Good morning, ladies and gentlemen. Thank you for standing by. Welcome to Stella-Jones' Q3 2019 earnings 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, please be advised that this conference call will contain statements that are forward-looking and subject to a number of risks and uncertainties that could cause actual results to differ materially from those anticipated. I would like to remind everyone that this conference call is being recorded on Thursday, November 7th, 2019. I will now turn the conference over to Eric Vachon, President and CEO. Please go ahead, sir.
Good morning, ladies and gentlemen. Thank you for joining us for this discussion on the financial and operating results for Stella-Jones' third quarter ended September 30th, 2019. Our press release reporting Q3 results was published earlier this morning. It, along with our MD&A, can also be found on our website at www.stellajones.com and will be posted on SEDAR today as well. Let me remind you that all figures expressed on today's call are in Canadian dollars unless otherwise stated. Before we begin, I would like to also remind you that on January 1, 2019, the company retrospectively adopted IFRS 16 leases but has not restated comparatives for 2018 reporting period. Please refer to our MD&A for further details. Let me now begin with a brief overview of the quarter.
We are pleased with our third quarter results, which saw EBITDA up 22% to CAD 96.1 million and increase in net income and diluted EPS to CAD 53.7 million and CAD 0.78 per share, respectively. We saw solid performances in our utility pole, railway tie, and industrial product categories, all of which generated increased sales stemming from a combination of higher pricing and volume. While sales in the third quarter reached CAD 626.6 million, decreasing slightly by CAD 3.4 million from 2018, profitability increased. We generated solid margins, even when adjusting for the impact of IFRS 16, and maintained a strong cash flow, which we used primarily to reduce debt and repurchase shares. The decrease in overall sales for the quarter was due to lower sales in the logs and lumber category, which was unfavorably impacted by lower lumber market costs, resulting in a sales decline of over CAD 20 million for the category.
Excluding this impact, overall sales for the quarter would have increased 2.5%. Sales in the residential lumber product category also declined because of lower lumber costs, but the impact was less pronounced as it was largely offset by higher sales volume. Looking at the third quarter results by product category. Utility pole sales reached CAD 211.5 million, up 5.4% from sales of CAD 200.6 million last year. Excluding the currency conversion effect, utility pole sales increased CAD 9.6 million, or 4.8%, primarily driven by increased sales prices coupled with healthy replacement demand. Railway tie sales amounted to CAD 190.7 million, up 1.6% from sales of CAD 187.7 million last year. Excluding the currency conversion effect, railway tie sales increased CAD 2.3 million, or 1.2%.
While we expected this delta to be more significant in the quarter due to ongoing strong demand and high selling prices, growth was partially offset as a result of the tight supply market for untreated railway ties, which has required us to treat railway ties that are not air-seasoned, resulting in longer treating cycle times. In addition, during the quarter, we manufactured finished product for a customer who later informed us they would only be taking delivery in the next few months. As a result, some third-quarter sales have been pushed out to the next quarters. Consequently, railway tie sales for 2019 will be flat year-over-year, and in turn, profitability will be impacted. Sales in the residential lumber category totaled CAD 158.2 million, down 1.4% from sales of CAD 160.5 million last year. Excluding the currency conversion effect, residential lumber sales decreased CAD 2.8 million, or 0.5%.
This variance is primarily explained by lower lumber prices, partially offset by higher sales volumes. Industrial product sales reached CAD 37.6 million compared with CAD 32.4 million last year. Excluding the currency conversion effect, sales increased CAD 4.9 million, or 15.1%, largely as a result of stronger rail-related and piling product sales. Sales in the Logs and Lumber category totaled CAD 28.6 million compared with CAD 48.8 million last year. Excluding the currency conversion effect, sales decreased just over CAD 20 million. As discussed earlier, this variance is a result of reduced selling prices, which is passed through to customers driven by lower lumber market costs, a decrease in lumber transaction volumes, as well as lower log sales due to the timing of harvesting activities. Turning now to profitability. Gross profit amounted to CAD 110.2 million, or 17.6% of sales in the third quarter of 2019, compared with CAD 97.4 million, or 15.5% of sales last year.
