Earnings Call Transcript - HLIO Q3 2022

Operator, Operator

Greetings and welcome to the Helios Technologies Third Quarter Fiscal Year 2022 Financial Results Call. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. As a reminder, this conference is being recorded. I'd now like to turn the call over to Tania Almond, Vice President of Investor Relations and Corporate Communication. Thank you. You may begin.

Tania Almond, Vice President of Investor Relations and Corporate Communication

Thank you, operator, and good day everyone. Welcome to the Helios Technologies third quarter 2022 financial results conference call. We issued a press release announcing our results this morning. If you do not have that release, it is available on our website at hlio.com. You will also find slides there that will accompany our conversation today. On the line with me are Josef Matosevic, our President and Chief Executive Officer, and Tricia Fulton, our Executive Vice President and Chief Financial Officer. They will spend the next several minutes reviewing our third quarter results, discussing our progress with our strategy, providing our updated outlook for 2022, and then we will open the call to your questions. If you turn to Slide two, you will find our safe harbor statement. As you may be aware, we will make some forward-looking statements during this presentation and the Q&A session. These statements apply to future events that are subject to risks and uncertainties, as well as other factors that could cause actual results to differ materially from where we are today. These risks and uncertainties and other factors were provided in our 10-K filed with the Securities and Exchange Commission. You can find these documents on our website or sec.gov. I'll also point out that during today's call we will discuss some non-GAAP financial measures, which we believe are useful in evaluating our performance. You should not consider the presentation of this additional information in isolation or as a substitute for results prepared in accordance with GAAP. We have provided reconciliations of comparable GAAP with non-GAAP measures in the tables that accompany today's slides. Please reference Slides three and four now. With that, it's my pleasure to turn the call over to Josef.

Josef Matosevic, President and Chief Executive Officer

Tania, thank you and good day everyone. This quarter, again, our team has kept their heads down to deliver for our customers, execute our plan, and drive results against the backdrop of a major hurricane, rapid and measurable change in foreign exchange rates, ongoing supply chain challenges, effects on Europe from a prolonged war, and a weak and restricted economy in China. We continue to innovate with new technology, capture market share, integrate our flywheel acquisitions, and diversify in applications and markets. In a nutshell, we are executing on our augmented strategy to continue to deliver on our long-term growth plans with top-tier margins. Our steadfast dedication to our customers, our technology innovation leadership, and our ability to leverage our unique vantage point as a pure play in hydraulics and electronic space provides us confidence that we will continue to outperform our competition. Protecting the business, our margins, and cash flow are top priorities in this environment. As I mentioned on our last earnings call, we have been making great progress executing on our manufacturing and operating strategy. We provided some excellent examples of our strategy at work at our recent sales site analyst day, for example. This includes leveraging the manufacturing expertise and operational footprint we gained with the acquisition of Balboa; we are moving the production of several product categories to our state-of-the-art low-cost operations in Mexico. Our strategy addresses our 'in the region for the region' approach that has enabled us to outperform lead times to our customers and gain market share. In addition, we are seeing our operating companies working closer together across R&D manufacturing as well as system sales. Our transformation to an integrated operating company is happening. This strategy provides the framework for a long runway of operational efficiencies that we are still in the early innings of executing. As we fold in more flywheel acquisitions over time and add new markets and products, there will always be something to optimize. We outlined examples of several current projects we have in process. I encourage you to review the analyst day deck and our website to learn more about the actions we are taking to drive efficiencies, productivity, and optimize our cost structure. This quarter, we further demonstrated our focus flywheel acquisition strategy, closing on Damon products. They are an excellent complement to our hydraulics platform. Damon imprints an established long-term relationship with a diversified customer base serving multiple end markets. Additionally, they have a differentiated value proposition with a strong engineering team that serves a breadth of applications across both custom and standard manifold design packages. With the Helios business system, we expect to leverage from a very successful small business to closer to a $100 million business over the next few years. We are thrilled to add them to the Helios corporate family. We continue to prove our innovation leadership capitalizing on our expertise in hydraulics and electronics; we created a breakthrough, one-of-a-kind solution that we expect to drive change throughout the markets we serve. Our recently announced solution creates electrical power by capturing wasted energy from hydraulic fluid, which can be used to support the growing number of electrical applications required on any type of equipment. This changes the paradigm, and we are serving the mega trend of electrification of hydraulics by creating power where it's needed. This is just one of many technology innovations that we have recently announced. We held a science fair tool led by our engineers during our analyst day to highlight the large number of new innovative, energy-efficient products we are bringing to the marketplace over the coming months as we execute on our innovation roadmap. All we do remains centered and now intends to protect our business, think and act globally, diversify our markets and revenue sources, and attract and retain talent, which is the backbone of our success. Thank you once again to all the Helios colleagues this quarter for the tireless work and dedication to our company. Let me now turn the call over to Trisha to review the financial results and discuss our updated outlook in more detail before I come back for some closing remarks. Trisha?

