Welcome to KP Tissue Third Quarter 2018 Results Conference Call. At this time, all participants are in a listen-only mode. Following the presentation, we will conduct a question-and-answer session. Instructions will be provided at that time for you to queue up for questions. If anyone has any difficulties hearing the conference, please press star followed by zero for 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, November 8th, 2018. I will now turn the conference over to Mike Baldesarra, Director of Investor Relations. Please go ahead.
Thank you, operator, and 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 third quarter of 2018 for Kruger Products LP, which I'll refer to as KPLP 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 uncertainties, 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 is 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 Q3 2018 results. 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 would ask that during the call, you refer to the presentation we have prepared to accompany these discussions, which is also available on the website. We'd also appreciate that during the question and answer period, for you to limit your questions to two.
Thank you for your collaboration. Ladies and gentlemen, I'll now turn the call over to Dino Bianco, our CEO. Dino?
Thank you, Mike. Good morning, everyone, and thank you for joining us on our conference call today. We are pleased to report continued sales growth for the third quarter as we continue to maintain our market leadership position in Canada. However, our results continue to be impacted by higher pulp and freight costs. Despite this difficult cost environment, we have undertaken several key initiatives that will strengthen our business over the longer term and reinforce our leadership position in the market, including the decision to proceed with the TAD2 project, and I'll address these initiatives in more detail shortly. Let's turn to slide five of the presentation for our third quarter highlights. In Q3 2018, revenue increased by 3.6% to CAD 348.4 million.
Revenues increased in the US and Mexico, but slightly decreased in Canada as we lapped a price increase pre-buy in 2017 in our Canadian consumer business, and AFH was softer due to a very competitive marketplace. Although Mexico was a solid revenue contributor for the quarter, due to the nature of our business model in Mexico, the profitability on that business is low. Adjusted EBITDA totaled CAD 28.3 million, a decrease of 28.2% over last year due to significantly higher pulp and freight costs. However, Q3 adjusted EBITDA was up 6% from the previous quarter, driven by the consumer segment and normal seasonality. Slide six presents the market pulp prices in U.S. and Canadian dollars.
Unfortunately, the picture is no different than other quarters, with NBSK pulp prices in Canadian dollars and BEK, which is eucalyptus pulp prices, are on upward trend since the end of 2016. Q3 pulp prices rose sequentially compared to Q2 and year-over-year in both US and Canadian dollars, and pulp prices in Canadian dollars continue to be at historical highs. As a result, overall higher pulp prices have had an impact on our Q3 results and will continue to have an impact for the remainder of 2018. And based on industry sources, we expect pulp prices in US dollars to remain high through 2019. Let's turn to slide seven, which summarizes the situation we are experiencing with freight costs. As you can see, these costs are also at an all-time high, and we expect that they will remain high for the balance of 2018.
In this marketplace, our primary focus has been on securing carrier capacity to meet our customer needs while we're trying to mitigate costs at the same time. On slide eight, we present the steps we have taken and the measures we are implementing to counteract these high input costs, which have risen 30% since the previous July 2017 price increase announcement. As indicated before, one of the major steps we have taken to mitigate the continuous rise in input costs is a price increase in our Canadian consumer business, which was announced on July 26th and will take effect in Q4 this year. We have completed the sell-in and expect the full impact to start materializing in the market in Q1 2019. Our other initiative consists of our value creation program that was announced last quarter, last quarter.
The smart cost reduction program is much larger in scope and size compared to our previous programs, as we are essentially doubling the size of expected savings compared to past years. We are continuing to make significant progress in this area. Finally, We are also gonna undertake a network optimization program that will involve a comprehensive review of our operations starting in Q4 of this year.... We will communicate more information about these programs when we release our fourth quarter results in March. We believe that these initiatives will allow us to improve our profitability within the next 6-12 months, and they should largely offset the significant rise in input prices. On Slide nine, we present an overview of our TAD2 project.
Following the success of our TAD1 machine, we recently announced our decision to proceed with a CAD 575 million investment in our TAD2 project. We believe that this second machine will significantly increase the competitiveness of operations and our brands, and will further reinforce our market strength in North America. We choose to build the plant in Sherbrooke, Quebec, as this location is well positioned for the products we are marketing and was the most financially attractive option. TAD2 will be designed to allow paper towels to be manufactured at very high speeds and is expected to produce an additional 70,000 metric tons per year at maturity. This project is central to our long-term North American growth strategy in the ultra-premium paper tissue segment.
