Earnings Call Transcript - DCO Q3 2022

Operator, Operator

Good day, ladies and gentlemen. And welcome to the Ducommun’s Third Quarter Conference Call. At this time, all participants are in a listen only mode. Following management's prepared remarks we’ll hold a question-and-answer session. As a reminder, this conference is being recorded today, November 7, 2022. I would now like to turn the conference over to Ducommun's Vice President, Chief Financial Officer, Controller, and Treasurer, Chris Wampler. Please begin.

Chris Wampler, CFO

Thank you, and welcome to Ducommun's 2022 third 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 US government defense spending, timing of orders from our customers, legal and regulatory risks, the cost of expansion and acquisitions, competition, economic and 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 those 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 third quarter Form 10-Q with the SEC today. I would now like to turn the call over to Steve Oswald for a review of the operating results. Steve?

Steve Oswald, CEO

Okay. Thank you, Chris. And thanks everyone for joining us today for our third 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. We've done an excellent job, the team and the leadership with safety protocols put in place since March 2020. We continue to follow best practices aligned with health authorities. Within the company, we have 188 cases of the Omicron variant in Q3 of 2022. Turning to the Q3 financial results. I'm happy to report that Ducommun's third quarter top-line performance was very strong, with the company delivering year-over-year revenue growth of 14%. Net revenues also exceeded $180 million for the first time since before the pandemic started in Q4 2019 and rose to $186.6 million. The commercial aerospace market’s continued recovery was a real bright spot once again in Q3 with Boeing 737 MAX business up 137% year-over-year, and the Airbus A320 also had sales up 70% year-over-year. Overall, commercial aerospace with Airbus, Boeing, Gulfstream, and others was up over 65% from Q3 2021. The commercial aerospace business also showed year-over-year revenue growth now for the fifth consecutive quarter, an excellent sign that the industry and build rates are recovering. The company's defense business after two years of unprecedented growth in 2020 and 2021 was only down slightly in Q3 but once again delivered solid performance with over $100 million in revenue. The company posted a solid gross profit of 20.7%, sequentially up but down year-over-year due partially to several one-time factors, which Chris will cover in his remarks. Adjusted EBITDA of $26 million represented a strong increase year-over-year, the highest since I joined the company in 2017. Adjusted EBITDA margins were 13.9% in Q3 as well. With this solid performance, we expect EBITDA to continue to be strong in the quarters ahead. The team also posted adjusted operating income margins of 9.2%, a good improvement from Q2. Quality of earnings was solid with the company reaching GAAP diluted EPS of $0.69 a share versus $0.78 a share for Q3 2021. But with adjustments, the diluted EPS of $0.96 a share was higher than last year. Some key drivers for the lower GAAP diluted EPS include the Guaymas fire-related expenses, restructuring charges, and loss on extinguishment of debt as part of the debt refinance. In regard to the revenue outlook comments mentioned in the Q1 and Q2 calls, we continue to see the company coming in at the high end of single digits for the full year, with the commercial aerospace industry recovery leading the way. We estimate that revenue will continue to be strong over the quarters ahead as we see more and more commercial aerospace volume return. Our high narrowbody to widebody ratio for the business is also a plus, but we will benefit as well from the news that deliveries of the 787 have resumed. Ducommun has a business aviation portfolio as well, supplying world-leading titanium products and other components, which continues to have good momentum, up 60% in revenue year-over-year with a strong backlog especially at Gulfstream. One area of our business I'd like to highlight as we move out of pandemic-related headwinds is the significant improvements of our commercial aerospace business within our structures systems segment during 2022. Commercial aerospace revenue within structures year-to-date was $122 million or roughly $0.60 higher than the year-ago period. In addition, Q3 2022 commercial aerospace revenue was $46 million or almost 75% higher than a year ago, a great sign that growth is accelerating in this part of our business. Finally, backlog at the end of Q3 2022 stood at $321 million or 36% higher than Q3 2021. So we are set up for excellent growth to continue now and in the future. Investors should also keep in mind our structures business is component-based, not wings or not sales, and we strive to produce products from only industry niche technology, such as titanium hot forming and super plastic forming. For our floating from defense primes, the work continues as we will meet our target for over $45 million in 2022, up from roughly $31 million in 2021. We expect to double it to $90 million plus in 2023 with a great deal of that in our circuit card business for Raytheon at sites such as Appleton, Wisconsin. The long-term run rate of these defense programs already commercialized is in development for offloading, will be over $125 million for Ducommun by 2025. For backlog performance, the commercial aerospace backlog increased sequentially for the fifth consecutive quarter from $276 million at the end of Q2 2021 to $431 million at the end of Q3 2022, an increase of over 55%. This was led by the 737 MAX Viasat for in-flight entertainment, the A220, A320, and Gulfstream, all of which we would expect after we came out of a very tough ‘20 and 2021 for this part of Ducommun’s business. The defense backlog remained solid in Q3 as well, ending the quarter at $467 million. The company's cost actions and lead organizational structure are continuing to pay dividends too. Our supply chain team has delivered another excellent quarter, managing supply chain. This is showing not only in our financials, but we cannot be in a better place with our customers regarding our on-time delivery and quality. Now let me provide some additional color on our markets, products, and programs. Beginning with our military and space sector, we posted third quarter revenue of $106.3 million, a slight decrease versus 2021. Despite being down, as mentioned earlier, it was greater than $100 million and a solid showing for the business in Q3. We saw increases in demand for F-18 Patriot missile and other missile programs, as well as other military and space programs. Third quarter military and space revenue represented 57% of Ducommun’s revenue during the period, down from 70% last year, and this trend will continue to reflect more balance with commercial aerospace. We also ended the third quarter with a solid backlog of $467 million, representing roughly 50% of Ducommun’s total backlog. Within our commercial aerospace operations, third quarter revenue increased year-over-year to $68.3 million, driven mainly by build rate increases on large aircraft platforms, in-flight products for Viasat, other commercial aerospace platforms, and business aviation. Ducommun expects this continued improvement in the commercial aerospace market overall to gain momentum for the rest of 2022 and 2023, and the future is bright across all our product offerings. The backlog within our commercial aerospace sector stands at $431 million at the end of the third quarter and was $145 million higher, a greater than 50% increase year-over-year from Q3 2021. With that, I'll have Chris review our financial results in detail. Chris?

