Earnings Call Transcript - DCO Q3 2021

Operator, Operator

Thank you all for standing by and welcome to the conference call entitled Q3 2021 Ducommun Earnings Conference Call. At this time, all participants are in a listen-only mode. Near the end of today’s session, we will have a question-and-answer session. Please also note that today's call is being recorded. I'll now hand the call over to your host, the Investor Relations Adviser of Ducommun Incorporated, Chris Witty. Sir, you may now begin.

Chris Witty, Investor Relations Adviser

Thank you and welcome to Ducommun's 2021 third quarter conference call. With me today are Steve Oswald, Chairman, President and CEO; and Chris Wampler, Vice President, Chief Financial Officer, Controller and Treasurer. 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 terms of and our ability to complete a potential sales leaseback transaction, the level of U.S. government defense spending, timing of orders from our customers, legal and regulatory risks, management changes, the cost of expansion and acquisitions, competition 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 other forward-looking statements which are subject to those risks. Statements made during this 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 will also include non-GAAP financial measures. Please refer to our filings with the SEC for a reconciliation of the GAAP to non-GAAP measures referenced on today's call. We filed our 2021 third 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?

Steve Oswald, Chairman, President and CEO

Thank you, Chris, and thanks everyone for joining us today for our third quarter conference call. Today, as usual, I'll give an update on the current situation of the company, after which Chris Wampler 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 with the safety protocols put in place since March of 2020. We continue to follow our best practices, aligning with health authorities throughout our many operations. The total number of cases is roughly 279 since the beginning of the pandemic and within the company we had 65 cases in Q3 of 2021. I also want to mention, the company will be following the OSHA vaccination requirements and we are currently awaiting those rules from the government. As mentioned in the press release, Ducommun's third quarter results were strong. The company is delivering year-over-year revenue of 9% all organic. The company's defense business delivered another solid performance and the commercial business showed year-over-year revenue growth for the first time since Q4 2019 in the quarter. The commercial aerospace markets are recovering and we are seeing some bright spots. For example, Spirit Aerosystems was 5% of revenue for the quarter and also going from being our 19th largest customer revenue in Q3 of 2020 to the fourth in Q3 of 2021. We are optimistic as well that Ducommun will start seeing meaningful OEM bill rate increases from recent comments from Airbus and Boeing starting in 2022. In addition to revenue growth, we posted solid gross margins of 21.6%, along with adjusted EBITDA margins of 14.6%. The team also posted adjusted operating income margins of 9%, which is excellent progress as we continue to build our track record of delivering impressive financial results in any environment. The quality of earnings was high as well; the company reached a GAAP diluted EPS of $0.78 a share versus $0.54 a share for Q3 2020, a 44% increase and adjusted diluted EPS of $0.83 a share versus $0.69 in 2020. Those numbers reflect the return to revenue growth commitment we had anticipated and communicated mid last year. This is also a great start for our investors, as Q3 was also the second consecutive quarter of year-over-year revenue growth with significant runway ahead. The company's third quarter revenue was higher with Ducommun's commercial business showing year-over-year growth for the first time since Q4 2019 up 34%, and continued solid defense business versus prior year. Defense business revenues continue to show excellent progress on shipments and robust business development. The majority of gains in Q3 include the F-18, F-35, UAVs General Atomics, which more than doubled, the Raytheon TOW program, and other missile programs. Our approach to the market continues to be innovative, products and processes that provide significant value to the defense customer along with striving for consistent high levels of service. The current numbers and backlog show we continue to be rewarded for this strategy. I also want to mention as in the past, the Raytheon Missile Defense business and the progress since signing the strategic supplier agreement with them in July of 2019. We have been hard at work in three areas, new programs, offloading, and share shift. And I'm happy to report that 2021 will be a record year overall with this legacy Raytheon business growing