Good day, welcome to the Caesarstone second 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 second quarter 2017 earnings press 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 morning. Good day, welcome to our conference call to discuss our second quarter results and our business outlook for the second half. Our second quarter top line was in line with our expectation and brings our first half year to about 10% growth. However, gross margin came under pressure, primarily as a result of cost-related challenges, which I will address in a few moments. I'd like to start with a few highlights from the quarter. The global sales increased by 4.6% and reached a new record of $149 million, compared to $142 million in the last year second quarter. On a constant currency basis, growth in the quarter was 5%. Adjusted EBITDA for the second quarter was $30 million, a margin of 20%. This was below our expectation. Adjusted net income was $17 million, and adjusted diluted EPS was $0.49.
In the quarter, we had some challenges at the gross margin level. This includes an approximately 35% increase in raw material for polyester compared to last year. It is worth mentioning that polyester prices have already begun to show some improvement in Q3. Additionally, we have continued to shift toward higher-end differentiated products that are enabling the brand to maintain its leading and innovative position. This is generally a desirable change in the mix, and we are very happy with the new products that we are launching. Nevertheless, our overall throughput reflects the longer cycle time needed to manufacture these products. In Richmond Hill, our throughput and yield performance continue to show consecutive quarterly progress. It is since Q3 2016. We are leveraging this progress and have decided to shift additional premium production to Richmond Hill in the second half of the year.
We believe that this will improve our response to the global market demand but may slow down our improvement locally in Richmond Hill. I would like to provide an update on each of our regions. We had a good second quarter in the U.S., which was up by 8.2% to $64.8 million, compared to $59.9 million of last year. We are happy with our top-line growth year to date, and we continue to invest in sales and marketing to drive the revenue performance. We will remain focused on execution to meet our goals in the remainder of 2017. Australia sales in the second quarter were $34.3 million, up by 2.3%, compared to $33.5 million of last year. On a constant currency basis, Australia was up by 1.8% in the second quarter.
The increase in sales was achieved despite weakness in the overall housing market, especially with single-family completion and renovation, which are the strongest sectors of our markets in Australia. Canada sales in the second quarter grew by 4.3% to $25.3 million, compared to last year, $24.3 million, which was an unusually strong quarter. On a constant currency basis, growing Canada was 8.7%. Sales in Israel were $10.8 million for the quarter, down 2.6% compared to last year. On a constant currency basis, sales were down by 8.1%. This reflects the generally more challenging market condition. Europe sales in the second quarter were $7 million, up 1.6% compared to last year. On a constant currency basis, sales were up 3%. The increase was primarily related to our transition to direct distribution in the U.K.
Revenue in the rest of the world during the quarter was up by 0.6% to $6.7 million. On a constant currency basis, revenue grew was 2.6%. Before I turn over the call to Yair to cover financial, as you should have already seen today, Yair has decided to leave the company and pursue other interests. Although he will be with the company through January of next year, it is appropriate to recognize his meaningful and important contribution and thank him for his seven years tenure with the company. I'd like to say thank you, Yair. Go ahead.
Thank you, Raanan, and good morning to everyone. Global sales in the second quarter increased by 4.6% to $148.9 million compared to $142.3 million in the second quarter of last year. On a constant currency basis, sales increased by 5%. Gross margin in the quarter was 34.9% compared to 42.1% last year. Compared to last year, the primary factors of the decrease in margin were an approximately 35% increase in polyester prices, lower throughput due to an increased mix of premium products, and a higher portion of total production coming from Richmond Hill, which continues to be higher cost production. Other factors were an increased component of fabrication and installation revenue related to strong growth at IKEA and exchange rate fluctuations that also pressured gross margin. We drove a partial offset to these factors with an ongoing improvement in our sales mix towards premium products.
