Q2 2023 Kadant Inc Earnings Call
Participants
Jeffrey L. Powell; President, CEO & Director; Kadant Inc.
Michael J. McKenney; Executive VP & CFO; Kadant Inc.
Aditya Madan; Research Associate; D.A. Davidson & Co., Research Division
Gary Frank Prestopino; MD; Barrington Research Associates, Inc., Research Division
Lawrence Tighe De Maria; Group Head of Global Industrial Infrastructure; William Blair & Company L.L.C., Research Division
Presentation
Operator
Good day, and thank you for standing by. Welcome to the Kadant's Second Quarter 2023 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 J. McKenney
Thank you, Abigail. Good morning, everyone, and welcome to Kadant's Second Quarter 2023 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 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 31, 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. Reconciliation of the non-GAAP financial measures to the most directly comparable GAAP measures is contained in our second 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 L. Powell
Thanks, Mike. Hello, everyone, and thank you for joining us this morning to review our second quarter results and discuss our business outlook for the second half of 2023.
I'll begin by reviewing our operational highlights for the second quarter. I'm pleased to report, we had another well-executed quarter with solid aftermarket demand for parts, combined with strong capital business, leading to record revenue, record adjusted EBITDA and record adjusted EPS.
Our operations teams around the globe continued to deliver exceptional value for our customers and perform at a high level as shown by our strong financial performance. They have done a great job of meeting our customers' needs in a challenging environment, and I want to thank them for their outstanding work and the results they generated.
Turning next to Slide 6. I'd like to review our Q2 financial performance. We achieved a number of new financial records in the second quarter driven by large capital shipments along with strong contribution from aftermarket parts. Revenue increased 11% to a record $245 million with solid growth across all regions and all operating segments. Strong execution contributed to a record adjusted EBITDA of $52 million, up 12% compared to last year and representing 21% of revenue in the second quarter. Our adjusted EPS was also a record at $2.54 a share.
As economic headwinds strengthen, second quarter bookings declined from the record set in the first quarter of this year. Capital project activity remains healthy. But as the scope of these projects is refined, the execution time line has, in some cases, been pushed out to a later date.
While the general slowdown in industrial activity over the past few months is reflected in our second quarter new order activity, we have a strong backlog and expect bookings in the second half of 2023 to be similar to the second half of last year. I'll provide more details on that when I review our operating segments.
Next, I'd like to discuss our 3 operating segments, beginning with Flow Control. As you can see on Slide 7, our Flow Control segment had solid bookings coming off of a record first quarter in 2023. Revenue in the second quarter increased 12% to a record $96 million with a strong contribution from capital projects. Our aftermarket parts revenue remained robust in the second quarter and made up 68% of total revenue.
Excellent operating performance led to record adjusted EBITDA and an adjusted EBITDA margin of 29.3%.
Our Flow Control segment's bookings performance in the first half of 2023 provided a good start to the year. We expect business to moderate in the second half, reflecting the overall softening in industrial production. That said, the fundamentals of our end markets remain healthy, and we are well-positioned to capitalize on new projects and opportunities.
Our Industrial Processing segment revenue in the second quarter grew 7% compared to the same period last year. Relative to our other operating segments, our Industrial Processing segment was more impacted by foreign currency translation in the second quarter. And when excluding the impact of FX, our revenue was up 9%. Strong operating leverage boosted EBITDA margin 40 basis points to 22.2%.
As you can see on Slide 8, our year-over-year bookings comparison is challenging for the second quarter as we had historic demand in the prior year period. The decline in capital business was largely in our wood processing product line, while demand for parts in this segment was comparable to the same period last year.
In our Material Handling segment, we achieved our best revenue performance since creating this segment with strong contributions from our bulk material handling equipment, leading to record revenue of $59 million in the quarter. Aftermarket parts demand for our high-performance billing systems, particularly in Europe, was also notable.
Bookings in our Material Handling segment were down 19% compared to the same period last year, largely due to reduced capital project activity in our billing product line. The record-setting revenue volume combined with solid execution by our businesses in this segment helped boost adjusted EBITDA margin to a record 22.9% in the quarter.
