Good day, welcome to Caesarstone's fourth quarter and full year 2016 earnings conference call. Today's call is being recorded. At this time, I would like to turn the conference over to Allison Kane 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 fourth quarter and full year 2016 earnings release, which is posted on the company's investor relations website.
With that, I'd like to now turn over the call to Yonatan Melamed, Interim Chief Executive Officer of Caesarstone. Yonatan, please go ahead.
Thank you, Allison. Good day, thank you everyone for joining us. I will start by providing some highlights of the fourth quarter. We grew sales year-over-year by 6% to $135 million. Our adjusted EBITDA was $30 million, a margin of over 22%. Adjusted net income was $18 million, and our adjusted diluted earn per share was $0.53. Also some highlights for the full year. We grew sales by 8% to a record level of $539 million. 2016 adjusted EBITDA was $130 million, a margin of over 24%. Adjusted net income was $81 million, and our adjusted diluted earn per share was $2.33. We closed our year with a stronger performance in the U.S., especially toward the end of the quarter, and with a solid growth in Australia and Canada.
We are pleased to begin 2017 with a better momentum in the U.S., where we remain highly focused on re-acceleration growth. We are working hard to constantly improve our operations and refine our approach to market. We are very pleased to add Lowe's Home Improvement as a new partner with our new Transform by Caesarstone, an innovative product solution. We expect this business to gradually ramp over the course of the year and to contribute more significantly thereafter. We have also started direct distribution in the U.K. to better serve this market and capture the significant growth opportunity we see there. We remain intently focused on ramping up our Richmond Hill manufacturing facility, which is an important part of our growth plan for 2017 and beyond.
As you know, I will remain interim CEO for a few more weeks until I will hand over the steering wheel to Raanan Zilberman at the end of February. It has been my pleasure to serve the company in this role and as a board member for more than eight years. I believe that Caesarstone is commercially and financially an outstanding company, which I am confident that Raanan will take to the next level. Thank you, and I would like to now turn the call over to Yair.
Thank you, Yonatan, and good morning to everyone. I will start with our regional revenue performance for the fourth quarter and full year. Fourth quarter sales in the U.S. were $55 million, down 2.8% compared to last year. With an improvement in our performance as the quarter progressed, this was better than we expected when we reported our third-quarter results. Overall, our core business was down year-over-year. IKEA showed strong growth on a relatively easy comparison from the fourth quarter last year, when our IKEA business was weak due to temporary changes in IKEA promotional events. For the full year, our U.S. revenue was $222.6 million, down 0.3% year-over-year, with a single-digit core growth offset by lower sales in IKEA. As we discussed last quarter, we have worked hard to improve our capabilities in the U.S. in several areas.
We have started to see the benefit of these investments. We intend to make further investment in the U.S. market in 2017. We also made strategic progress with the addition of Lowe's Home Improvement as a new customer in the U.S., commencing in the first quarter of 2017. We are introducing at Lowe's a new innovative solution called Transform by Caesarstone. Transform is an overlay quartz surface that can be installed in one day over an existing countertop. This is targeted at consumers interested in refinishing versus a complete renovation and represents an incremental business opportunity for both Lowe's and us. We expect that revenue growth associated with this business at Lowe's will be modest this year and stronger thereafter. Turning to Australia region, we grew fourth-quarter sales to $36.1 million, up 17.5% compared to last year.
On a constant currency basis, Australia was up 12.5% in the fourth quarter. Our execution in Australia remains excellent. For the full year, despite a tough housing market, we grew our revenue by 18.7% to $130.9 million, 19% constant currency growth. We grew fourth-quarter sales in Canada by 20% to $21.5 million in the fourth quarter. Growth was 20.3% on a constant currency basis. Like Australia, we've executed very well in a soft market. For the full year, we grew Canada sales by 21.2% to $85.7 million, partially driven by the IKEA ramp-up in the first half of 2016. Constant currency growth in Canada was 25.4% for the full year. Sales in Israel for the quarter were $9.8 million, up 2.3% compared to the fourth quarter last year. On a constant currency basis, fourth-quarter sales were up 1.8%. For the year, Israel was up 7.3% to $42.5 million.
