter performance. We came into the year with positive indicators for the construction market, and our business strategies enabled us to take full advantage of these conditions. As a result, we achieved our best-ever quarterly sales result, driven by strong organic growth of 5.4% and complemented by another 6.8% of sales growth from acquired businesses.We also recorded our best ever gross profit margin percentage performance as our reestablished import supply lines, which complements our domestically sourced product offering, and inclusion of the recently acquired Pacific Mutual Door business, contributed to the record result. The record top line and gross profit margin percentage results translated to the bottom line with EBITDA and profit per share up significantly as compared to the first quarter last year. Our performance allowed us to return $4.4 million of cash to shareholders in the quarter in the form of dividends and share buybacks. This is double what we returned to shareholders in the same period last year. Overall, it was an excellent start to the year, and I'm pleased with the progress we're making executing on our strategies.Turning our attention to the COVID-19 pandemic. I want to start by thanking the health care and emergency workers in our communities who are dealing with this pandemic on the front lines. I also want to thank our employees across North America, who have continued to supply essential infrastructure and construction products to our customers through these challenging times. As you know, many businesses have been forced to shut down or significantly scale back operations. We're fortunate that we weren't one of them as a supplier of building products HDI is considered to be part of the essential infrastructure supply chain. Not only are we permitted to operate, we are expected to.To meet this responsibility, we moved quickly to implement new health and safety procedures to protect employees across our operations. These included protocols for cleaning, social distancing, and where possible, working from home to minimize the chance of virus transmission. We also needed to respond quickly to the rapid change in demand levels that we saw starting in April. Following our very strong first quarter, our sales in April declined by about 23% as compared to March, with reduced economic activity impacting construction activity. We took swift and decisive action to manage our expenses and lower costs.Despite losing 23% of our sales pretty much overnight, our adjustments were rapid enough that we anticipate being operating cash flow breakeven in the month of April. And that's before considering changes in working capital. While cutting costs, we were also careful to keep our core productive capacity intact. If this proves to be a relatively temporary pullback, we want to be able to resume momentum without having to pause first and rebuild. And if it proves to be a more permanent downturn or the demand pull back goes deeper, we have contingency plans in place to further address costs.I mentioned that we are anticipating being operating cash flow neutral in April even before considering changes in working capital. So let's talk about our working capital. As it relates to working capital usage, our business is cash countercyclical. If our sales activity goes down, so does our investment in accounts receivable and inventory. We collect receivables, and we buy less stock, which releases cash. This release naturally takes a few months. It's a key feature of our business model. And it gives us tremendous flexibility to successfully manage through downturn conditions.Adding to our ability to manage through a downturn is our strong financial position and liquidity. As of March 31, we had no term debt, and we had over $100 million of liquidity at our disposal. That includes approximately $60 million in cash and another $40 million in unused borrowing availability. And while it's too early to say what the prevailing economic demand will be, we're well positioned to weather the impact.As we move forward, we will seek out opportunities to win new market share and to advance our product and technology strategies. We will also continue to evaluate potential acquisitions. We've already completed 1 transaction this year, which was our purchase of Diamond Hardwoods in March. That transaction bought us 2 additional locations in California and another $8 million in annualized sales. Our intention is to emerge from this global crisis as a strong and well positioned business, ready to deliver the type of performance we demonstrated in the first quarter of 2020.On that note, I'll pass the call over to Faiz to review our Q1 results with you in more detail. Faiz?

