Welcome to KP Tissue's second quarter 2019 Results Conference call. At this time, all participants are in listen-only mode. Following the presentation, we will conduct a question-and-answer session. Instructions will be provided at the time for you to queue up for questions. If anyone has any difficulty hearing the conference, please press star followed by zero for an operator assistance at any time. Before turning the meeting over to management, I would like to remind everyone that this conference call is being recorded on Thursday, August 8th, 2019. I will now turn the conference over to Mike Baldesarra, Director, Investor Relations. Please go ahead.
Thank you, Operator. Good morning, ladies and gentlemen. My name is Mike Baldesarra. I'm the Director of Investor Relations at KP Tissue Inc. The purpose of this conference call is to review the financial results for the second quarter of 2019 for Kruger Products LP, which I'll refer to as KP LP going forward. With me this morning is Dino Bianco, the Chief Executive Officer of KP Tissue and Kruger Products LP, and Mark Holbrook, the Chief Financial Officer of KP Tissue and Kruger Products LP. The following discussions and responses to questions contain forward-looking statements concerning the company's activities. Forward-looking statements involve known and unknown risks and uncertainty, which could cause the company's actual results to differ materially from those in the forward-looking statements. Investors are cautioned not to rely on these forward-looking statements.
The company does not undertake to update these forward-looking statements except if required by applicable laws. There's a page at the beginning of the written presentation which contains the usual legal cautions, including as to the forward-looking information, which you should be aware of. I'd like to point out that all figures expressed in today's call are in Canadian dollars unless otherwise stated. The press release reporting our Q2 2019 results were published this morning and will be accessible from our website at kptissueinc.com. Please be aware that our MD&A will be posted on our website and will also be available on SEDAR. Finally, I'd ask that you, during the call, refer to the presentation we prepared to accompany these discussions, which is also available on our website. We'd appreciate that during the Q&A period for you to limit your questions to two. Thank you for your collaboration.
Ladies and gentlemen, now I'll turn the call over to Dino Bianco, our CEO.
Thank you, Mike. Good morning, everyone, and thank you for joining us on today's call. Let's start with a review of our financial performance for the second quarter. We once again posted solid revenue growth with an increase of 7.9% driven by a combination of higher volume and the benefits from our recent price increases. By geography, U.S. sales increased by $16.3 million, or 14%, and Canadian sales grew by $5.3 million, or 2.6%. Adjusted EBITDA totaled $31.5 million, an increase of 2.9% over last year. More significantly, it was a 33.5% sequential increase over Q1 of this year, and we're also starting to see sequential improvement in our Away-From-Home business, which I'll talk about a little later. Our EBITDA improvement was driven by the benefit from our price increases and volume growth offset by unfavorable sales mix, higher cost of sales, and higher SG&A costs.
Pulp costs were essentially neutral on a year-over-year basis. As we look at market pulp prices, NBSK and eucalyptus prices in Canadian and U.S. dollars have come off their peaks in the latter part of 2018 and have continued to trend down since then. In Q2, NBSK pulp prices declined sequentially compared to Q1, but were still higher compared to last year in Canadian dollars and down 1% in U.S. dollars. BEK, or eucalyptus prices, were down 7% year-over-year in U.S. dollars. Based on industry forecasts, we expect that pulp prices in U.S. dollars will remain in a similar range for the remainder of the year. We're also pleased to give you an update on our critical TAD Sherbrooke project, which is progressing on time and on budget with an expected 2021 startup date.
As you know, this project is central to our long-term North American growth strategy in the ultra-premium paper tissue segment. On page seven, you'll see a glimpse of the construction activity as the building is well underway, and we've laid the foundations of the warehouse, converting, and paper machine buildings. We've also recently put in place the new mill's leadership team. We have a strong team comprised of both internal and external tissue experts, which should ensure a strong startup of the new facility. And we are currently working with existing and new North American customers who have already expressed a strong interest in our new ultra-premium tissue capacity, which, as I said earlier, will come on stream in 2021. Let's turn to our OPEX program.
