Hardwoods Distribution Inc. (OTCPK:HDIUF) Q2 2022 Earnings Conference Call August 12, 2022 11:00 AM ET
Company Participants
Ian Tharp – Investor Relations
Rob Brown – President & Chief Executive Officer
Faiz Karmally – Vice President & Chief Financial Officer
Conference Call Participants
Hamir Patel – CIBC Capital Markets
Meaghen Annett – TD Securities
Zachary Evershed – National Bank Financial
Jeff Fenwick – Cormark Securities
Operator
Good day, and welcome to the HDI’s Second Quarter 2022 Results Conference Call. Today’s conference is being recorded.
At this time, I’d like to turn the call over to Ian Tharp. Please go ahead, sir.
Ian Tharp
Thank you, Orlando, and good morning to those joining today, as we discuss HDI’s financial results for the second quarter of 2022. My name is Ian Tharp, Investor Relations for HDI. And joining me on the call today are Rob Brown, HDI’s President and Chief Executive Officer; and Faiz Karmally, HID’s Vice President and Chief Financial Officer.
HDI’s Q2 2022 earnings release, financial statements, and MD&A are available on the Investors section of HDI’s website at www.hdidist.com. These statements have also been filed on HDI’s profile on SEDAR at www.sedar.com.
Before we start today, I want to remind listeners that during this call, management may make forward-looking statements. These statements involve various known and unknown risks and uncertainties and are based on management’s current expectations and beliefs, which may prove to be incorrect. Actual results could differ materially from those described in these forward-looking statements.
Please refer to the text in HDI’s earnings press release and financial filings issued today for a discussion of the risks and uncertainties associated with these forward-looking statements. All dollar figures referred to today are in US dollars, unless stated otherwise. As well, our comments today will focus specifically on the second quarter of 2022. Financial details for the first six months of 2022 can be accessed either through SEDAR or our corporate website.
I would now like to turn the call over to Rob Brown. Rob?
Rob Brown
Thanks, Ian and good morning everyone. We’re pleased to share details of HDI’s strong results for the second quarter of 2022, and what we’re looking forward to now that we’ve closed out the first half of the year.
I’ll start today with our key financial and business highlights for Q2. Faiz will then provide further detail on our Q2 financial results, and I’ll finish off our prepared remarks with our outlook. Continuing the positive momentum we saw in Q1, we set a new all-time, quarterly high for sales in the second quarter. It was also near to our quarterly record for adjusted EBITDA and EPS performance.
Our team achieved these results, against a backdrop of strong market conditions. We executed well on the operating and strategic fronts and we capitalized on the expanded size and breadth of our business, supported by our two most recent acquisitions.
Commenting first on the market. Overall conditions have remained supportive, with consumer demand and product pricing, remaining resilient in Q2, despite a backdrop of rising interest rates. Our positioning as one of the largest architectural building products companies in North America, continues to be an important competitive advantage, as we source differentiated products from both, domestic and international suppliers for our customers.
As our teams have navigated the current market conditions, they’ve remained focused on execution of our strategy to deliver growth both organically and through acquisitions. Our organic sales growth in Q2 was $78 million, a 23% increase over Q2 of the prior year. Our acquired Mid-Am and Novo businesses contributed an additional $286 million, which is an 85% increase in sales compared to Q2 2021.
As we’ve outlined since we first announced each transaction, Novo and more recently Mid-Am, collectively represent transformational acquisitions for HDI. These additions have brought us leading management talent, important new access to the attractive Pro Dealer and home center channels and a significant increase in our addressable market to sell architectural building products.
On a combined basis, Novo and Mid-Am are on track to contribute $1 billion in sales in 2022 and are strong examples of our ability to deliver growth, through our acquisition strategy. Both companies are performing well, in line or ahead of expectations. Our teams remain focused on capturing additional synergies from these businesses.
On a combined basis, organic and acquisitions-related growth supported a substantial increase in our consolidated sales to $700 million in the second quarter. This was up by 107%, as compared to Q2 of 2021. As we grew the top line, we continued to capture healthy gross margins. Our gross profit percentage was 22% in the first quarter, similar to the 22.5% achieved in the same period in 2021.
Contributing to this strong gross margin performance, is the ongoing demand and supply dynamics in our main markets, and the value of our price pass-through model, which allows us to keep our selling prices closely aligned with the costs we incurred to get products to our customers. Our ability to pass-through costs has been essential, as we’ve managed the supply chain and product price inflation that’s been prevalent in our industry in the past 1.5 years.
