Caesarstone Ltd. (CSTE) Earnings Call Transcript & Summary

Good morning, and welcome to everyone to this session of the UBS Industrials and Transportation Virtual Conference. My name is Nishu Sood, and I am the building and building products analyst here at UBS. And it's my pleasure to welcome Caesarstone for this next session. From Caesarstone, we have Yuval Dagim, who is the CEO; and we also have Ophir Yakovian, who is the CFO. Both of them joined the company in 2018. And also, I have on the call, my colleague, Lauren Sclafani, who is UBS' Head of Corporate Access; and Rodny Nacier and Brad Cray of ICR. So we're going to get kicked off right away, and I'm very excited to host this presentation. There aren't many companies out there whose brand name is associated so strongly with the product category that they sell. It is the case with Caesarstone in quartz surfaces. So very excited to host this presentation. We're going to be doing a fireside chat type format. [Operator Instructions] And so we'll start off though with a brief introduction of the company by management, and then we will get started off with our discussion. Please go ahead.

Thank you, Nishu, for your introduction. Allow me to elaborate in a few minutes on the Caesarstone journey. Caesarstone is indeed a leading designer and producer of the engineered quartz surfaces. We actually invented the quartz category a few years back, a category which is growing globally from 10% in 2010 to 20% of the global countertop market today. We are #1 or 2 in our key markets, with a global market share of about 9%. As for our revenue split, about 2/3 of our business is in the Americas, mostly in the U.S. and Canada; just under 25% is in the APAC region, led by Australia; and the remainder is split between the EMEA region and Israel. Ophir and I, as said, have been with the company just about 2 years. And during this time, we have put in place our Global Growth Acceleration Plan to reignite growth and to better allocate internal resources. The plan has included expansion of our sales force in the U.S. very significantly, improving our logistic distribution network, technological infrastructure build, cost rationalization for better allocation of resources to be invested back in the business, invest in product innovation and more efficient management of our go-to-market supply chain and production. We are pleased with the implementation of the plan to date, which allowed us to deliver solid results in Q1 2020. We have experienced 7 consecutive quarters of core organic growth in the U.S., where we do see the greatest opportunity for growth. In addition, we recently expanded our product offering to all U.S. Home Depot locations. Early this year, we introduced our outdoor quartz product line. I think it's a novel market opportunity for quartz countertop industry, and we have exciting lineup of new product launches that we expect to roll out soon. Naturally, in recent months, our business has been impacted by COVID-19 crisis similar to other building product companies. It is important to say that our people are safe, and we are prepared to navigate the COVID-19 crisis from health and safety perspective as well as from business continuity ones. We have a clear strategy to guide us, and we have taken significant cost out of the business to meet demand. In addition, we have a very strong net cash position, with 0 financial debt. Lastly, we have a well-positioned leadership team, and we intend to come out of this pandemic stronger than we came into it, with an even better performing business. With that, I'll turn the call back to you, Nishu. So thanks a lot, and let's move on.

Thank you, Yuval. So thanks for the introduction to the company. Let's start off with the recent results. The first quarter, prior to the impact of COVID, marks significant progress for the company in terms of inflecting to growth again. You mentioned that the core growth had been positive for some time. The core growth was strong enough that in 1Q, for the first time in 7 quarters, you had nominal growth, principally on the strong U.S. demand. It wasn't all consistent, though, in terms of demand trends. There were some mixed results globally. Can you take us through the pre-COVID picture? How is demand sales momentum building across your different regions? Where was it somewhat more challenged? And yes, what was -- basically, let's start off with what was the state before the economic disruption.

I think it's a good reflection of the reality, Nishu. In the first quarter, probably until 10 days before the end of the quarter, we are performing quite well in all regions, and all regions were either better than last year or better than the plan. Altogether, we were performing better than the plan we put together for this year. A plan, which was quite, I guess, impressive from our perspective, with demonstrating growth year-on-year. So we also got to something like double-digit growth in the U.S., just a few days before the pandemic hits our business even though we finished the quarter still in a -- with some growth against the same quarter last year. So all in all, most of the regions were performing quite well and in line with our plan.

