Stella-Jones Inc.

Brian McManus - Chief Executive Officer Eric Vachon - Chief Financial Officer

Leon Aghazarian - National Bank Financial Benoit Poirier - Desjardins Securities Mona Nazir - Laurentian Bank Securities Michael Tupholme - TD Securities Justin Keywood - GMP Securities Brian Pow - Acumen Leon Aghazarian - National Bank Financial

Thank you. Good morning, ladies and gentlemen.

I'm here with Eric Vachon, Chief Financial Officer of Stella-Jones. And thank you for joining us for this discussion of the financial and operating results for the company's second quarter ended June 30, 2017.

Our press release reporting Q2 results was published earlier this morning, it can also be found on our website at www.stalla-jones.com and on SEDAR. Let me remind you that all figures expressed on today's call are in Canadian dollars unless otherwise stated.

Stella-Jones generated solid operating results during the second quarter. Total sales increased by 5.5% over the second quarter of last year and amounted to $594.2 million.

Acquisitions contributed $16 million, while the conversion effect from fluctuations in the value of the Canadian dollar had a positive impact of $16.9 million. Excluding these factors, the sales increased marginally.

Net income for the second quarter reached $48.9 million or $0.71 per diluted share. Eric will provide additional details in a moment.

Looking at second quarter results by product category, railway tie sales amounted to $214.2 million, a decrease of approximately 1% from the second quarter sales. If we exclude the currency exchange factor, sales decreased by 4.8%, as lower year-over-year pricing was partially offset by increased volume that resulted from earlier than expected deliveries for certain orders.

Turning to our utility poles, we saw a healthy demand in this category driven by organic sales growth in the southeastern United States. Second quarter revenue reached $167.5 million, a 17.3% increase over sales a year ago.

Excluding the contribution from acquisitions and currency exchange, sales increased by $3.7 million or 2.6%. In the residential lumber category, sales came in slightly higher over the previous year's second quarter reaching $153.2 million, while less favorable weather in Canada during the quarter as compared to last year's second quarter led to lower volumes.

Increased untreated lumber costs led to higher selling prices in this category. Turning to industrial products, sales reached $27.1 million, stable from a year ago.

Excluding the contribution from acquisitions and the currency exchange effect, sales increased 5% mainly due to lower sales and reimliments in Canada and lower sales of rail related products. Log and lumber sales amounted to $32.2 million, an increase of nearly 30% over the second quarter of last year.

The variation reflects the timing of lumber purchase and resale activities, as well as the timing of timber harvesting. During the quarter we continued to play substantial emphasis on integrating our most recent acquisitions and wrapping up production at our new facility in Cameron, Wisconsin.

On a company-wide basis, we also remain focused on improving operating efficiencies by adjusting production levels, maximizing operating efficiencies and minimizing costs for healthy organization. Eric will now provide further details about our second quarter results and financial position.

Eric?

Thank you, Brian. Gross profit for the second quarter of 2017 totaled $99 million or 16.7% of sales compared with $109.6 million or 19.5% of sales a year earlier.

The reduction as a percentage of sales reflects lower selling prices for railway ties and the less favorable geographical mix in the utility pole category. As a result of lower gross profit, operating income amounted to $74.5 million or 12.5% of sales compared with $83.2 million or 14.8% of sales in the previous year.

Net income reached $48.9 million or $0.71 per diluted share versus $54.7 million or $0.79 per diluted share last year. The reduction in net income resulted in a slightly lower cash flow from operating activities before changes in non-cash working capital components and interest and income taxes paid.

However, given more favorable working capital fluctuations this year versus last, mostly stemming from reduction in inventories, Stella-Jones generated solid cash flow from operating activities of $94.4 million, up from $33 million last year. Some of these funds were used to reduce long-term debt, which stood at $615.8 million including the current portion as at June 30, 2017, down from $698.5 million three months earlier.

