Ladies and gentlemen, thank you for standing by, and welcome to Q3 2021 Quanex Building Products Corporation Earnings Conference Call. At this time, all participants' lines are in a listen-only mode. And please be advised that today's conference is being recorded. I would now like to hand the call over to your speaker today, Mr. Scott Zuehlke, Senior Vice President, Chief Financial Officer and Treasurer. Please go ahead, sir.

Thanks for joining the call this morning. On the call with me today is George Wilson, our President and CEO. This conference call will contain forward-looking statements and some discussion of non-GAAP measures. Forward-looking statements and guidance discussed on this call and in our earnings release are based on current expectations. Actual results or events may differ materially from such statements and guidance, and Quanex undertakes no obligation to update or revise any forward-looking statement to reflect new information or events. For a more detailed description of our forward-looking statement disclaimer and a reconciliation of non-GAAP measures to the most directly comparable GAAP measures, please see our earnings release issued yesterday and posted to our website. I'll now discuss the financial results. We reported net sales of $279.9 million during the third quarter of 2021, which represents an increase of 32% compared to $212.1 million during the third quarter of 2020. The increase was largely due to increased demand across all product lines and operating segments, combined with increased pricing mostly related to pass-through of raw material cost inflation. More specifically, we posted net sales growth of 20.8% in our North American Fenestration segment; 19.3% in our North American Cabinet Components segment; and 85.8% in our European Fenestration segment, excluding the foreign exchange impact and despite the challenges presented by flooding in Germany during the quarter. As a reminder, both of our manufacturing facilities in the U.K. were shut down in late March of 2020 and did not resume operations until mid to late May 2020. We reported net income of $13.7 million or $0.41 per diluted share for the three months ended July 31, 2021, compared to $10.8 million or $0.33 per diluted share for the three months ended July 31, 2020. The increase in net income was mostly…

Thanks, Scott. Not unlike others in the building products space, our fiscal third quarter was affected by significant inflationary pressures and material shortages that impacted manufacturing schedules and taxed our operations. Late in the quarter, the growth of the COVID delta variant led to a resurgence of illnesses and required quarantines, which further impacted the already tight labor market. In addition, our plant in Heinsberg, Germany flooded in late July during the dose stating rainfall that fell over Western Europe. Despite these demanding challenges, we are pleased that we were able to announce another strong quarter of financial results and reaffirm our full year guidance for fiscal 2021. Before discussing our results, I would like to take a moment to thank our team in Heinsberg, Germany for their amazing efforts after the flood. Within just 14 days of the storms, the facility was back up and operating at full capacity and not one customer was shut down because of this weather event. The team there worked long hard hours to make sure our customers were supported. And they did a tremendous job under unbelievably difficult circumstances. Now looking at the macro environment in North America, demand for windows and doors remains very strong. Supply chain pressures remain the constraint and have resulted in extended backlogs for our customers and longer lead times for end consumers. Demand for cabinet components also continues to be strong. And according to KCMA, the number of average backlog days within the industry has risen to 66.9 days versus prior year levels of 37.7 days. Although the summer months in Europe usually bring a slight drop-off in demand due to holiday travel, current demand for our products in the U.K. and Europe remains consistently strong. We mentioned on the Q2 call that the glass shortages were…

Your first question comes from the line of Daniel Moore of CJS Securities. Your line is now open.

Thank you, George, Scott. Good morning. Thanks for taking the question.

Good morning, Daniel.

Good morning, Daniel.

Maybe talk about -- you gave some details in terms of key inputs and supply chain constraints. At the margin, are you seeing those abate about the same, getting worse, and any early indications as far as Hurricane Ida is concerned?