We are encouraged by the number of infrastructure projects already underway and the additional projects being planned since the passage of the infrastructure bill in the U.S. Inquiries for our material handling equipment continue to increase as infrastructure projects gain traction, and we are well-positioned to take advantage of this growing demand.
As we look ahead to the second half of 2023, the ongoing economic challenges lead us to believe demand for our products will be similar to that of the second half of last year. Our operations teams around the globe are executing well on their strategic initiatives and making positive strides to create and capture more value. Our robust backlog and ability to generate strong cash flows continue to have us well-positioned to capitalize on opportunities that may emerge as the year unfolds.
We expect to deliver record financial performance again this year and are raising our full year '23 revenue and EPS guidance.
With that, I'll turn the call over to Mike for a review of our financial performance in Q2 and our guidance outlook for the remainder of the year. Mike?
Michael J. McKenney
Thank you, Jeff. I'll start with some key financial metrics from our second quarter. Consolidated gross margins were 43.5% in the second quarter of '23, up 20 basis points compared to 43.3% in the second quarter of '22. This increase was principally due to higher margins achieved on capital projects, especially in our Industrial Processing segment, offset in part by a lower proportion of parts and consumables revenue, which represented 62% of revenue in the second quarter of '23 compared to 66% in the prior year.
SG&A expenses increased $4.7 million to $60 million in the second quarter of '23 compared to $55.3 million in the second quarter of '22 due to wage increases and incremental costs related to trade shows and travel. As a percentage of revenue, SG&A expense decreased to 24.5% in the second quarter '23 compared to 25% in the prior year period.
Our GAAP EPS increased 13% to $2.54 in the second quarter compared to $2.24 in the second quarter of '22, principally due to higher revenues. Our adjusted EPS was a record $2.54 in the second quarter '23, exceeding the prior record of $2.40 achieved in the first quarter of '23. The second quarter '23 adjusted EPS exceeded the high end of our guidance range by $0.39 due to higher revenue and better gross margins than forecasted.
We had record revenue in the second quarter of '23 driven by our highest quarterly parts and consumable revenue. Both our Material Handling and Industrial Processing segments exceeded their parts and consumables revenue forecast due in part to fulfilling additional orders from backlog.
Adjusted EBITDA increased 12% to a record $51.6 million compared to $46 million in the second quarter of '22 due to strong performance in our Flow Control and Material Handling segments. As a percentage of revenue, adjusted EBITDA was 21% compared to 20.7% in the second quarter '22.
Operating cash flow increased 20% to $22.5 million in the second quarter '23 compared to $18.8 million in the second quarter of '22. Free cash flow was up 16% to $13.7 million in the second quarter of '23 compared to $11.9 million in the second quarter of '22.
We had several notable nonoperating uses of cash in the second quarter of '23. Paid down debt by $25.1 million, paid $8.8 million for capital expenditures and paid a $3.4 million dividend on our common stock. I would also note that $3.1 million of the $8.8 million capital expenditure amount related to the facility project in China. The facility move has started and is expected to be completed in the third quarter, with the remaining capital expenditure of approximately $5 million to be paid over the next 2 quarters.
Let me turn next to our EPS results for the quarter. Our GAAP and adjusted earnings per share were $2.54 in the second quarter of '23 compared to $2.24 in the second quarter '22. As shown in the chart, the increase of $0.30 in adjusted EPS in the second quarter '23 compared to the second quarter '22 consists of the following: $0.63 due to higher revenue, $0.02 due to a higher gross margin percentage and $0.01 due to a lower tax rate. These increases were partially offset by $0.30 due to higher operating expenses, $0.05 due to higher interest expense and $0.01 due to higher weighted average shares outstanding.
Collectively, included in all the categories I just mentioned, there was an unfavorable foreign currency translation effect of $0.06 in the second quarter '23 compared to the second quarter of last year due to the strengthening 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 138 at the end of the second quarter '23 compared to 136 last year. Working capital as a percentage of revenue was 16.7% in the second quarter of '23 compared to 15.6% last quarter.
