Good day, welcome to Caesarstone's second quarter 2016 earnings conference call. Today's conference is being recorded. At this time, I would like to turn the conference over to Alison 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 second quarter earnings release, which is posted on the company's website. With that, I'd like to turn the call over to Yosef Shiran, Caesarstone's Chief Executive Officer. Yosef.
Thank you, Alison. Good day. Thank you everyone for joining us to discuss our second quarter. Our second quarter was strong. Our business is generally performing well. I would like to start with some highlights for the quarter. We grew sales by 11.6% to a new record of $142.3 million. Without currency impact, growth would've been 13.4%. We expanded our adjusted EBITDA to a new record of $39.8 million, margin of 27.9%, up over a point and a half compared to 26.3% in the second quarter last year. Adjusted net income was $25.4 million and our adjusted diluted EPS was $0.73 compared to $0.65 last year. I would like to give an update on each of our major markets for the second quarter. Second quarter sales in the U.S. were $59.9 million, representing 5% growth with core and IKEA business lower than expected.
Core business growth was offset by a year-over-year decline in IKEA. We believe our IKEA business will accelerate for the second half of the year and will support a higher growth rate in this region in comparison to the first half. I'm happy to notify that we have extended the agreement with IKEA for the U.S. markets until the end of 2017, which will allow us to further develop the business for the benefit of both us and IKEA. We see this as a demonstration of the successful cooperation with IKEA. We expect the agreement with IKEA Canada to be soon extended as well. Our U.S. team has been reinforced over the past quarter with new executives now on board. We continue to add talent and expand capabilities to better execute our go-to-market strategy.
We have a devoted team that works hard, and we believe that we will bear fruits going forward. We grew our sales in Australia to $33.5 million, up 24.9% compared to last year. On a constant currency basis, Australia was up 29.5% in the second quarter. Housing conditions in Australia have been better than originally forecasted for 2016. Our Australian team is doing a great job, and our business remains strong. We grew sales in Canada to $24.3 million in the second quarter, a growth of 26.8% or 33.1% on a constant currency basis. This was achieved despite weakening housing conditions. Our business in Canada is strong and our sales to IKEA continue to ramp up. Sales in Israel for the quarter were $11.1 million, up 16.3% compared to the second quarter last year. On a constant currency basis, sales were up 14.2%.
While it is a smaller market and generally mature, we are very pleased to see accelerated growth following strong execution. Europe sales were up 1.6% to $6.9 million and 0.1% down on a constant currency basis. As we noted, following a 41% increase in the sales in the first quarter, this business is volatile due to timing of orders. Revenue in the rest of the world was $6.7 million in the quarter, down 16.6% from last year and down 17.7% on a constant currency basis. Like Europe, these tend to be smaller and more volatile individual markets. Overall, our second quarter results were strong, and we are confident with our business. Thank you, and I will turn the call over to Yair.
Thank you, Yos, and good morning to everyone. I will start with our income statement for the second quarter. Sales in the second quarter increased by 11.6% to $142.3 million compared to $127.5 million in the second quarter of last year. On a constant currency basis, sales increased by 13.4%. We drove gross margin improvement in the quarter to 42.1% compared to 41.3% last year. This margin improvement was driven mainly by favorable product mix and economies of scale, and to a lesser extent, lower raw material costs and lower manufacturing costs in Israel. Those were partially offset by inefficiencies related to the U.S. manufacturing facility and negative exchange rate fluctuations. Operating expenses in the second quarter were $28.7 million, or 20.2% of sales versus $24.3 million last year, which was 19.1% of sales.
This increase in expenses was primarily due to increase in marketing and sales efforts, mainly in the United States, as well as legal settlement and loss contingency expenses that were not incurred in the prior year's second quarter. Operating income was $31.3 million, compared to $28.3 million in the second quarter of last year. Our operating margin was 22%, compared to 22.2% last year. Adjusted EBITDA in the second quarter, which eliminates share-based compensation and legal settlements and loss contingencies expenses, reached a new record of $39.8 million. This was a margin of 27.9% versus 26.3% last year. This year-over-year margin improvement reflects the improved gross margin I just mentioned. Finance expenses in the second quarter was $1.4 million, compared to $0.4 million in the prior year.
