CSTE - Caesarstone: Plant Closure Demonstrates That Customer Demand Is Shrinking

2023-07-29 02:08:37 ET

Summary

• Caesarstone's profitability has been declining, with operating income coming in at -$7.2 million in Q1 this year and sales decreasing.
• The decision to close a manufacturing plant is aimed at saving costs and improving the bottom line, but the impact on the balance sheet remains uncertain.
• The company needs to focus on increasing revenue growth quickly in order to achieve sustainable earnings growth and win back investor confidence.

Intro

We wrote about Caesarstone Ltd. ( CSTE ) back in August of last year when we stated that the bottom may be very well in for the industrial player. In fact, given the encouraging trends we were witnessing back then, we issued CSTE a Buy rating at the time. Our cautious bullishness (post-Caesarstone's Q2 earnings last year) stemmed from management maintaining its fiscal 2022 guidance after the reported earnings missed in that second quarter. Furthermore, despite the Q2 earnings miss, we were beginning to see a meaningful increase in the company's gross margin. This crucial profitability metric comes in for extra scrutiny in inflationary times in that investors are fully aware that they literally protect the company's hard-earned profit against elevated operating costs for example.

However, given that shares have lost close to half their value since we penned that piece 11+ months ago, the mistake we made with respect to that 'Buy' rating was not waiting for the 'true' technical buy signal to be realized. Let me explain. Below is a 7-year intermediate chart where we believed an inverse head & shoulders pattern (bottoming pattern) was playing itself out at the time. The bullish pattern however never gained any type of traction which meant the neckline (Resistance level which needed to be surmounted to confirm a new bull market in CSTE) never got tested. In fact, shares continued their pattern of lower lows soon thereafter and now the company has very real problems on its hands which we see below.

Lack Of Profitability

Beaten-down stocks attract us when they remain profitable. However, when a company struggles to maintain profitability, the financials can unfortunately unravel rather quickly namely in the balance sheet. In Q1 this year, Caesarstone reported -$7.2 million in operating income as sales decreased by almost 9% in the quarter. The decline in volume was one thing but for the company to witness higher raw material costs, elevated shipping costs, adverse forex trends as well as almost $37 million of operating costs means the company has a fight on its hands to remain solvent especially if the top-line sales trend remains soft in upcoming quarters.

We state this because of management's decision to close the Sdot-Yam, manufacturing plant which will result in the loss of approximately 150 jobs. Although ongoing restructuring costs will have to be dealt with here for quite some time, management believes that this decision will net the company approximately $12 million in annual savings which should automatically flow to the bottom line. The line of thinking here is that more funds will be available to build Caesarstone's brands far more aggressively going forward.

Before these savings can be realized, however, it will be the company's balance sheet that will take the brunt of those restructuring charges. This means we have to view CaesarStone through a different mirror going forward as the key 'growth' question (considering two production lines are going to be shut down) has yet to be answered.

Revenue Growth Required

Freeing up cash to protect the income statement is one thing but convincing investors that this very same cash can be allocated wisely to achieve earnings growth is a whole other question altogether. In order to achieve earnings growth in a sustainable fashion, Caesarstone needs to increase its sales, period. Consensus on this front is not encouraged by recent trends regarding the closure of the above-mentioned plant, hence the sustained dialing down of quarterly forward sales revisions.

Risks

Remember, Caesarstone's objective is to invest cash now in order to create more cash in the future. However, with debt recently coming on the balance sheet, and with jobs also having to be cut in order to raise cash, there is no guarantee that future invested capital will be able to provide the returns that investors will be looking for. In fact, management was vague on the recent earnings call concerning guidance for the rest of the year as well as how it intends to turn around the company's fortunes. Furthermore, although short interest remains at a mere 1%, Caesarstone's market cap of a mere $188 million means that a handful of large sellers could still meaningfully move the share price to the downside. Suffice it to say, caution is warranted at this juncture.

Conclusion

To sum up, the decision to close the Sdot-Yam manufacturing facility is firmly a defensive strategy by CSTE in what has become a very difficult trading environment for the company. Despite the cash savings which will eventually come from this decision, top-line growth remains the key problem for Caesarstone so it will be interesting to see if management can finally turn this company around. We look forward to continued coverage.

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