from less than $90 million in 2020 to over $115 million in 2021, an increase of more than 25% with much more runway ahead. Another highlight of this partnership occurred in Q3, as Ducommun won a contract with Raytheon, we'll now be supplying critical circuit card assemblies for the SPY-6 radar program with over a $15 million annual run rate. This is a major win for our defense circuit card business, on a very prestigious program and a great example of our ability to help defense primes off-load production and drive significant value for them with more opportunities ahead. In addition, I continue to be optimistic about defense opportunities for our company, despite the overall industry challenges. With examples like the SPY-6 just mentioned, GA becoming a larger customer, our newly developing Northrop relationship, and other revenue opportunities. As regards to the defense backlog remains strong and ending Q3 with a backlog of $498 million, the commercial aerospace backlog also showed some signs of recovery increasing sequentially for the second consecutive quarter from $276 million at the end of Q2 to $286 million at the end of Q3 2021 a very good sign. The total backlog was $836 million for the company and it's a good number based on the environment. The company's cost actions are also continuing to pay dividends. You can certainly see even before the pandemic the company was working on initiatives to offset the 737 MAX. The effectiveness of our operations leadership and actions show in the solid gross profit margins and the very good operating income percentages along with the diluted EPS. I also want to mention our pricing efforts continue and are having a positive impact. In regards to the outlook, a significant backlog of defense and more momentum in commercial aerospace provides good revenue in Q4 and again in 2022. We estimate that revenue will remain strong in defense, but over the quarters ahead, we will see more and more commercial aerospace volume return to come. I want to make clear to our investors and our analysts; we are very well positioned with our high narrow-body to wide-body ratio for our business, and also as importantly have the capacity supply chain and strong operating team to deliver in the forecasted rates ahead. We also remain active in the market for M&A looking for new companies that fit our model, and believe this will only be an accelerator to higher results. 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 $113.6 million, a slight increase versus 2020. The solid showing was from revenue on key defense platforms. As mentioned earlier, we saw increases in demand for F-35, F-18, UAVs, tow, and other missile programs. Third quarter military space revenue represented 70% of Ducommun's revenue in the period. We also contend to be very well-positioned for further growth as I mentioned earlier across defense platforms over the next several quarters in all sectors especially at Raytheon. And again we ended the third quarter with a strong backlog of $498 million, which represents 60% of our total backlog. Within our commercial aerospace operations, third quarter revenue increased year-over-year to $41.2 million, driven mainly by build increases on large aircraft platforms and we're also seeing some good year-over-year growth of our business jet customers both Gulfstream and Bombardier. Ducommun expects a meaningful improvement in the market overall in 2022 and 2023, and the future we believe is very bright. The backlog within our commercial aerospace sector stands at roughly $286 million at the end of Q3, a slight increase sequentially compared to Q2 2021 and the second consecutive quarter of growth for the company. Before having Chris review our financial results, I want to mention that our three acquisitions since I joined Ducommun have all been winners for the company, our shareholders and new acquisitions continue to be a very important component of our vision and strategic plan. Having said that available capital is a critical catalyst and therefore we have undertaken a review of our Southern California industrial legacy real estate portfolio. Industrial properties in Southern California as in Seattle and other areas are extremely high demand and the company recently initiated the marketing of one of our facilities as an expected sale leaseback transaction. We anticipate signing and closing on this transaction in the next few months. This transaction is expected to generate in excess of at least $90 million of after-tax cash that we'll then be able to deploy mainly for strategic acquisitions and debt repayment. We will also continue to evaluate additional sale-leaseback opportunities as we move forward in California and are excited about the opportunity and the value that we create for the company and our shareholders. With that, I'll have Chris review our financial results in detail. Chris?