The increase was primarily due to $0.5 million net losses related to currency exchange rate fluctuations in the second quarter this year, compared with net gains of $0.4 million in the second quarter of 2015. Our taxes in the second quarter were $3.6 million or 11.9% of income before taxes, compared to a 16.6% tax rate last year. Excluding the one-time favorable tax adjustment of $1.2 million related to tax audits of the years 2012 through 2014, carried by the Israeli tax authorities, our effective tax rate would have been 15.8% this quarter. Adjusted net income attributable to controlling interest, which eliminates share-based compensation, legal settlement, and loss contingencies expenses, as well as non-recurring tax credit, increased in the second quarter by 9.9% to $25.4 million, up from $23.2 million last year. Adjusted diluted earnings per share in the quarter were $0.73 on 34.9 million shares.
Adjusted diluted EPS last year were $0.65 on 35.5 million shares. The EPS increase mainly reflects the improved performance. Since our share repurchase authorization was put in place, we have used $29.8 million to buy back approximately 829,000 shares through the end of the second quarter. Turning to our June 30th balance sheet, we had cash equivalents, and short-term bank deposits of $55.7 million. Our net cash position from the end of 2015 went down by $9.9 million, entirely as a result of our use of cash to repurchase shares. Our free cash flow was $21.9 million in the first half of 2016. With respect to 2016 guidance, we are reiterating our full-year guidance for both revenue and adjusted EBITDA. Revenue guidance for the year remains at $550 million-$565 million, and our adjusted EBITDA guidance for the year remains at $138 million-$145 million.
Before we take questions, on behalf of our entire organization, employees, and the board, I would like to thank Yos. Yos has been a good friend and a great leader for all of us for the past seven and a half years and led the company to great achievements. Under his management, Q2 annualized adjusted EBITDA is almost equal to the company annual revenue when Yos joined. We will miss Yos, and we wish him best of success in the future. As we published on May 23rd, Yos' last day in office is August 21st. The board believes that a new CEO will be appointed by the end of September. Our chairman, Yonathan Melamed, will act as an interim CEO for any period in between. Thank you. We are now ready to open the call for questions.
At this time, if you would like to ask a question, please signal by pressing star one on your telephone keypad. Again, that is star one to ask a question. We'll go first to Michael Rehaut of J.P. Morgan.
Thanks. Good morning, and best of luck, Yosef.
Thank you.
First question I had was on sales growth, and in particular, the U.S. You mentioned in your prepared remarks that the IKEA business was down year-over-year, and I think that's contrary to your expectations. I was hoping to get a little bit more detail in terms of why you have confidence that that business will increase. Obviously, it's kind of been a little bit of a wild card over the last several quarters, and we were expecting a turn in that business this quarter. Then just more broadly, if that business had turned, maybe just to comment on the broader strength of the core business as you referred to.
Yes. I will answer it in a few words, and maybe try to better explain the situation there. First of all, our revenue from IKEA was below the projection, and we believe it was mostly due to gradual implementation of the promotional events. We expect the IKEA business to grow sequentially, and we see the orders spike increasing. Overall, we believe that the outlook for IKEA is very positive. As I said, we have just signed an extension to the contract with IKEA U.S., and we expect to sign the same soon with IKEA Canada, an extension of one year through 2017. This is as for IKEA. Overall, yeah, it was lower than we expected for Q2, but we think we needed to be a little bit patient, and it will start to grow again, compared to last year, of course, and then further.
As to the core, our sales organization in the U.S. should be larger and better managed to accommodate our current scale of operation and our additional growth opportunities. We believe that the step we take in reorganizing our sales and operations in the U.S. will lead to more robust and focused performance and to better achievements gradually in our core business. This is the situation between IKEA and the core. I hope it explains it. Yeah.
