Q3 2023 Quanex Building Products Corp Earnings Call

Participants

George L. Wilson; President, CEO & Director; Quanex Building Products Corporation

Scott M. Zuehlke; Senior VP, CFO & Treasurer; Quanex Building Products Corporation

Julio Alberto Romero; Equity Analyst; Sidoti & Company, LLC

Steven Ramsey; Senior Equity Research Analyst; Thompson Research Group, LLC

Presentation

Operator

Good day, and thank you for standing by. Welcome to the Q3 2023 Quanex Building Products Corporation 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 Scott Zuehlke, SVP, CFO and Treasurer. Please go ahead.

Scott M. Zuehlke

Thanks for joining the call this morning. On the call with me today is George Wilson, our President and CEO. This conference call will contain forward-looking statements and some discussion of non-GAAP measures. Forward-looking statements and guidance discussed on this call and in our earnings release are based on current expectations. Actual results or events may differ materially from such statements and guidance, and Quanex undertakes no obligation to update or revise any forward-looking statement to reflect new information or events. For a more detailed description of our forward-looking statement disclaimer and a reconciliation of non-GAAP measures to the most directly comparable GAAP measures, please see our earnings release issued yesterday and posted to our website.
I'll now turn the call over to George for his prepared remarks.

George L. Wilson

Thanks, Scott, and good morning to everyone joining the call. Let me first say how proud I am of our team this quarter as our strong execution delivered a record quarter from an earnings and a margin perspective and all of our operating segments realized margin expansion. I'm especially proud of these results because they came in a quarter when our top line results were somewhat challenged as compared to last year.
Looking back and as a reminder, 2022 was a year driven by record demand, elevated surcharge pricing across all operating segments and increased material index pricing in North America. Year-to-date in 2023, our top line results have been impacted by softer market volume and our pricing started to decline year-over-year during the third quarter, mostly in North America as raw material costs have come down.
However, as we stated in our previous 2 quarterly earnings calls, our shipments cadence this year has indicated that we are returning to more normal seasonality versus what was experienced during the last 2 years. That shipment trend continued through our third quarter. And as a result, our volumes were up versus the first half of this year.
In addition, we saw a return to more normal order pattern for our spacer products in Q3 which were impacted negatively by customer destocking initiatives throughout the first half of the year. Despite the lower revenue and in an environment of uncertain macroeconomic conditions, we continue to execute across the board and generated record net income and EBITDA for the quarter. This performance also translated into free cash flow generation that was meaningfully higher than the same quarter last year and enabled us to repay $25 million of debt. So overall, we are extremely pleased with our execution in the third quarter of this year.
I will now provide some insight into our view of the macroeconomic conditions we are facing. From a global perspective, we believe that consumer demand may continue to be pressured for the next 6 to 9 months due to higher interest rates, energy cost challenges in the winter months and lingering effects from pull forward demand for our products during the 2 years following COVID.
More recently, economists seem to be indicating that the macro fundamentals for new construction may recover faster than the R&R markets. From an input cost perspective, we are seeing signs that inflation of major raw materials have eased, and we are even seeing some cost increases for certain items. However, highly engineered components and chemical feedstock pricing remain relatively strong. Labor costs across the globe are also still high and the available labor markets remain tight. We think this situation will continue despite some volume softness as most companies will only reduce labor as a last resort when trying to manage margins. Logistics costs are somewhat mixed as fuel and carrier expenses remain high on domestic freight. One area of relief has been a significant reduction in ocean freight expense and container fees.
Finally, energy costs remain elevated, although not nearly as high as we might have anticipated a year ago. With all this being said, we expect a choppy start to fiscal 2024, but we anticipate an improving market in the back half of next year. Even with this backdrop, we are very confident in our ability to execute, and we are well positioned to outperform as the market improves. Our focus remains on controlling what we can control. Near-term macro headwinds and index-related pricing pressures present challenges for revenue, but the Quanex team continues to perform. As we head into our final quarter of the year, we feel we are well positioned to execute on our strategy and continue to create value for our shareholders.
I will now turn the call over to Scott, who will discuss in greater detail our financial results.

