Stella-Jones Inc.

Brian McManus - President, CEO & Director Eric Vachon - SVP & CFO

Hamir Patel - CIBC Capital Markets Benoit Poirier - Desjardins Securities Leon Aghazarian - National Bank Financial Justin Keywood - GMP Securities

Thank you. Good morning, everyone.

I'm here with Eric Vachon, Chief Financial Officer, Stella-Jones. Thank you for joining us for this discussion of the financial and operating results for the company's second quarter ended June 30, 2018.

Our press release reporting Q2 results was published earlier this morning. It can also be found on our website at www.stella-jones.com and on SEDAR.

Let me remind you that all figures expressed on today's call are in Canadian dollars unless otherwise stated. I will begin with a brief overview of the quarter.

Our second quarter results demonstrate strong sales growth, sales increased in the utility pole, residential lumber and logs and lumber product categories, driven by increased selling prices and market demand. This performance was partially offset by the continued temporary headwinds in the railway ties product category, primarily related to the transitioning of the Class 1 railroad customer to a full-service program.

We are also pleased to see our operating margins improved sequentially by 1.8% over the first quarter in-line with our expectation. Overall revenue amounted to $662.3 million versus $594.2 million in the same period last year.

The contribution from acquisitions was $26 million, while the currency conversion effect had a negative impact of $18.6 million, on sales. Excluding these factors, sales increased $60.7 million or 10.2%.

Net income for the quarter was $48.1 million or $0.69 per diluted share compared to $0.71 per diluted share a year ago. In a moment, Éric will discuss the financial performance of the company in greater detail.

I will now address the second quarter results by product category. Railway tie sales reached $201.3 million, down from $214.2 million for the same period last year.

Excluding the currency conversion effect, sales declined $4.7 million or 2.2%, primarily as a result of the company supporting the transition of the Class 1 railroad customer from a treating services only program to a full service black-tie program. We expect that this transition will negatively impact sales to this customer until the latter part of the third quarter.

The sales decrease was also due to continued soft pricing environment, which we have already started to see improved in most regions. Turning to utility poles.

Sales amounted to $179.3 million, up from $167.5 million for the same period last year. Excluding the contribution from acquisitions and the currency conversion effect, sales increased by approximately $17.6 million or 10.5%.

This growth was driven by higher volume for replacement programs coupled with increased sale prices from standard contract escalation and renewal causes. In the residential lumber category, sales were $203.6 million, up from $153.2 million for the same period last year.

Excluding the contribution from acquisitions in the currency conversion effect, sales increased by approximately $33.8 million or 22.1%. This favorable variance is primarily explained by higher selling prices as a result of lumber cost escalations being passed through to customers and to increase volume due to the company's expanding market presence.

In the industrial product category, sales reached $32.8 million, up from $27.1 million for the same period last year. Excluding the contribution from acquisitions and the currency conversion effect, sales increased 3.3% explained in most part by projects requiring our treated laminated products.

Finally, in our category of logs and lumber, revenue stood at $45.3 million, up from $32.2 million in the same period last year. This significant increase reflects higher selling prices due to increased lumber cost, coupled with increased harvesting activity related to procurement activities to support strong pole sales.

Turning to our network. During the quarter, we acquired Wood Preservers Incorporated, which manufactures, sells and distributes marine and foundation piling and treated utility wood utility poles located in Virginia.

We are currently in the process of integrating both WP and Prairie Wood -- Prairie Forest Products acquired in February in our operation. Once fully integrated, our network will be that much stronger.

Éric will now provide further details about our second quarter results. Éric?

Thank you, Brian. Gross profit amounted to $96.7 million or 14.6% of sales in the Second Quarter of 2018, compared with $99 million or 16.7% of sales in the second quarter of 2017.

The decrease in absolute dollars is primarily explained by the transition of a Class 1 railroad customer from a treating services-only program to a full service black-tie program. To accelerate this transition, the company acquired untreated railway ties from the Class 1 railroad customer, which increased cost of sales once these ties were treated and sold.

