Ducommun Inc /De/ Q2 FY2022 Earnings Call

Good day, and thank you for standing by. Welcome to the Q2 2022 Ducommun Earnings Conference Call. Please be advised that today's conference is being recorded. And I would now like to hand the conference over to Ducommun's VP, CFO, Controller and Treasurer, Chris Wampler. Mr. Wampler, please go ahead.

Thank you, Chris, and welcome to Ducommun's 2022 second quarter conference call. With me today is Steve Oswald, Chairman, President and CEO. I'm going to discuss certain limitations to any forward-looking statements regarding future events, projections or performance that we may make during the prepared remarks or the Q&A session that follows. Certain statements today that are not historical facts, including any statements as to future market conditions, results of operations and financial projections are forward-looking statements under the Private Securities Litigation Reform Act of 1995 and are, therefore, prospective. These forward-looking statements are subject to risks, uncertainties and other factors, which could cause actual results to differ materially from the future results expressed or implied by such forward-looking statements. Although we believe that the expectations reflected in our forward-looking statements are reasonable, we can give no assurance that such expectations will prove to have been correct. In addition, estimates of future operating results are based on the company's current business, which is subject to change. Particular risks facing Ducommun include, among others, the cyclicality of our end-use markets, the impact of COVID-19 on our operations or customers, the level of U.S. government defense spending, timing of orders from our customers, legal and regulatory risks, the cost of expansion and acquisitions, competition, geopolitical developments and disasters, natural or otherwise. These risks and others are described in our annual report on Form 10-K filed with the SEC, and our forward-looking statements are subject to these risks. Statements made during the call are only as of the time made, and we do not intend to update any statements made in this presentation, except if and as required by regulatory authorities. This call also includes non-GAAP financial measures. Please refer to our filings with the SEC for a reconciliation of the GAAP to non-GAAP measures referenced on this call. We filed our 2022 second quarter Form 10-Q with the SEC today. I would now like to turn the call over to Mr. Steve Oswald for a review of the operating results. Steve?

