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Ladies and gentlemen, thank you for standing by, and welcome to the Third Quarter 2020 Kadant Inc. Earnings Conference Call. At this time, all participants are in a listen-only mode. After the speakers’ presentation, there will be a question-and-answer session. [Operator Instructions]
I would now like to hand the conference over to your first speaker for today, Mr. Michael McKenney, Chief Financial Officer. Thank you. Please go ahead.
Thank you, Anne. Good morning, everyone, and welcome to Kadant’s third quarter earnings call. With me on the call today is Jeff Powell, our President and Chief Executive Officer. Before we begin, let me read our Safe Harbor statement. Various remarks that we may make today about Kadant’s future plans and expectations, financial and operating results and prospects are forward-looking statements for purposes of the Safe Harbor provisions under the Private Securities Litigation Reform Act of 1995.
These forward-looking statements are subject to known and unknown risks and uncertainties that may cause our actual results to differ materially from these forward-looking statements as a result of various important factors, including those outlined at the beginning of our slide presentation and those discussed under the heading Risk Factors in our Annual Report on Form 10-K for the fiscal year ended December 28, 2019, and subsequent filings with the Securities and Exchange Commission.
In addition, any forward-looking statements we make during this webcast represent our views and estimates only as of today. While we may elect to update forward-looking statements at some point in the future, we specifically disclaim any obligation to do so even if our views or estimates change.
During this webcast, we will refer to some non-GAAP financial measures. These non-GAAP measures are not prepared in accordance with generally accepted accounting principles. A reconciliation of the non-GAAP financial measures to the most directly comparable GAAP measures is contained in our third quarter earnings press release and the slides presented on the webcast and discussed in the conference call, which are available in the Investors section of our website at www.kadant.com.
Finally, I want to note that when we refer to GAAP earnings per share or EPS or adjusted EPS on this call, we are referring to each of these measures as calculated on a diluted basis.
With that, I will turn the call over to Jeff Powell, who will give you an update on Kadant’s business and future prospects. Following Jeff’s remarks, I’ll give an overview of our financial results for the quarter, and we will then have a Q&A session. Jeff?
Thanks, Mike. Hello, everyone. Thank you for joining us this morning to review our third quarter results and discuss our outlook for the remainder of the year. Since our last earnings call, the world has continued to be impacted by the COVID pandemic and increasing number of cases in Europe and U.S. continued to create depressed economic activity and uncertainty around the world.
I’ll begin by discussing how this impact our operations and our third quarter financial results. The effects of the global pandemic made the third quarter another challenging quarter in terms of predicting demand and overall business levels. As we continue to work under advanced safety protocols, I remain proud of our dedicated employees around the world for the work they have done and continue to do to serve our customers.
We had solid execution by our businesses in the third quarter along with various cost containment measures, which contributed to our strong margin performance. We also benefited from government employee retention assistance, which allowed us to maintain our talented workforce despite the lower business levels during the quarter. Our balance sheet remains healthy and our liquidity position is solid. Robust cash flows have always been the strength of Kadant and we expect this will continue as economies begin to recover.
Turning now to our Q3 performance, we had better than expected EPS results due to our Industrial Processing and Flow Control segments. This was further enhanced by government employee retention assistance that contributed to our solid adjusted EPS $1.31 a share. Our adjusted EBITDA margin was excellent at 19.4%, our cash flow was strong at $24 million.
Our parts and consumable revenue made up 66% of total revenue. On a sequential basis, parts revenue was up 6% to $103 million in the third quarter. As many of you know, growing our parts and consumable business is a key strategic focus. Overall, the quarter was better than expected and I’m really pleased with how our employees performed to deliver these solid operating results.
Next, I would like to review our performance in our three operating segments. While our Flow Control segment performed better than expected during the quarter, we continue to face a challenging market environment with industrial production weakening as quarter progressed. Product mix, improved operating leverage, and solid execution led to a strong adjusted EBITDA margin of 27.5% for the third quarter, up 70 basis points from the same period last year.
Although demand for aftermarket parts was solid and made up 69% of total revenue in the quarter customer delays in capital project execution and the inability of our employees to engage face-to-face with customers and prospects due to the pandemic suppressed our bookings performance. Looking ahead to the fourth quarter, we expect Q4 to show improvement in terms of both capital project bookings and demand for parts and consumables.
