Hardwoods Distribution Inc

TSX:HDI

Earnings Call Transcript 2019-Q2

[Operator]

Good morning. My name is Leonie, and I'll be your conference operator today. At this time, I'd like to welcome everyone to HDI's second quarter results conference call. [Operator Instructions] I would now like to turn the call over to your host, Mr. Rob Brown, President and CEO. Please go ahead, sir.

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

Thanks, Leonie, and good morning, everyone. Welcome to the call. Thanks for joining us. I'm going to start this morning with a brief overview of some of the highlights from our second quarter and first half to the year. Faiz Karmally, our CFO, will follow with a more detailed financial review, and I'll return to discuss our outlook going forward.HDI made important progress in the second quarter and the first half of 2019, even as we experienced softer operating conditions in U.S. construction markets, which were affected by a delayed start to the construction season and by mixed economic conditions. We significantly increased second quarter cash flow from operations to $18.2 million. We also achieved modest sales growth and exceeded our gross -- our target range for gross profit margin. Our results reflect the continued successful execution of our strategies. As you know, we've spent the past 2 years transitioning our import supply chain beyond China. Our import supply today is diversified in terms of source countries, and we've been successful in delivering a high-quality customizable proprietary product that our customers expect. That in turn is providing support to our margins.At the same time, our strategy of carefully managing the balance sheet and a reduction of inventory to normal levels has translated into very strong cash flow results. Our second quarter cash flow from operations was up by $15.6 million year-over-year, and for the first half, it was up by $34 million. This has enabled us to deliver on our capital allocation priorities in 2019. So far this year, we've financed our acquisition of Far West Plywood entirely with cash. We completed that acquisition in the first quarter and are well positioned to finance future acquisition opportunities. We've returned $5.8 million to shareholders through a combination of dividends and share repurchases, up from $3.1 million in the same period a year ago. And we've reduced our bank indebtedness with our leverage ratio just below 2x as of the end of the second quarter.I'm pleased to report that the Board has just announced another quarterly dividend of $0.08 per share. Our strategies are delivering results, and we're continuing to demonstrate that we have a resilient and well-diversified business model that can perform even during uncertain market conditions. We're also managing the business for the long term with continued focus on strategy execution, comfortable organic and acquisitions-based growth and balance sheet strength.I'll talk more about our strategies a little later in the call. But first, I'll pass the call over to Faiz to review our financial results. 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 second quarter and the first half of 2019, and then I'll provide some comments on our financial position and capital allocation plans. Starting with the second quarter consolidated revenue. Our sales increased 2.1% to $304.5 million. That's a gain of $6.4 million compared to Q2 2018 and it breaks down as follows: acquisitions accounted for $8 million of the year-over-year increase or 2.7%; and we realized a translation gain of $9.1 million related to the positive foreign exchange impact of a stronger U.S. dollar. This was partially offset by a $10.7 million or 3.6% decrease in organic sales.Looking at sales by geography. In the U.S., our sales were up by USD 1.6 million or 0.8% year-over-year. Sales from acquired businesses contributed USD 6 million, which was partially offset by a USD 7.6 million reduction in organic sales. The decline in organic sales reflects the delayed start to the construction season and mixed economic data that Rob mentioned earlier.In addition, sales in the hardwood lumber category in particular, which represented about 22% of our sales mix, were lower year-over-year. This mostly reflects lower pricing as a result of excess industry supply and a shift in demand to lower-value species. As it relates to Canada, sales were down $1 million or 2.6% lower as compared to Q2 of 2018. The change in Canadian sales reflects demand supply dynamics and the impact of government policy aimed at cooling the housing market.Gross profit grew by 3.5% in the second quarter to $55 million. That's a year-over-year improvement of $1.8 million, and it was driven by the higher sales and the higher gross profit margin percentage of 18.1%. Operating expenses were up $3.2 million year-over-year to $41.2 million. This reflects a combination of factors including: the impact of a stronger U.S. dollar on translation of U.S. operating expenses; added expenses related to acquired businesses; and a $0.8 million increase in bad debt expense. Note that last year's bad debt result was unusually low for our business and this year's result represents a return to more typical levels.Looking at our bottom line performance. We generated adjusted EBITDA of $21.2 million or 8.3% lower than a year ago. This primarily reflects the higher operating expenses partially offset by the increase in gross profit, and we generated adjusted profit of $8.7 million or adjusted diluted profit per share of $0.40, which compares to $11.1 million or $0.51 in the same period last year.Turning now to results for the first half. 6 month total sales increased by 4% to $591.6 million, a year-over-year improvement of $22.7 million. Acquisitions accounted for $15.3 million or 2.7% of this increase, while foreign-exchange translation had a positive $21.1 million impact. These gains were partially offset by a $13.7 million or 2.4% decrease in organic sales.In the U.S., sales were up by USD 2.8 million or 0.7% year-over-year. Acquired businesses contributed sales of USD 11.5 million, which was partially offset by USD 8.7 million reduction in organic sales. And in Canada, sales were lower by $2.6 million or 3.6%.The change in organic sales for the 6 months ended June 30, 2019, is primarily due to the same impacts as discussed in my commentary on sales for the 3 months ended June 30, 2019. First half gross profit increased by 3.9% to $106.1 million as a result of higher sales, and gross profit margin remained stable at 17.9% year-over-year.6 months operating expenses increased by $7.8 million, reflecting the translation impact of the stronger U.S. dollar on U.S. operating expenses, the addition of acquired businesses as well as added costs that support our growth strategies and return to more typical levels of bad debt expense. Adjusted EBITDA of $38.5 million was down $3.5 million year-over-year. This primarily reflects the higher operating expenses partially offset by the increase in gross profit. And we generated first half adjusted profit of $15.2 million and adjusted diluted profit per share of $0.70 as compared to $19.8 million and $0.91 in the same period last year.Looking now at our financial position and capital allocation priorities. We maintained a strong balance sheet, and as of June 30, 2019, our net bank debt-to-adjusted EBITDA after rent ratio was 1.9x, and our net bank debt-to-capital ratio was just 26%. We also had over $90 million of unused debt capacity available.Going forward, our capital allocation priorities are to continue to focus on supporting future growth and ensuring continued responsible management of the balance sheet, executing on our acquisitions pipeline and continuing to return value to shareholders in the form of dividends and share repurchases. Now I'll turn the call back to Rob.

