Greetings. Welcome to the Caesarstone fourth quarter and full year 2017 earnings conference call. At this time, all participants are in a listen-only mode. A brief question and answer session will follow the formal presentation. If anyone should require operator assistance during the conference, please press star zero on your telephone keypad. As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Alison Kane of ICR. Thank you. You may begin.
Thank you, operator. Good morning to everyone. Certain statements in today's conference call and responses to various questions may constitute forward-looking statements. We caution you that such statements reflect only the company's current expectations and that the actual events or results may differ materially. For more information, please refer to the risk factors contained in the company's most recent annual report on Form 20-F and subsequent filings with the Securities and Exchange Commission. In addition, the company will make reference to certain non-GAAP financial measures, including adjusted net income, adjusted net income per share, and adjusted EBITDA. The reconciliation of these non-GAAP measures to the most directly comparable GAAP measures can be found in the company's fourth quarter 2017 earnings release, which is posted on the company's investor relations website. With that, I'd like to now turn the call over to Raanan Zilberman, Chief Executive Officer of Caesarstone.
Raanan, please go ahead.
Thank you, Alison. Good day. Welcome to our conference call to discuss our fourth quarter and full year results, as well as our outlook for 2018. I will start by providing some financial highlights from our fourth quarter. We grew our fourth quarter revenue by 9.8% to a new fourth-quarter record of $148 million. On a constant currency basis, our growth was 7%. We continued to experience gross margin pressure in the quarter. This was primarily from lower throughput in Israel due to an increased portion of differentiated high products. We also saw some pressure from the increased polyester prices. On the positive side, while we still have much work to do at Richmond Hill, our organizational and operational improvements have begun to deliver benefits. I will speak about it more later. The fourth quarter adjusted EBITDA was $21 million, a margin of 14.2%.
This was within our guidance range, but in the lower end, despite the sustained stronger pace of sales growth. The adjusted net income was $8 million, and our adjusted diluted EPS was $0.22. To be clear, these highlights and the annual numbers I will give exclude the impact of the $70 million legal expense we incurred in the quarter. This is mainly the result of an arbitration commenced back in 2011. I'd like now to discuss the full year of 2017. We grew sales by 9.2% to a record of $588 million, with constant currency growth of 7.4%. Our 2017 adjusted EBITDA was $100.4 million. Adjusted net income was $50 million, and our adjusted diluted EPS was $1.45. This has been a challenging year. We were pleased with our top-line increase, especially with our 10% growth in the U.S. after a flat year in 2016.
We are also pleased with our first year of direct distribution in the U.K., which brought significant double-digit growth, and we believe it represents a solid growth opportunity going forward. At the same time, our growing quartz category has continued to evolve with increased competition for manufacturers in low-cost countries. Our intention is to accelerate the innovative stream of new products and to continue leading the global market with our premium brand. In addition, we have accelerated our efforts to diversify our production sourcing of basic design and colors to improve our competitive position. With respect to our manufacturing challenges, in Richmond Hill, the organizational changes that we have implemented in September have had a considerable positive impact. We saw a significant improvement from the third quarter in all the aspects, throughput, yield rates, and cost management.
In Israel, we continue to experience lower throughput as a result of the increased portion of our differentiated products, as well as their complexity level. While we expect some of the pressure to continue, we are working hard to implement the identified opportunities for improvement. In order to maximize revenue capture, we are building better level of inventories availability across all the regions. I would like now to provide an update on each of our regions for the fourth quarter and the full year. In the United States, we grew our fourth quarter sales by 10.3% to $60.6 million, compared to $55 million of last year. We believe that the United States hold a tremendous future potential for growth. For the full year, our sales growth in the United States was 10.2%, a significant improvement from last year's flat performance.
We are determined to keep our growth at a healthy rate in the year ahead. Australia sales in the fourth quarter were $36.7 million, up by 1.7% compared to $36.1 million of last year. On a constant currency basis, Australia was down 0.5% in the fourth quarter. This primarily reflects the continued weakness that the overall housing market is experiencing. As you know, we are quite well-penetrated in Australia, and so we feel the macro pressure in our business. For the full year, Australia sales were up by 5.1% to $137.6 million, and on a constant currency basis, the full-year growth rate was 2.1%. In Canada, a consistently strong contributor to our growth, we grew the revenue by 15% to $24.7 million in the quarter. On a constant currency basis, growth in Canada was 9.5%.
