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Quanex Building Products (NX) Q4 2018 Earnings Conference Call Transcript

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Quanex Building Products (NYSE: NX)
Q4 2018 Earnings Conference Call
Dec. 11, 2018 11:00 a.m. ET

Contents:

  • Prepared Remarks
  • Questions and Answers
  • Call Participants

Prepared Remarks:

Operator

Good day, ladies and gentlemen, and welcome to the Quanex Building Products Corporation's fourth-quarter and full fiscal-year 2018 earnings conference call. [Operator instructions] As a reminder, this conference call is being recorded. I would now like to turn the conference over to Scott Zuehlke, vice president, investor relations and treasurer. Sir, you may begin.

Scott Zuehlke -- Vice President, Investor Relations and Treasurer

Thanks for joining the call this morning. On the call with me today is Bill Griffiths, our chairman, president and chief executive officer; Brent Korb, our chief financial officer; and George Wilson, our chief operating officer. 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. 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 Brent to discuss the financial results.

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Brent Korb -- Chief Financial Officer

Thank you, Scott. I will begin with a review of the income statement and finish with comments on cash flow, the balance sheet and 2019 guidance. I will then hand the call over to Bill, who will provide additional color around our performance, as well as our strategy and expectations going forward. Net sales increased 4.8% for the fourth quarter to $244.1 million and 2.7% for the full fiscal year to $889.8 million compared to the same periods of 2017.

The increases were primarily driven by market growth, as well as price increases, mainly related to raw material inflation recovery and for the full year a favorable foreign exchange impact. We reported net income of $6.5 million or $0.19 per diluted share for the three months ended October 31, 2018 compared to $10.7 million or $0.31 per diluted share during the three months ended October 31, 2017. For fiscal 2018, net income increased to $26.3 million or $0.75 per diluted share compared to $18.7 million or $0.54 per diluted share for fiscal 2017. On an adjusted basis, net income was $7.6 million or $0.22 per diluted share during the fourth quarter of 2018, compared to $13.1 million or $0.37 per diluted share during the fourth quarter of 2017.

Adjusted net income was $22.7 million or $0.65 per diluted share for fiscal 2018 compared to $27 million or $0.77 per diluted share for fiscal 2017. The adjustments being made for earnings per share are as follows: LIFO inventory reserve adjustment, purchase price inventory step-up recognition, restructuring charges related to the previously announced closure of several manufacturing plants, accelerated depreciation and amortization for equipment and intangible assets related to these facility consolidations, accelerated depreciation for plant relayouts in the North American Cabinet Components segment, foreign currency transaction impacts, the net tax benefit related to the Tax Cuts and Jobs Act and transaction and advisory fees. On an adjusted basis, EBITDA decreased to $25.2 million in the fourth quarter of 2018 compared to $33.3 million in the fourth quarter of last year. For the full year 2018, adjusted EBITDA was $90.9 million compared to $99 million in 2017.

The decreases in adjusted earnings are mostly due to the negative impact of inflationary pressures throughout the year and an increase in selling, general and administrative expenses. The increase in SG&A expense was driven by an elevated medical cost, fire annual incentive accruals and a year-over-year increase in insurance-related legal expenses. Insurance-related legal expenses for the fourth quarter and full fiscal year of 2017 included a benefit of $2 million and $4 million, respectively, related to legal expense reimbursement from one of our insurance carriers. Before I move on to cash flow and the balance sheet, I want to remind everybody that we recently amended and extended our credit facility.

This underscores the progress we've made over the past two years improving our leverage profile, and it provides a number of benefits including the maturity date on our outstanding debt was extended by more than two years. The new terms and covenants are less restrictive and give us more flexibility with respect to returning capital to shareholders and the new pricing grid is more favorable by 25 basis points across all tiers. Now on to the cash flow and the balance sheet. Cash provided by operating activities was $104.6 million in 2018 compared to $79.8 million in 2017.

We generated free cash flow of $78.1 million in 2018, which represents an increase of 73% year over year, largely driven by a focused effort to streamline working capital. As a result of our strong cash flow and consistent with our commitment to continue to reduce our leverage while returning capital to shareholders, we repurchased $32 million in stock in the fourth quarter and repaid $28 million of bank debt during fiscal 2018. We also achieved our targeted end-of-year leverage ratio of two times net debt to last 12 months adjusted EBITDA, as of October 31, 2018, even after the $32 million stock repurchase. As noted in the Outlook section of our earnings release, we are forecasting revenue growth of 4% to 6% in 2019.