Tricia Fulton, Executive Vice President and Chief Financial Officer

Thank you, Joseph, and hello everyone. On Slides five through nine, I will review our third quarter 2022 consolidated results. As Joseph noted, we are executing to drive growth through innovation and acquisitions, protect earnings in tough market conditions, and support our future through the talent of our team. First, I want to address the most recent events in Sarasota with regard to Hurricane Ian. With our Sun Hydraulics operations in Sarasota, close to where many of the predictive models were forecasting a potential direct hit, we proactively shut down our operations for the safety of our team. As the majority of our cartridge valve manufacturing is located here, ultimately over 14 shipments were impacted. Thankfully, I'm happy to report that our colleagues are all safe and our facilities unscathed from the event, with an estimated $5.3 million impact on revenue unable to ship due to the hurricane and when we exclude the $8.2 million impact of foreign currency exchange rates, revenue in the quarter was basically unchanged from last year. It's important to note that the sales impact from the hurricane is not lost business; it just shifts the timing given the number of labor hours that were impacted geographically. The Americas were solid while EMEA and APAC, specifically China, clearly reflected the economic conditions in those regions. In terms of end markets, our recreational market growth was significant with strong double-digit increases, primarily driven by our new product wins that were several years in the making. We also had nice growth in the industrial market driven by machinery and energy, and the mobile markets grew as well. The diversification we now have in our end markets is much better than in the past, but the tough year-over-year comparison to the amazing performance our health and wellness market had last year is still having a drag on results. I will discuss this more in a moment. Current conditions prevented optimal operations in the quarter. Gross profit and margins declined on lower volume. The impact the hurricane had on operations, FX rates, and continued challenges with supply chain and logistics. We are realizing benefits from our manufacturing and operating strategy that partially offset the other items. We are focused on cost containment, and expenses were down 3% over the prior year. Adjusted EBITDA was $48 million and adjusted EBITDA margin was 23.2%. When normalizing for the hurricane, adjusted EBITDA margin would have been 23.6%. We continue to demonstrate we can provide top-tier margins even through a very challenging operating environment. Our effective tax rate in the second quarter was 23.6%, sequentially as expected and above the high end of our original guidance range, but down compared with the year ago level, primarily reflecting the impact of varying tax jurisdictions. Diluted GAAP cash EPS of $0.90 included a $0.03 impact for FX and an estimated $0.05 impact for the hurricane. On Slide 10, you'll find highlights of our hydraulic segment results. Sales grew 8% on a constant currency basis and normalizing for the estimated hurricane impacts. The effects to sales related to foreign currency exchange rates was $7.9 million in the quarter. In addition to the $5.3 million shipment delays from the hurricane, we estimate there were $6.6 million of sales delays in this segment due to supply chain shortages. This amount is up from $6 million last quarter. Hydraulic segment gross profit was impacted by unfavorable FX of $1.9 million and an estimated $2.3 million from hurricane impacts. Cost discipline resulted in a 7% reduction in FDA expenses over the prior year. Please turn to Slide 11 for review of our electronic segment results. Our electronic segment is more concentrated in the US, so foreign currency has less of an impact on revenue. We saw strong double-digit growth in recreational and industrial machinery as well as the construction markets. Our new product rollouts could not fully offset the decline we are seeing in the health and wellness market. Therefore, our net sales declined 15% over the prior year quarter. We are not expecting improved conditions from the health and wellness market over the next year given the global economic environment. Delays in electronic segment shipments because of supply shortages was an estimated $8.2 million, which improved from $9.1 million last quarter. We expect to continue to see this come down. The electronic segment gross profit was $22.8 million and gross margin of 30% is a direct reflection of the slowdown in the health and