We're also gaining solid momentum with our operational excellence, or OPEX program, which we initiated with the assistance of a third-party partner to help us drive savings across our manufacturing network. It's entering the sixth month and is progressing very well relative to our timeline and our goals. The initial focus was on 2 of our core facilities as well as our AFH facilities, with the goal of improving line efficiencies through increased productivity, improving our capacity, and reducing our waste. In Q1, we started to implement lean manufacturing practices, which resulted in reduced machine downtime, waste reduction, and increased machine speed. At the same time, we're also implementing a separate logistics project with another partner to drive down freight and warehousing costs across our North American network.
We believe that the financial benefits from these two initiatives will continue to build over time, and we continue to expect combined cost savings of $15 million-$20 million on a run rate basis by the end of 2020. I also want to repeat that these initiatives are not CAPEX dependent and focus primarily on process standardization and improvement. Finally, we believe that these initiatives will allow us to expand our existing capacity and reduce costs across the network in advance of the TAD Sherbrooke project. Let's turn to AFH. Earlier, I briefly talked about the AFH performance. Our Q2 Adjusted EBITDA improved by $3.6 million over Q1. This reflects an improvement in our AFH manufacturing network and the benefit of pricing, which we implemented in both Canada and the U.S.
Although we saw some pricing impact in Q2, the full benefit will lag due to the timing of our contract renewals and should have a bigger impact in Q3 and Q4. Even though AFH will continue to be affected by market outsourcing costs and price competitiveness, our cost structure initiatives and our pricing should drive further improved results as we move into the second half of 2019. Let me talk about our brands. They are the foundation of our success and have allowed us to build very strong market share in the Canadian market. At Kruger Products, we are committed to enhancing our leadership position in Canada, and we're stepping up our marketing programs and initiatives. Examples of this include our partnership with the NHL, our Made in Canada promotion, and our Tear Open to Win marketing program.
We face a market in Canada where private label continues to make gains, especially in the bathroom tissue category. To address this situation, we will launch new product innovations later this year to drive category growth and excitement. In addition, in the area of customer support, we are taking initiatives to further strengthen our position with our key customers and our key channels. Our Canadian consumer segment market share position remains very strong. We are maintaining our number one position in bathroom and facial tissue, and we're a solid number two in paper towels. Although we are disappointed in the market share drop in bathroom tissue, we have plans to improve this going forward, driven by innovation, improved quality, and increased customer and brand support. I will now turn the call over to Mark who will review our quarterly results.
Thank you, Dino, and good morning, ladies and gentlemen. Before reviewing our second quarter results, let me remind you that Kruger Products adopted the new IFRS 16 leases accounting standard effective January 1st, 2019, using the full retrospective approach. Under this approach, all comparative period information has been restated to reflect the adoption of IFRS 16. Note that IFRS 16 lease accounting had no effect on revenue or net income. For Adjusted EBITDA, IFRS 16 had a full year positive impact of CAD 16 million for 2018, and for Q2 2018, the positive impact was CAD 3.9 million. I'll ask you to turn to slide 13, which reviews our financial performance for the second quarter. Revenues were up 7.9% to CAD 365.7 million in the second quarter, compared to CAD 338.8 million for the same period last year.
Adjusted EBITDA increased to CAD 31.5 million from CAD 30.6 million in Q2 of last year and increased sequentially by CAD 7.9 million from CAD 23.6 million in Q1 of 2019. From a margin perspective, adjusted EBITDA decreased to 8.6% from 9% last year and increased from 6.7% in Q1 2019. In the second quarter of 2019, we recorded net income of CAD 0.9 million compared to CAD 1.6 million last year. The decrease was primarily due to an unfavorable change in the amortized cost of partnership units liability, also lower operating income and higher income tax expense that was partially offset by a decrease in interest expense and a foreign exchange gain. In the quarterly segmented view on slide 14, consumer revenue increased by 7.3% year-over-year to reach CAD 299.7 million. In the away-from-home segment, revenue rose by 10.8% to CAD 66 million.
