Hardwoods Distribution Inc

TSX:HDI

Earnings Call Transcript 2019-Q3

[Operator]

Good morning. My name is Joanna, and I will be your conference operator today. At this time, I would like to welcome everyone to the HDI Third Quarter 2019 Results. [Operator Instructions] Thank you. Mr. Rob Brown, you may begin your conference.

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

Thanks, Joanna. Good morning and welcome everyone. Thanks for joining us. I'm going to start this morning with a brief overview of some highlights from our third quarter and first 9 months. Faiz Karmally, our CFO, will follow that with a more detailed financial review. Then I'll return to discuss our outlook going forward. The third quarter was a very positive one for HDI as we strengthened our bottom line results, generated strong cash flow, increased our dividend and in October, completed an accretive acquisition. In terms of financial performance, we achieved our best gross profit margin in 2 years which in turn supported a 5% increase in EBITDA and an 11.2% increase in profit. Our third quarter gross profit margin, which increased to 18.2% from 17.8% last year was achieved as we gained traction with our revitalized import program. As you know, our import program has historically been both a competitive advantage and a profit builder for HDI. It's based on providing customers with high-quality, proprietary import product solutions that complement our domestic program. Over the past 2 years, we've been working to diversify our supply lines and source countries, so that we can continue to benefit from the advantages this program provides and our efforts are paying off. Our third quarter results were achieved despite continued headwinds in the domestic hardwood lumber segment, which impacted sales in that particular product category. Generally, though, sales in most of our other product segments were up year-over-year, underscoring the benefits of our well-diversified product program. I'm pleased to report that our stronger performance together with management of working capital and a reduction in our inventory to normal levels translated into very strong cash flow results again this quarter. Third quarter cash flow from operations was up $21.6 million year-over-year. And for the first 9 months, cash flow increased by $65.9 million. Our strong cash generation is supporting our ability to provide value for shareholders in a number of ways. First, it's supporting dividends including the 6% increase we announced earlier today. This increase brings our quarterly dividend to $0.085 per share or our annual dividend yield of over 2.5%. Our strong cash flow is also supporting share buybacks including the $3.2 million worth of shares we've repurchased in the first 9 months of 2019, and it's underpinning our strategy of pursuing growth through acquisitions. On that note, we closed our second acquisition of the year on October 28, with our purchase of Pacific Mutual Door Company. This is a highly profitable U.S.-based wholesale distributor of interior and exterior doors, custom millwork and ancillary products. We paid USD 34.5 million for the business subject to final working capital adjustments and it brings us 5 new operations, including a significant presence in the fast-growing Nashville, Tennessee metropolitan market. It also provides a complementary product, supplier and customer mix and annual sales of approximately USD 58 million. I should note that the acquisition is immediately accretive for shareholders. Overall, there is a very positive third quarter. We're pleased with the direction of the business, our success in executing our strategies and our continued track record of generating shareholder returns. We're also encouraged by the increasingly positive market outlook for U.S. construction. I'll come back to talk about that more in just a few minutes, 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 third quarter and the first 9 months of 2019. Then I'll provide some comments on our financial position and capital allocation plans. Starting with the third quarter consolidated revenue, our sales increased to $292.5 million from $290.4 million in the same period last year. That's a gain of $2.1 million and it breaks down as follows: Acquisitions provided $4.1 million of the sales growth accounting for a 1.4% increase in total sales. We also realized the translation gain of $2.6 million related to the positive foreign exchange impact of the stronger U.S. dollar. These were partially offset by a $4.6 million or 1.6% decrease in organic sales. This primarily related to the lower hardwood lumber sales resulting from excess industry supply and a shift in the market to lower value species. Looking at sales by geography, in the U.S., our sales were USD 194.8 million comparable to the USD 195.4 million in Q3 2018. Acquired businesses contributed sales growth of USD 3.1 million, and this was offset by a USD 3.7 million reduction in organic sales. As it relates to Canada, sales were relatively flat, increasing by $0.2 million as compared to Q3 of 2018. Gross profit grew by 3.3% in the third quarter to $53.3 million. That's a year-over-year improvement of $1.7 million, and it was driven primarily by the higher gross profit margin percentage of 18.2%Operating expenses increased $0.8 million year-over-year to $39.2 million. This reflects added expenses related to acquired businesses and the impact of the stronger U.S. dollar on translation of U.S. operating expenses. As a percentage of revenue, expenses were 13.4% compared to 13.2% in Q3 of 2018. Looking at our bottom line performance, we increased EBITDA to $20.7 million, up about 5% from the year ago. This primarily reflects higher gross profit, partially offset by higher operating expenses. We also increased profit by 11.2% to $8.9 million or diluted profit per share of $0.41. That was up from $8 million or $0.37 per share in the same period last year. Turning now to results for the first 9 months, year-to-date sales increased by 2.9% to $884.1 million, a year-over-year improvement of $24.8 million. Acquisitions accounted for $19.4 million or 2.3% of this increase, while foreign exchange translation had a positive $23.8 million impact. These gains were partially offset by an $18.4 million or 2.1% decrease in organic sales. In the U.S., sales were up by USD 2.2 million or 0.4% year-over-year. Acquired businesses contributed sales of USD 14.6 million, which was partially offset by USD 12.4 million reduction in organic sales. And in Canada, sales were lower by $2.4 million or 2.2%. The change in organic sales for the first 9 months ended September 30, 2019 is primarily due to the same impact as I discussed in my commentary on sales for the 3-month period and softer operating conditions in the first half of the year as U.S. construction markets were affected by the late start to the construction season and mixed economic data. 9-month gross profit increased by 3.7% to $159.3 million as a result of higher sales and a gross profit margin of 18% as compared to 17.9% in the same period of last year. Operating expenses increased by $8.7 million in the year-to-date period, reflecting the translation impact of a stronger U.S. dollar on U.S. operating expenses, the addition of acquired businesses, as well as added costs to support our growth strategies. EBITDA of $58 million was down $1.6 million year-over-year. This primarily reflects higher operating expenses, partially offset by the increase in gross profit, and we generated 9-month profit of $23 million and diluted profit per share of $1.06 as compared to $25.9 million and $1.20 per share in the same period last year. Looking now at our financial performance and capital allocation priorities. We maintain a strong balance sheet, and as of September 30, 2019, our net bank debt-to-adjusted EBITDA after rents ratio was 1.6x, and our net bank debt-to-capital ratio was just 23%. I'm also pleased to report that concurrent with the close of Pacific Mutual Door Company on October 28, we amended our U.S. credit facility to increase the revolving credit line to USD 150 million, extend the term for 5 years and lower the applicable borrowing rates. Going forward, this facility will allow us to continue executing on our capital allocation priorities, including supporting future growth and ensuring continued management of our 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]