Chris Wampler, CFO

Thank you, Steve. As a reminder, please see the company's 10-Q and Q3 earnings release for further description of information mentioned on today's call. As Steve discussed, our third quarter results reflected a period of strong performance. The third quarter saw a significant increase in commercial aerospace revenue. We remain encouraged by the continued strength in domestic and global travel, which should help support higher long-term demand and shipments going forward. There were a multitude of positive themes during the first nine months of 2022, and we are looking forward to building on this performance. Now turning to our third quarter results, let me review some of the highlights. Revenue for the third quarter of 2022 was $186.6 million versus $163.2 million for the third quarter of 2021. The year-over-year increase reflects $27.2 million of growth across our commercial aerospace platform, partially offset by $7.3 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, that's our overall growth combined with both organic and inorganic growth. Ducommun’s overall backlog at the end of the third quarter was approximately $954 million, reflecting recent growth across our commercial aerospace platforms. Our defense backlog was $467 million, and we remain positioned for continued solid performance for the rest of the year in 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 $38.6 million for the quarter versus $35.3 million in the prior year period, while gross margins were 20.7% in 2022 and 21.6% in 2021 respectively. On an adjusted basis, our gross margins were 21.5% in 2022 and 22.1% in 2021. We continue to share the adjusted gross margins as we have a higher amount of non-GAAP related cost of sales this year, mainly driven by our Guaymas fire-related impact and inventory purchase accounting adjustments related to the MagSeal acquisition. Like all manufacturing companies, we continue to work through a difficult operating environment with regard to supply chain efficiency and labor availability. While we're not immune to supply chain issues, we managed to 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 investments. Ducommun reported operating income for the third quarter of $13.2 million or 7.1% of revenue compared to $13.4 million or 8.2% of revenue in the prior year period. Adjusted operating income was $17.2 million or 9.2% of revenue this quarter compared to $15.3 million or 9.4% of revenue in the comparable period last year. The company reported net income for the third quarter of 2022 of $8.5 million or $0.69 per diluted share compared to net income of $9.6 million or $0.78 per diluted share a year ago. On an adjusted basis, the company reported net income of $11.9 million or $0.96 per diluted share compared to net income of $11.1 million or $0.91 in 2021. Adjusted EBITDA for the third quarter was $26 million or 13.9% of revenue compared to $23.9 million or 14.6% of revenue for the comparable period in 2021. This was the highest quarterly adjusted EBITDA since at least 2017. Now let me turn to our segment results. Our structural systems segment posted revenue of $73.2 million in the third quarter of 2022 versus $58.5 million last year. The year-over-year increase reflects $19.4 million of higher sales across our commercial aerospace applications, partially offset by $4.8 million of lower revenue within the company's military and space markets. Structural systems operating income for the quarter was $6.7 million or 9.1% of revenue compared to $4.5 million or 7.6% of revenue last year. The year-over-year operating margin increase was primarily due to favorable manufacturing volume. Excluding restructuring charges and other adjustments in both years, the segment operating margin was 13.3% in 2022 versus 10.2% in 2021. This is a very strong operating performance for the structural systems segment. As a result, the results from our MagSeal business, which was acquired in Q4 2021, are part of the structures business. Our electronic systems segment posted revenues of $113.4 million in the third quarter of 2022 versus $104.7 million in the prior year period. These results reflect $7.8 million of higher commercial aerospace revenue, partially offset by $2.6 million in revenue across the company's military space customers. Electronic systems operating income for the third quarter was $13.9 million or 12.2% of revenue versus $15.3 million