Consumer segment Adjusted EBITDA increased by $1.1 million to $35.4 million, and Adjusted EBITDA margin declined slightly from 12.3% to 11.8%. For the away-from-home segment, Adjusted EBITDA decreased by $0.6 million to a loss of $3 million, and Adjusted EBITDA margin stood at a similar level to Q2 last year at negative 4.6%. On slide 15, we review Q2 2019 revenue over Q2 2018, which was up by $26.9 million, or 7.9%. The increase was primarily attributable to the Consumer Canada price increase implemented in Q4 2018, price increases in the AFH segment, and the benefit of foreign exchange fluctuations on U.S. sales. By geography, Canadian sales increased by $5.3 million, or 2.6%, and in the U.S., sales grew by $16.3 million, or 14%. Mexican operations also saw their sales increase significantly, although it is a low-contribution business.
On slide 16, we provide further insight into our Q2 2019 Adjusted EBITDA, which increased year-over-year by CAD 0.9 million, or 2.9% to CAD 31.5 million, and gross margin for the quarter also increased from 10.4% to 10.9%. The increase in Adjusted EBITDA was driven by a combination of factors, including the positive impact of the Consumer Canada and AFH price increases and improved costs from operational transformation initiatives. These were partially offset by unfavorable foreign exchange fluctuations, unfavorable sales mix, the cost of outsourced manufacturing, production inefficiencies in the AFH business, and higher SG&A costs.
As Dino mentioned, pulp costs in the quarter were relatively neutral in Q2 compared to Q2 last year. On a sequential perspective, let's turn to slide 17, where we compare Q2 2019 to Q1 2019 revenue. Quarter-over-quarter revenues increased by CAD 14.7 million, or 4.2%. The consumer segment increased by 1.2%, whereas Away-From-Home increased by 20.5%.
Q2 is typically a higher quarter on a seasonal basis than Q1 for away-from-home, and was also positively affected by the AFH selling price increase. By region, revenue increased in Canada by CAD 10.7 million, or 5.4%, and in the U.S. by CAD 4.6 million, or 3.6%, whereas revenue decreased slightly in Mexico. On slide 18, Q2 Adjusted EBITDA increased by CAD 7.9 million, or 33.5%, compared to Q1, and gross margin improved from 8.8%-10.9%. Increase in Adjusted EBITDA was mainly driven by higher sales volume due to normal seasonality, the positive impact of the AFH price increases, and lower pulp prices in Q2 versus Q1, and cost improvements related to the operational excellence program.
I'll now turn to our liquidity and financial position on slide 19. Our cash position was CAD 115.4 million as at the end of Q2 2019, down from CAD 135 million at the end of Q1.
The Q2 cash position includes the TAD Sherbrooke project initial financing proceeds, net of spending on the project to the end of Q2, which has a net cash balance of $86.1 million. Overall net debt at the end of Q2 stood at $490.5 million, up $20.9 million from $469.6 million at the end of Q1 2019. Consequently, our net debt to trailing 12-month Adjusted EBITDA ratio is now at 4.4 times, up from 4.2 times at the end of Q1 2019. Looking forward, the TAD Sherbrooke project will result in the total company leverage increasing as spending on the project occurs over the next two years. I'll conclude my section by reviewing the CAPEX on slide 20. Our fiscal 2018 regular CAPEX was $33 million, excluding our TAD Sherbrooke project.
For fiscal 2019, we expect our CAPEX, excluding TAD Sherbrooke, to be lower between CAD 20 and 30 million, and our TAD Sherbrooke CAPEX to be between CAD 220 and 230 million. This provides a total CAPEX range for this year of CAD 240-260 million. Thank you for your attention, and I'll now turn the call back over to Dino.