The increase is explained by higher selling prices, lower lumber costs when compared to last year, and improved operational efficiencies. These factors were partially offset by higher volume for utility poles, higher production costs for railway ties, given the longer treating cycles, and the effect of currency translation. EBITDA stood at CAD 96.1 million, or a margin of 15.3%, versus CAD 78.5 million or a margin of 12.5% last year. The increase in EBITDA is explained by increased gross margins and the adoption of IFRS 16, which effectively subtracted CAD 8.4 million in right of use asset depreciation and CAD 1.1 million in financing expenses from cost of sales. With the adoption of IFRS 16, it becomes difficult to compare our EBITDA to last year.
As a general rule of thumb, you can subtract the reclass from cost of sales, or in this case, CAD 9.5 million from our Q3 2019 EBITDA, to make it more comparable. By doing this, you can see that our EBITDA increased over 10% year-over-year, a very healthy growth rate on a true comparable basis. Operating income stood at CAD 78.6 million or 12.5% of sales in the third quarter, compared to CAD 67.9 million or 10.8% of sales last year. Net income for the third quarter of 2019 was CAD 53.7 million or CAD 0.78 per diluted share, up from CAD 45.8 million or CAD 0.66 per diluted shares last year. Turning now to liquidity and capital resources.
Cash flow from operating activities before changes in non-cash working capital components and interest and income taxes paid, reached CAD 97.4 million in the third quarter, up from CAD 81.3 million when compared with the same period last year. The increase primarily reflects higher net income and the impact of IFRS 16. Combined with favorable changes in working capital items, we generated strong cash flow from operating activities of CAD 123.7 million versus CAD 91.3 million last year. As always, we continue to be mindful of our capital allocation. Maintaining a prudent use of leverage, ensuring sufficient maintenance CapEx, making acquisition at reasonable multiples, buying back shares, and paying dividends are all key priorities. We intend to maintain an optimal balance amongst all these facets.
In the third quarter, we used our cash flow to reduce debt by CAD 64 million, and in the absence of M&A, we used our normal course issuer bid program opportunistically to repurchase shares for CAD 30 million. We also supported purchase of property, plant, and equipment for CAD 14 million and paid dividends of CAD 10 million. We concluded the third quarter in a very healthy financial position. As at September 30th, 2019, our long-term debt, including the current portion, was CAD 562.8 million versus CAD 513.5 million as at December 31st, 2018. The increase mainly reflects higher working capital requirements, higher capital expenditures, and financing required for the acquisition of a residential lumber facility in Shelburne, Ontario, partially offset by the effect of local currency translation on U.S. dollar-denominated long-term debt.
On the dividend front, the board of director of Stella-Jones yesterday declared a quarterly dividend of CAD 0.14 per common share payable on December 19th, 2019, to shareholders of record at the close of business on December 2nd, 2019. Turning now to our outlook. For 2019, excluding sales for the logs and lumber product category, we expect higher year-over-year overall sales based on current market conditions, the current level of lumber prices, and stable currencies. This increase is driven by stronger pricing for railway ties and utility poles, as well as an increase in market reach for the utility pole product category. More specifically, in the utility pole product category, sales and margins for 2019 are expected to increase year-over-year, driven by both pricing and healthy demand for replacement programs.
In the railway tie product category, sales for 2019 are expected to be comparable year-over-year, explained by improved pricing, but offset by lower volumes as mentioned earlier. Management believes that the increasing cost of untreated railway ties, combined with a tighter supply market, will lead to continued upward selling pricing adjustments for the quarters ahead. In the industrial lumber product category, sales for 2019 are expected to be slightly below last year, given the slow start to the year and lower selling prices to customer as a result of the increased lumber costs. Management closely monitors variations of these commodity prices and adjusts its procurement practices accordingly in order to maintain dollar margin on a similar volume.
In the industrial product category for 2019, we expect higher sales driven by healthy demand for rail-related projects and piling products. It is important to highlight that sales for the logs and lumber product category, an activity used to optimize procurement and which does not generate margin, is closely tied to the market price of lumber. For 2019, we expect lower year-over-year sales for this product category, explained by lower lumber prices when compared to 2018 and reduced volumes. The decrease in sales for logs and lumber product category will favorably impact overall margins as a percentage of sales when taken as a whole with other product categories, and vice versa. For 2019, we also expect improved year-over-year margin on a consolidated basis. Higher margin will be primarily driven by increased pricing for railway ties, coupled with improved product mix and demand for utility poles.