Turning now to our Industrial Processing segment. We experienced strong demand for our wood processing equipment with bookings at their highest level since our record setting 2018. This demand was driven by a robust U.S. housing market and continued strong demand for wood-based products. Revenue in this segment declined 16% to $62 million year-over-year and down 5% sequentially. This decline was largely due to a slowdown in capital business during the quarter in certain end markets, particularly in paper and packaging.
Parts and consumables revenue on the other hand was solid and made up 68% of total revenue in the third quarter. Encouragingly U.S. housing starts continue to show strength and were $1.4 million in September, up 11% compared to the same period last year, which benefits our customers producing OSB and dimensional lumber. We are experiencing an increase in capital project activity and expect capital bookings to strengthen significantly in the fourth quarter.
Just last week for example, we received a large order for a turnkey recycled stock preparation system from a container board producer in the U.S. with a value of approximately $11 million and expect to receive additional capital orders as the quarter progresses. And our Material Handling segment, we saw improved project – capital project activity and increased demand for aftermarket parts in Q3 versus Q2.
Parts and consumables revenue in the third quarter made up 60% of total revenue, but it’s still below historical run rates. Capital bookings in our Material Handling segment increased 34% sequentially led by increased demand for our billers used in agricultural and waste processing applications. While this increase was coming into off of a week prior quarter, we are encouraged to see our customers showing increased confidence in their economic outlook by awarding these larger capital purchases. As in our other segments, we’re seeing increased market activity albeit still not on pace with prior years.
Looking beyond 2020, we continue to believe this segment has upside potential and its aggregates and food end markets as economies continue to recover from the pandemic. As we look ahead to the final quarter of 2020, we are seeing signs of increased project activity a number of end markets, particularly in our Industrial Processing segment with capital equipment expected to make up a larger portion of our product mix in Q4, we expect to show solid improvements in bookings compared to Q3. As was the case in the second and third quarters of this year, the uncertainty caused by the pandemic limits our ability to forecast the timing of orders. As a result, we will not be providing guidance for Q4.
I now like to pass the call over to Mike for review of our Q3 performance. Mike?
Thank you, Jeff. I’ll start with some key financial metrics from our third quarter. Slide 12 is a summary of some of the key financial metrics that I’ll comment on over the next few slides. Our GAAP diluted EPS was $1.28 in the third quarter, down 9% compared to $1.41 in the third quarter of 2019. Our GAAP diluted EPS in the third quarter includes $0.03 of restructuring costs, $0.03 from a discrete tax benefit, $0.02 of acquired backlog amortization, and $0.01 of acquisition costs.
In addition, our third quarter results included pretax income of $2.7 million or $0.18 net of tax attributable to government employee retention assistance programs related to the pandemic. These government assistance benefits were received by many of our subsidiaries around the world and enabled us to retain employees during the past two quarters. As our business continues to strengthen, we expect this benefit to decrease significantly in the fourth quarter.
Consolidated gross margins were 44.2% in the third quarter of 2020, up 140 basis points compared to 42.8% in the third quarter of 2019. Approximately 110 basis points of this increase was due to the receipt of government assistance benefits related to the pandemic. The remaining 30 basis point improvement is principally due to better product mix related to a higher percentage of parts and consumables. Parts and consumables as a percentage of revenue increased to 66% in the third quarter of 2020, compared to 61% last year.
SG&A expenses were $43.9 million or 28.4% of revenue in the third quarter of 2020 compared to $47.1 million or a 27.1% of revenue in the third quarter of 2019. The $3.2 million decrease in SG&A expense was principally due to reduce selling and travel related expenses and a $1 million benefit from government assistance programs.
Adjusted EBITDA decreased to $30 million or 19.4% of revenue compared to $32.3 million or 18.6% of revenue in the third quarter of 2019. On a sequential basis, adjusted EBITDA increased 13%, due to increased profitability and our Flow Control and Industrial Processing segments.
Operating cash flows were $24.4 million in the third quarter of 2020, which included a modest negative impact of $0.8 million from working capital compared to operating cash flows of $25.7 million in the third quarter of 2019. On a sequential basis, operating cash flows increased 11%.