Thank you, Mark. Finally, I will conclude the call with slide 21. Since the beginning of the year, we have set various initiatives in motion with the goal to improve our performance and restore sustainable profitability despite the ongoing business challenges. As we move into the second half of the year, our success drivers for the short to medium term will mainly come from improved pricing in the consumer and away-from-home segments, decreased pressure from input costs, increasing benefits of our OPEX program, and stronger marketing initiatives. More specifically, we will continue to grow the top line and volume across all geographies and segments. We've priced all of our businesses to offset fiber costs and restore margins, and we're creating a more efficient and capable supply chain network.
At the same time, we're preparing our path for the long term with our TAD Sherbrooke project and targeted investments that will help to further strengthen our brands. On top of this, and perhaps most importantly, we're building organizational capability and culture to meet the needs of today and tomorrow so that we can continue to deliver strong business results. As for our quarterly guidance, we expect Q3 Adjusted EBITDA to show improvement compared to both Q2 2019 and Q3 2018. In conclusion, we are confident that we have the right vision and strategies to move the company forward as North American tissue leader. I want to thank you for your time and attention today. At this point, Mark and I will be very happy to answer any questions that you may have.
At this time, I'd like to remind everyone, in order to ask a question, please press star and the number one on your telephone keypad. Your first question comes from the line of Hamir Patel from CIBC Capital Markets. Your line is open.
Hi, good morning. We've seen another move lower in hardwood prices in the past week. Could you maybe just give us some color on how much flexibility you might have left in your platform to substitute more hardwood for softwood?
Yeah, I mean, we have pulp substitution formulas, and we work it all the time based on the arbitrage, not just between hard and soft, within soft, within hard. Can I tell you we're pushing it as hard as, no pun intended, as hard as we can to take advantage of the cost differential between hardwood right now and softwood. I'm not going to give you a specific number, Hamir, but part of those savings are being reflected in our cost bundle as it relates to our fiber cost. So we are pushing that as hard as we can.
Thanks, Dino. That's helpful. And can you talk more about some of the innovation initiatives that you referenced planned in the Canadian market, and then also any update you can give us on White Cloud?
Yeah. So I also recognize, beyond my partners and friends in the analyst and financial world, I've got competitors on the line as well that are usually listening to these calls, so I want to be a little bit careful of what I say. I would say that I would characterize it as smart innovation. I think it's things that we probably should have done a little earlier to take advantage of some market situations as it relates to product segmentation, size differentials, etc. So those are the sorts of innovation I'm talking about. They're smart innovation. They help fill a void in our portfolio that exists today, and they should be able to drive overall market share for the business. They'll cover primarily bath tissue with maybe a little bit in paper towels as well.
Okay, great. Thanks, Dino. Anything else?
Oh, sorry, Hamir. White Cloud. So White Cloud, we're in about 12,000 stores and continue to build our distribution in the U.S. In some accounts, we've got a 5-share of tissue, which is a fantastic number, where we've really been able to promote it, and the customers got behind it. We have not yet launched a consumer initiative with White Cloud in the marketplace. It's more local marketing to drive velocity where we're listed. We continue to be listed online as well: Amazon, Walmart, etc. So it is a slow rebuild after, obviously, a change in focus to a wider distribution network for White Cloud. So we continue to move forward on that, Hamir, and we've got some innovation going in probably in 2020 on White Cloud in the U.S.
Great. Thanks, Dino. That's all I had. I'll turn it over.
Okay.
Your next question comes from the line of Sean Steuart from TD Securities. Your line is open.
Hey, good morning, guys. It's Sean.
Good morning, Sean.
Couple of questions. Mark, for you first, the Adjusted EBITDA of $31.5 million, is that before or after the consulting and M&A costs that look to be buried in your reconciliation statement?
Yes. So our Adjusted EBITDA includes the add-back of any operational transformation initiatives, so OPEX program fees, and also any M&A costs. So that would be included in that $31.5.
So sorry, that is before those costs.
Right. That's right.
Got it. Okay. It looks like your spending timeline for the Sherbrooke TAD project has been pushed a little bit. It looks like some of the spending you had previously planned for this year has been deferred into 2020. Can you give us any context on that? I presume the overall timing and scope of the project is unchanged.