Okay. Thanks, Faiz. I'll close today with a few comments on our outlook and our strategies going forward. HDI is well positioned for success as the only North American-wide distributor in our industry. We benefit from a comprehensive suite of products, including proprietary offerings from our global supply chain that provides us with a significant competitive advantage. Our business is also diversified, which provides an important offset to softness in any one product category or end market. We benefit from a North American-wide geographic footprint. A large base of suppliers and customers with no significant concentration in either, a wide array of architectural building products and participate in multiple end markets including residential, commercial, repair and remodel and other construction sectors. As it relates to the residential end market, as we look forward, we're encouraged by the outlook for U.S. construction demand. 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 favorable demographic characteristics of U.S. consumers offers good support for housing demand over the longer term. In the near term, numerous indicators are suggesting the residential construction activity to gain momentum as early as 2020. Recent data related to U.S. housing starts and building permits have been positive. And recent reports by a number of major U.S. homebuilders suggest improving construction activity in 2020. As a reminder, HDI's products are used in the finishing stages of construction. We would expect to benefit from increases in construction starts approximately 6 to 9 months later. In the interim, we'll remain focused on capitalizing on market opportunities and continuing our track record of performance. We've made good progress with our import program. We expect to keep building on results as our newer product offerings gain further traction. We're also building market share in the decorative surfaces and composite segments, which represent emerging high-growth markets for us. Internally, we are optimizing our platform, leveraging our size and strength to enhance our competitive advantages. And externally, we continue to pursue accretive acquisition opportunities in what is a fragmented North American industry. We've now completed 9 acquisitions in the past 8 years, added 47 locations and over $600 million in annual sales. Given the highly fragmented nature of our industry, our success in identifying and closing on acquisitions and our balance sheet strength, we expect to continue growing in this way. As always, we will manage HDI for the long-term as we move forward, our focus will remain on management of the balance sheet so that we can execute on our acquisitions pipeline, while also continuing to return value to shareholders in the form of dividends and share repurchases. With that, I want to thank everybody for their attention. I'll now turn the call back to the operator to provide instructions for the Q&A period. Joanna?