Chris Wampler, Vice President, CFO

Thank you, Steve, and good afternoon everyone. As a reminder, please see the company's 10-Q and Q3 earnings release for a further description of information mentioned on today's call. As Steve discussed, we are pleased with our third quarter results and our update about the outlook for the remainder of 2021 and beyond. Execution during Q3 like much of 2021 has been a journey focusing on areas that we can control. Demonstrating strong performance and minimizing the impact of some of the things we can't control like commercial aerospace recovery pacing along with other pandemic-related complexities make our Q3 performance even more noteworthy. Now turning to our third quarter results. Let me review some of the highlights. Revenue for the third quarter of 2021 was $163.2 million versus $150.4 million for the third quarter of 2020. The year-over-year increase reflects $10.4 million of growth across our commercial aerospace platforms and $2.6 million of higher sales within the military and space sector. All of this growth was organic. Ducommun's overall backlog at the end of the third quarter was approximately $835.5 million, the highest level since the start of the pandemic, reflecting strength in the military electronics markets as well as growth across our commercial aerospace platforms. 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 $35.3 million for the quarter versus $33.5 million in the prior year period, while gross margins were 21.6% and 22.3% in 2021 and 2020, respectively. The slight decline in margin year-over-year reflects unfavorable product mix. SG&A was $22 million in the third quarter versus $22.1 million last year, reflecting the company's ongoing cost controls and streamlined operations. Ducommun reported operating income for the third quarter of $13.4 million or 8.2% of revenue, compared to $10.3 million or 6.8% of revenue in the prior year period. Adjusted operating income excluding restructuring expenses and costs related to the previously reported Guaymas fire was $14.1 million or 8.6% of revenue this quarter compared to $12.4 million or 8.2% of revenue in the comparable period last year. Interest expense was $2.8 million in the third quarter of 2021 versus $3.1 million in the prior year period reflecting lower interest rates and a lower outstanding debt balance. The company reported net income for the third quarter of $9.6 million or $0.78 per diluted share compared to net income of $6.5 million or $0.54 per diluted share for the third quarter of 2020. Excluding one-time expenses, adjusted EPS for the third quarter of 2021 and 2020 was $0.83 and $0.69, respectively. Adjusted EBITDA for the third quarter was $23.9 million or 14.6% of revenue compared to $21.6 million or 14.4% of revenue for the comparable period in 2020 reflecting the items I just discussed. Now let me turn to our segment results. Our Electronic Systems segment posted revenue of $104.7 million in the third quarter of 2021 versus $103.5 million in the prior year period. These results reflect a $1.2 million increase in sales with the customers' military and space customers and a slight $0.2 million uptick in revenue across our commercial aerospace platforms. Electronic Systems operating income for the third quarter was $15.3 million or 14.6% of revenue versus $14.9 million or 14.4% of revenue in the prior year period reflecting the higher revenue and continued strong operational results at our performance centers. Our Structural Systems segment posted revenue of $58.5 million in the third quarter of 2021 versus $46.9 million last year. The year-over-year increase reflects $10.2 million of higher sales across our commercial aerospace applications and $1.4 million of greater revenue from the company's military-based markets. The year-over-year growth helps demonstrate the underlying commercial aerospace demand recovery from the trough levels in the prior year. Structural Systems operating income for the quarter was $4.5 million or 7.6% of revenue compared to $1.8 million or 3.8% of revenue last year. The year-over-year operating margin increase was due to favorable volume and fewer one-time charges. Excluding restructuring expenses and the impact of the Guaymas fire, the segment operating margin was 8.8% in 2021 versus 7.7% last year. SG&A expense for the third quarter of 2021 was $6.4 million or 3.9% of revenue versus $6.4 million or 4.2% of revenue in 2020. Turning to liquidity and capital resources. We have available liquidity of $99 million and generated $5.5 million of cash from operations this quarter compared to $4.9 million in the prior year period. Q4 is typically our strongest cash flow generation quarter and we expect that to be the case this year. Our investment in inventory and level loading performance centers continues to be the most significant component of our incremental working capital investment. Our trailing debt-to-EBITDA ratio was 3.2 at 2.2 times at the end of the third quarter. As Steve mentioned we are planning on an opportunistic unlocking of some of the equity we have in our Southern California real estate through a potential sale leaseback of our Gardena facility. Once completed we expect the result is that we are in an even better position to pursue acquisitions either with the cash we expect to generate or with the additional debt capacity created from potentially paying down debt. In terms of capital expenditures, we spent $3.4 million during the quarter reflecting lower investment requirements in the current economic environment. For the full year 2021 we anticipate spending between $16 million to $18 million in capital expenditures. In conclusion, the third quarter as expected once again highlighted the stability and strength of Ducommun's product lines and the efficiency of our performance center-focused factory operations. While military demand remains high, commercial deliveries are picking up a trend we see continuing and we believe will gather momentum in the quarters to come. We will stay focused on employee safety, growth, solid bottom-line results, and enhancing shareholder value as we assess the business for further ways to increase returns on capital. The company is in great shape as we look to deliver a strong finish to 2021 and head into 2022. I'll now turn it back over to Steve for his closing remarks.

Steve Oswald, Chairman, President and CEO

Okay, Chris. Well, thank you. And look I just want to finish up here. We're certainly proud of the results this quarter. It just gets us better positioned for when the commercial aerospace rates go up meaningfully we believe higher in 2022. We've got our commitments. We certainly have strengthened the company through a difficult period for us and for the entire industry. And that's really due to our effective strategy, our dedicated people, and our operational leadership. In closing, as in the past, I just want to thank and tell all our employees that I'm proud of them and all their efforts with the many challenges of the continued issues on the pandemic and the 737 MAX. All our members show up at our operations every day and though stressful, they get the job done for our customers, for our nations and allies, and each other. So with that, I'll turn it over for questions. Thank you.

Operator, Operator

Thank you, Mr. Oswald. Participants, we will now begin the question-and-answer session. Speakers, our first question is from Michael Ciarmoli of Truist Securities. Your line is now open.