As Mark will indicate a bit later, the financing structure will be non-dilutive to KPT shareholders, but will require a period of higher leverage ratios during the construction and startup period. I will now turn the call over to Mark, who will review our quarterly results and present the financing details of our TAD2 project.
Thank you, Dino, and good morning, ladies and gentlemen. I'll now ask you to refer to Slide 10, which summarizes our financial performance for the third quarter. Our revenues reached CAD 348.4 million, a 3.6% increase compared to last year. However, adjusted EBITDA decreased from CAD 39.4 million in Q3 last year to CAD 28.3 million in Q3 of 2018. From a margin perspective, adjusted EBITDA decreased to 8.1% from 11.7% last year, but improved sequentially from 7.9% in Q2, 2018. As Dino mentioned, higher pulp and freight costs continued to have a significant impact on our results, both sequentially and year-over-year. Net income stood at CAD 4.2 million in the third quarter, compared to CAD 16.5 million last year.
The decrease was primarily due to the lower Adjusted EBITDA, also an increase in interest expense, an increase in the change in the amortized cost of Partnerships u nits L iability, at- and a change in foreign exchange. These were partially offset by lower depreciation expense and a decrease in income taxes. In the quarterly segmented view on Slide 11, consumer revenue increased by 5.2% year-over-year to reach CAD 287.1 million, while away from home revenue decreased by 5% to CAD 59.4 million. Adjusted EBITDA decreased by CAD 2.8 million to CAD 35.3 million for the consumer segment, and decreased by CAD 6.6 million to -CAD 4.8 million for the away from home segment.
At the same time, margins decreased year-over-year in the consumer segment from 14% to 12.3%, and decreased in away from home segment from 2.9% to -8.1%. On Slide 12, we review Q3 2018 revenue over Q3 2017, which was up by CAD 12.1 million or 3.6%. The increase was due to the consumer selling price increase implemented in Canada in Q4 2017, increased sales volume in the U.S. and Mexico, and the favorable impact of foreign exchange fluctuations on U.S. sales. Looking at this regionally, sales increased by CAD 6.6 million or 5.8% in the U.S., and decreased by CAD 4.2 million or 2% in Canada.
Sales also increased significantly in Mexico, which, as Dino mentioned, has a low contribution business model. On Slide 13, we provide some insight into our Q3 2018 adjusted EBITDA, which decreased by CAD 11.1 million or 28.2%. Q3 gross margin also decreased from 13.5% to 10.3%. The decrease in adjusted EBITDA and gross margin was due to a significant increase in pulp and freight costs, an unfavorable sales mix, and the net unfavorable impact of foreign exchange fluctuations, partially offset by the Q4 2017 Canadian consumer selling price increase. The benefits from cost reduction initiatives and capital projects offset other manufacturing cost inflation. On Slide 14, we compare Q3 2018 and Q2 2018 revenue, which increased by CAD 9.6 million or 2.8%.
The consumer segment increased by 3.5% due to normal seasonality, whereas away from home decreased slightly by 0.3%. By region, revenue increased in Canada by CAD 2.7 million or 1.4%, and in the US by CAD 3.4 million or 2.9%. Revenue also increased in Mexico. On slide 15, Q3 Adjusted EBITDA increased by CAD 1.6 million compared to Q2. Gross margin also increased from 10% to 10.3%. The increase in Adjusted EBITDA and gross margin is explained by higher revenues due to normal seasonality, partially offset by higher fiber and freight costs... I'll ask you to refer to slide 16, which sets out our balance sheet.
Our cash position, including bank indebtedness , was CAD 26.9 million as of the end of Q3, 2018, up from approximately CAD 16 million at the end of Q2. Overall, net debt at the end of Q3 stood at CAD 462.4 million, down CAD 14.6 million from CAD 477 million at the end of Q2, 2018. As at the end of Q3, we had CAD 202.6 million in the current portion of long-term debt related primarily to our KTG subsidiary. We're in the final stages to refinance this portion of the debt, which now has an extended maturity date of December 31st. Our net debt to latest twelve-month Adjusted EBITDA ratio is now at 4.0 times, up compared to 3.8 times at the end of Q2.
