Michael McKenney - Senior Vice President, CFO Jon Painter - President, CEO

Rudy Hokanson - Barrington Walter Liptak - Seaport Global Securities Dan Jacome - Sidoti & Company

Good day, ladies and gentlemen, and welcome to the Kadant Inc. Third Quarter 2016 Earnings Conference Call. At this time all participants are in a listen-only mode. Later we will conduct a question-and-answer session and instructions will follow at that time. [Operator Instructions] As a reminder, this conference call is being recorded. I would now like to turn the conference over to Michael McKenney, Senior Vice President and Chief Financial Officer. Sir, you may begin.

Good morning, everyone, and welcome to Kadant’s third quarter 2016 earnings call. With me on the call today is Jon Painter, our President and Chief Executive Officer. Before we begin, let me read our Safe Harbor statement. Various remarks that we may make today about Kadant’s future expectations, plans and prospects are forward-looking statements for purposes of the Safe Harbor provisions under the Private Securities Litigation Reform Act of 1995. Our actual results may differ materially from these forward-looking statements as a result of various important factors, including those outlined at the beginning of our slide presentation and those discussed under the heading Risk Factors in our annual report on Form 10-K for the fiscal year ended January 2, 2016 and subsequent filings with the Securities and Exchange Commission. Our Form 10-K is on file with the SEC and is also available in the Investor section of our website at www.kadant.com, under the heading SEC Filings. In addition, any forward-looking statements we make during this webcast represent our views only as of today. While we may elect to update forward-looking statements at some point in the future, we specifically disclaim any obligation to do so even if our estimates change and you should not rely on these forward-looking statements as representing our views on any date after today. During this webcast, we will refer to some non-GAAP financial measures. These non-GAAP measures are not prepared in accordance with Generally Accepted Accounting Principles. A reconciliation of the non-GAAP financial measures to the most directly comparable GAAP measures is contained in our second quarter earnings press release issued yesterday, which is available in the Investors section of our website at www.kadant.com under the heading Investor News. With that, I’ll turn the call over to Jon Painter, who will give you an update on Kadant’s business and future prospects. Following Jon’s remarks, I’ll give an overview of our financial results for the quarter. And we’ll then have a Q&A session. Jon?

