Stella-Jones Inc.

Thank you. Good morning, ladies and gentlemen.

I'm here with Éric 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, 2019.

Our press release reporting Q2 results was published earlier this morning. It, along with our MD&A, can also be found on our website at www.stella-jones.com and will be posted on SEDAR today as well.

Let me remind you that all figures expressed on today's call are in Canadian dollars, unless otherwise stated. Before we begin, I would like to also remind you that on January 1, 2019, the company retrospectively adopted IFSR -- IFRS 16 leases but has not restated comparatives for the 2018 reporting period.

Please refer to the MD&A for further details. Let me now begin with a brief overview of the quarter.

We are pleased with our second quarter results given the short-term challenges experienced in certain markets. Sales were stable at $661.8 million and decreased $18.2 million or 2.7% when excluding the currency conversion effect.

This variation is primarily explained by lower sales for railway ties due to temporary shipment delays, decreased sales for residential lumber as a result of wet weather conditions and reduced sales of logs and lumber due to lower selling prices and volume. These factors were offset by higher sales and healthy demand for utility poles.

We saw our profitability increase, driven by improved pricing, better operational efficiency in the U.S. Southeast as well as lower lumber costs.

Net income for the quarter was $52.3 million or $0.76 per diluted share compared to $48.1 million or $0.69 per diluted share last year. We also continued to follow our strategy of continental expansion by completing 1 tuck-in acquisition in Ontario in April and finalizing our plant expansion in Cameron, Wisconsin.

In a moment, Éric will the financial performance of the company in greater detail. Looking at the second quarter results by product category.

Utility poles sales reached $206.3 million, up 15% from sales of $179.4 million last year. Excluding the currency conversion effect, utility pole sales increased $20.3 million or 11.3%, primarily driven by increased sales prices and continued volume increases in the U.S.

Southeast and overall healthy demand in the United States. Railway ties sales amounted to $194.7 million, representing a decrease of 3.2% from sales of $201.2 million last year.

Excluding the currency conversion effect, railway ties decreased $13.2 million or 6.6%. This variance is mainly explained by delayed shipments due to low railcar availability as well as the longer treating cycle times, which pushed the delivery of certain orders to the second half of 2019.

The longer treating cycles are a result of the tight supply market for untreated railway ties, which requires the company to treat railway ties that are not air-seasoned. Sales in the residential lumber category totaled $194.8 million, down 4.3% from sales of $203.5 million last year.

Excluding the currency conversion effect, residential lumber sales decreased $11.2 million or 5.5%. This variance primarily resulted from lower demand due to wet weather conditions in Eastern Canada and, to lesser extent, by lower pricing.

Industrial products sales reached $38.8 million, compared with $32.9 million last year. Excluding the currency conversion effect, sales increased $4.5 million or 13.8%, largely as a result of stronger rail-related product sales.

Sales in the logs and lumber product category totaled $27.1 million compared with $45.3 million last year. Excluding the currency conversion effect, sales decreased by $18.6 million.

This variance is a result of reduced selling prices driven by lower lumber market costs, a decrease in lumber transaction volumes as well as lower log sales due to the timing of harvesting activities. Éric will now provide further details on our second quarter results and financial position.

Éric?

Thank you, Brian. Gross profit amounted to $108.2 million or 16.3% of sales in the second quarter of 2019 compared with $100.2 million or 15.1% of sales last year.

The increase is explained by higher selling prices and better operational efficiencies in the U.S. Southeast.

These factors were partially offset by lower volumes and slightly higher production costs for railway ties. EBITDA stood at $94.2 million or a margin of 14.2% versus $80.1 million or a margin of 12.1% last year.

The increase in EBITDA is explained by higher gross margin and the adoption of IFRS 16, which effectively subtracted $8.1 million in revenues, asset depreciation and $1 million in financing expenses from cost of sales in the second quarter. With IFRS 16, it becomes difficult to compare our EBITDA to last year.