I'll answer this in a couple of pieces by product line. In North American Fenestration, I think we see the pricing and supply issues continue to remain pretty significant in anything that is chemical-related. So anything that derives from any sort of ethylene cracker plant is seeing the continued inflationary pressures. Too early to tell on Hurricane Ida. We know our supply base has not been impacted from a facility standpoint, but still evaluating the whole logistics and the ability to get products shipped through rails, trucks and ports. So it's still too early to tell. Hardwood pricing, we actually are starting to see some leveling off or slight increase, not leveling off, but the rate of inflation appears to be slowing. So we'll continue to look at that and anxiously await that time; and in Europe, things remain about the same.

Excellent. Really helpful. As we look out to fiscal '22, based on price increases you either put in year-to-date or have planned at this time and kind of based on today's pricing, how much of a top line growth benefit would that translate into next year, just kind of ballpark terms?

We're still evaluating what the point to 2022 outlook looks like. It becomes a little complicated because we -- our pricing increases are built into a couple. You've got the structural pieces that are built into selling price. You've also got anything that's surcharge-related that is really dependent upon where inflation goes. So that revenue number could be impacted negatively, if pricing starts to come down. So the revenue number is going to be really hard, and we're not at a point to be able to give you a good forecast at this point. But what we do anticipate is that regardless of what that -- if we start to see some softening in inflation, we do think that, that will correspond to improved profitability in 2022.

Got it. Helpful. And maybe one more, if I might. Leverage back all the way down to almost basically zero and generating more cash than you need. You mentioned M&A, particularly at these levels, would you look to be a little bit more aggressive in terms of share repurchases as well? I know you bought back some stock in the quarter, but any comments there would be helpful. Thanks.

I think our current strategy, as we stated, is we're going to continue to focus short term on paying down debt and then building cash on because we do think that there could be some potential M&A opportunities. Nothing's imminent, but we are seeing opportunities and we positioned our balance sheet very well to be able to look at a lot of things that could be accretive. The great thing about where we're at today is based, on our strategic plan, we don't think we need to do anything. And so we're not rushing to grow. We'll look, as I said, to things that enhance our growth profile and are accretive in terms of margin. If those exist, then we are in a very good position to capitalize. In terms of share buyback, we still do believe that we're undervalued. However, there are challenges with the low float that we have and the impact on us on the share buyback. We just think that, that's lower in our priority. If the position arises and we feel like it's the best thing to do, we obviously still have enough in the Board authorization to purchase stock. But I would rank that lowest on our priority list right now.

Your next question is from Julio Romero of Sidoti & Company. Your line is now open.

Good morning, George. Good morning, Scott.

Morning, Julio.

Good morning.

So I guess on the North American Fenestration segment, could you maybe rank order some of the margin challenges there? I know you called out the timing lags for index pricing as well as overtime costs. Just looking for a sense of how impactful these two were, and if one was more impactful than the other?

I think right now, the biggest challenge is on items such as resin and silicone. And again, things that are being driven by feedstock pricing, that's a bigger challenge right now than the labor piece for us short term, at least, from a financial perspective.

Got it. And I think you mentioned that you could see some potential impact from Hurricane Ida. I mean, have you -- do you have any other further granularity as to what you might expect coming out of the Gulf Coast?

No. Again, as we stated, we have been told that our major suppliers, their facilities were unaffected. So short term, I would say that that's very good news. Again, there's still congestion in the ports and all the logistics chain. So it could be a bumpy couple week road in terms of getting material because of the logistics chain. I don't believe it will have a significant -- or at least from what I know now, a significant long-term impact on supply, at least, with the supply base that we have.

Got it. And then just last one for me would be just, generally, you spoke about price increases you're working on in North America, aside from index pricing. Can you just speak to your maybe ability and confidence to pass through price aside from index pricing, in other words, to offset labor costs.

We pushed through price to offset the labor cost that we identified. I mean it's a structural change. I think every -- our customers as well as our suppliers, we're adjusting to the world we live in. It's not going to go backwards. It's a new labor market. And ultimately, consumers will have to dictate their ability to support that level of labor cost. That's not going to change, but we've been successful in getting price because we have to. It's not a margin grab. Our goal as it relates to labor is to remain margin neutral. And we've been very open and honest with our customers and are having meaningful conversations.