For the full year, Canada sales grew 14.1% to $97.8 million. On a constant currency basis, full-year growth was 12%. The sales in Israel were $9.9 million for the quarter, up by 1.2% compared to last year. On a constant currency basis, sales were down by 7.4%. For the full year, Israel sales were up by 4.6% to $44.5 million, but down 2.1% on a constant currency basis. This trend reflects the challenging market condition, and as you know, this is a highly mature market. Europe sales in the fourth quarter were $6.4 million, up by 22.7% compared to last year. On a constant currency basis, sales were up by 17.5%. For the full year, Europe sales were $28.7 million, up by 12%, and up by 11.2% on a constant currency basis.
The increase in the quarter and the full year primarily relates to our successful transition to direct distribution in the United Kingdom. Revenue in the rest of the world during the quarter was up by 31.8% to $9.9 million. On a constant currency basis, revenue was up by 23.1%. For the full year, sales in the rest of the world were $34.2 million, up by 9.9%, and up by 7.6% on a constant currency basis. I'd like to discuss now our decision on dividend distribution. As we announced today, we have decided to distribute a special cash dividend of $0.29 per share, enabled by our strong cash balance, our positive cash flow from operation, as well as our confident outlook for the future.
This is a return of excess cash that we believe is beyond what is required to fund our growth, either in terms of capital expenditure or working capital needs. We also announced a new dividend policy, where we intend to pay $0.10 to $0.15 per share on a quarterly basis, subject to a certain condition and at the discretion of the board of directors. We believe that this is a very appropriate way to return value to our shareholders without sacrificing our strategic options. As we announced today, we've appointed a new Chief Financial Officer, Ophir Yakovian. Ophir has a strong background in industrial and public companies traded in the U.S., and I believe he is a natural cultural fit for the company.
I would like once again to thank Yair for his many years of excellent service to the company, in which he was an important contributor to our success. Yair, thank you very much. Go ahead.
Thank you for the kind words, Raanan, and good morning to everyone. I will now refer to our income statement for the fourth quarter. Global revenue in the fourth quarter increased by 9.8% to $148.1 million, compared to $135 million in the fourth quarter of last year. On a constant currency basis, revenue grew by 7%. Gross margin in the quarter was 31.3%, compared to 38.1% last year. Relative to last year, the primary factors for the decrease in margin were lower production throughput in Israel, as Raanan described, higher material costs related mainly to polyester prices, lower average prices in some regions, and increased component of fabrication and installation revenue, which comes with lower margin, mainly related to our growth with IKEA. Operating expenses in the fourth quarter were $51.3 million, or 31.6% of revenue, versus $32.3 million last year, which was 23.9% of revenue.
This increase was mainly attributable to a $13.9 million increase in legal settlement and loss contingency expenses related mainly to the arbitration results with Kfar Giladi, as previously disclosed. I would note that following the publication of the award by the arbitrator, Kfar Giladi submitted a motion to correct the damage amount by approximately $3.7 million, which we objected and is pending the arbitrator decision. Excluding legal settlement and loss contingency expenses, operating expenses in the fourth quarter would've been $34.3 million or 23.1% of revenue compared to $29.2 million, which was 21.6% of revenue in the same quarter last year. This increase primarily reflects higher marketing and sales effort in the U.S. and the startup of direct distribution operation in the U.K. Our fourth quarter GAAP operating loss was $4.9 million compared to operating income of $19.1 million in the fourth quarter of last year.
Adjusted EBITDA in the fourth quarter, which eliminates share-based compensation and legal settlements and loss contingencies, was $21 million, a margin of 14.2%, compared to $30 million, a margin of 22.2% last year. This reflects the changes in gross margin and SGA items just discussed. Finance expenses in the fourth quarter were $1.1 million, up slightly from $1 million last year. Expenses related to exchange rate fluctuations were up by $0.6 million, the increase was offset with higher interest income from our bank deposits and reduced bank fees. Taxes in the fourth quarter were $35,000 compared to $2.8 million last year. We recorded a small tax expense this quarter despite the consolidated loss before taxes, given a higher portion of taxable income generated outside of Israel, where tax rates are higher.
