Kadant Inc. (NYSE:KAI) Q3 2022 Earnings Conference Call November 2, 2022 11:00 AM ET
Company Participants
Jeffrey Powell – President and CEO
Michael McKenney – EVP and CFO
Conference Call Participants
Kurt Yinger – D.A. Davidson
William Hyler – WDH Capital
John Franzreb – Sidoti
Operator
Good day, and thank you for standing by. Welcome to the Q3 2022 Kadant Earnings Conference Call. [Operator Instructions] Please be advised that today’s conference is being recorded.
I would now like to hand the conference over to your speaker today, Michael McKenney, Executive Vice President and Chief Financial Officer. Please go ahead.
Michael McKenney
Thank you, Michelle. Good morning, everyone, and welcome to Kadant’s third quarter 2022 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 January 1, 2022, 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 wanted to note that when we refer to GAAP earnings per share or EPS and adjusted EPS on this call, we are referring to each of these measures as calculated on a diluted basis.
With that, I’ll 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?
Jeffrey Powell
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.
I’ll begin by reviewing our operational highlights for the third quarter. I’m pleased to report we had a solid quarter with strong revenue performance and excellent execution across all our operating segments. This led to record adjusted EPS and adjusted EBITDA in the third quarter.
We had strong demand for aftermarket parts, while new capital order activity moderated as expected from the record-setting pace in the first half of the year. We continue to successfully navigate through an increasingly complex market conditions fueled by inflationary pressures, the strength in USD, China’s Zero COVID policy and lingering global supply chain constraints among other factors.
As I’ve commented many times before, operations teams around the globe continue to do an excellent job proactively managing these challenges and executing well, and this quarter was no different.
You can see on Slide 6, our Q3 financial performance was notably higher across most key metrics compared to Q3 of last year despite significantly affected by currency translation. Q3 revenue was up 12% compared to the third quarter of 2021 to $225 million and benefited from record capital shipments.
Excluding acquisitions, an unfavorable impact of FX revenue was up 19% compared to the same period last year. Solid execution contributed to our record adjusted EBITDA of $48 million and a record EBITDA margin of 21.3%.
All our operating segments delivered excellent adjusted EBITDA margin performance despite continuing inflationary pressures and ongoing supply chain constraints. As anticipated, bookings softened from the record-setting pace in the first half of the year as capital activity slowed while demand for aftermarket parts increased compared to the prior period.
I’ll review the performance of operating segments next, beginning with our Flow Control segment. Flow Control segment achieved solid growth in both revenue and bookings activity, with revenue a record $87 million in the third quarter up 14% compared to Q3 of last year. Bookings were $85 million, up 11% compared to last year. Organic bookings, which excludes acquisitions and FX, were up 19% compared to the same period last year.
Strong performance in our Fluid Handling product line in North America led our bookings growth in Q3. Improved operating leverage led to record adjusted EBITDA and an adjusted EBITDA margin of 29.4%.
High energy prices and a focus on decarbonization, particularly in Europe, continued to drive project activity in our Flow Control segment as our customers seek to optimize energy utilization. Our end markets remain strong despite the growing uncertainty in the macroeconomic environment. That said, we do expect spending to moderate in the months ahead as central banks continue to take actions designed to reduce inflation.
Our Industrial Processing segment revenue increased 5% to $86 million, despite being affected by an unfavorable foreign currency translation, excluding the impact of FX, revenue growth was 11% compared to the same period last year. Adjusted EBITDA was up 6%, while our adjusted EBITDA margin was excellent at 24%. As anticipated, demand for capital equipment slowed in Q3 in response to the major capacity additions completed over the past several years even as demand for aftermarket parts continued at a robust pace.
Our Wood Processing businesses, which have experienced significant demand for capital equipment during the past few years and contributed significantly to our financial results during that period are expected to shift towards a more aftermarket-based product mix as demand for lumber and OSB softens and the focus for manufacturers, shifts from capacity additions to plant optimization and operating efficiencies.
In our Material Handling segment, we experienced healthy demand for our bulk Material Handling equipment and aftermarket parts. Revenue was up 23% to $52 million with parts revenue making up 57% of total revenue in the quarter. Bookings in this segment were down 2% compared to the same period last year at $48 million in Q3. Excluding the negative effect of currency translation, bookings were up 3%.