[Faiz H. Karmally, VP, CFO & Secretary]

Thank you, Rob. And good morning, everyone. I'm going to provide a general overview of our results for the first quarter of 2020, and then I'll provide some comments on our financial position and capital allocation plans as well.Starting with consolidated revenue, we established a new quarterly sales record of $325.1 million. That's a gain of 13.2% or $38 million from a year ago and breaks down as follows: acquisitions contributed $19.4 million or 6.8% of the year-over-year increase, organic growth accounted for $15.5 million or 5.4%, and we realized a translation gain of $3.1 million related to the positive foreign exchange impact of a stronger U.S. dollar.First quarter gross profit also increased sharply, growing by 22.7% to $62.6 million. That's a year-over-year improvement of $11.6 million, and it was driven by the higher sales together with an all-time high gross profit margin percentage of 19.3% as compared to 17.8% last year. Our record gross margin performance reflects our success in reestablishing our import supply lines, and it also reflects contribution from the Pacific Mutual Door operations, which we acquired last October and which carries a higher gross margin profile relative to the rest of our business.Operating expenses for the first quarter were $6.4 million higher at $47.6 million. The addition of expenses from acquired businesses was the main reason for this, followed by investments to support our growth strategy. The impact of a stronger U.S. dollar on translation of U.S. operating expenses also accounted for a modest part of the increase. We generated quarterly EBITDA of $22.8 million, which was up 36.4% year-over-year. The strong result was driven by our higher gross profit, partially offset by the increase in operating expenses. Our income tax expense increased by $1.7 million year-over-year, reflecting higher taxable income. And profit grew 57.1% to $9.4 million from $6 million last year. While diluted profit per share improved to $0.44, $0.28 in the same period last year. Overall, it was a very strong first quarter for HDI. This is especially significant given that the first quarter is typically a seasonally slower period for our business.Looking now at our financial position and capital allocation priorities. Our balance sheet continues to be responsibly managed. As of the end of the first quarter, our net debt to adjusted EBITDA ratio was a conservative 2.1x. Our debt-to-capital ratio was 29%. We also had $102 million of liquidity available in the form of cash on hand and unused debt capacity.We remain confident in our ability to manage through short-term disruptions caused by COVID-19 situation. Going forward, our capital allocation priorities will include maintaining sufficient capital reserves to weather any impacts related to an economic slowdown, executing on our acquisitions pipeline, continuing to return value to shareholders in the form of dividends and remaining opportunistic as it relates to share repurchases and ensuring continued responsible management of the balance sheet.With that, I'll now turn the call back over to Rob.

[Robert J. Brown, President, CEO & Director]

Thanks, Faiz. Before we open the call to your questions, I just want to take a moment to congratulate our HDI team for an outstanding first quarter and to thank our employees again, along with our suppliers and our customers, for helping us fulfill our essential role in the infrastructure supply chain. As we move forward, we will continue to prioritize the health and safety of our people and continue to adapt our ways of doing business as necessary.These are difficult times, and we still don't know what the full impact of the COVID-19 pandemic will be, but I do know that we are well prepared to respond to the challenge. Our business is larger. It's stronger and it's more diversified than ever. We have a business model that's proved itself through over 60 years of changing economic conditions and it's well positioned to absorb impacts. This also isn't our first experience managing through rapid demand change. Our leadership team has considerable practical experience gained in the 2008 global financial crisis. We promote from within here at HDI. All of our key leaders were here in 2008, and we know how to adjust our business. And our balance sheet is in excellent shape, as Faiz described. And we maintain significant financial flexibility.With that, I thank you for your attention. I will turn the call back to the operator to provide instructions for the Q&A answer period. Colin?

[Operator]

[Operator Instructions] So your first question comes from Yuri Lynk of Canaccord.

[Yuri Lynk]

I just want to dig in a little bit on what you're seeing so far. So when -- was there any impact in March from COVID? And when exactly did you start to notice the drop-off in sales?

[Robert J. Brown, President, CEO & Director]

A little bit of softening in the last 2 weeks of March, Yuri. And then it was really upon us from very early April. So that minus 23% that we've described really happened all at once. And then, frankly, it's leveled at that activity.

[Yuri Lynk]

I obviously don't know what March's sales were, but how would it compare to kind of the average month in Q1? You did about $110 million. Would it be down 23% from that number? Or just we have to come at a better feel.

[Robert J. Brown, President, CEO & Director]

Yes. No, that's a good question. So March, we've chosen as kind of a month-over-month change. But March is indicative of pace for the first quarter. It's a reasonable proxy.