Our net debt, that is debt less cash, decreased $10 million or 10% sequentially to $87 million. This is the lowest net debt position we've had since 2017. We were able to pay down $25 million revolving credit facility debt in the second quarter of '23. And as a result, our leverage ratio, calculated in accordance with our credit agreement decreased to 0.51 at the end of the second quarter '23 from 0.64 at the end of the first quarter of '23.
We have a strong balance sheet and are well-positioned to take advantage of investment opportunities with our current net debt position, current borrowing capacity of $257 million available under our revolving credit facility, and an additional $200 million of uncommitted borrowing capacity.
Now I'll update our guidance for '23. We are increasing our full year revenue guidance to $925 million to $940 million from $910 million to $935 million, and we are increasing our adjusted EPS guidance for the full year to $9.15 to $9.35 from $8.90 to $9.15. The adjusted EPS guidance excludes $0.04 in estimated relocation costs associated with one of our facilities in China. Our revenue guidance for the third quarter of '23 is $229 million to $236 million, and our adjusted EPS guidance is $2.19 to $2.29, which excludes $0.04 of estimated relocation costs.
As always, I'll caution here that there could be some variability in our quarterly results due to several factors including the variability of order flow and the timing of capital shipments.
We now anticipate gross margins for '23 will be 43% to 43.5%. This implies gross margins in the remaining quarters will be slightly below 43% as the mix is expected to be more heavy-weighted towards capital in the second half of '23.
As a percentage of revenue, we now anticipate SG&A will be approximately 25%.
We continue to anticipate our tax rate for the remaining quarters of '23 will be approximately 27%, and we now anticipate CapEx spending in '23 will be approximately $38 million to $40 million, up from $32 million to $34 million as we were able to accelerate some investments originally planned for '24. Our CapEx, for 2023, CapEx spending includes approximately $9 million related to our facility project in China.
That concludes my review of the financials, And I'll now turn the call back over to Abigail for our Q&A session. Abigail?
Question and Answer Session
Operator
(Operator Instructions) Our first question comes from the line of Gary Prestopino with Barrington Research.
Gary Frank Prestopino
Could you just go -- for my purposes, as a new analyst following the company, could we just -- maybe just go into some of the puts and takes on the year-over-year bookings? They're down somewhat dramatically, I suppose. So could -- is that just really a function of what you're seeing economically a slowdown? Or was last year just a big year in terms of bookings due to catch-up from the pandemic?
Jeffrey L. Powell
Yes. So I think it's really a combination of two things. Last year, at the time that was $266 million was a record for us, quite strong. And so -- and of course, the first quarter of this year was $275 million, a new record. So we kind of look at -- when we look at our bookings, some of maybe what we thought would come in the second quarter moved in the first quarter. So we had the very strong $275 million in the first quarter.
But there is -- I think there's no question there is a little bit of an industrial slowdown. If you look at the overall economy, what we're seeing is that the service side of the economy is doing quite well and the industrial side is slowing down some. So I think a little bit of it is -- comparing to a record at the time last year, a little bit of it is having such a phenomenal first quarter at the $275 million combined with a little slowdown in industrial production.
It tends to be our capital equipment that shifts around. Our parts are pretty stable, and they're pretty flat actually. So it's really the timing of capital from one quarter to the next and a little bit of a slowdown. I think people are just taking a little more of a wait-and-see approach, trying to see what the Fed is going to do. Interest rates have gone up, of course, which increases the cost of borrowing money. And so I think it's a combination of all those factors.
Operator
Our next question comes from the line of Lawrence De Maria with William Blair.
Lawrence Tighe De Maria
Just as a follow-up on the earnings -- sorry, the orders question, can you just give an idea of how much worse were orders compared to your expectations in the quarter? And what gives you confidence that those second half bookings will come through at the levels you said they were? Do you have the pipeline and the conversations and good visibility on that? That's the first part.