Solid execution helped boost adjusted EBITDA by 40% and adjusted EBITDA margin by 240 basis points compared to the same period last year. As expected, demand moderation in our billing business has impacted the results in our Material Handling segment. That said, we are experiencing growing business activity for our bulk Material Handling equipment across various sectors.
As we look ahead to the remainder of 2022, we are well-positioned to finish the year with record results. We have a significant number of capital projects to deliver in the upcoming quarter, and our backlog remains at a near record level.
As global economic challenges continue to mount, we expect new order activity to moderate. It’s in uncertain times like these that our organizational strength stands out, and I’m confident our operations teams around the world will continue to deliver outstanding results and a record year.
I’d like to pass the call over to Mike now for his review of our Q3 financial performance.
Michael McKenney
Thank you, Jeff.
I’ll start with some key financial metrics from our third quarter. Consolidated gross margins were 42.5% in the third quarter of 2022 compared to 41.9% in the third quarter of 2021, which included a 110 basis point negative impact from the amortization of acquired profit and inventory.
Parts and Consumables revenue represented 63% of revenue in the third quarter of 2022 compared to 66% in the prior period. SG&A expenses were $53.2 million in the third quarter of ’22, an increase of $0.8 million compared to $52.3 million in the third quarter of ’21. It was a favorable foreign currency translation effect of $3.4 million in the quarter and a reduction in government assistance benefits of $0.3 million.
We also incurred acquisition-related costs of $0.4 million and $1.3 million in the third quarter of 2022 and 2021, respectively. The remaining increase in SG&A expense is primarily associated with increased incentive compensation and travel-related costs due to improved business conditions.
As a percentage of revenue, SG&A expenses decreased to 23.7% in the third quarter of ’22 compared to 26.2% in the prior year period. Our effective tax rate was 26% in the third quarter of ’22, lower than we anticipated, due in part to tax benefits from the reversal of tax reserves associated with uncertain tax positions.
Our GAAP diluted EPS was $2.35 in the third quarter, up 34% compared to $1.75 in the third quarter of 2021 and our adjusted diluted EPS increased 21% to a record $2.38. Our third quarter 2022 adjusted diluted EPS exceeded the high end of our guidance range by $0.29 due primarily to higher revenue in our Wood Processing and Doctoring, Cleaning, & Filtration product lines and a lower effective tax rate.
Adjusted EBITDA increased 17% to a record $47.8 million compared to $40.9 million in the third quarter of 2021 due to strong performance in our Flow Control segment, which had record revenue and adjusted EBITDA in the quarter. Adjusted EBITDA as a percentage of revenue was a record 21.3% in the third quarter of ’22 compared to 20.5% in the prior period.
Operating cash flow decreased 34% to $24.9 million in the third quarter of ’22 compared to $37.9 million in the third quarter ’21. Free cash flow decreased 46% to $18.5 million in third quarter ’22 compared to $34.6 million in the third quarter. The decreases in operating cash flow and free cash flow were principally due to an increase in working capital in the third quarter of ’22 of $13.6 million compared to a decrease in working capital in the third quarter ’21 of $6.3 million, a change of $19.9 million.
We had several notable nonoperating uses of cash in the third quarter ’22. We paid down debt by $11.5 million in the quarter and paid $6.4 million for capital expenditures, which included $2.2 million for our facility project in China. We also paid a $3 million dividend on our common stock and $2.7 million to buy a facility in Germany at the end of its lease.
Let me turn next to our EPS results for the quarter. In the third quarter of 2022, our GAAP diluted EPS was $2.35. And after adding back $0.02 of acquisition costs and $0.01 of restructuring costs, our adjusted diluted EPS was $2.38. In the third quarter of ’21, our GAAP diluted EPS was $1.75, and after adding back acquisition-related costs of $0.22, our adjusted diluted EPS was $1.97.
As shown in the chart, the increase of $0.41 in adjusted diluted EPS in the third quarter ’22 compared to the third quarter ’21 consists of the following: $0.68 due to higher revenue partially offset by $0.13 due to higher operating expenses, $0.08 due to lower gross margins, $0.03 from a higher tax rate, $0.02 due to a decrease in amounts received from government assistance programs and $0.01 from higher net interest expense.
Collectively, included in all the categories I just mentioned was an unfavorable foreign currency translation effect of $0.15 in the third quarter of ’22 compared to the third quarter of last year due to the strengthening of the USD.