Looking forward, the TAD2 project will result in the leverage ratio increasing as spending on the project occurs over the next 2 years. On slide 17, we present an overview of the TAD2 project financing, which is expected to be non-dilutive to KP Tissue's shareholders. Our newly created subsidiary, which will own and operate the TAD2 project, Kruger Products Sherbrooke Inc., will be financed by 60% debt and 40% equity. The equity component is comprised of CAD 125 million from Kruger Products LP in the form of long-term senior secured fixed debt, a new accounts receivable factoring program, and cash. The equity component also includes a CAD 105 million convertible debenture with Investissement Québec at a fixed 3% capitalized interest rate over 10 years.
The weighted average cost of capital for the CAD 575 million of TAD2 financing is expected to be in the 5%-7% range. Furthermore, the existing KTG debt of $147 million is being refinanced concurrently with the TAD2 project and is expected to be an 18-year term loan with an anticipated fixed interest cost in the 6%-8% range, compared to 14%-15% under the current KTG debt structure related to the TAD1 project. We expect the closing of various debt financings to occur prior to year-end 2018. Finally, as we can see on slide 18, our expected CapEx for fiscal 2018 is between CAD 70 million and CAD 80 million, of which CAD 30 million-CAD 35 million is allocated to the TAD2 project. Approximately CAD 40 million-CAD 45 million is regular CapEx for 2018.
CapEx decreased to CAD 37.5 million in Q3 2018 from CAD 12.5 million a year ago, due to the Crabtree TMA project. Year-to-date CapEx for the TAD2 project was approximately CAD 15 million. Thank you for your attention, and I'll turn the call back over to Dino.
Thank you, Mark. Let's now turn to slide 19. Beyond TAD2, our other key focus is to strengthen our away-from-home business, where we hold a leading position in Canada with a market share of approximately 30% and a growing presence in the U.S. across multiple segments. As I mentioned earlier, the continued higher pulp and freight costs, combined with a competitive AFH environment, were the main reasons behind the weak performance of our AFH segment. This segment is less flexible in terms of selling price, as pricing will generally increase when annual customer contracts are renewed. At this time, the intense competitive environment is also limiting our capacity and ability to increase prices with our customers. In the coming months, we will undergo a company-wide optimization program with a deeper dive in AFH in order to reset this business.
Let me turn to slides 20 and 21, where we provide a summary of our share position in the Canadian consumer segment. Despite a challenging Q3, our business remains healthy as we continue to be the overall leading tissue company in Canada. We are the market leader in bathroom tissue and facial tissue, and have a strong number two position in paper towels. Let me take a little time to explain the market share decrease in bathroom tissue in particular. It can be explained by three factors. One, we discontinued a sub-line in Cashmere bath tissue in 2017. Two, we exited a low-profit customer segment early in 2018. And three, we continue to see growth in large-sized, private label format, formats, particularly in bathroom tissue. We plan to rebuild our shares in 2019 through increased marketing investment, new products, and strengthened customer support.
Turning to slide 22, this is a high-level presentation of our vision, our mission, and our five pillars that will allow us to drive strong revenue, profit, and shareholder value. These pillars include building our consumer muscle, expanding in the U.S. and Mexico, building an efficient supply chain, evolving our customer strategy, and having a winning team and culture. This is a five-year journey with various initiatives over that time period. I'll communicate the details of the strategic plan in more detail over the coming months. Finally, I would like to conclude the call with slide 23 that summarizes our objectives and the steps we have taken and will pursue for fiscal 2018 and into 2019. Our key objectives are to build revenue, grow market share, and service our private label customers... also return our away-from-home business to profitability and proceed with the TAD2 project.
In order to mitigate continuous pulp and freight price increases, we have taken appropriate measures, which includes a price increase announced in Canada Consumer, and we're also looking to price our US private label and our North American AFH businesses. We have escalated a value creation program, and we are also going to be undertaking a company-wide network optimization program in 2019. We will continue to leverage our TAD product market potential with the successful startup of TAD2. In the away-from-home segment, we are resetting the AFH business to create a more efficient manufacturing footprint. And in the US, we will continue to build a premium private label business and pursue our White Cloud brand repositioning. Looking forward, KPLP continues to have strong long-term business fundamentals.
