Good day, welcome to the Caesarstone third quarter 2017 earnings conference call. Today's conference is being recorded. At this time, I would like to turn the conference call over to Allison Cain of ICR. 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 third 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, Allison. Good day, welcome to our conference call to discuss our third quarter results and our business outlook for the rest of the year. Third quarter revenue increased by 7.2% to a new record of $155 million. On a constant currency basis, growth was 4.6%. Gross margin was far below our expectation as a result of challenges related to our manufacturing performances. Our third quarter adjusted EBITDA was $26 million, a margin of 16.5%. This mainly reflects our gross margins results. Our adjusted net income was $13 million, and adjusted diluted EPS was $0.37. At last, our free cash flow generation in the quarter was $11 million. Before I go through our regional performance, I would like first to discuss our manufacturing challenges and our gross margins in the quarter. In Israel, throughput and margins came under pressure in both of our manufacturing sites.
The main reason for the reduced throughput is our product mix shift to premium and differentiated products. That continue and brings with it, at least for the moment, longer cycle time and longer setup time per model. Again, I would like to mention that the shift of mix differentiated premium products enable us to maintain our premium position in the market and our prices. We are confident that those challenges are addressable, and with the right management, the right focus, and the right process, and with time, our gross margin should improve. In Richmond Hill, after three quarters of consecutive improvement, this quarter, we took a step backward in performance. As we discussed last quarter, this was partially expected given our decision to expand the range of production to higher-end products. Those products requires longer cycle time to manufacture.
The pressure was more significant than what we had expected, and to make things more challenging, the plant was shut down for a full week as a result of Hurricane Irma. Following the recent trends, I have decided to take several action items, few of which I would like to share with you now. I have decided to appoint a new VP of Global Operation, and we are already running a selection process. I've already placed a new leadership team in Richmond Hill, including a new plant manager, a new operation manager, and few new department managers, and a team of technical and manufacturing experts, all coming from Israel. I can tell you that those changes have started beginning in October and already have a positive impact in several dimension.
In the Israeli plants, I've taken several steps, including the appointment of two new plant managers, actually rotating them, and a new production manager to enhance the managerial structure and capacity of management. We are starting to implement a series of improvement process to shorten the cycle time and to minimize the idle time. Those improvement processes can take some time, but if we will implement them correctly, they will yield the expected result. In addition, in order to better meet demand for our products, we have been utilizing some OEM production for basic SKUs under our strict specification and our robust quality assurance process. I would like to provide an update on each of our regions.
In the U.S., revenue was up by 6% to $61.9 million compared to 58.4 million. Our business in the U.S. was impacted slightly by Irma and Harvey, and we believe that the activity is on an annual growth rate of around 9%-10%. We as well believe that our current throughput is resulting in a miss of some opportunity to accelerate our revenue growth even further. In Australia, sales in the third quarter were $37.1 million, up by 4.1% compared to 35.6 million last year, and on a constant currency basis, Australia was up by 0.1% in the third quarter. The stability in sales was achieved despite the continued weakness in the overall housing market as we reported in the last two quarter.
Canada sales, which have consistently been a strong contributor to growth, increased in the third quarter by 14.2% to $25.6 million compared to last year, $22.4 million. On a constant currency basis, growth in Canada was 9.8%. Sales in Israel were $12 million for the quarter, up 6.1% compared to last year. On a constant currency basis, sales were down 0.3%, and this is reflecting a challenging market condition. Again, we've been talking about that in the last quarter. Revenue in the rest of the world during the quarter was down by 4.7% to $9.2 million. On a constant currency base, revenue was down by 8.6%. In Europe, sales in the third quarter were $9 million. They were up by 28.2% compared to last year. On a constant currency basis, sales in Europe were up by 25.4%.
This increase was primarily related to our performance in the U.K. I'd like to reserve some final thoughts after Yair comments on the financial. Yair, please go ahead.