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, increased to 130 at the end of the third quarter of ’22 compared to 113 at the end of the third quarter ’21. This increase was primarily driven by a higher number of days in inventory.
Working capital as a percentage of revenue was 12.8% in the third quarter ’22 compared to 13.5% in the third quarter ’21.
Our net debt, that is debt less cash, decreased $16 million sequentially to $135 million at the end of the third quarter ’22. Our leverage ratio calculated in accordance with our credit agreement, was 0.94 at the end of the third quarter ’22 compared to 1.05 at the end of the second quarter of ’22.
Our net interest expense increased $0.2 million to $1.5 million in the third quarter of ’22 compared to $1.3 million in the third quarter of ’21. At the end of the third quarter we had $205 million of borrowing capacity available under our revolving credit facility, which matures in December of ’23.
Now turning to our guidance for the fourth quarter and full year of 2022. We are narrowing our revenue guidance for 2022 to $890 million to $896 million, revised from $890 million to $905 million due to approximately $10 million in capital shipments moving into the first half of 2023 as a result of customer-requested delivery changes and supply chain delays. In addition, we are narrowing our adjusted EPS guidance to $8.80 to $8.97 from $8.80 to $9.
For the fourth quarter, we now anticipate revenue of $217 million to $223 million and adjusted EPS of $1.90 to $2.07. I want to outline some of the potential risks impacting our guidance. In the last month of the third quarter, our largest subsidiary in China was impacted by China’s Zero COVID policy requiring them to shut down for a short period of time and then gradually reopening it again to full capacity. This only had a modest impact on the quarter as the subsidiary was able to increase capacity once reopened. However, there continues to be a potential risk for further government-mandated shutdowns in this region.
In addition, other risks that could impact our guidance include supply chain challenges, strengthening of the USD, geopolitical tensions and inflation. We continue to anticipate gross margins for the full year of ’22 will be $42.5 million to 43%. Gross margins in the fourth quarter will be approximately 70, 80 basis points lower than the third quarter as a result of the mix shifting towards more capital. As a percentage of revenue, we continue to anticipate SG&A will be approximately 24.5% to 25% for the year. We expect our tax rate for the fourth quarter will be approximately 28%.
We hope these guidance comments are helpful. That concludes my review of the financials, and I will now turn the call back over to the operator for our Q&A session. Michelle?
Question-and-Answer Session
Operator
[Operator Instructions] Our first question comes from Kurt Yinger with D.A. Davidson. Your line is now open.
Kurt Yinger
Great, thank you and good morning everyone. By my math, capital bookings were down maybe 35% to 40% versus Q2. And you touched on it, right? Q2 was a very good quarter. So not an easy comp. But — when you talk to your customers, do you get the sense that’s just a kind of a knee-jerk reaction to some of the changes we’ve seen in the macro and just pushing some projects out? Or do you think it’s more reflective of kind of a new baseline on the capital side, whether that’s a digestion phase coming in or really a sustained pullback with the current environment?
Jeffrey Powell
Yes. I think it’s a little bit of all of the above depending on the market and the geographic region. Certainly, we have certain markets that have just been on a — an amazing kind of investment program over the last couple of years. And they need to take delivery of that equipment and get it installed up and operating. And we still have businesses that — that aren’t going to deliver product in 2024. And so that are fully booked for the year.
And customers don’t like placing orders for things that are going to be delivered two years from now, not knowing what the economic conditions might be then. So a little bit — we’ve been talking about this all the year that we expected things to moderate in the back half of the year because they were just so strong really for the prior four quarters. They were very, very strong.
Some of the business, as you saw on the Flow Control side, the bookings were up substantially, that’s being driven in part by energy prices because an awful lot of those projects are justified by saving energy. So it really varies quite a bit around the world.
China, of course, as everybody knows, has been impacted by their Zero COVID policy. There’s some hope that maybe around the March time frame, they’re going to start — they’re rethinking that now. They may change that program and maybe open things back up a little bit there.
So I think it’s a little bit of all the above, really. I don’t think it’s a new baseline globally going forward. It’s going to very much be a function of the market in the geographic region. But the Feds are clearly trying to talk down economy right now. And I think people are — some people are taking a wait-and-see attitude to just what that means.
