Day, and welcome to the Caesarstone 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, and good morning to everyone. Certain statements in today's conference call and responses to various questions may constitute forward looking statements. We caution you that such statements reflect only the company's current expectations and that the actual events or results may differ materially. For more information, please refer to the risk factors contained in the company's most 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 GAAP measures can be found in the company's Q2 earnings release, which is posted on the company's website. With that, I'd like to turn the call over to Yost Sharon, Caesarstone's Chief Executive Officer. Yost?
Thank you, Alison. Good day, and thank you, everyone, for joining us to discuss our Q2. Our Q2 was strong and our business is generally performing well. I would like to start with some highlights for the quarter. We grew sales by 11.6 percent to a new record of $142,300,000 Without currency impact, growth would have been 13.4%.
We expanded our adjusted EBITDA to a new record of $39,800,000 margin of 27.9 percent, up over 1.5% compared to 26.3% in the Q2 last year. Adjusted net income was $25,400,000 and our adjusted diluted EPS was $0.73 compared to $0.65 last year. Now I would like to give an update on each of our major markets for the Q2. 2nd quarter sales in the United States were $59,900,000 representing 5% growth with core and IKEA business lower than expected. Core business growth was offset by 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 agreements 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 $33,500,000 up 24.9% compared to last year. On a constant currency basis, Australia was up 29.5% in the 2nd 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 $24,300,000 in the 2nd quarter, a growth of 26.8% or 33.1 percent 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 $11,100,000 up 16.3% compared to the Q2 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 percent to $6,900,000 and 0.1% down on a constant currency basis. As we noted, following a 41% increase in the sales in the Q1, this business is volatile due to timing of orders. Revenue in the rest of the world was $6,700,000 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 2nd quarter results were strong, we are confident with our business. Thank you, and I will turn the call over to Eyre.
Thank you, Yoss, and good morning to everyone. I will start with our income statement for the Q2. Sales in the Q2 increased by 11.6% to $142,300,000 compared to $127,500,000 in the Q2 of last year. On a constant currency basis, sales increased by 13.4%. We drove gross margin improvement in the quarter to 40 2.1% 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 2nd quarter were $28,700,000 or 20.2 percent of sales versus $24,300,000 last year, which was 19.1 percent 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 quarter second quarter in the prior year Q2. Operating income was $31,300,000 compared to $28,300,000 in the Q2 of last year. Our operating margin was 22% compared to 22.2% last year. Adjusted EBITDA in the 2nd quarter, which eliminates share based compensation and legal settlements and loss contingencies expenses, reached a new record of $39,800,000 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 2nd quarter was $1,400,000 compared to $400,000 in the prior year. The increase was primarily due to $500,000 net losses in the Q2 of 2015. In the Q2 of 2015. Our taxes in the 2nd quarter were $3,600,000 or 11.9 percent of income before taxes, compared to a 16.6% tax rate last year. Excluding the one time favorable tax adjustment of $1,200,000 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 2nd quarter by 9.9% to $25,400,000 up from $23,200,000 last year. Adjusted diluted earnings per share in the quarter were $0.73 on 34,900,000 shares. Adjusted diluted earnings per share last year were $0.65 on 35,500,000 shares. The EPS increase mainly reflects the improved performance. Since our share repurchase authorization was put in place, we have used $29,800,000 to buy back approximately 829,000 shares through the end of the Q2.
Turning to our June 30 balance sheet. We had cash, cash equivalents and short term bank deposits of $55,700,000 Our net cash position from the end of 2015 went down by $9,900,000 entirely as a result of our use of cash to repurchase shares. Our free cash flow was $21,900,000 in the first half of twenty sixteen. 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 $550,000,000 to $565,000,000 and our adjusted EBITDA guidance for the year remains at $138,000,000 to $145,000,000 Before we take questions, on behalf of our entire organization, employees and the Board, I would like to thank Jos.
Jos 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 Jos joined. We will miss JOS and we wish him best of success in the future. As we published on May 23, Yoss' last day in office is August 21. The Board believes that the new CEO will be appointed by the end of September.
Our Chairman, Yonatan Nelamed will act as an interim CEO for any period in between. Thank you, and we are now ready to open the call for questions.
We'll go first to Michael Rehaut of JPMorgan.
Thanks. Good morning and best of luck, Yoss. 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 wildcard over the last several quarters and we were expecting a turn in that business this quarter. And 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 would like to I will answer it in few words and maybe try to better explain the situation there. So 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 IKEA business to grow sequentially, and we see the orders spike increasing. Overall, we believe that the outlook for IKEA is very positive.
And we as I said, we have just signed an extension to the contract with IKEA U. S. And soon and we expect to sign the same soon with IKEA Canada, an extension of 1 year through 2017. And as to the so this is as for IKEA. So overall, yes, it did it was lower than we expected for Q2 and but we think it just we needed to be a little bit patient and it will start to grow again compared to last year, of course, and then feather.
Our sales and 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. And 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. So this is a situation between IKEA and the Core. I hope it explains it.
Yes? Just so I heard correctly, you said from 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 so IKEA in Q2 was it grew, but it was still below the absolute number of IKEA last year. So there was a decline in IKEA between Q2 '16 to Q2 'fifteen. So we expect that going forward that IKEA will get stronger with the events. So of course, in absolute numbers, it will change and also we expect to see, of course, a positive growth rate for IKEA.
Okay. And then, Gus, 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?
Yes. So again,
from a wide angle, of course, first of all, I think maybe to emphasize that we view the current growth rates in the state as temporary, and we believe that the U. S. Market represents a strong growth opportunity for us. As to what we do there, so 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.