Got it. Now in the U.S., the -- maybe the biggest driver of sales seem to be the new Home Depot partnership. That is exciting from a sales growth potential just given the size of that channel and the breadth and their ability to reach a -- your ability to reach consumers in a new way. Whenever you start off a new partnership with Home Depot, investors oftentimes wonder where -- what kind of factors -- obviously, there's no inventory load-in, I believe, because it's mostly custom orders. But was there any special promotional activity that might have benefited sales as you ramped up with Home Depot? And what is the longer-term structure of sales support for the partnership to drive its success?

I think it was a -- it is a few years old strategy to get into the big box channel, and quite successfully, we agreed with Home Depot on a full distribution to all their stores in the U.S. closer to Christmas time last year. So we started the quarter with a full presence in almost 2,000 stores of Home Depot, with a nice variety of 13 models branded with Caesarstone. Having said that, I think the ramp-up of the revenue is pretty much in line with the expectations, and we do see it as a natural progress. There was not a significant promotion plan at the time. I think we are making sure that we are giving good service. So our team is around those stores to make sure that we are on the call to any assistance needed to support the store team. But all in all, there was nothing special that we did in terms of commercial activities. It is important to mention that we are very happy with this progress, and it was definitely helping us to deliver good results in the first quarter.

Right. Now in other regions around the world, there was -- you mentioned some sales pressure from a continued competitive environment. Again, still thinking pre-COVID and trying to assess where the progress that the company was making under the Global Growth plan leading into this economic crisis, what was the competitive situation? How -- had it begun to settle out in some of your key markets such as Australia? What are some of the key things that you were observing that might have given you comfort or pause as it came to -- when it comes to competitive pressures in some of your other key markets?

I think, initially, back in 2019, when this question was asked regarding the exit of the Chinese product offering from the U.S., we always refer to the fact that we are a global company, and we're not really sure whether it would be positive or negative because we will be seeing more Chinese offering in other markets of ours, namely -- or mainly Canada and Australia. I think that is what we experienced in the second half of 2019. So we were not hit by surprise, and I think the team in both countries learned how to cope with this increasing competition level. In addition, we are, ourselves, having an OEM supply from China. So we are competing better ourselves in the market, and our competitive power in those markets is as strong as before. So all in all, I think we have seen some bottom of this competition in terms of volume, and it has been flattened out just before COVID-19 impact.

Just to add to that, Nishu, in Australia, the global housing market -- the housing market, sorry, in Australia is very soft. I mean I think it's the softest market that we have experienced in the past decade or so. So that, coupled with more intense competition, some credit shrinkage to mortgages, et cetera, there is -- that creates a very challenging market condition. So I think Australia, we've seen a negative trend recently, and that continued prior to the pandemic that was expected. And I think that we saw some stabilization in that market in the first quarter. And in Canada, again, it's not the same -- as weak as Australia, but it was a softer market -- housing market conditions compared to what we've experienced in 2018 and before, and this has also impacted our results there.

Got you. Got you. And shifting to gross margins. You had a very strong gross margin performance in 1Q prior to the crisis. Can you walk us through -- just given how significant the improvement was, and it was obviously notable -- obviously, that's one of the main goals of the Global Growth Acceleration Plan is to improve your gross margins to the 32% to 35% range longer term, significant progress on that 1Q, again, pre the crisis hitting. The major -- what was the major driver there? Can you walk us through kind of the impacts on the -- was there a pricing benefit in some of your markets in the U.S. perhaps? Was there -- if there were costs taken out, what specific cost categories drove that gross margin improvement? It was a large improvement, so I wanted to dig into the specific drivers of it, please.

