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
