Stella-Jones Inc.

Good morning, ladies and gentlemen. I'm here with Silvana Travaglini, Chief Financial Officer of Stella-Jones.

Thank you for joining us for this discussion of the financial and operating results for Stella-Jones’ full year and fourth quarter ended December 31, 2019. Our press release reporting full year and Q4 results was published earlier this morning.

It, along with our MD&A, can also be found on our Web site at www.stellajones.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 IFRS 16 leases, but has not restated as permitted comparative figures for the 2018 reporting period. Please refer to our MD&A for further details.

I will begin with a brief overview of our full year results. We delivered solid financial and operating results in 2019, concluding the year with sales and EBITDA growth.

For the 19th consecutive year, we increased sales, reaching $2.2 billion despite challenges of the tight untreated railway ties supply market. Higher sales were supported by solid performances in our utility poles, railway ties and industrial product categories, which more than compensated for the over $40 million decline in sales in the logs and lumber product category, unfavorably impacted this year by lower lumber prices.

Led by sales growth and consistent with our guidance range, EBITDA rose 28% to $312.9 million in 2019 and net income amounted to $163.1 million or $2.37 per share, up 16% and 20%, respectively. After adjusting for the impact of IFRS 16, our EBITDA margins increase to 12.9%, up from 11.5% in 2018.

For the year, we generated good operating cash flows, considering the significant increase in untreated inventory required to meet anticipated 2020 sales. Our strong balance sheet allowed us to return over $100 million to our shareholders, while continuing to pursue our growth strategy by acquiring a key residential lumber production facility and investing strategically in our network.

In line with our capital allocation approach, which is focused on balancing growth and returns, today we announced the 7.1% increase in the quarterly dividend, reflecting our commitment to deliver continued value to shareholders. Turning to our fourth quarter results.

Total sales in the fourth quarter increased to $439.9 million, up 1.6% compared to last year. Excluding the currency conversion effect, sales grew $4.4 million or 1%.

Utility poles sales amounted to $190.9 million, down slightly from $192 million generated in the fourth quarter of 2018. Excluding the currency conversion effect, sales decreased by 1.5%.

Despite higher selling prices and healthy replacement demand for distribution poles in the U. S., sales were unfavorably impacted by the lower level of transmissions pole projects in the fourth quarter compared to Q4 last year.

Railway ties sales increased to $131.3 million. Excluding the currency conversion effect, sales rose 3.1%.

The increase in sales stemming from improved pricing from Class 1 and non-Class 1 customers and ongoing strong demand was mitigated by limited availability of untreated tie earlier this year. During the fourth quarter, given the improvement in the availability of supply, we replenished our untreated tie inventory to levels required to meet anticipated 2020 sales.

Residential lumber sales totaled $61.1 million, relatively unchanged compared to the fourth quarter last year. Excluding the currency conversion effect, sales increased by 1.2%.

The reduction in the market price of lumber, which flows through to our selling prices, was more than offset by the continued organic growth in sales volumes and more winter booking sales compared to Q4 2018. Industrial product sales amounted to $26.3 million, up from $23.1 million recorded in the previous year's quarter.

Excluding the currency conversion effect, sales increased by 13% as a result of stronger volumes, mainly for preplating and crossing products. Logs and lumber sales, which are closely tied to the market price of lumber, were relatively unchanged at $30.3 million in Q4 2019.

Silvana will now provide further details regarding our results and financial position before I conclude with our outlook for 2020. Silvana?

Thank you, Eric and good morning everyone. Turning to profitability.

Operating income rose to $41.4 million or 9.4% of sales in the fourth quarter, compared to $31.8 million or 7.4% of sales in the same period last year. The improvement was primarily attributable to higher selling prices for utility poles and railway ties, which more than compensated the decrease in volume for transmission poles and higher production costs for railway ties due to longer treating cycles.

The decrease in the mark-to-market losses related to diesel and petroleum derivative commodity contracts also improved operating income in the fourth quarter by $9.6 million, while the adoption of IFRS 16 did not have a significant impact. Fourth quarter EBITDA improved to $58.8 million, yielding a margin of 13.4% compared to $41.8 million or a margin of 9.7% in Q4 of 2018.

The increase was mainly driven by stronger pricing and the favorable mark-to-market variation related to derivative commodity contracts, partially offset by higher costs for railway ties. EBITDA in the fourth quarter also benefited by approximately $8 million from the favorable impact of the new lease standard, as operating lease expenses are now recorded as depreciation and interest expense rather than operating costs.

