Hardwoods Distribution Inc

TSX:HDI

Earnings Call Transcript 2021-Q2

[Operator]

Good morning, ladies and gentlemen, and welcome to the HDI Q2 2021 Results Conference Call. [Operator Instructions] This call is being recorded on Monday, August 9, 2021. I would now like to turn the conference over to Mr. Rob Brown. Please go ahead.

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

Thanks for that rousing introduction, Ash. Good morning, everyone. Welcome. Thanks for joining us. The second quarter brought significant financial and operational achievements for HDI. I'll start today with some of the highlights. Faiz Karmally, our CFO, will follow. He'll provide a financial review, and I'll return and I'll discuss our outlook going forward. I'm very pleased to report that we accelerated the record-setting pace we established in the first quarter by generating even better results in Q2. This included new all-time record highs for sales, gross margin percentage, adjusted EBITDA and profit. On the market front, we continue to benefit from a very strong construction environment in the U.S. and Canada, which delivered robust demand and stronger product prices for our products. We were able to leverage HDI's unique strengths to make the most of these conditions. One of our strengths is our strong supply lines, both domestic and imported which enable us to respond to increasing product demand even under tight supply conditions. Not only were we able to keep our existing customers supplied, but we also attracted new business and grew market share during the quarter. We were also able to respond to growing demand without an equivalent increase in operating expenses. That was thanks to our highly efficient business model. Our price pass-through model helped us keep selling prices closely aligned with product costs in an inflationary environment, meaning the sales growth we achieved carried through to our bottom line. The end result was record sales of $338 million compared with 22.5% gross margin percentage to deliver outstanding profit results. Our second quarter adjusted EBITDA grew 149.5% to $44 million. Profit per share climbed significantly by over 225% to $24.3 million or $1.14 per share. Now keep in mind that in terms of year-over-year comparisons, last year's second quarter was weaker than normal due to the onset of the COVID-19 pandemic and its effect on the global economy. However, these second quarter results are still the best in HDI's history and outstanding in their own right. I want to thank our HDI team for helping us achieve this remarkable performance. And I'm pleased to say our results were just 1 of the highlights of a very busy quarter. Our other major achievement was the announcement of a significant and transformative transaction for HDI, the Novo Building Products acquisition. Novo is a respected large-scale distributor of architectural building products to the U.S. pro dealer and home center retail markets. The acquisition, which closed last week, brings us 14 new facilities and 1,400 employees serving 29 U.S. states and over 7,000 customer locations. Novo also brings an exceptionally good strategic fit. This transaction adds significant size and scale to our platform while meeting our objective of expanding market share and adding to our roster of architectural building products. It significantly increases the size of our current addressable market by giving us turnkey access to the pro dealer and home center retail segment with a high-performing business and well-established brands. Novo's operations are also highly complementary to our own with no significant customer overlap. Importantly, Novo strengthens our presence in the residential and repair and remodel end markets where we see a multiyear runway for growth. So Novo checks a lot of boxes on the business and operations side, and it's equally attractive from a financial standpoint. In terms of financial contribution, the business, on an annualized basis is expected to achieve revenues of USD 640 million, and EBITDA of over USD 55 million in 2021. Importantly, it's also expected to be over 30% accretive to earnings per share before synergies. I should add that the acquisition also makes efficient use of our capital structure. We were able to finance the $303 million transaction with senior secured debt at very attractive borrowing rates, while still maintaining a strong balance sheet post close.Overall, this is an important step in HDI's growth and future success, and it comes at an excellent time for us. Our base business is operating exceptionally well and generating record results, and we see a very positive multiyear outlook for our markets going forward. I'll come back to talk more about our outlook and how Novo fits into it in just a few minutes. But first, I'll call on Faiz to review the quarter's financial results for 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 second quarter of 2021, and then I'll provide some comments on our financial position and capital allocation plans subsequent to the Novo transaction. All figures are in U.S. dollars, unless otherwise stated. Starting with consolidated revenue, we generated very strong sales of $338 million in the second quarter. This was up 58.5% or $124.7 million from a year ago. Of this, organic sales accounted for $105.8 million or 49.6% of the sales growth, and acquired businesses accounted for $19.5 million or 9.1% of the sales growth. In our U.S. operations, sales increased by $100.5 million or 52.7% year-over-year. The majority of this was organic growth with an additional $19.5 million of sales growth from acquired businesses. In Canada, sales were up $26.3 million or 84.1% year-over-year, entirely on organic growth as we captured market share with our ability to source product in tight supply conditions. We also benefited from higher product prices and increased demand. Turning to gross profit. This climbed 82.3% to $75.9 million in the second quarter. The strong improvement reflects our record sales results paired with the best ever gross profit margin of 22.5%. This compares to 19.5% in Q2 last year and primarily reflects an increase in product selling prices without a corresponding increase in costs. Turning to operating expenses. These were $11.7 million higher year-over-year at $41.9 million. This primarily reflects the return to more normal operating conditions after last year's pandemic slowdown and the addition of the operations of acquired businesses. We also had some onetime transaction costs related to the Novo acquisition. I want to highlight that as a percentage of sales, operating expenses were lower in the second quarter at 12.4% as compared to 14.2% in the same period last year. This is a good indicator of our operating leverage and reflects our success in continuing to tightly manage expenses across our business. As Rob noted, we achieved exceptional growth on the bottom line with second quarter adjusted EBITDA climbing 149.5% year-over-year to $44 million. This was driven by the record sales performance and gross margin percentage in addition to the strong operating leverage at the expense line that I spoke about previously. Profit grew an even more substantial 229% year-over-year to a record $24.3 million for the quarter. While adjusted profit per share climbed to $1.28 from $0.37, an increase of 245.9%. These are all new records for HDI and it was a great quarter for our business. Looking now at our financial position and capital allocation priorities. We ended the second quarter in a very strong financial position with a responsible balance sheet and strong cash-generating capabilities and significant liquidity. We have since leveraged this financial strength to complete the Novo acquisition with senior secured debt at attractive borrowing rates. Post acquisition, our balance sheet remains in very good shape with pro forma leverage expected to be below 3x by the end of this year. We're making very efficient use of our capital structure, and going forward, we remain confident in our ability to support our business strategies and continue creating value for shareholders. On that note, our capital allocation priorities will include continued responsible management of the balance sheet, supporting the organic growth, executing on our acquisitions pipeline and returning value to shareholders in the form of dividends while remaining opportunistic as it relates to share repurchases. Now I'll turn the call back over to Rob.

