Good day, welcome to Caesarstone's third quarter 2016 earnings conference call. Today's call is being recorded. At this time, I'd like to turn the conference over to Allison Kane of ICR. Please 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 earnings press release, which is posted on the company's website. With that, I'd like to now turn over the call to Yonathan Melamed, Chairman of the Board of Caesarstone.
Yonathan, please go ahead.
Thank you, Allison. Good day, thank you everyone for joining us. I will start by providing some highlights of the third quarter. In the third quarter, we grew sales by 5.5% to new record of $134.3 million. Our adjusted EBITDA was at $37.5 million, a margin of 26%. Adjusted net income was $24.3 million. Our adjusted diluted EPS was $0.70. The company achieved record performance. Many of our regions continue to demonstrate substantial strength. At the same time, we are intendedly focused on re-accelerating growth in the U.S. We are investing in expanding our marketing and sales capability in this region and are making other strategic and operational changes that we believe will improve the business and generate growth.
With respect to our Richmond Hill manufacturing facility, we continue to face challenges steeper than anticipated, and we have not been able to achieve optimal throughput and manufacturing efficiency to date. We have identified the major issue, and we are focused on optimizing our manufacturing processes and on improving efficiency, throughput, and cost. We expect the plant performance to improve significantly in let's say 2017. Yesterday, we filed our proxy material for the annual general meeting of shareholders to be held on December 6, 2016. In line with our corporate objective to enhance the company's global growth and market positioning, we are pleased to announce some significant changes to our Board of Directors. Dr. Ariel Halperin will be the company's new Chairman of the Board. Ariel is a managing partner at Tene Investment Funds and has a long history of guiding Caesarstone to success.
Additionally, we have nominated two prestigious and very experienced individuals as new Directors, Mr. Roger Havrilesky and Mr. Eric Herschmann. Roger spent over three decades building McKinsey & Company until his retirement in 2006 and has advised top management over 100 public and private companies. Roger also serves as Director for several leading global companies and has been instrumental to their growth. Eric previously served as the Vice Chairman and CEO of Southern Union Company, a former Fortune 500 energy company, where he oversaw tremendous growth over his 11 years career there. We are excited for Roger and Eric to join us and believe that once elected, they will provide significant value to our company and its growth objectives.
While I will remain interim CEO until Raanan Zilberman's arrival during the first quarter of the next year, I will be stepping down as Chairman of the Board upon conclusion of the annual general shareholder meeting. It has been an honor serving as the Chairman, and I wish the Board, including the existing and new Directors and the company's management and employees, best of luck. Thank you, and I would like to now turn the call over to Yair.
Thank you, Yonathan, and good morning to everyone. I will start with our regional performance for the third quarter. Third quarter sales in the U.S. were $58.4 million, down 5.4% compared to last year's third quarter. Core business slightly declined, and the IKEA business sequentially improved but still generated lower revenue than the same period last year. As Yonathan mentioned, we have made important investments to help expand our capabilities in the U.S. Over the past several months, we have appointed new executive management, added people, and improved processes to our sales teams, increased our marketing activities, and we are implementing a revised and more focused go-to-market strategy. While there is some time required before these actions impact revenue, we believe we are taking the right steps to enhance growth.
Although we are not yet providing guidance for next year, it is our expectation that we will resume revenue growth. Turning to Australia, we grew third quarter sales to $35.6 million, up 21.8% compared to last year. On a constant currency basis, Australia was up 16.6% in the third quarter. Our execution in Australia has been consistently strong, as demonstrated by such growth rates despite declining housing conditions. We grew sales in Canada to $22.4 million in the third quarter, growth of 13% or 12.6% on a constant currency basis. Our business in Canada has remained strong, especially given challenging housing conditions in the first full quarter anniversary of our sales to IKEA. Sales in Israel for the quarter were $11.3 million, up 6.4% compared to the third quarter of last year. On a constant currency basis, sales were up by 5.8%.
