Wednesday, December 13, 2017

A current AIM International Fund Holding: Caesarstone Ltd. (CSTE) by Andrew Crossman. "Cut Caesarstone"


Caesarstone Ltd. (CSTE, $24.20): “Cut Caesarstone”

By: Andrew Crossman, AIM Student at Marquette University


Disclosure: The AIM Equity Fund currently holds this position. This article was written by myself, and it expresses my own opinions. I am not receiving compensation for it and I have no business relationship with any company whose stock is mentioned in this article.

 Summary

Caesarstone Ltd. (NYSE:CSTE) manufactures and sells quartz surface slabs used for countertops and other interior surfaces, and they derive revenue from the United States, Austrailia, and Canada.

• The introduction of producing premium quartz products at Richmond Hill manufacturing site is a potential recovery driver, but is currently a drain on gross margin.

• Growth in sales revenue fails to pass through to bottom line due to raw material prices, negative weather impact, and operating inefficiencies.

• Increased competition drives Caesarstone’s production focus to the high-end quartz products.  

• Lower guidance for Q4 signals continued downward trends.

Key points: Caesarstone has been recovering from a 2015 price drop on the heels of missed earnings, lower guidance, and a report published by Spruce Point Capital Management accusing the company of selling low quality products at premium prices. Despite having a short position in the firm, subsequent management actions confirmed accusations.

In 2015, the firm opened a production facility in Richmond Hill, Georgia to produce higher quality quartz in response to investor worries. Currently, management attributes a decrease of 3% to Caesarstone’s gross margin as a result of increase production costs at this facility. Sales revenue growth has not covered increased costs, but is a potential driver of net income growth as operations improve in efficiency, increasing quantity and decreasing costs.

Sales growth has increased at a 5yr CAGR of 15.7%, but management has failed to maintain margins. In the latest earnings call, negative impact on gross margin were attributed to increases in the price of polyester (1.5%), losses from Hurricane Irma (0.5%), and changes in operations at their Israel production facility (3%). Management expects the price of polyester to decrease and losses from Hurricane Irma are expected to have short term effects on gross income. A shift to differentiate product output from the Israel increased production cycle and set up time, and could have a long-term effect on margin.

Caesarstone has faced increased competition in the medium quality countertop segment, which previously composed a high percentage of sales revenue. Management has cited increased competition as a driver behind the product shift to higher quality goods, stating that they will continue to compete on a lower level for medium quality market cap.

Guidance on EBITDA and sales were revised to the lower end of previous estimates, signaling little to no expected increases in operational efficiencies in Q4.

What has the stock done lately?

The stock has traded lower off of disappointing Q3 earnings results. Increased competition has been pointed to as a driver of margin compression and lower free cash flow. Active managers decreased position size in the stock of nearly 1M shares during the Q3, continuing a sell-off trend which has been present for the past year.

Past Year Performance: The stock is trading at a near 52-week low off of disappointing operating results as Caesarstone fails to break the operating structure that was previously in place. Investor confidence in management’s ability to overhaul has decreased shown through expectations for FY17 EBITDA at 19% lower than FY16. The stock is currently trading at a discount to P/E (ntm), EV/EBITDA, and P/sales historical averages.

Source: FactSet

My Takeaway

There could still be value in Caesarstone if management is able to successfully transition to serve higher end consumers at reasonable margins. Signals of a return to increasing EBITDA margins have been far and few between as management has shown the ability to grow sales, but has a poor track record for carrying those increases through to the bottom line. Exacerbated by decreased pricing power due to increased competition, Caesarstone’s share price will struggle to climb back up to levels of CY15. This position should be considered to be sold out of the AIM international equity portfolio.

Source: FactSet

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