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

Yes. Great. Thanks, Faiz. I'll close today with our market outlook and a few comments on our strategy going forward. On the residential construction side, housing permits and housing starts are the best we've seen in years, and all indicators suggest they'll remain strong. There's a real lack of housing supply in the U.S. caused by years of reduced building activity relative to population growth. Interest rates are also at low records and demographics are highly favorable with the largest population segment, millennials, now entering their home-buying years. The COVID-19 pandemic has further accelerated housing demand, with many households seeking more living space and moving to suburban markets to find it. At the same time, North Americans are spending more of their time and disposable income on fixing up their homes. This, combined with the aging of existing U.S. housing stock, is contributing to a robust multiyear outlook for the repair and renovation market. They are supported in this by rising home equity and availability of low-cost consumer capital. All of this sets the stage for continued strong demand from the residential construction and repair and remodel markets. And with Novo on board and orienting us more strongly towards these markets, we're better positioned than ever to benefit. The demand outlook for U.S. commercial markets is more mixed, which is not unusual for this large and diverse market. For us, commercial encompasses construction activity in health care, education infrastructure, public buildings, hospitality, office space, retail facilities and recreational vehicles. Some of these end markets are recovering faster than others. But as a whole, the commercial construction market is expected to grow in 2021. As always, the broad nature of our participation gives us access to many different parts of this market, which works to our benefit. With an overall strong growth environment forecast for the balance of 2021, there is the potential for supply constraints and further price inflation through this year. But as I noted earlier, we have an advantageous supply position, and we expect to have consistent and predictable access to the products we need. So our outlook remains very positive. And Novo acquisition has only improved our prospects. With this transaction, we have significantly increased our size and scale while diversifying our business from a supply chain, product category, geographic and customer segment perspective. And we've achieved this at a time when our markets are enjoying multiyear runways for growth. We're proud not only of this acquisition, but of our longer track record of successful growth. Novo represents our tenth acquisition in 5 years. In that time, we've more than tripled the size of our business from revenues of under $500 million to pro forma sales today of over $1.7 billion. As we move forward, we expect to continue capturing market share through both organic and acquisitions-based growth. We have a strong track record of completing successful acquisitions, and there remains significant opportunities in our fragmented industry. So the future looks very promising. We're confident in our ability to continue achieving growth on an accretive basis for our shareholders. With that, I thank you for your attention. I'll now turn the call back to the operator to provide instructions for the Q&A period. Ash?