Thank you, Raanan. Good morning to everyone. Global sales in the third quarter increased by 7.2% to a new record for any quarter of $154.7 million compared to $144.3 million in the third quarter of last year. On a constant currency basis, sales grew by 4.6%. Gross margin in the quarter was 32.1% compared to 40.5% last year. The primary factors of the decrease in margin were higher portion of total production coming from Richmond Hill, where we are still incurring higher production costs, lower throughput in Israel for the reasons discussed before. Higher material costs related mainly to polyester prices, the impact of the Hurricanes in the U.S. during the quarter, and increased component of fabrication and installation revenue, which comes with lower margin related to our growth with IKEA.
Operating expenses in the third quarter were $38.7 million or 25% of sales versus $30.3 million last year, which was 21% of sales. I would like to note that legal settlement and loss contingency expenses this quarter were $5.7 million compared to $1 million in the same quarter of last year. Recently, we have seen an influx of subrogation claims filed by the Israeli National Insurance Institute, NII, providing for reimbursement of its payment related to damages paid or that will be paid to plaintiff if we are found liable for the plaintiff damages. Given that recent development, we have made a one-time $4.3 million adjustment to the net liability exposure for all claims outstanding as of June 30th, 2017, under a new assumption that each of the individual claims filed against us will be followed by a future NII subrogation claim.
Excluding legal settlements and loss contingencies related to silicosis, operating expenses in the third quarter were $33 million, 21.3% of sales, compared with $29.3 million or 20.3% of sales last year. This increase was primarily due to increased strategic investment, specifically marketing and sales in the United States and the shift to direct distribution in the United Kingdom. Third quarter operating income was $11 million, down from $28.2 million in the third quarter of last year. Adjusted EBITDA in the third quarter, which eliminates share-based compensation and legal settlement and loss contingency expenses, was $25.6 million, a margin of 16.5% compared to $37.5 million, a margin of 26% last year. These reflect the changes in gross margin and SG&A items just discussed. Finance expenses in the third quarter were $1.6 million, up from $1.1 million last year.
Finance expenses related to exchange rate fluctuation increased by $0.8 million, offset by an increase of $0.3 million in interest income from bank deposits. Taxes in the third quarter were $2 million, 20.9% of income before taxes, compared to a 15.8% tax rate last year. This effective tax rate increase is related to a bigger portion of taxable income generated outside of Israel, where tax rates are higher. Adjusted net income attributable to controlling interest in the third quarter was $12.7 million, compared to $24.3 million last year. Adjusted diluted earnings per share in the quarter were $0.37, compared to $0.70 last year. Both relates to 34.5 million shares. Turning to our September 30th balance sheet. We had cash equivalents, and short-term bank deposits of $136.5 million.
This compares to $129.4 million at the end of the second quarter, with $10.6 million in free cash flow generated during the quarter. With respect to our 2017 guidance, given our year-to-date results, our manufacturing throughput position, and the cost-related challenges, we are updating our guidance as follows. We are narrowing our revenue guidance from a previous range of $580 million-$595 million to a range of $580 million-$590 million. Our expected range of adjusted EBITDA for the year is $100 million-$105 million, down from our previous guidance of the lower part of the range of $119 million-$126 million. Thank you, and I will switch back to Raanan for a quick summary.
Thank you, Yair. Indeed, our revenue for the quarter have set a new record, and we are somewhat pleased with it. However, it is clear that the challenges in manufacturing have yielded margin that are below our expectations. As I mentioned, we believe that we have already identified the main challenges and that they are all addressable. As shared with you before, we have commenced implementing countermeasures, and we expect gradual margin improvement to follow soon. While focusing short-term on increasing the throughput of our production, we are continuing to leverage on our key strong assets that never change. The differentiated and the creative product line, the brand that is the top of mind in the industry, and our very strong grip in the channels to the market.
Looking ahead, I can say that the basic fundamentals are positive for us, as the demand for quartz is still growing, and our products and brand are top-positioned globally. Thank you. We are now ready to open the call for questions.
Thank you. At this time, we'll be conducting a question and answer session. If you'd like to ask a question, please press *1 on your telephone keypad. A confirmation tone will indicate your line is in the question queue. You may press *2 if you would 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. Thank you. Our first question comes from the line of Michael Rehaut with JPMorgan. Please proceed with your question.
