Earnings Call Transcript - LYTS Q2 2020

Operator, Operator

Greetings, ladies and gentlemen and welcome to the LSI Industries Second Quarter 2020 Results Conference 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. It is now my pleasure to introduce your host Jim Galeese. Thank you, you may begin.

Jim Galeese, Host

Good morning, everyone. We issued a press release before the market opened this morning, detailing our fiscal second quarter results. In conjunction with the release, we also posted a conference call presentation in the Investor Relations portion of our corporate website at www.lsi-industries.com. Information contained in this presentation will be referenced throughout today's conference call. I would like to remind you that management's commentary and the responses to questions on today's conference call may include forward-looking statements about our business outlook. Such statements involve risks and opportunities and actual results could differ materially. I refer you to our Safe Harbor statement, which appears in this morning's press release as well as our most recent 10-K and 10-Q. Today's call will begin with remarks summarizing our fiscal second quarter results. At the conclusion of these prepared remarks, we will open the line for questions. With that, I will turn the call over to LSI CEO, Jim Clark.

Jim Clark, CEO

Jim, thank you. Good morning, all. Let me start this morning with a few highlights of the last quarter. I'm encouraged by the progress we've made in our second quarter. Although top line sales in Lighting lagged behind last year, we had significant improvement in our margins, underlining our effort to move away from low-value, highly commoditized business into higher-value, differentiated opportunities. In our Lighting segment, we enjoyed a better than 4% gross margin improvement and better than an 8% operating income improvement when compared to last year's results. We are committed to improving this even further. As part of our customer-first initiative, the majority of our executive management team is spread out across the country in early January, with the mission for each person to visit with two or three of our reps and agents. The goal is to create a personal contact with our partners in the field, getting a firsthand view of the opportunities and challenges they experience daily. The meetings are generally scheduled for one to two hours, with the majority of them extending far beyond the scheduled time, with some lasting as long as six hours. We came back from these meetings energized by the input of our partners in the development of a more personal connection. The mission now is to sort through the feedback received, look for the opportunities, and assure our agents and reps that we are truly partners in their business as much as they are in ours. On this trip, we visited with more than 20 reps, and we still have a number of reps to go, and this is something we will do again soon. Expanding on the partner visits, we had approximately 24 of our top reps come in and visit with us in Blue Ash in the middle of last month. We committed the entire leadership team to the meeting, having everyone from manufacturing, engineering, quality, order entry, sales, and finance participate. Much like the field visits, we were listening to our partners, looking for input, sharing feedback, and planning for the future. I could not have been happier with this visit and the commitment these folks have to our company. Most of them have been LSI partners for decades, and they truly exemplify the word partner. Luckily, January is the longest month of the year, and we took full advantage of it by holding our national sales meeting in Cincinnati last weekend. We were able to get our entire sales team together, including Jeff Davis, our new Commercial Leader, for three days of intensive training, including new sales processes, product reviews, competitor updates, and new product introductions. Along the lines of new products, in the last quarter, I'm pleased to say we released six new products. Over the next few quarters, we plan to release two times that number. On the Graphic side of the business, I would like to note that the petroleum business has achieved nine consecutive quarters of growth. We have worked to be engaged in a string of new projects. As we've discussed in prior calls, these new projects tend to be multi-year ventures, and we go through an efficiency and learning curve. That curve directly relates to our margin performance; the more experienced we become with the project, the more effective we become, and the margins improve. A good example of this margin improvement cycle is in our digital signage business. Over the last two quarters, we've been able to improve customer satisfaction and differentiate ourselves from our competitors, all while improving margins by better than 5%. Simply put, we're providing better service than our competitors. The customers recognize it, and they're willing to pay for it. Continuing with the Graphics topic, last week, LSI joined in on an inaugural celebration with Valero, marking the opening of their first Mexico location. This was no small event. It included a seven-piece mariachi band and a full extended celebration on-premise. This was a well-attended, full-scale event. Our logistics and implementation mechanisms allow us to provide the exact same high-quality brand image to our marketers in Mexico as in the United States. We like to say whether the project is in Kansas City or Mexico City, LSI is a sought-after trusted partner in petroleum branding, and our customers can be assured of a consistent, high-quality experience. That's why so many of the world's largest petroleum companies are working with LSI. In general, the Mexico projects are ramping back up. However, we have heard from a number of our partners that there have been some expanded regulatory requirements added to the process, which is adding time to approval and permitting. We do not anticipate or expect any loss of business. Our project start dates have been extended to account for this longer approval process. As I mentioned previously, we've invested in an expansion and efficiency improvement plan in our Houston facility, which is the primary manufacturing location for our petroleum-related Graphics projects. Last summer, we added approximately 40,000 square feet, and we've made considerable workflow improvements, all while managing a heavy workload and without impacting production or customer satisfaction. I was down in Houston a few weeks ago with Jim Galeese, and we're pleased with the progress these folks have made in the continuing operations ahead of us. I expect that it will take us another quarter or two before we realize the full impact of these changes, but it's very exciting to see the improvements. As many of you may have noted, we entered into a definitive agreement last month to sell our 210,000 square foot Graphics facility in North Canton and move into a smaller facility right down the road from our current location. With changes in print technology and improved workflow design, we simply didn't need the space we were in. The burden and cost of carrying that excess space just didn't make sense. This move will allow us to retain a highly skilled and valuable workforce in Canton while introducing a number of efficiencies in the layout and production flow of our North Canton operations. We'll be going through a build-out and moving into the new building over the next few months. However, we anticipate closing on the sale of this building towards the end of this quarter, Q3. On a completely different note, I wanted to talk about events in China for a minute. As you know, we are principally an American-made and manufactured product. With that said, we do source some components from the Far East. Each year, we have plans in place to account for known disruptions like the Chinese New Year and contingency plans to address issues like shipping strikes, tariffs, etc. I can't say that we had the coronavirus specifically in mind, but we have plans in place to address issues just like this, which could cause possible supply chain disruptions. At this point, we've analyzed our exposure to critical parts distribution and disruption from China, and we feel comfortable that we should be able to weather any disruption for some time. Obviously, it's hard to predict what the long-term impact could look like, but being an American-made product should prove to be another benefit to our partners and customers, and we hope any disruption they may experience will be minimal, if at all. Regardless, we all hope for a speedy resolve to this issue. In closing, I want to reflect back over the last year; the company has gone through a lot of positive changes. We have put a lot of time into our operations and sales plans to be ready for the second half and for the future. Margins continue to improve. Operating income is up, and debt, which was over $50 million this time last year, is down below $10 million today. Although we still have a way to go, I know that we have plenty of opportunities remaining in front of us both operationally and commercially. I'm looking forward to a strong second half. With that, I'll turn it back over to Jim Galeese for a closer look at our financials.