wellness market. FDA expenses were managed well down 9% in light of the weakness in sales. Please turn to Slide 12 for review of our cash flow. Cash flow was strong in the quarter as we generated $30 million in cash from operations. CapEx came in at 4% of sales for the quarter and 3% year-to-date. We continue to expect CapEx for the year to be in the range of three to 4% of sales free. Cash flow was again nearly $22 million in the quarter. We have generated over $52 million of free cash flow year-to-date. As we have noted before, we are intentionally investing in working capital to meet customer demand, outpace the competition, and deliver on our commitments. In the quarter, our cash conversion rate was 105% back above 100%. You can see on Slide 13 that we have a strong balance sheet and significant financial flexibility to execute our strategy for growth. Total liquidity at the end of the quarter was $168 million. Our net debt to adjusted EBITDA leverage ratio was 1.9 times. We believe this puts us in a solid position to capitalize on current market conditions to make selective bolt-on acquisitions. Now let's turn to Slide 14. I want to take a moment to review our longer-term growth plans. We set at our investor day in June 2021 and put some perspective around the health and wellness market. When we acquired Balboa Water Group in November 2020, their annual revenues were north of $100 million. In 2021, they nearly doubled their revenues, significantly outperforming our M&A model and accelerating our return on investment timing. On the acquisition, they capitalized on the pandemic trend of consumer investment while people were not traveling as much; the deal was perfectly timed for Helios shareholders to benefit from the market trends. In addition to adding a new end market to our business, they brought complementary technology as well as the state-of-the-art low-cost manufacturing facility in Tijuana, Mexico. As Joseph described, we are leveraging that facility and our manufacturing and operating strategy and expect several benefits from it over time. As you know, that industry is currently going through a normal market correction coming off such a boom cycle, which is impacting our 2022 performance and comparisons. We continue to remain on our trajectory path to achieve our original destination of at least $1 billion in revenues by the end of 2023, which we have accelerated by two years. We have executed on several high-quality flywheel acquisitions along the way to help us reach our goal. We continue to have a very active pipeline of potential acquisitions and feel confident in our ability to take advantage of an unstable market environment to continue to advance toward our long-term financial goals. Please turn to Slide 15. We are adjusting our 2022 outlook down to accommodate for known factors. We are cautious given inflation, the decline in consumer spending, China restrictions, the war in Ukraine, and foreign exchange. High inflation may continue to slow the global economy and is also causing a pullback in consumer spending, which is directly impacting the health and wellness market. Weakness in the economy in China driven by continued restrictions is negatively influencing demand in that region. Significantly rising energy costs in Europe, driven by the prolonged war, have slowed the economy in EMEA for our firms and driven up fixed costs of our manufacturing facilities. The strength of the US dollar negatively impacts results generated in currencies other than USD. These issues, of course, are all driving the widely discussed global recession. As noted, we are reducing revenue and adjusted EBITDA while expecting a slightly lower adjusted EBITDA margin; it should remain in top-tier performance. Higher interest expense and a higher effective tax rate will also impact the bottom line. Despite all of this, I believe we can protect the business, cash flow, and earnings and that the Helios business system provides the structure and discipline to execute our long-term plans. Against these headwinds, we remain confident in our ability to achieve our accelerated longer-term growth targets. This will be accomplished through a combination of the diversification of our business, continuing to bring innovative products to market, and the progress on our manufacturing and operating strategy. We are focused on our continued evolution into system sales as we become an integrated operating company, as well as our active acquisition pipeline to drive growth. We believe we are in a unique position to be opportunistic because of the strength of our balance sheet and our significant liquidity.