Railway tie margins were also impacted by increasing untreated railway tie costs in the second quarter. The decrease in gross profit is also attributable to a higher operating cost in the U.S.

Southeast, where Stella-Jones continues to work on reducing its cost base and improving logistical flow. In addition, the higher lumber costs, which are passed through to customers via higher selling prices have contributed to increase the cost of sales, but have also put downward pressure on margins as a percentage of sales.

These cost increases were partially offset by the effect of currency translation. As a result of the reduction in gross profit, operating income stood at $71 million or 10.7% of sales, down from $74.5 million or 12.5% of sales in the second quarter a year ago.

As we explained last quarter, we expected our margins to be softer in the first half of the year. Note, that margins in the second of the year are expected to improve over the first half.

Similarly, net income for the second quarter of 2018 was $48.1 million or $0.69 per diluted share, down from $48.9 million or $0.71 per diluted share in the second quarter of 2017. Cash flow from operating activities before changes in noncash working capital components and interest and income taxes paid was $81.7 million for the second quarter of 2018, compared with $83.2 million for the same period in 2017.

However, given higher working capital requirements, this year versus last year, Stella-Jones generated cash flow from operating activities of $62.4 million in the second quarter of 2018, as compared to $94.4 million for the same period last year. In the second quarter, our cash was primarily used to finance the Wood Preservers Incorporated acquisition of $28 million, invest in CapEx for $12.5 million and pay dividends of $16.6 million.

As of June 30, 2018, Stella-Jones' long-term debt, including the current portion, was $581.2 million versus $455.6 million as of December 31, 2017. The increase mainly reflects higher working capital requirement, financing for the acquisitions of Prairie Forest Products and Wood Preservers, higher capital expenditures as well as the effect of local currency translation on U.S.

dollar denominated long-term debt. As a result, Stella-Jones' total debt-to-EBITDA ratio was 2.5 versus 1.9 as of December 31, 2017.

Finally, the Board of Directors of Stella-Jones, yesterday, declared a quarterly dividend of $0.12 per common share payable on September 21, 2018, to shareholders of record at the close of business on September 3, 2018. I will now turn the call back to Brian for the outlook.

Thank you, Éric. Based on current market conditions and assuming stable currencies, we expect higher year-over-year overall sales for Stella-Jones, driven by pricing as well as increased market reach for the residential lumber, utility pole and logs and lumber category.

Operating margins are expected to improve in the second half of 2018 when compared to the first half of the year. However, the progression of operating margins in the second half of 2018 will be slowed down by increasing untreated railway tie costs until sale prices can be adjusted.

As a result, we expect 2018 overall operating margins to be slightly lower than last year. Having said this, in 2020, we remain confident that our EBITDA margins will return to the 15% range on an annualized basis.

In addition, we plan on spending between $30 million and $40 million on property, plants and equipment in 2018, and our overall effective tax rate is expected to be approximately 26.5%. Let me discuss our outlook by product category.

In the railway tie product category, pricing is expected to improve in the second half of 2018 with the related margin gains will be partially offset by rapidly increasing cost of untreated railway ties. We expect that this raw material cost increase will lead to continued upward selling price adjustments in the quarters ahead.

The spot market pricing should also benefit from the tightening of the untreated railway tie supply. These adjustments will have a positive effect on margins in 2019 and going forward.

In the utility pole product category, sales in the second half of 2018 will benefit from both pricing adjustments and strong demand. We also expect a better sales mix within the product category for the upcoming quarters.

However, these factors will be partially impacted by slight cost increases for certain wood species in the timing of price adjustments. In addition, we continue to work at optimizing our operations in the U.S.

Southeast, which will lead to improved margins in the second half of 2018. In the residential lumber product category, sales for the second half of 2018 are expected to increase year-over-year as we expand our market reach and benefit from increased pricing, driven by higher wood cost.