Europe sales were down by 1.2% to $7 million and were down 1.4% on a constant currency basis. The revenue in the rest of the world, after two consecutive quarters of decline, was up 14.8% to $9.6 million in the quarter, growth of 14.4% on a constant currency basis. This region tends to be smaller and includes more volatile individual markets. Altogether, global sales for the third quarter increased by 5.5% to a new record of $144.3 million, compared to $136.8 million in the third quarter of last year. On a constant currency basis, total sales increased by 3.8%. Gross margin in the quarter was 40.5% compared to 39.5% last year. This full point of stronger margin was driven primarily by lower raw material costs. Operating expenses in the third quarter were $30.3 million or 21% of sales versus $29.4 million last year, which was 21.5% of sales.
Excluding legal settlements and loss contingencies related to silicosis, operating expenses in the third quarter were $29.3 million, 20.3% of sales, compared with $24.7 million or 18% of sales last year. This increase was primarily due to increased strategic investment, specifically in marketing and sales in the U.S. I note that legal settlement and loss contingency expenses were $1 million in the third quarter this year, compared to $4.7 million in the same quarter last year when we initially recorded the liability related to silicosis. Operating income was $28.2 million, compared to $24.7 million in the third quarter of last year. Our operating margin was 19.5% this quarter, compared to 18.1% same quarter last year. Adjusted EBITDA in the third quarter, which eliminates share-based compensation, legal settlements, and loss contingencies expenses, as well as other non-recurring items, was $37.5 million, a margin of 26%.
This compares with last year's adjusted EBITDA of $36.2 million, a margin of 26.5%. This slightly lower margin mainly reflects our increased spending to support stronger growth in the U.S. Finance expenses in the third quarter were $1.1 million, compared to finance expense of $0.1 million in the prior year. This increase was primarily due to $0.2 million losses related to currency exchange rate fluctuation in the third quarter of 2016, compared with net gains of $0.7 million in the same quarter of last year. Taxes in the third quarter were $4.3 million or 15.8% of income before taxes, compared to a tax rate of 17% last year. The lower tax rate this quarter related to elimination of certain deferred tax liabilities.
Adjusted net income attributable to controlling interest, which eliminate the same item as mentioned above, was $24.3 million in the third quarter as compared to $24.4 million same period last year. Adjusted diluted earnings per share in the quarter were $0.70 on 34.5 million shares. Adjusted diluted earnings per share last year was $0.69 on 35.5 million shares. We completed our full share repurchase authorization during the quarter. In total, since the plan was put in place, we used $39.4 million to buy back a total of 1.1 million shares. Turning to our September 30th balance sheet, we had cash equivalents, and short-term bank deposits of $74.5 million, up $11.9 million from the end of the second quarter, despite a share repurchase activity of $9.7 million during the third quarter.
Our net cash position from the end of 2015 went up by $6.4 million even after we consumed $39.4 million for share repurchase. For the first nine months of this year, we generated $48.7 million of free cash flow. With respect to our 2016 guidance, we have updated our view of the full year to include softer-than-expected performance in the U.S. We now expect full-year revenue in the range of $524 million-$534 million, and full-year adjusted EBITDA in the range of $125 million-$130 million. Thank you. We are now ready to open the call for questions.
Thank you. We'll now be conducting a question and answer session. If you'd 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 key. Once again, that's star one if you'd like to be placed in the question queue. Our first question today is coming from Michael Rehaut from J.P. Morgan. Please proceed with your question.
Thanks. Good morning, everyone. First question I had was on the U.S. I was just curious, obviously, you guys are in the middle of making adjustments, investing, and revising your go-to-market strategy. I'm curious from a competitive standpoint, if you can give us a sense of an update of, number 1, where the market is today, if you've seen continued growth in the broader engineered quartz market. Number 2, if there's been any change from a pricing standpoint, more broadly.
