Good day, and 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 Alison Kane of ICR. You may begin.
Thank you, operator, and 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 Q3 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 Renan Zilberman, Chief Executive Officer of Caesarstone. Renan, please go ahead.
Thank you, Alison. Good day and welcome to our conference call to discuss our Q3 results and our business outlook for the rest of the year. 3rd quarter revenue increased by 7.2% to a new record of $155,000,000 On a constant currency basis, growth was 4.6%. Gross margin was far below Our 3rd quarter adjusted EBITDA was $26,000,000 a margin of 16.5%. This mainly reflects our gross margins results.
Our adjusted net income was $13,000,000 dollars and adjusted diluted EPS was $0.37 At last our free cash flow generation in the quarter was $11,000,000 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 3 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 urecanirumab. Following the recent trends, I have decided to take several action items, few of which I would like to share with you now. So I have decided to appoint a new VP of Global Operations 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 2 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 results. 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. Now I would like to provide an update on each of our regions.
In the United States, revenue was up by 6% to $61,900,000 compared to 58.4 Our business in the United States was impacted slightly by Irma and RV and we believe that the activity is on an annual growth rate of around 9% to 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 3rd quarter were $37,100,000 up by 4.1% compared to 35,600,000 dollars last year. And on a constant currency basis, Australia was up by 0.1% in the 3rd quarter. The stability in sales was achieved despite the continued weakness in the overall housing market as we reported in the last two quarters.
Canada sales which have consistently been a strong contributor to growth increased in the 3rd quarter by 14 0.2 percent to $25,600,000 compared to last year $22,400,000 And on a constant currency basis, growth in Canada was 9.8%. Sales in Israel were $12,000,000 for the quarter, up 6.1% compared to last year and on a constant currency basis sales were down 0.3% and this is Revenue in the
rest of the world during the quarter
was down by 4 Revenue in the rest of the world during the quarter was down by $4,700,000 to $9,200,000 and on an open currency base revenue was down by 8 point 6%. In Europe, sales in the 3rd quarter were $9,000,000 and they were up by 28.2% compared to last year. And on a constant currency basis, sales in Europe were up by 25.4%. This increase was primarily related to our performance in the United Kingdom. I'd like to reserve some final thoughts after Yair comments on the financial.
Yair, please go ahead.
Thank you, Arnam, and good morning to everyone. Global sales in the 3rd quarter increased by 7.2% to a new record for any quarter of $154,700,000 compared to $144,300,000 in the Q3 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 3rd quarter were $38,700,000 or 25 percent of sales versus $30,300,000 last year, which was 21% of sales.
I would like to note that legal settlement and loss contingency expenses this quarter were $5,700,000 compared to $1,000,000 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 payments related to damages paid or that will be paid to plaintiff if we are farmed liable for the plaintiff damages. Given that recent development, we have made a one time $4,300,000 adjustment to the net liability exposure for all claims outstanding as of June 30, 2017 under a new assumption the each of the individual claims filed against us will be followed by future NII subrogation claim. Excluding legal settlements and loss contingencies related to silicosis, operating expenses in the 3rd quarter were $33,000,000 21.3 percent of sales compared with $29,300,000 or 20.3 percent of sales last year. This increase was primarily due to increased strategic investments, specifically marketing and sales in the United States and the shift to direct distribution in the United Kingdom.
3rd quarter operating income was $11,000,000 down from $28,200,000 in the Q3 of last year. Adjusted EBITDA in the Q3, which eliminates share based compensation and legal settlement and loss contingency expenses, was $25,600,000 a margin of 16.5% compared to $37,500,000 a margin of 26% last year. These reflect the changes in gross margin and SG and A items just discussed. Finance expenses in the 3rd quarter were $1,600,000 up from $1,100,000 last year. Finance expenses related to exchange risk fluctuation increased by $800,000 offset by an increase of $300,000 in interest income from bank deposits.
Taxes in the 3rd quarter were $2,000,000 20.9 percent of income before taxes, compared to a 15.8 percent 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 3rd quarter was $12,700,000 compared to $24,300,000 last year. Adjusted diluted earnings per share in the quarter were $0.37 compared to $0.70 last year, both relates to 34,500,000 shares. Turning to our September 30 balance sheet.