Thanks, Mike. Turning to results. Hello, everyone. Thanks for joining us this afternoon for review of Kadant's third quarter and nine month results and a discussion of our business outlook. First let me say that with another strong quarter for us across the broad range of matrix positioning Kadant for another year of strong profitability in 2016. As you've seen in our earnings release, we've tweaked our revenue guidance range for the year, slightly lowering the revenue midpoint and slightly increasing the midpoint for GAAP and adjusted deluded earnings per share. The drivers of our strong third quarter results are consistent with our growth strategy and represent a combination of acquisition growth, mainly from recent acquisition of PAAL which boosted sales of our stock preparation product line and organic growth in both our doctoring, cleaning, and filtration and fluid handling product lines. The key financial takeaways from Q3 are high profitability levels and strong cash flow, which have been achieved throughout 2016 despite myriad industrial spending in most of our global markets. Now, to review the financial highlights of the quarter. Revenue for the quarter increased 15% just 106 million, mainly from our recent acquisition as well as good top line growth in our doctoring, cleaning and filtration and fluid handling product lines. Gross margin was strong and nearly 46% despite parts and consumables representing only 58% of revenue, compared to 69% of revenue last year. As you recall, after our recent acquisition, we reset our expectations for companywide growth margins to 45%. So, the year-on-year decline in growth margins was not unanticipated. This quarter strong growth margin performance was achieved despite the reduced percentage of parts and consumables, because of the higher gross margins for our capital projects product side. We refer to net income of $9.2 million, a 6% increase from 8.6 last year. Adjusted EBITDA increased 6% to 16.2 million or 15% of revenue. GAAP deluded earnings per share reached $0.82 or $0.17 above the top of our guidance range and represented a 5% increase over last year's third quarter. I'd also like to highlight a strong operating cash flow which reach 16 million in the third quarter and 35 million for the first nine months of this year up 24% compared to the first nine months of last year. We ended the quarter with net cash of $2 million. The only disappointment in the quarter was our bookings of 95 million which came in 4% below last year's level despite the inclusion of booking from our recent PAAL acquisition. In Slide 7, we show the internal growth of our business, which we define as our performance excluding the impact of acquisitions and foreign currency translation. Internal revenue growth in the third quarter was 1%. Internal growth for bookings was -16% reflecting the challenging industrial markets for operating in. internal growth for adjusted earnings per share were -8% versus a very strong Q3 of last year, which had a high percentage of parts and consumable resulting in very high gross margins and overall profitability. Our parts and consumables revenue was down 8%, while bookings decreased 1% this quarter compared to the same period last year. Year-to-date internal growth was 3% for revenue and approximately 6% for adjusted earnings per share. Bookings were down 10%. Our revenue and bookings were parts and consumables were down 2% and 3% respectively. Looking at revenue and booking trends on Slide 8, you can see the impact of weak industrial activity in both of these matrix. Thanks to our recent acquisition, we are able to report revenue and growth, revenue growth on our third quarter versus Q3 of last year. The third quarter bookings decline a 4% year-on-year was a result of declines in our stock preparation and fluid handling product lines. By contrast, our doctoring, cleaning, and filtration and wood processing product lines showed solid bookings growth. For the first nine months of this year, revenues were 314 million up an 11% and bookings were 290 million down 4%. As we noted in our press release, we're cautiously optimistic that we will see a sequential increase in bookings in the fourth quarter. Turning to our parts and consumables business in Slide 9, you can see the revenue decline 3% in the third quarter compared to a year ago, while parts and consumables bookings were up 5% compared to last year's third quarter. Bookings were just shy of 64 million up from 61 million last year reflecting the contribution from a recent acquisition. We've seen continued softness on our parts and consumables business particularly in North America. History would tell us that this should revert to full normal levels, but we have not seen this year. Year-to-date parts and consumables represented 62% of total revenues. As you can see from Slide 10. We're truly a global company with operations in 18 countries throughout the world. Our recent acquisition of PAAL which is based in Europe, changed the geographic mix bringing Europe up to 27% of revenues and reducing North America to 50%. PAAL has the number one market share position in Europe for balers for recycling and waste handling. We believe there is an important opportunity to expand PAALs reach into the North American market by offering its reliable high performance German engineered equipment here. More to come on this once ready to put our plans in action. Looking at Slide 11. You can see that our revenue and bookings in North America had suffered an over the last two quarters from a general environment of economic uncertainty which has impacted both our capital and parts and consumables business. In the third quarter, our North American revenue dropped to 47 million from last year's 55 million a 15% decline from a strong period of 2015, reflecting lower sales of both capital equipment and parts and consumables. North American bookings were flat on a sequential basis but declined 14% compared to last year's third quarter. As we've noted before, 2015 was an excellent year for us in North America which has made for some difficult comparisons in 2016. That said, bookings for last few quarters particularly for parts and consumables have been less than we expected. There is clearly some caution by our North American customers which is impacting buying patterns. Like North America, Europe was experiencing soft market conditions but a result have benefitted from the PAAL acquisition, which enabled us to report a 73% year-on-year revenue increase for the region and 34% growth in bookings. Sequentially both revenues and bookings were slightly below second quarter levels. We do expect to see a sequential improvement in bookings in Europe in Q4 as we're closing in on several sizable capital projects. Turning now to Asia. This was a strong revenue quarter for us as revenues were up 56% driven by a 55% revenue growth in China. In terms of bookings, we continue to experience low levels. As I mentioned last quarter, we do see increased coding activating and I'm pleased to report that after the quarter close, we received a $2 million order for stock prep system for recycled linerboard mill in China and we have a pending order from another stock prep system in Asia for $3 million. We do not recognize the pending orders of booking until it’s finalized and we received a signed purchase order and the associated down payment. In addition, there are several other projects in the pipeline which we hope to land by the end of the year or the first part of 2017. Finally, I'd like to make a few comments on our rest of the world revenues in booking. Rest of the world accounted for 9% of our revenues in the first nine months of 2016, and we continue to see volatility in the third quarter. Revenues were up 25% year-on-year driven by increased revenues in our stock prep product line in South America. Bookings were up a 11% in South America and up 7% overall in the rest of the world. Let me close my remarks with a few words about our outlook for the rest of the year. As I mentioned earlier, we tweaked our guidance for the full-year taking several factors into account. First our third quarter performance came in well above our internal expectations. That said, the second half of the year is evolving pretty much the way we expected it would. In the end, we reduced the midpoint of our revenue guidance range by $4 million to reflect a lower than expected bookings in the third quarter. Second, based on our strong earnings per share performance in Q3, we now think our full-year GAAP and adjusted deluded earnings per share will be slightly ahead of where we thought and they will come in and we'll increase the midpoint each by $0.01. For the full-year 2016, we expect to report GAAP deluded earnings per share of $2.76 to $2.82 on revenues of 412 million to 416 million. Our 2016 guidance includes $0.15 of acquisition cost, $0.12 of expense related to acquired inventory and backlog, and a $0.02 benefit from discreet tax items and a $0.02 gain from the sale of asset. Excluding the acquisition related cost and other income, our adjusted deluded earnings per share guidance for 2016 is 299 to 305. For the fourth quarter of 2016, we expect to achieve GAAP deluded earnings per share up $0.57 to $0.63 on revenue of 98 million to a 102 million. Overall, we expect 2016 to be the best year on our history for revenue and the second best year on our history for earnings per share despite the very challenging business conditions worldwide and a reduction in industrial spending. Our ability to outperform the markets we serve is driven by our unique value added line of products and parts and consumables, our worldwide team of technical experts to support our customers and our history of smart acquisition. Our profitability matrix and strong cash flow provide significant finance to resources to fund various capital allocation opportunities which drive cadence long term growth. These include internal growth initiatives as well as acquisitions which we'll discuss in more detail at our Investor Day on December 1st in New York City. I'll now pass the call over to Mike for additional detail in our financial performance in Q3. Mike?