or 14.6% of revenue in the prior year period, primarily reflecting a favorable product mix, partially offset by favorable manufacturing volumes. Excluding restructuring charges and other adjustments in both years, the segment operating margin was 12.9% versus 15% in 2021. While not at the top end of the range the segment has operated, this was a solid quarter for the electronic segment. Restructuring update. As a reminder, we approved and commenced the restructuring initiatives in Q2 2022. Our team is taking these restructure actions to accelerate the achievement of our strategic goals and better position the company for stronger performance in the short and long term. During Q3, we incurred $0.6 million in restructuring charges. The majority of these charges were severance and benefits-related. The macroeconomic environment has been dynamic since we started this initiative. And as such, we continue to assess the appropriate scope and activities. During periods of company restructuring, difficult decisions are made, and one example is our decision to move work from our wire harness and cable assembly facility in Berryville, Arkansas, to other Ducommun facilities, such as our reopened Guaymas facility along with our Joplin Performance Center. This consolidation will provide additional leverage from scale in Joplin, as well as more fully utilize our expanded Guaymas, Mexico facility. These decisions are especially difficult as they have a direct impact on the jobs of some of our common teammates, and as a company, we feel we will be providing above-market compensation and benefits for those impacted. We now expect to incur another $7 million to $10 million in expense for facility consolidation, severance, and impairment of long-lived assets over the next several quarters. We plan to update all investors on further details during the December 8th investor meeting in New York. We have available liquidity of $221 million as of the end of the third quarter. We used $5.5 million of cash in operations this quarter compared to cash provided by operations of $5.5 million in the prior year period. A higher use of cash in the current year quarter was primarily due to increased inventory and contract assets as we work to not only meet customer requirements but also be positioned to take on drop-in work. Our 12-month debt to adjusted EBITDA ratio was 2.6, which remains among the lowest in the last several years. As we previously announced during Q3 2022, we completed a refinancing of all of our debt on July 14th with favorable terms. The new credit facilities have a five-year term and will mature in July 2027. In addition, at the same leverage ratio, the interest rate spread in our new credit facilities is more than 200 basis points lower than the Term Loan B that 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. To conclude the financial overview, in the third quarter, we posted strong results through balanced contributions from our two segments while continuing efforts to position the company for strong long-term performance as we maintain a robust backlog, continue to work on our restructuring initiatives, and improve our long-term debt structure. I'll now turn it back over to Steve for closing remarks.

Steve Oswald, CEO

Okay, thanks, Chris. And in closing, look, it was a strong quarter. It was our best so far in 2022 coming out of another tough year in 2021. The themes are commercial aerospace recovery as we move forward, defense is in good shape with offloading active, our lean cost profile, excellent supply chain, strong customer preference, and very positive refinancing outcome are all going to be tailwinds for us. As I usually do, I like to again thank our employees, investors, and other stakeholders, as we have been through an unprecedented time in the past couple of years, and we're in excellent shape moving forward. I will now open it up to questions. Thank you.

Operator, Operator

Our first question comes from Ken Herbert with RBC.

Ken Herbert, Analyst

I wanted to start by asking about the margins in structural systems. There was a significant improvement both in the operating margin and adjusted EBITDA this quarter. Can you clarify if there was anything unusual this quarter? It appears that volume on the MAX contributed positively, but what should we consider as the main factors behind the sequential and year-over-year margin improvement in that segment?

