Hardwoods Distribution Inc

TSX:HDI

Earnings Call Transcript 2017-Q4

[Operator]

Good morning. My name is Sharon, and I will be your conference operator today. At this time, I would like to welcome everyone to the Hardwoods Distribution Inc. Q4 and Year End Results Conference Call. [Operator Instructions] Mr. Rob Brown, President and CEO, you may begin your conference.

[Robert J. Brown, Chief Executive Officer, President and Director]

Thanks, Sharon, and good morning, and welcome, everyone. Thanks for joining us. I'm going to start this morning with some comments on our 2017 year, and Faiz Karmally, our Chief Financial Officer, will follow with a review of our fourth quarter and full year financial performance. Then I'll return to discuss our strategy and outlook going forward. I'm very pleased to report that we achieved record results in 2017. Our revenues exceeded the $1 billion mark for the first time in our history. We also achieved record bottom line results with adjusted EBITDA climbing 22% year-over-year to $56.3 million, adjusted profit 23% to $31.2 million and adjusted profit per share increasing $0.11 or almost 8% to $1.46. Our results enabled us to distribute a total of $5.6 million in dividends to our shareholders which, combined with share price appreciation, provided a total 2017 return to shareholders of 14.6%. I want to note that we achieved this strong performance even while responding to the market disruption caused by the U.S. trade case against hardwood plywood imported from China. You may recall that approximately 11% of our sales prior to the trade case were affected. We navigated through this trade action throughout 2017, although feeling some impact from this in the latter part of the year as we dealt with purchasing and market-driven dynamics. I'll elaborate on this a little bit further. As it relates to purchasing dynamics, the preliminary antidumping duty of 57% was announced at the end of the second quarter, and there was a risk that this duty could have been applied to purchases made prior to the announcement date. To ensure the company did not have retroactive exposure to the antidumping duty, we purchased more hardwood plywood from wood brokers rather than buying directly from the mills in China. The introduction of the broker into our buying channel raised our product cost. However, it also eliminated our potential exposure to retroactive antidumping duties. In December, final combined duties of 206% were announced. In the fourth quarter, we continued selling hardwood plywood that had been sourced through third-party brokers instead of buying directly from Chinese mills, as we typically would. So in the second half of the year, certain of our import products carried a higher cost base than normal, which reduced our margins on this product category. As it relates to market dynamics in the second half of the year, the imposition of a preliminary 57% antidumping duty at the end of the second quarter, and combined with 206% duty in the fourth quarter, made buying Chinese product going forward largely uncompetitive in North America. Our expectation was that product prices in the second half of the year for hardwood plywood in North America would rise, as a result, which would help recover the additional sourcing costs. However, the anticipated price appreciation did not emerge, because there proved to be a substantial supply of Chinese hardwood plywood in North America that arrived prior to the preliminary and final duties being imposed. So in the second half of the year, with had impacts for this particular product category on both the buying and selling side. We estimate this lowered our gross profit by $2.2 million in fiscal 2017. The good news is that through this process we kept the business, we retained and we grew sales with our customers, despite sourcing shifts arising from rule changes on imports throughout the year. Looking forward, we expect some downward pressure on gross margin percentage through mid-2018 due to the outcome of the trade case. Potentially countering this impact, however, is our expectation now that our sales will benefit from rising hardwood plywood prices in North America. Supply availability in this category is tightening, increasing product values, which will, in turn, be passed on to our customers in the form of higher prices. With respect to acquisitions, 2017 was a successful year. The accretive Rugby acquisition that we completed in mid-2016, which effectively doubled our size in the U.S., is now fully on board after a very smooth integration. I'm pleased to report that we also completed 2 additional transactions in 2017, acting on the pipeline of acquisition opportunities that Rugby brought us. From a high-level perspective, our results also reflect the culmination of a business strategy that we began pursuing 7 years ago. That was when we set out to capture the growth that followed the extended downturn in residential and commercial construction markets. Back then, our revenues were approximately $200 million, we had 26 locations and approximately 2,100 customers. Fast forward to today, we're now North America's largest distributor in our industry. We have 63 locations, the majority of which are in the U.S., and a team of more than 1,100 employees serving over 35,000 customers. We've achieved a compound annual sales growth rate of 25% over 7 years, we've grown EBITDA to $55.6 million in 2017 from $4.6 million coming out of the downturn in 2010. As we move forward, with our increased capabilities, we now have the opportunity to create a world-class distribution company. I'm excited to talk more about this with you, but first I'll ask Faiz to review our Q4 and 2017 financial results in some more detail. Faiz?