I guess there are a few moving pieces quarter in gross margin. Can you maybe break out some of the components and then, I guess, a bit on how they're trending most recently? Then, with all the initiatives and plant changes, what do you see as the potential recovery path over the next one to two years, knowing that some polyester prices are out of your control, but you had some success, with differentiated products, just a little bit there.
Mike, it's Yair. We are not sure about the quality of your line. It was almost impossible to hear you. I understood the question to be quantifying the different drivers in gross margins. That's what I will do. If there was something else that we missed, welcome to ask it further. With regards to the gross margin drivers, I would divide contemporary external issues, raw material prices, basically polyester, which is at an impact of 150 basis points negative on the gross margin. Also, the U.S. weather with the different hurricanes, impacted our results at around 50 basis points. We have other midterm temporary items that we should resolve. Richmond performance, which is still
A lot more costly than the Israel performance. Because Richmond Hill becomes a bigger portion of our performance, it had an impact of 300 basis points to our gross margin. Israel's throughput was 250 basis points negative, again, due to increased portion of differentiated product with longer production cycle time and setup time. The one thing that continues to carry over for us, which we see it very positively, but in gross margin, it is somewhat taking it down, though in operating margin it's a neutral impact. It's the increase of fabrication and installation portion of revenue, which impacted our margin, our gross margin, by 50 basis points.
Thank you. Our apologies for the poor audio quality. We'll move on to our next question from the line of John Baugh with Stifel. Please go ahead with your question.
Thank you. Good morning. Could you discuss, I heard sort of 2 different stages, I'm talking about the Richmond Hill production and then Israel. It sounded like you've made a bunch of managerial changes in the U.S., and you alluded to some favorable impact already. I guess, I'm curious as to what metrics or commentary you can give us that gives us a frame of reference to improvement, if any, in the U.S. plant from the third quarter through October. The same kind of commentary in Israel, where it sounds like the changes there will take longer to implement. I'm curious there whether there will be worse performance gross margin-wise in four Q from three Q in the Israel production. Thank you.
Thank you, John. Let's take it one by one. Let's start with the Richmond Hill plant. A few months ago, when I joined the company and I looked at the performance at Richmond Hill, I shared with you that there were six, seven months of consecutive improvement in the plant. When we say improvements, we talk mainly about the two parameters, the quantity, the throughput, and the qualities, the yield. Basically, those two parameters are resulting in the ultimate parameter, which is the cost per slab that we manufacture, and later on impacting the gross margins. I was very positive. It looks like it was not sustainable. Definitely the hit that we are getting now in Q3 was because the performance went backwards in August and especially in September.
I've decided that we need a plan B. As mentioned before, I've implemented a plan B already. Just to give it some more light, the problem in Savannah, in Richmond Hill, is definitely not the equipment. As I mentioned before, it's top of the line. It's a Rolls-Royce equipment. There is no issue with the equipment or the plant. The production of the quartz is pretty challenging technical expertise, and you need know-how. The American team that was there couldn't cope with the gaps of the know-how, and I had to decide a tough call to move an Israeli team with already existing know-how to replace the leadership team, because it needs to be an immediate reaction. I'm talking about additional seven people from the management team and probably another seven technical engineers to support them, and they are running the plant right now.
When I mentioned that we see improvements in results and significant improvement, I mentioned again to those two parameters, the throughput and the yield, the quality. It's not because they are better manager. It's all about know-how. I believe that we are in the right direction. I don't want to make big promises because it's the first month, but I have good feeling because these are very experienced people that run the operation over here. I prefer not to look at the last two years. I prefer to look ahead. I feel that we are having right now the right plan with the right people, and I am very positive about how Richmond Hill is going to look like in the coming period.
Regards to Israel, let's take things in proportion because when talking about challenges in the operational processes in Israel and the manufacturing, you have to appreciate that we know the entire industry. We are visiting our competitor. We see other plants. We are considering to buy others. We don't know any of our competitors that is producing in the throughput of Caesarstone. I can assure you that the throughput is the higher end in the industry. We don't know of any competitor that is able to produce between $90 million and $100 million from a production line. The phenomena that we are talking about is a phenomena of few percent. From this high peak, we went back few percent. Few percent, by the way, it's a lot of money. The direct reason, and the immediate reason is not because somebody was not doing what he needs to do.