On a constant currency basis, Israel growth in 2016 was healthy at 6.3%. Europe sales in the fourth quarter were down by 5.1% to $5.2 million and were down 3.8% on a constant currency basis. For the full year, Europe sales were up 6.9% to $25.6 million, up 7.1% on a constant currency basis. We are very pleased to have begun direct distribution in the United Kingdom as of January 1st, 2017. This is the first time we have shifted to direct distribution without acquiring the previous distributor. We believe that there is an opportunity for a meaningful increase in the market revenue growth over time. We expect that this move will have a drag on our operating income margin in 2017 as we ramp up our infrastructure and capabilities.
Revenue in the rest of the world was up 4.2% to $7.5 million in the fourth quarter, growth of 5.2% on a constant currency basis. For the full year, the rest of world was down 1.3% to $31.1 million and down 1% on a constant currency basis. Altogether, global sales for the fourth quarter increased by 6% to $135 million compared to $127.4 million last year. On a constant currency basis, total sales increased by 4.8%. For the full year, growth was 7.8% to a record of $538.5 million. This was above the high end of our most recent guidance. Without currency impact, growth was stronger, 8.4% over prior year. Gross margin in the fourth quarter was 38.1% compared to 37.9% last year.
Lower raw material costs and increased content of higher-margin product were partially offset with higher costs in Richmond Hill plant and the increased portion of IKEA revenue, which has a significant low margin fabrication and installation component. Full-year gross margin was 39.5% in 2016 versus 40.1% in 2015. Operating expenses in the fourth quarter were $32.3 million versus $25.6 million last year. Such expenses in the quarter included $3.1 million for legal settlement and loss contingencies, composed of, among other things, a provision related to the potential settlement of certain legal proceedings. Although we are not able to discuss details at this point, if such a settlement materializes, we would see it as a positive outcome. Excluding the total provision under legal settlement and loss contingencies, operating expenses in the fourth quarter were $29.2 million, 21.6% of sales, compared with $25.6 million or 20.1% of sales last year.
This increase was primarily due to increased strategic investment, specifically marketing and sales in the U.S. Operating expenses for the full year were $119.7 million or 22.2% of sales, compared to $103.8 million last year, or 20.8% of sales. Operating income was $19.1 million compared to $22.6 million in the fourth quarter of last year. Our operating margin, excluding legal settlement and loss contingencies, was 16.5% this quarter, compared to 17.7% last year. For the full year, operating income was $92.8 million compared to $96.4 million in the prior year. Adjusted EBITDA in the fourth quarter, which eliminates share-based compensation, legal settlement, and loss contingencies expenses, as well as other non-recurring items, was $30 million, a margin of 22.2%. This compares with last year's adjusted EBITDA of $30.4 million, a margin of 23.9%. For the full year, adjusted EBITDA was $130.3 million, a margin of 24.2%.
This is an increase from $125.7 million last year, a margin of 25.2%. The slightly lower margin, both in the fourth quarter and for the year, mainly reflects our increased marketing and sales spending to support stronger growth in the U.S. Finance expenses in the fourth quarter was $1 million, compared to finance expenses of $0.7 million in the prior year, mainly reflecting increased revolving credit usage and banking activities. For the full year, finance expenses were $3.3 million compared to $3.1 million in 2015. Taxes in the fourth quarter were $2.8 million or 15.4% of income before taxes, compared to a tax rate of only 11.7% last year. The increase in effective tax rate is mainly due to two factors. One relates to production allocation between our plants in Israel that are subject to different tax rates.