Pete Osterland, Analyst

Hey, good evening. This is Pete Osterland on for Mike. Thanks for taking our questions. First just a question on what you're seeing with the conditions in the labor market right now. Are you expecting any issues related to the vaccine mandates in the near term? And looking into next year, do you have the resources you need in order to ramp up to meet rising demand just thinking about the higher production rates you're expecting to see in commercial aero?

Steve Oswald, Chairman, President and CEO

Yes. Look a couple of things. First just at the end of your end question we do. We think that we're going to have the resources. I think we've been pretty careful about keeping our best people even despite some of the challenges in commercial aerospace on the team. So I feel going into next year we're in very good shape. So that's one thing. The second thing is that we're going to follow the OSHA requirements. And so as everybody knows, this is still in Washington being worked out. So we don't know when that's going to be effective and what that's actually going to look like. But we believe it's going to be either you're vaccinated or you get tested once a week. But that's just speculation at this point. But that's what we're going to follow. We feel good about our position and we're looking forward to the work to be honest with you.

Pete Osterland, Analyst

All right. Great. Thanks. And then just turning to margins at 15%, your EBITDA margins in the Structural Systems were down a bit just compared to I think it was 17% in the second quarter. So just wondering what drove the step back on a sequential basis. Were there any particular platforms that impacted product mix, or are you seeing any input cost headwinds that had an impact versus prior quarter?

Chris Wampler, Vice President, CFO

No, thanks for the question. I think sequentially that's the type of movement we end up with that type of movement quarter-to-quarter depending on how the utilization is and how the mix is. So there's no single platform that's sort of driving that. That's more just a combination – a little bit of the mix but also the structures businesses for sure are working off of the low basis from the trough and on the bill back. So there's a little more volatility as we sort of get this recovery fully going.

Pete Osterland, Analyst

Great. Thanks. And then just lastly, if I could on raw materials, are you experiencing any raw material tightness on the metals side, whether for titanium or any other basic materials?

Chris Wampler, Vice President, CFO

I would say, we're all aware. I think everybody is keenly aware of the challenges that are out there broadly. But in our particular case, when we look at most of our raw materials particularly with things like titanium and what we do through our couple of key customers with Airbus and Boeing, there's a lot of things that we get source directed. And so we feel comfortable on the supply we've got on a lot of that. We've got other places. We've got LTAs that we've been able to sort of leverage and try to get ahead of where we need strategic components, so we feel good about that. It's not without an issue coming up now and then but overall we feel like we've been in a good spot.

Pete Osterland, Analyst

All right. Thanks very much for taking the questions.

Steve Oswald, Chairman, President and CEO

Great. Thank you for joining us.

Operator, Operator

Next question is from Ken Herbert of RBC. Your line is now open.

Ken Herbert, Analyst

Hi, good afternoon, Steve and Chris.

Steve Oswald, Chairman, President and CEO

Ken, good afternoon.

Chris Wampler, Vice President, CFO

Hi, Ken.

Ken Herbert, Analyst

Hey, Steve. I wanted to first ask about the Spy-6 announcement you just made. When does that revenue start to ramp, or when do you get to that sort of $15 million a year incremental run rate? And how would you comment about the broader environment today that you're seeing for outsourcing opportunities on the defense side in particular as the primes start to lower their outlook for top-line growth into the 2022, 2023 time frame?

Steve Oswald, Chairman, President and CEO

Yes, great question, Ken. We're very proud of our work on the SPY-6. I anticipate that this will be a significant milestone in 2023 since it is a high-level program with only a few components. However, it will take time to acquire all the necessary inspection equipment, and several steps need to be taken. I would say we can expect this to materialize around early 2024, and we are quite proud of what we have achieved so far. In terms of our defense business, I'm optimistic because our market penetration remains relatively low. I've noticed increasing competition, which is putting pressure on margins, and companies that were once more vertically integrated are now facing challenges. They are moving towards more fixed pricing models. Given our various processes and capabilities, we feel confident about the next few years. More updates will follow.

Ken Herbert, Analyst

Okay, that's great. I wanted to follow up on the margin question. I know you're not providing specific guidance yet, but as we consider fiscal 2022 and the mix headwinds you faced this quarter, is there any reason to believe that as the commercial segment grows in importance, there will be implications for gross margins? Could this present a significant challenge as commercial ramps up and growth in the defense sector slows, or how should we approach this?

Chris Wampler, Vice President, CFO

Yes. Let me start and Steve can certainly jump in anywhere. I think the sequential question and some of the mix is not necessarily indicative of our future. The programs we have, particularly those where the rates will be coming back, are going to be beneficial. Overall, the volume will also be very helpful. I believe both factors will make our path over the next several quarters more hopefully predictable with some potential for upside. However, there is nothing specific driving that at the moment.

