Description

If you’re a fan of HGTV, you will have likely been educated by the likes of the Scott twins on Property Brothers or Joanna Gaines of Fixer Upper that the kitchen contributes the most value to a home, and is certainly where you realize the highest ROI for most home renovations.  And if you know that, you may also know that one of the hottest items to install in order to add value or, as Joanna might say, some “wow factor”, to your kitchen is a quartz countertop.

Caesarstone (CSTE) is the pioneer and leading brand in the secularly growing engineered quartz countertop market.  Trading at 5.7x LTM EBITDA, CSTE’s valuation is now over 3 turns below its historical average and 6 turns below comps, more than pricing in the risks that have recently caused investors to flee.  The current share price implies an unlevered yield of 10% on a turn of net cash and trough margins, and 75% upside to our $34 price target.

Background

CSTE was founded in Israel by a kibbutz (or a communal settlement) called Sdot Yam in 1987.  Originally a manufacturer of floor tiles, CSTE was on the brink of bankruptcy when the CEO, Amos Amir, took a gamble on a new product in order to save the company and, by extension, the kibbutz.  Using a technique to bind polyester resin and stone pieces he learned from an Italian company called Breton, Amos tried applying the process to quartz, which hadn’t been done before because of quartz’s hardness.  After some early struggles, they figured it out and the company took off, eventually leading to an investment in 2006 by Israeli private equity firm Tene Investments and an IPO in 2012 at a $350mm valuation. Sdot Yam’s 700 members all became millionaires.

Today, engineered quartz is the fastest growing category within the $93Bn global countertop market, growing at an 18% CAGR since 2010 versus the market’s 5%(1).  The reason is straight forward – it’s a technically superior product, is cheaper than other stone alternatives, and designs have improved to the point where they have widespread adoption from architects and designers worldwide.  As a senior executive of one of the largest stone surfaces distributors in the world told us, everyone wants the look of marble in their home but hates the maintenance – once quartz could mimic the look of marble, its popularity soared.

(1) CSTE Investor Presentation, November 2017

Quartz has roughly 16% share of the global countertop market today, with its biggest runway in the US, which is less than 15% penetrated by quartz versus the 87% and 45% penetration rates it has in Israel and Australia, respectively.  Quartz penetration should march up to 50% in the US, and several U.S.-based fabricators and designers confirmed that while most of the installed base of countertops they see are either marble or granite, 75%+ of new installations use quartz.

CSTE remains a leader in this market, with industry participants we’ve spoken with generally agreeing that it’s one of the top two color and design innovators in the category.  Copycats in Asia often refer to Caesarstone model numbers or color names when describing their own. Other leading brands mentioned alongside CSTE include Cambria, Silestone (Cosentino), and Viatera (LG).

Investment Overview

CSTE shares fell from a high of $44 in May 2017 to $30 in August as input cost inflation and a string of seemingly never-ending issues at the company’s new production facility in Richmond Hill, GA wreaked havoc on the company’s margins.  This left the company at a valuation of 8x LTM EBITDA with a turn of net cash and 20% EBITDA margins – still cheap and healthy relative to building product comps despite the hiccups.

Then the floor fell out from under the company during its Q3 earnings call.  The company missed sell side EBITDA estimates by nearly 25% and slashed full year 2017 guidance by over 15%.  The midpoint of lowered guidance implied EBITDA margins of 17.5%, a sudden and precipitous drop from the 24-25% the company had maintained fairly consistently for the five years prior.  And, for the first time, management cited issues at the company’s Israeli facilities as contributing to margin declines – until then, CSTE’s Israeli facilities were the only reliable operation amidst all the margin noise of the past year.  Further, EBITDA guidance for 2018 given on their Q4 earnings call in February implying a 17% EBITDA margin at midpoint didn’t help allay any of these concerns. Investors, understandably fatigued with this name, have sent shares down to $20, more than 50% below 52 week highs.