Just so I heard correctly, you said for IKEA, you used the words, a more gradual implementation of the promotional events. Is that right?
No, the promotional events are back, but the growth rate. IKEA in Q2, it grew, but it was still below the absolute number of IKEA last year. There was a decline in IKEA between Q2 2016 to Q2 2015. We expect that going forward, that IKEA will get stronger with the events. Of course, in absolute numbers, it will change, and also we expect to see, of course, a positive growth rate for IKEA.
Okay. Then, are you able to describe a little bit more in terms of some of the changes in the U.S. team? You mentioned new executives and new people in place, and just to get a better sense of what you're doing, either through new people or new strategy, you said to kind of better capitalize and organize the efforts.
Yeah. Again, from a wide angle, of course, first of all, I think maybe to emphasize that we view the current growth rates in the U.S. as temporary, and we believe that the U.S. market represents a strong growth opportunity for us. As to what we do there, we believe that we can leverage the sales by improving our performance and adjusting it to the current scale of the business and maybe to illustrate within our activities, we recruited new executive teams, we increased our sales force, and we are launching new products, which we believe will be appreciated by the American consumer. In general, we are trying to make sure that the way we manage the sales organization is adequate to the size and the opportunity.
I think it takes a little bit longer than we expected, but we are confident that we are taking the right steps, and we will see the fruits going forward, as I said.
We'll take our next question from George Staphos with Bank of America Merrill Lynch.
One good morning or good day, and, Yos, good luck to you as well. I guess, first question I had, piggybacking on Mike. In the third quarter, should we expect IKEA in the U.S. to be up year-on-year? You said it would grow sequentially, but should we be having positive comparisons year-on-year?
We wouldn't like to get into, first of all, regions guidance and, of course, not to start to break down the core and IKEA. Overall, we expect the second half in the States to be stronger than the first half. We believe that our IKEA business will accelerate gradually through the second half of the year and will support the high growth rate in this region in comparison, as I said, to the first half. Again, I cannot get into specific quarters, but IKEA is What I can say is that we see a healthy pipeline that's getting stronger, and we see IKEA coming back. Now with the extension for additional year, we see this as a positive trend, and we believe it will be a good business for both IKEA and Caesarstone.
Okay. Yos, just on the U.S., and maybe one other question on IKEA. In the past, maybe taking the last one first, have you discussed how far out you wanted to re-extend with IKEA, or was it always a one-year extension that you had in mind? In the U.S., the slowdown in growth, would you attribute any of it at all to increased competition, or you really don't see any change in the run rate there?
IKEA, the IKEA contract was for two years. We extended it for even more than two years, and now we extended it for a further one year. It, of course, also matters in decision of IKEA, and we try to accommodate and meet the ideas of both sides, IKEA and us. As of now, it is extended through 2017. As to the rest of the business, we still have a lot of work to do, and we believe, as I said, that the growth opportunity in the States is much bigger, and we believe that it will come, but it will take some time.
Okay. My last question, I'll turn it over. Two-part, one, the investment in marketing and sales and G&A, is that reflective of the changes that you've already made in the organization or reflective of growth-related spending that you are doing looking out to the future? Have you seen any effect at all from Brexit, in terms of consumers, purchasing patterns, any kind of trend in volume early in the quarter? Thank you.
I think your first question, the answer is both. I think as to Brexit, we don't feel it. We don't see any impact currently on our business.
Okay. Thank you.
Thanks.
We'll go next to Mike Dahl of Credit Suisse.
Hi, thanks for taking my questions, Yos, best of luck.
Thanks.
Just to follow on to the last couple lines of questioning around the U.S. Yos, one other question I'd have is, you're in a lot of markets that are much further developed as far as adoption rates for quartz, yet you're still seeing substantial growth in some of these markets. Is there anything you see structurally about the U.S. or anything else you can kind of help us understand outside of some of the company-specific issues you've discussed that are kind of making this growth ramp more gradual than you initially thought? How much of it is potentially just also product launches that haven't yet hit the U.S. versus some of these other regions? If there's any more color you can give us on those things, that might be helpful.