Having said this, given that some railway tie sales have been pushed out over to the next quarters, profitability for 2019 will be impacted. As a result, we have adjusted our EBITDA guidance range to be between CAD 310 million-CAD 315 million. Adjusting for this impact of IFRS 16, this will represent a year-over-year increase of over 11%. Furthermore, we plan on spending CAD 60 million-CAD 70 million of capital expenditures in 2019. This includes the planned expansion at Cameron, Wisconsin, as well as the Shelburne acquisition and upgrades. For 2020, based on current market conditions and assuming stable currencies, we expect higher year-over-year overall sales for Stella-Jones, driven by stronger pricing and increased market reach in the utility pole, railway tie, and residential lumber product categories.
As a result, operating margins in absolute dollars and as a percentage of sales are expected to improve over 2019, primarily driven by pricing improvements and operational efficiencies. Our strategy remains intact, as we will continue to focus on optimizing our operations across the organization while seeking acquisitions to further expand our presence in our core product categories. This concludes my prepared remarks, and I will now be pleased to answer any questions you may have.
Thank you. At this time, if you would like to ask a question, please press star followed by the number one on your telephone keypad. Your first question comes from the line of Walter Spracklin from RBC Capital Markets. Please go ahead.
Yeah. Thanks very much. Thanks for taking my question. I guess focusing here on the 2020 with the push forward of the sales into 2020, and the reduction in EBITDA associated with that, would we see a kind of similar lift to what we would have otherwise expected in 2020 as a result of that push forward? I don't know if you can give any color around what your view is around the current consensus being around, let's call it CAD 335, CAD 340 for next year, if that's consistent with what you're seeing in terms of what you can see looking forward into 2020 so far.
Great. Thank you, Walter, for the question. To answer, you got multiple aspects to your question. The push of sales forward will obviously be accompanied with the EBITDA margin into next year. You're completely correct that those sales, some of them will move into Q4 and Q1 of next year, and the EBITDA margin will follow as well. With regards to quantifying EBITDA levels for 2020, I will defer to our call we'll have for Q4 in March. I'm going next week to meet our team at a budget meeting where I'll have better guidance and a better view on next year's numbers.
Okay. Would that apply as well for CapEx program at this point? Can you give us some indication as to whether just directionally, do you see it being up or down relative to 2019?
I'd be happy to guide you on CapEx. We believe a CAD 50 million mark would be in line with our historical spend.
Okay. I'll queue up. Thank you very much.
Thank you.
Your next question comes from the line of Hamir Patel from CIBC Capital Markets. Please go ahead.
Good morning.
Good morning, Hamir.
Eric, could you speak to the state of the M&A pipeline and if you see any more opportunities in any particular product category?
Perfect. Thank you, Hamir. As we've discussed in the past, there are several targets that the company has identified in the North American market that we are continually in discussions with. We're working diligently and in discussions with some of these sellers to be able to establish a deal, which obviously would be in line with historical discipline that we have with regards to multiples.
Okay. Great. Thanks, Eric. I wanted to turn to the tie side. From your discussions with customers, do you have a sense yet as to whether volumes will be up or down next year, and any differences that you're seeing maybe between the Class Is and the short lines?
Certainly. Obviously, as we stated in our outlook, we're seeing improved sales next year and improved margins. Although we're going to budget next week, I do have a sense of preliminary numbers that we based our outlook on. For Class Is, overall, we're seeing growth in volume and in the details, there's plus and minuses in there. Net, it would be an increase for us next year. We see demand for the non-Class I market to continue to be strong. We do plan on taking an opportunistic approach to that market since we'll most likely be doing less boultonizing next year since our dry inventory program is much healthier than it was last year at the same time.
Okay, great. Thanks, Eric. That's all I had. I'll turn it over.
Thank you.
Your next question comes from the line of Benoit Poirier from Desjardins Capital Markets. Please go ahead.