[Yuri Lynk]

What -- how fixed are your selling and distribution and administrative expenses? I know you mentioned on the call, I think, you're trying to balance in case things come back fairly quickly, which they might, but what's your ability to address those costs? Or can you give us a split between variable and fixed components in there?

[Robert J. Brown, President, CEO & Director]

Yes. I -- there are -- there's fixed and semi-fixed and variable, and I don't have a specific split I'll offer on the call. But I would say our 3 biggest cost buckets are people, freight and rent. People, obviously, is very variable, whether it's headcount or how folks get to. And you'll have seen in the release that we've already reduced our workforce by about 10% in the month of April. And I mentioned earlier in the call that we've got plans if we need to do more to take cost out of the business, but we want to see where demand takes us before we hurt productive capacity.The other key expense buckets are freight and rent. And in the case of freight, there is significant amount of flexibility there that you can drop trucks and reduce the -- basically, the number of units that you've got flowing. So that's a nice lever for us with some good variability. The one that has the least amount of variability, as you would expect, is our leases. So the rent we're paying in our facilities is -- those are obviously committed under lease. And to take cost out of that is a longer-term effort. We have, I believe, 14 leases renewing in the current year. You obviously would look at those. But if you're into a longer downturn, you would be adjusting rent through sublets or other means. And just as we did in 2008, there are some things that can be done on that basis, if required.

[Yuri Lynk]

Okay. Last one for me. Similar vein, I mean, the gross margin was very, very strong. And what do you think gross margin will do given the drop in sales? And I guess is there any kind of mix shift that favors gross margin up or down? Or any color you can provide on the -- on how that's -- the sustainability of that level in this environment?

[Robert J. Brown, President, CEO & Director]

Yes. There's a few things going on there. I would say that the PMD acquisition we did in Q4, which was sizable for us, helps and it'll continue to be a help throughout the comps for the balance of the year. So we'll have that benefit in Q2, for instance. In terms of the margin overall, I mentioned we are going to be releasing cash. That's the objective through working capital reduction. When you're reducing inventory, you do have a tendency to be willing to take a reduced margin at times in order to move through certain sales. So I could see some downward pressure in that regard. Q1 was obviously a very strong result, but we haven't called out in our release that we expect any material change from looking at the normal trading range you've seen in the past.

[Operator]

Your next question comes from Zachary Evershed of National Bank.

[Zachary Evershed, Analyst]

First one for you this morning on bad debt write-offs. Back during the Great Recession, what level of write-offs did you experience? And how are you viewing that risk now?

[Faiz H. Karmally, VP, CFO & Secretary]

Zach, Faiz here. I can take that one. So if I think back to the global financial crisis, as a percentage of sales, our bad debts then were a little over -- there was 1 year where it was a little over 2%. I believe that was our worst experience. In terms of how we think about it now, I would describe the business as having really no significant concentration in terms of customers. So our largest customer as a percent of sales, which we've disclosed previously, is less than 2%. So there's diversification in terms of where the risk sits, not only number of customers and size of balance as I just spoke about, but even geographies, as you know, North American-wide footprint. So weakness in 1 or 2 or 3 geographies. Again, the risk is spread out from that perspective. And in terms of what we're doing here internally, that's a key focus for us. I mean, Robert mentioned not only our -- the executive team, but the managers who are running our businesses, many of them have been around and seen the last downturn. And so collection of AR, monitoring things, daily agings, being tough on collections, those are all things that are normal course for us that we're just doing. So we feel good about where the risk sits today, and we're monitoring it as conditions change, but that gives you some added context as to how we think about it.

[Robert J. Brown, President, CEO & Director]

I'll maybe just add one comment to that, which is the AR is looking solid so far, obviously, monitoring it closely. But a number of our customers, many of them got PPP money out of U.S., so that's been helpful, and that was absent in the 2008 crisis, Zach.