Chris Wampler, CFO

The volume was always helpful. When we consider the performance centers and the structural systems group, we experienced what I would describe as normal flow through the majority of them. However, I believe that what allowed us to achieve a significant step up and reach the higher end of expectations for the quarter was a strong book of business that came from a couple of facilities. This created a favorable opportunity for us, and that’s what we will aim to return to.

Ken Herbert, Analyst

As we evaluate the defense business, when should we anticipate positive growth, and when do you believe that bookings and the backlog will have reached their lowest point so we can start to see some organic acceleration in that sector?

Steve Oswald, CEO

Let me take that on, Ken. Look, we're obviously active. It's always a little bit of timing of orders. We've had a lot of positive news, especially on programs such as Apache with the Poland order and lots of things that are going to drive our defense business higher. We're looking definitely into 2023, probably midyear, that we're going to see something. But again, we're continuing to work the offload, continuing to build a book of business with Northrop and other places, but it's a bit of a timing issue and a little bit of a lull here.

Ken Herbert, Analyst

It seems like the issue is related to timing. Is it related to customer contracts, delays in budget, or supply chain challenges that are affecting your delivery and shipping capabilities? Can you provide a bit more detail on this?

Steve Oswald, CEO

It's not a supply chain issue. While some of our peers might suggest otherwise, the matter at hand is more about the timing of orders and the flow through of demand. FMS will sometimes assist us, and sometimes it won’t. We are somewhat affected by this, particularly with certain products. I'd say the trend is leaning more in that direction for sure.

Operator, Operator

Please stand by for our next question. Our next question comes from Mike Crawford with B. Riley.

Mike Crawford, Analyst

Regarding the restructuring. How much of that would you say is attributable to consolidating some of these niche acquisitions you've made in the past few years? And I guess further to that, did some of these companies formally use different facilities that they're now completely out of?

Chris Wampler, CFO

The restructure is unrelated to the acquisition companies. It focuses more on our core business as we aim to optimize our operations. The recent developments regarding the wire harness and the Berryville situation relate to our main business. However, the acquisitions continue to offer specialized engineered products within their established areas, and we are progressing with them.

Steve Oswald, CEO

We are exploring opportunities for consolidation where it makes sense. Despite the unfortunate incident at Guaymas a couple of years ago, our operation is now fully operational and has recently expanded. We aim to consolidate and make strategic decisions regarding our square footage going forward.

Mike Crawford, Analyst

And regarding that, is there any further development in your thought on perhaps doing a sale lease back at your other large California facility that’s kind of a hidden real estate asset value on your books?

Steve Oswald, CEO

December 8th, Mike. December 8th, we'll have more color on that. But I would just say, look, it's absolutely ongoing. The sale of Gardena was a real home run for the company for our investors, and we have more to come there. So we'll have more to say in the Investor Day, but we are continuing to look at it. It's something that's active.

Operator, Operator

Our next question comes from Michael Ciarmoli with Truist.

Michael Ciarmoli, Analyst

Steve, just on defense. I mean, you're not going to give us 23 guidance. But I'm just trying to understand the $45 million of sort of the outsourcing now thinks that's going to grow to $90 million. I mean, that's going to put you in a pretty good revenue trajectory next year. I mean, is that the right way to think about your defense revenue growth? Should we be thinking more than 10% growth? And then if we get some more broader thawing of the defense supply chain, could that be additive?

Steve Oswald, CEO

Yes, Mike, there are a couple of things to note. We had a strong performance in 2020 and 2021, with a 40% increase. This marked a significant shift for the company in defense. We're entering this year with a robust pipeline of programs. I believe that the outsourcing arrangements with Raytheon and SPY6 will materialize. However, we are facing some challenges regarding the timing of orders, particularly related to Foreign Military Sales. So, while I don't anticipate growth to be extraordinarily high, it's still a positive narrative. As you mentioned, we are entering this year in a strong position.

Michael Ciarmoli, Analyst

Just to follow up on Ken’s question, it seems like you are managing the supply chain effectively. However, do you believe that some of the timing issues are related to other companies in the industry? We've been hearing about many supply chain challenges. Could this be the reason for the timing concerns? Additionally, we’re also noticing delays from contracting officers. Should we view the timing as influenced by these factors, and when the supply chain begins to improve, might that create new opportunities for you?