As a result, the ratio of total debt to total capitalization reached 0.37 to 1 as at June 30, 2017, down from 0.42 to 1 three months earlier. Subsequent to the end of the quarter on July 5, Stella-Jones reduced its committed revolving credit facility by US$100 million reducing total borrowings available under this facility to a maximum of US$475 million.

This reduction was made possible by the completion earlier this year of private-placed senior notes totaling US$150 million. Finally, the board of directors of Stella-Jones declared a quarterly dividend of $0.11 per common share payable on September 22, 2017, to shareholders of record at the close of business on September 1, 2017.

I turn the call back to Brian for the outlook.

Thank you, Eric. Looking ahead as we've previously indicated, Stella-Jones expects higher year-over-year overall sales in the second half of this year.

Overall operating margins, however, will remain affected by the soft pricing in the railway tie category and a less favorable geographical sales mix for utility poles. In the railway tie category, given the early delivery of certain orders in the second quarter, we expect sales to be relatively stable in the second half of 2017 as compared to last year.

We anticipate that the year-over-year effect of lower pricing will be offset by higher volume. In the utility pole category, we expect normal maintenance demand patterns to return and demand for special products to further improve.

These factors should result in higher year-over-year sales of utility poles. In residential lumber, which continues to grow as an important product category for Stella-Jones, the company expect to further benefit from continued demand for new construction and outdoor renovation projects in the North American residential and commercial markets.

A principal focus of the company going forward will be to further leverage the strength of its continental network. We believe our deeply stablished position in our markets together with our constant efforts to improve customer service enable us to capture more of our existing clients business and to win new customers throughout North America.

Additionally, generating cash and maintaining a prudent leverage ratio will remain priorities. The solid cash flows provided by operating activities will be used to reduce debt, invest in working capital and in maintaining an optimal dividend policy to the benefit of shareholders.

Over the long-term, Stella-Jones also remains committed to continental expansion. We will look at all opportunities that meet our investment requirements and which promise to create further value for shareholders.

Eric and I will now be pleased to answer any questions you may have.

Hi. Good morning guys.

Hi. Good morning.

So just a quick question on the ties, you mentioned there was some timing differences which led to probably a little bit better organic growth number I could say on the tie side, can just talk to us a little bit about that? And then as it relates to that you also mentioned in your outlook section that you expect sales for the ties to be stable year-over-year so does that mean that kind of the Q2 and Q4 we won't get kind of the pushback from that as well in the quarter?

To answer the first part your question really I would say the pool forward is more based on some comments we made at the end of Q1 where we expected a slightly softer Q2. So deliveries were stronger or going out earlier than we thought they would.

And really what's happened then Leon and I think this will answer the second part of your question is it's going to create a slightly softer than we expected Q3 but we expect the back end which was on a year-over-year comparable last year was a very soft Q4 that's where we think it will help make the whole second half relatively flat. Whereas we said most of this will be driven - well not most, it will be driven by higher volumes which will offset the pricing decreases we've seen.

Okay. Great.

That's good color and speaking of pricing, what trends are you seeing in the market, I mean do you still expect to continue to expect correct inventory to flow out of the system by late '17, is that still the case?

I think we're probably seeing now that it may take a little bit into 2018 but we're certainly seeing some improvements out there. And I would say in a lot of the markets we're starting to see the pricing level off.

Okay. And then just quickly for me on the margin side before I turn it over, you're guiding for return to historical levels by the end of 2018, would that imply about that 15% to 15.5%, is that kind of where we should be seeing that?

We would be comfortable with that, yes, and you're referring to EBITDA margins just over, right.

Yeah, absolutely.

Okay.

Yeah, okay. Thanks guys, I'll turn over.

Thank you, Leon.

Yeah. Good morning gentlemen.

Hi, Benoit.

And just to come back on the railway tie, so basically you're looking for flat revenues and could you mention the split between volume and pricing for the total year?

For the total year or you mean the back end of the year?