Jim Galeese, CFO

Thank you, Jim and good morning everyone. Summarizing key fiscal second quarter financial statistics, net income was $1.7 million, compared to a net loss of $15.8 million last year. Earnings per diluted share were $0.07 versus a loss of $0.61 in the fiscal second quarter of 2019. Sales for the second quarter were $82.4 million versus prior year of $89.5 million, reflecting our demand shaping initiatives. On a non-GAAP basis, adjusted net income was $1.6 million compared to $900,000 in the same period prior year. Non-GAAP earnings per diluted share were $0.06, double the $0.03 a share last year. A complete reconciliation of second quarter GAAP and non-GAAP results is contained in our press release and 10-Q. The company generated $13.8 million of free cash flow in Q2, reducing net debt to $9.2 million. Net debt has been reduced to approximately $30 million in the last 12 months. The company's net debt to adjusted EBITDA ratio is now 0.7 times. Working capital decreased by $23 million or 31% versus prior year, reflecting continued improvements in both dollars and days of working capital. In January, we announced the definitive agreement to sell the Graphics manufacturing facility in North Canton, Ohio. Under the terms of the agreement, the company will receive approximately $8 million in gross cash proceeds. The net proceeds will be used to further reduce debt, fund innovation, and other business investments. A regular cash dividend of $0.05 per share was declared payable on February 26 for shareholders of record on February 18. Next, I'll briefly comment on the performance of our two reportable segments, starting with Lighting. Sales were $53 million versus $64 million last year. The gross margin rate improved by 420 basis points to 29%, and adjusted operating income improved 8% to $3.2 million. Lighting adjusted EBITDA was $4.8 million or 9% of sales. The 420 basis point gross margin rate improvement includes the positive change in sales mix, driven by our demand shaping actions, moving away from commodity low margin products, as well as the cost savings realized from the New Windsor plant closure. Exiting Q2, we are on track to achieve the annualized new winter savings target of $4 million. Lastly, recent project order activity has been positive, high single digits above last year. Shifting to the Graphics segment, Graphics generated sales growth of 12% for the quarter, representing the ninth consecutive quarter of year-over-year growth. Growth was driven by multiple verticals, including petroleum and quick-serve restaurants. The outlook for the next several quarters in the program-driven petroleum vertical is strong. The combination of an increasing backlog, growth in the program activity with new customers, and the announced four-year extension with Chevron Texaco has led to this robust performance. Graphics segment adjusted operating income for the quarter was $1.7 million versus $900,000 in the prior year. Operations, productivity, volume leverage, and overall expense management was responsible for the increase. Graphics adjusted EBITDA for the quarter was $2 million or 7% of sales compared to $1.3 million or 5% in the prior quarter. Let me finish with a couple of additional comments on the North Canton facility project. In addition to the $8 million cash proceeds, the sale and relocation to a smaller leased site in the North Canton area will generate a small annual net cost savings. With lower facility fixed costs offset by the new lease, we also retain our experienced skilled workforce, ensuring we maintain our customer service capabilities during this transition. I'll now return the call back to the moderator.