[Operator]

[Operator Instructions] Your first question comes from Yuri Lynk with Canaccord Genuity.

[Yuri Lynk]

Congratulations on the nice quarter. I just want to make sure I've got a handle on the gross margin. So you've historically talked about an 18% to 19% range as typical. Clearly, we're well above that. Does the -- the performance in the quarter on gross margin, is that solely reflective of selling through inventory that you were able to pick up at a lower price into the higher price environment? Or is there an opportunity for you with higher prices to add more margin? I guess what I'm asking is, is this -- if prices were to level out here, would you eventually expect to get back into the more typical range?

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

Yes. So I'll take a run at that one. We're seeing -- I guess a few comments. We're seeing strength across really almost all of our product categories. So it's not specific to any one area. Some of this, as you're pointing out, is due to market conditions. There's been tight supply, strong demand. We've moved our prices up expeditiously in that environment. And with the price pass-through model we have, it's allowed us to keep prices moving and that's benefited the bottom line. So yes, this is a very strong margin performance at the moment. But we do attribute some of this to our platform. direct import program is now operating on all cylinders, and that brings benefits to the mix. We also have the majority of our locations now on 1 ERP system. We're getting better information real time. It's leading to better pricing and purchasing decisions. So in terms of sustainability, while we don't give forward guidance, I would say that we anticipate gross margin to be stronger than our historical 18% to 19% range going forward. In 2020, just to remind everyone, we averaged over 19% gross margin, and that was in a COVID year before we'd really seen a lot of product price inflation. We've really seen the product price inflation more of a 2021 phenomenon. And then the last comment would be as we bring in Novo, that's also going to impact the gross profit percentage line as well, and it will do so positively.

[Yuri Lynk]

So it's more than just the accounting pickup initially. It sounds like there's a lot more positives explaining the margin performance.

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

Yes. And I don't want to leave you with the impression that the market hasn't helped. Of course, it has. But I also want to give you the impression that we think there's some sustainability in some of the lift that we've seen.

[Yuri Lynk]

Okay. Just want to turn to the M&A market. I'm wondering if now that you're with Novo, you're in with different customer segments, pro centers and dealers, which you have no exposure to before. Has that changed the universe of targets that you look at? I mean, we used to talk about kind of a dozen acquisition targets that were of a large size, over $100 million. Is that still the case today? Are you still kind of looking at the same group of companies? Or has that expanded now along with the size and scale of your business?

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

No, it's definitely expanded. And I think we're very pleased it's expanded without us going out of our lane. The products that are coming with Novo are entirely familiar to us. What Novo is bringing is an expanded addressable market, as you said, into the home center and pro dealer channel, which we really didn't participate in before. And it's as attractive, from a size perspective, as the kind of fabrication industrial customer channel we've been most focused on. So with a bigger addressable market that Novo has brought us, it also brings us a bigger addressable pipeline of potential acquisitions. And yes, there are some scale opportunities within that pipeline. So it's helpful in that way.

[Operator]

Your next question comes from Hamir Patel with CIBC.

[Hamir Patel]

Congrats on the strong quarter. Rob, how much of the 50% organic growth was pricing versus volumes? And then on the pricing side, can you maybe give us a sense as to how that broke down by some of the key categories?

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

Yes. So we don't put out specific price versus volume detail. And frankly, Hamir, as we've talked about in the past, it's tough to capture across all of our product categories because we sell with a number of different volume measurements. But what I would say is that when you look at that growth percentage that you described, and there's a piece that's organic and a piece that's acquisition, the majority is organic. It's not all product price appreciation. We certainly can look at the customers that we've been selling and understand where we've had new customer acquisition, accounts that we weren't selling previously, and we can look at existing accounts and understand when we're selling new product categories to them that we perhaps didn't have before, so capturing more wallet share. So it's difficult to put a specific pin on how much is price versus volume, but I can tell you that we're not just riding stronger product prices here. We're also gaining market share. The price inflation that we've seen has been fairly consistent across all product categories with the exception, perhaps of doors. We saw more product price inflation last year in doors. But if you look at hardwood lumber, that's up -- hardwood plywood, that's up on both a domestic and an imported basis. And embedded in these prices is inclusive of higher freight costs today to get the product from manufacturers to our door, and then from our door to customers as well.