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

Thanks very much, Faiz. I'll close today with a few comments on our outlook and our strategies going forward before we open it up for some questions. As I noted earlier, we experienced softer operating conditions in the first half of the year. We view current conditions as a temporary pause, not a directional change in the market. The current level of U.S. housing starts and inventory remains below the long-term average. This, paired with the low levels of current housing inventory and the favorable demographic characteristics of U.S. consumers, offers good support for housing demand over the longer term. As we move forward, we will continue to execute on our corporate strategies. We expect to make continued progress on our import program and reestablish our competitive advantage as our input product offerings gain traction. We're also building market share in the decorative surfaces and composite segments, which represent emerging high-growth markets for us. Internally, we're building on our competitive strengths as we create a level of resources, support and sophistication that's unmatched by anyone in our industry. And externally, we continue to pursue accretive acquisition opportunities in the fragmented North American market. We have a robust pipeline of targets, the size and balance sheet strength to go after them and a track record of making successful acquisitions.As we move forward, our focus will remain on responsible management of the balance sheet so that we can execute on our acquisitions pipeline and also continue to return value to shareholders in the form of dividends and share repurchases. In summary, our outlook for the business is positive, and we remain focused on managing HDI for the long term as we create an even stronger and more successful business.With that, I want to thank you for your attention. I'll turn the call back to the operator to provide instructions for the Q&A period. Leonie?

[Operator]

[Operator Instructions] Your first question is from Yuri Lynk from Canaccord.

[Yuri Lynk]

Just trying to get a handle on how your outlook might have changed for the back half of the year. You were previously looking for growth in both sales and gross margin, that line which has been removed. So maybe just a little bit of color on how your outlook on the back half has evolved since we last spoke?