The second relates to higher taxable income outside of Israel, where tax rates are higher. For the full year, our tax rate was 14.5% compared to 14.8% last year. Adjusted net income attributable to controlling interest, which eliminates the same items as mentioned above, was $18.1 million in the fourth quarter compared to $19.7 million same period last year. For the full year, adjusted net income was $81.2 million compared to $83.7 million last year. Adjusted diluted earnings per share in the fourth quarter were $0.53 on 34.4 million shares. Adjusted diluted earnings per share last year were $0.55 on 35.5 million shares. For the full year, adjusted diluted EPS were $2.33 versus $2.36 in 2015. Turning to our December 31st balance sheet. We had cash equivalents, and short-term bank deposits of $106.3 million. Our cash flow from operation peaked at $35.9 million in the fourth quarter.
During 2016, we generated $78.1 million of free cash flow and used $39.4 million to repurchase 1.1 million shares, 3.2% of our total shares outstanding. With respect to our 2017 guidance, we are expecting revenue in the range of $580 million-$595 million. With respect to adjusted EBITDA, we are guiding to a range of $119 million-$126 million. We see 2017 as a transformative year, and this guidance reflects mainly our intention to further expand our investment in key markets, particularly in the U.S. and the U.K. We believe that our strategy, coupled with such investments, will re-accelerate our growth rate and improve our overall performance starting 2018. The guidance also reflects higher involvement with builders and big boxes and related increase in the fabrication and installation services, which contains lower margin, as well as an increase in polyester prices. Thank you.
We are now ready to open the call for questions.
If you would like to ask a question, please press star then one on your telephone keypad. A confirmation tone will indicate your line is in the question queue. You may press star two 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 pull for questions. The first question today comes from Michael Rehaut of J.P. Morgan. Please go ahead.
Thanks. Good morning, everyone.
Good morning.
First question, I was hoping to get a little bit more detail or specificity around the EBITDA guidance for 2017. Obviously, you are looking at margins to be down, and the EBITDA dollars to be down despite a stronger top-line sales growth even potentially than 2016. You referred to a bunch of items, Yair, that I guess is driving that outlook. Expanded investment in the U.S., U.K., more builders, and related fabrication and higher raw material prices, polyester. I was hoping to get a sense of what each of these factors is responsible for the lower EBITDA or the decline in EBITDA margins, however you want to put it. More specifically even, what you feel is perhaps one-time investments or leverageable investments, versus kind of more of a permanent mix shift in your business.
Hi, Mike. Thank you for the question. Yes. Basically, the EBITDA margin down are a result of two main factors. One is a substantial investment in our M&S, and the other one is a channel mix change in the U.S. With regards to marketing and sales, we are investing substantially in sales and marketing, mainly in the U.S., which is consistent with our marketing expansion strategy, as well as in the U.K. With regards to the U.S., we believe that the investment has already contributed to our momentum, and I hope that it will continue like that. With regards to the U.K., we need to really build a full direct distribution organization. On both angles, I believe that those are transitional in nature, and we will see a leverage on both aspects after 2017. With regard to the channel mix, we are growing in big boxes.
We are going to grow in the commercial builder segment as well. The growth in the big boxes segment require the fabrication installation component service, that we believe is a major competitive advantage that we have, but it carries a lower gross margin. On the marketing and sales side, I believe that this is transitional. On the channel mix, yet to be seen, but I believe that after 2017, we will see a faster growth rate in our top line with a related profitability. Maybe as a final note, just to remind us all, myself included, that we do have also a polyester price increase that is reflected in this guidance, along with the oil prices that are going up.
Just to get a better sense of this, Yair. You have talked in the past about IKEA and the lower gross margins with those revenues. Correct me if I am wrong, but I think you have also kind of described it as operating margin neutral in that you have had also lower SG&A, and it is kind of an offset. Is that something that we should think similarly with the Lowe's business model?
I think in Lowe's, we do invest a little bit more this year. We need to build the infrastructure for this execution. We need to do a lot of prepare marketing material across the whole chain and be ready for a nice launch and execution. I'm not sure that this year it's the story. I hope that it will be the story in years thereafter.