Okay. Chris, thank you, and thanks, everyone, for joining us today for our second quarter conference call. Today, and as usual, I will give you an update on the current situation of the company, after which Chris will review our financials in detail. The company remains focused first and foremost on the health and safety of our employees. The team has done an excellent job of implementing safety protocols put in place since March 2020. We continue to follow our best practices in aligning with health authorities. And within the company, we had 106 cases of the Omicron variant in Q2 of 2022. Turning to the Q2 financial results. Ducommun's second quarter performance was very good. The company is delivering year-over-year revenue growth of 9%, in line with 2022 guidance. The commercial aerospace market's continued recovery was the real bright spot in Q2 with Boeing 737 MAX business up over 200% year-over-year, and the Airbus A220 also had a significant increase of 200% growth year-over-year. Overall, the commercial aerospace sector with Airbus, Boeing, Gulfstream and others saw an increase of over 50% from Q2 2021. I also want to add that our commercial aerospace business has shown year-over-year growth for four consecutive quarters, which is an excellent sign, and we're just getting started. The company's business in defense, after tremendous growth of roughly 40% over the past two years in 2020 and 2021, was only down slightly in Q2 but still delivered a solid performance of over $100 million in revenue. The company posted gross profit of 19.9%, which was down year-over-year and was partially impacted by several one-time factors, which Chris will cover in his remarks. Additionally, we had a strong bounce back for adjusted EBITDA margins to 13.8% in Q2 from the Q1 number, which is very pleasing to see, and we expect EBITDA to continue to grow in the quarters ahead. The team also posted an adjusted operating income margin of 8.2%, which reflects good progress in the first half of 2022 as we build on our track record of effective operational leadership and cost management. The quality of earnings is solid too, with the company reaching GAAP diluted EPS of $0.34 a share versus $0.69 for Q2 2021, and adjusted diluted EPS of $0.76 a share versus $0.81 in 2021. Some key drivers for the lower diluted EPS include restructuring charges, climate fire-related expenses, and inventory purchase accounting adjustments for the MagSeal acquisition last December. On the customer side, Raytheon Technologies was again our #1 customer in Q2 revenue, and we continue to benefit from the strategic supplier agreement signed with them back in 2019 for the missile and defense business. We've been hard at work with current and new programs, offloading and share shift with them, and we look forward to continuing to leverage that relationship in the second half of this year and into 2023. We're also taking that model now to Northrop Grumman, which year-to-date is our third-largest customer in revenue. NG has been a success story for Ducommun since 2018, where we have almost doubled the business. This is all part of our plans to build a second defense prime customer, similar to the $150 million a year we currently do with Raytheon. I've also mentioned in previous calls about the offloading from defense tranches and the benefits for the company. The work continues, and we will target approximately $45 million in 2022, up from roughly $31 million in 2021. We then expect to double it to $90 million plus in 2023, with a great deal of that in our circuit card business for Raytheon. Q2 highlights include the recent offloading win for us on circuit cards for the next-generation jammer. This program will be a top priority moving forward for the defense industry. The initial order in Q2 was over $15 million. The products were produced at our Appleton, Wisconsin facility and were awarded due to our high level of performance and strong relationships. We're also driving the SPY-6 offload for circuit cards and have built and tested 500 of the first card with excellent results. This program is moving at a conservative pace, which is right, and we hope to be fully turnkey on this card by Q2 of 2023. The best news is the long-term run rate of programs already commercialized or in development for our defense sector will be over $125 million by 2025. For backlog performance, the commercial aerospace backlog increased sequentially for the fourth consecutive quarter, from $276 million at the end of Q2 2021 to $419 million at the end of Q2 2022, showing over a 50% increase. This was led by the 737 MAX, Viasat for in-flight entertainment, A320, A220, and Gulfstream, all of which you would expect after coming out of a very tough 2020 and 2021 for this segment of Ducommun's business. Defense backlog remained solid in Q2 as well and ended the quarter at $494 million. The book-to-bill ratio for Q2 was 1.1%, and we are thrilled that for the second consecutive quarter, the backlog for Q2 reached a new all-time high of $976 million for the company. The company's cost actions and lead organizational structure are continuing to pay dividends too. Our supply chain team delivered another excellent quarter managing materials along with SG&A spending, particularly at the corporate level, which is among the best in the industry. In regards to the revenue outlook comments made last quarter, we continue to anticipate high single-digit revenue growth this year as the commercial aerospace industry recovery continues, along with our significant backlog in defense. We estimate that revenue will remain very strong over the quarters ahead as we see more and more commercial aerospace volume returning. Our high narrow-body to wide-body ratio for the business will also aid us given the current challenges facing the wide-body aircraft. However, we were very pleased for us and the entire industry to see the 787 news last Friday night. Another bright spot for Ducommun is our business aviation portfolio, which is up more than 50% in revenue year-over-year with a very strong backlog, especially with Gulfstream. Another important area for company investors is M&A. We continue to actively look for companies that fit our model, which will accelerate our results now and in the future. We had a significant win with the acquisition of MagSeal in December. I'm happy to report that the numbers are ahead of plan, the team is intact, and growth plans on revenue, investment, and pricing are moving forward. Another highlight is our Nobles business acquired in Q4 2019, where we are bringing on a new program in the second half of this year, supporting the new Oshkosh Striker vehicle with the ammunition handling system. We will be the sole source and will significantly increase revenue in the second half of 2022. Finally, we announced and commenced a restructuring initiative in early Q2. Our team is taking this action to accelerate the achievement of our strategic goals to better position the company for stronger performance now and in the future. While we are finalizing some details as to timing and certain remaining actions, including facility repositioning-related expenses, impairment of long-lived assets, and severance, we've taken some actions and related charges during Q2. Now let me provide some color on our markets, products, and programs. Beginning with our military and space sector, we posted second quarter revenue of $106.7 million, a decrease versus 2021. Despite being down, as mentioned earlier, it was greater than $100 million, so it was a solid showing for the business in Q2. We saw increases in demand for F-18, F-16, Aegis, MIR missile, MagSeal products, and data radar systems. The second quarter military and space revenue represented more than 60% of Ducommun's revenue in the period, down from 70% last year. This will change more over time to reflect our balance with our commercial aerospace business. We also ended the quarter with a solid backlog, totaling $494 million, which represents 51% of Ducommun's total backlog. In our commercial aerospace operations, second quarter revenue increased year-over-year to $57.1 million, driven mainly by bill rate increases on large aircraft platforms, business aviation, and in-flight products for Viasat and other commercial aerospace platforms. Ducommun expects continued improvement in the commercial aerospace markets overall for the remainder of 2022 and 2023, and the future is very bright across our product offerings, including our industry-leading titanium structural business. We ended the quarter with a backlog in our commercial aerospace sector of approximately $419 million, which was a 50% increase year-over-year from Q2 2021. With that, I'll have Chris review our financial results in detail. Chris?

