Morning, ladies and gentlemen. Thank you for standing by. Welcome to Stella-Jones Second Quarter 2018 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 0 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 Wednesday, August 8, 2018. I will now turn the conference over to Brian McManus, President and CEO. Please go ahead, sir.
Thank you. Good morning, everyone. I am here with Éric Vachon, Chief Financial Officer of Stella-Jones. Thank you for joining us for this discussion of the financial and operating results for the company's Second Quarter ended June 30, 2018. Our press release reporting Q2 results was published earlier this morning. It can also be found on our website at www.stella-jones.com and on SEDAR. Let me remind you that all figures expressed on today's call are in Canadian dollars unless otherwise stated. I will begin with a brief overview of the quarter. Our Second Quarter results demonstrate strong sales growth. Sales increased in the Utility Pole, Residential Lumber, and Logs and Lumber product categories, driven by increased selling prices and market demand.
This performance was partially offset by the continued temporary headwinds in the Railway Ties product category, primarily related to the transitioning of a Class 1 railroad customer to a full-service program. We are also pleased to see our operating margins improve sequentially by 1.8% over the First Quarter, in line with our expectations. Overall revenue amounted to CAD 662.3 million versus CAD 594.2 million in the same period last year. The contribution from acquisitions was CAD 26 million, while the currency conversion effect had a negative impact of CAD 18.6 million on sales. Excluding these factors, sales increased CAD 60.7 million or 10.2%. Net income for the quarter was CAD 48.1 million or CAD 0.69 per diluted share compared to CAD 0.71 per diluted share a year ago. In a moment, Éric will discuss the financial performance of the company in greater detail. I will now address the Second Quarter results by product category.
Railway Tie sales reached CAD 201.3 million, down from CAD 214.2 million for the same period last year. Excluding the currency conversion effect, sales declined CAD 4.7 million or 2.2%, primarily as a result of the company supporting the transition of a Class 1 railroad customer from a treating-services-only program to a full-service black-tie program. We expect that this transition will negatively impact sales to this customer until the latter part of the Third Quarter. The sales decrease was also due to a continued soft pricing environment, which we have already started to see improve in most regions. Turning to Utility Poles, sales amounted to CAD 179.3 million, up from CAD 167.5 million for the same period last year. Excluding the contribution from acquisitions and the currency conversion effect, sales increased by approximately CAD 17.6 million or 10.5%.
This growth was driven by higher volume for replacement programs, coupled with increased sales prices from standard contract escalation and renewal clauses. In the residential lumber category, sales were CAD 203.6 million, up from CAD 153.2 million for the same period last year. Excluding the contribution from acquisitions and the currency conversion effect, sales increased by approximately CAD 33.8 million or 22.1%. This favorable variance is primarily explained by higher selling prices as a result of lumber cost escalations being passed through to customers and to increased volume due to the company's expanding market presence. In the industrial product category, sales reached CAD 32.8 million, up from CAD 27.1 million for the same period last year. Excluding the contribution from acquisitions and the currency conversion effect, sales increased 3.3%, explained in most part by projects requiring our treated laminated products.
Finally, in our category of logs and lumber, revenue stood at CAD 45.3 million, up from CAD 32.2 million in the same period last year. This significant increase reflects higher selling prices due to increased lumber costs, coupled with increased harvesting activity related to procurement activities to support strong pole sales. Turning to our network. During the quarter, we acquired Wood Preservers, Inc., which manufactures, sells, and distributes marine and foundation piling and treated wood utility poles located in Virginia. We are currently in the process of integrating both WP and Prairie Forest Products acquired in February in our operation. Once fully integrated, our network will be that much stronger. Éric will now provide further details about our Q2 results. Éric?
Thank you, Brian. Gross profit amounted to CAD 96.7 million or 14.6% of sales in Q2 2018, compared with CAD 99 million or 16.7% of sales in Q2 2017. The decrease in absolute dollars is primarily explained by the transition of a Class 1 railroad customer from a treating services only program to a full-service black-tie program. To accelerate this transition, the company acquired untreated railway ties from the Class 1 railroad customer, which increased cost of sales once these ties were treated and sold. Railway tie margins were also impacted by increasing untreated railway tie costs in Q2.