It was mainly because we introduced, in the last year, around 24% new products. The way to survive in this competitive environment of the market nowadays, is to keep on introducing new products again and again and again, like the Rugged Concrete. Like all these new products that we've launched last year, and I can tell you, and I can assure you, more surprise to come in 2018. That comes with a toll, absolutely with a toll. To be unique, to be special, you have to complicate it, because otherwise everybody knows to do it. That takes longer cycle time, longer setup, more complicated equipment, and that brought a regression in the throughput. You ask me if I'm happy, certainly not. You ask me if it is addressable, yes.
I think that we've seen it in the past, that when you introduce a mass throughput of new products, you go backward, and now you need to go back to the basic of manufacturing, lean manufacturing, improvements of team, working on the shop floor. Employees, technical people and management, and to do the do, to try and to cut it back again. This is the challenge that we will try to mitigate in the near future. By the way, I have no problem with the local management. I mainly rotate people, mainly to energize and to bring new vivid into the battle. It's a good team, actually a world-class team, and I'm sure that the numbers will be at the right place in the future.
Thank you for that detail. The changes, first of all, you took, it sounds like 14 people from Israeli production over to the U.S. Will that have some kind of an impact on the Israeli facilities? It just sounds to me like the fourth quarter margin of compression for Israeli production will continue.
It's two fair comments. For the first one, I would say, I believe that we have enough redundancy and enough depth in the managerial structure. A matter of fact is that actually after the changes, I can tell you again that October performance on the two plants in Israel were much better than any month of the last quarter. No immediate impact. I believe that we have the right team. However, as you mentioned, it's not a push of a button. I can tell you that with the change of the management and with the changes that we do in Israel, it is a very quick result operation. In Richmond Hill, there is no issue. I believe the curve will be faster.
In Israel, as somebody that grew up from the shop floor, I can tell you it is a manufacturing battle with hundreds of KPIs, with Kaizen team, this work needs to be done. It won't be overnight. Again, I'm telling you, we haven't seen in the past anyone, any other manufacturers that know to manufacture quartz better than Caesarstone. At the end of the day, it will come back to where it needs to be. I believe, to be honest, it's not pleasant to be with such a report and with such a margin, these are internal problems that should be solved. They are managerial. The real constraint is always the market, this is where we should focus at the end of the day.
If I could ask one more question, and focus on U.S. revenue. You mentioned a 9%-10% rate. I assume that is adjusting for what you think was a hurricane impact or maybe anything else unusual that didn't happen in Q3. I guess my question is, when I look at the comparisons to the prior year, Q3 was your easiest comparison in terms of U.S. revenue growth. What channels of distribution or customers, or what gives you the confidence that you're looking at that this 9%-10% rate is sustainable out, say, the next 2-4 quarters? Thank you.
Yeah. First of all, let's take it into proportion. We grew this quarter 6%. You can calculate, again, the impact of Irma-Harvey was relatively small, okay? As compared to the 8%-9%, or 9%-10% that we mentioned. The number for the quarter is 6%. Drilling down into the channel, I would say that the big news of this year is definitely our improved throughput with IKEA. We are doing better. I think that in terms of managing the channels, I feel a little bit more comfortable nowadays with what we are trying to do with the channels, more than what we are already doing, but with what we are trying to do. I think we talked about it a little bit in the past, and I'm ready to say a few words now.
First, with the kitchen and bath channel, which is the bread and butter of the company, I think it's a simple game. We are trying to increase the proximity. This is where we are very strong. This is where we make our money. It's true that there's a lot of competition there, but we have already identified a series of actions that are already undergoing. At the end of the day, if we'll do them correctly, again, kitchen and bath should remain the backbone of what we do. In the contractor and the builder channel, here, I believe that we have some new cards to play, and I believe that we will evolve our strategy and go beyond of what we have done in the past.
Generally speaking, without too many details, I think that we need to sell to the contractors and builder more than just the slab, and we need to give them a full solution, and we need to have a stronger grip on the entire value chain. This is a competitive market, you better sell product and a service and not just a product. Otherwise, you are between the hard and the rock. Here we are working on that, and I believe that with time, we will continue to improve the position. By the way, it was a good market for us this year. It grew nicely. With the big box, this is our biggest potential. I mentioned it in the past. We talked about it.