Operating expenses in the second quarter were $32.6 million, or 21.9% of sales, versus $28.7 million last year, which was 20.2% of sales. The increase in operating expenses as a percent of sales primarily reflects our increased investment to improve sales and marketing capabilities, particularly in the United States, as well as the shift to direct distribution in the United Kingdom. Second quarter operating income was $19.3 million, down from $31.3 million in the second quarter of last year. Adjusted EBITDA in the second quarter, which eliminates share-based compensation and legal settlement and loss contingencies, was $29.6 million, a margin of 19.9%, compared to $39.8 million, a margin of 27.9% last year. This reflects the changes in various gross margin and SG&A items I just described. Finance expenses in the second quarter were $1.4 million, similar to last year level.
Our taxes in the second quarter were $3.1 million, 17% of income before tax, compared to an 11.9% rate last year. I would remind you that last year second quarter, we had a one-time favorable tax settlement in Israel that saved us four percentage points of tax rate. This quarter, increases in taxes from higher U.S. production and higher taxable income in other regions were offset by a favorable reduction of tax brackets in Israel. Adjusted net income attributable to controlling interest in the second quarter was $16.9 million, compared to $25.4 million last year. Adjusted diluted earnings per share in the quarter were $0.49 on 34.6 million shares. Adjusted diluted earnings per share last year were $0.73 on 34.9 million shares. Turning to our June 30th balance sheet, we had cash equivalents, and short-term bank deposits of $129.4 million.
This compares to $121 million at the end of the first quarter, with $9.3 million worth of free cash flow we generated during the quarter. With respect to our 2017 guidance, given our year-to-date results and outlook for the second half, we are maintaining our guidance for the full year of 2017. Accordingly, our revenue range for the year remains $580 million-$595 million. Taking into consideration our performance in the second quarter and our cost-related challenges, our expected range of adjusted EBITDA for the year remains $119 million-$126 million. However, we currently anticipate it to be at the lower part of the range. With the expected continued improvement in our revenue in the U.S., we expect Q3 and Q4 to be similar in revenue and adjusted EBITDA.
Finally, while I will be here until the beginning of next year, I would like to take the opportunity to thank the management team, the board of directors, and the many investors and analysts that I've worked with for their support and collaboration during my time at Caesarstone. It has been a pleasure to work with so many good people, both inside and outside the company, and I'm very proud of what we have achieved as a team at Caesarstone during the last seven and a half years. Thank you, and I will switch back to Raanan for a quick summary.
Thank you, Yair. Before we go to question, I would like to take the helicopter view on the second quarter and the challenges and opportunities ahead. On the top line, the market is growing. We are growing by 10% year to date. I believe that we need to further refine our go-to-market strategy to fully capture our potential. The competitive environment dynamic and the fact that the mass market is developing, it will require from us, on one hand, to enhance our position as a premium brand and accelerate innovation. At the same time, to play in all the segments of the market. I would like to see us continuing to shift to a world-class commercial organization, embracing and enriching our offering, and increasing the grip on the entire value chain.
On the margins, and especially on the gross margin front, although we had pressure from several direction in Q2, we stay focused on our A target to reduce the cost per slab produced in Richmond Hill. This is achievable. As our quantities and yields are continuing to improve, and as we increase utilization, I believe cost per slab will come down. Thank you, and we are now ready to open the call for questions.
Thank you. We will now be conducting a question and answer session. 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. Our first question comes from the line of Michael Rehaut with JP Morgan. Please proceed with your question.
Hey, good morning. This is Neil Boss Mullican for Michael Rehaut. Yair, we're not as happy with the other release this morning, but, we'll appreciate your time through January. Starting with gross margin, the pressures you've seen recently, a lot of it was due to the polyester up 35% year-over-year, but maybe you're beginning to see some relief in Q3. Maybe could you add a little more detail on what you're seeing most recently with gross margins?