[Faiz H. Karmally, Chief Financial Officer and Vice President]

Thank you, Rob, and good morning, everybody. I'm going to provide a general overview of our results for the fourth quarter and full year, and then I'll provide some comments on our financial position. Starting with revenue. Fourth quarter sales increased to $247.4 million, that's a gain of $8 million or 3.3% compared to last year, and it breaks down as follows: the addition of Eagle Plywood and Lumber and Downes & Reader Hardwood Company, both acquired in 2017, accounted for $7.7 million of the year-over-year increase in revenue. We also achieved organic growth of $10.6 million or 4.4%. These gains were partially offset by the $10.3 million negative foreign exchange impact of a stronger Canadian dollar. In our U.S. operations, fourth quarter sales were up by USD 14 million or 9% with organic growth in the U.S. accounting for $7.9 million of the year-over-year increase in sales or 5.1%. Acquired businesses contributed USD 6.1 million to the organic -- to the growth. In our Canadian operations, sales were relatively flat at $31.8 million compared to $31.7 million in Q4 last year. On a consolidated basis, fourth quarter gross profit grew by 2.3% to $44.5 million. This increase reflects the higher sales, partially offset by a slight decrease in gross profit, primarily related to the trade case that Rob discussed. As a percentage of sales, our gross profit margin was 18% compared to 18.2% last year. Without the impact of the trade case, we estimate that our gross profit margin would have been 18.5% in the fourth quarter. Operating expenses were up a modest $0.3 million year-over-year, primarily related to the addition of expenses from the acquired businesses and an increase in cost to support organic growth, partially offset by a decrease in expenses due to the impact of the stronger Canadian dollar on translation of U.S. operating expenses and a decrease in amortization. We generated fourth quarter adjusted EBITDA of $10.7 million, which was slightly lower than the $10.9 million we achieved in Q4 last year. Adjusted EBITDA in the fourth quarter was reduced by an estimated $1.2 million, related to the trade case. And we reported adjusted profit of $5.7 million as compared to $6.6 million in Q4 2016. Fourth quarter adjusted profit was reduced by an estimated $0.7 million related to the trade case. Turning now to our full year results, where the 12 months ended December 31, 2017, our sales climbed to 31.4% to over $1 billion. This represents an increase of $247.7 million from 2016. Of this increase, $224.1 million was driven by acquisitions. This included the positive impact of Rugby, which we acquired in mid-2016 as well as Eagle Plywood and Lumber and Downes & Reader Hardwood Company. Another $37.1 million was driven by organic growth, representing an organic growth rate of 4.7%. These gains were partially offset by a $13.5 million negative foreign exchange impact of the stronger Canadian dollar. Sales in the U.S. were up USD 195.6 million or about 39.3% year-over-year. Acquired businesses contributed USD 172.6 million, and organic growth accounted for USD 23.1 million or an organic growth rate of 4.6%. In Canada, sales grew by $6.1 million or 4.7% compared to 2016. Gross profit increased by 33.5% year-over-year to $191.9 million as a result of the higher sales together with a higher gross profit margin. At 18.5%, our profit margins compared favorably with 18.2% in 2016. This reflects higher gross margin from the Rugby operation, partially offset by the trade case impacts on gross margins. Operating expenses for the year increased by $37.9 million, mostly due to the addition of the acquired businesses. And adjusted EBITDA grew by 22% to $56.3 million. This reflects the higher gross profits, partially offset by higher operating expenses. And finally, adjusted profit for 2017 increased by 23% to $31.2 million. This improvement was driven by a higher adjusted EBITDA, partially offset by increases in income tax expense, net finance costs and depreciation and amortization. Turning now to our financial position. We continued to strengthen our balance sheet through the year. As at December 31, 2017, our net debt-to-EBITDA ratio had improved to 1.6x from 2.1x a year ago. And our debt-to-capital ratio decreased to 27.6% from 30.1%. We also had $66.7 million of unused debt capacity available. Going forward, we're well-positioned to pursue our strategies, fund growth and support our dividend. Now I'll turn the call back to Rob