Ken Herbert, Analyst

Okay. And then just finally when you complete the sale leaseback assuming that goes through it looks like you'll have capacity probably close to $200 million if not more. How does the M&A pipeline look? And how are you thinking about M&A relative to other uses of cash, a debt reduction? I mean is there a certain point at which if you don't do an acquisition you'll start to get more aggressive on the leverage, or how do we think about that?

Steve Oswald, Chairman, President and CEO

Yes, I think you're spot on there. I think look we're right now focused on closing the transaction. We're thrilled about it by the way especially spicy taking advantage of these red-hot industrial markets. So that's a big positive. We're going to hopefully close the transaction. We're going to have this I think unique opportunity. We're in the game. We're very active right now. As you know our strategy is around really trying to find products that are engineered that can help us on the aftermarket and continue to drive that strategy which we've been rewarded for. So, I think that will continue. We'll have to see how everything is opportunistic with acquisitions. So, we might down the road think a little bit about lowering leverage and doing some debt pay down. We might do that. So, I think that's why the remarks were kind of a little bit of both. I think that's fair at this point.

Ken Herbert, Analyst

Okay. And it sounds like this is just Gardena. Is there similar opportunities as we think about Monrovia or Carson or some of your other Southern California footprint that could also be in the mix down the road?

Chris Wampler, Vice President, CFO

Yes, Ken. I mean as we sort of try to lay that out it's more that we're reviewing all of the owned facilities. Certainly, some we own some we lease but the ones that are owned as a part of the evaluation. Having said that the one that's been front and center here that we decided to share progress on and sort of where we're headed is Gardena. And we're sort of focused on that. We've not done a sale-leaseback transaction here in literally ever probably but for a very long time at a minimum. And so we're sort of focused on working through that one and then we'll keep everybody updated on where we go from there.

Steve Oswald, Chairman, President and CEO

Yes, I think that's fair. I mean but again we're going to review our property.

Operator, Operator

Perfect. All right. Thanks guys. Next quarter.

Steve Oswald, Chairman, President and CEO

Okay, thanks Ken. Appreciate this.

Operator, Operator

Next question is from Mike Crawford of B. Riley Securities. Your line is now open.

Mike Crawford, Analyst

Thank you. So nice strength in the fixed-wing platforms. What about rotary wing? Is that a long-term secular decline in business in that market, or do you see a rebound in the future there?

Steve Oswald, Chairman, President and CEO

I have a few points to share. First, there has been a significant change in FMS sales related to rotary programs. While there may be some challenges with Apache and other platforms, we're also seeing developments with the Black Hawk. Overall, we're involved in many platforms and believe we're in a solid position. Additionally, many of the products we manufacture for these platforms are often sole sourced and unique. While this isn't always the case, it applies to a lot of our rotary work. So whenever there are opportunities, we are likely to capture them. I feel positive about our rotary segment. It may be somewhat flat, but I anticipate that we will ultimately be okay.

Mike Crawford, Analyst

Okay. Thanks Steve. And then just similar to the new programs offloading and share shifts that you're garnering at Raytheon. Is there anything you can comment on the same at Airbus?

Steve Oswald, Chairman, President and CEO

Airbus has recently won the D2P, which marks significant progress considering that five years ago they were not well-known. Now, they are becoming a preferred partner with several firms. Looking ahead, as they ramp up production and commit fully, I anticipate more business will come our way because their in-house titanium operations have limitations. As the bill rates increase, we expect to capture more opportunities. Being recognized as a preferred partner is a major advantage for the company. Overall, I foresee positive developments for both Boeing and Ducommun, or rather Airbus and Ducommun.

Mike Crawford, Analyst

Okay. Thank you.

Steve Oswald, Chairman, President and CEO

Thanks Mike.

Operator, Operator

Thank you, participants. There are no further questions in the queue. I'll now turn the call back over to Steve Oswald for closing remarks.

Steve Oswald, Chairman, President and CEO

Okay. Well, thank you. I just want to set along again on behalf of the whole team, we appreciate everybody's support. We're coming to the end of 2021. It certainly has been I think a good year for the company despite all the challenges. And we certainly wanted commercial aerospace to come back a little bit further, but has not yet. But we feel very good about 2022. Our team is ready for these increases and looking forward to continued growth overall defense M&A and I'll leave it there. So again, my thanks for your time today on the phone and be safe and have a great evening.

Chris Wampler, Vice President, CFO

Thanks everyone. Thank you.

Operator, Operator

That concludes today's conference call. Thank you all for joining. You may now disconnect.