Thank you, Jon. I'll start with the gross margin. Consolidated product gross margin were 45.6% in third quarter of 2016, down a 190 basis points compared to 47.5% in the third quarter of 2015. The decrease in gross margins from last year's third quarter was due to the inclusion of PAALs results in the quarter and an unfavorable product mix. As we indicated in our last call, PAALs gross margins are lower than cadence and as a result, we revised our guidance and gross margins for the year to approximately 45% to reflect this. Our higher margin parts and consumables revenue represented 58% of total revenue in the third quarter of 2016, compared to an unusually high 69% in the third quarter of 2015. Now, let's turn to Slide 18 and our quarterly SG&A expenses. SG&A expenses were 33.5 million in the third quarter of 2016, up 4.3 million from last year's third quarter and included an increase of 3.2 million from our recent acquisition of PAAL and a favorable foreign currency translation effect of 0.3 million. SG&A expense as a percentage of revenue was 31.8% in both the third quarters of 2016 and 2015. Let me turn to our EPS results for the quarter. In the third quarter of 2016, GAAP deluded earnings per share was $0.82 and our adjusted deluded EPS was $0.81. Adjusted deluded EPS excludes a $0.01 charge for acquisition cost related to the acquisition of PAAL and a $0.02 benefit from a discreet tax item related to the release of valuation allowances associated with state taxes. In the third quarter of 2015, GAAP deluded EPS was $0.78 and there were no adjustments to EPS. The increase of $0.03 in adjusted deluded EPS in the third quarter of 2016 compared to the third quarter of 2015 consists with the following. A $0.11 to the operating results from PAAL and $0.03 due to our lower effective tax rate. These increases were partially offset by $0.06 in higher operating cost and $0.05 due to lower gross margin percentages. Collectively included in all the categories I just mentioned was an unfavorable foreign currency translation effect of $0.02 in the third quarter of 2016 compared to last year's quarter due to the strengthening of the US dollar. Let me also take a moment to compare our deluded EPS results in the third quarter to the guidance we issued during our August 2016 earnings call. Our GAAP deluded EPS guidance for the third quarter of 2016 was $0.62 to $0.65. We reported GAAP deluded earnings per share from continuing operations of $0.82 in the third quarter of 2016. This $0.17 increase over the high end of our guidance range was principally the result of better than expected operating results from our stock preparation product line in China and North America and our fluid handling product line in China and Europe. In addition, our tax rate was lower than projected due to the release of valuation allowances associated with state taxes and the geographic distribution of earning. Now, let's turn to our cash flows and working capital matrix starting on Slide 20. Cash flows from continuing operations were 15.59 in the third quarter of 2016, down 0.4 million from 15.9 million in the third quarter of 2015. For the first nine months of 2016, cash flows from continuing operations were up 24% to 34.7 million. And we are on track to have one of our best years in operating cash flows. We had several notable non-operating uses of cash during the third quarter of 2016. We paid down debt of 1.2 million and paid a dividend of 2.1 million. We also expanded 1.8 million CapEx. There were no share repurchases during the third quarter of 2016. Let's now look at our key working capital matrix on Slide 21. Our days in inventory decreased to 95 days from a 123 days in the third quarter of 2015 as a result of several large capital orders that shipped in the fourth quarter of 2015. We had a sequential decrease in our AP days to 39 days and our days and receivables has remained fairly consistent at 60 days in the third quarter of 2016, compared to 58 days last quarter. Looking at our overall working capital position, our cash conversion day's measure calculated by taking days and receivables plus days in inventory and subtracting days in accounts payable was a 116 at the end of the third quarter of 2016, up 14 days in the second quarter of 2016 and down 19 days from the third quarter of 2015. Working capital as a percentage of revenue was excellent at a 11.6% in the third quarter of 2016, compared to 12.7% in the second quarter of 2016 in 14.7% in the third quarter of 2015. Strong cash flows from operations in the third quarter contributed to a sequential increase in our net cash position. Net cash, that is cash less debt at the end of the third quarter of 2016 was 2 million compared to a net debt of 9.4 million in the second quarter of 2016. That concludes my review of the financials and I'll now turn the call back to the operator for a Q&A session. Operator?