In summary, demand was solid and product pricing resilient through the end of second quarter. Our focus on growth sourced organically and from acquisitions, delivered a significant increase in sales and continued strength in gross margins.
Even as we factor in higher levels of operating expenses, we need to operate our expanded platform. Our adjusted EBITDA increased to $78.6 million, which is a 79% increase over Q2 last year. We’re very pleased with this performance throughout our business in Q2 and year-to-date.
I’ll turn the call now to Faiz to review our financial results for the quarter in some more detail. Faiz?
Faiz Karmally
Thanks, Rob, and good morning, everyone. I’m going to provide an overview of our results for the second quarter of 2022. I’ll also outline our financial position and capital allocation plans. Again, I’ll remind those listening that all dollar figures Rob and I use today are in US dollars, unless we’ve stated otherwise.
Starting with consolidated revenue, our Q2 sales were $700.3 million, which was an increase of 107% or $362.2 million from Q2 in 2021. Focusing on our organic sales, healthy market demand supported higher product prices and we achieved $78.2 million of growth in organic sales in Q2, which represented a 23.1% of our consolidated sales growth.
Our acquired businesses contributed $286.2 million, or 84.7% of our year-over-year growth in sales. Our acquisitions-based sales growth consisted of $201.7 million in revenue contributed by Novo and a total of $84.5 million from Mid-Am. Q2 was the first period we have reported that has included a full quarter of financial results from Mid-Am.
Looking now at our regional activity. Our US operations generated Q2 sales of $645.9 million which was 122% higher than the same period last year. US-based sales increased by $354.5 million with organic sales growth accounting for $68.3 million or 23.5% of the sales growth and acquired businesses accounting for the remaining $286.2 million of the total sales growth.
Our Canadian operations also performed well in the second quarter. Canadian sales for Q2 rose by CAD 11.9 million, which was a 20.6% gain compared to Q2 in 2021. The gains we captured in Canada were entirely driven by organic growth.
Turning next to gross profit. We posted a 102.6% improvement to $153.8 million in Q2 2022. This significant growth was supported by our record sales results, contributions from Novo and Mid-Am and delivery of a strong gross profit margin percentage.
Our Q2 gross margin of 22% is similar to the 22.5% we posted in Q2 of last year. And as Rob mentioned earlier, it reflects the positive demand-supply dynamics in our markets and the advantages we gained from our price pass-through model, which has been invaluable to us as we navigate the many supply chain and cost inflation challenges we continue to face.
Our operating expenses for the second quarter were $92.9 million, which were $50.9 million higher than Q2 of 2021. The increase in operating expense primarily relates to the operations of Novo and Mid-Am, which account for $40.3 million of the increase.
We also incurred $8.4 million related to investments to support our growth and amortization of intangible assets acquired in the Mid-Am and Novo transactions of $4.9 million in the quarter. As a percentage of our sales, operating expenses were 13.3% as compared to 12.4% in Q2 of 2021.
Moving now to adjusted EBITDA. For Q2, 2022, it increased 78.6% over Q2 of last year to $78.6 million. As a percentage of sales, our Q2 adjusted EBITDA margin was 11.2%. And finally, our profit for the second quarter came in at $41.9 million, which was 72.4% year-over-year growth rate and our per share profit climbed to $1.77, an increase of 55% from $1.14 per share posted in Q2 of 2021.
Turning our attention now to the balance sheet. As of June 30, 2022, our leverage ratio, which is the ratio of our net bank debt-to-adjusted EBITDA after rents, was 2.9 times which is 0.4 times lower than our leverage ratio at the end of Q1, 2022.
We continue to operate comfortably within the leverage and interest coverage ratios required by our current debt facilities and we remain on track to further reduce our leverage ratio to the latter half of 2022. We ended the second quarter with substantial unused board capacity of over $165 million.
Our capital allocation priorities are focused on paying down debt, financing the growth of our business, both organically and through accretive acquisitions and providing incremental total returns to shareholders through our dividends and share repurchases.
With that, I’ll turn the call back over to Rob. Rob?
Rob Brown
Yeah. Thanks, Faiz. I’ll finish our prepared comments this morning with our view on end markets and our strategy to continue to build the value of HDI over the long-term then we’ll take your questions.