Adjusted EBITDA guidance of $97 million to $107 million represents year-over-year margin expansion of approximately 70 basis points at the midpoint. From a capital expenditure standpoint, we expect to spend approximately $25 million to $30 million in 2019. For modeling purposes, it is appropriate to make the following assumptions for 2019: depreciation of approximately $36 million; amortization of approximately $15 million; SG&A of $105 million to $110 million; interest expense of approximately $11 million and a tax rate of 24%. I will now turn the call over to Bill for his prepared remarks.

Bill Griffiths -- Chairman, President and Chief Executive Officer

Thank you, Brent. As we announced at the end of our third quarter, our strategy for the foreseeable future is to maintain a healthy balance sheet and return excess capital to shareholders. As a result, we had an even greater emphasis on working capital management and cash flow generation during the fourth quarter. As Brent just mentioned, this led to exceptional free cash flow of approximately $78 million in fiscal 2018, including approximately $51 million in the fourth quarter alone.

To put this into perspective, the $78 million of free cash flow for fiscal 2018 equates to $2.23 per diluted share and a strong free cash flow yield, both of which compare very favorably to the current consensus averages for our peers. Our strong free cash flow generation enabled us to fund a doubling of the dividend, the repurchase of 1.9 million shares for approximately $32 million, while still maintaining a leverage ratio of two times, a level we are comfortable with. Our full-year adjusted EBITDA of $91 million was about $12 million shy of the low end of our guidance. This shortfall was primarily driven by increased incentive payments as a result of our strong free cash flow performance, along with an unforeseen increase in medical expenses.

To provide some context, we generated approximately $33 million more in free cash in 2018 than we did in 2017. While incentives in 2018 were about $11 million higher and medical expenses were almost $4 million higher than the prior year. Consistent with industry peers, we experienced softer-than-expected sales in August and September. Despite this softness, we continue to outperform the market in all segments from an underlying growth perspective.

This is primarily due to the greater weight into R&R versus new contraction. During the fourth quarter, our North American engineered components segment achieved underlying growth of 5.1%. And in Europe, despite all the turmoil surrounding Brexit, underlying growth was 5.9%. The North American cabinet components segment had a strong quarter all around with underlying growth of 8.2% and growth margin expansion of 225 basis points compared to last year.

This marks the second consecutive quarter of significant gross margin expansion in this segment. We are pleased with our progress here and will continue to focus on operational excellence to further enhance productivity and drive margin expansion. So while there is currently some pessimism within the building products sector, our current view isn't as negative. We believe we will see 4% to 6% revenue growth in 2019 compared to the 6% underlying growth we realized in 2018.

In addition, while we expect inflation to continue in 2019, particularly with respect to logistics, benefits and healthcare costs, we are confident that we can pass these costs on through pricing initiatives. As such, we expect the slight improvement in 2019 in adjusted EBITDA margins in our North American engineered components segment with flat to slightly declining margins in our European engineered components segment and continued meaningful margin expansion in our North American cabinet components segment based on the expectation for the productivity improvements. Accordingly, as Brent said, we expect adjusted EBITDA of between $97 million and $107 million in fiscal 2019. CAPEX was a little lower than planned in 2018 due to delays in a couple of major projects, which have been pushed into this year.

Even with this carryover, we anticipate spending $25 million to $30 million in fiscal 2019. We remain laser-focused on generating cash flow and we will continue to aggressively manage working capital. The exceptional working capital performance in the fourth quarter is clearly a onetime benefit. However, we are confident that this level of working capital as a percentage of sales is sustainable.

And as a result, free cash flow in 2019 should be between $50 million and $55 million. We will continue to delever and opportunistically buy back stock. In summary, we agree that new residential construction has slowed, but we are more weighted to repair and remodel the new construction and we believe that the R&R market will continue to strengthen. In addition, we see a favorable trend with our customers outsourcing more component business as a result of labor constraints and we are also winning back some of the business we lost over the past few years.

All in all, we enter 2019 with more optimism than pessimism. We remain committed to a disciplined approach to capital allocation by maintaining the strong balance sheet and returning capital to shareholders. Our board and management team are confident in the fundamental strength of our business and our ability to drive efficiencies and deliver sustainable growth and shareholder value creation in the coming years. And with that, operator, we'll now take questions.

Operator

Thank you. [Operator instructions] Our first question comes from Daniel Moore with CJS Securities. Your line is open.

Dan Moore -- CJS Securities -- Analyst

Bill, Brent, good morning. Thanks for taking the questions.