As a general rule of thumb, you can subtract the reclass from cost of sales, which in this case is $9.1 million for our Q2 2019 EBITDA to make it comparable. Operating income stood at $76.7 million or 11.6% of sales in the second quarter compared to $71 million or 10.7% of sales last year.

Net income for the second quarter of 2019 was $52.3 million or $0.76 per diluted share, up from $48.1 million or $0.69 per diluted shares last year. Turning to liquidity and capital resources.

Cash flow from operating activities before changes in noncash working capital components and interest and income taxes paid reached $95.3 million in the second quarter, up from $82.2 million when compared with the same period last year. Cash flows provided by operating activities generated $25.6 million in liquidity versus $62.4 million last year.

This is primarily explained by an increase in working capital. We use this liquidity and our credit facilities to support purchases of property, plant and equipment for $27.5 million, including the April Shelburne, Ontario acquisition for $9.2 million and dividend payments of $19.4 million.

During the quarter, we amended our credit agreement and increased our credit facility by USD 100 million, now providing financing up to USD 425 million. This will provide us with greater flexibility to manage our working capital requirement and make strategic acquisitions.

As at June 30, 2019, our long-term debt, including the current portion, was $619.7 million versus $513.5 million as at December 31, 2018. The increase mainly reflects higher working capital requirements, higher capital expenditures and financing required for the acquisition of Shelburne, partially offset by the effect of local currency translation on U.S.

dollar-denominated long-term debt. Finally, the Board of Directors of Stella-Jones yesterday declared a quarterly dividend of $0.14 per common share payable on September 20, 2019, to shareholders of record at the close of business on September 2, 2019.

Turning to our outlook. We reconfirm our general outlook for 2019.

We expect higher year-over-year sales based on current market conditions, the current level of lumber prices and assuming stable currencies. This increase is driven by stronger pricing for railway ties and utility poles as well as increased market reach for the utility pole product category.

This overall increase in sales is expected despite lower sales in the logs and lumber product category. We also expect improved year-over-year margins on a consolidated basis.

Higher margins will be primarily driven by increased pricing and volumes for railway ties coupled with improved product mix and demand for utility poles. More specifically, in the utility pole category, sales and margins for 2019 are expected to increase year-over-year, driven by both pricing and healthy demand for replacement programs.

In the railway ties category, sales and margins for 2019 are expected to improve year-on-year, primarily driven by pricing. Sales in the latter half of 2019 will benefit from second quarter delayed sales and healthy demand.

We believe that the increasing cost of untreated railway ties, combined with a tighter supply market, will lead to continued upward selling price adjustments for the quarters ahead. In the residential lumber product category, sales for 2019 are expected to be stable year-over-year as higher demand and market reach are expected to be offset by lower selling prices to customers as a result of lower lumber costs.

It is important to highlight that sales for the logs and lumber product category, an activity used to optimize procurement and which does not generate margin, is closely tied to the market price of lumber. We expect lower year-over-year sales for this product category explained by lower lumber prices when compared to 2018 and reduced volumes.

The decrease in sales for the logs and lumber product category will favorably impact overall margin as a percentage of sales when taken as a whole with other product categories and vice versa. Furthermore, we plan on spending between $60 million and $70 million in capital expenditures for 2019.

This includes the plant expansion carried out in Cameron, Wisconsin, as well as the Shelburne acquisition and upgrades. Our strategy remains intact as we will continue to focus on optimizing operations across the organization while seeking acquisitions to further expand our presence in our core markets.

Before we open the call up for questions, Brian would like to say a few words. Brian?

Thank you, Éric. As you all may know, this will be my last conference call as President and CEO of Stella-Jones.

I will be stepping down in October after over 18 years. It has been a real privilege to lead this company, and I'm confident that our management team continue to build upon the excellent culture we have formed together while writing some new and exciting chapters of their own.

Let me take this opportunity to thank all the employees of Stella-Jones for their dedication and the investors in our company for their support. I look forward to watching the company as it continues to grow.

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

Brian, you previously guided for a full year EBITDA in the $325 million to $330 million range. I think you said plus or minus $10 million last time.