Looking at the near-term market dynamics, as central banks increase interest rates to slow inflation, we’re closely monitoring for any signs of negative impacts that interest rates or other factors may be having on customer activity levels and also on product pricing. Over a multiyear basis, we continue to see strong market fundamentals in HDI’s end markets, which include in the repair and remodel market, which comprises approximately 40% of our sales.
The current rise in mortgage rates is creating an incentive for people to stay in their homes and high home equity levels along with an aging housing stock are helping to drive strong sales of repair and remodeling activity. As well in residential construction, which comprises another 40% of our sales, even as home financing costs are on the rise, we expect that the structural underbuild of housing in the US to support an extended demand curve for housing. There also remains today a significant gap between housing starts and completions. And with our products typically installed in the latter stages of construction, we believe this will provide additional support for demand.
For commercial markets, which comprise approximately 15% of our overall sales, we have very diverse participation into end markets there including education, hospitality and office construction and this positions us well to capture opportunities as each segment addresses its specific demand drivers. We continue to see a number of factors that support the demand outlook for our products. However, in the event that we do begin to see a decline in economic conditions, I want to emphasize the resilience that’s built into our business model.
From a financial perspective, our balance sheet is strong provides us with significant financial stability. Our business model converts a high proportion of EBITDA to operating cash flow before changes in working capital. And importantly, our operating track record shows that during periods of reduced economic activity, we naturally release working capital investment resulting in an additional source of cash.
I would also highlight the following attributes that we’ve successfully built into our business model and which we believe stabilizes our business across market cycles. We’re highly diversified by supplier, by customer and by geography through our 86 locations across North America and we believe this mitigates the risk associated with any one particular geography. We’ve also developed a very diverse product portfolio, generally comprised of specialty and higher-margin products. We have no one product category exceeding 20% of our pro forma sales.
As Faiz mentioned, we’ve maintained a strong balance sheet and generate significant cash flow. And we’ve proven our ability to deliver meaningful growth through organic expansion as well as our acquisitions program. The Architectural Building Products market is fragmented and there remains significant market share for us to capture.
I’ll finish my prepared comments today by again reiterating our belief in the value we’ve created, as a leading provider of specialty building products in North America. And that we see far more that we can accomplish as our size, breadth and capabilities expand over time. Even as we take the current market backdrop into account, we continue to see misalignment between the value inherent in our business and the current market price of HDI’s common shares.
In the first half of 2022, our strong financial performance has enabled us to continue our program of share repurchases. Year-to-date, we’ve purchased a total of 335,000 common shares for CAD 10.6 million with continued activity in July and also here into August. We intend to continue to actively assess share repurchase levels as an important component of our capital allocation plan going forward.
With that, I will just thank you for your time this morning and I’ll ask our operator Orlando to please provide instructions for the Q&A period. Orlando?
Question-and-Answer Session
Operator
Thank you. [Operator Instructions] And we will take our first question from Hamir Patel with CIBC Capital Markets.
Hamir Patel
Hi. Good morning. Rob, what proportion of the synergies that you expected from Novo and Mid-Am has been achieved already? And are you seeing upside to those initial numbers as you’ve continued to integrate the businesses?
Rob Brown
Yes. So I would say we’re still in relatively early innings on capturing synergies from those businesses. We’ve done well on the cost side, which is looking at common providers of non-product services in many cases and being able to get preferential rates. There’s probably a bigger opportunity on the cross-selling side Hamir, with products that we can bring from one respective business to the other. That’s been slower simply, because we’ve been in such a fragmented sourcing market, as you know for the last year and half. So things we might have done sooner have been delayed just simply by supply dynamics, but that remains an opportunity that’s still in front of us for us to capture.
Hamir Patel
Great. Thanks, Rob. That’s helpful. And just on the product pricing front, could you speak to how pricing has evolved as we’ve moved into Q3? And any sort of major differences in pricing trends across the product categories?
Rob Brown
Yeah. So I mean, pricing has been quite resilient this year, certainly, through midyear. The price appreciation that we saw in 2021, we peaked on that. And I would describe things as more stable to slight softening, as an overall statement, but still hanging in at very high levels, and it’s just representative of the fact that, the cost of manufacturing these products is up whether it’s labor or freight or material input costs.
There’s been some ups and downs between the product groups. We actually remain on allocation in some product categories, and other categories, have come off somewhat in pricing. The domestic hardwood lumber as an example is a little off relative to where it was a year ago, but we got other categories that as I say are – remain reasonably tight at this time.
Hamir Patel
Okay. Great. Thanks, Rob. That’s all I have for now. I’ll get back in the queue.