Okay. What type of impact, just on the higher polyester costs, either on a dollar or margin basis, do you expect that to impact 2017?
Yeah. polyester is around 50, 60 basis points of the margin erosion. The marketing and sales infrastructure and the channel mix are more or less similar numbers to each other. Not similar to the 50, but similar impact.
Okay. One last one, and I appreciate it, and I'll get back in the queue. In the past, you've given, on the gross margin, kind of the puts and takes, in terms of how the quarter has been impacted. That 38% kind of flattish year-over-year, but for 4Q, you mentioned some positives and negatives. I was hoping if you could give us, as you have in the past, kind of a degree of magnitude of what some of the positives were and some of the negatives that you listed.
Yeah.
On a basis point.
Yeah. Basically, better product mix or higher content of differentiated products with higher margins. This and the reduced raw material cost was each around 100 basis points. FX was also slightly favorable at the neighborhood of 50 basis points this quarter.
CFP pressured the margin by around 120 basis points, and increased fabrication installation component, given the IKEA growth, reduced the margin by around 80 basis points.
I'm sorry, what was the 120, Yair?
120 was the Richmond Hill performance.
Right. Thank you. Okay, thanks very much.
You're welcome.
The next question comes from John Baugh of Stifel. Please go ahead.
Thank you. Good morning, Yonatan. Good morning, Yair.
Good morning.
Can get some sense of what the plant in Georgia produced, I don't know, maybe for the year, more importantly, what was the rate of production in Q4, say, versus Q1, or entering here in 2017?
Yes. In Q4, Richmond Hill was a bit of a disappointment for us. Also, we did a lot of fundamental change there, which intentionally slowed us down. For next year, our revenue growth for next year is dependent upon a significant throughput improvement in Richmond Hill as well as improved quality rate and improved cost efficiency. We are looking at a significant ramp-up in 2017 in Richmond Hill relative to 2016. It still is not going to be similar to the Israeli plants in performance. This will take more than 2017, I believe that as the time go by, Richmond will have to increase the performance because Israeli is kind of our % utilization. With that, we will see leverage in their performance.
Yair, can you look at yield or scrap or however you measure quality currently and see a meaningful improvement, and now it's just a matter of ramping speed, or are there still big fundamental changes you're going through right now to try to improve those things?
Yes. We are making a lot of changes now. We are expanding shifts to scale up production. We are increasing the manpower for those shifts. We have quite heavy dedicated on-site support from Israel now to do further equipment engineering optimization and continue training over there. We are heavily investing in processes improvement over there. If I can judge by our performance in the last two weeks, I would say that I'm encouraged. We need to see it continue like that, and it is a key factor for our top-line growth next year, in 2017.
Right. Thank you. I'm curious on the EBITDA margin guidance, which I calculated at the midpoint, down over 300 basis points, and you touched on polyester. I'm curious, though, is there, embedded in that assumption, a like-for-like price reduction or more competitive promotional effort, or are all those pressures the U.K., and channel mix, and starting up with Lowe's, et cetera?
John, we normally don't comment on pricing. We intend to remain synonymous with premium brand, product, and quality, and innovation here. At the same time, we are certainly implementing a competitive multi-channel strategy with distinct offering for each channel. I think that this is what we are discussing here for the most part.
Could you comment on the U.K.? How much revenue did you do there this past year, roughly the size of that countertop market, and what the penetration rate is currently? How we might think about how your revenues should ramp over the next several years.
Yes. The U.K. currently is a market where quartz penetration is still below all of our main regions. To our estimate, it is below 10% in volume, 10% of the market. It is relatively dominant by European competitors. We had quite a reasonable presence there. Now going direct, we believe that we will make a much faster growth, and we can increase the top line in a significant manner. Though, again, the baseline from where we start is not very significant. I would say also that in the second half of 2016, our revenue performance in Europe was negatively impacted by this move.
Okay. My last question, as it relates to Lowe's, is there a plan in the future to sell slabs more than just the retrofit product you are talking about, or is that not in discussion?