Josef Matosevic, President and Chief Executive Officer

Thank you very much, Tricia. Clearly, we are all in these challenging global times together. This is when companies that remain critically focused on their purpose and mission, stay incredibly close to their customers and partners, and keep investing in their people and technology will be the long-term winners. I believe the Helios team is up to the challenge, and the value proposition of our augmented strategy provides the framework for us to win. We are driving market share, protecting our margins, creating innovative sticky solutions, leveraging our earnings power, and delivering on our long-term goals. Where there are challenges, there are always opportunities. Because of this, I strongly believe we have the line of sight to continue to drive scale and achieve our accelerated milestone of reaching at least $1 billion in revenue by 2023 with top-tier margins. With that, let's open up the lines for Q&A please.

Operator, Operator

Thank you. We will now be conducting a question-and-answer session. Our first questions come from the line of Jeffrey Hammond with Key Bank Capital Markets. Please proceed with your questions.

Unidentified Analyst, Analyst

Hey, good morning everyone. This is David on for Jeff. Can you just walk us through the electronic weakness specifically regarding the health and wellness declines a little bit more? Are you seeing a more stock in North America similar to other residential markets? Are there more moving parts, and I guess on this just how do you expect this to progress in your term?

Josef Matosevic, President and Chief Executive Officer

Yeah, as we talked about on the last few calls, we started to see inventory levels rising in Europe primarily from goods that were being shipped out of China and into Europe, and that market slowed first. Throughout the quarter, we started to see the slowing also in the Americas, but certainly not to the degree that we thought in Europe or in APAC. There's probably some destocking going on in the Americas, but the majority of that destocking needs to happen in EMEA as we go forward. We're still getting some good news for 2023 from our North American customers. It really seems to be focused more on Europe, but with the economy, the way it is, interest rates the way they are, I think it's going to be probably a few more quarters than we had anticipated before we start to see that market turn back up. But we know that it will turn back up; this is a short-term problem that we're having right now with it, but certainly I think there's a lot of opportunity going forward, and we saw that we are coming off of a record year last year in that market and we were able to take advantage of that very well, I think. So this is just a normal market correction, we believe.

Unidentified Analyst, Analyst

Okay, great. And then I guess kind of staying on that topic, just can we parse out the headwinds and electronics between the health and wellness and supply chain and relative to these headwinds, how should we be thinking about new products as an offset to some of the weakness and supply headwinds?

Josef Matosevic, President and Chief Executive Officer

Yeah, we had an analyst day here just a few weeks ago, and I think the folks got a very good sense of what products we are introducing to the market in 2023 and beyond. We knew we would be in a correction stage, especially in the health and wellness but working closely with our customers and conducting our customer perception study a couple of years back and continuing to follow up, we knew we had to hunt. Over the last couple of years, we heavily invested in products that are not just going to be complementary to what we are doing but will clearly help us diversify into other application markets and, most importantly, get us the system sales capability that we are really active in making very sticky. So a few specific examples in the health and wellness area with our Helios sense of engineering excellence, working together with innovation teams, we are bringing products into the market over the next few quarters that will clearly diversify above and beyond the health and wellness industry more into the specialty vehicles area and other applications that we clearly laid out in our analyst day. So look, we feel pretty confident; yes, this is a pullback. We do believe that we are nearing in many areas about in the health and wellness, and we should start seeing flight recovery. Asia is obviously still a wild card as we have a substantial growth opportunity there as well. But the new products over the next couple of years in the electronics segment in the health and wellness end, on the innovation side, we are more than satisfied with what you currently see.

Operator, Operator

Thank you. Our next questions come from the line of Mig Dobre with Baird. Please proceed with your questions.

Mig Dobre, Analyst

Thank you. Good morning everyone. Trish, I appreciate the context on Balboa $200 million of revenue or close to it in 2021. If we're looking at Q3 and your Q4 guidance, what sort of revenue level or revenue run rate for Balboa is implied in our Q4 guide?