Has there been any change to that outlook?

No, there hasn't. But I'll get Éric to reconfirm since he's going to be leading with the back end of the year.

Yes. So Hamir, yes, we confirm our outlook for the guidance on the EBITDA is the same.

Okay. Great.

Éric, that's helpful. And in Q2, you guys pointed some deferred sales in Q2 due to shipment delays on the ties side and weather headwinds in res lumber.

Could you quantify what those were in each segment? And how much of the res lumber do you expect to pick up in Q3?

The easier answer will be on the railway ties side of things just because of it's -- call it, easier to quantify. I would say we're looking at roughly between $10 million and $15 million on the deferred sales part for the railway ties.

When you look at the residential lumber, I think what we've started to see already July was actually a good month for us, and we're hopeful that we'll play in some catch-up on the bad weather we experienced in April and May. So I'd be very difficult to give a number around the residential, except obviously you can see in the results that we're a little bit below what was last year.

And some of that, of course, is the pricing because of the lower lumber costs.

And then just turning to the poles side, it looks like revenue growth there was still pretty healthy, double-digits. How much of that was price and how much was volume?

It was kind of -- well, it was a bit of both and there was even some mix, because what we're also seeing is -- we saw some healthy demand on the transmission side, poles as well, and that's expected also to continue certainly for the back end of the year and even well into 2020. Operator Your next question comes from the line of Michael Tupholme from TD Securities.

On an overall basis, you're continuing to guide to year-over-year revenue growth in 2019. Just wondering, when we think about the overall business, your revenue growth on an organic basis in the first half is sort of flat.

How should we think about the quantum of organic revenue growth in the back half?

Éric, did you want to...

Yes, certainly right. So looking at the -- it was the -- considering stable FX impact, I think we could see in general terms some low single-digits organic growth for the second half of the year.

Okay. And that's with the benefit of some of the deferred sales from Q2 coming through in the second half?

Yes.

Okay. And are all of the issues you encountered in the ties segment in the second quarter in terms of availability of railcars, is that all overcome now?

Or is that back to normal?

Yes. For the most part, it is back to normal, and we expect to see strong shipments in the back half of the year.

In addition to that, too, as we mentioned, one of the things we're up against is dealing with a very tight supply market right now for the untreated ties. And so that's forcing us to do our boultonizing process, which requires us to balance the capacity of our facility.

So that's going to push out some of the deliveries later in the year as well just in terms of the availability of the finished product.

Okay. And I know you did mention that in the release, but the sort of the tight availability of raw material in the ties segment, that's been an issue for a while.

Was that already kind of contemplated in your outlook for the year when you communicated that to the market earlier? Or was the expectation that you were going see some improved availability?

The expectation that we were going to see some improved availability kind of during Q2, but unfortunately, as you'd be aware, Louisiana got hit with a -- I'm not sure if it was classified as a hurricane or tropical storm, but a lot of additional wet weather moved into that area. And we've also seen record rainfall in a lot of our other procurement areas.

So again, the positive news is we've seen some good improvements in the very recent weeks in terms of availability of what's coming in and -- but we've got catch-up to do in terms of replenishing beyond the white stock, if you want to call it, the untreated stock.

Okay. And then just looking at the outlook commentary, I know you indicated that, in general, it hasn't really changed on an overall basis.

But if we look at the commentary as it relates to the margin outlook, you're talking about higher year-over-year margins in all product categories previously, whereas now we're simply talking about higher on a consolidated basis. So can you just speak to specifically what's changed on the margin outlook?

It sounds like overall it's not necessarily different, but some of the underlying pieces, it sounds like they may be changed a little bit.

No, not significantly, Michael. I guess we were more comfortable with the overall approach.

Obviously, we've seen that it was going on with the residential lumber and the log prices and -- or the lumber prices, that's a bit harder to predict. So that might be a bit flattish in progression.

But I think, overall, we still remain very confident with the general outlook in the main product categories.