Kurt Yinger
Right. Okay. That makes sense. And just going off one of the comments you made on some of your subsidiaries being booked out more than a year. Do you feel like the bookings you’ve seen over the last couple of quarters on the capital side, give you better visibility in the past? In terms of how quickly those might turn over? Or do you think 2023 is still very much kind of TBD depending on bookings activity over the next, call it, two to three quarters?
Jeffrey Powell
Yes. I mean we haven’t really started focusing hard on ’23. We’re right now, we’re principally focused on finishing the year. And we have an awful lot of projects that we have to get completed and shipped. That’s a big challenge for everybody.
So obviously, we’ll — during the call for the fourth quarter, we’ll be giving our outlook and guidance for next year. But I don’t think right now that we have a formed opinion on exactly what next year is going to look like. Other than we know we have a strong backlog going into the year. So we know we’re going to be quite busy fulfilling the existing orders.
Kurt Yinger
All right. That’s fair. Well, appreciate the details, and good luck here in Q4, guys.
Operator
Please standby for our next question. Our next question comes from William Hyler with WDH Capital. Your line is now open.
William Hyler
I appreciate the call. Question, Kadant has been a big beneficiary of the large number of recycled containerboard conversions announced the past five years or so — has been a powerful trend. I would assume we may start seeing a slowdown in this going forward. Remind us what divisions were the biggest beneficiaries of the trend? And what end markets do you see as maybe best positioned to offset this if we do start seeing a slowdown of new capital in containerboard conversions?
Jeffrey Powell
So we tend to look at the — on our paper side at the market, it’s the developed countries and the developing countries. And as you know, the developed countries are growing at a slower rate, less greenfields, less new plants and more conversions, where in the developing world, we’re still see most of the projects are still new capacity, new greenfields.
And you’re right. Certainly, in North America, there was — there’s been a fair number of conversions over the last many years. And I think the market is kind of taking right now a wait-and-see attitude to what the — what the dynamics look like when those all come online, many of them will be coming online here over the next six months or so.
We’re seeing strong activity in interesting markets. I would say India, the Middle East, Eastern Europe, and that’s kind of where you’re seeing new projects, new developments. So that will — and we expect that to continue. So that will offset the maybe a little bit of a slowdown in moderation in the developed world here over the next year or so.
As you think of markets outside of the developing world, I think China is still a major market. And they’ve really got to sort , I think, through their COVID policy because that’s really slowed down their industrial production. It has been fairly disruptive. I don’t think that’s sustainable over a long period of time. So we’re expecting sometime in ’23 they sort through that, get back to a more normal growth rate and investment cycle.
So that’s what I would expect as kind of Middle East, Eastern Europe and Asia, India. And India is the biggest market, the fastest-growing market for us, although it’s a small base right now. And as you might recall, we made an acquisition there last year ago to start of manufacturing there and to put more boots on around there. So that’s a market that we think is going to continue to show strength. But really, it’s — I think it’s a China market that really needs to sort itself out here.
William Hyler
So you think that the conversions will continue to be — or greenfield will be — continue to be a positive factor for a number of years to come?
Jeffrey Powell
So right now, the latest estimates I’ve seen, Bill, say that they expect kind of that packaging — the packaging paper business to grow at about globally to grow — about 4.8% a year for the next 10 years.
So that’s actually a little faster than global GDP is forecasted to grow and as you know, that’s principally been driven by a couple of things. One, of course, is e-retail around the world that continues to grow at a faster pace than overall retail.
And then the second is the migration to more sustainable kind of environmentally friendly low-carbon materials, the migration away from plastics and other things, particularly in the food side of it. So those two drivers, I think, are driving kind of the forecasts that show it growing faster than GDP over the next 10 years.
William Hyler
All right. And Flow Control is probably the biggest beneficiary of that trend from a…
Michael McKenney
Yes, it would be the Industrial Processing segment, Bill. That’s where our stock preparation — now Flow Control does benefit, but the biggest beneficiary is in Industrial Processing via our stock preparation product line.
William Hyler
Okay. Okay. And I appreciate that. And just real quick, I know you used to break down your China revenues and you don’t do that anymore, but can you just give us a little color on how revenues in Asia may have shifted and changed over the last three, four years? Because I know Vietnam got a little bigger and rest of Asia. Are you a little less reliant on China than you used to be as a percentage of total Asian revenues? Or is it still pretty much the major source?
