NCI Building Systems’ (NCS) CEO Don Riley Presents at RBC Capital Markets Global Industrials Conference (Transcript)

NCI Building Systems, Inc. (NYSE:NCS)

RBC Capital Markets 2017 Global Industrials Conference Call

September 13, 2017 3:00 P.M. ET

Executives

Don Riley – President and Chief Executive Officer

Mark Johnson – Chief Financial Officer

Analysts

Bob Wetenhall – RBC Capital Markets

Bob Wetenhall

Good afternoon everyone, it’s Bob Wetenhall from RBC Capital Markets. Thank you for joining us at our Annual Industrials Conference. Real excited today to have the NCS team joining us here from Houston, Don Riley, new CEO; and Mark Johnson, CFO. Thank you for making the trip gentlemen, appreciate it. I was hoping just to start because you are based in Houston and the unfortunate weather events, if you could just kind of recap how you are dealing with the devastation there and what the operational impact has been on the company?

Don Riley

Yes, that was an awful tragedy for a lot of people that impacted that community and impacted the lives of our employees in a material way. We’re happy to say that there wasn’t any loss of life in the NCI family. There were – about 10% of our employees were directly affected by materially bad flooding or an impact on their communities, and we have two major plants there and we have two depot locations there in our corporate headquarters.

And we had minor flooding in a couple of the plants and flooding at one of the depots, but all of them are fully operational and up and running now and Houston is still not fully dried out, but it is getting pretty darn close. So as we share, we have experienced a short-term dampening effect in the Texas markets tied to that, but we fully expect going forward to that there will be a recovery coming.

Bob Wetenhall

That is good news. So it sounds like you are back in business. Maybe you could remind me Mark, what are your guidance targets for this year?

Mark Johnson

Sure. So we gave guidance for our fourth quarter. We widened our range of guidance a little bit because of the hurricane that had just occurred in Texas and it’s a large market for us. We widened our range, so we gave guidance of $48 million to $62 million in EBITDA for the quarter, which roughly puts the midpoint of our annual guidance at about 167, 169 million I believe.

Bob Wetenhall

Got it. And so when you are thinking about – before we get into kind of more recent financial events, can you talk me through about what NCS really makes in the customer base? Just give me a brief nutshell, you have multiple business units inside the NCS umbrella, but what’s the core competency of the company and really the rational for the business?

Mark Johnson

Sure. It’s a pretty straightforward. We are a vertically integrated billing materials company focusing on steel materials that we start with oil coding and so we quote our own material that goes through our business lines. Whatever excess capacity we have in that business we sell externally in the marketplace, but the primary emphasis is for our own internal manufacturing and production. That coil coating then feeds into three other key business lines.

The first one we refer to as legacy components. That’s where we provide pieces and parts into the industry that’s doing a building construction, a single scan siding, roofing panels, [indiscernible] so all the products and parts that a contractor may buy to assemble a building. They play in all end users and we go to market through hundreds and thousands of customers across all of North America and then we have…

Bob Wetenhall

When you say go to market, I mean, do you have a retail storefront, how is distribution achieved for that?

Don Riley

Great. So we have since people that are actually selling to these end customers who are buying the products from us. So it’s not a distributor. We are directly selling to those customers who may be actually using the product to build buildings themselves or they may be selling to someone who is actually getting ready to finish a building. And these are 40 years to 50 years of relationships that have been built. So they are very strong and then they are very sticky associated with the company. They have been with us for a long time and they are a great customer base.

Bob Wetenhall

Got it. So you have an established client base that you service with a direct sales force. And talk about the third leg of the business.

Don Riley

So the third leg of the business is our engineering building systems where we actually will provide engineering services to develop and design the envelope that we will certify and so we will provide the structural steel for the buildings, as well as the siding and roofing and other buyouts that a contractor may need to furnish that total envelope in the building. So at that point we’re providing the whole package to a customer who is in, we will ship it to his site and they will begin the erection for that building.

So we’re adding value in the process of doing the engineering services and bringing the materials together and then shipping them to a site in the bill sequence for them. And again we have a dedicated builder network that we work with that is 40 years in the building that is their bidding on projects out in the marketplace across all end users and again a very sticky customer base that has been with us for a long time.

Bob Wetenhall

Got it. That’s a great overview of the business. You’re vertically integrated, you buy steel, you paint it and then you fabricate it, can you talk to me about, from the CFO chair, steel prices are volatile, what’s the impact if steel prices rise on inventory in either direction, how do you manage that input cost volatility and what’s your ability to pass on changes to the customer base?

Mark Johnson

Great question Bob. So steel obviously is a big part of our business. It represents approximately 50% of our cost of goods sold and it is a volatile commodity and effectively that cost passes due to our customers generally speaking fairly seamlessly, and the reason that that occurs is because we don’t manufacture anything and put it on a shelf, everything we manufacture is to customer specific order.