Yes, sure. In terms of gross margin, we had a few components in the play. As we mentioned, polyester cost increase of approximately 35% was a factor of around 200 basis points, and we believe this is temporary. As we mentioned, prices are starting to go down, I believe there will be some relief. FX was another 100 basis points approximately, and the environment in FX also appears to be improving and again, it's not in our control anyway. We have the impact of the higher amount of new differentiated product that we have been manufacturing this quarter. This was a pressure of around 200 basis points. With regards to Richmond Hill, it's a bit more complicated to explain. On one end, Richmond Hill improved, as Raanan mentioned, and improved consistently quarter-over-quarter since Q3 2016.
There is more and more production coming out of Richmond Hill as a proportion to the total production, and Richmond Hill is still not as efficient as Israel. Overall, when you take those two elements together, Richmond Hill in total was 150 basis points headwind for us. We had the increased fabrication and installation component that we view as a very positive and a very good element of our value proposition. It hurt our margin, but it's good for our operating margin. In gross margin, it was a headwind of around 100 basis points as well. All of those pressure drivers were partially offset with a better product mix because we continue to deliver and sell more and more differentiated product, and that contributed 100 basis points positively.
Okay. That's helpful. I appreciate the detail, and it's good to hear the Richmond Hill improvement. Kind of how that factors into overall guidance, kind of looking to revenue guidance, maybe towards the low end on EBITDA. Is it sort of that you're more expecting a bigger contribution from big box retail and the builder channel, and maybe a little more investment in the U.S. towards the back half, or is this more a factor of how you see commodities trending?
No, I would say the following. First, just to give us a perspective, as a matter of fact, for the first half of the year in total, our results, both in revenue and adjusted EBITDA, are pretty much in line with our original plan for the year. However, the margin challenge in the second quarter was quite significant, and we do not have good visibility on the pace or extent of improvement in the second half. Therefore, we believe that it will be more prudent, and we expect that we will end up at the lower half of the EBITDA range.
Okay. That helps.
Thank you. Our next question comes from the line of Susan Maklari with Credit Suisse. Please proceed with your question.
Thank you. Good morning.
Good morning.
Good morning, Susan.
To start out with, can we talk a little bit about Australia? It seems like that's a market that has held up well for you, even though we've been hearing about this housing slowdown, and it seems like maybe that caught up with you this quarter. Can you just talk about what changed there, especially as we think about it more sequentially, perhaps, and how we should think about that going forward?
Yes. We have a great business in Australia, and we've been operating very well there for a long time, and even through some very tough market environment. The products are doing extremely well there, and we have a very solid execution. The current housing condition in Australia are not favorable for us. Renovation and single-family new completions, and which are our strongest segment, as Raanan mentioned, are actually dropping quite a lot. We believe, however, that we have grown our share of premium product, and we successfully continue to innovate and to remain the market leader in Australia in both retail and single family. Also, we have strong expectation for our upcoming product launch in Australia, which is coming pretty soon. Again, given the macro environment now, the housing environment, I'm not sure we will see a major rebound there in terms of growth rates.
Okay, that's helpful. Thanks. Turning to the U.S., you mentioned that the mass market here is continuing to develop. I guess, can you give us some update on maybe how your rollout at Lowe's is going and any other initiatives that you have around thinking about increasing your distribution channels here?
Yeah. Our launch of Transform in Lowe's, it continues to gain momentum. In terms of operational indicators, there is a very high level of consumer satisfaction for those projects that we executed on. It is still very slow in adoption and very small in revenue. However, it is, again, a very nice product. There is high satisfaction, currently, there are discussions with Lowe's on the next phase of the rollout, and we believe there will be a rollout coming soon.
Okay.
The magnitude of-
Yes.
It's not going to be a national rollout, but it will be a phase 2 of a rollout.
Okay. About how many stores are you in now?
Go ahead, Yair.
We are today at around 200 stores in selective states of the U.S. Raanan wanted to add something. Raanan?