Yeah. No, strictly a timing on the cash outflows on TAD 2 project. Our purchasing commitments are as planned, and it's really just timing. So we are very back-half-weighted on the spending this year. We're expecting to spend about $180 million between July and December, and very heavy again in Q1 2020. So no change in terms of the overall plan, just timing of the cash outflows.
Okay. One last quick one. The OPEX gains that you guys cited, how much on an annual run rate of the $15-$20 million would have been in the Q2 numbers?
So Sean, what I would say is, first of all, let me step back for just one second to give you context. There are four things going on to stabilize our manufacturing footprint. One is the OPEX, and that's by far the biggest. It's got short-term benefits as well as a long-term plan for how we want to create excellence in manufacturing. That's number one. The second one is we've done a couple of major asset maintenance projects on a couple of our critical paper machines that were due for maintenance, and those have now come back up in early Q2 and are performing extremely well. The third thing we've done is re-engaged a lot of our OEM equipment suppliers to fix some of the ongoing issues that we've had on some of our, quite frankly, mostly on our converting lines.
And then the fourth thing we did is we put SWAT teams that are internal resources and maybe some retired personnel to go into locations and help blitz to fix some challenges. And that was particularly in AFH. So I don't want to make it sound like it's just OPEX. There's four things going on. On the OPEX project itself, we had said we're looking at a $15-$20 run rate. I hope to hit half of that run rate by the end of this year. And we started to see some of the financials in Q2. More of that will come in Q3 and Q4.
I would characterize it as a fairly small portion of that number coming through in Q2, although the foundational work around getting the discipline in place, getting the training in place, and all those things are starting to create collateral benefit in our network that we may not just necessarily track as an OPEX benefit.
That's great detail, Dino. I appreciate it. That's all I have, guys.
Okay. Thanks, Sean.
Your next question comes from the line of Paul Quinn from RBC Capital Markets. Your line is open.
Yeah. Thanks very much. And good morning.
Good morning, Paul.
Just a question on the AFH segment. I noticed a $3.6 million improvement, but you're still running a loss. What are the critical things you need to see in that part of your business besides the implementation of the price increase, and are you going positive in 2019?
Yeah. So let me start with we've priced now, so I think we're at market, comfortable with where we are with respect to fiber costs. So we've got that piece. Our volume continues to be strong, both in Canada and the U.S. So I think that piece is running well. We still have work to do on the network. We are reducing significantly any outsourcing, particularly on finished goods. We're essentially now out of that. We've got some paper outsourcing, which we've always had on AFH. So if we can stabilize and get the operating efficiencies out of our two AFH converting facilities, we should be back in positive black territory as we exit the year. I think you and others have asked the question, what can this business deliver?
I think it certainly can, in its existing model frame, deliver a mid-single-digit EBITDA margin, and recognizing that covers a significant amount of fixed costs from KP in general. I think that's kind of the model we're aspiring to, and we think we could start getting there in the next few quarters if we get the cost structure fixed.
Okay. Just looking at your market share in bathroom tissue, you've lost a little bit over 2.5% of the market in the last few years. Just wondering who's been taking market share and how you're going to go about reclaiming the higher percentage?
Yeah. So what's going on in market share? There's a few things going on. First of all, the quick answer to yours is most of the market share has been going to private label. They continue to grow in the market, and most of the branded players have been, to some extent, or other losing share, including ourselves. What's been going on, Paul, is particularly in the last 18-24 months, is pricing has moved up in the market because of pulp. It's created disequilibrium. So you get new price points in the market. They are a shock to the consumer who's used to buying at a certain price, 14-15 cents a roll, now having to pay over 20 cents a roll. There's a bit of a consumer shock.