So in broad terms we are shipping something that the customer has ordered and we’re quoting it to him at the time they are ordering it. So we are not locked into a price point like selling a refrigerator or something like that. But there are three parts to our business, three segments. And two of those segments represent about 50% of our volume or what I would call quick turn businesses because we will take a sale of the day and we will ship that product next week or the week after, so it is very fast.

In fact we are shipping out of stuff that’s already an inventory, and then the other half of our business of our volume is a longer-term sale, it’s our buildings group. And it will take an order today and typically ship a building in about 90 to 120 days. So we won’t even start manufacturing that order for that period of time. We will start manufacturing at a week or two before it could be delivered. So there’s a longer time lag between sale and actual development of that product.

So those two different sales cycles, the fast and the longer term create a different impact on our margins as those play out. So in the shorter term business steel prices go up, they will actually start selling faster, selling at a higher price point than our inventory basis. So that margins will expand, but in the slower turn or the longer turn business they will start to see some margin compression because they may go back to that customer and get a price increase if needed, but will they get the complete margin on that incremental cost of steel, sometimes they don’t.

So their margins will compress a little bit. Generally speaking these two parts of our business will offset each other and we will have a net zero impact as a result. However, I would say that because of the volatility and the speed with which inventory and cycles change in 2016 and 2017 we saw about an 80 basis point benefit from steel declining in 2016.

So a net benefit about 80 basis points, but then in 2017 because of the slowing of the activity levels in the fourth quarter – third quarter and fourth quarter we’re actually going to see a detriment to our margins as a result of steel of approximately 100 basis points. So between the two of those you average those, you have kind of a normalized margin.

Bob Wetenhall

So it’s kind of something you can move through the volatility over an extended time frame, but if you just look at any one point in time it can have an outsize impact on a 90-day look?

Mark Johnson

On a quarterly basis you are going to have our outsized impact. On a segment of our business you could have an outside segment, but generally speaking you are not going to see more than 30 to 80 basis points impact positive or negative to the consolidated company.

Bob Wetenhall

And talk to me for a minute, if we just fast forward to recent history it kind of was like strong pricing, but soft volumes in the last quarter, what’s going on volume wise, you had raised your guidance lowered the guidance, is there a change in the marketplace that’s impacting your visibility right now?

Mark Johnson

That’s a great question. So we comment that from several different perspectives. We look at a cocktail of metrics and statistics to look out 12 to 14 months on what’s going on in an industry sector and we will use low-rise nonresidential Dodge Data. We use architectural building index, and then we use residential construction starts because when they are out 12 months to 14 months ahead of this, generally around those communities, then you are seeing a lot of the buildings rebuild. And when you put those together they give us about a 90% correlation to what we are going to see over a 6 month to 12 month horizon.

When you look at those statistics, I have told 12 to 14 months, we see 3% to 6% growth rate for our businesses. And when you then start to look at how does that correlate to what we’re seeing inside of our businesses today in our insulated metal panel business, which is growing low double-digit rates we continue to see that as the growth curve for that and it reacts a little different because that’s more about taking share from non-traditional or other traditional products and that whilst tilts-ups and so it’s actually growing at an accelerated rate because it is taking share from leather products and then in our legacy businesses we’re seeing that low slow growth rate and that hesitation or slowness started probably towards the end of Q1 that we talked about in our hesitation and have continued to see that. So…

Bob Wetenhall

What do you think – I understand the material substitution from the insulated metal panels and it sounds like it has got great adoption. What do you see in the legacy business, the hesitancy and also is the reluctance you’re seeing to make the purchase decision consistent with ABI and Dodge Data or is there a [indiscernible] where you suggest, I mean is it just a transitory or is this a, new trend line that we should be focused on.

Don Riley

We don’t necessarily see a new trend line as for a period within that low-rise non-res. We have been seeing 3% to 6%. What we have experienced, there is a couple of things. One, we have seen within our customer base that they had struggled in getting skilled labor. If you remember coming out of the election last year there was enthusiasm in a burst of activity in our area, and we realize that and then our customers had to consume that and so they had this bubble land skilled labor and we hear about skilled labor across all the sectors these days.

Then as the year began to progress, not only did we continue to hear about skilled labor, but the enthusiasm, our customer base is a lot of small shops, entrepreneurs, the enthusiasm of our potential tax reforms started to wane enthusiasm over a healthcare reform began to wane. So I think there are views on the marketplace from being really high enthusiasm started to wane a bit, and they got a bit conservative and getting over their skies and investments and their end customers similarly.

And we’re starting to see that come back a little bit, but that’s what we think led to in our area of maybe instead of seeing 3 to 6, we’re probably seeing to 2 to 4 and our forward-looking indicators and bookings “support” that 3% to 6% us being in the lower-to-mid range of that when you look at our bookings and our legacy businesses and our open orders in the visibility we have.