[Zachary Evershed, Analyst]

That's really great color. And then you mentioned that the -- you don't see any reason that gross margins would depart from historical trading ranges. Would that be the 17% to 18% pre-Pacific Mutual Door or the kind of 18% to 19% range post-Pacific Mutual Door?

[Faiz H. Karmally, VP, CFO & Secretary]

Yes. Zach, what we're referencing there is that, that 18% to 19% historical range. And that's traditionally where we've been. Last year, we were outside of that, as you recall the reasons for that. But historically, it's 18% to 19%.

[Zachary Evershed, Analyst]

Perfect. How is your neighbor book shaping up? And you mentioned that the hit came all at once and then it's kind of leveled out there. But directionally versus April, have you seen any improvement in May?

[Robert J. Brown, President, CEO & Director]

Sorry, Zach, I missed that. What kind of book?

[Zachary Evershed, Analyst]

Your order book, sales levels.

[Faiz H. Karmally, VP, CFO & Secretary]

The order book.

[Robert J. Brown, President, CEO & Director]

Yes. So nothing to add beyond what I -- you saw on the -- in the release, which is that we've seen that kind of pull back by about 23%. Nothing we would add to that.

[Zachary Evershed, Analyst]

Okay. And one last one for me. In terms of takeout targets, you mentioned that you're evaluating potential acquisitions. Is there anything holding you back from closing on a transaction?

[Robert J. Brown, President, CEO & Director]

So the diligence is obviously a little more challenged. But I would say that when you look at our pipeline, we typically have been in and seen these targets from a site-visit perspective than we would have had through sometimes years of exposure, relationship building with key managers and owners. So that's a little bit one that becomes more challenging. But I don't think it's prohibitive. Most of the financial diligence is frankly done behind the scenes and remotely anyway. You would just need to be able to close a transaction to go and do the onboarding with employees, and finally, inventory accounts. So more challenging, but like all things today, I think that people can still be creative to get there.

[Operator]

And your next question comes from Jeff Fenwick of Cormark Securities.

[Jeffrey Michael Fenwick, MD & Co]

I guess I wanted to focus my questions on liquidity, and you had that $60 million of cash at the end of the quarter. Can you just describe how you're able to manage that cash balance? How much of it ends up getting cycled back, paying down your revolver and the ability to sort of support yourself through that softer period here through April and into May?

[Faiz H. Karmally, VP, CFO & Secretary]

Jeff, it's Faiz here. I'll take that one. So in terms of how we're thinking about that cash balance, it's really going to depend on the working capital release. So in our filings last night, I'm sure you noticed, we're in April -- I'll use April as an example. In April, we said we anticipate being cash flow breakeven before considering changes in working capital. And so if that holds true, your changes in working capital, and we anticipate that being a release of cash flow, the phase that goes is to pay down debt. And that's the way the business model, I would mention, worked in the global financial crisis as well. So depending on the working capital release, that release, again, in April would have gone to pay down debt, not the $60 million of cash we had on our balance sheet as of the end of March. So I mean, the answer is, really, it depends quite heavily on working capital and the timing of when that comes off the balance sheet and turns into cash. I would say in terms of debt balance at a leverage ratio of 2 today and with the liquidity we're sitting on, that is not an uncomfortable place for us to be. And so we're talking about paying down debt, which is important, but it's not something that we feel we have to do right now either. Does that answer your question, Jeff?

[Jeffrey Michael Fenwick, MD & Co]

I think so. And I guess a follow-on from that is just can you describe what sorts of conversations you've had with your lenders? And discussing that sort of thing in terms of their comfort level. And I know part of the draws as an ABL is how they're valuing your inventory and your working capital. So are there some dynamics there that you're trying to be mindful of as well?

[Faiz H. Karmally, VP, CFO & Secretary]

Yes, there's actually, because we know they'd normally have to report. Nothing's really changed from the bank's perspective. They continue to value our working capital the way they always have. There's been no change or -- from their perspective. We have conversations with them regularly. They're very supportive partners. I mean, there's no real -- nothing really to report in terms of change.