Our research suggests that while there are some structural changes in the industry that will prevent CSTE from reaching the EBITDA margins of the past, the manufacturing issues in Richmond Hill and Israel that have contributed to roughly half of the margin loss in the last year are fixable.  Investors are overlooking the upside to the 17% EBITDA margins CSTE has guided to for 2018, creating a favorable trough-multiple-on-trough-margin dynamic, backstopped by free cash flow generation and a fortress balance sheet.

Fixable Manufacturing Issues

CSTE’s manufacturing problems began with the opening of the company’s new Richmond Hill facility in May 2015.  The $135mm state-of-the-art facility was built to meet the growing demand for quartz countertops in North America, which CSTE had been servicing from its lines in Israel.  However, from the moment its doors opened, this facility was plagued by quality issues, production shortages, and management turnover. The company struggled to push factory utilization above 50%, and a shortage of slabs led to share losses in 2016.

In order to pick up Richmond Hill’s slack, CSTE was forced to push its Israeli facilities to above published capacity for most of 2016 and 2017, and for the most part this effort was successful.  Then, beginning in 2016 and through 2017, CSTE launched 12 new slab designs that threw a wrench into this tenuous balance, and as orders came in for these new colors, CSTE’s Israeli facilities ran into problems ramping production.  The process of switching colors on a line is difficult even for established colors; new colors will usually involve numerous stops and starts as the mix of quartz, resin, and pigment is calibrated to full production levels. With no slack in capacity in Israel, this wreaked havoc on production.

Richmond Hill

We spoke with three of CSTE’s largest competitors and over 20 customers (primarily fabricators) to get to the bottom of the issues at Richmond Hill and a consistent theme emerged: manufacturing quartz slabs is like baking a cake.  The process is surprisingly exact, with one factory manager telling us that a kilogram too much of resin in a 20 ton mixture can compromise the entire batch. But there’s also a critical element of experience and feel required to calibrate the process as necessary – an experienced line manager can grab a fistful of mixture and can tell if something is off and what to adjust.  In other words, just because you have Mom’s recipe doesn’t mean you know how to make her cake.

When CSTE opened the doors to its Richmond Hill facility, they did so with a locally hired team that had been trained for roughly six months before being asked to ramp production on the facility’s two lines.  By comparison, when CSTE opened its second facility in Israel (in Bar Lev), the company first embedded a team within its existing facility in Caesarea for an entire year. Only then did this team open up the Bar Lev facility, and even then with just one line, expanding to two only after that first line was running smoothly and up to capacity.

Local management for the Richmond Hill facility was simply unprepared and in over their heads.  We haven’t gotten a great explanation for why CSTE didn’t ramp Richmond Hill more deliberately, but after several attempts at band-aid fixes, the company finally sent in their A-team from Israel to get things right (a plant manager we met with is part of that team).  They have committed to stay in Richmond Hill for two years to make sure it gets done, and results have come quickly.  Output in Richmond Hill has improved by over 40% since the Israeli team arrived in September 2017, and with Richmond Hill already stabilized (it didn’t contribute to margin erosion in Q4, the first time since it opened), CSTE has guided for this facility to start contributing to margin improvement later this year and into 2019.

Looking at the actual path CSTE took from the 26.1% margins it achieved in 2014 to 17.5% in 2017 is also instructive:

Note: 350bp decline in “Other” in 2017 includes: 160bp from polyester resin inflation, 70bps from lower margin fabrication & installation revenue, 70bps of higher Opex, 50bps Other

Richmond Hill contributed to roughly 720bps of margin erosion cumulatively from 2014 to 2017.  In prior years, CSTE was able to help offset this headwind to an extent through introduction of higher margin new products and some production efficiencies in Israel.  What’s notable in 2017 is the sudden negative contribution from Israel. We’ve been told by management that the 210bps negative impact from Israel’s production issues went hand-in-hand with the lack of help from new product introduction: lower throughput there not only led to inefficiency-driven margin losses, but prevented CSTE from realizing margin benefits from increasing production of higher-margin slabs.