Rob Brown
Thanks, Hamir.
Operator
All right. And moving on, we’ll hear from Meaghen Annett with TD Securities. Please go ahead.
Meaghen Annett
Thanks. Good morning. Just on the outlook. It seems like there’s been a bit of a shift there and maybe more caution in your tone, just more so related to the near-term performance of those key end markets. Mid to long-term it seems like you remain quite positive there. So first off, would you say that’s a fair characterization? And if so does that outlook put more emphasis on allocating capital to reducing leverage?
Rob Brown
Yeah. Hey, good morning, Meaghen. So you’re quite right on the mid to long-term. It’s all the things I said in the prepared comments, we feel very good about that. In terms of – and for the reasons we described. In terms of the more shorter term, I think everybody is just on a little bit more of a cautious footing, because of the increase in interest rates and central banks trying to fight inflation. So we don’t operate on an island. We’re cognizant of that as well and so we’re acknowledging that in our outlook. But I would say, we’ve continued to be very pleased with the level of underlying demand that, we’ve been experiencing day-to-day with customers. And following on to Hamir’s comment pricing has remained quite resilient.
Meaghen Annett
And second question is on the gross margin. Can you just give some color as to the drivers of the year-over-year decline there in the quarter? Still a strong performance there but anything to call out that weighed on that year-over-year?
Faiz Karmally
Meaghen, good morning. It’s Faiz here. I can take that one. So, on the gross margin percentage, I think you’re just starting to see, a little bit of normalization. In the previous year, we did – and we talked about, achieving some benefits related to the ability to pass on price increases fairly expeditiously just the way the market was moving. Of course, our average cost does take some time to catch up to that. So in the previous year, we were operating a little higher in terms of the gross margin percentage.
And we’ve talked about – there’s a number of things that allowed us to achieve that. One of them was as we previously described a little more transitory and that was this ability to get ahead of your cost a little bit as prices moved. I would say that, a lot of that is behind us now, and so you’re just seeing some normalization there on the gross margin line.
Meaghen Annett
That’s it for me. Thank you.
Operator
[Operator Instructions] And next we’ll hear from Zachary Evershed with National Bank. Please go ahead.
Zachary Evershed
Good morning, everyone. Congrats on the quarter.
Rob Brown
Thanks, Zach. Good morning.
Faiz Karmally
Hey, Zach.
Zachary Evershed
We’re seeing shipping rates for containers coming down from the highs. Are you seeing that come down in your cost as well? And do you pass those savings through to your customers?
Rob Brown
We do over time, and it is that price pass-through model. So we’re seeing some easing in container rates as you mentioned over time that worked its way through average costs by lowering them. And consequently that will be a lower sell price to customers. I would just, remind and caution you not to just look at one data point across now a very large business. So that would relate to a proportion of our business that we bring through outside of North America in containerized volume. We’re still seeing relatively strong freight rates for domestic product transfers within North America. But yes, you’re right containers rates are easing somewhat.
Zachary Evershed
And could you remind us of the relative split between your domestic sourcing and your foreign sourcing? And how much freight makes up your cost of goods?
Rob Brown
I’ll take the first and I’ll throw the freight one at Faiz. So roughly a third of our products that we sell today are sourced from outside North America balance of domestic.
Faiz Karmally
Yes. And freight as a percentage of cost of goods sold, it’s going to be in the single-digits, Zach, mid single-digits in terms of the percentage of our cost of goods sold.
Zachary Evershed
That’s helpful. Thanks. And then while we’re on the topic of sourcing from outside North America. Do you have any insight into why getting new suppliers were included in the anti-circumvention list? Any color you have is helpful.
Rob Brown
Yes. I mean, it’s still early days on that. I guess, the first thing, I would say is, a product that we are involved with we have very high degree of confidence it is outside the scope of the case that this relates to. Our understanding, and as I said, we’re still looking at it is that as the Department of Commerce has sought information from mills in Vietnam, some of that information is being determined to be deficient, or unusable for whatever reason to be determined. And there was a long list of those that were on that in that categorization and four of ours were included there. So we need to be given a little more time here to do some more work and see what the implications of that are.
Zachary Evershed
And so that sounds like you have a good degree of confidence that the ultimate impact of any duties the probability is very low. But if it were to come to pass, could you give us a sense of the potential magnitude of any retroactive duties?
Rob Brown
Too early for that, Zach. And frankly, we’re — this determination relates to a circumvention inquiry that the DOC launched over two years ago. So they’ve come up with a decision here at the end of July, we just need a little more time to spend with it. As I said, it’s just — it’s early days.