The customers don't want to promote at the higher price because they don't want to go up the higher price and potentially be embarrassed in the market. So you've got less promotion going on. And then you've got private label, which even though their prices move up, they still become the lower price, and it becomes more important for consumers who are price-sensitive when prices move up. So you've got all those factors going on that have impacted us and everybody else because we're the share leader. And the other thing that happened with us is we chose not to pursue some low-margin business this year. We made a conscious decision not to pursue it and try to build our brand longer term in the right way. So that had a bit of an impact on us as well. So those are some of the dynamics that are going on.
The fix is it's not a short-term fix. It's a long-term fix. Part of it is you got to make sure the price gaps are right. You don't have to be the cheapest product, but you got to make sure the value is there for the brand. The second thing is you've got to do more innovation, which we are. I think we have an opportunity to improve our quality of some of our products to step them up even more. Then the last piece is to make sure that we are supporting our brands with more investment and communication that's relevant for the consumer.
Great. That's all I had. Best of luck.
Okay. Thanks, Paul.
Again, if you'd like to ask a question, please press star and the number one on your telephone keypad. Your next question comes from the line of Zachary Evershed from National Bank. Your line is open.
Morning, guys. Congrats on the quarter.
Good morning, Zach. Thank you.
You mentioned a step up in marketing programs. When should we expect the ramp-up in marketing spend, and can you give us an idea of the magnitude there?
Yeah. Back to my earlier point, I know my competitors listen to this call, so I want to be very careful. You will see an increase in Q2 in terms of marketing investment. We are up high single-digit in terms of dollars spent across multiple activities. I talked about the NHL promotion, which has been very successful, even though we got into it late, and we'll continue to do more there. We've done a couple of consumer promotions. We did a Made in Canada, which I talked about. We've got some innovation going out. We've got more media going out, both traditional and social media in the marketplace. So you're starting to see you're going to start seeing some of that this year. And quite frankly, I'll be very clear, you will continue to see a ramp-up in our marketing investment because we are a branded company.
We're the share leader, and we want to maintain that position. We are in a bit of earn it before you spend it mode because of the volatility that's going on in the market and in our manufacturing base. As soon as that stabilizes, I think we'll unleash even more. We're cautiously increasing our investment to support our brands.
That's helpful. Thank you. And you've also addressed the capacity and maintenance constraints that came in in the quarter. So I'm wondering if we could go into a little bit more detail about the split between Away-From-Home and consumer and how much machine time from Away-From-Home is still being split over to the consumer segment.
So that's a difficult question to answer. I mean, I can answer it related to our new asset that we put in a few years ago in our Crabtree facility, which was primarily going to be an away-from-home machine. I think the split at the time was going to be 80/20 for away-from-home, and it is now more a 60/40 for consumer. And it's just because the margin structure is better on consumer, and that's caused some of the challenges that we saw in away-from-home that we had to go buy more paper on the market. We also had a primary asset in one of our facilities. One of the ones that I talked about where we did increased maintenance was chugging, struggling to get to the finish line before we went to maintenance. So that caused some shortages in capacity. We had to go into market.
We've now rectified that position, and that asset is performing extremely well. So all those things will start to help. We still always have been and will continue to buy some grades of paper on the market for away-from-home. That's been the case for many years, and will likely still continue until TAD 2 comes on board. But that has not been the driver of the decline in cost for AFH. It's been some of these one-offs that have happened that we're trying to fix.
That's really helpful, caller. Thank you. Now, just one last one for me. Did you guys look at the Orchids assets when they were at auction?
Of course we did. Yes. I mean, obviously, I talked about on M&A, we're going to look at everything. We knew about Orchids for a long time. We looked at it. We assessed whether there was value there for us. Certainly, there was value, but obviously, there was more value for the ultimate winner who ended up buying that asset. But we did look at it for sure.
Great. Thanks so much. I'll turn it over.
Thanks.
There are no further questions at this time. I turn the call back over to the presenters.
Okay. Thank you for joining us on this conference call this morning. We look forward to speaking with you again in November of 2019 following the release of our third quarter results. Thank you to everyone, and have a great day.
This concludes today's conference call. You may now disconnect.