Industry participants generally laud the company’s manufacturing expertise, and across the board either corroborated the narrative above or agreed it made sense.  The company managed the ramp of Richmond Hill and production across its lines poorly, but nearly to a person, each competitor and customer we spoke with stated that fixing these issues was only “a matter of time”.  One large competitor recalled that they had similar issues when ramping up a new line, and today are having similar trouble ramping up production of recently launched colors as well. Stabilizing the Richmond Hill operations was a critical first step, and the two-year commitment by the team from Israel suggests that recent improvements will continue and are sustainable.  On its fourth quarter earnings call, CSTE also announced that they’d be outsourcing production of lower end, basic slabs – this is a strategy employed by several of CSTE’s larger competitors and one that makes sense. Along with ramping production in Richmond Hill, this frees up capacity in CSTE’s Israeli facilities to produce the more complicated (and higher margin) colors that the company has had trouble ramping to date.

Commoditization Concerns

Some industry participants call Caesarstone the “Kleenex of quartz”.  Take a look through Architectural Digest or Houzz and it’s clear CSTE still boasts strong brand equity, particularly among the architects and designers that are most influential in promoting new design and color trends.  One of CSTE’s largest competitors admitted that CSTE is the one company everyone specs their design and work against. This is important because, ultimately, this is a design-driven business, and it’s the best way for CSTE to face the oncoming tide of Chinese competition.

A couple of years ago, Chinese quartz countertop products were universally acknowledged as vastly inferior.  One fabricator indicated you could tell as soon as you cut into the slab – they were brittle, the colors were off, and they were easy to stain or burn (due to too high a mixture of resin).  Today, many Chinese competitors are able to manufacture basic color slabs that are virtually indistinguishable from CSTE and other branded quartz producers while selling at up to half the price.  And while CSTE (and other branded competitors) have largely been able to hold onto pricing so far (per the latest 20-F, ASPs were still up for CSTE in 2017), the company admitted for the first time in its Q4 earnings call that they’ve had to start lowering prices for some SKUs.

It’s true that Chinese competitors have proven adept at copying existing designs, but CSTE has been at the forefront of introducing new and more complex ones.  New designs help CSTE stabilize overall ASPs as they’re typically introduced at much higher price points, and higher complexity designs are simply more difficult to copy.  As an example, at a trade show in Las Vegas, we saw a range of “calacatta”, or marbled, slabs from a variety of Chinese manufacturers. While some manufacturers displayed slabs that looked just as good as branded peers, others looked as if a toddler went wild with a sharpie.

It’s for this reason, as told by the head of one of the country’s largest fabricator associations, that Chinese product is “mostly infiltrating industries like hospitality, where they only need basic colors and builders are more cost conscious and less worried about quality.”  CSTE will have to lower pricing at this end of their color spectrum to compete. That said, lower quartz prices are also helping to expand the market. Up to now, engineered quartz’s success has come at the expense of natural stone, namely marble and granite. With prices at the low end of quartz dropping, the industry is now seeing quartz start to take share from laminate, which can cost $40/square foot fully installed vs. the $55/square foot at the low end for quartz.  Laminate represents over 30% of the US countertop market that has largely been closed off to quartz.  Greater access to growth here should help offset some of the pricing pressure the industry expects to face at the low-end.  This growth includes gaining share within the home center channels, where CSTE already has a strong presence as the sole provider of all quartz kitchen countertops in IKEA across North America.  Further home center penetration would counter some of the growth headwinds associated with Chinese competition and would also confirm that recent production issues are getting resolved.

Tene Ownership

More than three years after cashing out of its first investment in CSTE and making a 5x return, Tene re-established a position, purchasing 1,000,000 shares for $43.5mm (or $43.50/share) in September 2016, when both the Richmond Hill issues and rising Chinese competitive threats were well-established.  This investment was made from Tene’s Fund III and represented 14% of the fund’s committed capital (i.e., it was a big bet). The investment came with a call option for 2,000,000 more shares and 2 board seats. Sdot Yam continues to own a little over 30% of the company today. Tene acquired the right to vote Sdot Yam’s shares as part of the investment (except for actions that would dilute the kibbutz).