I guess we will have to wait and see. Currently, it is the Transform by Caesarstone.
Okay. Thank you so much for answering my questions. Good luck.
You're welcome.
The next question comes from Lena Rogovin of Chardan Capital Markets. Please go ahead.
Hello. Congratulations on strong revenue growth. I have a couple of questions. The first one is, again, on the U.K. What's roughly the expected CapEx for 2017 to launch the distribution? My second question is about Canada and Australia. This year was incredibly strong, even in both in constant currency and in reported terms. It looks like double-digit growth is unlikely to be sustainable, so what should we expect going forward? My last question is about legal expenses, which were relatively high in the fourth quarter. What was the reason for that? Thank you.
Okay. You give me too much credit to remember all the questions, but I will try. With regards to U.K., there isn't a significant CapEx there. We need to do some stuff in creating the offices and the warehouse and everything. The main investment is in marketing and sales and putting together all the sales force organization, as well as having a strong presence within the kitchen and bath studios, the architects, and all of those things. A lot of investment in expenses, not so much in CapEx. With regards to Canada and Australia, we are delighted from our results in both regions. This year that was actually executed despite a weakening housing market. In Canada, our first half of the year was also by the ramp-up of the IKEA business. The cold off was very strong, there was also a push from the IKEA ramp-up.
In the second half, IKEA basically reached its anniversary, our growth is our growth. With regards to next year, the signals about the housing markets in both regions are not extremely optimal for us, we plan to continue and grow. Without getting into any regional guidance for 2017, I would say that we expect U.S. and Canada to be our fastest-growing regions next year. Regarding the legal expenses, it is too early for us at this point to disclose details regarding the potential settlement which we provided for or accrued for. I can just repeat and say that if this settlement materialize, we would view it as a positive outcome. Until this reached, we prefer not to comment.
Okay. Thank you very much.
You're welcome.
We have a follow-up question from Michael Rehaut of J.P. Morgan. Please go ahead.
Thanks. Yair, just wanted to follow up about the U.K. and the investment there. Just wanted to get a sense, number 1, if you could give us an idea roughly in terms of the $ investment, in 2017, and I assume you're saying it's no CapEx, I assume it's kind of an incremental $ expense in 2017 with initially minimal revenues. Just trying to get a sense of that $ investment for the year.
I guess secondly, why the departure from typically acquiring a distributor, which is what you've always done in the past, if there is a team that or a person or a group of people that you've been in discussions with, that you feel there's an ability to grow it from the ground up, particularly given it's obviously, from a distance and a core market for you, it's not necessarily an obvious country to kind of go in, particularly in an organic way.
Yes. With regards to the second question first, Mike, we've contemplated all options about our way to go direct in the U.K., and we decided that the best value option for us would be to just establish our own organization. There are many reasons for that. I prefer not to be specific on those, but, let's just say that we did a lot of preparation ahead of time in the second half of 2016, and I believe we are rock and rolling as we speak and start to do business there. I see it as a very positive move for the company, and I believe, again, that while it is not helping EBITDA, both certainly not margin, but not even an absolute number, it will be a good move for the company over time.
Can you give us a sense of the $ investment in 2017?
It drags our EBITDA in $ for few $ million.
Great. Thank you.
This does conclude the question and answer session. At this time, I'd like to turn it back to management for any additional or closing remarks.
Thank you, everyone. As we close the call, on behalf of our entire company, I would like to thank Yonatan for his service, particularly these past few months as our interim CEO. We are deeply grateful for his efforts and contribution over the years. We are pleased to see the strength of our business reflected in our results globally and in the recent improvement in the United States. We have good new opportunities, particularly in the United States, both in the core market and in the bigger box channels with IKEA and now Lowe's. We look forward to continuing to demonstrate our ability to drive growth and shareholder value. Thank you all for participating today.
This concludes today's teleconference. You may disconnect your lines at this time.