Your next question is from Reuben Garner of The Benchmark Company. Your line is now open.

Thanks. Good morning guys. So I guess to start, is there any way to quantify how much volume or revenue you guys have lost this year, specifically in the North American Fenestration business, just from challenges in the windows industry in getting product out the door? In other words, can you talk about the visibility that you have or the runway you have on the demand side? I know windows has been one of the most backed up building products over the last year. Is that something that you guys look at as a positive as you move into the next six to nine months or so?

Yes. And I'll answer that in two phases, Reuben. First, in terms of visibility, we don't have great visibility because a lot of our customers' ability to ship windows is dependent, not only on the products that we ship, but their ability to get installation labor on their side, the homebuilders labor as well as their ability to get other components, especially from Asian sources where there's a significant lack of containers. So, it's really hard to put an evaluation on what revenue could have been had those all put together. In terms of our ability, I think we've done a pretty good job of being able to continue to supply what demand. What we think that this does do for a long term, and I kind of mentioned it at the end of my comments is that it's going to extend the cycle. You're not losing revenue. It's just extending and pushing it out. And that's why we continue to be optimistic for longer than just a short-term view of our markets.

Okay. That's great. And then have you guys -- maybe this is something where you don't really have visibility into, but curious if you've noticed a major shift in mix of products sold, specifically in the fenestration business? I mean, do you guys benefit with your spacers from higher quality, more, I guess, energy-efficient windows being installed? Are you seeing any meaningful changes in the market?

No, it's a great question. Our spacer offering ranges from entry level up to the very high end where we have a pretty strong portfolio. I think we continue to see strong demand across all the lines. So I think what it does show is that the new build -- new construction still remains strong, but so does R&R. And the continuation and the extension of lead times kind of highlights the first question that you asked and really is being pushed by our customers and the homebuilders' abilities to fulfill their demand from the installer side.

And then last one for me. The Cabinets business, with all the supply chain issues and particularly freight coming in from -- ocean freight got out of control recently. I mean, what are your customers saying about the in-sourcing trend? Do you guys think that, that can even pick up more steam? Do you have the capacity to serve even more market share? And then any meaningful change in your pricing power because of what's gone on that you guys might be able to get some catch-up as we move into the next year or two?

Our ability to be able to handle more volume is really going to be dictated by the successes of our ability to go get new labor. I think we're well positioned from a machine capacity as the lumber and the hardwood supply starts to open up. So our ability to go out and get labor which, as I mentioned, we -- within the quarter, we made some adjustments, and so we're in evaluation period to see as what we've done moving the needle. Early indications is, it's starting to have some success. So I think we're a little too early to answer that question. I think if we're able to get labor, then we could take -- we, by all means, can take on more in-sourcing and assist in that. I think in terms of our pricing, the market is I think we have pricing power, but there is a market there in that you can't go to certain levels. And I think we continue to have conversations with our customers around that. We're going to get paid for the fair value and what we do bring to the process. But we also need our customers to be successful. So we look at these as partnerships, and we'll continue to work on it. The third piece to your question, Reuben, is -- and I mentioned in Q2 and the project continues. We are looking at adding potentially a new cabinet facility, and we're in some site selection process. So that project continues to go on. And once that is launched, then hopefully, that will again add some additional value for us to go after some incremental volume.

Great. If I could sneak one more in, Scott, the price/cost pressure that you've got this year from kind of a steady rising commodity environment, do we need prices to roll over in order for next year to pick up some margin? Or if they level off, you guys will still have a tailwind because you won't have that, I guess, headwind that you had in this fiscal year?

Yes. The issue really this year has been we keep chasing price. So even as those indexes trigger, we continue to chase. So we're behind the eight ball there. So as raw material prices at least stabilize, that will help. But what's really going to help is when raw material prices start going the other way, and it's anybody's guess as to when that will happen. We do think that there's going to be some stabilization going into the end of this year into early next year. So we do feel comfortable that profitability will be better next year and the demand very strong.