I want to note that we recorded a one-time credit of approximately $1 million related to the recent U.S. tax reform, given our net deferred tax liability balance in this region. Adjusted net income attributable to controlling interest in the fourth quarter was $7.7 million, compared to $18.1 million last year. Adjusted diluted earnings per share in the quarter were $0.22, compared to $0.53 in the same period last year. Both figures are on 34.4 million shares. I would like to quickly review our full-year financial performance. Revenue for the full year was up 9.2%, growth of 7.4% on a constant currency basis. Gross margin was 33.5% in 2017, compared to 39.5% last year.
Similar to the fourth quarter, the annual change in margin was driven by a combination of lower manufacturing throughput in Israel, higher raw material costs related to polyester prices, increased portion of production in Richmond Hill, and increased component of fabrication and installation revenue. Operating expenses in 2017 were $156.7 million or 26.6% of revenue, compared to $119.7 million or 22.2% of revenue last year. I would point out that legal settlement and loss contingency expenses were $24.8 million in 2017, compared with $5.9 million last year. Excluding legal settlement and loss contingency expenses, operating expenses would've been 22.4% of revenue, compared to 21.1% of revenue in 2016. That reflects mainly the planned investment in marketing and sales capabilities that are supporting better growth in the U.S. and the newly established direct distribution operations in the U.K.
GAAP operating income was $40.5 million compared to $92.8 million in 2016. Our adjusted EBITDA was $100.4 million, a 17.1% margin, down from $130.3 million last year, a margin of 24.2%. This decrease primarily reflects the gross margin pressure and the investment made within our business this year in sales and marketing. Our taxes for the year were $7.4 million, compared to $13 million last year. As % of income before taxes, the 2017 rate was 21.2% compared to 14.5% in 2016. The effective tax rate increase is related to a larger portion of our taxable income being generated outside of Israel, mainly in the U.S., where tax rates are higher. In addition, the proportion of non-deductible expenses out of the taxable income was significantly higher in 2017. Adjusted diluted earnings per share in 2017 were $1.45 compared to $2.33 in the prior year.
Turning to our December 31st balance sheet, we had cash equivalents, and short-term bank deposits of $138.7 million, with $38.3 million in free cash flow generated during the year. In addition to Raanan's comments on the decision regarding the dividend, which I certainly agree with, I will note that the dividend record date is February 21st, 2018. The dividend is payable on March 14th, 2018, subject to applicable withholding tax. With respect to our view of 2018 and our guidance, we are expecting revenue in the range of $612 million-$632 million. With respect to adjusted EBITDA, we are guiding to a range of $102 million-$110 million. In this respect, we would like to note that we expect Richmond Hill overall year-over-year impact to be positive due to operating improvements, partially offset by its becoming a larger portion of our total production.
In addition, we expect a continued negative impact from increase in polyester prices. Given our strong performance in the first quarter of 2017, we expect the first quarter to be the most challenging year-over-year comparison on both revenue growth and adjusted EBITDA. Thank you. I will turn it back to Raanan for closing remarks.
Thank you, Yair. Looking ahead at our 2018 challenges and opportunity, I can see the following vectors. We will continue to experience headwinds from the following vectors. 1, as you mentioned, and as I mentioned before, evolving low-cost competition in the U.S.A. 2, it's external factor, is the increase of polyester prices. Number 3, which I mentioned as well before, softer housing condition in few of our markets, including Australia, Canada, and Israel. At the same time, we expect to benefit from tailwind due to, 1, the improvement in the manufacturing of Richmond Hill. This is going on a good direction. 2, our new and differentiated exciting product. 3, the strong brand position. 4, the fundamental growth that exists in the category. We will remain focused on the high end of the quartz market.
With the developing and growing opportunities that exist today in the mass market, we will seek for opportunities on the high end of those segments. In terms of performance, as we just guided, we are planning to continue and grow the top line between 4%-7.5% and increase our adjusted EBITDA between 2% and 10%. Thank you. We are now ready to open the call for any question.