Basically, Mike, just for me to understand that I'm answering your question precisely, you're asking, in essence, how do we compare the execution in Canada and Australia, for instance, compared to the U.S.? Is this what you're asking, or?
Right. Yeah. Effectively, part is how you compare the execution of Caesarstone in the U.S. versus those markets, but part is also a market question in that.
Oh
Is there something different about the structure, whether it's distribution or something else in the U.S. that's making this growth ramp more difficult to sustain than in some of those other markets?
I think basically, the United States is much bigger than Australia and Canada, and is a tougher challenge to control on one hand. On the other hand, the market is very healthy. We don't have numbers, we don't have an exact quantification of the quartz growth rate, but we feel that the quartz segment continues to grow, and it's really a matter of our execution. Of course, with the market growth, the competition is growing as well, it's not new to us, and we are also competing in Canada, in Australia, in Israel, everywhere. We are used to competition. I think it's more, get adapted to the size of the States. We grew very fast there, almost four times in the last few years. We need to adjust the organization to the new scale and to make it ready for future growth.
It's a bit more complicated than Canada and Australia. In addition to that, in Canada and Australia, we are number 1 in terms of brand and size, and it's not the case in the States. Of course, we are striving to get there, we still need to work hard for that. I hope this helps.
We'll go next to Susan Maklari of UBS.
Thank you. Good morning. Can you talk a little bit about the U.S. plant here, and how that has progressed, and maybe how you're thinking about it coming further online through the back half of 2016?
Hi. Are you asking about the progress in the plant in Richmond Hill?
Yes.
Again, as you know, this factory is very important strategically. So far, we see just the burden financial-wise, but of course, we expect that in the future it will help us to deliver better results. It was definitely negatively significant in Q4 last year and Q1, and I'm happy to say that in Q2, we managed to control it better, and we expect it to get better gradually with time and with the people gaining more experience and more control over the processes there. There is a huge potential. As I said, so far, we just see the negative impact, but I'm confident that the positive impact will also arrive in the future.
Okay. Do you expect it to basically be much further along by the end of this year? Will you be shipping products, do you know?
No, we ship products from the States. Of course, we optimize our production allocations between the States and Israel. As I said, gradually we see the plant in the States getting more and more efficient.
Okay. Yos, congrats on doing such a great job there. Can you just give us a little bit more detail on the CEO search and perhaps where that stands? I know that you mentioned you expect someone there by the end of September, any further information on that?
I think so. The board appointed a committee that deals with it. To my opinion, very professional, I'm sure they will or expect that they will find an adequate new CEO soon. Hopefully sooner than later. They are looking for somebody that can manage a global company with high growth. Hopefully, they will be able to present somebody soon.
Okay. Thank you.
Thanks.
We'll go next to John Baugh of Stifel.
Thank you. Yos, best of luck in your future. Enjoyed working with you. I was wondering if you could give us the FX headwind to EBITDA in the second quarter and what it is now year-to-date, and what the outlook for that is for 2016.
Yes. Hi, John. FX was around 100 basis points drag for the second quarter relative to 2015. We looked at the current exchange rate and took them into consideration when we reiterated our guidance.
Thank you for that. Maybe back to the plant and the drag, it sounds like you're making progress. I'm curious, is that progress due to increased production and absorption of fixed costs, or are you also seeing less scrap and better unit production costs, or any more granularity there? Thank you.
Yeah. The plant performance is progressing. We've succeeded to establish control over spending and processes in the plant, and we are slowly ramping it up as demand dictates and focus on further improvement of quality rate. I don't want to get specifically into whether we produce more, but we certainly improve the processes and the performance there.
I was curious on the new product launches. Are those that I think you were saying were specific to the U.S.? Any color on the timing and what types of products we're going to see?