Yeah. Good morning, Eric. Just to come back on the previous question related to boultonization, could you maybe provide some color about the percentage of your railway ties that is using boultonization, and where should we see the improvement going into next year, and whether we are looking for a normalized boultonization going back to 2021?
Right. Benoit, without quantifying it, I can tell you this year, Q2 and Q3 heavily used the boultonizing process as we saw depletion in our inventory levels, and that is related to availability of product in the market or the untreated tie in the market. What we've seen in the last few months, our key procurement areas have dried up, and we are seeing hardwood logs made available to sawmills, and our procurement team is quite happy, quite pleased actually with what we've been able to procure on a monthly basis. We are building our dry program slowly but surely, closing the year and going into next year. Definitely the boultonizing process will be used much less. The gain there for us is the throughput or the quantity of ties we can produce at a given facility in one month.
Obviously, as we've discussed in the past, when you boultonize, your cycle time is much longer than when you use a tie that has properly air seasoned. Therefore, having more product being available for sales, we will most likely take better advantage of requirements in the non-Class I business.
Okay, perfect. That's great color. Eric, could you maybe provide some color about the railway ties, the composite aspect, whether there's been some change in the market demand given we are dealing with a wet environment. Have you seen any change on the composite tie demand with respect to that?
Great question, Benoit. Thank you. We have ongoing discussions with other railroads in North America, being Class Is and the short lines and so on. We're not seeing a shift from wood or away from wood to substitute products. There's no change in trends. Several of our clients do not spec either composite or concrete, and those that do, well, actually they'll procure small quantities annually simply for their own purposes.
Okay. That's pretty good. When we look at utility poles, given the wildfire, we've seen some strong growth so far, but could you comment about the organic growth expectation for utility pole, and also given the technology that you have in terms of putting a mesh on the wood, about the update on the success so far?
Okay. Obviously the wildfires on the U.S. West Coast are very unfortunate. We have our emergency teams ready 24/7, and we've been supporting our clients for quick adjustments to supply product. Will come the phase of rebuilding, and that will stretch over several quarters, Benoit. It's not as if we will see a huge spike. It will be a lift over, let's say, the three or four next quarters of next year. You should not expect us to have a big spike and comment in a conference call that we've got increased sales because of these events. This is always also a great opportunity for us to leverage our network and to demonstrate to our customers that we've got strong inventory levels and have the ability to service them from different locations.
Okay. When we look at 2020 residential lumber, what would you expect given the dynamics? I'm talking here pricing versus volume for 2020 residential lumber. Any color you could provide, Eric?
Well, it's always difficult to predict the cycle on the lumber markets, and we've seen sawmills closed in Canada in recent months, and hard to predict that impact as well. What we're seeing now is an opportune time now to procure lumber at a reasonable price, and we're actually getting into more longer term commitments to ensure that we're building next year's program. I would suspect that on the revenue side, what is going to be driving the increase is very much related more to volume.
Okay. That's great color. When we look at your inventory of railway ties, could you maybe provide some color about what we should expect in terms of working cap for the full year in 2019, but also next year, given you might be able to, or you'll be successful in building more inventory? Just wondering if there's a big impact we should expect in terms on the working capital.
I do expect a cash draw in our cash flow on that inventory line. Last call, I guided around CAD 40 million. I would say it's in that range of CAD 40 million-CAD 45 million. Obviously, if we can procure more railway ties, we will. It's also a question the hardwood logs have become available. The sawmills are cutting them, and we're buying everything we can to build our dry program. Also keep in mind that there's a rhythm to which the sawmills can deliver. If for any reason we can optimize and get more inventory in, we will definitely take that opportunity. Right now, I will guide to CAD 40 million-CAD 45 million.
For 2019, Eric, or even for next year?
No, for 2019. Honestly, maybe probably most likely for next year, because it is going to take us several months into next year to continue rebuilding that dry inventory level. Obviously, it depends on the pace, but yes, I would suspect there could be a draw again next year.
Okay, perfect. Okay. With respect to the CFO role, could you provide an update on the CFO search, Eric?