Bill Griffiths -- Chairman, President and Chief Executive Officer

Good morning, Dan.

Brent Korb -- Chief Financial Officer

Good morning.

Dan Moore -- CJS Securities -- Analyst

Bill, I apologize in that I'm going to ask a question that I know you tried to answer in detail already, but in terms of the outlook for next year for fiscal '19, 4% to 6% top-line growth of -- just talk about or maybe expand on what gives you confidence there? And specifically, what are you looking at in terms of price versus volume? You mentioned starting to win back some business that you lost, any more detail or specifics you can give there? And what kind of FX impacts are we looking are based on rates right now? That's a mouthful, but I'll start with that.

Bill Griffiths -- Chairman, President and Chief Executive Officer

So as you are aware, the comps this year versus '17 included some lost business in '17. If you take that out, the underlying growth numbers, which are the ones I just quoted, for the full year are around 6%. So we won't have those negative comps in 2019. So the expectation is, we'll see, perhaps, some softening as the homebuilders slow down.

But we've demonstrated underlying growth of that magnitude now for the past few quarters. In addition to compensate for some of the softness in new construction, we do believe that R&R will continue to strengthen. We have a very healthy pipeline of business that's under quotation and negotiation right now, so the order of some $30 million of customers that are considering outsourcing more product. That's not to say that we'll get awarded all that business.

All those decisions will be made positively, but it's the biggest pipeline of new potential business we've had in several years. We've recently been awarded a couple of contracts that actually are a business that we lost over the last few years. Not all of it, by any means, but in the range of $10 million to $15 million worth of business. So collectively, I mean, we are pretty optimistic, even though we recognize the new construction part of this is likely to soften through at least the first half of next year.

And then, the gross margin level is -- we, kind of, ended the year about where we expected it to be. Obviously, the big miss was a couple of large one-time items that fall mostly into SG&A. We demonstrated last year, albeit, somewhat late in the year, our ability to pass on price for some of the inflationary concerns. We are currently working on pricing initiatives for early in 2019, and clearly we expect to be able to pass those through.

So when you put all that together, we are very confident of the outlook we've just laid out.

Dan Moore -- CJS Securities -- Analyst

Great color. That's helpful. And you gave a little bit of detail on EBITDA expectations by segment. Could you break out or, perhaps, is it maybe rank order, growth expectations, top line by segment next year?

Bill Griffiths -- Chairman, President and Chief Executive Officer

I think we are going to continue to see some strong growth in cabinets and in North American fenestration, assuming some of the projects we are working on come to fruition. I think with all the turmoil in Europe, our expectation is that growth there will probably be the slowest in 2019, and margins probably will be tougher to expand in Europe as well. There is clearly a great deal of uncertainty. We're obviously very pleased with the way we ended the year, given everything that's going on, but we're probably a little more pessimistic about Europe than we are North America at this point.

Dan Moore -- CJS Securities -- Analyst

Helpful. And lastly for me on the SG&A front, you're guiding to relatively flat, slight increase obviously versus the kind of spike in Q4. What are your expectations for incentive compensation in terms of what you're accruing for next year versus this year? And what are we -- what are the key drivers? And in terms of medical, what drove that spike in Q4? And is that very much of a onetime, more sustained, how should we think about that?

Bill Griffiths -- Chairman, President and Chief Executive Officer

So on incentives, we always accrue at target at the beginning of the year and then we adjust as we go through the year based on performance. Clearly, we had a renewed focus after the strategic review and the announcement at the end of the third quarter on generating cash in Q4. That drove some exceptional performance, which we believe is sustainable and that in turn drove higher-than-target incentives in Q4. The medical was primarily a result of a number of bad or excessive claims that obviously we can't talk about.

But all you need, because we are self-insured, is a heart transplant, a premature baby, etc., etc., and that's what drove those costs up. Now by the same token, we've also seen elevated benefit in healthcare costs anyway. So what's factored into 2019 is an increase in general medical cost, but a heart attack or a premature baby is completely unpredictable and that's really what drove the bulk of that $4 million. 

Dan Moore -- CJS Securities -- Analyst

Understood. I'll jump back in queue. Thank you.

Operator

Thank you. Our next question comes from Kathryn Thompson with Thompson Research. Your line is open.

Brian Biros -- Thompson Research -- Analyst

Hey, good morning. This is Brian Biros on for Kathryn. Thanks for taking my questions. I want to start off with the softening you mentioned in August and September, if you could maybe expand on that at all if there's any buckets that that falls into as the cause or impact on a segment basis would be helpful.