Thank you. If you would like to ask a question, please press star one on your telephone keypad. A confirmation tone will indicate your line is in the question queue. You may press star two if you'd like to remove your question from the queue. For participants using speaker equipment, it may be necessary to pick up your handset before pressing the star keys. One moment please, while we poll for questions. Our first question comes from the line of Michael Rehaut with JP Morgan. Please proceed with your question.
Hey, good morning. This is Neil Boston-Milliken for Mike. I guess starting on gross margins, I appreciate your commentary there. I guess, given the result this quarter and your guidance implying roughly flat EBITDA margins, how do you think about gross margins in 2018? Then, I guess, is a significant piece of that the shift to big box, or what do you see as improving? Or is it sort of a level you could expect to persist for two to three quarters?
Thank you for the question. If you take our mid-range guidance, it implies basically same EBITDA margins of 2017. I prefer to not break the guidance by P&L item. We do expect some operating expense leverage this year. The conclusion is that there will be slightly lower gross margin taking into account polyester prices and increased fabrication and installation.
Just to make sure that we are all aligned, total dollar of gross margins are going to go up, okay? If you'll do the math, as Yair said, you will see that it will be around the $10 million. The margins are going to stay more or less the same, as Yair mentioned. Okay? Total dollar are going to go up.
Okay, that's helpful. I guess just looking at marketing and selling, and G&A, do you see that as kind of continuing to increase with further investments as you're continuing the U.S. strategy? Or is that sort of flatlining?
We made a big investment in 2016 and '17 in the U.S. We also started our distribution operation in the U.K., which was another point of investment. While we intend to grow the expenses, we believe that our top-line growth will leverage this. In percentage, we believe that operating expenses should be lower than last year, excluding legal settlement and loss contingencies.
Okay. That's helpful.
Thank you. Our next question comes from the line of Susan Maklari with Credit Suisse. Please proceed with your question.
Hi, this is Chris on for Sue. Thanks for taking our questions. I want to touch on some of the lower ASP you guys are seeing in some of your regions. I know you said it's driving some of the gross margin pressure. I was wondering if you could touch on what regions you are seeing those pressure and whether or not, what's driving the lower selling prices there?
Yeah. Looking at the ASP, I'll first refer to your question on the region. Primarily, it's coming from the U.S. and Australia. However, we see low-cost competition coming also in China and other markets. As I said, the main markets right now are U.S. and Australia. You have to look inside the price pressure because it's very interesting. If you look at the same model, like for like, there is clear erosion in prices. However, the way we protect ourselves to try and to cope with it is in two ways. First, what we do is that we are coming ongoing basis with new and exciting products that allow us to charge for higher pricing. This is offsetting some of the like for like price erosion.
Naturally, we are selling more and more in the U.S. and less and less in countries like Israel or the rest of the world, this is helping as well. If you look from the top, you don't see really price erosion. However, inside there is a price pressure, and the way to cope with it again, is those unique and differentiated product which bring with them the toll of more longer cycle times, more complicated production, higher cost, and therefore, longer cycle time, and the pressure on the gross margin, instead of from the top, it's coming from the bottom. I hope that this was a good enough explanation.
Yeah, thanks. That was very helpful. Then just my second question, I was hoping to touch on the U.K. growth strategy. I was wondering if you could explain if there's any differences in the competitive landscape versus the U.S. or Australia or some of the other regions, what's kind of driving success there?
Yeah. U.S. market is a pretty virgin island. We have only one major competitor, therefore, we still see a fundamental demand that exists in the market. What works for us as well is that we moved from a distributor to a direct distribution, we take more responsibility on the entire supply chain, with that, we feel that we are entering the relationship with our value chain. We feel that there is a lot of what to gain in the market. It's not a market of hundreds of millions of dollars, but it is a market of, let's say, around $100 million that we can still continue and grow significantly. We see it as a good opportunity, we've got a good outlook for the market.
Great. Thanks for that.
Thank you. Our next question comes from the line of John Baugh with Stifel. Please proceed with your question.