Michael J. McKenney
Yes, Larry. The orders came in on forecast. That was the forecast for the quarter. So no disappointment there. That is what we anticipated. Again, as Jeff mentioned, we had an extraordinarily strong first quarter bookings performance as we noted. So it's -- you're looking at first quarter bookings, which were extraordinarily strong and also second quarter of last year at $266 million. We also indicated it was a phenomenally strong order quarter for us, especially in both periods on the capital front.
Lawrence Tighe De Maria
Okay. And then the pipeline into the second half that gives you that confidence?
Michael J. McKenney
Yes. I think as Jeff said, our parts and consumables business is very stable. We are seeing a little -- some softness on the capital bookings front, and that's what folks have forecast.
Lawrence Tighe De Maria
Okay. And then -- now we start to think about long term again through the second half and kind of low orders that we are starting that we're having kind of now. Give us some high-level thoughts, if you can and are willing to do it, what it means into '24 if we're looking at, is this a trough year? Is it -- do we sort of start off soft based on the orders and then look for reacceleration in industrial from (inaudible) and other things? Or can you actually think about even growing margin earnings next year because of 80/20 and positive price? Any kind of high-level puts and takes on how to start to frame next year based on where the orders are now would be really helpful.
Jeffrey L. Powell
Yes. Of course, as you know, it's always -- when you sit here just closing the second quarter, it's a little challenging to know exactly what's going to happen next year and particularly because the Fed is still on a campaign to try to get control of inflation. But I think we're encouraged by the fact that the -- in particular, our wood group, the builders are starting to see improved demand. The -- a lot of the forest product companies have released earnings and had strong earnings and are somewhat optimistic. So I think that sector, I think they're hoping that might come back a little bit next year.
Our Material Handling side, in particular, the bulk equipment handling side, that's been ramping up with this infrastructure bill that really is just now starting to be spent. It takes a while for the government to start spending that. So our customers kind of try to get ahead of that and make some investments in their business, so they're prepared when that money starts to flow, but it really is just it hasn't really hit the market yet.
But it's -- I would say that it's still a bit early for us to predict. What the experts are saying is they expect maybe things will be slow in the first half of the year and that in the second half, things will start to pick back up. There might even be -- some people even predict there might be some rate cuts in the second half of the year. I have no idea whether that will be the case or not. But I think we believe that there will be some improvements as the year progresses.
I think -- we think that it's going to it's going to be kind of flat and stable the rest of this year with last year, probably start out that way, the first of the year, then we would expect to see investments start to be made as the year progresses and our customers get a little more visibility on exactly where interest rates top out at and kind of what the Fed's action might be.
But it's -- I would say these are more uncertain times because you do have these central banks. I mean, in China, the bankers are actually trying to spur growth because they're growing. They're worried about disinflation and inflation. So they're trying to increase demand. Europe, of course, is just essentially flat this quarter, up maybe [0.001 or 0.002]. So there so is a fair amount of variability around the world right now and what the different bankers are doing to impact their economies. But we think, generally speaking, that things should improve as the year goes on next year.
Lawrence Tighe De Maria
Okay. That makes sense, and I appreciate. Obviously, it's difficult to make those calls right now. Last question, you talked about, obviously, M&A capacity center in the balance sheet. At some point, do you ever considered share repurchases? And is -- are we at the point where we're getting closer to actionable M&A? Or is it just a good pipeline and still waiting for things to align?
Michael J. McKenney
So I would say, Larry, on the share repurchase, yes, we have a $50 million authorization outstanding. We always have an authorization available to utilize. So that is always in the mix for capital deployment. And I would also say, for us currently right now, there is a lot of activity on the M&A front. We're seeing a lot of companies come out. So that is certainly always in play for us also.
Jeffrey L. Powell
Yes. I would say our deal flow, we talk about -- we have a corporate development group that focuses on that. I would say the deal flow was surprisingly weak last year, but it has bounced back nicely this year. So there's a lot of activity, a lot of discussions, a lot of companies out there that are interested in being acquired. So our group is quite busy right now looking to try to find companies that are good strategic fits for us at the proper value.