I thought you were comments was flat sales for the year as a whole or –.

No, I'm sorry, we were referring to the back end of the year, the back half is where our comments were in regards to a - we anticipate a roughly flat back end and that'll be entirely driven by volume because that will be offsetting the decrease in selling prices.

Okay and what about the trend in terms of selling price these days Brian?

As I mentioned to Leon, I think we're starting to see it sort of flatten out in most regions, there's still some pressures in certain regions, but I think we're starting to see selling prices sort of level off. And I think what we're also seeing is as we're turning our inventory we're starting to realize catching up a bit on the white wood high side in terms of some of that lower cost flowing through which will hopefully shield the slight improvement in our margins in the back half of the year for a time.

Okay. And with respect to your comment on EBITDA margin to 15% to15.5% by the end of 2018, is this for the full year or mostly related to the - on an annualized basis by the end of the year or it's for the full year, Brian?

I would say more based on an annualized kind of as we get to the back end of 2018 is what we're seeing now. We maybe a little earlier than expected but I'd rather take conservative approach.

Okay, okay, perfect. And any impact on the wild fires if you could provide some color for each business segment whether there is an impact on the pricing or wood?

On the railway side, there's no impact in that. That's primarily a hardwood market and based most supplies coming from the East Coast.

Utility poles, it is hampered some of our ability to get into the forest in those regions but as you know we draw from a large area for our needs. So we're able to offset that and we do have a good set of inventory.

Finally on the residential lumber side, I would say that's where we're seeing pressure in terms of some availability and rising prices, but as we mentioned earlier on we do have - we had the opportunity to adjust our selling prices up a number to reflect the higher cost for the white wood component.

Okay. And when we look at utility pole, Brian, any thoughts on when you have this caution with utility customers about anticipated rate increase this year, so how does it look and the implications for on the pole side in terms of traffic for the second half?

So far this year we're - I would say we're a little more bullish than I would have been in Q1 we're starting to see some solid demand overall including on the transmission side, we expect to see some good results in the back end of this year, as well as slowing into 2018.

Okay. Perfect.

And you mention comments about Continental expansion, were you referring to residential lumber on whether you could expand south of the border eventually, are you still studying that opportunity and could you maybe make some comments around there?

We're still looking at it. And I was more referring to our continued expansion both in the poles and the ties but we still look to study what opportunities would exist out there south of the border on the potential side.

Okay, perfect. And last one for me, how the ramp up of your new facility in Wisconsin and your ability to bring an incremental revenues in the region?

I would say it's really started to go well especially as we got towards the second half of Q2 as would be normally expected any startup we had a couple of bumps here and there, but the plant is now operating very well and certainly appreciate all the work our team has done both at that location and the help of others throughout the company to get it up and going. I'm pleased and I think we'll see further contribution as we go forward.

Okay. Thank you very much for the time.

Thank you, Benoit.

Hi. Can you hear me?

Yes. Hi, Mona.

Hi, how are you? Sorry.

No problem.

Thanks for taking my question. So, firstly, I wanted to touch on the margins and when you spoke of overall lower margins than historical levels, you had given guidance for 13% for the year with some sequential improvement over time so going from Q1 to Q4.

Given that the first half of the year is coming in already at about 13%, what I'd be out of line to say that there are some upsides to your guidance level and we're still expecting some sequential improvement. I just wanted to discuss given your commentary in the outlook section of the continued pressure on margins.

I would say no, you wouldn't be completely out of line.

Okay. Perfect.

And then secondly just on M&A landscape and I know on the previous caller asked about what you were referring to with Continental expansion. I know you constantly assess various market opportunities, pole market is fragmented, but then you've been known to kind of pull out of a surprise especially the residential growth looking back.

I thought it's better to ask a question if acquisition targets remain solely on the pole and tie side country tuck ins, are there any new markets or opportunities and just on that with the FX rate where it is in the political situation in the U.S. Is there any discussion of potentially hold off on U.S.

targets or everything still okay, multiples are okay and booking opportunity?