Thank you.

Bill Griffiths -- Chairman, President and Chief Executive Officer

Yes. So the short succinct answer there is, as you are all aware, because the homebuilders for the most part reported a pretty soft end to the summer and September was the end of the fiscal quarter for a number of our customers. So many of our window customers slowed their order intake pretty significantly in August and September, I think because the homebuilders had seen a slowdown. After their fiscal quarter closed, orders picked up again in October and October was actually a very strong month for us.

So some level of recovery in the month of October. And frankly, one of the reasons we're optimistic is we're in the process of closing out November, which also looked pretty strong as well relative to last year.

Brian Biros -- Thompson Research -- Analyst

Gotcha. On the share repurchase, $60 million in the program, you guys spent, I think, $32 million of it in the quarter or so just over half of the entire buyback program. Private placement, was that kind of a wall of opportunity? Or does that kind of signal a desire to get through that $60 million and move on to whatever is next down the pipeline? Or how do we think about that? Because I think the previous commentary was that $60 million would be spent over like multiple quarters, already through half of it?

Bill Griffiths -- Chairman, President and Chief Executive Officer

Yes. So that was a one-time opportunity, not part of an ongoing strategy to burn through the $60 million quickly. As we said, the share repurchase is based on an at-market opportunity, it's not a 10b5-1 plan. Therefore, we have a limited number of days that we can trade and we have, obviously, a limited number of shares because of the relatively low float that we can buy at any one point in time.

And we are obviously, cognizant of the balance between keeping the leverage ratio around two times and the share price. I think it's probably safe to assume that once we get through today's call, Brent and I will be spending some significant time planning moves for next week, when the window opens for us. So I still expect the balance of $28 million to take some time to consume as we go through 2019.

Brian Biros -- Thompson Research -- Analyst

Helpful. Thank you. I'll get back in the queue.

Operator

Thank you. Our next question comes from Kenneth Zener with KeyBanc Capital Markets. Your line is open.

Unknown Analyst

Hi, this is Brendan on for Ken actually. You touched a little on this before but just trying to understand what can create the low end and high end of your margin guidance? Is it sales tied to volume or is it pricing? What happens if you can't get price, can you still hit that target?

Bill Griffiths -- Chairman, President and Chief Executive Officer

Yes. I mean, obviously, leverage through volume is important. But clearly, pricing, we're very confident, we can get it through, but I think there is some sentiment now with the homebuilders at least, they maybe have reached a price threshold and will have difficulty passing higher home prices on to consumers in this environment. That eventually trickles down, but we're at the lower end of the food chain, and I don't think we will see as much pushback as the homebuilders will see.

So we're confident, but the hedge is there in terms of margin guidance. Clearly, in an inflationary environment, it is more difficult to get margin expansion.

Unknown Analyst

Great. Thank you. That's all I have.

Operator

Thank you. Our next question comes from Julio Romero with Sidoti & Company. Your line is open.

Julio Romero -- Sidoti & Company, LLC -- Analyst

Hey, good morning, gentlemen.

Brent Korb -- Chief Financial Officer

Good morning.

Bill Griffiths -- Chairman, President and Chief Executive Officer

Hey, Julio.

Julio Romero -- Sidoti & Company, LLC -- Analyst

So I wanted to start out with the cabinet segment, can you just comment on that, the gross margins there? I saw 16.8%, might be the strongest since 1Q of '16, I believe. So can you just talk about what's driving that? And what should gross margins look like for 2019?

Bill Griffiths -- Chairman, President and Chief Executive Officer

Yes. Look, as we've said all along, we've invested an awful lot of time, money and resources into productivity improvements in that business, while at the same time shifting the product mix to be more in line with what's been happening in the marketplace. It's been slow in coming, but I think finally we are seeing the results of those productivity improvements flowing through. We've had two strong quarters of margin improvement there.

Our expectation is that we will continue to see a similar level of improvement as we go through 2019. And the corollary to that, too, as we've explained before, part of these productivity improvements automatically cause a reduction in inventory. A good portion of the working capital improvement through inventory reduction came out of the Woodcraft operation in the fourth quarter, so the two are tied together, and again, gives us confidence of the sustainability of the working capital levels as a percentage of sales.

Julio Romero -- Sidoti & Company, LLC -- Analyst

Understood. And you laid out an expectation for a slight margin improvement in the North American Engineered Components segment, can you just bridge out the driver of that expected improvement? Is that, kind of, just based on the volume leverage, or is there another key component there that's going to drive that?