Yair, good luck in your future endeavors. Thank you for your support. I guess, a question first on inventory. It's up 30% roughly year-over-year. Is that a good thing or a bad thing? Is that planned? What's the composition of inventory finished versus work in process? Are you in a better stocking position? Any color on the inventory.
Generally speaking, we've taken a principal decision to increase our inventory, and the reason is that we are coming into days where there is a lot of competition out there in the market. People, consumer, are expecting to a quick response. There were days when we were alone, and people were willing to wait few weeks to get those slab, not anymore. Actually what you see is just a beginning. We've taken a decision to increase the inventory in 2018 by a little bit more, let's say another half of a month in the U.S.A. in terms of inventory and even there in some other places. All in all, we see it as a positive thing, and we believe that with better inventory, there will be better availability and better serving the needs. It's absolutely not coming from lack of control.
It's a managerial decision, and it's going to continue.
Okay. There was commentary about diversifying sources, and I would assume that this is the commodity quartz you're selling, but not making. I guess I'm trying to get a sense of how much of your business currently is sourced, and then what, in terms of a cost benefit, do you see in 2018 or beyond in sourcing from other areas?
Well, John, let's start from first the principle. The principle is that, with the low-cost competition, there is a very interesting phenomenon. A new market is emerging, market that was not exist before. Historically. Inventing and working in the high premium market. That's where we pointed all the years, and these were our consumer and customer. With low competition, it's more affordable, and people that could not afford in the past are consuming now, quartz. Caesarstone need to decide if we want to take part in this market. We can stay where we are today, serving the premium market, or we can say, "Let's look at the mass market.
Maybe not compete in all the range, but let's take the premium part of it, the upper part of it, and be relevant to people over there." A good example is the big box, but it's not just in the big box. It's happening in all the segments. It's happening in the K&B. It's happening with the contractor. This is a strategic decision that we are now debating nowadays. One of the way to address that competitive market is to be relevant, both with the cost of the product, but also with its supply chain. This is the motivation to try and diversify the sourcing of the commodities product. I think at this stage, we don't want to reveal how much of it is done internally or externally. I would say that it's not a major thing.
The majority of what we do, we do on our production line and with our full control. By the way, the entire OEM production is under our control and our specification, but not just theoretical one, including our people at the source, making sure that the quality is maintained as the level that we expect to have in Caesarstone.
Raanan, not to put words in your mouth, but are you trying to say that while Caesarstone will stay at the high-end, whether it's K&B or possibly big box or builder channel, that you need a product offering in a lower price point to be competitive? Or maybe win the high-end business along with the growth in the middle or lower price points. Is that essentially the strategy or the shift here?
To some extent, I would say it's fair, but it is even more than that. Think about OEM as a kind of a muscle that you want to have to answer a certain range of your demand, but also as a muscle that gives you flexibility to fluctuation of inventory need, of supply need, et cetera. I think most of the manufacturers today, definitely the big manufacturers today, try to maintain certain degree of flexibility with outsourcing. It's a new era for us. It's the second year. First year went pretty well, and we are considering to strengthen that muscle, absolutely.
Okay. My last question relates to capital spending and the dividend decision and maybe production capacity. In theory, I think you have 100 million of capacity per line. You have seven lines. You gave us your revenue guidance, and I believe it takes two years, give or take, before production can begin from decision to commit capital. It would appear that paying a sizable dividend, and no one else plans to add capacity, that you plan on growing your revenue through a lot more of sourced product? Am I wrong, and you have plans to expand capacity, just haven't announced it yet?
Well, John, it's a fair observation. I would say a mixture of it, which means, one, we believe that we have sufficient money. By the way, the dividend is relatively not a big dividend. Let's take it in proportion. We are talking about small numbers. However, one, we still believe that we have enough money to invest if we will decide to invest in capacity. Nevertheless, it's true, as what you say, in the short term, I believe, and it goes with what I said in the past, that the company needs to step by step move the center of gravity from industrial company to a commercial company. I believe that building the muscle of OEM, allowing us to use capital and resources to the commercial side of the business or in the future to M&A if it's needed.