Certainly won't get into a political discussion on the call, but in terms of going forward I would say there's nothing that's changed out there that would concern us from continuing to look for those opportunities that that lie in our main product categories. As I had mentioned to Benva, we are examining potential opportunities on the residential I think it's probably a little early for that.

But in terms of continuing to look down if the U.S., currency doesn't concern us because we're financing with a U.S. dollar debt anyways.

So I think we're still very comfortable Mona to continue to move forward.

Okay, perfect. And just lastly for me one of your main competitors had reported very weaker or weak tie growth for the same period and spoke of continued pressure for the balance of the year.

I know you're not going to comment on someone else's financial results but looking at your model and where we've seen so much improvement in ties from even last quarter, what is the main driver and what is the variance versus the end market trend? And maybe it's your competitive advantage or the contract or the customers that you have in place but just wondering if you could shed a little bit more light on the variance there?

Thanks.

I think you answered your own question a bit. I think probably a combination of customer mix I'd also like to chalk it up to our great sales team and just overall management team, I'll give them a lot of credit for really the job they're doing out there, but I think some of it is both where the geographical mix happens to be and where some of our plants are located as well.

I think we've been fortunate and even customer mix.

Okay. That's it for me.

Thank you.

Thank you, Mona.

Thanks. Good morning, Brian and Eric.

Hi, Michael.

Brian, can you break down the 4.8% organic decline in the quarter in tie sales between volume and price?

It's definitely all price because volume was up, so the entire fact I prefer not to get into the full details of the price effect, but as you can certainly see our volume has offset the pricing decrease to mitigate the full decline that would have been felt by just the price.

Right. Okay.

I'm trying to get a sense for that the components to understand one or the other but yeah, I get directionally what's happening in terms of the offset but we can't get into what evolves, for example.

So let's say that let's call it roughly 10% is pricing and then you can work it backwards of what the volume was required to offset that. How's that.

That's helpful. Thank you.

And then the pole forward from into Q2 from Q3, how significant was that?

I'm not going to say it was extremely significant, but it was a good goal and I think some of that was maybe we were a little bit too conservative and how we thought it might sort of pulled out over the year. So we're being cautious in terms of especially Q3 on a year-over-year but as I pointed out I think the back end of the year Q4 but really a lot to do with the fact we have a very weak comparable in 2016 to go against that Q4 is where that'll help to offset the softer Q3 and that's why we're kind of saying we expected to be fairly flat for the back end of the year with obviously being driven by volume.

Overall back half sales flat year-over-year, some - still some weakness I guess in Q3 but made up in Q4.

That's what we're expecting at this point.

Okay. And then on the utility pole side, the 2.6% organic sales growth I know you talked about seeing better demand on the transmission pole side, so how much of that growth would have been transmission pole driven or special projects driven versus your - ?

Yeah, I may have been a little unclear on that it's actually the first half of the year is it hasn't been, we had large Muskrat Falls project last year in the first half of the year that actually created a strong first half on transmission. I was more looking forward to the back end and into 2018 is where we're going to see that uptick on the transmission side.

So it's entirely driven by the distribution in fact it's even helping to offset a slight decrease in transmission. So I was more just pointing to that looking forward.

Okay. So the distribution increase would have actually been better than the 2.6% distribution alone?

Correct, yes.

Okay. And is that I mean I don't know exactly what the number is but it sounds like sort of low mid single digit growth, which is pretty healthy.

Is that in any way tied to any kind of a pickup in sort of the replacement - the longer term larger scale replacement cycle that has been talked about in the past, is it the front end of that in any way or is this not yet showing up in that sense?

No, I mean maybe a small part of it might be, but it's really just to do with some growth we're seeing in the southeast and really some additional capturing of some additional market share.

Brilliant. Okay.