[Robert J. Brown, Chief Executive Officer, President and Director]

Okay. Thanks, Faiz, for that. As we move into 2018, our company has now achieved the size and scale that brings significant benefit to our customers and supply partners. We have 3 of the industry's best-known and most respected distribution brands, we have greater depth in our senior management team and we're attracting the industry's best people across our operations. We've become the leading choice of suppliers looking for a sophisticated North American-wide distribution engine. And as Faiz noted, we have a strong balance sheet to support our future growth. Having arrived at this exciting place in our history, the next question is, how do we leverage these strengths for reaching even greater success? A common solution for growth-oriented companies is to bring acquired businesses together under a single name and identity. They seek scale, but at HDI, we recognize that customers identify strongly with our existing distribution brands, each of which has distinct qualities. And as a selling organization, we've benefited greatly from our entrepreneurial, customer-centered approach to the business. We're more agile and successful when we keep decision-making close to the customer. Accordingly, we will move forward with the business structure that retains our existing distribution brands, but supports them with the collective strength and growing capabilities of HDI. To realize this vision, we'll continue to place our 3 distribution brands at the top of our organizational chart with HDI underpinning their success. We want our brands to continue to be the face to our customers and to retain significant autonomy in executing their business plans. But they will be able to draw on the size and strength of HDI to access marketing support, sophisticated information technology solutions, professional human resource management, highly developed global import capability, vendor management and other capabilities. So what do we see going forward? On the market front, we expected the unevenness, and recent moderate growth seen in the U.S. housing market will continue into 2018. We believe this market will make its way back to historical levels of about 1.5 million annual housing starts, but it's going to take some time. And in the commercial market, forecasters are predicting 4% growth in 2018. Put that together, and we're anticipating lower- to mid-single digit organic market growth for our end markets and products in 2018. We'll seek to outperform that organic market growth expectation by executing on our own strategic initiatives and to capture additional growth by completing further acquisitions. As for the trade case, in 2017, we demonstrated, we could meet customer needs despite the significant disruptions and suffered no significant loss of customers or market share. Going forward, we'll work closely with our vendors to establish supply channels for any products affected. We expect our 2018 profitability will also benefit from the lowering of the U.S. corporate tax rate to 21% from 35% previously. To put this in perspective, we had -- or had a 21% tax rate being in effect in 2017 our adjusted diluted EPS would've been $0.13 or 9% higher. We're excited by our prospects going forward and deeply proud of the evolution of HDI so far. We're not just getting bigger, we're focused on quality, integrity and professionalism as we create long-term value for all our stakeholders. Our outlook remains positive, the business is in very good shape heading into 2018. With that, I want to thank you for your attention. And I'll turn the call back to you, Sharon, to provide instructions for the Q&A period.

[Operator]

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

[Yuri Lynk]

I just want to make sure I understand the impact in the first half of '18 that you're anticipating regarding the trade case. If you're not using brokers anymore, and you've already started to see prices pick up, what's going to cause gross margin to be under pressure? Is that the inventory that you've got on hand that has to still work its way through?