Michael McKenney
It’s still really pretty much the major source, Bill.
William Hyler
All right. Okay, appreciate it.
Operator
Please standby for our next question. Our next question comes from John Franzreb with Sidoti. Your line is now open.
John Franzreb
Good morning, guys. Thanks for taking the questions. In your prepared remarks, you mentioned capital projects shifting out of the fourth quarter and into the first half of 2023. What’s the magnitude and the size of those projects in total? And what segments are you most impacting?
Michael McKenney
Well, overall, aggregated to approximately $10 million in projects that were shifted out. And I would say it’s really — it’s predominantly in the Industrial Processing segment in both — we had movement both in some — in the stock prep product line and the wood processing product line. Well, I’d say most in the wood processing product line, where customers are a little behind on their projects and just requested delivery of equipment, either in the first or second quarter ’23.
Jeffrey Powell
John, when these projects ship, they go into a mill that’s got a lot of civil work that has to be done. And of course, everybody is feeling the supply chain constraints. And so — and labor shortages and everything else. So if they’re slower and getting all the civil work done, they’re just not ready to accept and install the equipment. And that’s really kind of what — and of course, being the last quarter of the year, if they delay delivery by two weeks at the end of the year, that shifted into next year. So that’s really, I think, what we’re experiencing.
John Franzreb
Okay. So you’d expect most of this to be delivered in the first quarter? Or am I putting words in your mouth?
Michael McKenney
Well, I would say first half. There’ll be a good chunk in the first quarter, but it’s all been shifted to the first half of ’23.
John Franzreb
Right. Fair enough. And then just — what your thoughts on commodity prices? Metal prices have been coming down since peaking in the spring, but we’re not seeing a lot of real traction from that and a lot of companies reported results yet. Have you been any kind of a beneficiary of lower metal prices? Do you expect to be any time in the future? What are your thoughts about input costs?
Jeffrey Powell
Yes. So you’re right. I mean, our biggest single purchase cost is stainless steel, and it had dropped nicely, I’d say, through August. But in September and October, it’s kind of flattened out. Actually, in October, it actually increased a little bit.
If we look at the kind of — if you look at the future prices through, say, mid next year, they’ve got declining a little bit more, but not dropping precipitously. I would say if you look at our gross margins, they’ve been very steady and exactly what we expected. So I would say we’ve not benefited from it, and we’ve not been hurt by it. We’ve kind of stayed on top of it. Our guys around the world have stayed on top of it and done a good job.
So we’ve neither really benefited nor been hurt by it. But we certainly welcome the prices moderating. And if the — central banks are successful in slowing — so in the economy is down, we would expect prices to continue to drop later next year.
John Franzreb
Okay. Fair enough. And I guess one quick question, I guess. You talked about the shift maybe from capital equipment work to maybe more of a — maintaining the facility higher aftermarket sales and industrial processing. How would that process payout?
Is that like a one, two quarter set? Or is it a one, two year set?
Jeffrey Powell
I don’t know. That would be honest with you, we don’t know. I know that if you look at, for instance, on the housing side, if you look at kind of the consensus for next year, they’re predicting somewhere around, I think, 1.35 million starts a month, which is clearly down from certainly ’21 and ’22. So it’s really, I think, going to be a function of what the Fed do with the interest rates because the demand — the underlying demand for housing in particular, is still there very strong. Millennials are still in the prime house buying years. It’s just an issue with interest rates going up and some availability down.
So I don’t know. I mean the underlying fundamentals over the next many years are very strong. It’s just a question of what interest rates do.
John Franzreb
Okay, guys, thanks. Take my questions. I appreciate it.
Operator
[Operator Instructions] At this time, there are no further questions. I would now like to turn the conference back to Jeff Powell for closing remarks.
Jeffrey Powell
Thank you, Michelle. So before wrapping up today, I just wanted to leave you with a few takeaways. 2022 is shaping up to be the best year in our history across a wide range of metrics. We made solid progress this year on our efforts to accelerate revenue growth and boost our profitability despite the challenging macroeconomic environment. And lastly, as we work through our backlog, we expect to deliver excellent cash flows.
We want to thank you for joining the call today, and stay safe.
Operator
This concludes today’s conference call. Thank you for participating. You may now disconnect.
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