And then I guess just in terms of trying to interpret the outlook commentary I mean it sounds like there have been a few moving pieces with you had to pull forward but then sorry this is on I guess specifically on the tie side I mean. Yet the same time you're talking about some of the margin pressures maybe persisting a little longer than you would have originally anticipated so I'm trying to get a sense for ties overall has your outlook - are you saying your outlook is now improved from what it was or is it just there's a few different moving pieces but it's kind of largely similar to what it would have been last quarter?

Yeah, I think that's fair way to put it, Michael. It wouldn't have changed all that much, it's just kind of shifted around in terms of the timing throughout the year and just strictly related to railway tie.

Okay. And I guess your comments around maybe seeing a bit of upside potential in 2017 on the overall margin, EBITDA margin expectation that would seem to suggest that the margin pressures on ties, it possibly extending into '18, they have become any greater this year than you expected but maybe just going to persist a little longer?

Yes, that's fair. And then being partially offset just by what we're anticipating to be a bit better mix on the utility pole side in terms of behavior to the transmission.

Got it. Okay.

All right that's all for me. Thank you.

Thank you.

Good morning. Thanks for taking my call.

Hi, Justin.

Hi. Just on the working capital accounts, the accounts receivables jumped quite substantially from Q1.

I assume this is a normal seasonal trend, but should we expect this to reduce just as sharply for the next quarter or will it be more gradual?

Eric perhaps be my expert on receivables and working capital will answer this one.

Certainly, thanks, Brian. So, Justin, I mean the accounts receivable to Q2 is typically or historically has always been our strongest quarter.

Q3, moving on to Q3 and Q4, it will peep her down and receivables will turn accordingly. I can assure you that our DSO collections remain constant over time.

We have a solid customer base and there are no collections issues behind that.

Okay. And then on the inventory, should we expect a similar level for Q3 just given some potential impacts on the residential lumber side due to the weather or should we also expect a normal seasonal decline there?

I think Justin not clear, you're asking you mean related to the fact that supply may be a little tight and slightly higher pricing because really what we've seen in the first part of the year is inventories have been coming down really a lot to do with the fact that our railway tie pricing is dropping the value of that inventory is coming down even though volumes are not coming down by the same speed as the costs going in. But I would say it is normal for residential lumber to go up towards - as we get the back end of the year as we're going to be building once again for the 2018 season.

So, there is a substantial drop on the residential lumber inventory in Q3. Would that be fair?

That's fair. It's going out, but we try to have it coming in at the same speed now whether there will be some supply constrictions that may see more of that towards the back end of the year.

It's difficult to say at this point in time. I think a lot will have to do with - the fire is getting under control at west and we'll see what happens on the lumber duties as well.

Okay. That's helpful.

And then just maybe a broader question in the trend I see developing. Some of the railways seem to be implementing new technologies as part of their maintenance programs.

I'm wondering if you just expect any of these to be affecting the railway tie sales over the longer term either positively or negative.

At this point I believe we're going to see it being relatively neutral. I think it's just going to make sure that they're changing the right tie up.

Okay. Thanks for taking my questions.

Thank you, Justin.

Good morning. Thanks for taking my call.

Hey, Brian.

Can you just on the utility pole side, I'm still trying to wrap my head a bit around the geographical mix and just try to understand whether it's a near-term item or more of a structural change in sort of how the business is going to go going forward?

Well, certainly, that's a great question and I would say it is certainly going to continue to see growth in that market just by the nature of - that's where a lot of our potential acquisitions lie. I would say we have experienced sort of last year and parts of even this year a little bit softer in the other markets, but that's starting to come back, so the mix will start swing back a bit, which will be helpful, but then, of course, as we expand and do more acquisitions, that could then be a little bit more heavily weighted down there as well.

Okay. Great.

Thanks. And then just more on SG&A, just referenced lower profit sharing in the quarter, is there potential for a catchup in the back half of the year or how should we view that run rate for expenses?