The decrease in gross profit is also attributable to higher operating costs in the U.S. Southeast, where Stella-Jones continues to work on reducing its cost base and improving logistical flow. In addition, the higher lumber costs, which are passed through to customers via higher selling prices, have contributed to increase the cost of sales but have also put downward pressure on margins as a percentage of sales. These cost increases were partially offset by the effect of currency translation. As a result of the reduction in gross profit, operating income stood at CAD 71 million or 10.7% of sales, down from CAD 74.5 million, or 12.5% of sales in Q2 a year ago. As we explained last quarter, we expected our margins to be softer in the first half of the year. Note that margins in the second half of the year are expected to improve over the first half.
Similarly, net income for the second quarter of 2018 was CAD 48.1 million, or CAD 0.69 per diluted share, down from CAD 48.9 million or CAD 0.71 per diluted share in the second quarter of 2017. Cash flow from operating activities before changes in non-cash working capital components and interest and income taxes paid was CAD 81.7 million for the second quarter of 2018, compared with CAD 83.2 million for the same period in 2017. Given higher working capital requirements this year versus last year, Stella-Jones generated cash flow from operating activities of CAD 62.4 million in the second quarter of 2018 as compared to CAD 94.4 million for the same period last year. In the second quarter, our cash was primarily used to finance the Wood Preservers, Inc. acquisition of CAD 28 million, invest in CapEx for CAD 12.5 million, and pay dividends of CAD 16.6 million.
As at June 30th, 2018, Stella-Jones' long-term debt, including the current portion, was CAD 581.2 million versus CAD 455.6 million as at December 31st, 2017. The increase mainly reflects higher working capital requirements, financing for the acquisitions of Prairie Forest Products and Wood Preservers, higher capital expenditures, as well as the effect of local currency translation on U.S. dollar-denominated long-term debt. Stella-Jones' total debt to EBITDA ratio was 2.5 versus 1.9 as at December 31st, 2017. The board of directors of Stella-Jones yesterday declared a quarterly dividend of CAD 0.12 per common share, payable on September 21st, 2018, to shareholders of record at the close of business on September 3rd, 2018. I will now turn the call back to Brian for the outlook.
Thank you, Eric. Based on current market conditions and assuming stable currencies, we expect higher year-over-year overall sales for Stella-Jones, driven by pricing as well as increased market reach for the residential lumber, utility pole, and logs and lumber product categories. Operating margins are expected to improve in the second half of 2018 when compared to the first half of the year. The progression of operating margins in the second half of 2018 will be slowed down by increasing untreated railway tie costs until sales prices can be adjusted. We expect 2018 overall operating margins to be slightly lower than last year. Having said this, in 2020, we remain confident that our EBITDA margins will return to the 15% range on an annualized basis.
We plan on spending between CAD 30 million and CAD 40 million on property, plant, and equipment in 2018, and our overall effective tax rate is expected to be approximately 26.5%. Let me discuss our outlook by product category. In the railway tie product category, pricing is expected to improve in the second half of 2018, but the related margin gains will be partially offset by rapidly increasing costs of untreated railway ties. We expect that this raw material cost increase will lead to continued upward selling price adjustments in the quarters ahead. The spot market pricing should also benefit from the tightening of the untreated railway tie supply. These adjustments will have a positive effect on margins in 2019 and going forward. In the utility pole product category, sales in the second half of 2018 will benefit from both pricing adjustments and strong demand.
We also expect a better sales mix within the product category for the upcoming quarters. These factors will be partially impacted by slight cost increases for certain wood species and the timing of price adjustments. We continue to work at optimizing our operations in the U.S. Southeast, which will lead to improved margins in the second half of 2018. The residential lumber product category, sales for the second half of 2018 are expected to increase year-over-year as we expand our market reach and benefit from increased pricing driven by higher wood costs. The effect of adjusted residential lumber selling prices as a result of higher wood costs will have a slight downward impact on margins as a % of sales for the year.