Operator
(Operator Instructions) And our next question comes from the line of Adi Madan with D.A. Davidson.
Aditya Madan
Filling in for Kurt Yinger today. And just a couple of quick questions for me. So could you give us more color on the backlog? And like how would you characterize it? When does it extend out into the cancellation rate or anything else we should know about it?
Michael J. McKenney
Well, Adi, our back -- we ended the quarter with a backlog of $363 million. So as you know, we ended the first quarter with a record backlog of $393 million. And just as a benchmark, that $363 million would be a very high backlog for us. It would be our third highest backlog, only eclipsed by the first quarter of '24, and then mid '22, we had a higher backlog in the second quarter of '22. So we have a very strong backlog.
And in regards to your question, I think you were saying about cancellations, That's very rare for us. We -- it does happen on occasion. But a good chunk of the backlog is capital. It kind of breaks out 70-30, 70% of the backlog is capital. So majority, far and away, in backlog is capital. And our customer base, when they commit to a capital project, they tend not to back off of that. So it does happen on occasion, cancellations, but not much.
Aditya Madan
Got it. Got it. Yes, that makes sense. And then you talked about your wood clients. And so when it comes to mill taking downtime over the quarter, how did that trend? And how do you expect that to be going forward, maybe for the full year? Also, if you could talk about it more broadly?
Jeffrey L. Powell
Yes. The first quarter, the mills on the wood side were slow and demand was down, but it surprisingly picked up quite a bit in the second quarter. Prices firmed up. And our parts business was quite strong, which tends to be an indicator of operating rates. So I would say on the wood side, things seem to be improving. Now it's very much a function of interest rates. And I think everybody is trying to adjust to the new rates. But there's almost no kind of used inventory coming on the market. Everybody's locked into these very low-interest-rate loans. They don't want to trade out a 3% mortgage for 7%. And so almost all of the home purchases now are new construction because of that. And so of course, that drives a lot of our customers' demand.
So I think if you look at the underlying fundamentals of demand in the housing sector, you look at the millennials, which are going to peak around 2030 as far as prime house buying. And then also, the average age of homes on the 20 to 40 year, which is when major remodeling takes place, that's at a quite high rate, too. So the underlying fundamentals for wood were actually quite good for the next several years. And I think there's been this momentary challenge with the Fed raising rates to try to crush inflation.
But as rates start to come down, whether it's middle of next year or the end of next year, I think you're going to see the wood sector come back very strongly because there's just so much underlying demand. And these millennials aren't going to live in their parent's basement forever. They want to get out. And so there's just a lot of demand, and we've underbuilt for 10 years now or more. So I think you're starting to see some improvements now, and we expect that will absolutely continue and will accelerate as soon as rates top out and start to come down some.
Aditya Madan
Right. And then just going back to capital allocation from your comments, is it fair to say you're leaning more towards like sticking with the dividend and increasing the dividend relative to M&A?
Michael J. McKenney
I would say, no. That wouldn't be true. We have a dividend and although we can't promise, our goal is always to -- we strive to try to increase it every year. So in all likelihood, we'll be continuing with the dividend. But that really, I would say, is not impacting what we choose to do on M&A at all.
Operator
(Operator Instructions) That concludes the question-and-answer session. At this time, I would like to turn it back to Jeff Powell for closing remarks.
Jeffrey L. Powell
Thank you, Abigail. And before wrapping up the call today, I just want to leave you with a few takeaways. Despite the slowing economies, the second quarter was another record-setting quarter, and our operations teams deserve a lot of credit for producing these results. We have strong market positions and expect stable demand during the second half of the year. And finally, our balance sheet continues to strengthen, and we are actively pursuing new growth opportunities.
And with that, I want to thank you for joining the call today, and we look forward to updating you next quarter.
Operator
Thank you for your participation in today's conference. This does conclude the program. You may now disconnect.