I hope there is a catchup, because that will mean that we're doing better overall as a company, because it's really entirely based off of how we're performing from an EBIT standpoint.

Okay. Great.

Thanks so much.

Okay. Thanks, Brian.

Thanks for taking the follow-up. Brian, just on the EBITDA margins, consolidated EBITDA margins for this year, can you just help me think about the back half of the year?

I mean there was some discussion earlier. It sounded like you still saw potential for progression.

But how should we think about the next few quarters? And I gather you got some benefit a little bit from this pull-forward, but just the back half of the year and particularly where you exit the year in terms of EBITDA margins.

I think a lot of it, Mike, was going to be timing on some of the project orders that have really picked up for us and how much of that's going to fall into this year. But it's certainly going to have a positive influence on us.

So, if we're tracking sort of around that 13% now, I think we could see finishing the year north of back. So, whether it's going to be a little over 13, 13.5, the crystal ball is not quite clear enough to give a more accurate number right now, but I'm comfortable and I think we can expect that to come up.

But that's - so would you talk about 13, just over 13, you're talking about full year?

Yes. Yeah, I'm sorry.

Yes, yes.

By the time you get a yes to the fourth quarter, you will have put a lot of the pricing pressures associated with the price coming down on the tie side and the margin impact sort of behind you. I realize you're now suggesting maybe that creeps a little bit into '18, but where do you think you kind of exit the year with a lot of those pressures sort of behind you and then I guess some of the other pieces that are moving at this point?

Yeah. Well, I'm hoping that we're going to exit the year sort of a little north of the 13.5.

Bear in mind, of course, we'll have to look at the full back end of the year because Q4 always has the lower volumes that put a bit of pressure on an EBITDA margin, but I'm more talking about the entire back half. So, I'd like to think we're going to be coming out of that towards the higher end of 13.

Right. Okay.

And so, when you began to answer the question we're talking about, some of it depends on how the - I think you suggested how some of the projects play. You're talking about the special projects with the transmission?

Correct. Yeah.

That's right.

So, some of that should start to hit this year, but you also…

Yeah. There should be a good amount, but we're also - we're seeing already indications of it continuing well into 2018, which is very encouraging.

Okay. And so, not to take up too much time here, but just what is it that's driving that pickup?

I know I think the downturn in that part of the business was largely tied to resource activity. Is there a resurgence and resource related demand or is it something else?

No. It just seems to be some bigger maintenance projects.

It seems some of it is tied to some green energy initiatives. So, it's pretty well a mix, but we're certainly happy to see it.

Got it. It makes sense.

Thank you.

Thank you, Michael.

Hey, guys. Just one quick follow-up for me, just on the inventory side, I mean, historically we see obviously a big buildup in Q1 and Q4 given the fact that predominantly selling in Q2 and in Q3.

Can you talk to us about the level of inventory that you're comfortable with now and if you're comfortable with that now?

Well, we're - I guess the easy answer to it is we're comfortable where we are now from an inventory standpoint. We were well positioned to continue where we expect to go and we will see those seasonal patterns that we do all the time, but kind of as we explain, what's helping us certainly is the lower white wood pricing on the ties.

We'll have a bit of headwind on inventory costs as we go forward just because of higher lumber prices, but I believe the ties will continue to offset that.

Okay, so the current number that we're seeing right now that should be more reflective of the understanding obviously the seasonal component, because it was a very huge drop-off between the Q1 and the Q2. So, this is kind of more what you're in line with what you're more comfortable with.

Yeah. I think maybe a better way to answer that is that as we go into '18, I would expect that we'd probably be, all things being equal, similar levels at that point in time as we see now, Q2 would be similar to what we are experiencing now or at the end of Q2.

I think that's kind of what you're getting at.

Yeah, exactly. Thank you.

No problem.

Well, thank you everyone for joining us this morning. We look forward to speaking with you again in our next quarterly call.

Hope everybody has a great day. Take care.