[Operator]

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

[Yuri Lynk]

Good job on the margins. I guess, when I'm looking at my model, I mean, I've got your most recent kind of target range was 17% to 18%. There's no mention of that in this MD&A. And then prior to that, prior to the trade case...

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

Hey, Yuri.

[Yuri Lynk]

Hello? Yes.

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

You're kind of breaking up on us. Yes. Sorry, you're just kind of breaking up on us a little bit. Maybe you should start that with over?

[Yuri Lynk]

Yes. So just looking for some color on gross margin range. It used to be 18%, 19% before the trade case, 17% to 18% more recently. So just, is -- are the improvements you made sustainable? How should we think about gross margin into 2020.

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

So hopefully, you can hear me. You were kind of in and out on our end. Unfortunately, I do know you're asking about the margin and maybe a little bit of more color there. So I'm going to take a bit of a flyer on a response and let you follow up if I don't hit the mark and hopefully, we can hear you a little bit better. So yes, we were pleased with the improving trend in the gross profit margin, that's obviously come back up into what has traditionally been more normal territory for us, in the 18% to 19% range, it's really reflective of in the first half, while we had largely rebuilt our supply line from an import perspective, we were still working through some excess inventory, which was holding our inventory back. That problem has now largely been dealt with, and we're now moving forward with our new supply line. In terms of the margin moving forward. The other comment I might just make is that with the acquisition of PMD, that's going to have some impact as well as it's a slightly higher-margin business. Operator, are you with us?

[Operator]

Your next question is from Nick Corcoran from Acumen.

[Nick Corcoran, Equity Research Analyst]

I just wanted to get a little bit more color on the top line growth. I think in Q2, you said there's a delay to start to construction season and mixed economic conditions. I'm just wondering what you saw in Q3 and what you're expecting going forward?

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

Sure. And I heard all that. So thanks, Nick. Yes, the first half of the year, the delayed start to the construction season is really a reference to the fact that there was weather-related implications in the first half. We've said we don't typically talk weather, but we simply saw our customers closed for a number of sales days in the first half, and that was a drag on our first half sales. We also had kind of more mixed conditions entering into the year, when it was unclear how the economic environment was going to unfold coming into 2019. You'll remember, there was discussion of perhaps a couple of interest rate increases. And in fact, we've ended up seeing the opposite now going the other direction. So as we've tipped over into the second half and Q3, specifically, as we say, those weather-related concerns have gone away. We're now back to what we would consider more normal operating conditions as it relates to demand. And you saw that we actually were off a little bit in terms of organic growth. That's primarily related to the one product category that I mentioned in my comments, Nick, around hardwood lumber. If you were to exclude that, we were actually finding some organic growth net-net on the rest of our product categories. So it's not a huge, high-growth environment that we saw in Q3, but setting aside the hardwood lumber perspective, we did find some organic growth there.