Bill Griffiths -- Chairman, President and Chief Executive Officer

No. It will be mostly volume leverage with the underlying assumption that inflationary costs have passed through in price.

Julio Romero -- Sidoti & Company, LLC -- Analyst

OK. And then just on CAPEX, you had full year of about $26 million, I think that came a little bit lower than what you guys had mentioned earlier in the year of $35 million. You mentioned some delayed projects. Does that imply, only maybe $2 million or $3 million of the $10 million of growth CAPEX you initially targeted was deployed? Just hoping if you can, kind of, reconcile that for us.

Bill Griffiths -- Chairman, President and Chief Executive Officer

Yes. So initially we guided toward $35 million of CAPEX. As we went through the year, I think we reduced that guidance to closer to $30 million, because clearly, we could see that we did not need to put that extra $5 million into the business. The $4 million shortfall was really two projects that are delayed and are now already commencing in 2019.

And as I say -- and I think we've said pretty consistently that after three years of $35 million a year investment and $26 million this past year, the ongoing run rate of $25 million to $30 million is about right in a non-recessionary environment.

Julio Romero -- Sidoti & Company, LLC -- Analyst

That's helpful. So I guess, for this year, the $25 million to $30 million, does that imply $5 million in growth CAPEX? Or is it a little more that, implied in the guidance?

Bill Griffiths -- Chairman, President and Chief Executive Officer

Yes, that's about right.

Julio Romero -- Sidoti & Company, LLC -- Analyst

OK. And then just last one for me here. $78 million of cash flow was very strong and you've good free cash expected for next year. But just, as I think about your cash usage, given the $28 million left on the share repurchase, is it prudent to maybe expect a debt pay down in the back half, if the repurchase is deployed and you have some good free cash coming into the financial statement of that kind?

Bill Griffiths -- Chairman, President and Chief Executive Officer

Absolutely. That's exactly the right way to think about it. As you know, the first half of the year, we're often a cash consumer and we expect to be this year. But we will continue the share buybacks.

But you are right, our expectation is, we will, in fact, continue to de-lever, as well as use up most, if not all, of that $28 million in the authorization by the end of the year. But a lot of it could be back-end-loaded, because, as you know, that's when we generate our cash.

Julio Romero -- Sidoti & Company, LLC -- Analyst

Helpful. I appreciate you taking my questions, and good luck in 2019.

Bill Griffiths -- Chairman, President and Chief Executive Officer

Thank you.

Operator

Thank you. Our next question is a follow-up from Daniel Moore with CJS Securities. Your line is open.

Dan Moore -- CJS Securities -- Analyst

Thank you again. I know you don't want to get into quarterly guide, but just you gave interesting color around October, kind of bouncing back, how do we think about the cadence of growth and any comments on margins, kind of first quarter or first half starting out the year, relative to your full-year guide?

Bill Griffiths -- Chairman, President and Chief Executive Officer

So we were -- as I said, October was strong. I think some of that was recovering from the shortfall in August and September. November was pretty decent, actually. And now we're into holidays and the beginning of winter.

I would not read too much into high level of growth in the first half compared to next year, particularly with the uncertainty around the new construction. I mean, it certainly looks as though the winter and early spring are going to be slow for new construction. I do think we'll make that up in terms of R&R. But I wouldn't get too aggressive on the first half of the year.

Daniel Moore -- CJS Securities -- Analyst

But it doesn't like first quarter at least is coming out at negative, relative to your positive growth expectations?

Bill Griffiths -- Chairman, President and Chief Executive Officer

At this point, I will be shocked if it's negative.

Daniel Moore -- CJS Securities -- Analyst

OK. Helpful. I appreciate the color again.

Operator

Thank you. And I'm showing no further questions at this time. I would like now to turn the call back over to the CEO Bill Griffiths for closing remarks.

Bill Griffiths -- Chairman, President and Chief Executive Officer

Thanks, everyone, for joining us today. Happy holidays to everybody, and we look forward to talking to you in March. Thank you.

Operator

[Operator signoff]

Duration: 34 minutes

Call Participants:

Scott Zuehlke -- Vice President, Investor Relations and Treasurer

Brent Korb -- Chief Financial Officer

Bill Griffiths -- Chairman, President and Chief Executive Officer

Dan Moore -- CJS Securities -- Analyst

Brian Biros -- Thompson Research -- Analyst

Julio Romero -- Sidoti & Company, LLC -- Analyst

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