Tene’s two board seats are occupied by Dr. Ariel Halperin and Dori Brown, both founding partners of Tene and previous CSTE directors pre-IPO.  Having met with Dr. Halperin and the management team, we know Tene remains actively involved in this investment and is rigorously reviewing options to recover their losses and make a return.

Summary Financials and Valuation

Key Model Assumptions

• 5% annual revenue growth: a deceleration from prior years as growth in Canada and Australia moderates based on softening housing data
  • US growth of 8%, below the low-to-mid teens growth at which the market is growing and the low-teens rate at which competitors expect to grow in 2018.
• Margins: by 2019 CSTE will be able to recover roughly 300bps of the 700bps in manufacturing related gross margin losses they’ve suffered over the last few years.  Factoring in higher SG&A from planned marketing expense increases implies EBITDA margins of 19% in 2019, or a 150bps improvement over 2 years.
• Capex of $21mm: $3mm/year per line, per management guidance.
  • Capex in 2014 and 2015 was elevated due to construction of Richmond Hill
• Other: $5mm/year cash outflow related to litigation payouts

Since late 2015, CSTE has traded at an average 9x LTM multiple while comps currently trade at a median of 11.5x(2).  Today, CSTE is at the lowest trailing multiple it has ever traded.

(2) Prior to 2015, CSTE traded closer to 20x - we’ve excluded these years as we don’t believe that multiple reflects the current state of the business.  Over its entire trading history, CSTE has averaged a 12.5x multiple.

The valuation implies a low-margin, FCF-negative, shrinking business.  Instead, based on 2018 guidance we estimate unlevered FCF of roughly $50-55mm, implying a 10% unlevered yield.  While growth will decelerate, CSTE should still grow EBITDA at a low-to-mid single digit rate, aided by a market enjoying double-digit secular growth.  Each of CSTE’s competitors we spoke with expects to achieve at least 10% growth this year, and all believe CSTE can do the same assuming no further production issues.  The solid balance sheet highlighted by a lack of debt and over a full turn of EBITDA in cash provides a strong backstop.

This comp set consists of building products companies with strong brand equity in industries facing commodity competition from China.  It illustrates the wide valuation disparity of CSTE versus peers. For example, AFI, which has a strong brand but competes in the lower-growth flooring industry, and has experienced structurally lower margins, EBITDA declines, and scant FCF, trades at nearly 2 turns more than CSTE.

Risks

• Continued manufacturing issues – any further significant hiccups, with the new outsourcing strategy or improvements in Richmond Hill.
• Rapidly intensifying China competition – as evidenced by deteriorating pricing or accelerated share losses especially if China starts moving up into more complex colors or designs.
• Raw material cost inflation – raw materials account for 42% of COGS, and of that, polyester resin (specifically unsaturated polyester resin) accounts for 35%.  Inflation in polyester resins contributed roughly 160bps to the margin degradation CSTE experienced last year, and is expected to be a headwind again in 2018.  Note that while the company states that resin prices should follow oil, the better commodity to track is benzene (itself a derivative of oil). 2018 guidance assumes current resin prices throughout the year.
• Housing – a major housing downturn in any of CSTE’s markets.
• Silicosis – CSTE and other manufacturers instruct that their slabs should be cut using a wet saw because when cut dry, quartz produces silica dust.  Inhaled for long enough periods, this can lead to a condition called silicosis, or a scarring of the lungs. Lawsuits have been brought against the quartz slab manufacturers, including CSTE, by fabricators who claim to have developed silicosis while working on these slabs.  In January 2018, CSTE and the plaintiff settled a class action suit seeking $56mm for $2.6mm (the settlement still needs to be approved by the Israeli District Court). There continues to be 105 individual lawsuits pending against the company, for which CSTE estimates its total potential liability to be $33mm.  CSTE has product liability insurance that covers the company for $12.4mm and has reserved roughly $33mm on its balance sheet for all bodily injury claims.

Catalyst

• Stabilization in margin headwinds from Israeli production

• Margin benefits from recently launched new product introductions