First question, when we look at the overview of the railway tie industry, we look at the inventory closer to, well, $13 million, which is really below the historical trough, the inventory-to-sales ratio at 0.62. Could you talk a little bit about the dynamics and the confidence that eventually the inventory will get replenished?

And also talking to Class 1, what do you foresee in the future? When I look at the CapEx, it sounds overall stable for the next 2 to 3 years.

So any thoughts about what you -- we should expect from Class 1 railroads given the slight decline in volume?

Certainly, overall demand from Class 1 is expected to continue to be healthy. We continue to see them invest in maintenance of their rail lines.

And your point on near-historical lows in both in terms of inventory and inventory to sales on the railway ties side is clearly a good indication of a healthy market for us or opportunities for us going forward. Really, it's just a matter -- our procurement team is doing an outstanding job of getting everything that's available out there into our plants, and they'll continue to do that.

And we just recently had a meeting on that and they remain confident of continuing to get what we need. It's a little hand to mouth, but we're making it work.

Okay. And with respect to boultonization, would you be able, Brian or Éric, maybe to quantify the impact on the margins and whether you have enough capacity for boultonization going forward given the current low inventories?

Yes. Really, the effect on margins is rather minimal overall, especially when you consider that there's often additional charges or we have to build it into our pricing on it from what we're doing there.

It's more to your second part of the question, which is the capacity at our facilities from a standpoint of the longer cycle times do tie up a bit more capacity. But we have a very strong network, and what we're doing -- the team is doing a great job of shuffling that capacity to meet the customer needs across the network.

So we have enough capacity to treat what's coming in and we'll continue to do that. So -- as we continue to move forward and we hopefully continue to see the strong incoming untreated ties, that's going to further help us as we start to get more and more ties up in the deck to dry.

Okay. And for the profitability of the utility pole, you've been working to improve profitability in the U.S.

Southeast. Could you maybe give an update on where you are and maybe comment about the overall M&A opportunities you see in the segment and the overall business?

Sure. I'll comment just sort of on our success we've realized in the Southeast.

It -- as people know, we've been speaking about it for a little while. We're a little slower than we would have liked to in the rationalization of the acquisitions we had done there and the integration.

But we're certainly -- while not all the way there, we've seen some very good improvements and that's certainly showing through in our cost overall. In terms of the opportunities from acquisitions, Éric, I'm happy to let you comment on that.

Certainly. So we're -- Benoit, our plan is unchanged.

We are still considering the similar targets in our plan over the next several months and that hasn't changed. We still have ongoing discussions with different parties.

Okay. Perfect.

And last one for me. When I look at the work -- the change in working cap, obviously, the impact on the residential lumber made some impact in Q2.

How should we be looking at the working capital movement in the later part of the year? And maybe if you could give kind of the expectation for the full year and the implication on the balance sheet standpoint maybe.

Well, Benoit, where we stand today if we look at a few of our product categories, first, the railway ties, we know we need to replenish a bit more inventory on that. And so we can definitely expect a bit of cash draw on the railway ties side.

There's some -- also some opportunity in the residential lumber. Right now the market is -- I don't want to qualify it as a low, but it's -- historically, it's sort of attractive.

So we definitely will be looking to, before the end of the year, to prepare for next year season on the residential lumber. So I do expect a cash draw, call it, somewhere between $30 million and $40 million on a cash draw at the end of the year.

Okay. For the total year or so, a big boost in the second half and now, okay, some catch-up, meaning that your debt/EBITDA ratio will improve from the level at the end of Q2.

Exactly.

Okay. Perfect.

Assuming no acquisition.

So Brian, lots of inbound questions after your announcement, speculation as to why you're moving. It does seem to be all of a sudden.

It wasn't kind of sensitive -- the market wasn't really sensitized to it, if you want to put it that way. Anything you can provide in terms of how we could answer those questions when they come in?

I'm sure you've gotten a few and just interested in how you've been answering them.

Well, I've been answering them exactly the same way for everybody, Walter. It's really after 18 years at the helm, there's never really a good time or there's never necessarily how much time is the right amount of time.