Yes, that's a good question. First, with -- that came as planned, more or less. So we've expected that. It's not -- it didn't come for us as a surprise. I think that the main factor is the capacity utilization of our factories. We've increased it to approximately 90%. If we take 24/7 of the 100%, then we were close to 90% increase in capacity in all of our factories, both in Israel and in Richmond Hill, and we were on the path to go into full utilization later in that year. That obviously -- plans were changed. But the factory utilization, I think, is the most -- the biggest contributor to the expansion of gross margin. So this was one thing. Second thing you mentioned, the more we sell in the U.S., the better mix and the prices that we get. So the regional and product mix was another factor. We also had lower raw material prices that also helped us. And on the flip side, we had the foreign exchange negative impact, and the supply chain costs that were higher than we've planned for the quarter, and this is something that we should have avoided. But we had some circumstances, and we had higher supply chain cost -- related costs in the quarter. So these were the main factors that drove it. The main one is -- by far, is the utilization of the factories, because that increased the fixed cost absorption per unit, and that's the major contributor. And if you ask about the long term -- you mentioned the long-term goal of 32% to 35%, so I think that looking at the first quarter, getting close to 29%, we're out being at full utilization. So I think that if you go to full utilization of our factories with all the Global Growth Acceleration project to improve productivity and supply chain efficiency, mainly in the U.S. -- improving the distribution in the U.S., and our introduction of new and innovative product that bear a higher gross margin, we think that 32% to 35% is achievable. And to mention lastly is that Q1 is the smallest quarter for us in terms of revenue and the lowest in terms of gross margin due to seasonality. So we should have done better in subsequent quarters in 2020.

Got it. No, that's great. You actually anticipated my next question as well, which was, yes, the longer-term targets. The big box sales often -- or sometimes bring concerns about gross margin dilution to investors. That doesn't necessarily have to be the case, but some investors are concerned -- can be concerned about that. Is there any comment you can give us on whether investors should be concerned about growing sales through the big boxes as it might impact gross margins?

Nishu, I think that, all in all, we are positioning quite well in Home Depot. The models and the colors and the products we have there are not supposed to -- advise us with any dilutions on margins. And we are not expecting that. We kind of have it in our long-term plans anyway. But we are not expecting any dilution of our margin on the fact that we are penetrating more with Home Depot.

Right, right. Okay. And you mentioned that a major driver of the gross margin improvement in 1Q was improved capacity utilization. Turning to now the economic crisis, and obviously, the impacts that, that is having on demand for not only you folks, but for many, many companies in -- across many industries. You have cut capacity in response to the economic crisis. How much have you cut it roughly? Are you matching it to the pace of demand decline that you were seeing recently? Or are you -- you're cutting it in anticipation of some recovery in the back half of the year? How are you managing? How much are you cutting capacity? And how are you thinking about the capacity versus potential for demand improvement later in the year?

We should put a light on what we did in 2019, because it's kind of the second exercise for us on adjusting our capacity to market demand. And in 2019, it was down to demand that we were -- could or couldn't create in the markets, and this time around, it's a global change in demand. But we are kind of practiced ourselves last year, and we demonstrated that we can be agile enough not to build inventory, actually to reduce inventories and to burn less cash, actually creating $50 million more last year. So we're going to do something similar this year. Now on the back of global change in demand, but with the same exercise, we're going to be adjusting or we are adjusting our capacity to the current demand. We feel that we have a very healthy inventory position in all our markets, and the inventory is now in the markets and not in our yards. So very close to the markets to be able to be very quick to respond to any market demand. So whatever the scenario will be that recovery or another recovery, we will be there to serve our -- to service our customers at the best, with a very short time to market.

Got it. This is actually a good time to discuss the inventory. You mentioned the inventory, and there, you've been quite successful in reducing your inventory levels and maintaining customer service levels. You've reduced your inventory from $158 million at the end of '18 to $127 million at the end of '19. And so where do you stand in terms of reducing or taking excess inventory out of the system? Now I know it's difficult to do this, but I want -- I'm asking this question in terms of separating out the significant fluctuations we've seen because of COVID. So maybe the way to ask the question is, before the economic crisis began here, were you done in terms of your inventory adjustments? Or were you looking ahead and saying, we can make the system even leaner? Or we can make the system even leaner in terms of inventory over the next few years?