[Nick Corcoran, Equity Research Analyst]

And then can you maybe just frame that in the context of your historical comments about lower to -- low single-digit growth in the U.S. and nominal growth in cabinet. Have you seen any changes that way.

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

I would say it's fair to say that from an overall economy perspective, we're in a little bit of a lower growth period, whether you look around the world at the major economies and see what's going on with GDP. Where we're maybe focused on a little bit more is double-clicking on to the industries we participate in, and we actually see some good upside there, particularly around res in the U.S., mortgage rates are off another 100 basis points from where they were a year ago. There is significant pent-up demand for folks that are looking particularly for the homebuilders to build an entry-level product. And there's not a lot of inventory in the market. So we actually feel good about the underlying demand, it could unfold in 2020 related to residential housing, in particular, the planning assumption that we've talked about of low -- lower single-digit growth being what the market will do. I don't think we're coming off that in any kind of meaningful way.

[Nick Corcoran, Equity Research Analyst]

That's great color. And then the last question for me. You closed the acquisition of Pacific Mutual about 2 weeks ago. Can you just speak to how the integration is going and maybe the positive takeaways from that acquisition now that you're actually inside business?

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

Sure. So once you get the keys, yes, you always get a different look from the integration perspective, it's going very smoothly. We're quite well practiced in terms of onboarding employees positively into joining the HDI team here. So that tends to go fairly seamlessly. The company we bought was on the same computer system. So that always makes for a nice changeover as well. It's a period of change for employees. If you do not have to layer on systems change at the same time, that's very beneficial. The -- we had a good look at the folks before the closing ended in terms of who's coming across from a management perspective, and it's a very strong team. So we already felt comfortable with that, but it's really been validated by our first couple of weeks into the business. So overall, yes, I'd say we're very positive above the acquisition. The -- some of the benefits, I think you asked about, it's a very profitable segment for us, the door distribution segment takes it from about 10% to about 15% of our overall mix. So we like that, geographically, entry into door and miller distribution in the Midwest, complements what we're doing in doors in the west already today, and we weren't previously in the national market, which is a very attractive growing metro. So we like that. Customers, no significant overlap, suppliers, very good strategic fit with what we were already doing. So overall, we think it's going to be a good one.

[Operator]

The next question is from Maggie MacDougall from Cormark.

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

I was wondering if you could just comment a bit on the market conditions generally in the U.S. in terms of supply and demand for hardwood lumber? I know that prices are lower, and you broke that out in terms of the impact on your quarter, but wondering if you've seen any response from sawmills? Or if there's been any demand response from other markets internationally? Or anything going on that maybe we may not be aware about -- aware of, but is worth noting.

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

Okay. Yes, sure. Happy to talk a little bit more about that category, and that's roughly 25% of sales. So we're not talking about the other 75% of what we sell. But within the supply-demand dynamics, the reason that pricing is down in that category, a couple of things going on. The biggest one being that a significant portion of that product has historically been exported and exported heavily to China with the tariffs back and forth between the Trump administration and the administration in China. There's now an import tariff in China that's placed on Hardwood exports from the United States to China. So that's a 25% tariff, and it's really resulted in a lot of wood that would typically have gone to Asia is now left in North America and supply-demand being what it is, the oversupply here has caused pricing to fall. The -- in terms of response in the industry, it's still maybe a little bit early days, but we have seen some mills shut down. So some capacity has come off the market. And the nose that remain running are often doing so at reduced shift capacity, again, to take some of the volume off of the market. I would -- I think it's worth noting, so I'm not sure if I said it in my prepared comments that the hardwood lumber pricing is off about 20% year-over-year. Our sales, while they're off, they're not off that much. So it's been little bit painful having price deflation in hardwood lumber, but we've managed to maintain our share and volumes and perhaps, kicked up some as well.

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

Okay. That's very helpful. I was also hoping you could give an update on your M&A pipeline and thinking with regards to end market product exposure? And then whether or not there may be any vertical integration opportunities for you?