We had several notable non-operating uses of cash in the third quarter of 2020. We repaid $25.5 million of debt, paid a $2.8 million dividend on our common stock and paid $1.8 million for capital expenditures. Free cash flow increased 7% sequentially to $22.6 million in third quarter of 2020. Free cash flow decreased 4% compared to $23.6 million in the third quarter of 2019.
Let me turn next to our EPS results for the quarter. In the third quarter of 2020 GAAP diluted EPS was $1.28 and our adjusted diluted pass was $1.31. In comparison, the third quarter of 2019, our GAAP diluted EPS was $1.41 and our adjusted diluted EPS was $1.38, which included a $0.02 discrete tax benefit.
As shown in the chart, the decrease of $0.07 in adjusted diluted EPS in the third quarter of 2020 compared to the third quarter of 2019 consists of the following: $0.55 cents due to lower revenue, $0.01 due to higher weighted average shares outstanding. These decreases were partially offset by $0.18 due to government assistance programs, $0.17 due to lower operating costs, $0.10 due to lower interest expense, $0.02 due to higher gross margin percentages and $0.02 from an acquisition.
Collectively, included in all the categories I just mentioned was $0.01 favorable foreign currency translation effect in the third quarter of 2020 compared to the third quarter of last year, due to the weakening of the U.S. dollar.
Looking at our liquidity metrics on Slide 15, our cash conversion days, which we calculate by taking days in receivables plus days in inventory and subtracting days in accounts payable, was 140 at the end of the third quarter of 2020 compared to 128 at the end of the second quarter of 2020 and 122 at the end of the third quarter of 2019. The increase in cash conversion days was driven by a higher number of days in inventory due to a number of factors, including delays in capital project deliveries, weakness in capital project activity, and delays in maintenance spending by our customers.
Our subsidiaries manage their inventory supply to ensure that critical components are available for customers as needed and the time of these purchases has been difficult to predict in this environment. Working capital as a percentage of revenue was 15.6% in the third quarter of 2020 compared to 14.8% in the second quarter of 2020 and 14.6% in the third quarter of 2019.
Our net debt, that is debt, less cash, decreased $18 million or 8% to $204 million at the end of the third quarter of 2020 compared to $222 million at the end of the second quarter of 2020. We repaid $25.5 million of debt in the third quarter and have repaid $41.9 million in debt in the first nine months of 2020. During the quarter, we repaid our real estate loan, which had a remaining principal balance of $18.9 million by borrowing from our revolving credit facility. This effectively swapped debt with an annual interest rate of 4.45% under the real estate loan for U.S. revolver debt currently at 1.65%, which at current rates would reduce interest expense by over $500,000 on an annual basis.
In addition, our leverage ratio calculated in accordance with our credit facility decrease to 1.88 at the end of the third quarter of 2020 compared to 2.03 at the end of 2019. As a result of being below 2, the applicable margin on our revolver debt will decrease by 25 basis points, which at current debt levels would reduce our interest expense by roughly $600,000 on an annual basis.
Regarding guidance, the current environment continues to make forecasting difficult. We have noticed an increase in demand for our parts and consumables products. And on the capital side, we anticipate a sequential increase in bookings in the fourth quarter. Given the current uncertainty, we will not be providing guidance for the fourth quarter of 2020. We will reevaluate providing guidance next quarter. While we are not providing guidance, I would like to provide a few directional comments on our outlook for the remainder of the year.
We currently anticipate a modest sequential increase in revenue for the fourth quarter. I should caution here that if country start locking down, that could impact the timing of when projects are delivered. We also anticipate the fourth quarter product mix will be weighted more towards capital than the third quarter.
Last quarter on our call, I gave a few directional comments indicating our revenue for the year could decrease roughly 11% to 14% compared to 2019. Our current view is that the revenue decrease compared to 2019 would be closer to the lower end of that range. We anticipate that we will remain eligible for some government assistance programs, however, as our business strengthens the benefits from these programs in the fourth quarter will be significantly less than amounts received in the second and third quarters.
We recognized $0.5 million in the third quarter and $0.9 million on a year-to-date basis of restructuring costs related to the reduction of employees across our businesses. In aggregate, we expect these year-to-date restructuring activities will reduce our cost structure by approximately $4.1 million annually. We may incur additional restructuring costs in future periods as we continue to monitor the impact of the pandemic and the resulting global economic downturn on our businesses.