Most of the launches this year happened around June, July. In the States specifically, this will be a line of more traditional colors, more granite-inspired, but also marble-inspired. There will be an extension basically of traditional colors with a partial add of what is called transitional. Between modern and traditional colors.
It's just a start. We don't have indication yet of the reception in the market, but according to initial responses that we got, at least part of it seems promising. We will have to wait, and we'll be happy to report about it later.
Yos, what are the price points of those Supernatural, above, below? Where are we price point margin wise on those?
Most of the granite look are priced in the classical range, in the regular range. Part of it, which are very unique, will be priced at the Supernatural area.
Okay.
Thank you.
My last question, any developments on silicosis, any new cases, claims, et cetera? Thank you.
Yeah. As to silicosis, we continue to deal with the lawsuits in Israel, including the lawsuits that were filed this year and in the quarter as reported. Also, we have one claim in Australia in which there was no significant development. In general, the big picture remains the same.
Thank you. Good luck.
Thanks.
As a reminder, it is star one if you would like to ask any questions, star one please. We'll go next to Michael Rehaut of J.P. Morgan.
Thanks. Wanted to focus on what I feel was one of the real bright spots of the quarter. It hasn't been talked about as much yet. The gross margin had very strong sequential improvement and basically, after three quarters of very sizable year-over-year declines, versus a year ago, you had a positive margin. Just wanted to get a sense of, Yair, I think you highlighted that FX currency was 100 basis points drag. If you're able to quantify what some of the other positive drivers were from a basis point standpoint, and also how to think about the back half of the year, if we should be expecting something above 40% as well, or if there's anything that should drive it back below 40%.
Okay, Mike. Maybe you asked it from the point of previous quarter. Maybe I don't know if you want the answer sequentially or year-over-year, but let me maybe start sequentially. We saw a major gross margin improvement related to improved mix of our product, regional mix, which also got better with Canada and Australia growing so much. That, along with volume, was almost 600 basis points. There was 450 basis points related to Sorry. There was 150 basis points of improvement related to Richmond Hill. The Richmond Hill was better than last quarter on its relative to its drag on the margin. This was offset with a couple of other small factors. FX wasn't much of a big deal between those two quarters.
If you look at it year-over-year, product mix and volume contributed 350 basis points to margin, material cost, and lower manufacturing cost in Israel was each around 50 basis points. Those two factors were offset with Richmond Hill drag that was approximately 250 basis points relative to last year, FX was a drag of 100 basis points.
You said year-over-year materials and lower-
Lower manufacturing cost in Israel.
50 basis points each?
Yes.
Okay. How do you think about the back half, Yair? Again, substantial improvement sequentially. Do you think that 42% is a reasonable number? Obviously over time, the inefficiencies from Richmond Hill should continue to abate. How should we think about the back half?
We don't really provide guidance by line items, all our expectations are built into our guidance. One thing I want to mention, though, is we took into consideration an expected increase in SG&A, mainly related to our investment in the U.S. market. That was one factor, of course, of many others. That's what I can say about the second half of the year.
All right. Thank you.
Thanks.
We'll go next to Mike Dahl of Credit Suisse.
Hi, thanks. I think you just addressed my question around gross margins with the answer to Mike's questions. I'm all set. Thank you.
At this time, we have no further questions in the queue.
Okay. Just some closing remarks on my end. I would like to thank everyone. It has been an honor to be part of the Caesarstone success story, and to have had the opportunity to lead its transformation to become a strong, innovative, global company, with a worldwide known premium brand, cutting-edge technology, and a winning strategy. Our people have all worked together to create a solid, globally recognized leadership position and significant opportunities for the future. I would like to express my thanks and appreciation to Caesarstone's current and past directors and employees worldwide. Without them, this great journey wouldn't have been as successful and as meaningful. It has also been my pleasure over the past years to engage with our investors and analysts. I'm grateful that you shared our vision and success, and thankful for your support and confidence.
I wish all of Caesarstone's investors, management, and employees lots of success in the promising future ahead. Thank you again.
That does conclude our conference for today. We thank you for your participation