Tricia Fulton, Executive Vice President and Chief Financial Officer

Yeah, on the electronic side certainly Balboa is affecting the Q4 numbers. We're still seeing a lot of strength of innovation, and we talked about the new product rollouts that they've had. Recreational markets are still going very well for us both in marine and vehicles. So the impact that you're seeing on Q4 is pretty much all being driven by the Balboa demand cycle.

Mig Dobre, Analyst

Right? But just look, I'm not clear as to what the revenue run rate is here. Is this business now reverted back to a kind of $100 million base that you had when you initially acquired it? Is this sort of revenue run rate here, or is it different?

Tricia Fulton, Executive Vice President and Chief Financial Officer

We don't really like to give out specific business unit targets. We're looking at the electronics and hydraulic segments as segments, especially as we're rolling acquisitions into them. But certainly, the run rate is significantly lower than what we saw in 2021.

Mig Dobre, Analyst

Because I think this is the thing that we're all grappling with here, and David was asking about this earlier on too, as we're trying to sort of right size our estimates for 2023. We're really trying to understand the magnitude of the headwind that is coming from this health and wellness market. What's kind of baked into the pie for the second half of this year and what might still be on the come in the early part of '23? So I don't know if you can help at all with that dynamic.

Josef Matosevic, President and Chief Executive Officer

I think a fair way of answering your question is, when we acquired Balboa in particular, we were just north of $100 million. Now, revenue obviously jumped up as it was almost double-sized and now it pulled back to more into the $150 million to $160 million type of range. We think that in some cases we are seeing the bottom and seeing some slight recoveries in particular in North America. We will be in Europe actually next week, all week long, and getting a good feel for where the markets are trending in Europe. While you see, before falling back to the levels that we have acquired the company, we don't see that we are right now somewhere in between those two numbers, when we acquired them versus when we peaked. I think that's the most factual way we can answer your question at this point.

Mig Dobre, Analyst

Okay, that's helpful. Sorry, go ahead.

Josef Matosevic, President and Chief Executive Officer

Maybe just at the same time, as you saw in our day, we have developed new products in particular on the Balboa side, considering the energy cost in Europe; you know, under a heat pump, for example, as you saw, that will help us mitigate some of the headwinds and certainly help us with the sales in Europe. But you should have a very good feel for where these products are going and what our opportunity is. So we are really not too worried, not too concerned. We got plenty of feedback from our customers' direct feedback a few days here in a couple of weeks where the orders actually peaked quite nicely. We just need the Asian market to open up and Europe to stabilize a little bit more and we should be well on our way.

Mig Dobre, Analyst

Understood. My final question again, if I look at your implied fourth quarter guidance revenue, EBITDA earnings, shouldn't we think of this as being really probably the baseline run rate for 2023? Any variances relative to Q4 that you would call out for us, Trish into next year? Thank you.

Tricia Fulton, Executive Vice President and Chief Financial Officer

I think that the run rates going, I don't know that we want to look at it necessarily as the run rates for 2023, but possibly heading into it in the first quarter. I do think that with all of the new products coming out, that we have both in electronics and hydraulics, we're going to be able to drive additional top-line revenue in 2023 that will get us above that run rate as we go forward. Certainly it could hold true for Q1, but not for the full year of 2023 given new products plus the rollout of new products that we have coming out at innovation, which have been really years in the making with the relationships we have with those OEM.

Operator, Operator

Thank you. Our next questions come from the line of Nathan Jones with Stifel. Please proceed with your questions.

Nathan Jones, Analyst

I guess I'll follow one from Mig. Maybe we can talk about parts of the electronics business that aren't Balboa. You talk about strength in marine and recreation, obviously exposed to consumer spending trends there. I think generally speaking in the US at least, there's a lot of complaining about inflation, but it hasn't really stopped consumer spending at all yet. So what are you guys thinking about the risk of those markets slowing down as the Fed continues to raise interest rates and inflation is generally going to bind into consumer sentiment? What's the risk that you see a drop off in those businesses going into 2023?