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

Sure. In the previous outlook, we had indicated that we felt the second half was going to bring some -- a stronger sales environment. We've not really seen that unfold over the course of Q2. You'll see the numbers in the MD&A that on an organic basis it's continued to kind of be in that negative 2% to negative 3%. So I think we're looking for a little bit more of a sign herein on what direction that's going to go. I think it's very positive that we've got one and possibly more interest rates coming so it's not something that we saw coming into the years as a likely outcome. But overall, we have grown total sales in the current year on both a year-to-date and a Q2 basis. Acquisitions will have to be a continued part of that because we're not seeing the same level of growth on an organic basis. So as we talk to our operators, who in turn talk to all of our customers, they remain actually quite encouraged about the second half of the year. But I think we just need to see that emerge a little bit more strongly on the order file.

[Yuri Lynk]

Yes, I mean, certainly the macro data, as it pertains, to housing has been, I guess, lackluster at best. I mean shouldn't -- should we -- to be prudent, shouldn't we be assuming the low single-digit organic growth -- negative organic growth to persist until we see the broader housing macro turn a little bit? Is that the right way to think about it?

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

Yes, I think, the way to -- that we think about it is we haven't seen it in first half. While we're getting good feedback from our businesses around possibilities for the second half, and I'm talking about sales here. Until we see that start to print, the organic environment seems to be in that negative 2% to negative 3%, which is what we saw in the first half. Now as it relates to margin, we actually came in just a little bit stronger or at the top end of the range that we anticipated on margin in Q2, and that piece is encouraging. So we expect that to give us a little bit of continued support, even if the organic sales is not necessarily as strong as it has been. And as I mentioned, the other piece on the sales force is what we can accomplish on acquisitions. And we're in August now. I think we'd be disappointed if we don't get something more done over the course of the balance of the year, and we continue to pursue that angle.

[Operator]

Your next question is from Maggie MacDougall from Cormark Securities.

[Maggie Anne MacDougall, Director of of Institutional Equity Research]

I was wondering if you could give us some additional information around your alternative sourcing strategy overseas. And particularly, I'm curious as to whether or not you saw the benefit from that new product in all 3 months during Q2, or if perhaps you had more of that inventory landing and being sold later in the quarter rather than earlier?

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

Sure. I'll take the second first and then go back to the alternate sources. So we actually are achieving, from a volume perspective, container flow volumes that are quite favorable in terms of rebuilding the import advantage that we previously had. I'm very encouraged with that. I would say our rivals have favored segment -- something later in the quarter than earlier in the quarter. So that product is positioned. I would say, it's a fair comment that we saw some bit of that in Q2. But the expectation is there should be some further benefit building. The other comment I would make is I talked in my remarks about the cash flow generation that we've had second quarter and year-to-date, some of which has come through inventory reduction. We were heavy, as you recall, coming into the year. Moving through excess inventory, like that can sometimes also bring a margin drag, that'll be a little bit of an offset. So we feel a good chunk of that is behind us now, and we're actually feeling quite good about the post-profit percentage going forward. On the alternate sourcing strategies, the -- I mean it's predominantly a Southeast Asian strategy, which is typical in terms of fiber flow in the globe right now. So the comment I would make on that is when you try to have a more diversified approach, China used to offer very much a one-stop shop solution. And its taken time to rebuild what we had in terms of productive capacity previously. And we've tried to rebuild that from multiple sources to put -- build a little bit more of a cushion, should there be trade disruption from any one country in the future.

[Maggie Anne MacDougall, Director of of Institutional Equity Research]

Okay. Just circling back on Yuri's original question around the, sort of, shift in language on the outlook. I guess I'm interested in what's on -- in the domestic cabinet and manufacturing market in the U.S. because I would think that if there are threats of trade actions against Chinese cabinet makers that could have some benefit to you guys later this year or maybe in 2020. So could you give us an update on that situation? And then your views on whether or not that could be beneficial for you down the road?

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

Maggie, I missed the last part, whether that could be?

[Maggie Anne MacDougall, Director of of Institutional Equity Research]

Beneficial in the future.