Thank you. [Operator Instructions] And our first question comes from Rudy Hokanson from Barrington. Please, your line is now open.

Okay. Thank you. Can you hear me okay?

Yes. Hi, Rudy. Go on.

Hi, Rudy.

Okay, great. Fine, thank you, nice quarter.

Thank you.

A couple of questions. In both cases where you were talking about your operating income performing better than expected or maybe where the strength in operating income came from. You mentioned China, both with fluid as well as with stock prep. I was wondering if you could comment on what you're seeing in China right now. If it's something that looks like a trend or if it was just something that came up in the quarter?

So, I'll tell you. I would say right now, and kind of looking forward and I'm kind of talking more about bookings as I look forward but obviously that turns into revenue. It's probably the part of the world right now, I'm feeling the best about. I mean, we have definitely seen a pickup in order activity. When I kind of said I think we'll have a sequential increase in bookings on the fourth quarter, China is a big reason for that. So, in terms of the performance, the revenue performance and the income performance in China and in all of our units operating there was quite good. The bookings in the third quarter weren’t terribly good in China, but I do see that turning around in fact, frankly the orders I just talked about pretty much get you a long way towards what we did for all of the third quarter. So, I am feeling pretty good about China going forward, I would say. First time I've said that and probably two or three years.

Okay, good. Also, can you tell us a little bit about your progress on PAAL right now? Now that you've headed within the company for a while, any changes you're making or what you see as developing there or plans you might have forward as we start looking out to 2017, even though those might not be said yet?