Zachary Evershed
Got you. Thanks. Maybe just two more. Builders are reporting an uptick in cancellations now. Any worries on that front on your end? It does sound like volumes are still quite strong now.
Rob Brown
Yes. I mean, we read the same things that you do and we look to what we described in our comments just the balance and diversification that we have in our business. So we don’t have all our eggs in one basket. And then we look at how we’re doing in terms of our current sales pace, which we can frankly see every night. And it continues to be ticking along quite nicely. So nothing that we’re kind of seeing yet that I would tie back to that data point, which is for future sales, but we’re keeping a close eye on it of course.
Zachary Evershed
Very helpful. Thanks. Then last one for me. Commercial has been a bit of a mixed bag for a while. How do you view your business mix there? Any interest in pushing it in a specific direction?
Rob Brown
I mean, we really do like the commercial piece. And while, it’s call, it 15% of the bigger company. It’s still very important and it provides — it’s a more stable, I guess, over time demand driver for our products. And as you mentioned, it covers a lot of different sectors.
So we like it. We continue to focus on it. We’ve got the right product mix to be effective servicing customers that are focused on more commercial millwork applications than say residential or repair and remodel. We also have I think as you know our DesignOneSource, which is a separate and distinct sales force that focuses on calling on architects and designers and creating pull-through demand for our branded products and their activity levels and think number of appointments and getting into architect and designs centers continues to be very, very good. So that’s all encouraging and points to again underlying demand for us sales for the future as we like to say on that sales side.
Zachary Evershed
Thank you very much to the color. Great quarter. I’ll leave it there.
Rob Brown
Thanks, Zach.
Operator
And we’ll take a question from Jeff Fenwick with Cormark Securities. Please go ahead.
Jeff Fenwick
Hi. Good morning everybody. So I just want to start my questioning with inventory and inventory levels, obviously, running a bit higher than you typically have in the past and you called out some reasons for that in your release. What’s your take on how this develops through the back half of the year? Are the supply chain issues easing up a little bit and maybe allowing you to work that inventory lower? How do we think about that going forward?
Faiz Karmally
Yes. Jeff, good morning. Faiz here. So in terms of the inventory yes – and we’ve – just to level set on the inventory. Yes we’ve talked about that for the first six months of the year. And our expectation was always, it would really be in the second half where we would start to see a working down of that inventory, just given what we’re seeing on the supply chain side, particularly on the overseas and the import side with global supply chains, the way they were and the way they still are a little bit. So I would say this is unfolding as we sort of expected.
In terms of what we expect in the back half of the year, we do expect to work down inventory that even at current sales pace, there’s going to be a reduction of inventory in the back half of 2022. If you look – I’ll give you an example, if you look at our – just to help you kind of understand how we’re thinking about it. If you looked at our days of inventory total and that’s including in transit, which has grown for the reasons I mentioned. Today we’re running at maybe 100 days of inventory. And I expect to get that down into the 80s by the end of the year. So we do plan on seeing a meaningful reduction in the back half of 2022.
Jeff Fenwick
Okay. That’s helpful and obviously frees up some cash for you along with your own operating cash flow, so maybe we could just speak a bit priorities there for the uses. You did a little bit of share buyback activity in the quarter, a little bit of debt repayment. Like what’s the balance between the two do you think going forward?
Faiz Karmally
Yes. I think we still continue to allocate capital in those two areas here in the short term. I mean the share repurchases I think our filing probably went up yesterday, if not it will so. We’ve continued to be active on that into July here into August. But I mean the focus in the short term is really paying down debt.
The share repurchases as you’ve seen we’ve taken a pretty moderate approach it makes sense to do so and we’ve got the capital to do it. But the focus here in the next couple of quarters is really just to get the leverage down, which we’ve started to do here and we’ll continue to do more of that in the back half, particularly as we generate some of that cash through the reduction of inventory.
Jeff Fenwick
Great. Thanks for that color. That’s all I have.
Operator
[Operator Instructions] And currently, I’m not seeing any additional questions. I’ll turn the call back to Rob Brown for closing remarks.
Rob Brown
Okay. Thanks, Orlando for hosting us today and everybody else for joining on the line. Follow-up questions, please do reach out to Ian Faiz or myself, we’d be happy to chat with you further.
Operator
And this does conclude today’s call. We thank you again for participating. You may now disconnect.
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