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

Sure. So the pipeline is active and strong. There's, at this point in the cycle, if I could describe it that way, there seems to be good interest in potential sellers having conversations about moving on with their business. We've fully staffed this function. I think, as you know, and have a full-time Senior VP engaged on it. Very experienced guy, the ex-President of Rugby has remained with the business since we bought Rugby in 2016. So we've got the resources, both from a capital perspective and a human capital perspective. There's very active discussions going on. The end market products because of the diversification in our industry -- pardon me, in our product base now, we're really participating in all of 8 what I would call the main architectural building product categories, and we've got opportunities that we can pursue within any number of them. And you just saw that with the Pacific Mutual Door acquisition. There's a great opportunity to go a little deeper in the door distribution segment, and we did that. So that's really how we're thinking of it. It's largely a strategy I would describe as there's lots to do within architectural building product distribution. Vertical integration is not a particular focus. If you're thinking of that in terms of going forward into the customary base or backwards into the vendor base. But I would say within our distribution basket, we tend to choose to do more value added. So I don't quite call that vertical integration, but the ability to add value through some light manufacturing within distribution is open to us.

[Operator]

The next question is from Zachary Evershed from National Bank.

[Zachary Evershed, Analyst]

Congrats on the quarter. So most of my questions have already been answered, so I'll look a little bit longer term. From where you're sitting today in the markets as they are, how are you feeling about the achievability of your long-term targets.

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

Yes. So I think by the achievability of the long-term targets, you're kind of talking about the $1.5 billion sales number being attainable over -- out through 2022, 2023, which is what we've described. And the constituent parts of that are really -- the market's going to grow organically. We want to take some share growth, and we will have some acquisitions growth that complements that. So I would say we're feeling very good about that, Zach. From a market growth perspective, the -- well, we've seen a little bit of a weaker demand environment, setting aside the hardware lumber category, we're actually getting good traction in our other product segments. And from a share perspective, the things that we are focused on with respect to the decorative surfaces category. Again, those are growing faster than the rest of our category. So I feel quite good we're tracking with our kind of underlying assumptions there. On the acquisitions piece, which has been to add another $175 million, $200 million of acquired sales, over the period, we're pacing it ahead of that. And as I described in my response to Maggie, we're feeling quite good about the pipeline.

[Zachary Evershed, Analyst]

That's great color. And just one more small follow-up on the hardwood aspect, there's the drop in price about 20% year-over-year that you guys haven't felt fully, but then there's also a shift in market preference to lower-valued species. Do you view that as a structural change or a temporary shift.

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

Yes, I wish I had a crystal ball to give you a precise answer. But I mean today's end consumer very much likes a kind of clean often white, almond gray kitchen kind of finishing perspective, which you don't need to buy a higher value species such as the Cherry Lumber, which you would typically stay in, you can buy a lower value species and paint to achieve the same or to achieve the look that you're after. So it's a shift. I don't know if and when it shifts back -- excuse me, Zach, but it has been a piece of the pie in terms of hardwood lumber sales being lower just because those lower value species, obviously, go out the door at a lesser value.

[Operator]

The next question is from Hamir Patel from CIBC Capital Markets.

[Hamir Patel]

Rob, could you give us an indication of what percentage of the plywood category sales, the imports comprised in the quarter? What percent do you want to grow that to? And then how long do you think it takes to get there?

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

Yes. So we don't have a number out there for you, Hamir, as it relates to breaking down that specific category, unfortunately. So what I can say is that imports today comprises in terms of our overall sales, roughly 25% of our sales. So we actually feel quite good about the level that we've -- that we're operating at today relative to free trade case, if I can put it that way.

[Operator]

Thank you. There are no further questions at this time. You may proceed.

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

Okay. Thanks, Joanna, and thanks, everyone, for joining the call today. If you've got follow-up questions, please do reach out directly to Faiz and myself, we'll be happy to answer your questions.

[Operator]

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