Sure. I mean, there is kind of three areas of sort of fundamental opportunities with PAAL. And one of the things I will say about PAAL, we're lucky it's a business that has excellent management and it's just doing fine almost stand alone. Then the question is what can we add to that? The main thing I think we can add to PAAL is assisting them and getting into the biggest market in the world which is North America. So, that means because their equipment is sort of a mission critical to these large waste handling facilities, it means helping them have a sales and service network here to support a customers will buy it and that I would say is a prime focus on working with people and finding a way to sort of get that done here and the state getting a first reference, all that kind of stuff. So, that will be as a multi-year project certainly, but I do think we have a great opportunity for things I talked about in the past with a competitive environment I think is very favorable to our coming into that market. The other two areas are while one is China, where we do have low cost manufacturing. We very much respect the German build and German manufactured quality that comes that PAAL is associated with, but I think they do have some stuff that's currently outsourced that we may have opportunities to lower some cost by manufacture in China. Third, is Brazil. There is import duties and so forth in Brazil. We have some manufacturing operations in Brazil and we may be able to help them become more competitive in that market. So, those are probably the three areas for PAAL.

Are they all ready in Brazil?

They do a little bit of sales in Brazil. They do actually sell, I would say in South America and Latin America in general, Mexico, they did some sales actually this quarter in Argentina. Brazil, I would say less so, it's the biggest market by far in South America. And I think they would benefit by having some way to manufacture some other products down there.

Okay. And then two financial questions. One, could you give us some guidance on what you think the tax rates is likely to be for the year or for the fourth quarter. I mean, how should we look at the tax rate. And the second question I have is that when your net debt now is cash and you bought a call in part with the idea that you had plenty of room to leverage, can you maybe talk about how you're looking at your balance sheet right now?

I'll let Mike go against with the tax question. Yes, go ahead Mike with the tax question.

Hi, Rudy. We had guided a 30% to 31% for our tax rate for the year but our year-to-date rate is a little under 28% right now. We're at 27.8%. So, looking at the fourth quarter, even if we come in on the low side of our guidance which was 30 to 31 for the year, we're going to end up under 30% for the year.

Okay.

So, that's on the tax. That's on the tax rate. And in regard to your question in terms of our balance sheet right now we have about 36 million available on our revolver and we also have an uncommitted unsecured 50 million facility if we need to utilize that.

And I think, just adding a little bit to that, Rudy, I know in the past we talk, we're not afraid of some amount of leverage. I think, given our high percentage to spare parts and consumables and relatively stable earnings and the cheap cost of capital. Some amount of leverage, I would say modest, would be quite appropriate for us.

Okay. I'll stop with those questions. Thank you, very much.

Okay. Thanks a lot.

Thank you. And our next question comes from Walter Liptak at Seaport Global Securities. Your line is now open.

Hi, thanks. Good afternoon, guys.

Hi, Walt.

Hi, Walt.

So, I want to ask a follow-on to the China question. It's good to hear that it's finally turning positive after a couple of years or are you able to comment like that. But why do you think it's turning, is it the economy that’s getting better there or is it just projects that have been pushed out for too long and start now?

That's a little bit of a puzzlement. I will say that the liner a business in China is doing well. They're making good money. The other grades I would say less so. There's still annulment of some of these projects are more in middle and western China, but frankly there is some of them are also in Southern China where we hear stories about some overcapacity. I think a lot of these guys are looking forward they're really looking forward to it overall kind of pickup. It will not, I don’t in any way think that we're going to get back to where we were on the early 2000s where you had demand growth up close to 10% a year. Most of the projections for demand growth in China are still kind of a mid to lower single digits. But it's not just its stock prep, its fluid handling, its water management, it’s a number of our product lines where we are seeing a good coding activity, new machines going and all that kind of stuff.

Okay, that’s great. What do you think the timing will be in China for some of those projects that are in the pipeline?

As I said, I think we're going to get the bookings. We've already got a bunch in Q4, I think we're going to get more. We'll probably get some in the first quarter of the year. In China we don’t do percent complete, so you wouldn’t be seeing that revenue really probably until the second half, yes.

Okay. And then you also called out capital projects in believe in Europe to the you thought we're going to come through.

Yes. I mean, yes. Yes, there's kind of a one kind of larger project in particular that we're feeling pretty good about. I hope to get it this quarter but if not it will certainly be early at 2017. But I'm actually pretty optimistic we'll get that this quarter.

Okay. Are these the kind of orders that would fill in the first half of the year or make you feel good about the?