Yes. Thank you, Mike. We believe that the countertop market in the U.S. is doing well, and specifically quartz. The housing condition are also reasonable. With regards to competition, although we do not have current data, we believe that the quartz market continues to grow, and as the quartz opportunity grows, the competition grows as well. And we also see Chinese manufacturers entering the market more intensely. It seems that the lower segment of the market has had more growth in general and is led by Chinese manufacturers. We are currently competing in the mid-to-high-end of the market, where product quality, service, innovation, design, and service matters. Low-cost manufacturing competes with us as well, but we believe that our differentiation and multi-channel strategy will prevail.
In particular, in terms of the Chinese competition, that's not obviously a new trend, and would you say that trend has changed dramatically or accelerated negatively in the most recent quarter? Or are you referring to more just a general trend over the last couple of years?
No, I think it's a general trend that continues. There isn't a big change here.
Okay. Just second question on the manufacturing. I think in the prepared remarks, Yonathan referred to challenges in the new plant. But at the same time, if I heard it right, you've identified some of the issues, and are hopeful that you'll see more improvement in 2017. So I was curious if you could give us a little more detail on what was identified, what you believe you've been able to correct, if I have that right, and what perhaps that was in terms of a drag on gross margins in the quarter?
Yes. Okay, Mike. The bottom line performance of the plant in Q3 was disappointing for us in both throughput and yield rates. However, we have established few very important improved processes now in order to shorten idle time and maintenance interruptions, and to reduce the number of substandard slabs and improve the overall efficiencies. We also continue to recruit experienced people as we go and enhance training. While the bottom line of Q3 was not good, I believe that there is now some momentum for improvement. It will take time, but there is a positive momentum. If I'm going on a year-over-year, how it impacts our margin, basically, Richmond Hill kind of dragged us around 150 basis points. On the other side, our Israeli plants performed very well and basically offset all of this drag.
Great. Thank you.
Thank you. To continue placing the question queue, please press *1 on your telephone keypad. Our next question today is coming from Susan Maklari from UBS. Please proceed with your question.
Thank you. Good morning.
Hi, good morning.
You mentioned in your remarks that as part of your U.S. strategy, you're revising your go-to-market and how you're approaching that. Can you just give us a bit more detail there on the changes that are coming through and how we should expect those to come together for next year?
Yeah. Susan, as you know, we are in the process of improving our performance in the U.S. to accommodate the current business scope and our challenges. We have been implementing several steps, including new local management, organizational changes, expansion of our marketing and sales team, adding talent, updating certain sales processes, and enhancing visibility for the brand and other strategic and operational steps. However, this improvement process is proving to take more time to implement than we anticipated, and it is also evident that some more time will be required before we can see the benefit of it. It's clear that the U.S. revenue was below our expectation this quarter, and we are unable to meet our plans for the year, as for the U.S.
Having said that, we are optimistic that there is a significant growth potential in the U.S. and that we are taking the right steps to leverage it. We are rolling out a new product launch in the U.S. as we speak and are planning to extend the market scope we are covering with our product offering. We believe that the steps we take in reorganizing our sales operation in the U.S. will lead to more robust and focused performance and to gradual better achievement in our core business. There has been and will be other changes to improve our presence in all the market segments, but a couple of those changes are competitively sensitive and I cannot specify them right now. I think we are looking at 2017. Yes, we are not providing guidance for 2017, but we expect U.S. business to return to notable growth next year.
Yair, is the new local management here, is that in addition to the changes that you made earlier this year? Are those people that you are re-swapping out, or are they just a further addition to those?
At the beginning of the year, we just did the change and brought Dan from Canada into the U.S. Dan had to identify all the organizational gaps that he has in his current organization. Very recently, in the last three months, he brought a lot of executive talent in, and we brought a lot of strength into our sales force. We grew our marketing and sales ad count by 20% so far for the year in the U.S., expecting to complete a 25% growth by the end of the year. Bringing Dan in was not a final solution. He needs to make changes, and it takes some time.
Okay. Can you just also kind of give us an update on those new product introductions? I know that those launched a little earlier this year in the U.S. How has the traction been with that, and how does that compare to where you expected it to be?
To be quite honest, there was a launch earlier this year, there was some operational issues that we had with it, we did a complete relaunch with some brand-new product, also relaunch of few product that we launched early in the year, not in a very successful manner. This time, we did a major marathon through all the regions in September and October. We see some very good initial response on those and are looking forward to leverage ourselves as the results.