Certainly. We have engaged a third-party firm to help us recruit, and we're right now in the thick of the process. Things are moving along very well. I'm quite pleased with the process. It's always difficult to predict when these processes conclude, but let's say I'm hopeful that in the next few months, we'll be making an announcement to the market for a replacement for the CFO position.
Okay. That's great color. Thank you very much for the time, Eric.
My pleasure, Benoit.
If there are any additional questions at this time, please press star one on your telephone keypad. Your next question comes from the line of Michael Tupholme from TD Securities. Please go ahead.
Thanks. Good morning.
Good morning, Mike.
Good morning. Thank you. Eric, can you provide any further details around the customer decision to defer sales, and if you do have a sense and it's possible to share that? Also, is it fair to say that this is not in any way indicative of any kind of a general trend, and it's a specific situation?
Thank you, Mike. I don't want to talk customer specifics, but I did mention the fact that it's a customer, it is not an industry-spread trend, and there is no change in trend. As much as I can say, we have good relationship with this customer and have a long-term relationship, and we're supporting them in this change. My understanding is that they're better managing their own internal inventory, and we're just pushing some sales into next year. We know that we'll have strong demand from them in the coming year.
Okay. You've talked a little bit about improving conditions on the procurement side in terms of raw fiber availability.
Just wondering, you've also talked about expecting some price-driven growth in the ties segment in 2020. I'm just trying to square those two comments. If availability of raw material is improving, yet you're still confident in seeing some pricing growth, is that just that the comps are a little bit easier maybe in the first half, or is this a function partly of your commentary about trying to be more opportunistic in the non-Class I market?
Yeah, that's exactly it. It's in the non-Class I market because the first half of 2019 saw some price increases in the railway ties. Year-over-year, in the first half of next year, in that non-Class I business, we'll have opportunity to nudge up pricing just a bit. Exactly. You're spot on.
Okay, perfect. With respect to the utility pole segment, still healthy growth this quarter, but it did come down from where it was in the second quarter. If I recall, the last conference call, you had talked about the potential for seeing double-digit organic growth for the full year 2019. Any commentary on sort of if there's been any changes in the, I guess, in the outlook or the organic growth outlook for the utility pole segment?
No, not at all. When you compare year-over-year, I can say as much as in 2018, we did have in Q3 an important transmission project, which obviously ended last year, and we did not have a replacement project, if you want, for that specific sales volume for this year. Demand remains healthy. To your point, I am hopeful to see a strong close to the year. Call it like the mid-single digits, but it still will be very healthy.
Okay, perfect. Then just lastly, the 2019 EBITDA guidance range that you provided, just to be clear, in terms of sort of what's driving you towards that type of range versus what you'd previously communicated, is that mainly a function of the shift in deliveries for this one particular customer into next year on the tie side, or are there other factors that went into that change?
That is the main factor there, Mike.
Okay. All right, thank you.
My pleasure.
Your next question comes from the line of Maxim Sytchev from National Bank Financial. Please go ahead.
Hi, good morning.
Good morning.
Eric, I just had one question. I'm not sure if you can provide this data point, but in terms of if you're going to be doing less boultonizing next year, can you maybe walk us through in terms of how we should be thinking about this in terms of the margin impact, the potential lift from that? Can you maybe quantify that?
Quantifying it is difficult. There's two aspects to it. One is when we have to use the boultonizing process, it is in accord with our customers, and we do get a bit more of a compensation for it. Where the cost efficiencies are a bit higher, there's less absorption of fixed cost because we absorb our fixed cost based on volumes produced. There's definitely a better allocation of our fixed cost, and there's definitely an uplift. Difficult for me to quantify it. It's a good question. I could have one of our analysts run some models on it, and I could follow up with you eventually, but it's not a data point I would have at this point.
Still, just in terms of how we should think directionally, it should help the margin profile. Is that a fair assessment?
Oh, yeah. It would, but it would be like in decimals of a percentage point, right? We're not talking significant lift.
Okay. That's great. That's it for me. Thank you very much.
Thank you.
There are no further questions at this time. Monsieur Vachon, I turn the call back over to you for closing remarks.
Thank you for joining us on this call, and we look forward to speaking with you again at our next quarterly call.
Thank you, ladies and gentlemen. This concludes today's conference call. Thank you for your participation. You may now disconnect.