Yes, that's a good point. I think we kind of summarized ourselves that the inventory level that we entered 2020 with is the place we want to be. So probably a bit more than $127 million. We kind of expect it to be $130 million, $135 million, and this is where we will be in 2020. We will adjust our production in line with it so not to create mountains of inventory again. So $130 million, $135 million will be probably the right place for us still to be with a healthy inventory level to serve the markets.

Got it. Got it. So it sounds as though the progress there was substantial. Maybe not complete, but fairly substantial. Thinking about the -- turning back to capacity, managing capacity utilization heading into the crisis was a significant driver of your success in terms of margin. Obviously, an important plank of the Global Growth Acceleration Plan. The overall industry's level of capacity, global capacity, obviously, coming out of places like China and Turkey and India, was part of what pressured the overall industry substantially in 2016 to 2018 period. Where do you see that standing now? If there was excess capacity that had built in the industry or growth in capacity far faster than what the market was supporting, how has that corrected since then? And do you still see substantial overcapacity? And again, I know that the crisis will introduce additional challenges. I guess I'm thinking more where was capacity standing relative to demand globally in the industry early in 2020.

The increase in capacity over the last, let's say, 3 to 5 years, was also on the back of increasing the quartz penetration in the market as the right application for countertops. Actually, we do believe in more and more consumers in the U.S., and kind of believe that this is the right material for countertop as a whole. So the increase in capacity was actually to serve a greater market. And as I mentioned, maybe I mentioned it for globally. But if you look at the U.S., the increase in capacity over the last 4 years, also the increase in penetration was from 15% 4 years ago to something like 22% in just last year. So more and more consumers in the U.S. are getting used to have countertop in their kitchens. And for that, actually, the increase in capacity was serving -- servicing them very well. Yet, we are more -- competing more on the premium level with other companies like us. And we will not be really competing in each and every consumer segment with Eastern countries' offering, if you like, from the Far East. So I think -- I was -- we were not experiencing a lag or overcapacity, and it's more about the current crisis that is driving everyone to -- I guess, to adjust the production capacity to the current demand. So it's kind of an overall approach on all companies.

Got it. Got it. Yes. No, that makes sense that -- yes, especially at the lower price point segments, that the capacity can create demand and vice versa as well, obviously. But -- so the -- with the exit of the lower-priced Asian imports into the U.S., that -- obviously, price point, average price point has likely risen for what is sold on quartz surfaces in the U.S. How should investors then think about the quartz share of the market? So as you mentioned, the U.S. consumer has become more and more familiar, and the U.S., I think, is 45% of your sales. So the U.S. consumer has become more and more familiar with quartz countertops or surfaces overall in recent years, and the penetration, as you folks point out in your investor presentation, went from 5% to 22% in '18. But with the absence of lower cost imports, it -- did it fall in 2019? I mean was there enough increased substitution or market share gains for quartz versus other products? Or did the lack of the lower cost imports, do you think, limit the quartz share growth in the U.S. in '19?

Let me start with the view, and then Ophir will be adding on the price point, et cetera. But I think I would like to start with, if you like, the role of the brand in this conversation in the market. And as penetration is increasing and more and more consumers are getting to used to -- to use the quartz as the material for their countertop application, the Caesarstone brand, which is relatively powerful brand, and there are some other strong brands in the market, their role is actually to trade up consumers from the current, if you like, propositions of quartz to the more premium ones on the -- in our example, the Caesarstone brands. So our job is also not just to increase penetration, which is always, but also to make sure that the consumers are, at the end of the day, are choosing us as the quartz solution for their countertop.