[Robert J. Brown, President, CEO & Director]

I'd maybe just add that like there's muscle memory in the management team, this is the same bank and it's the exact same bankers that we went through 2008 with. So we know each other pretty well and there's sort of high degree of trust and understanding of the business, would be my perspective.

[Jeffrey Michael Fenwick, MD & Co]

Okay. And I guess one last follow-up on that one is if that's working well for you, you've got some excess cash, you're going to squeeze some cash out of the working capital. You briefly referenced share buybacks, but would you look at potentially maybe take that up a step if the stock continues to be weak?

[Robert J. Brown, President, CEO & Director]

Yes. We've left that on the table because we think that's the right thing to do. We take a pretty common thoughtful approach to how we manage the business. And the same will continue with how we approach acquisitions, which came up earlier. And then if we are spending money on share buybacks. Kind of view it like the market, when you've got market disruption, you've also got opportunities. So if there's good long-term value opportunities that arise, we'll look at those. And to your point, yes, we stabilized the business in April. We expect to release cash from working capital over the coming months, and we're conservatively financed with a lot of liquidity. So we didn't see the need to specifically exclude acquisitions and share buyback opportunities from our range of options we've left them in play.

[Operator]

Your next question comes from Hamir Patel of CIBC Capital Markets.

[Hamir Patel]

Rob, could you speak to how demand in April fared across your different geographies? And then also, if you noticed any notable differences between commercial and res? And related to that, in areas of the U.S. that have started to reopen, are you seeing a noticeable uptick in demand?

[Robert J. Brown, President, CEO & Director]

Sure. So we don't generally call out too much around how geographies fared in terms of different demand. We would if there was something quite specific that stood out, but there's not. I mean, generally, we saw a bit of a chaotic closing across the U.S. that occurred at various geographic levels. That did have some impact on some specific locations, but nothing I would kind of call out as saying, this state was terrible or that state was great. We did see earlier more progressive closures in California, as an example, so we have more customers kind of go down there, and us sitting out here in BC [Audio Gap]Washington state was also hard hit. So we saw a little bit more closure activity there. But on the plus side, you're also seeing those businesses come back online now. Commercial versus res, nothing to report at this point, at least through March, April. Trends that we tend to see in end markets of each were fairly, fairly similar. So -- and then in terms of reopening, it's kind of a little bit too soon to say because the reopenings of states are happening now. I would say that a lot of our customers, like us, have been open the whole time. Just through April, it's now at reduced activity levels, and it remains to be seen, as they tend to open up the rest of the economy more fully, how much of those activity levels will return.

[Hamir Patel]

Great. And then could you just give us an update on that Kitchen Cabinet trade case, where things stand? And how you see that affecting demand later in the year?

[Robert J. Brown, President, CEO & Director]

Yes. So you'll recall that preliminary antidumping and CVD duties were imposed. This is on ready-to-assemble cabinets coming from China to the United States. That's the flow we're talking about. That case was affirmed. It went in front of the final tribunal -- trade tribunal of the U.S., which is the ITC, and they confirmed the case. So those duties are now in place. And the impacts of that are probably twofold. One, you'll see new volumes of imported cabinets likely flow to the U.S. from different places. So China has been knocked out of the game largely on pricing because of duties, but others will step into their shoes. But there also, I think, will be a pickup in terms of domestic activity. So we are selling to U.S. domestic cabinet manufacturers, and this is good news for them. If the demand that was previously satisfied from an import solution now becomes demand that they're capturing domestically, and we're supplying product to them. It's too soon to say what that demand will look like, but is a good thing.

[Operator]

[Operator Instructions] There are no further questions at this time. You may proceed.

[Robert J. Brown, President, CEO & Director]

Appreciate that, Colin. Thank you. And I just want to thank everybody for joining us. I do appreciate your interest and your questions, and feel free to give Faiz and I a call. If you've got follow-up items, we'd be happy to talk to you. Thanks, all.

[Operator]

Ladies and gentlemen, this concludes your conference call for today. We thank you for participating and ask that you please disconnect your lines.