Josef Matosevic, President and Chief Executive Officer

Nathan, on the innovation side, knowing what we know now, folks are having a really strong year. And again, as Tricia said earlier, you know, our investments over the last two years in the TED product line into the diversification give us a very strong confidence level that this journey will continue. The products that have been rolled out in 2023, as you know, the TED business becomes very sticky for a minimum of two to three years, and then there's a refresh, and then it continues. So we really feel very confident that innovation will continue to grow with strong margins and have a very solid year as it stands right now.

Nathan Jones, Analyst

So your view is that the market share gains from new product rollouts in '23 can offset any end market weakness that you see for innovation?

Josef Matosevic, President and Chief Executive Officer

Yeah, the key comment here, Nathan, is for folks to understand is that, as I mentioned during our analyst day, traditionally, you know, innovation has been a marine and recreational customer supply and now we are really diversifying this into many other applications with that product line and that is the strength of innovation going forward. It's no longer just a two-key market; it's an expanded, broader market offering with much stickier solutions leveraging the entire technology play of innovation. And on top of that, you have the hydraulics coupled in on the system sales side. It's really a good deal here. So I don't see the headwinds, but I think we are very, very comfortable saying that innovation will continue to succeed with very strong margins.

Tricia Fulton, Executive Vice President and Chief Financial Officer

Just to add on to that a little bit, Nathan, we're already starting to see some really good and interesting opportunities with the open view displays that we have had a couple press releases about through innovation, and those are brand new opportunities and ones that we couldn't have gotten with our existing product line under the good, better, best strategy. So we're very encouraged by what we're seeing from the marketplace related to that specific new product.

Josef Matosevic, President and Chief Executive Officer

And in particular, Nathan, the two areas that you will see probably sooner than later are the diversification into the energy market and general industrial; what we call it. That's where applications will go here next.

Nathan Jones, Analyst

And clearly gaining market share in markets that you weren't in before is all incremental. Maybe we could just go on and talk a little bit about Damon. I know you guys were very excited when we were down there in September. Can you talk about the revenue and financial profile of the business now, and what it adds to the fourth quarter, what the financial targets are for Damon over the next three to five years? I know you talked about getting it to a hundred million of business and how you get from point A to point B on that.

Josef Matosevic, President and Chief Executive Officer

Yeah, certainly. As you stated, we are really very excited about the product offering, but more importantly the people and technology and engineering capability. It's a very sound business, very profitable diversified markets that we were not in before. The relationship is a very sound business. The financial performance for this year is really not material as we just closed this. What we expect over the next year as we continue to develop a very focused and execute our very focused augmented strategy in terms of having a center of excellence, diversifying, and really closing in on the system sales application, we feel we can leverage the hydraulic segment with electrification and get to the $100 million number as we outlined in our press release. Next year you will see a baseline run rate anywhere between $35 million to $50 million type of range, and then it continues from there.

Nathan Jones, Analyst

And the strategy to get to that $100 million, how you're leveraging the footprint with legacy business, etc., in order to get to that $100 million, what drives the growth to get there?

Josef Matosevic, President and Chief Executive Officer

Yeah, it's twofold. One is organic application that we are continuing to execute our manufacturing strategy with a center of excellence and in the region for the region leveraging our faster brand from Europe into North America and then coupling our system sales application where we can do a system within the Damon footprint and leverage their engineering capabilities to do more in the diversified markets and couple in other products in hydraulics and electronics within the Damon four walls to get into the applications and markets they're currently serving. So it's a combination between organic new products, and there could be another flywheel acquisition that we add for electrification to speed the process up.

Mig Dobre, Analyst

Great. I'll pass it on. Thanks for taking my questions.

Operator, Operator

I would now like to turn the call back over to Tania Almond for any closing comments.

Tania Almond, Vice President of Investor Relations and Corporate Communication

Great, thank you, operator, and thank you everyone for joining us today. We appreciate your interest in Helios and look forward to updating all of you on our fourth-quarter results next year. Please feel free to reach out to me throughout the day with any follow-up questions. Have a great day, and stay healthy. Take care.

Operator, Operator

Thank you. This does conclude today's teleconference. We appreciate your participation. You may disconnect your lines at this time. Enjoy the rest of your day.