But I'm extremely confident in the position we are today. I'm also extremely confident in the overall team that we built over these past 18 years.

But really, I'm -- I chose this time to step aside. I'm at an age where if I was going to have another chapter in my career, shall we say, I viewed it as this could be more or less the best time.

I didn't want to leave at a point where the company was in really bad shape or certainly not at a point where the company had peaked out. I didn't that would be great to our team.

So I think there's some great opportunities that lie ahead for the company. And I'm pleased with my personal decision, if you want to say.

And I'm here until October to help with the transition and working closely with the Board and management to ensure a smooth transition.

Certainly wish you the best of luck in that next chapter, Brian.

Thank you, Walter.

Yes. And Éric, this has been certainly a growth story driven by acquisition, and the question becomes now whether given the acquisition pace has certainly slowed and whether you see going forward a significant pickup in that pace and therefore kind of that growth trend to reestablish itself from an M&A perspective.

But if not, would you consider re-examining how you -- how the capital structure of the organization runs? Specifically, would you look at higher leverage and a higher dividend payout ratio in the event that you were not able to identify your target level of acquisitions?

Thank you, Walter. I read 2 parts in your question, the M&A portion and capital allocation.

The second part of your question, the capital allocation piece, I think it's too early to have that discussion. And there's some internal discussions happening with the Board.

What I can tell you we do have our sights on certain acquisitions and expanding our network through a potential M&A -- or not potential, but upcoming M&A. There are ongoing discussions with different parties.

As you know, these discussions take their own time. They have their own pace.

Each acquisition has its own nature. But I'm quite confident that there's still some attractive acquisitions that we'll keep adding to our presence in North American market in our product categories.

Okay. If they were to not come to fruition, would that be one of the options you would bring to the Board in terms of how you would structure your organization from a capital structure standpoint going forward?

Yes, certainly. I'm quite optimistic that there are some acquisitions that are ahead of us.

But to your point, yes, we're not going to stand idle and wait around. We're definitely going to have an action plan.

Okay. Great.

Your guidance for CapEx was similar to last year. I think last time I jotted it down.

Is that -- it seems that you did have a fairly significant pickup in the second quarter here. Would you -- is that guidance still in place for similar to last year?

Well, we did reiterate that it's going to be -- or we didn't reiterate, we put that it's going to be a bit higher than last year. But most of that is explained by the acquisition that we did in Q2 because of the way it's getting treated.

Normally, the acquisition will not be part of the CapEx, but it's being treated as an acquisition of assets and therefore appears under our -- did I explain that well, Éric?

Yes, you did.

Yes. Just like it...

Trying to attempt my -- use my accounting skills but -- and that's really why you see the slight change in terms of the uptick in our expected. That combined with the fact that we're also planning on upgrading the facility.

And so you had $51 million last year, up $9 million for the acquisition, gets you the $60 million, up on another $5 million for reinvestment in the facility?

Yes.

Yes. We put I think approximately $6 million in the MD&A.

Yes. We guided between $60 million and $74 million for the year.

So you're right, you're on target.

All right. Okay.

Looking at your poles segment, I think you had a good quarter. You had been guiding high single-digit organic growth in 2019.

It was up 11 -- over 11% in the second quarter. Are you still -- are we dipping into double-digit now given how the second quarter has trended?

Or are we going to see a step down because some of that -- the moving parts of the second quarter?

Sorry, Walter. We just -- for some reason we missed part of that -- the question.

I believe your question was related to whether we expect to kind of see that slightly higher than high single-digit growth to continue for the balance of the year. Was that...

That's right. Given how well you did in the second quarter, even if we keep you at the high single-digit, you're going to be into the double-digit territory.

Yes, Walter. We're seeing very strong [Technical Difficulty] obviously coupled with price increases that we've been passing through because of higher raw material costs.

But yes, I would agree with that.

Maybe just a couple of points of clarification. The revenue guide for ties being up, residential being flat.