Finally, sales for the logs and lumber product category will continue to grow as a result of increased harvesting activities and the impact of the higher cost of lumber. Since this business does not generate any margin, sales growth in this product category will further reduce overall margins as a % of sales. In the short term, we will focus on integrating the recent Prairie Forest Products and Wood Preservers, Inc. acquisitions, as well as optimizing operating capacity and minimizing costs throughout the organization. As we indicated in the last conference call, we commissioned additional pole treating capacity at the end of the second quarter, which will help improve customer service and our operating costs in the U.S. Southeast. Over the long term, our strategic vision focused on continental expansion remains intact, as we believe that the fundamentals of each product category remain strong.
Our vision is to solidify Stella-Jones as the North American leader in the pressure treatment of wood for railway ties and utility poles, while diversifying into other product categories that are aligned with the company's established competence. As we have done for over a decade, we are committed to our established business while pursuing a disciplined program of acquisition. This strategy has helped us to consistently enhance shareholder value, and we are confident we'll continue to do so. Éric and I will now be pleased to answer any questions you may have. Thank you.
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. Again, that's star followed by the number one on your telephone keypad. Your first question comes from the line of Hamir Patel from CIBC. Please go ahead.
Good morning.
Good morning.
You pointed to the escalation in untreated cross ties as tempering the margin recovery over the rest of the year. How long do you think it'll take to pass that on based on the timing of your contracts?
For the most part, it depends at what point. We're kind of chasing the higher cost up, I would suspect, by the end of the year into the first quarter, we'll have already had price adjustments through, and we'll see at that point if the upward pressure on untreated ties continues. We've certainly seen a sharp increase in the last several months.
Great. Thanks. That's helpful. Do you have a sense yet as to how the Class Is are thinking about their tie purchase programs for 2019? Is it looking flat or are you expecting some growth there?
It's a bit mixed. Some are probably going to be down a bit while others are up. I think on balance, the mix within our customer group, we're probably going to be up a bit overall in the Class Is.
Great. Thanks. That's all I had. I'll turn it over.
Great. Thank you.
Your next question comes from the line of Leon Egizian from National Bank Financial. Please go ahead.
Hey, good morning, guys.
Good morning.
Great performance on the residential lumber side. I mean, the organic growth number was quite strong there. I know you mentioned lumber prices were a pretty big factor. Can you help us quantify that a little bit? I mean, was it a big volume impact there, or was it really on the pricing side? Just maybe help us understand that a little bit better, please.
Sure. About two-thirds would be related to price, one-third would've been volume.
Okay. You also mentioned that on the lumber side as well as some of the other segments, that you're seeing an increased market reach. Can you explain to us what that means about that? Are you in more geographies now than you were before, or are you in different contracts that you've gained, or how should we see that side of things?
A bit of both. We're in more geographies because of our acquisitions or our acquisition related to Prairie Forest Products. That geographically got us into a region where we weren't before. Additionally, within the same geographical areas, we've expanded some of what we refer to as our dealer network, which would be the non-box store.
Okay. Just two quick kind of clarification things from my end would be on the CapEx, you mentioned CAD 30 million-CAD 40 million for 2018, you've already spent north of CAD 25 in the first half of the year. Is that to understand that the second half is gonna be very minimal in terms of spend, or is that an additional CAD 30-CAD 40?
No, our guidance is for CAD 30-CAD 40 for the whole year on the CapEx.
Okay. No, that's what I thought. Just wanted to clarify. The last point would be on the logs and lumber side, obviously, that number was quite high as well. You mentioned that it is low margin to no margin. Just trying to understand, like if it wasn't for logs and lumber, what kind of EBITDA margin would we be looking at for the quarter?
The impact, if we would've had it, call it the same or no growth maybe in that product category, it had approximately about a half a percent on the EBITDA margin.
Great. Thanks. I'll turn it over.
Thanks, Leon.
Your next question comes from the line of Benoit Poirier from Desjardins. Please go ahead.
Yes. Good morning, gentlemen. Just related to the outlook, could you mention some color with respect to the railway tie, but mostly for the non-Class 1 railroad for 2018 and 2019?
In terms of where we expect demand to be? Is that I'm sorry, just a little unclear on the question.
Yeah, exactly. In terms of demand, what you would expect from the non-Class railroad for the remainder of 2018 and 2019, Brian?
Yep. We expect actually it'll continue to be healthy. I think certainly, we've seen a real tightening in inventories, as an industry, and that is certainly gonna help us, hopefully, from a profitability standpoint and margin standpoint, in the quarters ahead. We've worked through as an industry, the pendulum's probably swung in the other direction now. We went from too much to now we're seeing a real tightening in the untreated availability of ties. That's gonna, I think, help us in the quarters ahead.