However, due to continued pressure from high input costs, Q4 2018 Adjusted EBITDA is expected to be lower than Q4 2017, which was CAD 33.7 million. We are confident that we have the right vision and strategy to move the company forward and create increased value for our shareholders. Thank you for your time and attention, and at this point, Mark and I will be pleased to answer any questions you may have.
At this time, I would like to inform everyone in order to ask a question, please press star then one on your telephone keypad. If you would like to withdraw your question, you may press the pound key. We'll pause for a brief moment to compile the Q&A roster. Your first question comes from Sean Steuart with TD Securities. Your line is open.
Thanks. Good morning. A few questions. Appreciate the, the incremental detail you've given us on the, the TAD2 financing terms. Are, are you in a position yet where you can provide some broader context on expected contribution from the project, returns on the project, EBITDA guidance, any context you can provide there yet?
I would say we are not, you know, but it is a very similar project to TAD1. So I think if you use that as a surrogate, you'd probably be in the right space.
Okay. But when you've reached financial close, you guys were pretty categoric about targets for TAD1 once that project was in place. Should we expect that you're going to provide that sort of guidance eventually?
Hi, Sean. We see this as being an integral part of the overall business, so it would be unlikely that we would give a specific amount as we had done in TAD1, but certainly we'd be talking about it at length in every conference call as to how the progress is going.
Got it. Second question is on pulp costs. You guys, I believe, don't participate in the spot market too aggressively. Can you speak to discount spreads, though, on list and how that has trended and what you might expect in the near to mid-term on your discount spread for pulp input?
Yeah, Sean, it's Dino. I won't talk about our position specifically. I think your point about we don't participate in the pulp market is correct. We do operate off a discount. What we are seeing in the market and what we are hearing is that after years of spreads actually increasing, we're now seeing a reverse in that trend as it relates to 2019 and beyond. So I think anybody who's buying on a discount is starting to see contraction in that discount. Nothing significant, but it is definitely moving in a different direction than it has been for the last few years.
Okay, that's all I have for right now. I'll get back in the queue. Thanks.
Thanks, Sean.
Thanks, Sean.
Your next question comes from Paul Quinn with RBC Capital Markets. Your line is open.
Yeah, thanks very much. Good morning.
Good morning, Paul.
Morning, Paul.
The CAD 575 million on TAD2 is a whopping big number. Just wondering if you could break that down between the paper machine cost and converting.
Paul, at this point, I think we would leave that for a future disclosure as to how that all breaks down. Certainly, it's a significant portion is paper making and converting, and there's also a brand new state-of-the-art plant involved as well. So, we'll break that down in the future for you.
Okay. And then, maybe, Dino, you could, I understand you're embarking on this network optimization. Maybe you can give us some high-level thoughts as to what that program is about and what it hopes to deliver.
Yeah, Paul. So we're early in the process. Essentially, we'll look at our entire North American network, not just manufacturing, but distribution, also any outside co-manufacturers that we use. The primary focus will be on increasing our operating efficiencies on our lines. Obviously, as you increase operating efficiency, you drive down costs, plus you also increase capacity, which will allow us to produce our needs internally versus a mix today, where some are produced externally. So OEE, as we call it, will be the primary focus. Waste reduction will be another focus. Yield reduction, as you can imagine, price of fiber, any savings in yield will yield big dollars.
And we are also looking at transportation and warehousing optimization across the network. So those are the primary focus areas, and that will, I think we've always done a good job within our facilities of trying to maximize or minimize our cost structure, maximize our profit. This one is gonna look across, and we'll also look at how we load our assets, and is there a better way, more efficient way of loading our assets than we're doing today?
Okay. Thanks for that color. And then just, even negative margin and away from home for a couple quarters now, how long are we expected this to persist?
Well, a couple of things. I mean, you know, that business, all that I've talked about with pulp and freight obviously hits that business. It's more recycled fiber in that business, but those prices continue to escalate, as virgin pulp has escalated as well. Then you overlay the very competitive market that exists in AFH. We have tried to raise prices through Q2. We had some competitors scoop some of our business, which is why you see a bit of softness in Q2, so we are refocusing our balance to protect our business, at the same time, trying to get pricing up.