Thank you, Steve, and good day to everybody. As a reminder, please see the company's 10-Q and Q2 earnings release for further description of information mentioned on today's call. As Steve discussed, our second quarter results reflected another period of solid performance. The second quarter saw a strong increase in commercial aerospace revenue. We remain encouraged by the continued strength in overall travel demand, which should drive higher demand and shipments going forward. We're pleased with many aspects of our first half of 2022 and are looking forward to building on this performance. Now turning to our second quarter results, let me review some highlights. Revenue for the second quarter of 2022 was $174.2 million versus $160.2 million for the second quarter of 2021. The year-over-year increase reflects $19.5 million of growth across our commercial aerospace platforms, partially offset by $6.3 million of lower revenue within the military and space sector. A portion of the year-over-year increase is directly attributable to MagSeal, which we acquired in December 2021. Thus, our overall growth was a combination of organic and inorganic growth. Ducommun's overall backlog at the end of the second quarter was approximately $976 million, an all-time high for the second consecutive quarter. This reflects recent growth across our commercial aerospace platforms and sets up the company for strong top-line performance for the second half of 2022 and beyond. Our defense backlog remained strong at $494 million, and we remain positioned for a strong second half of the year for our defense business. As a reminder, we define backlog as potential revenue based on customer purchase orders and long-term agreements with firm fixed prices and expected delivery dates of 24 months or less. We posted total gross profit of $34.6 million for the first quarter versus $36.8 million in the prior year period, with gross margins of 19.9% and 23% in 2022 and 2021, respectively. The decrease in margin versus a strong comparison last year reflects short-term changes in the product mix, partially offset by favorable manufacturing volume from commercial aerospace and our continued focus on costs, where we've done an excellent job. We certainly expect over time that our segment and company margins will reach the levels we achieved pre-pandemic. On an adjusted basis, our gross margins were 21.1% in 2022 and 23.4% in 2021. We are sharing the adjusted gross profit as we have more non-GAAP related cost of sales items than in most quarters. Examples of these include our Guaymas fire-related impact, our MagSeal inventory step-up, and our inventory-related restructuring costs. In addition to these, keep in mind that the incremental rent and property tax resulting from our Gardena sale leaseback in Q4 2021, which overall was a major benefit for company investors, added 0.8% to the cost of sales in Q2 of 2022. Excluding the adjustments, combined with the impact of the Gardena-related incremental costs, our GP would have been nearly 22%. Like all manufacturing companies, we are working in a challenging operating environment in regard to supply chain efficiency and labor availability. While we are not immune to supply chain issues, we managed to get through another quarter without significant supply chain impacts due to our proactive supply chain efforts, executing strategic buys, leveraging our performance center flexibility, and utilizing inventory that we had invested in previously. In the past month, challenges around material availability, while still manageable, are becoming more prevalent. The level of gross profit adjustments will ramp down throughout the remainder of 2022, and we are confident that we can continue our margin expansion journey in 2023 and beyond. Ducommun reported operating income for the second quarter of $7.8 million, or 4.5% of revenue, compared to $13.1 million, or 8.2% of revenue in the prior year period. Adjusted operating income was $14.2 million, or 8.2% of revenue this quarter compared to $15 million, or 9.4% of revenue in the comparable period last year. As a reminder, our definition of adjusted operating income starting last quarter includes an add-back for acquisition-related intangible asset amortization expense. As a result of this change, we have recast prior comparable numbers using this methodology. The company reported net income for the second quarter of 2022 of $4.1 million, or $0.34 per diluted