Driven by the growth in operating income, net income for the fourth quarter increased 34% to $27.7 million or $0.41 per share. Turning to liquidity and capital resources.

With our resilient business model, we were able to deliver a solid performance in 2019, including generating $305 million of cash flow from operating activities before the effect of working capital changes and interest and income taxes paid. The improved availability of untreated ties and the anticipated 2020 sales growth for utility poles resulted in an over $160 million increase in inventories this year.

This largely explains the reduction in cash from operations to $89.9 million for the year. Together with additional borrowings under our syndicated credit facilities of $126 million, we returned for the full year, $109.1 million to our shareholders, consisting of $70.6 million of share buybacks and $38.5 million of dividends.

As part of the company's normal course issuer bid, we repurchase in 2019 1.8 million shares at an average price of $38.47. We also invested $65.8 million in capital expenditures.

This included spending to finalize our plant expansion in Cameron, Wisconsin, and the acquisition and upgrade of the Shelburne, Ontario asset, which expanded our network of residential lumber treating facilities. As at December 31, 2019, our long-term stood at $604.9 million and our leverage ratio remained low at 1.9 times.

We concluded 2019 in our very healthy financial position. Yesterday, the Board of Directors of Stella-Jones declared a quarterly dividend $0.15 per common share, representing an increase of 7.1% over the previous quarterly dividend, payable on April 24th to shareholders of record at the close of business on April 3rd.

This represents the 16th consecutive year of dividend increase. I will now turn the call back to Eric for the outlook.

Eric?

Thank you, Silvana. Based on the assumption that current markets and economic conditions stabilize and foreign exchange rates and raw material prices remain comparable to those with the prior year, we expect higher year-over-year overall sale, mainly driven by increased market reach in the utility pole, railway tie and residential lumber product categories.

More specifically, in the utility pole product category, sales and margins for 2020 are expected to improve due to better pricing, healthy demand for replacement programs and greater market reach. In the railway tie product category, both sales and margins are forecasted to increase.

Improved untreated railway tie inventory availability should lead to opportunistic sale to Class 1 and non-Class 1 customers. We also expect a stronger mix of non-Class 1 sales, which will support improved margins.

In the residential lumber product category, we are forecasting higher sales, mainly driven by volume increases and market reach. Management closely monitors changes in the North American lumber market and adjusts pricing accordingly in order to maintain dollar margins on similar volumes.

While absolute dollar margins are expected to increase as a result of higher volumes, margin as a percentage of sales, should remain at levels similar to those of 2019. In the industrial product category, sales are expected to be slightly lower in 2020 as rail regulated maintenance should require less bridge and crossing components.

For logs and lumber product category, sales in 2020 are forecasted to increase mainly due to higher lumber volumes. It's important to highlight that this product category is used to optimize procurement and does not generate margin.

Sales growth in our three core product categories is expected to support an improving in operating margins. As a result, notwithstanding additional acquisitions, EBITDA for 2020 is forecasted to be in the range of $320 million to $345 million compared to $312.9 million in 2019.

In terms of capital expenditures, we plan on spending between $45 million and $65 million in 2020. This includes an investment for storm water control and the construction of a new distribution center to improve operating performance at the newly acquired Shelburne facility, as well as expenditures to implement a new ERP system.

As a follow up to our press release from last December regarding pentachlorophenol supply, we have ceased taking steps to produce this preservative. We're currently working with our customers to offer a variety of solutions for the treatment of utility poles.

Our robust network is well positioned to offer a wide range of preservatives that are suitable and approved for wood utility poles throughout North America. We believe that the fundamentals of each product category will remain strong.

As a result, we will continue to focus on optimizing operating capacity, while seeking acquisitions to further expand our presence in our core product categories. With our solid financial position, we have the flexibility to continue to carry out our growth strategy and deliver sustainable long-term value to shareholders.

This concludes our prepared remarks. We will now be pleased to answer any questions you may have.

So just starting on the margin, expectation for margin expansion, you mentioned two items. So first of all, you had indicated that there was an increase in untreated wood inventory and that you expect that to improve.

And you also mentioned a stronger mix of non Class 1 sales, which would lead to increase in margin. Is this something you're seeing your visibility on that you're seeing evolve, and you're comfortable putting out there for 2020?

Or is it something that you're predicating it on, but have not seen examples or demonstrated indications of either of those at this point?

So, the comment on inventory is, as you know, last year, we had tight supply in the market and we had opportunities in the fourth quarter actually, great opportunities to increase our inventory levels of untreated ties, which positions us very well to be able to answer to the non-Class 1 demand, I'll start with that one. So we do see very active coating activities in this commercial contractor business for railway ties.