I'm not certain or sure that it's -- is that including sort of FX gains in the first half? Or is that sort of an organic number aside from that?

It's not that clear to me.

That would be including FX gains as if we're starting to date, I think.

Right. Okay.

And then the working cap number, Éric. I think you said $30 million, $40 million investment.

I wasn't sure if that was for resi later in the year or that's sort of like an annual number for the consolidated business.

That's consolidated. It would be a draw for total inventories.

Okay. And then on the availability of ties supply, just -- are you actually -- I mean do you guys have enough inventory?

Are you able to source what you need? Or is there sort of any cause for concern or issues there on your end?

There's certainly no cause for concern from the standpoint of it growing in the forest. If we look at the availability of hardwood that are out there, there's certainly more than enough.

It's really just getting access to it given some of the weather conditions that have been experienced. And again, we've seen record rainfall levels in some of the key procurement areas.

Now again, it's a little early to call it that it's -- we're back on track, so to speak, but we have certainly seen some good improvements in the last probably 3, 4 weeks in terms of the inbound of what's coming in. So there's no fundamentally -- fundamental change, if you want to call it, from that standpoint.

And I think that was more to your question.

Yes. I guess I presumed it's sort of an industry-wide issue and then you extend the lead times [indiscernible].

Oh yes, yes. That's certainly, absolutely.

Yes. And then you extend the lead times of your customers, I mean they're understanding why.

Yes, yes. Very much so.

And working with us as best they can.

Right. Okay.

Brian, congratulations and good luck on whatever you decide to do.

Thank you very much.

Just a couple of follow-ups here. The industrial products segment had a very robust growth in the quarter, 13.8%.

I think you said that was attributable to demand for rail-related products. Is that -- I guess any more color as to why it was so high?

And is that a level you think you can maintain in the second half?

So Michael, to answer your question, the rail-related products will be the bridges and the crossings and so on, and the demand really is a functionality of projects when the railroads do maintenance and they come across the need for these products, we're always there to supply them and we have capacity allocated to that. I think we will see some good growth here for -- well, as we -- as our outlook says for the whole year, we will have growth in sales and margin, and that product category is included.

It might not be to the tune of that percentage for the quarter, but that quarter is part of what is boosting the -- or supporting the category's growth for the year.

Okay. And then you've been -- or this has come up a couple of times.

But just on working capital, just so I'm clear, the $30 million to $40 million that you referenced a few times, Éric, that is the investment you expect in the second half of the year? Or is that for the full year?

Yes, yes.

So how should -- I mean maybe the -- I actually did the math and it's been -- what is the expectation for the full year in terms of changes in noncash working capital?

Yes. So I'm sorry, Michael.

So again, the change for full year will be -- if I look at the cash flow at the end of the year, there'll be a draw of $40 million for the inventory line, that's a bit of a way to put it.

Okay. Okay, sorry.

And then the CapEx guidance you provided, can you just reiterate that, please?

Yes, certainly. So we had given guidance I believe -- well, so our guidance now is $60 million to $70 million.

And we have given guidance of $40 million to $50 million. The incremental portion, if you want, the Southern acquisition was treated as a purchase of asset and not a business combination.

So that $9.2 million falls under the PP&E line. So that's a bit of -- part of the explanation.

And then following this acquisition at the Shelburne facility, we're doing upgrades at that facility to the tune of approximately $6 million.

Okay. And then just lastly, I mean, I realize this hasn't -- it hasn't been that much time since -- Brian, since you made the -- or the company made the announcement about your decision to step down, but is there any update at this point on the search for a new CEO?

I guess, really, all I can tell you at this point is that the Board of Directors has put together a committee. They have started a process, and they've engaged an outside third party to be part of that process as well.

Okay. And sorry I don't recall if this was mentioned, but was there any sort of timelines put around how long that process is expected to take?

There's not. And really, that'll be up to the Board.

But I think the Board certainly wants to ensure that it's done in a timely fashion as close to possible with my exit. But they'll take the time that's required.

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