Scott M. Zuehlke

Thanks, George. On a consolidated basis, we reported net sales of $299.6 million during the third quarter of 2023, which represents a decrease of 7.5% compared to $324 million during the third quarter of 2022. The decrease was mostly attributable to softer market demand and lower pricing in North America. Net income increased to $31.7 million or $0.96 per diluted share for the 3 months ended July 31, 2023, compared to $25.9 million or $0.78 per diluted share for the 3 months ended July 31, 2022. After adjusting for onetime items, net income increased to $31.9 million or $0.96 (sic) [$0.97] per diluted share for the quarter compared to $26.2 million or $0.79 diluted share for the same period last year.
On an adjusted basis, EBITDA for the quarter increased to $48.5 million compared to $44.2 million during the same period of last year. The increase in earnings for the 3 months ended July 31, 2023, was largely attributable to operational efficiency gains, cost control and a decrease in income tax expense. As such, we were able to realize margin expansion in each of our operating segments and on a consolidated basis.
Now for results by operating segment. We generated net sales of $177.1 million in our North American Fenestration segment for the third quarter of 2023, a decline of 4.1% compared to $184.7 million in the third quarter of 2022, driven by a decrease in volumes due to softer market demand and lower pricing.
Excluding the contribution from the LMI business we purchased at the beginning of our fiscal year, revenue would have been down approximately 15% year-over-year in this segment. We estimate that volumes in this segment declined about 12% year-over-year with the remainder of the revenue decline versus Q3 of 2022 due to a decrease in price.
Adjusted EBITDA increased slightly to $27.7 million in this segment compared to $27.1 million for the same period of 2022, which equates to margin expansion of 90 basis points year-over-year. Operational and sourcing initiatives continue to result in benefits that are outpacing inflation and giving us the ability to expand our margins. This group also continues to do a good job of controlling divisional SG&A despite the lower volumes.
Our Quanex custom mixing business, formerly LMI, continues to perform above expectations. We generated net sales of $55.4 million in our North American Cabinet Components segment during the quarter, which was 23.6% lower than prior year. This decrease was driven by lower volumes and lower index pricing for hardwoods. We estimate the volumes declined by approximately 16% in this segment year-over-year, with the remainder of the revenue decline versus Q3 of 2022 due to a decrease in price mostly related to index pricing tied to the decline in hardwood costs.
Adjusted EBITDA was $5.4 million for the quarter compared to $5.6 million in the third quarter of 2022. The time lag related to our hardwood index pricing mechanism in this segment helped us with profitability this quarter after hurting us on that front in Q3 of 2022. And we also did a good job of controlling costs in Q3 of this year. These factors together led to adjusted EBITDA margin expansion of 200 basis points compared to the third quarter of 2022 in this segment.
Our European Fenestration segment generated revenue of $67.9 million in the third quarter, which represents a slight increase compared to $67.6 million in the third quarter of 2022. We estimate that volumes declined approximately 6% year-over-year in this segment, while pricing was up by approximately 3% and positive foreign exchange translation impact came in at about 3% as well. Adjusted EBITDA came in at $18.6 million for the quarter compared to $12.1 million in the third quarter of 2022. Pricing held up nicely during the quarter and we continue to perform well from an operational standpoint, which led to adjusted EBITDA margin expansion of 940 basis points year-over-year.
Market softness was offset by share gains in our U.K. vinyl extrusion business as well as normalized buying from our European spacer customers as inventory rebalancing pr0ojects appear to have come to an end. Continued improvements in operational metrics, combined with sourcing initiatives and pricing carryover all contributed to realizing margin expansion in this segment.
Moving on to cash flow and the balance sheet. Cash provided by operating activities improved to $64.1 million for the third quarter of 2023, which represents an increase of 24% compared to $51.7 million for the third quarter of 2022. We did a very good job managing working capital and the value of our inventory continued to decrease during the quarter due to easing raw material inflationary pressures, which had a positive impact on working capital.
Free cash flow was $56.7 million for the quarter, which was another record and represents an increase of 23.3% compared to $46 million we generated in Q3 of last year. Our balance sheet continues to be strong. Our liquidity keeps improving and our leverage ratio of net debt to last 12 months adjusted EBITDA was 0.3x as of July 31, 2023. Excluding real estate leases that are considered finance leases under U.S. GAAP, we are essentially net debt free. As George mentioned, we are able to repay $25 million of debt during Q3.
We will remain focused on generating cash, paying down debt and opportunistically repurchasing our stock. We will also maintain our focus on growing the company through organic, inorganic and innovative growth opportunities as they arise, while continuing to preserve our healthy balance sheet. As always, the goal is to create shareholder value. Based on year-to-date results, conversations with our customers and recent demand trends, we are updating our guidance for fiscal 2023 as follows: Net sales of $1.125 billion, adjusted EBITDA000 of $150 million to $155 mi1llion, tax rate of 20%, which is lower than previously indicated, mainly due to a larger portion of our income being subject to a 10% preferential tax treatment in the U.K. In addition, our guidance for free cash flow is now $90 million to $95 million for fiscal 2023, which would be a record for Quanex and is about 50% higher than prior guidance, driven by improved results and solid working capital management.
From a cadence perspective, for the fourth quarter of this year versus the fourth quarter of last year, we expect revenue to be down 3% to 4% on a consolidated basis. By segment for the fourth quarter of this year compared to the fourth quarter of last year, we expect revenue to be up 1% to 2% in our North American Fenestration segment, down 23% to 24% in our North American Cabinet Components segment and up 8% to 9% in our European Fenestration segment. On a consolidated basis, adjusted EBITDA margin is expected to be up 250 to 350 basis points in the fourth quarter of this year compared to the fourth quarter of last year.
Operator, we are now ready to take questions.

Question and Answer Session

Operator

(Operator Instructions). And our first question will be coming from Steven Ramsey of the Thompson Research Group.

Steven Ramsey

Maybe to start with on the customer inventory rebalancing and fenestration not being a headwind anymore, kind of going forward, do you think customers intend to run light on inventory for a time? Have they discussed the factors that will govern their restocking plans in the future?