And therefore, it will also have availability we do believe we'll have a chance to see certain demand from Class 1s.

So based on that, you feel fairly comfortable that based on those indications and the actions you've taken, you should see margin enhancement as early as the first quarter?

That is correct.

And then interestingly on your shareholder return strategy, I noticed your buyback, you ramped it up in the fourth quarter here for $70 million total for the year. The dividend increases net $4 million additional, so it seems that you're directing a higher focus here on your buyback.

Can you talk a bit about your strategy there? Is that just based on the share, where you see the shares today?

Or would you consider increase dividends on a more regular basis to appeal to more income oriented investors?

So the approach we’re in a balanced approach and we want to be mindful of leverage. I understand your question about the dividend.

It was important for the board to show a year-over-year increase as we want to demonstrate that we continue believing in our capacity to generate strong cash flows, although, we want to be prudent with the leverage going forward, in particular as we mentioned in the outlook that we maintain our position to be able to grow our network through potential M&A in the coming months, coming year.

And on the M&A side, there's obviously some disruption emerging here. We have not seen you overly active on that front.

Can you talk about is this due to willingness on the seller here, just not at this point willing to step up? Is it a disconnect in the multiple of price offered?

Is there an opportunity here in 2020 for you to really ramp up your acquisitions given everything given the climate?

So, we've been constantly active with a few sellers over the last year and are continuing discussions with sellers. So I'm being prudent honest, because as you know, these processes take their own time and have their own approach.

I'm confident that we can conclude potential acquisition at historical multiples. I don't think the multiple is necessarily the road-block it's more the process to get there.

But management still remains quite confident in our ability to bring some M&A to the finish line.

Final question here is on sensitivities to economic activity given COVID-19 if it turns out to have a wider spread demand impact. You accurately pointed out I believe that you consider ties to be fairly low on the sensitivity range with regards to economic activity.

Polls, would you characterize as perhaps same directionally, but perhaps a little less than ties and then as you go into things like residential lumber and so on, then we get into more sensitive. Is that the right way to characterize the aspects of your business?

Yes, I agree with what you're saying. We haven't seen any disruption in our supply network.

We are in a very healthy position on the inventory side. We think if there would be some short-term disruptions, we could definitely be able to navigate through it and continue consistent supply to our customers.

So I think your view on that is accurate.

So in your commentary, you just touched on the 2020 outlook and that's revenue, particularly in the pole segment, also related margin improvement. The guidance range is helpful.

But I'm just wondering if you could quantify, if we're thinking about the consolidated revenue growth range, is kind of low-single digits. Are you comfortable with that, or could it be higher?

And just on that margin range. How much expansion could we expect year-over-year?

So either one of those.

So, total growth on -- so as you know, our business there, Mona, and welcome back by the way. So as you know, our three different categories have different dynamics.

We've always guided our utility pole product category to be a mid-single digit and that we will, I sustain that assumption going forward into for, also for 2020. Our railway tie product category, which we've historically tied to inflationary growth, could be slightly higher, simply because we this year have sufficient inventory to be able to answer to all inquiries from potential customers.

And then we talked about growth in our residential lumber product category as we're seeing some great opportunities in 2020 to service some stores that we will qualify into dealer network or the non-big boxes if you want. I don't know if that's helpful.

No, that's very helpful. Okay, perfect.

And then if we're just looking at the leverage, just touching kind of on Walter's question and you speak about your desire to do M&A. Is there any change in appetite from the management or board?

I mean, historically, you've done one to two acquisitions a year that has equated to $70 million plus in revenue contributions. Is that still the case, or can be expected to down from that acquisition growth?

There's no change in views and there's definitely appetite within management and myself included and the board to pursue M&A and to grow our footprint. We are very disciplined in the multiple we want to play, or we want to pay.

We're also willing to work with seller that have quality assets to sell. It would be easy for us to do an acquisition in the short term with a high multiple and assets that would require a lot of CapEx going forward but that's not how we've been doing things over time.

I understand your question in the sense that we did not have -- well we have a small acquisition last year in the residential lumber business, which will actually be of great use and be a good contributor in our 2020 performance. But to answer your question, there's no change in appetite and we're actively seeking some targets.

We're actually in discussions with them as well.

And that's a perfect segue, so targets that you were speaking about or have started talking to in the last 12 to 18 months. Are those targets still, are still discussion still occurring with some of them or is it new targets that you are looking at?

We are currently in discussion with targets.

Eric, is your outlook factoring in any benefits from the 45G shortline tax credit extension and how meaningful could that be, because from I understand that's sort of retroactive for two years and renewed for all five years?