Your next question is from Steven Ramsey of Thompson Research Group. Your line is now open.

Good morning, guys. I wanted to follow up on the capacity and labor utilization topic to make sure I understand your previous commentary, George, was it the ability to take on more volume. Is that in all segments? Or are you talking just the CAD MC segment? And I guess to connect the dots, does CapEx need to increase from this $30 million-ish level for you to be able to take on more volumes over the next year or so?

So the first part of your question, my answer was generally directed towards cabinets, our ability to take on additional revenue in the North American Fenestration segment. Screens, it would be partly labor and going after a new geographic segment of the country that's not served. But for the most part, the North American Fenestration growth would be dictated on our ability to get raw materials. Cabinets is going to be more labor driven. As it relates to your CapEx question, early insight is we anticipate 2022 might have a higher level of CapEx for growth initiatives. And we're comfortable with that and feel like our cash flows, in terms of all of our objectives, supports that and would position us well for good growth.

Okay. Great. And then on the inventory investment you've made that makes sense so far. I guess how do you think about incremental investment in inventory from here, do you think inventory will take up more capital early on in 2023 or 2022? Or will that investment moderate as you move forward?

I would anticipate probably a growth in inventory. Listen, right now, if we can get raw materials, we're going to get them. That's kind of the mode we're in right now. Us and probably every other business, if there are critical components, you buy what you can get. So ultimately, what we want to get to is to a point where we can start building some levels of finished goods to improve our fill rates and start getting the backlog down. But that's going to take some time. But long answer to -- yes, I think that will be part of our cash usage in 2022 and probably into 2023.

Okay. Great. And lastly, just to maybe make sure I understand something. This elevated backlog you have, it seems to be a common thread in all the building products and construction world. For you, this backlog burn off to more normalized backlogs. Do you expect that to happen in the next couple of quarters? Or do you really not have this much visibility into that as you would like?

I wish I had better visibility. I think that over the course of the last 1.5 years, that's the one thing that has changed is the level of visibility through all of our customer change. I anticipate that it's going to take a solid 12 to 18 months for the whole industry to start bleeding that down. It is a large backlog that's being driven by multiple things. You've got the labor challenges. You've got raw material. You've got freight issues. So there's not one silver bullet that if this clears up. So I think it's going to be a 12 to 18 months. And again, that's what we keep saying why we think that the cycle is going to be extended by multiple years because of that phenomenon.

Your next question is from Ken Zener of KeyBanc. Your line is now open.

So, Scott, good morning.

Good morning.

Morning, Ken

So I want to touch on a couple of issues here. And it kind of goes, George, Scott, if you could give any context of perhaps the past so we can see how Quanex is different. When we're talking about extrusion, I'm stretching -- I think it was 2012, '13 when you guys -- when pricing really -- costs left out on you guys and you didn't have these contracts in place. But you probably remember a little better than I did. Could you put it in context how, especially on the extrusion side, the price contracts, which I think you guys have to the pipe index, if you could just kind of give us clarity about what those indexes are tied to. And how it's different than the last cycle when you guys didn't have, I think, fixed price contracts, just in terms of like what the underlying index is, how much of your business is tied to that and kind of a lag, if you would, just explain that a little better?

So -- and this is just in North America, remember. Because in Europe, we don't have -- so on the vinyl extrusion business, the indexes are really based on CDI. And that's purely the mechanism to determine the index pricing. And then depending on the customer, there's a level that's shared. So in most cases, like 80% of that index -- or the increase or drop is push back to the customer, and then we absorb a certain piece of it. Each contract is a little different, but that generally gives you the feel. As it relates around your question to 2012, I just don't have the detail in front of me, Ken. I joined the Company in '11, so I was obviously with the spacer business at that time. So I would be remiss to be able to give you an answer with that

Fair. Fair. Scott, do you want to take a stab at it? Or should I move on?

I joined in 2016.