The effective adjusted residential lumber selling prices, as a result of higher wood cost will have a slight downward impact on margins as a percentage of sales for the year. Finally, sales for the logs and lumber product category will continue to grow as a result of increased harvesting activities and the impact of the higher cost of lumber.

Since this business does not generate any margins, sale growth in this category will further reduce overall margins as a percentage of sales. In the short term, we will focus on integrating the recent Prairie Forest Products and Wood Preservers Incorporated acquisitions, as well as optimizing operating capacity and minimizing cost for the organization.

As we indicated in the last conference call, we commissioned additional pole-treating capacity at the end of the second quarter, which will help improve customer service and our operating cost in the U.S. Southeast.

Over the long term, our strategic vision focused on continental expansion remains intact as we believe that the fundamentals of each product category remain strong. Our vision is to solidify Stella-Jones as North American leader in the pressure treatment of wood for railway ties and utility poles, while diversifying into other product categories that are aligned with the company's established confidence.

As we have done for over a decade, we're committed to our established business while pursuing a disciplined program of acquisitions. This strategy has helped us consistently enhance shareholder value, and we are confident we'll continue to do so.

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

Brian, you pointed to the escalation in untreated crossties as tampering the margin recovery over the rest of the year, how long do you think that it'll take to pass it on based on the timing of your contracts?

For the most part, it will be -- it depends at what point does the -- we're kind of chasing the higher cost up, but I would suspect by the end of the year into the first quarter, we'll -- we've already had price adjustments through. And we'll see at that point, if the upward pressure on untreated ties continues, but we've certainly seen a sharp increase in the last several months.

Great, thanks. That's helpful.

And do you have a sense yet as to how the Class 1s are thinking about the tie-purchase programs for 2019? Is it looking flat?

Or are you expecting some growth there?

It's a bit mixed. Some are probably going to be down a bit, while others are up.

So I think on balance, the mix within our customer group will probably going to be up a bit overall in the Class 1.

Great performance on the residential lumber side. I mean, the organic growth number was quite strong there.

I know you mentioned lumber prices were a pretty big factor. Can you help us quantify that a little bit?

I mean, was it a big volume impact there or was it really on the pricing side? Just maybe help us understand that a little bit better please?

Sure. About 2/3s would be related to price, and 1/3 would have been volume.

Okay. And you also mentioned that you're on the lumber side as well as some of the other segments, but you're seeing an increased market reach, can you explain to us what that means about that?

Are you in more geographies now than you were before or you're in different contracts that you've gained, or how should we see that side?

A bit of both. We're in more geographies because of our acquisitions -- or acquisition related to Prairie Forest Products.

So that geographically got us into a region where we weren't before. And then, additionally, within the same geographical areas where we've expanded some of what we refer to as our dealer network, which would be the non-bock story.

Okay. And just two quick, kind of, clarification things up from my end will be, on the CapEx, you mentioned $30 million to $40 million for 2018.

I mean, you've already spent north of $25 million in the first half of the year. So is that to understand that the second half is going to be very minimal in terms of spend or is that an additional $30 million to $40 million?

No. Our guidance is for $30 million to $40 million for the whole year on the CapEx.

Okay. No, that's what I though, I just wanted to clarify.

And then, last point would be on the logs and lumber side. Obviously, that number was quite high as well, and you mentioned that is low margin to no margin.

So I'm just trying to understand like if it wasn't for logs and lumber, even what kind of EBITDA margin we'd be looking at for the quarter.

The impact, if we would have had it, call it the same or a no growth may be in that product category. It had approximately about 0.5% on the EBITDA margin.

Just related to the outlook, could you mention some color with respect to the railway tie, but mostly for the nonclass railroad for 2018 and 2019?

In terms of where we expect demand to be, is that -- I'm sorry, just a little unclear on the question.

Yes, exactly. In terms of demand, what you would expect from the nonclass railroad for the remainder of 2018 and 2019, Brian?