Given the current uncertainties regarding what the future holds across our end markets and geographies, it’s difficult to provide firm guidance at the moment. However, we’ve given these directional comments to help provide insight into how we see our current business environment.
That concludes my review of the financials. And I will now turn the call back over to the operator for our Q&A session. Operator?
Thank you. [Operator Instructions] And we have our first question comes from the line of Chris Howe from Barrington Research. Your line is now open.
Good morning, Jeff and Mike.
Hi, Chris.
Good morning, Chris.
First off, I wanted to follow-up on some previous comments that you’ve made surrounding the Material Handling segments, given all the politics that are in the environment now. Can you talk about what type of benefit, whether it be qualitative or quantitative you might see from infrastructure spending to this segment?
Yes, it would have to be, obviously, qualitative at this point, but that business obviously is very sensitive to kind of infrastructure development and infrastructure spending. And then in prior periods, when there has been a federal sponsored infrastructure spending bill that particular business has benefited greatly from that. It’s interesting during the pandemic, many of our customers in that market were not deemed essential, and so they were shut down.
And so one of the reasons why, I think, we’ve seen a more moderate booking level in that business this year is because a lot of our customers have just started back up or trying to kind of repair their balance sheet, because they were forced to be shut down for an extended period of time. But going forward, once the pandemic is behind us, any increased spending the infrastructure will we would expect to see benefit them in a meaningful way.
Great. That’s helpful. And following up on that question with leverage it 1.9 turns, understanding a lot is in flux as we step outside our door here in this environment. But is it possible that opportunities could become available to allocate your capital towards acquisitions in this segment of the tuck-in variety as we look into the fourth quarter or next calendar year?
Yes, I think I might’ve mentioned this a little bit on the last call, but clearly, during the deeper part of this pandemic there just wasn’t a lot of activity, a lot discussions. You couldn’t travel, you couldn’t meet with people. So there clearly, as I would say pent up opportunities from sellers that had planned to sell their business this year and were not able to, from private equity funds that had plan to sell some of their portfolio companies and were not able to. And then there’s also, I think, some questions around what the capital gains tax rate may look like in the future, depending on our election outcomes.
So we – I would say, we are seeing our business development group is seeing quite a bit more activity level going on right now as we get towards the end of the year. And so as we’ve said, we didn’t really slow down. We continue to pursue strategic opportunities. There just weren’t a lot of them to share because of the pandemic. But I think everybody in the investment banking community would confirm that the activity levels picked up quite a bit here in the last couple of months.
Okay. Lastly, for the Industrial Processing segment, a great quarter showing strong demand based on U.S. housing. Perhaps, you can comment on these trends continuing. Do you think there is a long tail and perhaps with us still being entrenched at home that this demand trend could continue through the first half of next year.
The industry analysts, that focus on pricing – lumber pricing, which is probably the best indication demand. They actually are forecasting that these prices are going to remain at an elevated level for the next potentially two to three years. And so they’re talking about a fairly robust market for the foreseeable future.
Great. That’s all I have. I’ll hop back in the queue.
Thank you. Our next question comes from the line of Kurt Yinger from D.A. Davidson. Your line is now open.
Yes. Good morning, Jeff and Mike
Hi, Kurt.
Good morning, Kurt.
I just wanted to start off on the capital equipment side. I mean, it seems like every day, the list of containerboard projects gets a little bit longer. Obviously, you touched on the strength in wood products and even on the box board side, there’s some big projects upcoming. And so just wanted to see from an end market perspective, there’s a lot of momentum heading into 2021. And just curious, if there are any markets or regions that you still have real reservations about looking ahead.
Well, as you know, we just mentioned this new conversion project. We just received an order for and there’s others out there. So I think the North American market, there’s some activity there. Asia and China in particular is still in a state of flux because of the waste import ban, which goes into full effect at the end of this year. So the – our Asian customers are quite active and busy, but they’re really trying to sort out exactly, where they’re going to make future investments.