So that tax credit is what is prompting all the quota inquiries in that non Class 1 business, so it's a very insightful for you to bring that up. It is a credit that every year there's a short line, or expecting to see there's going to be renewed, it's always a bit of a, the credit is not going to happen.

We might be less active in maintenance if the credit is available. The short lines are more active.

So in this case, it is factored in behind our expectation for strong demand for non Class 1 business.

And then, Eric, could you speak to, in Q1, the rail blockades and Canada. How has that affected the business for the various segments?

The answer is utility poles and residential lumber have had suffered no impact. We moved a lot of inventory by truck.

We also have a lot of distribution centers across North America to supply customers. We didn't see any impact.

Obviously, having the Canadian rail network being offline for over 25 days slowed down shipments to the Canadian Pacific and the CN. Happy to see that car flow started up again late last week and over last weekend actually.

So I expect our railway tie sales for the first quarter to be impacted, but the sales will be at least equivalent to last year's sales results for the first quarter.

And could you elaborate more on the preservative options you're exploring to replace penta when that supply comes to an end in two years?

So penta supply will be available for the next, call it, 20 some 22 months. So we have plenty of time to actively work and we are actually active working with our customers to seek what their preferences are going to be going forward.

The company has access to a very wide range of preservatives. We mastered a process.

We have supply agreements in place. So right now it's more a question of working on the thoughtful transition with our customers.

Just looking at the inventory replenishment. Could you talk a little bit about what kind of working capital we might see in 2020, given there was almost $146 million usage in 2019?

And does it mean that balkanization will be very much reduced in 2020 and maybe kind of the impact on margin, given your ability to replenish the untreated railway ties? Thank you.

So, last we spoke is back in November, December last year, we thought that our ability to replenish would be much longer in time. So we would actually accelerated our ability to replenish untreated ties.

So therefore, I don't expect a significant investment in untreated ties for at least, call it, seven, eight months ahead of us in 2020, simply because we've got sufficient to be able to answer our customer requirements. To your other part of your questions, we do expect very little balkanizing.

Tere's always some going on but we never necessarily refer to it, because it doesn't have any impact on the business, so balkanizing is something that should be behind us. As we're heading into the back half of the year and we get better visibility on our 2021 expected sales, we might have to ramp up and hopefully, we will have to ramp up a bit of working capital to be able to answer future sales into 2021.

So that's how I'm viewing working cap investment for railway ties, it's also true for utility poles.

So probably some working capital investments still in 2020, but much less versus the $146 million made in 2019, right?

Yes, definitely much less and most likely closer to the back half of the year when we have proper visibility on our 2021 sales.

And with respect to the lumber, could you maybe elaborate a little bit with respect to the dynamics with China here? How the impact demand and supply and which segments are impacted with the dynamics with China?

Thanks.

I mean, there's no significant dynamics, especially not with our residential lumber nor with poles, because I mean residential lumber is sourced out of Canada, utility poles and ties as well. The only impact that we actually saw is there, and this is a very getting really deep into the weeds and the explanation.

But what we saw last year is the early low prices of grade lumber in hardwoods in North America, driven in part by the inability to export it to China, pushed our hardwood sawmills to cut more railway tie, that's actually where the supply came from, is we saw the vast majority of hardwood mills in the fourth quarter cut railway ties instead of cutting grade lumber. So if anything, we've had a bit of a positive effect there to help us replenish on inventory.

Other than that, we're not seeing much effect in our business.

And with respect to the ERP system implementation, could you maybe mention the overall capital envelope and maybe also the timing for the implementation, Eric?

So, implementation will span over, but we need -- we're issuing the project. So there's a development phase and the implementation phase.

We're looking at 24 to 30 month rollout, if you want. CapEx will be in the range of $20 million to $25 million.

If I can quote these numbers, generally, we're still working with our consultants to finalize pricing on it but that with the raise but that’s over that 30 month period, if you want.

And last one for me, when we look at the organic growth from utility pole, down 1.5% in the quarter. Although, it seems that it was driven by transmission poles.

So is it the fact that there was a tough comparison versus the Q4 last year? And how does it look like for transmission pole?

Thanks.

So you answered the question. We had a tougher comp in Q4 this year.

We had very strong sales, which were project driven in Q4 2018. Going forward into 2020, my basis is 2019, we're seeing sales growth for transmission poles in 2020.

Eric, maybe just a follow up on Benoit's last question there about utility poles. Can you just comment on what the distribution poles’ organic growth would have looked like in the fourth quarter as we sort of put transmission poles’ tough comp issue aside?