share, compared to net income of $8.4 million, or $0.69 per diluted share a year ago. The decrease year-over-year was primarily due to lower gross profit of $2.1 million and higher restructuring charges of $3.2 million, of which $0.5 million was included as cost of sales. On an adjusted basis, the company reported net income of $9.3 million, or $0.76 per diluted share, compared to net income of $9.9 million, or $0.81 in 2021. Adjusted EBITDA for the second quarter was $24.1 million, or 13.8% of revenue, compared to $23.4 million, or 14.6% of revenue for the comparable period in 2021. Moving back to a $24 million adjusted EBITDA result is a nice step up sequentially from the $20.1 million in Q1 of 2022. Now let me turn to our segment results. Our Structural segment posted revenue of $64.5 million in the second quarter of 2022 versus $57.4 million last year. The year-over-year increase reflects $12.8 million of higher sales across our commercial aerospace applications, partially offset by $5.8 million of lower revenue within the company's military and space markets. Structural Systems operating income for the quarter was $1.3 million, or 2% of revenue, compared to $5.6 million, or 9.7% of revenue last year. The year-over-year operating margin decrease was primarily due to an unfavorable product mix. Excluding restructuring charges and other adjustments in both years, the segment operating margin was 9.4% in 2022 versus 12.4% in 2021. Our Electronic Systems segment posted revenue of $109.7 million in the second quarter of 2022 versus $102.8 million in the prior year period. These results reflect $6.7 million of higher commercial aerospace revenue, partially offset by $0.6 million of lower revenue across the company's military and space customers. Electronic Systems operating income for the second quarter was $13.6 million, or 12.4% of revenue, versus $14.4 million, or 14% of revenue in the prior year period, primarily reflecting an unfavorable product mix, partially offset by favorable manufacturing volume. Excluding restructuring charges and other adjustments in both years, the segment operating margin was 13.9% in 2022 versus 14.3% in 2021. During our Q1 call, as Steve mentioned, we announced a restructuring initiative that had commenced. Our team is taking action to accelerate the achievement of our strategic goals and better position the company for stronger performance in the short and long term. During Q2, we incurred $3.2 million in restructuring charges, the majority of which were severance and benefit related. We expect to incur another $3 million to $5 million in expenses for facility consolidation, severance, and impairment of long-lived assets over the next several quarters. Turning to liquidity and capital resources, we have available liquidity of $137 million. We generated $25 million of cash from operations this quarter compared to $5.5 million in the prior year period. This was a strong result for the company, and we expect to see our contract assets become a year-over-year cash inflow catalyst over the next several quarters. Our 12-month debt-to-adjusted EBITDA ratio was 2.4 and remains among the lowest in the last several years. In terms of capital expenditures, we spent $4.2 million during the quarter. Going forward, we anticipate spending between $17 million and $19 million for the full year 2022 for sustaining capital and ongoing product development. As Steve mentioned earlier, subsequent to the quarter end, we previously announced the completion of refinancing all of our debt on July 14 with favorable terms. The new credit facilities consist of a $250 million Term Loan A and a $200 million revolving line of credit. We upsized our revolver from $100 million to $200 million. The new credit facility has a 5-year term and will mature in July 2027. Additionally, at the same leverage ratio, the interest rate spread in our new credit facility is more than 200 basis points lower than the Term Loan B we had at the end of Q2 2022, and slightly favorable to the Term Loan A that we had at the end of Q2 2022. In conclusion, in the second quarter, we posted solid results while growing our commercial aerospace backlog, setting us up for continued strong performance for the second half of 2022 and beyond. Our Q2 performance supports our view of 2022 as a transition year with momentum and performance building as we move through the year. I'll now turn it back over to Steve for his closing remarks.