Bob Wetenhall

Got it. So it sounds like this is kind of four transitory disruption due to less enthusiasm as opposed to a break in trend and I think your predecessor hit for an extended period said the market is choppy and now said it’s more stable. From your commentary it sounds like the market is stable, except you had a momentary pause in demand? Is that accurate to say?

Don Riley

That’s accurate.

Bob Wetenhall

When you are thinking about, forget about the quarter, let’s talk big picture. NCS, 2020 what do you guys look like?

Don Riley

So, I’m excited about the potential going forward. We – my predecessor has done a lot of work in focusing on our facility rationalization, getting our commercial organization aligned and how we want to go to market in more efficient, getting supply chain playing a more critical role in the business. And now we want to build off of that platform and drive forward. And there’s three exciting areas that we’re fully committed to.

We’re going to be sharing a more detail over time. First one is, two of the three are all about cost becoming more efficient and making sure that in a low growth environment that we’re performing the way we want to in the marketplace and outperforming in the marketplace. So one is in advanced manufacturing, you consolidated all these facilities rationalizing, but there is a lot of opportunity inside of the four walls to get leaner or more efficient take labor-intensive functions and to automate them.

Key areas for us with a lot of labor are frame production for our engineering buildings business, trim manufacturing for our legacy components and buildings business, and then door manufacturing. All very labor intensive. When you automate that you’re going to get a cost improvement in your manufacturing cost and you get quality improvement, which will drop to the bottom line and then we will be much more flexible as a business in being able to scale up or scale down wherever the marketplace takes us.

Bob Wetenhall

Does this require advanced manufacturing initiatives, sound like they are mainly to lower headcount and more automation, do you have a CapEx budget increase to fund these improvements?

Mark Johnson

There will be a small increase in CapEx funding. We typically have had CapEx in the range of 1.5% to 2%. I think over the next couple of years we would see us be closer to that 2%. Not outside of our [indiscernible].

Mark Johnson

So it’s not a material massive change in capital spending, I know you kind of [indiscernible] significantly more capital into the business, but we are going in a intelligent manner put it in and keep it within, what we think are reasonable ranges for the business and the cash flow we generate.

Bob Wetenhall

Great. And so yes some very tangible line of site items on the checklist, you mentioned two other aspects to your growth strategy.

Mark Johnson

And the second one is in the area of continuous improvement, which is also a cost focus and efficiency focus. And we’ve had a team and organization do a great job in lean and six sigma inside of our manufacturing business and they’ve made us a lot more efficient in that area. We have taken that leader and build a team around him and are going to focus on the commercial side of the business, as well as all of our back office operations. And we see significant opportunity over a three-year horizon in simplifying the business and more consolidation of back office, and materially improving our quality of which when you look at that that there is significant cost in that horizon that we see coming out of the business.

So we’ve actually trained over 100 people in the last 90 days on these capabilities, on the commercial side of the business. Really exciting, on the last 30 days we’ve brought our group together, 25 people, identifying what the projects initiatives are. So these aren’t things that we are – we have a vision, but no path forward and these are actually things. We have the path forward and the plans on the tables and have begun the execution. So, those two areas are clearly critical we think to the cost side of the formula and on our path forward on continuously improving that overall structure of gross margin and ESG&A and dropping down to the bottom line.

Bob Wetenhall

So it sounds like you have advanced manufacturing initiatives, which are great. It sounds like you have continuous improvement initiatives to drive quality, what was the third component of the strategy?

Mark Johnson

The third point is more around very focused growth, which is what we refer to as NCI Solutions. What we have found with and it was part of the basic premise of the acquisition of Century and Metl-Span, it was, these are great opportunities. Insulated metal panels are going to have an increase in share in the marketplace, which we are seeing, and, but what we also felt there was we have these great customers that we talked about earlier in our legacy business.

They’ve been with us 40 years, they have broad access across all end users, and we felt that if we filled the right internal team to help take those products from insulated metal panels from Century and Metl-Span and drive them through these legacy business we could get accelerated growth. And I think we shared, we built the model and we shared in the last quarter. We had 80% year-over-year growth in insulated metal panels through those legacy past.

We obviously won’t get. If I got 80% year-over-year for the next five years you would be, you know we would all be kissing babies, but we’re excited about that and we see that continuing in that potential there. We then took that model as we have a door business that’s really nice sleepy business, but not growing at a high pace, high margin like insulated panels and we put it through the same model and grew that also at 80%. So we see this as a core competency that we can take products adjacent to the core products our customers are using and if we can add value and show how they can put them through that channel, the customers will buy it and consume it and increase our sales rate.