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

Okay. Yes. So I mean the U.S. domestic cabinet manufacturing segment goes obviously with how housing is doing, and you'll have your view and we've talked about that before. But there is this external variable, which is RTA cabinetry -- sorry, ready-to-assemble cabinetry, so think of a flat pack cabinet that arise and then is assembled instead of being prepared as a fully boxed cabinet. There is a case against manufacturing of RTA cabinets from China. Yes, we do see that as a potential positive for our customer base. The U.S. cabinet industry has estimated, since you asked, somewhere between 1/4 of magnitude $15 billion per year, and the filing for the RTA cabinet case suggested that, that was a $4 billion business today. So roughly a 1/4 of the market. Not sure if those numbers are right or not. But if you see a hole of that magnitude created in the market, it's going to create fragmentation which would benefit our customer base. I agree with your comment that, that will take some time. The RTA case is winding its way through the process. We've had the first event, which is the preliminary CVD duty, and that came in at 16% for most makers. There's some exceptions to that. But for most importers that was the number. The preliminary anti-dumping duty is still to come probably over the next 60 to 90 days, don't have the date in front of me just now. But that's already put a dent -- a little bit of a dent initially into the margins that will be associated with continuing a Chinese RTA.

[Maggie Anne MacDougall, Director of of Institutional Equity Research]

Okay. And then one final question from me. You made a little comment in your disclosure around a shift among some customers into lower-end or lower-value hardwood lumber product. And wondering if you could give us your view on perhaps the reason for that. And then if there is some evolving product strategy that maybe required to ensure that you're capturing your fair share of the market.

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

Yes, great question. So that is just referencing. I guess I would take the opportunity to say hardwood lumber as a category is about 22% of our total sales. So it's an important piece but by no means the majority. The -- what we've seen there is as style has moved towards more of a European-styled cabinet, and consumers are looking for a lot of whites and grays and clean looks in their kitchens, that's meant itself to a lot of product that gets painted rather than stained. So hardwood lumber species that are -- that take paint well are typically lower-value species like a Poplar as opposed to selling, for instance, Cherry lumber or Walnut, as an example. So that shift into lower-value species is just really reflective of the type of cabinet that some folks want. The backside of that, the way that we're participating, I mentioned it in my opening comments is our focus on greater participation in a decorative surfaces market and composites market. So while we see some shift going on with under the hardwood lumber, we see a corresponding uptick in our sales in these other categories, which, to some extent, are just walk down from what used to be done in the lumber category.

[Operator]

[Operator Instructions] Your next question is from Zachary Evershed from National Bank Financial.

[Zachary Evershed, Analyst]

Congrats on the quarter guys. You said you'd be disappointed if there wasn't action in the acquisitions space by the end of the year. Can you give us some more color on the size and depth of your pipeline?

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

Sure. So as you know, we've fully staffed, and we've been pursuing and nurturing the pipeline for some time. The -- we've got, let's say, hundreds of names in there that we're ranking, managing relationship and pursuing as what I would describe as a long-term strategy. Acquisitions are going to be a little bit lumpy at times. So on the first half, we've got roughly $15 million of acquired sales in first 6 months results. We've said that we want run rate to be doing $30 million to $50 million in acquired sales to augment our organic growth with acquisitions growth. Some years are going to be higher than that, some years are going to be lower. What I can say is that the activity levels that we've got ongoing have been very encouraging. So as I say, probably be disappointed if we don't get something more done by end of year. But we're thinking of this as an off-peak and long-term strategy with a lot of runway.

[Zachary Evershed, Analyst]

Have you seen any change in the competitive environment at the deal table?

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

I think that there's -- yes, there's a little bit more appetite and interest to have conversations. And I think it's probably related to the comment that Yuri made earlier, which is just the sentiment around the industry and the outlook is maybe a little bit more subdued than it's been in the recent past, and that's positive as it relates to the acquisitions program.

[Zachary Evershed, Analyst]

One last one for me. Given that your comfort level is significantly higher than where your leverage currently sits, especially with the adjustment that you guy show in your financials. Should we expect a tick up in buyback activity if we don't see acquisitions in the books?

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

Two things. I think Zach we've got -- we introduced the NCIB, as you know, a quarter ago, and we've had decent activity in there. Cash returns to shareholders are not quite but roughly double where they were in terms of pace a year ago. So we're going to keep a really close eye on that and obviously, monitor around the overall cash usage. And as you discussed, yes, we are higher -- or pardon me, we are comfortable with a higher armed leverage as needed to support acquisitions. But we're well positioned right now.

[Operator]

There are no further questions at this time. Please proceed.

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

Okay. Thanks for your attention. And if there's follow-up questions, do please reach out to Faiz and myself, happy to chat with you.

[Operator]

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