Okay, Chris, thanks. In closing, just a few comments here. Certainly, it was a very good quarter and a solid first half for us coming out of another tough year in 2021. I think the themes for me are a commercial aerospace recovery moving to the next level. I believe defense is in good shape, especially with our offloading activity still high. Our acquisitions are performing at a very good level, and we're bringing on new business. We have a lean cost profile, which has benefited us throughout the pandemic and, obviously, in 2022. Additionally, we had an excellent refinancing outcome, which I believe will help drive the company to the next level with strong funding. Those are just some of my thoughts as we wrap up the comments. I'd also like to take the time to thank my team, Ducommun employees, along with our investors, suppliers, and stakeholders for their support. We've been through an unprecedented time in the past few years, and I believe we are in excellent shape to move forward. We've done a great job managing the business and maintaining a level of excellence in 2020 and 2021. I think all that hard and smart work will pay off in the next few years. So with that, I'll open it up for questions.

Our first question will be from Ken Herbert of RBC Capital Markets.

Steve, maybe just wanted to start off. Most of your defense customers and peers have seen a significant supply chain disruptions in the second quarter. Subsequently, a lot of them are calling for a substantial inflection positively in sales into the back half of the year as these near-term issues are transitory and get worked out. To what extent were you seeing similar supply chain constraints? Or to what extent has that impacted your business in the second quarter? And similarly, are you also perhaps looking for an inflection on the defense side at some point in the back half of the year in line with what many of your customers expect to see?

Yes. Ken, thanks, and I appreciate the question. So first, we've done a comparatively good job in the first half of 2022. We have an inventory strategy and build inventory in specific areas for certain customers. So I believe that has paid off for us, particularly in our circuit card and connector businesses. Therefore, we've managed better than others, partly due to that. That's my first comment. We think that we're still going to experience some challenges, especially regarding our card business. For other businesses like titanium sheet and others, we feel like we either have the situation managed well or have an inventory position where we're comfortable for the second half of the year. However, I do foresee challenges in circuit cards during Q3 and Q4, but we have a plan to work through it, and we don't think it's material.

Okay. Appreciate that. And if I could, I appreciate the detail you provided on the offloading opportunity. I think you mentioned that business doubles in '23 with an opportunity up to $125 million or so in '25. How should we think about the margins on this offloaded work? To what extent are you perhaps getting a little aggressive initially to win some of this work? And as that volume grows in terms of the offloading, how accretive can that be to margins over the next couple of years?

I think a couple of things. First, look, when we offload from a defense standpoint to a very low-cost operation in Wisconsin or Tulsa, Oklahoma, we already had a very positive arbitrage. So we are able to provide that value, which defense brands obviously appreciate, along with our performance because there are two sides to offloading. First, defense wants to drive margins up. They seek cost savings, but they also need the parts. Thus, we've established a track record, I believe, which is going to help us in the near and mid-term as we move toward $125 million. I believe margins will remain similar to what we're seeing now. Chris is nodding his head that we're likely to see comparable results moving forward. One of the benefits of offloading is that we deliver a lot of value there, especially from a high-overhead operation like a defense prime. So we can achieve stronger margins as we progress. Looking further down the road, we believe the $125 million figure, especially with the SPY-6 and NGJ, will be significant for us.

Yes. And just to add to Ken's first question, I mean, as Steve mentioned, we have not had significant supply chain issues. Part of that is our flexibility to be able to move around any issues that arise, which really helps. But regarding the back half of the year, we don't have a significant pent-up demand that is suddenly going to break free. There might be some demand from customers, but as Steve said, we feel we've mitigated the situation fairly well; however, there is still work to do, and the environment remains challenging.

Great. And just finally, on commercial aerospace, it's nice to see some significant volume flowing through there. Could you just comment on where you are in terms of MAX production rates and how you're viewing that through the back half of this year and into early next year?

Yes. We're obviously thrilled, as I mentioned. It has been a couple of tough years, and I think we're in a great position with the MAX, both with Spirit and directly with Boeing. We're running probably right around 28% to 31%; it fluctuates just a bit, but that's the range we're seeing. We're expecting that and are planning for this through the end of this year, and we're thinking that is going to remain constant at least through the first six months of 2023. So we’re maintaining our current position.