So, we are focused in how do we increase the adoption rate of insulated metal panels, how do we educate the market place, continue to support that growth, but then once we get about 18 months into the next three-year horizon, we’re going to be looking at either your joint ventures, partnerships or companies that we can acquire that will expand those adjacent products that will stand alone and be accretive on their own, but we can help accelerate their growth through our legacy channels and that to me is really exciting about the potential of the business.

Bob Wetenhall

That is great way to reinvigorate top line. Balance sheet, I think is 2.5 times, I think you are on track to do like at least 50 million and free cash flow in the ballpark, what are your capital allocation priorities as CFO?

Mark Johnson

So our capital allocation priorities, we really have four, the way we think about it. The first one is to fund the initiatives that Don was speaking to earlier. As I indicated that would be in the 2% of revenue range. Once we get pass that we are very focused on maintaining our net debt leverage, we have 2.5 times as our optimal target, we’re below that now. So just making sure we stay in that range and we get our maturities all aligned accordingly.

And then third, and it’s something we have done and we will always continue to do as we’ve opportunistically returned value to shareholders through share repurchases, and so I think we’ve demonstrated the ability to do that over the last couple of years and would continue to do that in the future. And then fourth, we would keep our dry powder and cash flow to fund some of these accretive opportunities that Don was just speaking about.

Bob Wetenhall

It has the pipeline looked, do you have your finger on some opportunities now or you have been CFO in short time, but is there stuff already in process that you feel confident?

Mark Johnson

I am the CFO and I will damn confident with executing the next 12 to 18 months. So the way we think about it is the next 18 months we view as opportunistic. So we are not actively chasing or pursuing. We are defining what the adjacent products look like that are either right before us in the build cycle or with us in build cycle or we’re buying out for the customer today, so it’s like doors and windows, skylights, other trend or things that come right after the cycle.

And so over the next 18 months, while we have these other initiatives that we think are high value, if something comes along we see something we will actively look at that, but then we will be working on building a better defined pipeline and become more aggressive after we get past that 18 month window and then we will clearly move from opportunistic to driving, it is the way we have the plan laid out right now.

Bob Wetenhall

What on the platform more excites you and as CEO what’s your biggest concern that keeps you up at night right now?

Don Riley

What’s exciting is the insulated metal panel business and the fact that we have demonstrated this engine that the legacy business isn’t just this sleepy low slow growth opportunity and it is actually an opportunity to drive other products through there. I think if I, you know what concerns me or keeps me awake at night, one of the things is around just making sure that we stay competitive on the insulated metal panel front. We have a really great competitor out in the marketplace and that we’re investing in R&D to ensure that we’re always on the front edge of that and don’t get disrupted or dis-intermediated by something they may be doing. I always want to be competitive and be ready to drive that product because that’s a big, big opportunity for us.

Bob Wetenhall

And when you are thinking, you just raised guidance then you lowered guidance, how much do you feel now and I recognize everybody is still making assessment of the Hurricane, it does sound like back to business based on your earlier comments, do you feel, what’s your confidence level into year-end with the current guidance, your conviction?

Don Riley

Well it’s only been a couple of weeks since we had our earnings call, and we intentionally we are trying to give guidance that we have high degree of confidence and that really hasn’t changed.

Bob Wetenhall

And your pricing was robust in the quarter. And how strong do you anticipate pricing will be into year-end, do you see a continuation, you had some stuff over 10%, which is pretty healthy?

Mark Johnson

Now pricing has been strong and we’re committed to pricing certain cases and define circumstances were committed to price over volume and making some intentional decisions there for low margin activities. So I don’t anticipate any going backwards on price.

Bob Wetenhall

So you are sticking to commercial discipline, it sounds like there were some severe volume headwinds that impacted the quarter, do you think the extent of the decline in the product categories was just kind of all three categories took it on the chin this quarter, do you see kind of recovery of trend line to more normal shipment levels?

Mark Johnson

Well before you answer that Don, one of the things that’s in play is there was a seasonal pattern last year. It was a little bit unusual because of the rapid price increases. So it made the year-over-year comparisons in the third quarter and fourth quarter a little bit different as a result. So the quarter growth looks stymied and the fourth quarter growth isn’t as bad as what you thought it was in the third quarter. So, I think that normalizes out and what you end up with is that low slow growth in the legacy products that Don was talking about.

Bob Wetenhall

Got it. So it’s over accentuated just due to seasonal comps falling out of line.

Mark Johnson

That plus we added the concern around the Harvey demand in the fourth quarter.

Bob Wetenhall

And you feel like it’s back to business now and like your plans in the network is…

Don Riley

Yes. From an operating perspective, we’re completely back to normal at this juncture.

Bob Wetenhall

Good. Well congratulations on the new role. Don, we’re really excited by your leadership and the vision and that you have outlined today and Mark, thanks, it is always great to have you guys. Thanks again for making the trip out.

Don Riley

Thank you. Appreciate it.

Question-and-Answer Session

Q –

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