Okay. Good. Yes, I remember, that was -- I have to go relook at the transcript. But it seems as though, obviously, you guys confidence is there in the catch-up. So I think you talked, George, about $6.4 million of costs, and you were referring to the cabinet business that was net cost inflation that you would -- you do expect to recover. And you talked about that being about 400 basis points or 360 basis points of cost that you still expect to recover, that you've incurred and you expect to recover. Is that accurate when you gave that figure?

That is correct. So yes, and that would be -- it's just the timing of the index. So you would add it to the revenue as well as the income base and then net it out. Yes. At some point, we anticipate recovering that. And again, it's going to be time based.

And would you say that number -- is that 100%? I mean, is that how much cost inflation you guys have had in that segment? Because I just think you're giving such clarity there. Or is that like what hasn't been recovered? I'm just trying to sense how much of your business is running price versus volume, I guess, because inflation, notwithstanding the 10-year not moving, is clearly out there. So is there a sense that you could break down volume versus price, I guess, generally for your businesses?

That's going to be purely price. And obviously, the volume dictates the piece of that. I mean the reason why there's so much clarity in the hardwood pricing is because it's a very clear and simple index based on the different species. So we track it, we monitor it, and we know the number very close, so.

Got it. Okay. I do appreciate that. Last question, kind of taking a step back because it seems like you're kind of you have a good problem with your leverage. As you noted earlier, if you buy back stock, you're thinning out what's already a thin float. You're doing organic investments. You talked about some of that stuff in Europe. You're talking about a cabinet facility right now. Could you just -- this is a bigger question, but could you talk about how you're thinking about deploying capital relative to your cost of capital and the return on that. Because cabinets, it's been about five years since you've owned the Company. The margins -- you're improving, but it's not -- I don't know. It doesn't appear that it would be hitting your returns on capital. So how are you guys making those decisions to keep investing money there as opposed to something else with that business?

Yes. No, it's a very fair question. I think we look at it holistically. And what I would say without getting into any level of granularity here, Ken, is if you look at our return on invested capital over the last four or five years, we've obviously made it a priority in terms of improving that metric and how we choose to invest all of our incremental cash. And over the last couple of years, our return on invested capital has grown to a level that it's meaningfully above now our working average cost of capital. So without getting into the details of what we do by each segment, I think in general philosophy, I think the track record has shown that we've executed on that. And I think it's a focus, and we'll continue to evaluate all opportunities based on those metrics. And I'm going to this generic in that.

That's fine, George. That's fine. I mean because it is you're getting to the point where your leverage is so low, your options for capital deployment and then inhibitors to your current returns on capital. It's a good problem, but I think it's one of the things that I've had conversations that do focus on that element.

Your next question is from Daniel Moore of CJS Securities. Your line is now open.

Yes, just a quick follow-up. In terms of the impact of the flood in Germany, is there a quantifiable dollar impact on revenue? Or were you able to service out of inventory and/or other locations?

We were able to service inventory. There was a week or two lag before we were able to do that. And then on the cost side, we're estimating about $300,000 expense impact. No real lost revenue because it's just pushed to the right.

Perfect. Very helpful. And then lastly, the guidance, it feels like revenue should be trending toward the higher end of the guidance range given price increases. Is that a fair thought process? And on EBITDA, maybe -- I don't know, lower to the midpoint of the range relative to the pricing pressures that you're seeing? Or any comment that you'd be willing to share there? Thank you. Sorry, go ahead, Scott.

I think for the most part, Dan. That is correct. We're still comfortable with the range is higher on the revenue side, lower on EBITDA, based on everything we're talking about with respect to inflation and labor, et cetera. So yes, I would say you're accurate.

No questions at this time. And I would like to turn the conference back to George Wilson for further comments.

I'd like to thank everyone for joining, and we look forward to providing an update on our next earnings call in December with our full year results. Thank you all very much.

Ladies and gentlemen, this concludes today's conference call. Thank you for participating. You may now disconnect.