Our next question will come from Mike Crawford of B. Riley Securities.

Steve, maybe I have a different twist on the supply chain question. Unlike Mercury Systems, which saw numerous difficulties, particularly securing semiconductors, perhaps your same adjacency TTMI Technologies last night talked about not having any issues, in fact, having favorable inventory cost of metal coming down, but more importantly, is seeing lead times decrease. Thus, the question for Ducommun is, if you are also seeing lead times decrease, does that imply that conversely, we might see some kind of pause in orders from customers who can afford to wait to place their orders or work through some of these buffer stocks you established to manage during this post-pandemic period?

Mike, it's Chris. I'll jump in first. To that point, and certainly, you provide real-time information there. On our side, we are not experiencing consistent messages suggesting that we're reaching a position where lead times are coming down yet. Further, whether that starts to happen, we believe it's still a while before it impacts our workflow as well in terms of customer order placements. Just think it’s likely to take some time to reach that point, but that's quite different from what we've encountered and been discussing weekly in our operational calls.

Okay. All right. And then just a final question relates to capital allocation. You do have one other valuable property in California. Are you exploring a sale leaseback for it as you did with your larger property last year?

Yes. That's a great question. I’d say it's still to be determined. We do have one other major property, and we're constantly exploring options. The market remains strong here. I'd say, at this point, we are still reviewing it and would like to leave it at that concerning the Q2 call. More information will come.

And next, we have Peter Osterland of Truist Securities.

It's actually Mike Ciarmoli. Just a keeper question, quick follow-ups. On the commercial aerospace side, the Structural Systems Aero revenues were down sequentially. Is that just timing, or is anything changing around there? I know you just laid out what you expect from the MAX and going forward. But any color on a bit of a dip in that area?

Mike, I don't think there's anything systematic there. That's more about timing.

We’re fine. I mean, we just got back from the airshow not too long ago, and I know there were concerns about engines and forgings, which are valid. But from a comp perspective, we’re eager, we’re excited, and we want the orders.

Okay. And then on defense, we're hearing a lot from your customers in the sector in general. However, we are observing pretty strong order flow out there, and you had a slight dip in the backlog sequentially. What are your observations regarding the ordering environment and the pipeline of opportunities in defense?

Yes. I will start it off and then Steve can add in. I think on the defense side, again, we anticipate timing. Usually, we see significant orders, but they tend to hit at irregular intervals. Thus, we view this as a quieter period leading to an increase in activity for us in the next quarter. Overall, we're monitoring activity and opportunities closely, and there's still a good flow of prospects.

Yes. We're on several major programs, and sometimes, as you pointed out with Apache, we encounter fluctuations that lead to slight headwinds in a given quarter due to FMS orders and budget considerations. Nonetheless, we feel optimistic about incoming orders, especially with the next-generation jammer that was commercialized to the military in 2021. That will translate into significant revenue for us.

Got it. And just excellent free cash flow in the quarter, even with some inventory build there. I think you mentioned you could likely unwind some of these contract assets. What should we expect for second-half free cash and the inventory build?

Yes. I would expect, well, first of all, we felt very good about Q2. Our first half typically shows an outflow in Q1 and we start to break even and generate a bit in Q2. For Q3 and Q4, I anticipate our performance will align similarly, aiming for free cash flow akin to the $20 million we saw. That’s a reasonable estimate.

This concludes the Q&A session. I would now like to turn the conference back to Steve Oswald for closing remarks.

Okay. Thank you, and thanks, everybody, for joining us today. We also appreciate the support of your time. We feel good about it so far, and we’d like to hear your feedback. We think this is beneficial for the company and for our cadence. It gives us a bit more opportunity with our analysts as we adjust to the 2:00 PM Pacific Time slot; it’s notoriously crowded. Thank you for the change and the support. We're optimistic about the future and appreciate your continued support. Have a great day and stay safe. We look forward to speaking again soon.

Thank you all, you may disconnect, and have a pleasant day.