We had cash, cash equivalents and short term bank deposits of $136,500,000 This compares to $129,400,000 at the end of the Q2 with $10,600,000 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 $580,000,000 to $595,000,000 to a range of $580,000,000 to $590,000,000 Our expected range of adjusted EBITDA for the year is $100,000,000 to $105,000,000 down from our previous guidance of the lower part of the range of 119 dollars to $126,000,000 Thank you. And I will switch back to Arnon for a quick summary.
Thank you, Yair. Indeed our revenue for the quarter has 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 changed. 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 position globally. Thank you and we are now ready to open the call for questions.
Thank you. At this time, we'll be conducting a question and answer Thank you. Our first question comes from the line of Michael Verhoe with JPMorgan. Please proceed.
So I guess there are a few moving pieces quarter in gross margin. Can you maybe break out some of the components and I guess a bit on how they're trending most recently? And then with all the initiatives and plant changes, what do you see as kind of the potential recovery path over the next 1 to 2 years, knowing that some like polyester prices are out of your control, you had some success here with differentiated products, just a little bit there.
Mike, it's here we are not sure about the quality of your line. It was almost impossible to hear you. But I understood the question to be quantifying the different drivers in gross margin. So that's what I will do. And if there was something else that we missed, welcome to ask it further.
So with regards to the gross margin drivers, we have temporary external issues, raw material prices, basically polyester, which is had 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. Then we have other midterm temporary items that we should resolve.
Richmond deal performance, which is still a lot more costly than the Israel performance and 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 products with longer production cycle time and setup time. And then 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. So 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 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 United States, and you alluded to some favorable impact already. I guess, I'm curious as to what metrics or commentary you can give us. It gives us a frame of reference to improvement, if any, in the U.
S. Plant from the Q3 through October? And then the same kind of commentary in Israel, where it sounds like the changes there will take longer to implement. And I'm curious there whether there will be worse performance gross margin wise in 4Q from 3Q in the Israel production? Thank you.
Thank you, John. Let's take it 1 by 1. Let's start with the Richmond deal plan. A few months ago when I joined the company and I looked at the performance at Richmond deal, I shared with you that there were 6, 7 months of consecutive improvements in the plants. When we say improvements, we talk mainly about the 2 parameters, the quantity, the throughput and the qualities, the yield.
And 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. So I was very positive, but it looks like it was not sustainable. And 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 and as mentioned before, I've implemented a plan B already. Just to give it some more light, the problem in Savanna in Richmond Hill is definitely not the equipment.
As I mentioned before, it's top of the line, it's the Rolls Royce equipment. There is no issue with the equipment of the plant. The production of quartz is pretty challenging technical expertise and you need know how. And 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. So I'm talking about additional 7 people from the management team and probably another 7 technical engineers to support them
and they are running
the plant right now. When I mentioned that we see improvements in result and significant improvement, I mentioned again to those 2 parameters, the throughput and the yield, the quality. It's not because they are better manager, it's all about know how. And I believe that we are in the right direction. I don't want to make big promises because it's 1st month, but I have good feeling because these are very experienced people that run the operation over here.
And I prefer not to look at the last 2 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 deal is going to look like in the coming period. Now, with 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 in the industry. We don't know of any competitor that is able to produce between $90,000,000 to $100,000,000 from a production line. The phenomena that we are talking about is a phenomena of few percentage.
From this high peak, we went back few percentage. Few percentage, by the way, it's a lot of money. And 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.
Now 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. And that takes longer cycle time, longer setup, more complicated equipment and that brought a regression in the throughput. Now you asked me if I'm happy, certainly not. You asked 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. And this is the challenge that we will try to mitigate in the near future. By the way, there's no I have no problem with the local management. The changes that I did was mainly to energize and to so I mainly rotate people, mainly to to into the battle. But 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. So the changes, first of all, you took, it sounds like 14 people from Israeli production over to the United States. Will that have some kind of an impact on the Israeli on the Israeli facilities? It just sounds to me like the 4th quarter margin compression in Israel production will continue.
It's 2 fair comments. For the first one, I would say, I believe that we have enough redundancy and enough depth in the managerial structure. And a matter of fact is that after the changes, I can tell you again that October performance on the 2 plants in Israel were much better than any month of the last quarter. So 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 it will 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's team and this work needs to be done.