So Europe is a percent complete market. I will say that typically if we get something in the fourth quarter, the first quarter maybe you'd recognize 10% of the revenue. It's not a big number, the bigger impact would be the second and third quarters of next year.

Okay, great. And --.

Yes. We lag it, we did get it in Q1 push everything back a couple of quarters but I think will.

Okay. And so, just so I understand the guidance with bookings down it sounds like 10% in the quarter excluding PAAL. Your -- and that's aftermarket parts or consumables pickup in the fourth quarter. That's why you guided conservatively for the implied fourth quarter.

Right. I mean, if you really look at it, what happened in the third quarter. We certainly had much, we'd higher we beat the quarter by $0.17. So, we were kind of a lush and riches in earnings per share extra but our bookings were lower and so therefore you lower the -- we expected to have higher revenue in Q4 from higher bookings in Q3. And now we're again going to have lower revenue in Q4, but we have enough, we were enough over in earnings per share in Q3, I think we pretty much end up as we thought we would.

Okay. Okay, so I'm good. Thanks, guys.

All right, thank you Walt.

Thank you. [Operator Instructions] And our next question comes from Dan Jacome with Sidoti & Company. Your line is now open.

Good evening.

Hey, Dan.

Dan, it's good to have you back.

Yes.

I'm back in action.

You are. That's great, yes.

Yes, no. nice job. I can't say that many names in the paper ecosystem are topping top line and bottom-line estimates. So, excellent.

Yes.

So, I just want to ask you this Analyst Day that's coming up, it'll I'm pretty excited about this. I think I hope get the story out there. And sorry if I missed it, do you have any idea of like what kind of might be not the furious thunder here but what might be the focal points. Or what do think are going to be some of the two or three elements you might want to address that day for the investment community?

Well, I mean in general, the way I kind of see it is, there is two parts of our growth as you know. Yes, internal growth and in the past I've talked about a number of internal growth initiatives we have. So, the two, we have two kind of operating guys, who each kind of have more or less half the company reporting to them. They are going to be talking about a little bit more detail about their business but in particular focusing on some growth opportunities. How are we going to grow a little bit faster than the market? So, they would, that's kind of the internal growth side. then I think we'll also spend a little bit of time on acquisitions, how we think about acquisitions, how we integrate them and we'll have actually one of our recent acquisition one of our targets, the management from one of our targets come up and give you a little bit of perspective from their point of view. Why did, what did they see as the pros and cons of joining with Kadant. How did we help or not them perform better ones they were part of Kadant. And then what kind of role on that in the kind of some kind of a long term picture of how we expect to grow going forward.

Okay. And then just to double check, I don’t mean covering too long. Is this your first Analyst Day or in a while or what is?

It’s the first ever, yes. It's the first one ever.

Well, that's excellent, yes.

So, we, yes. I mean maybe shame on us, we haven’t maybe paid the attention we should but I do think it will help people get a better understanding of the company itself meet more people than me and Mike. And maybe get a little bit of deeper picture. So, shameless plug but I think it's 2 o' clock in the PAALs hotel New York City December 1st.

Okay. Looking forward to it.

Yes.

Yes.

Thanks, Dan.

Thank you. [Operator Instructions]. And I'm showing no further questions in queue at this time. I would like to turn the conference back over to Mr. Jonathan Painter for closing remarks.

Okay, thanks operator. Before closing, I'm going to share with you what I consider the key takeaways from the quarter. First it was an excellent quarter driven by strong profitability despite the fact that parts and consumables were only 58% of revenues. Second, as we talked about bookings levels had been impacted by the weak industrial markets, but we do see encouraging signs in China and Europe and expect a sequential bookings increase in Q4. And finally, we expect 2016 to finish about where we thought it would but the relative contributions in the third and fourth quarter are different than we expected. So, thanks very much for your support. I hope to see many of you at our Investor Day conference in December 1st in New York. And we look forward to updating you in quarters to come. Thanks very much.

Thank you. Ladies and gentlemen, thank you for your participation in today's conference. This does conclude the program and you may now disconnect. Everyone have a great day.