[Hamir Patel]

Okay. That's helpful. And then for the $55 million of annual EBITDA that Novo is expected to generate in 2021, how much of that would show up in your results this year based on when the deal closed?

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

Hamir, it's Faiz here. So in terms of if I would talk about Novo's kind of profiling compared to ours around seasonality. And as you know, we have some seasonality. It's not huge, but the Q2 and the Q3 tend to be a little stronger than the Q1 and the Q4. But a couple of points in terms of bottom line, if you're looking at the trends. And so I would say that Novo's business is similar in that fashion. So if you took that $55 million number that we've disclosed and if you just straight line it, you'd say, well, there's going to be 5 months of results in the HDI's numbers, but then you may just want to account for a little bit of that seasonality in the Q4 being the slowest quarter of the 4 quarters. So you could approach it that way. So not quite 5 12, maybe a little less, but not much less is the way to think about that.

[Operator]

Your next question comes from Zachary Evershed with National Bank.

[Zachary Evershed, Analyst]

Congrats on a great quarter. So thus far, in July and August, can you tell us a bit about the pricing trending versus Q2, given that we saw prices coming up throughout Q2 there?

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

Yes. So pricing momentum, first half of the year most categories saw price increases, and a combination of tight supply and then strong demand was driving that momentum. We don't anticipate these market factors to really abate much at all in Q3. And it creates some opportunity for us as HDI because we generally have products. So size and scale make us important, and -- if not the most important -- very important customer for our vendors. We've got the balance sheet to take inventory positions that others can't, and we're sourcing product through our global supply chain. So I think we're well positioned in terms of product supply. We're not seeing prices really soften at this point. So no deceleration. I wouldn't describe it as prices continue to accelerate. I would say that they're holding quite well.

[Zachary Evershed, Analyst]

That's great. And then given that it was still climbing in Q2, and we're seeing no deceleration now, do you think it's fair to assume that thus far in Q3, you're running above the 22.5% gross margin range?

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

Well, we -- as you know, don't give forward guidance in that way. I mean, my comment would be that the prices are continuing to look very good through Q3. Q3, you've got fourth of July and you've got people go and they take some holidays, but it tends to still be a very strong quarter for us from a seasonal perspective. And as I say, the product pricing environment still looks real good at this point.

[Zachary Evershed, Analyst]

Fair enough. And then with the balance sheet up to about 3x, how do you balance opportunistic tuck-ins against your leverage comfort zone?

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

Zach, Faiz here. I can take that. So yes, just to make sure we're all, I guess, playing with the same numbers, effective at the close, we think we'll be slightly above it 3x on a pro forma basis in terms of leverage. But that comes down very quickly. By the end of the year, comfortably below 3x on the pro forma leverage ratio. To your question around the tuck-ins. And it's a good question because I wouldn't say that we've paused the work that we do on the M&A front, all that good work we do around the pipeline and qualifying targets and adding into our pipeline and then working those. That's also happening. I mean we've got dedicated resources doing that. And so that work is ongoing, and that's going to present opportunities going forward. The tuck-in, there's lots of them, as we've talked about before. And I don't think we're constricted from doing those. I mean, if you look at our balance sheet, even at 3x, and as I mentioned, that comes down very quickly. But in the back half of this year, if you were to do a small tuck-in, if that was to present itself and be an opportunity for us. It just doesn't really move the needle on leverage given the size of the business anymore. Those tuck-ins, as you know, we can spend $10 million, $15 million, $20 million on a purchase price. So in terms of leverage, it just doesn't move the needle very much on the base business given the size and the cash flows we're going to generate over the couple of quarters here. So we're still actively working the pipeline. And if an opportunity presents itself, I think we're ready to act. I don't see our balance sheet being a restraint there.

[Operator]

[Operator Instructions] It appears we don't have any more questions. Mr. Brown, you may proceed.

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

Okay. That's great. I want to thank everyone for joining us, appreciate your interest as always, and please contact Faiz or myself if you've got some follow-up thoughts or questions, and happy to talk to you. Thanks very much.

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

Thank you.

[Operator]

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