Excuse me. India, India is the fastest growing market right now, although, it’s starting at a small base, but it’s one of the faster growing markets. And so we think there’s – we’ll expect to continue to see some opportunities there. I would tell you that right now, Europe is probably one of the more challenging markets, you probably have seen in the headlines in the last few days that their new infection rates are really spiking. And there’s talk about, I guess, putting curfews in place, there’s some discussions about lockdowns, although nobody’s done that yet. But I would say, probably, Europe, it looks like Western Europe is really struggling with the pandemic right now. And we would expect that’ll probably result in them recovering more slowly than in the rest of the world.
Okay. That’s helpful. And looking back bookings activity on the capital side seems to correlate pretty well to revenue two or three quarters out. And without trying to pin you down to a specific quarter or anything like that, I mean when would we need to see real momentum there to get back to capital being a positive revenue growth contributor? And is that something that just given the weakness here in 2020 is maybe more relegated to the second half of next year kind of at best?
Yes. It’s – that’s a challenging question Kurt, because the – this pandemic is unprecedented. And so trying to understand when our customers are comfortable enough with the recovery to start really making big investments in new capital is for us right now very challenging to forecast. We just have not seen something like this. We know in traditional recessions, they really try to strengthen the balance sheets and they don’t make a lot of investments.
And then when you recover, there’s a little bit of a pent-up demand and you normally will see a nice pickup. I would expect that, that we would ultimately see that here. But again, this is such an unusual time that it’s really challenging for us to forecast that. We have some customers that are so – takes the wood processing sector. They’re so busy and so profitable that they don’t want to shutdown to do any upgrades of equipment.
And that could be the same for certain packaging suppliers and others of course, are operating at reduced rates. So you’re right. The timing is that, you usually see at a couple quarters later because of the build cycle for the bigger capital equipment. But I just don’t know that we right now have confidence in when we’re going to see that uptick. As we mentioned, we do think there’ll be some strengthening in Q4. We since the close of the quarter, we’ve gotten – we started to see some nice orders come in. But it’s very difficult to forecast what 2021 is going to look like at this time.
Right, right. Okay, that’s helpful and fair. And then just switching to parts and consumables, I mean the backdrop seems a lot better than it did a couple months ago. And Mike talked about the directional guidance for the fourth quarter, but I mean it just seems like that part side to really come back, especially with the destocking dynamic you’ve seen. And so I’m just wondering what might be holding that back here in the near-term from really recovering more strongly.
I think there’s a couple of things. One is, I think customers are still being pretty cautious on their inventory levels. And the other is that in many cases, we’re still unable to get people in to do audits and service calls and the kind of things that normally lead to parts sales. So we’ve got kind of two challenges that we’re dealing with the continued caution of our customers, which is somewhat understandable, and then just the challenge in getting our service people and to the mills.
Okay, okay. And then just lastly, a two-parter on gross margins. Could you I guess, breakout the exact dollar amount over the last two quarters from the government relief programs? And then secondly, just at a high level looking to 2021 seems like there’s a little bit of inflation on steel, maybe capital strengthens and some mix impact there. Just curious how you’re thinking about the positives and negatives on gross margin looking ahead.
Sure, Kurt. Well, I’ll give you the absolute numbers that have been included in the margins – in gross margins. For the second quarter, it was a $1.3 million and for the third quarter, $1.6 million. And I gave the impact in the call there was 110 basis point impact in the third quarter,
Got it.
So I think I would say looking forward on the commodity price increases, generally I’d say we’d hope to be able to pass that on. So if that does occur, we’ll hopefully not see much of an impact on our gross margins as a result of that.
Okay, okay. That’s awesome and very helpful. Good luck in the fourth quarter, guys.
Thank you.
Thank you.
Thank you. [Operator Instructions] And now I would like to turn back the call to Mr. Jeff Powell for closing comments.
Thank you. Before wrapping up the call today, I wanted to just leave you with a few takeaways from the quarter. The health and wellbeing of our employees has been and continues to be our top priority. And I’m proud of our employees working to serve our customer’s needs through these uncertain times. Financial health is excellent and our liquidity position is stronger today when the crisis began earlier in the year as evidenced by our improved debt leverage ratio of 1.88. Our ability to generate strong free cash flow remains solid and a cornerstone of our business model. I want to thank you for joining the call today, and we look forward to talking to you next quarter.
Ladies and gentlemen, this concludes today’s conference call. Thank you for participating. You may now disconnect.