[Robert J. Brown, Chief Executive Officer, President and Director]

There's some of that, but I think I'd just like to correct when you say we're not using brokers anymore. There's been an uptick in the mix towards more domestic product, Yuri, which from a margin perspective, is less advantageous to us. So I said, we've kept our customers and product, which was our primary objective heading into keep all of our customer business. We've been successful with that. But the mix of products that we're selling now is more heavy to domestic solutions, which does have some margin compression to compare to what we were sourcing in the past. In terms of the first half, I would say that we had expected price appreciation in this product category to happen more quickly than it has. We're starting to see that emerge more now with tightening of supply. And that will help offset or counteract a lower margin by simply selling more dollars on the top line.

[Yuri Lynk]

Okay, got it. That makes sense. Given your -- the margins should be a bit compressed in the first half. Overall, should we expect your adjusted EBITDA margin in '18 to be similar to the 5.4% you generated in last year?

[Robert J. Brown, Chief Executive Officer, President and Director]

I think the way we've kind of described it is we had -- from a gross profit perspective, we've kind of had impacts of $1 million to $1.2 million drag on margin dollars in third quarter and in fourth quarter. And we've said that heading into 2018, we can see that drag continuing. So for me, it's really going to be dependent upon how quickly we see the price appreciation take hold in the market place and being able to pass that on to customers, for one. And then, we also anticipate there are going to be alternate supply solutions that emerge from around the globe. If China is knocked out of the game, there will be other options, they just take more time to develop. We've really only had the trade -- the final trade case decision out there for about 3 months, and building offshore supply lines is something that takes a little bit more time than that.

[Operator]

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

[Hamir Patel]

Rob, you talked about wanting to grow market share in your shareholder letter. Was curious what do you think your overall market share is today? How does that vary by region? And what is the sort of level of share that you are targeting?

[Robert J. Brown, Chief Executive Officer, President and Director]

Yes. So we actually did do some work on this recently, Hamir. We've gone through fairly significant market analysis and strategic review process. Our estimate is that our addressable market in the categories we participate in are roughly about a 10% market share in North America. So we're just getting into double digits, despite the fact with our 63 locations, we're far and away the largest in our space. There is a range to answer your second question by region. In some regions that market share can be upwards of 30% and approaching mid-30s. In others, we're really low-single digits. So when we look at the opportunity, if you look out, say the next 5 years, when I talked about all the capabilities that we're bringing to the table as a scale operator in our industry, we do think that there's very strong opportunity for us to take share in existing markets and in existing product categories, without kind of needing to stray into other adjacent space to find growth. We've got a lot of growth we can find where we play today.

[Hamir Patel]

Thanks, Rob, that's helpful. And may be just comment on how may be the MD&A pipeline is looking? And has U.S. tax reform changed the multiples that vendors are seeking? And perhaps, how much you're willing to pay as well?

[Robert J. Brown, Chief Executive Officer, President and Director]

Yes, good question. In terms of the pipeline, I'm very pleased with it. It is robust as we've ever had to work with, frankly, and we're really looking at it as setting up a multiyear runway here to line up deals that we can complete to layer on top of organic growth -- the decisions with acquisitions growth. I think your comment around pricing and U.S. tax reform, there is -- we are seeing some of that. I mean, we're into a multiyear run where owners have enjoyed pretty good results, and multiples are stronger than they had been in the past. Having said that, we still, in this market environment, think we can transact and that there's deals that make sense for us to do it complete. So we're still active in the marketplace.

[Operator]

[Operator Instructions] Your next question comes from Russell Stanley from Echelon Wealth Partners.

[Russell Stanley, Equity Analyst of Special Situations]

Just coming back to the question on margins and your view that, I guess, the price appreciation has been a little slower in coming than expected. What's been the driver there? Was there just more product out there than you originally estimated?