And in general, we are trying to make sure that the way we manage the sale organization is adequate to the size and the opportunity. And it takes a little bit 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 of Bank of America Merrill Lynch.
As well. I guess first question I had piggybacking on Mike. So in the Q3, 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?
So we wouldn't like to get into, 1st of all, region guidance and of course not to start to break down the core and the and IKEA. But overall, we expect the second half in the States to be stronger than the first half. And 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. So 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. And 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. 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 is it always a 1 year extension that you had in mind? And then in the U. S, have 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?
So, IKEA, the IKEA
contract was for 2 years. Now, we extended it for additional even more than 2 years, and now we extended it for a further 1 year. It's, of course, also matters and decision of IKEA, and we try to accommodate and the ideas of both Art, IKEA and us. So as of now, it is extended through 2017. Now as to the rest of the business, we still have a lot of work to do and we believe, as I said, that we can grow the growth of Odeentiv 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. 2 part. 1, the investment in marketing and sales and G and 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? And then 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.
So 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 and Yoss, best of luck. Just to follow on to the last couple of lines of questioning around the U. S. I guess one other question I have is, you're in a lot of markets that are much further developed as far as adoption rates for courts and yet you're still seeing substantial growth in some of these markets.
So 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? Or and then also 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.
So basically, Mike, just for me to understand what 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 States? Is this what you're asking or Right.
Yes. 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. 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?
So I think basically, the United States is much bigger than Australia and Canada. I mean, it's 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 course growth rate, but we feel that the course continue the pause signal continues to grow.
And it's really a matter of our execution. Of course, with the growth with the market growth, the competition is growing as well, but it's not new to us and we are also competing in Canada and Australia and Israel everywhere. So we are used to competition. So I think it's more get adapted to the size of the states. We grew very faster, almost 4 times in the last few years.
And we need to adjust the organization to the new scale and to make it ready to for future growth. So 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 together, but we still need to work hard for that. So I think this 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 twenty sixteen?
Hi. Are you asking about the progress in the plant in Richmond Hill?
Yes.
So 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 significant 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 the 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.
So do you expect it to basically come be much further along by the end of this year? Will you shipping products?
No, we ship products from the States. Of course, we optimize our production allocation between the States and Israel. And as I said, gradually, we'll see the plant in the states getting more and more efficient.
Okay. And then, Joost, congrats on doing such a great job there. But 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, but any further information on that?
I think so. The Board appointed a committee that deals with it, to my opinion, very professional. And I'm sure they will or expect that they will find adequate new CEO soon, hopefully sooner than later. And they are looking for somebody that can manage a global company with a high growth. So hopefully, they will be able to present somebody soon.
Okay. Thank you.
Thanks.
We'll go next to John Fahl of Stifel.
Thank you. And, Yost, 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 Q2 and what it is now year to date and what the outlook for that is for 'sixteen?
Yes. So hi, John. So FX was around 100 basis points drag for the Q2 relative to 20 15. And we looked at the current exchange rate and took them in consideration when we reiterated our guidance.
Thank you for that. And 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 cost or any more granularity there? Thank you.
Yes. So the plant performance is progressing and we have 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. So I don't want to get specifically into whether we produce more, but we certainly improved the processes and the performance
there. And then 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?
Yes. Most of the launches this year happened around June, July. And in the States specifically, this will be a line of more traditional colors, more granite inspired, but also marble inspired. So there will be extension of basically of traditional colors with a partial add of what is called transitional. So it's between modern and traditional colors.
So 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.
And, Yoss, what are the price points of those supernatural, above, below? What where are we price point margin wise on those?
So most of the Granite Luka are priced in the classical range, in the regular range, but out of it, which are very unique, will be priced at the supernatural area.
Okay. And then my last question, any development on silicosis, any new cases, claims, etcetera? Thank you.
Yes. So as to silicosis, we continue to deal with the lawsuits in Israel, including the losses 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. And in general, the big picture remains the same.
Thank you. Good luck. Thanks.
We'll go next to Michael Rehaut of JP Morgan.
Thanks. I wanted to focus on what I feel is the real 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 3 quarters of very sizable year over year declines, you had a positive year versus a year ago, you had a positive margin.
So just wanted
to get a sense of
Yair, I think you highlighted that FX currency was 100 basis points drag, but what some of the other positive 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. So maybe you asked it from the point of previous quarter. So 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 going so much. And that along with volume was almost 600 basis points.
Then there was 4.50 basis points related to sorry, and then there was 160 basis points of improvement related to Richmond deal. So Richmond deal was better than last quarter on its relative to its drag on the margin. And there was this was offset with a couple of other smaller factors. FX wasn't big or much of
a big
deal between those two quarters. If you look at it year over year, then product mix and volume contributed 3.50 basis points to margin, material cost and lower manufacturing cost in Israel was each around 50 basis points. And those two factors were offset with Richmond deal drag that was approximately 2 50 basis points relative to last year and FX was a drag of 100 basis points.
And you said year over year materials and lower
Lower manufacturing cost in Israel. 50
basis points each?
Yes.
Okay. And so then how do you think about the back half EIE? I mean, again, substantial improvement sequentially. Do you think that 42% is a reasonable number? Or and obviously, over time, the inefficiencies from Richmond Hill should continue to abate.
So how should we think about the back half?
We don't really provide guidance by line items and everything all our expectation are built into our guidance. One thing I want to mention though is we took into consideration an expected increase in SG and A, mainly related to our investment in the U. S. Market. That was one factor, of course, of many others, but 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, 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. So I would like to thank everyone. It has been an honor to be part of the sales from success story and to have had the opportunity to lead its transformation to become a strong, innovative, global company with a worldwide non 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.