Steve Oswald, CEO

I think it's pretty simple, and I think it's both. I mean, we've been a little more strategic in our buying. Being a smaller company, we're able to move a little quicker on things. We've done a few of those things with semiconductors and titanium. But absolutely, I think between supply chain issues that other OEMs and timing of orders from the State Department, I mean, that continues, and I think that's going to more of the same, unfortunately.

Michael Ciarmoli, Analyst

And then maybe, Chris, just on free cash flow. How should we think about that going forward? Obviously, inventory continues to build. I mean, we're seeing that among a lot of suppliers out there. But maybe just some color as to how you're thinking about cash flow and as it relates to working capital?

Chris Wampler, CFO

Comments well taken. And I'd say, you know, first off, Q4 is always our sort of cash quarter. So we'll look to that again this year to get our yearly cash flow back to a sort of a reasonable range. We had a really nice Q2, Mike, and that really put us a little ahead of where we probably would have intended to be; Q3 a little lighter. So we're looking to sort of make it happen in Q4. And as you move forward, I mean your point’s right on. I mean, so what we’re looking to do is grow the business with the contract assets and inventory as a percent starting to come down, flat dollar amount might be level as we're growing. But that's really where there's going to be some additional cash that comes into the model over the next several quarters.

Steve Oswald, CEO

And Mike, just to comment on the cash too. Look, we're using some cash strategically, and I mentioned this in my remarks. I mean, since I've been here, we've never been in a better place with our customers across the board on on-time delivery and quality. I mean, it's been super. So just heads up on that, and it's paid off.

Michael Ciarmoli, Analyst

And the contract assets, is that mostly tied to defense timing, any sort of milestones there? If I'm looking at inventory and contract assets, do you think you get tailwinds from both, or do we think we get an unwinding of the contract assets?

Steve Oswald, CEO

No, you'll start to see it come through both. I believe that over several quarters, the percentage on both sides of the business should decrease.

Operator, Operator

Our next question comes from Ken Herbert with RBC.

Ken Herbert, Analyst

Chris, wanted to clarify on that last comment. Are you still expecting to be positive free cash flow for the full year?

Chris Wampler, CFO

Yes, I mean the fourth quarter will come through strong to get us to a positive free cash flow.

Ken Herbert, Analyst

And obviously, I don't want to get in front of things too much here. But as you think about the business over the next couple of years, what's the right framework we should think about the cash generation potential of the business, maybe as a percentage of EBITDA or some other way that you look at it? I mean, where could that get to in the next couple of years as you continue to see success on the defense side and continued ramping on the commercial aerospace side?

Chris Wampler, CFO

I mean, I think, well, number one, I would say, we'll talk a little more about it at the Investor Day with a little more detail on cash flow, Ken. But I would say, again, we're at an inflection point. We have and we've talked about a little bit through this year, not knowing exactly where the pivot is, but we're ready for that to start moving. And again, as the business breaks free and things start to happen, that's a lever for our cash generation that will be there. If you looked historically, as the business was sort of this size, having free cash flow of $20 million plus is really where we've got to get back to first and then we keep moving from there.

Ken Herbert, Analyst

And we're coming up on the one-year anniversary of MagSeal. I mean I think you've been on sort of a deal of you’re. How does the M&A pipeline look, and where are you focusing your efforts?

Steve Oswald, CEO

Look, I mean, I'm sure you’re hearing this from other folks too. It's a bit slow. We certainly like it more active, but that's our reality. We do continue to work our proprietary deal pipeline, which is outside of the regular relationships we have with bankers. We're active; we're looking at things as they come through, we're meeting with people. We really like these acquisitions, at least one a year, hopefully. And they've been a nice accelerator for the company, so more to come and we are active.

Operator, Operator

There are no further questions at this time. And so I will pass it back to Steve Oswald for any closing remarks.

Steve Oswald, CEO

Okay. Thank you, Michelle. And thank you everybody for joining us. Great questions. It's good to be together again. Look, we couldn't be more happy with Q3. Again, it's been a long journey. We had defense come in big time in 2020 and 2021, and that's still, I think, moderating nicely. But we're thrilled to see commercial aerospace back moving forward. We think it's going to be great for our team, for our overall company, and for our investors. So I want to wish you a great day. Again, thanks for joining us.

Operator, Operator

This concludes today's conference call. Thank you for participating. You may now disconnect.