Yeah. Hi, Susan. This is Raanan. As Yair said, we are in 200 stores, and we have decided together with Lowe's to expand the test and the pilot to another 200 stores. It's a positive development. If you recall, when we met, we discussed about the position of Caesarstone in the mass market. Historically, as you know, Caesarstone is a premium brand, which targets mainly the K&B, which is a premium sector.
The build-around contractor. The two ends of the market, and actually pretty much neglected the mass market. This remains a target for the company, and it's more than a discussion now, and definitely a target. I believe this is a potential future development for the company, because this is a market that is growing. Quartz is accepted by wider part of the population, and Caesarstone needs to be there.
Okay. Thank you, Raanan.
You're welcome.
Thank you. Our next question comes from the line of John Baugh with Stifel. Please proceed with your question.
Thank you. Good morning. Yair, thanks for your efforts, and good luck in your future endeavors. I'm sure we'll be in touch.
Thank you.
I guess my questions. Thank you for all that color on gross margin, too. I did all the math that netted to a 650 basis point headwind. Not to be nitpicking, but, I think that would be a 41.4% gross margin down slightly from the prior year, like 70 basis points. My question is simply, is there, in terms of the competitive pressure, is there anything going on that's affecting your gross margin that's promotion or discount or responding to competition, in these results? Or really no, it's minor factors that are accounting for that other 70 basis point?
Thank you, John. No, the answer is clear. The gross margin headwind is not coming from ASP. I think that we are doing very good with the ASP. I think actually even a little bit positive. This is in line with what Yair explained about the differentiated product that slowed down the cycle time and the throughput. The strategy to keep on differentiating with the product, with the offering, till now is a good strategy because we've been able until now to maintain the average sales price. Although, as you mentioned, and it's fair to say, there is a competition. Going back to your explanation about the gross margins, if you could follow the different lines, you could have noticed that they are breakdown into four buckets.
Few of them are total external and temporary, like the 300 points, the 200 are coming from the polyester, and 100 from the FX. It's temporary and it's in external. The ongoing FNI that is developing, which is all in all, a positive things with 100 basis point. Our main challenge are what we believe are indeed negative impact and will remain with us maybe few quarters, one, two, three, and we will have to cope with them. This is, as Yair said, the transition to Richmond Hill, because you have to understand that every slab that we move from Israel to the U.S., we are taking a slab from a low-cost manufacturer, and we are moving it to a manufacturer that right now is with higher cost.
At the end of the day, once it will be fully utilized and fully loaded, the cost will be in a different place. This is a painful transition. This will remain in time, for some time, until we will make this break-even point, or at least close to it. Then there's the differentiated product. To cut a long story short, with some of the headwind, we have concern as they are going to stay for some time, and some are external and temporary. This is more or less the picture. John, just to add, all the rest of the difference that I didn't fully reconcile to was a bunch of very small things. I just went to the highlight of the story.
Okay. Thank you for all that color. A point of clarification, Yair, you mentioned something about Q3 and Q4 being similar in revenue and EBITDA. Was that to the first half? Was that to Q2? Just to clarify what you were saying there. Thank you.
What I'm saying is that, normally, in our normal seasonality, Q3 is a very strong quarter or strongest normally. However, this year, what I'm saying, there is an increased momentum in the U.S. for us, or that's at least what we expect to have. Therefore, it will result in our expectation in a way that the results on the top line as well as adjusted EBITDA on dollar-wise, will be very similar for Q3 and Q4.
Okay. then.
Am I clear enough?
Yes. Thanks for that. The commentary around Canada, I know Ontario just had a real estate tax you mentioned it was a tough compare to the prior year. How do we think about Canada, I don't know, for the next several quarters in terms of growth outlook? You can throw in the IKEA commentary on that as well. Thank you.