Okay, perfect. Maybe the question is for Éric. When you say about a slight decline in the overall EBITDA margin in 2018, could you provide some color or quantify a little bit what is the overall EBITDA number we should expect for the whole year, Éric?
Are you talking in absolute dollars or percentage?
In percentage.
Either.
Yeah.
About 12.5 annualized, Benoit.
Okay. For the full year. Okay. That's great color. When we look at the utility pole, given the trend toward higher interest, could you provide some color on if it impacts the outlook for your utilities, whether it could trend into lower CapEx or whether you haven't seen any impact so far?
We haven't really seen any impact so far. I think we remain fairly bullish that we're continuing to see healthy maintenance programs.
Okay. That's very good. Could you comment a little bit about the outlook for M&A now that you performed some acquisition this year, whether there's still a pipeline for 2018 or mostly 2019?
I would say, as you're aware, we're always looking at opportunities. I think the timing of those opportunities is difficult to judge sometimes just based on everything from due diligence requirements to the sellers' interests themselves in terms of the timing. I would say, we're confident we have some other ones ahead of us. Whether that will hit 2018 or 2019, it's hard to say at this point in time.
Okay. Last one for me, could you provide an update on the progress related to the growing the U.S. residential lumber? You made some comments in the past quarter, I was just curious to know if there's kind of an evolution in terms of U.S. residential lumber. Thank you.
On the U.S. residential lumber side, we continue to see a healthy program being driven out of the Northwest at our Tacoma facility. I think at this point in time, our focus on acquisitions is going to remain primarily on the pole and tie side, I think to expand beyond a residential presence in the U.S. will take acquisitions of assets. I would say that's still a wait-and-see, and probably a little further out.
Perfect. That's great color. Thank you very much.
Thank you.
Thank you, Benoit.
If there are any additional questions at this time, please press star, followed by the number one on your telephone keypad. Your next question comes from the line of Justin Keywood from GMP Securities. Please go ahead.
Good morning, and thanks for taking my call.
Hi, Justin.
Hi. On the working capital, as you mentioned, it was high in the quarter and the accounts receivable seemed to spike. I'm wondering, is this just normal seasonality, and should we expect that to come down substantially in Q3?
Yeah, you're exactly correct, Justin. It is a seasonality. Day sales are very stable, comparable year-over-year, and no collections issues, but you're right, the higher amount is related to the volume of business.
Okay. On the debt ratio, it was 2.5 in the quarter, there was an amendment on the accordion loan that expands the available credit quite substantially. I'm wondering what's the comfort level for you on the debt ratio, and is this affecting any acquisition plans?
Historically, our comfort level is when we start to approach three or just a little bit over three times EBITDA is where I would say we start to feel a little uncomfortable. We do get the benefit in any acquisition, not from a reporting standpoint for our ratio, but for how the bank would view our ratio, is that we get to include the pro forma of any acquisitions that we would've done. That would help bring the ratio down. We still have some good horsepower available for the acquisitions that we have in the pipeline. We're still sitting good now, and we expect as we roll through Q3 to further see debt levels come down for sure.
Okay. Just finally, on the growth in residential lumber, there was mention of increasing market share. I'm wondering, is this capturing new customers or just expanding with existing?
It's actually a bit of both. We've picked up some new customers and, of course, our existing customers continue to perform very well, we like to think because they're with the right supply partner.
Okay. Is there opportunity to increase that share more, or are you kind of reaching the limits?
I think we're still able to expand on the dealer side of the market and we'll certainly help our existing customers to continue to grow. I think there is opportunity. I think the greater opportunity, as per one of the previous questions, would eventually lie in the U.S., but at this point in time, like I said, our near-term focus will be on poles and ties.
Great. Okay, great. Thanks for taking my questions.
Thank you, Justin.
Thank you, Justin.
There are no further questions at this time. I turn the call back over to Mr. McManus for closing remarks.
Great. Well, thank you everyone for joining us on this call, and we look forward to speaking with you again on our next quarterly call. Have a great day.
This concludes today's conference call. You may now disconnect.