Okay, thank you.
Thank you. As a reminder, that's star one to be placed in the question queue. Our next question is coming from John Baugh from Stifel. Please proceed with your question.
Thank you for taking my questions. Good morning. Could you maybe address your, I guess, two things on the U.S., where IKEA goes in the fourth quarter year-over-year? I recall that it was very weak in the prior year fourth quarter. I assume the guidance for revenues assumes U.S. declined in the fourth quarter. That implies core U.S. is down year-over-year. Do I have that right? What would be your assessment as to why your core U.S. sales are down, you've lost market share?
In terms of IKEA, we'll start with IKEA, John. We see sequential growth of the IKEA business from the bottom that we experienced in the fourth quarter of 2015 and the first quarter of 2016, though the recovery has been slower than we expected. Overall, our outlook for IKEA is positive. Yes, we are expecting our U.S. revenue to be down year-over-year in the fourth quarter, and you are right that we expect a better year-over-year IKEA growth in Q4, and therefore, the conclusion is that the core will be weaker on a year-over-year comparison. As I already said before, the implementation of the transition plan is taking longer than expected. However, we are optimistic that we will return to notable growth next year.
Yes. Is it possible to be specific on where you've lost business, in terms of distribution channels or price points or anything more granular in terms of why or where the erosion is occurring?
Yeah. The overall performance now is just not good enough. We are taking steps and measures and revising our strategy and organization, and we believe that we will return back to growth. There is no specific segments now that are worth discussing.
Okay. On the plant Yair, is it your expectation that, as we move into 2017 or maybe inclusive of the fourth quarter, that the throughput and yield results you've seen, you mentioned some momentum, are going to narrow that gross margin drag?
First of all, I want to just remind us that we brought the new executive to the plant, actually, at the very beginning of Q3, and I think there is a lot of steps being taken now, significant steps to improve all processes. We anticipate that many of the issues will be resolved in 2017 and expect to be in a reasonable utilization rate by the end of 2017. It will be a gradual improvement, and with the growing global demand, we expect utilization rates and associated cost to be much better next year. Again, it's not only a matter of gross margin leverage or not, it's a matter that we intend to grow our top line, and we need this throughput from this plant.
Okay. Any update on the silica lawsuits? Any numbers around additional claims or any color there? Thank you.
No, there was a few new claims coming in and few settlements that we closed on, the overall $1 million is the results of all these blended events. We'll give more specific numbers as to number of litigation at the 20-F. In general, the picture is basically the same.
Thank you. Good luck.
Thank you.
Thank you. Our next question today is coming from Lina Rogova from Chardan Capital Markets. Please proceed with your question.
Yes. Thank you for taking my question. I actually have two questions. The first is very similar to the previous one. During the last conference call, you mentioned that you expect some U.S. revenue recovery towards the second half of the year, and you also mentioned some positive signs you see there. What exactly happened, and why the core business was so slow even quarter-on-quarter. The second question is, if U.S. production facilities can be used for production for other regions, not just for the U.S., in order to improve utilization rates, if there is not enough potential demand in the U.S. as well. Thank you.
Okay. With regards to the first question, as we said before, we are implementing a lot of things, and we are now in a transition plan execution, and it just take longer than we thought. Basically the plant, for the most part, it serves the North America market. We can send product from there to other regions, but it's basically up to how we divide the all supply that we have. The U.S. utilization now in Q3 was not a demand-dictated result. It was our own performance that we want to improve.
Okay. Thank you.
Thank you. We've reached the end of our question and answer session. I'd like to turn the floor back over to management for any further closing comments.
Thank you, everyone. We are pleased to see the strength of our brand and success of our product translating into good performance in most of our regions. We believe that we are taking the right steps to re-energize our business in the U.S. Thank you for your attention today.
Thank you. That does conclude today's teleconference. You may disconnect your line at this time and have a wonderful day. We thank you for your participation today.