Yeah. Actually, I don't think we need to discuss Ontario stuff. For the first half, if you look at the first half of the year, growth in Canada on a constant currency basis was almost 15%, which is very strong and in line with our expectation. Q2 growth rate should be taken in the context of a very tough comp over Q2 2016, which is what we said to begin with, entering to the quarter, both for the U.S. and for Canada. We believe that U.S. and Canada will be still our fastest-growing market in 2017. Since we maintain the revenue guidance, I guess we know what that means.
Great. My last question, maybe for Raanan, is, you mentioned, I think it was eight, I can't remember the precise number. You were asking internally sort of eight key strategic questions of the organization. I'm just curious where you are in that process or journey and what, if anything, you could share with us, that's perhaps different from when we last visited in New York in May. Thank you.
The situation is like that. I think that I have accomplished. When I shared with you the things, it was my insight. I am now in a situation that I am fully aligned, not just with my management, but also with the Board of Directors, on the strategic direction that we need to take as a company. Obviously, I feel not so comfortable to talk about strategy over the phone. I would say that I have the full support of the Board of Directors and the management on the direction that we want to take. Many of the vectors that I shared or that I had in mind, a few, if I recall, I even shared, are ongoing. It's not in the drawer.
It's definitely ongoing, and I allocate for that a big part of my time, because the way to go forward is not to work harder. It's not going to get better just by sweat. We need to evolve because the market is evolving. We have high ambitions, and, therefore, we will have to embrace some bold steps.
Great. Thank you. Good luck.
Thank you, John.
Thank you. Once again, as a reminder, 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. Our next question comes from the line of Lena Rogovin with Chardan Capital. Please proceed with your question.
Thank you. Good afternoon. I got two questions, if I may. My first question is about operating expenses as a percentage of revenues, which we see on a quarter-on-quarter basis, decline quite significantly. The question is, does this mean that in Q1, there were some one-off costs, and what should we expect going forward in Q3 and Q4? My second question relates to recently announced partnership with Nebraska Furniture Mart. The question is, how significant it could be for your U.S. business? If it is significant, who is in charge of F&I in this partnership? Thank you.
Okay. Thank you, Lena. In terms of operating expenses, in Q1, you have two combinations. One, it's a massive marketing and sales effort because there are major exhibitions that are both in the U.S., in Canada, and in Milan, at the very beginning of Q2. There is a lot of spending that goes to those exhibitions. Q1 on one end is pretty loaded in marketing and sales expenses on one end, and then because it's our lowest revenue quarter in percentage, it even makes it a tougher thing. The drop this quarter was not a major surprise to us. No, there is no saving in OpEx here. We intend to continue and support our expanded efforts in the U.S. and in the U.K. We expect the trend of OpEx on a year-over-year basis to continue to not be favorable.
Yeah, Lena, on Nebraska Furniture Mart, this is exactly in line with what I say that we are aiming to the mass market. In the United States, when we think about the mass market and the retail, we normally talk about the two monsters, Depot and Lowe's. There are many regional and national mid-size player, and Nebraska Furniture Mart is one of them. This deal that we strike is really in line with our new approach. Let's get into the retail. Let's be a mass market partner to the consumer.
Okay, thank you very much. In the case of Nebraska, who is going to do fabrication installation?
We have our value-added capabilities on this. We are not doing it independently. We are working with selective fabricators on that part.
Okay, it's not going to be the same as in IKEA.
We do not have all the details here, but I guess it's part of what we have been discussing for quite a while, which is using our value proposition to be able to give a very easy solution to retail channel in terms of delivering a surface solution to the consumers.
Okay, this is very helpful. Thank you.
You're welcome.
Thank you. There are no further questions at this time. I would like to turn the call back over to Raanan Zilberman for closing remarks.
Thank you, Allison. I think we are pretty much at the end. Thank you for your attention today. We are looking forward to talking to you in the next quarter. Have a good day.
Thank you. This concludes today's teleconference. You may disconnect your lines at this time. Thank you for your participation. Have a wonderful day.