I think it's a decision that is not in conflict with the decision to bring some value in a marginal way or in a reasonable way with the dividend. To cut a long story short, there's no conflict.
Yes, the needs that we will have in the short term, probably we will have sufficient resource to use or will be used by outsourcing.
Thank you.
Thank you. Our next question comes from the line of Lena Rogovin with Chardan Capital. Please proceed with your question.
Hello. Thank you for taking my questions. Actually, I have two. The first is about revenue growth in the U.S. in Q4. We see some acceleration, compared to previous quarters. The question is, what was the reason for that? Is that the market in general was stronger, or is it because of the product mix, and what should we expect in the next quarters? My second question is about production issues in Israel. When you say that you expect pressure to continue, is that something you know how to manage in the foreseeable future, or that's the new reality, the production of the differentiated product? Thank you.
Okay. Hi, Lena. On the revenue growth side, indeed, we were pleased with the revenue results for the quarter. It was above the growth rate that we demonstrated in the second and the third quarter, primarily because of the U.S. growth rate and the growth rate in Europe and in the indirect market in general, partly because of U.K. growth.
Yeah. Which, by the way, U.K. growth, it's an easy comp. I have to be fair and say that it's an easy comp, because last year, in the second half of the year, when we had to terminate the distributor, it was very tough there. Just want to make a note.
Yeah. Thank you. I was actually asking about the U.S. growth specifically.
Oh. U.S. growth, again, in Q1 was better, 17%. It was eight and 6%, back to 10%. We had a very good curve off this quarter compared to Q2 and Q3. Actually, the growth rate of IKEA decelerated a bit.
Just to echo on what Yair said, I do agree. We had a very strong Q1 and a very good Q4. In the middle, it was a little bit softer. I take the opportunity to stress what Yair already mentioned before, that due to the fact that we had a very strong Q1 in 2017, we are expecting, in terms of growth, a little bit softer growth in Q1 this year. As you know, our company is based on a lot of fixed cost, and if Q1 is going to be a little bit softer in terms of growth, then it means that the margins will follow. If you ask about the outlook or the development of the quarter during 2018, it will be fair to say that we will start a little bit slower than what we are expecting the year to end.
In regards to your question about the Israeli plant, it's a good question, and I must admit that it's a little bit different case than the one in Richmond Hill. In Richmond Hill, when I joined, I recognized that there is two main issues. One was leadership issue in the plant, the second was knowhow transfer. Therefore, we assembled a solution that was kicked off in August and immediately brought the result, and I believe that we are on a good path. As Yair said, I believe that this is the last year that it was a negative contributor to the margin. In Israel, it's a different situation. I think I mentioned to you in the past that I've been traveling, and I've seen quartz manufacturers all over the world. Some of them we wanted to buy. Some of them are our suppliers, et cetera.
The throughput, I can tell you, the throughput in the Israeli plants are the best in the world. I don't know any quartz manufacturer in the world that have such a throughput as the throughput in Israel. However, it will be fair to say that we are amounting more and more complexity on those plants in order to differentiate from the rest of the market. With that, we are suffering a slower throughput. Now, the way to cope with it is not to change somebody or not to move transfer from the United States. Those are not going to help. What we need to do is what you do in industrial life. It's a very detailed, competent, thorough work of operational excellence, Kaizen team, et cetera, to try and to improve it. I can say that we definitely rock the boat.
We hired an external company to work with the team on Kaizen events. We are putting a lot of efforts. We are changing the incentive system in the plants. We are focusing on a daily base on the issues. It those kinds of things that you don't solve overnight. In our assumption, that was also translated to the guidance, we took a target in 2018 to stabilize the erosion that we've seen in the throughput during 2018. I'm expecting a very slow stabilization and then step-by-step ramp up. I'll be smarter in quarter or two from now, and we can discuss it further.
Thank you very much. That's very helpful.
You're welcome.
Thank you. There are no further questions at this time. I would like to turn the call back over to Mr. Zilberman for any closing remarks.
I'd just like to say thank you for your time and attention today. We look forward to update you on our business next quarter and talk to you soon again. Bye.
Thank you. This concludes today's call conference. You may disconnect your lines at this time.