George L. Wilson

In terms of the customer inventory rebalancing, I think all of our customers now that the supply chain has noticeably improved across the board. I think that they will and do feel comfortable running at lower levels of inventory. So -- but I think they're at that point already. I think most companies have been very aggressive of balancing their working capital, not unlike us. And that they'll continue to run at these levels. The good thing with that is I think we are at a point that we are at that stable level now. So I don't think we'll see any impact in what we see right now and in the near future is a normal ordering pattern on a go-forward basis.

Steven Ramsey

Okay. Got you. Got you. And then on the North America operational and sourcing benefits that helped this completed quarter, how much more do you have on that journey going forward? And when do you start lapping the benefits of that in the P&L?

George L. Wilson

So when we look at our indexes, because they are time-based and usually trigger on either a 30-, 60- or 90-day lag, depending on the customers and whatever the index pricing mechanism is, the point in time where the cost curve flattens out, that's when we'll start to see the bottom of that. So as long as raw materials continue to trend down. I think we'll always be ahead of it. At the point in time that it flattens or starts to tick back upwards again, that's when you'll see kind of a reconciliation or an equilibrium as it relates to pricing and the timing of purchases with raw materials.

Steven Ramsey

Okay. Helpful. And then last quick one for me. How much was mix and impact to third quarter results? And how much is mix embedded in the fourth quarter guidance?

George L. Wilson

I think what we saw from a third quarter perspective is that really mix did not have much of an impact at all. It's been pretty consistent. Versus prior quarter, the additional spacer sales, I think, probably plays a little part, but not meaningful. And I would suspect that going into our fourth quarter, we won't see much of an impact on mix as well. It's pretty consistent with where we're at and what we planned and where we've guided.

Operator

And our next question will come from Julio Romero of Sidoti & Company.

Julio Alberto Romero

Maybe to start on the European segment. It was really impressive margin performance there, might have been your best margin performance in that segment in company history. You talked about a couple of the drivers of that margin, price, operational efficiencies and the shared gains in vinyl extrusion. Can you maybe rank order those drivers and talk about the confidence and how sustainable the European margin go forward is?

George L. Wilson

In terms of our European margins, it was a very good quarter and a lot of it has to do with timing. We were behind in pricing during the previous year. And so as we move forward, what we're starting to see now is the timing impact of the price increases that we put through. On a go-forward basis, I think we will be able to hold some margin. I do see that we will see pressure. So I think we expect that, that margin percentage may retreat a little bit and as raw materials drop and as discussions with customers go forward, we will be in a position that I think pricing and margins will be pressured on a go-forward basis.

Julio Alberto Romero

Okay. Got it. And then can you maybe just talk about the LMI integration? How much revenue is expected to -- from LMI in the fourth quarter? And any progress update on the potential revenue synergies there?

Scott M. Zuehlke

Let me take that backwards. So on the synergies, we had previously disclosed that we had exceeded the $500,000 a year synergy target. I think as we continue to dig and learn more about that business, we have realized more synergies than that, probably between $500,000 and $1 million. I think there's still some digging to do and some work to do there, but that business continues to perform very well. As far as revenue from that business in 4Q, as you know, we don't break it out by product line. That's just lumped into NAF. But it would probably be similar to 3Q.

Julio Alberto Romero

Okay. And then -- that's really helpful. And then the $500,000 million to $1 million synergies achieved, are they all cost related? Or are there revenue synergies in there as well?

George L. Wilson

No. At this point, they're all cost-related synergies. The initiatives that we have from a revenue-generating perspective, they're going to take a little longer, although we're excited about those opportunities on a go-forward basis. But in terms of time it takes to qualify new customers and new materials, it's going to take a little longer. We would expect those benefits to probably start impacting next year's revenue, probably mid-year.

Julio Alberto Romero

Got it. Really helpful. And then just last one for me is just you upped your cash flow expectation for the year. You've paid down some debt. Just how does the improved financial profile kind of help you think about go-forward cash deployment?

George L. Wilson

I think we'll continue to stay on the strategy that we have. I think with the interest costs where they're at, we'll continue to pay down debt because I think that, that is absolutely a smart move for us. But we'll continue to also invest in some new revenue-generating opportunities. We've invested a little more in R&D, and we're doing some things on that side for organic growth. We'll continue to look pretty heavily at opportunities for inorganic growth, although, again, as we've talked about in the past, we'll make sure that if we do pursue anything that it will hit the metrics and the targets that we're looking to meet our strategy objectives.
And then finally, if we continue to be clicking along at the same cash flow generation into the fourth quarter, we'll continue to have discussions with the Board on our dividend policy. But I would probably rank those as cash debt, opportunistically buying back stock in the market in what open times. As a reminder, we don't have any sort of structured buyback plan. So we have to be opportunistic in the market. And then obviously, the growth. So I would prioritize them in that ranking right now.

Operator

And I would now like to turn the conference to George for closing remarks.

George L. Wilson

I'd like to again thank everyone for joining the call today, and we look forward to providing an update on our next earnings call in December. Thank you.

Operator

And this concludes today's conference call. Thank you for participating. You may now disconnect.