We expect actually that it will continue to be healthy. I think, certainly we've seen a real tightening in inventories as an industry, and that is certainly going to help us from -- hopefully from a profitably standpoint and margin standpoint in the quarters ahead.

But we're -- we've worked through as an industry, depend on -- it's probably swung in the other direction now. We went from too much to now where we're seeing a real tightening in the untreated availability of ties.

So that's going to, I think, help us in the quarters ahead.

Okay. Perfect.

And maybe the question is for Éric. When you say about the slight decline in the overall EBITDA margin in 2018, could you provide some color or quantify a little bit what is the overall EBITDA number we should expect for the whole year, Éric?

Are you talking in absolute dollars or percentage?

In percentage.

Either.

Yes.

About 12.5% annualized, Benoit.

Okay, for the full year, okay. That's great color.

And when we look at the utility pole, given the trend or higher interest, could you provide some color on if it impacts the outlook for your utilities, whether it could turn into lower CapEx or whether you haven't seen any impact so far?

We haven't really seen any impact so far. I think, we remain fairly bullish that we're continuing to see healthy maintenance programs.

Okay. That's very good.

And could you comment a little bit about the outlook for M&A, now that you perform some acquisition this year, whether there's still a pipeline for 2018 or mostly 2019?

I would say, we're always -- as you're aware, we're always looking at opportunities. I think, the timing of those opportunities is difficult to judge sometimes, just based on everything from due diligence requirements to the seller's interest themselves and in terms of the timing.

So I would say, we're confident we have some other ones ahead of us whether that will hit '18 or '19. It's hard to say at this point in time.

Okay. And last one for me.

Could you provide an update on the progress related to the growing the U.S. residential lumber.

You made some comments in the past quarter, so I was just curious to know, is there, kind of, an evolution in terms of U.S. residential lumber?

On the U.S. residential lumber side, I mean we continue to see a healthy program being driven out of the northwest at our Tacoma facility.

I think, at this point in time, our focus on acquisitions is going to remain primarily on the pole and tie side. And I think, to expand beyond our residential presence in the U.S., we'll take acquisitions of assets.

So I would say that's still a wait-and-see, and probably, a little further out.

On the working capital, as you mentioned, it was high in the quarter, and the accounts receivable seem to spike. I'm wondering is this just normal seasonality?

And should we expect that to come down substantially in Q3?

You're exactly correct, Justin. It is the seasonality.

Day sales are very stable comparable, year-over-year, and no collection issues, but you're right that the higher amount is related to the volume of business.

Okay. And then on the debt ratio, it was $2.5 million in the quarter, and there was an amendment on the accordion loan that expands the available credit quite substantially.

I'm wondering what's the comfort level for you on the debt ratio, and is this affecting any acquisition plans?

Historically, our comfort level is when we start to approach 3-year, just a little bit over 3x EBITDA, where I would say, we start to feel a little bit uncomfortable. We do get the benefit in any acquisition, not from a reporting standpoint for a ratio but for how the bank would deal ratios that we get to include the pro forma of any acquisitions that we would have done.

So that would help bring the ratio down. So we still have some good horsepower available for the acquisitions that we have in the pipeline.

We're still sitting good now. And we expect as we roll through Q3 to further see debt levels coming down for sure.

Okay. And then just, finally, on the growth and residential lumber, there's mention of increasing market share, I'm wondering is this capturing new customers or just expanding with existing?

It's actually a bit of both. We've picked up some new customers, and of course, our existing customers continue to perform very well.

So we'd like to think because they're with the right supply partner.

Okay. And is their opportunity to increase such share more or are you, kind of, reaching the limits?

I think, we're still able to expand on a dealer side of the market, and we'll certainly help our existing customers to continue to grow. So I think, there is opportunity.

I think, the greater opportunity, as per one of the previous questions, would eventually lie in the U.S. But at this point in time, like I said, our near-term focus will be on poles and ties.

Great. Well, thank you, everyone, for joining us on this call.

And we look forward to speaking with you again on our next quarterly call. Have a great day.