And Nishu, if you look at the data for -- import data to the U.S. of quartz countertops, so it's -- you can see that the -- there was -- the Chinese were pretty much replaced by other low-cost manufacturer, mainly India and Turkey, were the main replacement, but other low-cost manufacturers, such as Eastern European and others. So eventually, there's no vacuum. And if there's a demand for low-cost product, it will be available from different sources. So our potential in the U.S., we never based it on the tariffs. It's good to have less competition, if that's the case, but we think that there's a huge potential in the U.S. for us. We are under covered in many of the areas that we operate. We don't have enough well -- good coverage, and the Global Growth Acceleration team, together with the creation of the North America region at the beginning of 2019 that we've set with the new management team, we think that is taking the region and the U.S. in the right direction, and I think that we already seen the -- we've seen the results coming. And we hope that once the crisis and the economy rebound, we can pick it up from where we left it and continue the trend.

Got it. Got it. And the quartz, if you look at the market shares of quartz in your various end markets, it's such a wide array, ranging from the low 20s -- in the -- low to mid-20s in North America to the mid-40s in Australia to the 80% range in Israel. So how should investors, and how are you thinking about the continued market share growth? In Europe, I believe the levels are perhaps lower. And so is that an opportunity? Where -- the U.S. is, as you've mentioned, the greatest opportunity. Is that just because of size? Or how should investors frame the longer-term growth opportunity for quartz taking share from other materials in surfaces in your various end markets?

The 2 drivers that we can address this question by could be, maybe if they're looking in the history, and if you look at the U.S. penetration from 5% to 14% to 22% penetration of quartz as a solution for countertops, this is one dimension that you might be taking forward, say, okay, if the journey is like that and consumers find these applications the right -- or maybe there is some room to grow in the future, maybe getting closer to Canada, which is 20, 25 and still growing or maybe even Australia, which is -- which almost every second countertop in Australia is made of quartz. And also, if you look at the more formal note from Fredonia as a benchmark, they're expecting something like a 6% CAGR increase in over the next few years for quartz. And it's the faster material that is growing in countertop. So if you take those 2 drivers, if you like, and put them to together, you'll say, okay, there is some room to grow in terms of quartz share. And in addition, we think we have our own play in the market, and there is room for us to grow our own market share in the U.S. and in North America as a region.

Great. Great. We should probably turn to -- we've been talking more about the longer-term potential, and obviously, the progress under the Global Growth Plan. Just turning to the impact of the economic cycle here. Let's start with housing markets. Housing markets fell sharply, housing activity fell sharply in many markets, including the U.S. with the stay at home orders and the lockdowns. But there has been a surprising rebound in housing activity in recent weeks. So I wanted to get your thoughts on how do you think this will affect your company. On the one hand, there's the argument that, that housing rebound is just consumers seeking more space, and affordability has been an issue. If they're just seeking more space, they don't care about the quality of that space. They don't care if it has quartz surfaces, they just need the space. But on the other hand, the dollars that would have gone towards travel, entertainment might now go towards remodeling. How do you think that, that all shakes out and affects your company?

First, I think it's quite encouraging inputs to get from the market that they see some rebound in the housing market. It's definitely a positive sign. Yes, we are looking on the way we enter to this crisis, and we, as mentioned in few other questions before, we think we entered to the crisis in a relatively strong position. So we have the leadership team in place. We have the North American region running for the second year quite smoothly. We have a greater sales division in the U.S. to address and to cover the different markets better, and we have a healthier inventory position in all our warehouses in the U.S. So if we will add it to the fact that we would like to take ourselves as relatively agile and fast-acting company and team, I think we will be -- whatever the recovery scenario will be advised to us, we will be there to act promptly and to make sure that we take advantage of these opportunities, servicing the customer -- our customers faster maybe than others, and maybe even increasing our market share in our main markets, in the U.S., but also others. So I think it will be difficult to predict what will be the recovery shape in the market. But it's important for us to be ready for any of the scenarios. And we are working on a few scenarios. And Nishu, that way or another, we will find ourselves adjusting our plan anyway. But as we demonstrated so far, we will be doing that in the coming weeks and months according to the read that we will get from the market.