It won't be overnight. But again, I'm telling you, we haven't seen in the past anyone, any other manufacturers that no 2 manufacturers quartz better than Caesarstone. So 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, but these are internal problems that should be solved there are managerial. The real constraint is always the market and this is where we should focus at the end of the day.
And if I could ask one more question and focus on U. S. Revenue. You mentioned a 9% to 10% rate. I assume that is adjusting for what you think was a hurricane impact or maybe some anything else unusual that didn't happen in Q3.
But 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 are you what channels of distribution or customers or what gives you the confidence that you're looking at that this 9% to 10% rate is sustainable out, say, the next 2 to 4 quarters? Thank you.
First of all, let's take it into proportion. We grew this quarter 6%. So you can calculate the again the impact of Irma and Harvey was relatively small, okay, as compared to the 9%, 8%, 9% or 9%, 10% that we mentioned. So the number for the quarter is 6%. Drilling down into the channel, I would say that the big news of this year is But 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.
And 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 is a lot of competition there, but we have already identified a series of actions that are already undergoing. And 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 a slab and we need to give them a full solution and we need to have stronger grip on the entire value chain. This is a competitive market.
So you better sell product and a service and not just a product, otherwise you are between the hard and the rock. So 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 and I think it will take time. But from the moment that I stepped in the company, I targeted 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. So it's not a theory, it's something that we are trying to execute. And at last even the stone supplier we have identified some potential in that channel. So 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 it will 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
Susan Maklari with Credit Suisse. Please go ahead with your question.
Hi, this is Chris Klot on for Susan. I just want to drill in a little deeper on that 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. But if you want the other side of the moon for the reduced performance in the operation and the story about the differentiated product is the fact that we did not erode price so far.
Now this is not a pledge for the future. It might happen. It is a very competitive market. But as I mentioned before, one of the way to keep your position is to try and to be sophisticated and with USP on the product and that's what we are trying to do. Unfortunately, it came with the toll that it came.
So to answer to your question, yes, there is a tough competition. Yes, it's increasing. And the reason are very simple. Crowd is accepted by the mid and the low segments of the consumers segments And there will be always demand for low cost solution. And Caesarstone will have to live with it, serving the top end, probably the mid end and some selective projects etcetera, etcetera.
We will have to live with this environment. However, the good news, the market is growing. The market is growing.
Okay, thanks for that. And then I was hoping you could provide some color on some of the demand you're seeing for new products. So as you guys work through these production issues, do you think do you see that these new products are being accepted by the marketplace?
The product that we launched in 20 70, absolutely. It's been for a while that Caesarstone is a trendsetter. So we normally we come with new products and the phenomena that we see or the question that we see is how fast other will imitate it, okay. So we never look at others, never. And we know that people are imitating, imitating the product look like, sometimes the name, the look of the website, even look like's name.
These haven't been changed. So yes, to your question, the products have been accepted very well. As I mentioned before, we are working on some new things in the pipeline to maintain the color leadership and even maybe beyond this to touch even some attributes of the slabs.
Thank you. The next question is from the line of Lena Rogovin with Chardan Capital. Please proceed with your question.
Thank you. I have a couple of questions. My first question is about production volumes. Could you just provide a breakdown for Israel and for Richmond Hill as percentage of total production? And my second question is about the margins.
When do you believe that it is still realistic to get back to the previous levels of margins? I'm also talking about the gross margin. And when should we expect start seeing some margins improvement? Thank you.
Okay. So while we are not providing throughput breakdown between the plans, Richmond Hill this year improved its throughput compared to last year significantly. However, it's still
far below
Israel, but it's a much bigger portion of our production today relative to last year. With regards to margin, as Ronald said, we implemented many steps here in the company. We see some very encouraging results in October, and we believe that we will see a gradual margin improvement, too early to say to what level.
But I think it will be fair to say we have provided guidance. So I think you can it's very easy to make a derivative for the Q4 because you have all the information. So we've been very cautious and I think for good reason because as I mentioned again, it's not a push of a button. These are industrial process, they will take time. But if you ask me, Ranan, are you confident that you can bring it to where it should be?
Then I say the answer is yes. Should we expect it to see it in Q4? My answer is no. Okay. We'll 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 will turn the floor back to management for closing remarks. Thank you. Matt, the floor is yours for closing remarks.
Yes. Thank you very much. And 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.
So 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.