We also, the other thing that has happened here, we talked a little bit about this at a previous call, is because it's part of an integrated network, when we make decisions that benefit the company and benefit consumer, they tend to be the right decisions for the company, but unfortunately, AFH gets a negative hit from that, whether it be the fact that we use a line for a consumer, and AFH might have to go buy product on the market at a higher cost, or if we shut down a line and remove any overheads, that may go to a consumer business, and AFH might have to actually add some overhead, even though the decision is a better decision for the total company.
So there's a bit of, there's a bit of marketplace, and there's a bit of just the way that we account for decisions that we make as a company that is affecting that business. I do wanna remind you, you know, EBITDA certainly is a measure, but that business absorbs a significant amount of allocated overhead. So we take a view of the benefit it provides for the total business. Now, when will it turn? I'm not gonna predict that, but I think we're doing some pretty good initiatives. One is, we are in phase two of a three-year phase around creating a dedicated converting site for our away from home business.
And then the network optimization that I talked about, just a minute ago, will include AFH and will also go a little deeper in AFH to be more of a business end-to-end in AFH. So we expect that to yield AFH-specific value. So, we think those initiatives will certainly help restore our AFH profitability. At the same time, we're also moving on pricing. We continue to push the pricing rock up the hill, you know, so it's always a challenge, but we are seeing some progress there while at the same time protecting our customer base.
Very well. Thanks very much. That's all I had. Cheers.
Thanks, Paul.
Your next question comes from Hanbo Xiao with Desjardins. Your line is open.
Good morning. It's Hanbo filling in for Keith.
Good morning, Hanbo.
Good morning. I was wondering if you could give us your thoughts on what is continuing to push up the price of NBSK, even at these levels. In other words, is this just a demand issue, or is there something else going on here?
Well, I'll tell you what the experts are—I'm not an expert in this area, but I'll tell you what the experts are telling me and what we're continuing to hear in the marketplace. You've got the China demand factor, which is happening just as that country continues to urbanize and use of tissue is increasing. You've also got the fact that China has essentially shut the door on recycled fiber, so that's putting more pressure on virgin. And then on the supply side, you really have no major capacity coming on stream until 2020, 2021. And on top of that, you've had some unplanned downtimes in some of the major mills over the last year.
So you've got, you've got demand increasing, no new supply, and actually some supply erosion based on unplanned downtime. And I think all those—the combination of all those factors is driving NBSK to where it is today. If there is any good news, at least short term, we're starting to see some of the Chinese spot prices starting to stabilize. So, you know, is that indicative of a future trend? I don't know, but it, it's, it's a good sign nonetheless, versus what we've seen in the last few quarters.
Great. Thanks for that color. Second question, if pulp prices and freight costs continue to rise or stay elevated, you know, with the additional requirements for TAD2 in terms of CapEx and interest, would this impact your views or potentially the board's view on the CAD 0.18 dividend?
I think at this point, when we look at our dividend track record, we've certainly had a dividend record of continuing to keep the same dividend each quarter. The board makes that decision each quarter as we go through, but at this point, there's been no decision to change that. In fact, the board just approved the next dividend at the same level for the January payment, so.
To your point, if the pressures on pulp continue, obviously we would look at additional pricing if that was necessary and related to the market. We would look at increasing our cost recovery or cost reduction programs that we're undertaking next year. We would respond to those marketplace headwinds with some marketplace actions to try to rebalance our margin.
Okay, great. Thanks very much.
Thank you.
Your next question comes from Zachary Evershed with National Bank. Your line is open.
Good morning.
Good morning.
Morning.
We have some guidance for TAD2 CapEx in 2018. I was wondering if you could give us any color on 2019, how front-end loaded the spend would be?
Yeah, think about the TAD2 project as over a little more than 2-year period from now. So you could look at the spend fairly evenly over that period, and then there'd be a bit that would come in in 2021 as we go live with production. So fairly evenly spent over that two and plus year period.
That's helpful. Thank you. In terms of capital allocation, we just went over the dividend. With the share price down to where the dividend is around a 10% yield, have you given any thought to share buybacks?
No, at this point, that hasn't been considered.
Okay. That's it for me. Thank you.
Thank you.
There are no further questions at this time. I will now turn the call back over to the presenters.
Well, thank you for joining us on this conference call this morning. We look forward to speaking with you again in March 2019 , following the release of our fourth quarter results. Thank you, and have a great day.