One trend that seems set to accelerate with the COVID crisis is online shopping. And at first glance, surfaces, countertops would seem to be pretty resistant to online shopping. But then when you begin to think about samples and online configurators for surfaces and pricing tools, I mean, Home Depot has a decent tool in this regard. How is your business overall set up to handle the increase in shopping from home? Is it channel dependent? Does it favor then the more sophisticated retail channel? But what about dealers? So how overall do you see your -- the industry or your business' preparedness for increased e-commerce?

So although none of us were really prepared in 2019 for the COVID-19 event, we, in our Global Growth Acceleration Plan, we actually launched 2 pillars to address exactly this point, and it's under the technology transformation pillar and the go-to-market pillar. And in those 2 pillars, we actually looked into it, it was kind of a year ago, when we started looking at the assets and the way we do business with consumers and customers, and we figure out that we need to do something different and to make sure that we are bringing more tools to our teams to communicate and engage consumers and customers. And this is exactly what we are working on. And although we have a very -- we had a very rich investment or CapEx plan for this year, one that we needed to change and to make sure that we are managing the cash -- our cash very closely and stop some of the projects, we haven't stopped any of the projects that is around our go-to-market new models and the technology transformation project that we are working on. So when we are working on new engagement tools and maybe some to support new growth engines, we are keeping on investing behind those projects. And I think, sooner rather than later, we'll be able to present to our teams and to our business partners some new tools of doing business with us.

Got it. Got it. The -- in terms of the shutdown impact on your production, you mentioned in your most recent quarterly call that all of your facilities have continued to operate. Is there any update there? Any impacts on the shutdown? Or obviously, reopenings in terms of your production and supply chain? And yes, so just any update there?

Indeed. We are adjusting our production capacity, as I've mentioned before, according to the inventory level of this year. And this is, again, a change from a year ago. So we are really close to the inventory level of each and every SKU in our DCs. And we are producing in line with the level of this inventory. And we needed to adjust our production capacity starting June this year, of course, a few days ago, and we are now taking some capacity out in our Richmond Hill plant, and we'll be operating 5 days in full only 1 line of the 2. And in the 5 lines that we have in Israel, I guess, 4 of them will be moving to work 5 or 6 days a week and not 7 -- and not 24/7, as they operated until the end of May. So this is the way we're adjusting our production capacity in order to the -- according to the inventory level.

And in terms of covenant in destruction to the business, so there was no -- disruption to the business, sorry, there were no -- nothing -- health and safety is very important for us, and we put all the measures and procedures to ensure the employees' health and safety. And this did not affect our production.

No disruptions in the supply chain, either from raw material perspective or sending the finished goods to the market. So full business continuity all those months long.

Got it. Your balance sheet is -- and we just have, I think, another 2 minutes here. The -- your balance sheet is very strong. You have a net cash position, and it should serve you well heading into the downturn just for managing the volatility of demand. Does it also create any opportunities perhaps in terms of acquisitions or other investments?

We introduced -- in the Global Growth Acceleration Plan, we introduced a pillar of business development, something we were working -- or we have been working for the last 12 months. In line with the strategy we presented to our Board of Directors in December, we will be continuing to pursue opportunities under those pillars of our strategy. And obviously, our position is allowing us maybe to act upon those opportunities as we will find them attractive to our company. Once we find those bolt-on acquisitions or other businesses that can be part of the Caesarstone portfolio, we will be working on that and advise the market accordingly.

Got it. I think we're at our time at the end of the session. I want to say thank you to Yuval and Ophir and also to the folks that are attending this broadcast and also to my colleagues and the folks from ICR. Thank you, again, to everyone.

Thank you very much, Nishu.

Thanks for having us. Thank you.