That's a tough question Michael, simply because we don't provide that detail in color. The best guidance I can give you is to stick to that mid-single digits for next year based on the 2019 results.

And then just a question about the sort of some of the commentary you made in the outlook regarding sales growth. When I look at the commentary this quarter versus last quarter, it reads fairly consistently.

Although, last quarter when you talked about 2020, you were including some discussion around calling for price increases and I know it does sound like you're calling for some price gains on the utility poles side. But on an overall revenue basis, is pricing expected to be a driver to some growth, or is that utility poles pricing increase is getting netted out somewhere else?

I guess the best way to look at it is to think more on the product mix since we’ll have more non-Class 1. There's a bit of better margin there for better pricing on the non-Class 1 business.

But I think you're right that volume will definitely be a driver for railway ties for us next year, or in 2020, I should say, this year.

And then, Eric, again, just on the outlook you are indicating that the outlook is predicated on the assumption that current market and economic conditions stabilize. And I understand it's sort of hard to look forward given some of the volatility recently and to really make sense of that.

But to what extent have you tried to incorporate any conservatism in this guidance in this outlook in view of what appears to be some concerns around the economic outlook?

So to answer your question, Mike. Right now, as I stated before, we're not seeing any disruptions on the supply and we're not seeing any the pull back from customer demand.

To your point, there's lots of volatility in markets right now. It's very difficult to understand where the price of the barrel of oil is going is going to go.

And obviously the coronavirus could have some sort of impact from low to significant in North America. All of these items are very difficult to decipher.

At this point, it's very early in the year. We're trying as well, right now, we're reaching out to customers and suppliers.

We're being thoughtful about where the impacts would come. We're working on contingency plans internally.

But I guess I’m most likely will be able to provide a bit more color on that when we talk at our Q1 conference calls?

But at this point in your conversations with customers, has there been any change in tone or anything that would suggest that what they've been telling you previously is potentially in the process of altering?

No, we haven't had and we consistently talk, obviously, with our utility pole customers, it’s obvious that we're talking a lot these days and we're discussing about changing preservatives. And we also talk regularly with all the Class 1 customers.

And no one has indicated a shift in their expectations for this year and I'll say so far.

I had a quick question in terms of the commentary that Koppers was making on their conference call, talking about growing market share in the RUPS division, which overlaps with your utilities and ties, obviously. Just wondering, as I think you're telegraphing also sort of increasing market reach and your main competitors looking for market share gains.

Just in terms of how do you think the pricing dynamic might play out in this type of situation?

I think Koppers has always been active in our industry. As you know, we compete against each other in utility poles and railway ties.

So, I wouldn't expect any less from them to say that they're going to try to leverage opportunities in a market where the non Class 1 business as coating and utilities are looking to do more -- increasing their replacement cycle. We are in very different markets in the utility pole business, so I don't see that necessarily being a concern.

On the railway ties business, we have our annual contracts with our customer that sort of guide the pricing and guide our how we service or do the volumes, I want to measure my words here, but how we -- the volumes that we service our customers. So there we're left with the non Class 1 business to which, we as the company Stella-Jones have very strong ties.

This is how we, “grew up” in the U. S.

market through all the acquisitions we did, starting in 2008 where we acquired a lot of businesses with some Class 1 business, but we're always have been heavily weighted to the non Class 1 business and have serviced them very well. So I'm quite confident that we'll be able to leverage healthy pricing, which leads into the better mix and the increasing margin for that product category.

And actually do you mind, I'm not sure if you historically have disclosed this, but percentage of revenue that comes from non Class 1 for ties. Just like a ballpark, is it 20%, 40%, anything you can provide there?

We've quoted in many occasions in the past and I’ll reiterate it, roughly we’re 65% revenue in Class 1 and 35% non Class 1.

And then one last question on ERP. Do you mind maybe just sharing a little bit in terms of which processes will the ERP will try to optimize, is it procurement, sourcing everything, just if you don't mind providing some incremental color?

So we're looking for the full suite of the ERP system. So it covers the procurement and sale, the finance and the logistics.

And when was the last time you implemented an ERP system?

We've been working with our in-house system for the last 26 years. So this would be -- we've done many projects of implementing different modules and different tools within the company.

This would be, I guess, our first attempt at revisiting our entire ERP system. Rest assured that we are working with a few third-party consultants that have deep knowledge in being able to execute these projects and we staffed accordingly to be able to support it.

So you will have, as you said, a third-party helping you and actually implementing the actual ERP, right?

Alongside with dedicated internal resources, yes.

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