[Robert J. Brown, Chief Executive Officer, President and Director]

Yes, is the short answer, and I'll add a little detail to that. So during 2017, importers had a choice, they could continue importing and take the risk of retrospective duties potentially being imposed, or they could decide that, that was too big a bet to place. We were in the latter category. So while we stopped directly importing from our mill partners in China, others continued to do so. We didn't have visibility of that at the time, obviously, we can't see what other importers are choosing to do. But it became apparent that many of them did choose to land a lot more product in North America than we anticipated. They were willing to take the gamble on retroactive duties. So we've really just had to -- a period of time where we've had to work through that inventory. And it definitely impacted the latter half of 2018, and there's still product available in the market today that's working its way through the system. But as I mentioned earlier, we're starting to see things tightening.

[Russell Stanley, Equity Analyst of Special Situations]

Great. And just further on that. In terms of the pricing that you're seeing, you've mentioned starting to see some tightening in these affected products, what about the rest of your products? Are you seeing -- what are you seeing in terms of pricing there? I know it's tough to generalize given the variety but any color you can provide there?

[Robert J. Brown, Chief Executive Officer, President and Director]

Sure. So we just talked about hardwood plywood as a general category in the category of Hardwood lumber. We're also seeing upward pressure there really driven from a foreign perspective with a number of -- the export market is very strong, including competition for logs that would normally be saw-milled in North America. A lot of those are being purchased and shipped overseas. So as you've got less supply, we're seeing some upward pricing pressure in that category as well. In, I guess the third category I'd maybe call out would be composite products, particleboard and MDF that's been a little bit more stable.

[Russell Stanley, Equity Analyst of Special Situations]

The final question. You talked about the organic growth in local currency terms that of the U.S.? Can you give us some color, I guess, as to where some of that strength was? Was it balanced between Rugby and the rest of the Hardwoods traditional business? Or was there some differences there in terms of the organic growth?

[Robert J. Brown, Chief Executive Officer, President and Director]

No, it was balanced. One of the nice things about having an expanded business in the U.S. is you have a little bit of a wider view in terms of how things are growing across different brands and across different companies. And we are getting growth out of both Rugby and the hardwood side.

[Operator]

[Operator Instructions] Your next question comes from Leon Aghazarian from National Bank Financial.

[Leon Aghazarian, Special Situation Analyst]

I just -- most of my questions were asked already. So just on the end market side, particularly in the U.S. I mean, could you give us some color on to the split between residential and commercial?

[Robert J. Brown, Chief Executive Officer, President and Director]

Yes, generally speaking, Leon, we think of commercial as being about 1/3 and residential being 50% or a little bit greater, and then the balance is just other things, such as recreational vehicle manufacturing and other items.

[Leon Aghazarian, Special Situation Analyst]

And there is nothing different there in terms of trends. Like do you see any of those being materially stronger one versus the other? Or kind of the same level that you've been seeing recently?

[Robert J. Brown, Chief Executive Officer, President and Director]

No, Jim -- I mean when we described our outlook going forward, the U.S. housing market has been a little bit unpredictable. We saw some numbers this morning. It was real strong in January and then little bit weaker in Feb. But overall, we've got commercial expectation is, it looks like about 4% growth is what's being called for next year. On the residential side, if you look at the Kitchen Cabinet Manufacturers Association, they finished up 2017 with year-over-year growth of about 3%. It's about -- that represents about $6 billion of sales based on their membership. So that's kind of where things are running both sides of those 2 biggest channels we're in.

[Operator]

[Operator Instructions] We do not have any questions over the phone at this time. I will turn the call over to the presenters.

[Robert J. Brown, Chief Executive Officer, President and Director]

Okay, thanks, Sharon. I'm sure people want to go. Just thanks for joining us today, and we do appreciate the interest in questions. If you've got further follow-on thoughts or suggestions or questions, do please contact Faiz or myself.

[Operator]

This concludes today's conference call. You may now disconnect.