I can't report on any breakthrough. I think it will take time, but from the moment that I stepped in the company, I target it as something that we need to do. I believe in it, and we are taking action items. It takes time, but I believe that at the end of the day, we will crack it. It's not a theory. It's something that we are trying to execute. At last, even the stone supplier, we have identified some potential in their channel. To cut a long story short, if you ask me, I feel that we haven't exhausted those channels, that actually there are more opportunity that if we'll be sophisticated and good in execution, that can give us a differentiation to the Chinese player. They are very competitive with the price.
We need to be competitive with the brand, with the service, with the channel, and with the customer experience. This is something that it will be very hard for them to compete with.
Thank you. Our next question is from the line of Susan Maklari with Credit Suisse. Please go ahead with your question.
Hi, this is Chris Claudon for Susan. I just want to drill in a little deeper on that competitive and the competitive landscape. Are you seeing any changes in pressure from imports and domestic competitors?
It's a good question. I'll tell you why. We do see increase in the landscape. There is more competition. If you want the other side of the moon for the reduced in performance in the operation, the story about the differentiated product is the fact that we did not erode price so far. This is not a pledge for the future. It might happen. It is a very competitive market. As I mentioned before, one of the way to keep your position is to try and be sophisticated and with USP on the product, that's what we are trying to do. Unfortunately, it came with the toll that it came. To answer to your question, yes, there is a tough competition. Yes, it's increasing, the reason are very simple. Quartz is accepted by the mid and the low segments of the consumer segments.
There will be always demand for low-cost solution, Caesarstone will have to live with it, serving the top end, probably the mid-end, some selective projects, et cetera. We will have to live with this environment. However, the good news, the market is growing.
Okay, thanks for that. I was hoping you could provide some color on some of the demand you're seeing for new products. As you guys work through these production issues, do you see that these new products are being accepted by the marketplace?
The product that we launched in 2017, absolutely. It's been for a while that Caesarstone is a trendsetter. Normally we come with new products, the phenomena that we see, or the question that we see, is how fast others will imitate it. Okay? We never look at others, never. We know that people are imitating the product look like, sometimes the name, the look of the website, even look like name. These haven't been changed. Yes, to your question, the product has been accepted very well. As I mentioned before, we are working on some new things in the pipeline to maintain the color leadership, even maybe beyond this, to touch even some attributes of the slabs.
Thank you. As a reminder, to ask a question today, you may press star one. The next question is from the line of Lena Rogovin with Chardan Capital. Please state your question.
Thank you. I have a couple of questions. My first question is about production volumes. Could you just provide the breakdown for Israel and for Richmond Hill as a percentage of total production? My second question is about the margins. Do you believe that it is still realistic to get back to the previous levels of margins? I am also talking about the gross margin. When should we expect start seeing some margins improvement? Thank you.
Okay. While we are not providing a throughput breakdown between the plants, Richmond Hill this year improved its throughput compared to last year significantly. However, it is still far below Israel, but it is a much bigger portion of our production today relative to last year. With regards to margin, as Raanan said, we implemented many steps here in the company. We see some very encouraging results in October, we believe that we will see a gradual margin improvement. Too early to say to what level.
I think it would be fair to say, we have provided guidance. I think it is very easy to make a derivative for the Q4 because you have all the information. We have been very cautious, I think for good reason, because as I mentioned again, it is not a push of a button. These are industrial processes, they will take time. If you ask me, Raanan, are you confident that you can bring it to where it should be? I say the answer is yes. Should we expect to see it in Q4? My answer is no. Okay? We will see improvements, but you can do a very easy exercise to see what we guided for Q4.
Fair enough. Thank you.
Thank you. At this time, I'll turn the floor back to management for closing remarks. Thank you. The floor is yours for closing remarks.
Yeah. Thank you very much. Thank you for the attention and the interest in the company today. We appreciate it. I think that we now have a lot of work to do in-house, and we look forward to updating you on the continued progress in the next quarter, yes? Again, thank you very much for your support. Have a good day, and we'll talk to you soon again.
Thank you. This concludes today's conference. You may disconnect your lines at this time.