Operator, Operator

Thank you. Ladies and gentlemen, we will now be conducting a question-and-answer session. Thank you. Our first question comes from the line of Craig Irwin with Roth Capital. Please proceed with your question.

Craig Irwin, Analyst

Good morning and congratulations on the progress with your balance sheet. The first question I wanted to ask is about the $9.2 million, down from $38 million a year ago. This obviously does not include the $8 million in cash or net cash from your facility sale, right? That's not in the remaining $9.2 million.

Jim Galeese, CFO

That's correct.

Craig Irwin, Analyst

Excellent, excellent. So then as we look at the fiscal third quarter, your March quarter, this has traditionally been your most seasonal quarter, just due to the overall seasonality in the Lighting business and the way things progress. How much of an opportunity really is there to squeeze the balance sheet a little bit more? I mean, you guys have leaned out your working capital so aggressively over the last couple of years. Do you see much of an opportunity to continue to sort of drip some cash out of your existing assets?

Jim Clark, CEO

Yeah. Craig, this is Jim Clark. Good morning and thanks for being on the call. And thanks for the question. You're right. I mean, going from $38 million down to $9 million, and we'll continue to move on that even through this quarter. I just want to be clear, that does not include the $8 million. I know I answered that question kind of quickly. It does not include the $8 million from North Canton. I do believe we have some additional leverage to pull. We've got, as I mentioned in my comments a few minutes ago, we've still got a list of things that we can work on and I believe there's some additional efficiencies we can achieve, and we have things we can continue to go after.

Craig Irwin, Analyst

So then the – so I was maybe just a tad high in the quarter. I completely understand the softness in the Lighting market. I think you guys are outperforming versus some of the behemoths out there, right. But as we look at the third quarter, I'm kind of scratching my head and asking if we are likely to stay profitable. Do you feel that there are any significant levers that can allow you to outperform the market on revenue maybe in the third quarter, or the North Canton facility sale would have a modest impact on the net profitability, but the door – as Chenango down, how should we be looking at potential profitability and puts and takes in the third fiscal quarter?

Jim Clark, CEO

Craig, I've always said we needed to build a better business before we could build a bigger business. And we needed to keep that in mind. In Q2, as we moved away from that highly commoditized business, we knew we were going to put pressure on our top line. But as you can see through the financials, we certainly carried it through in margin on the bottom line. There is clearly pressure from some of the bigger players in the Lighting market in general, but as I've said a number of times, it's a $15 billion opportunity annually. I think for a company like LSI, it's about shares more than it is about market direction. We have a lot of room in front of us. In Q3, which is traditionally our weaker quarter and it's highlighted by the fact that we put a lot of time into our outdoor projects, Q3 would certainly expose a little bit of weakness relative to indoor. We have some plans that I think, and we have some things that are coming in that are going to make Q3 better than we did last year. No question about it. Now our challenge is, can we do it and mitigate the losses that we experienced last year? The answer is yes, we will see a stair-step improvement. But our goal right now is to maximize that in terms of the improvement and minimize the impact. I do think that Q3 remains a quarter of challenge for us.

Craig Irwin, Analyst

Great, and then one of the things we're starting to see in the Lighting industry is that some of the very large customers are coming back and taking a look at some of the smaller, more nimble suppliers. We've encountered one customer in particular that looks like they're close to changing to a similarly sized company that I don't think you will compete with directly. Are you seeing the level of engagement with the top 50 customers in the market maybe shift a little bit? Are you finding more doors that are opening because of your well-run domestic manufacturing and your history of on-time delivery, continuous improvement? How is this potentially working for you in the current environment, given people see lower risk in doing business with domestic manufacturers?

Jim Clark, CEO

Well, I will tell you that I want to hit that in a couple of points. In my comments a few minutes ago, we took the first two weeks of January and went out and visited our agents. I mean, we sat across the table from them and visited with them. I think that differentiates us a lot in the industry, and it's a very positive response. The folks see what we're doing, they hear the messages, and this is through our agents and our end-users; they hear the message, they see the progress. To your point, they look and say, 'These guys are credible.' They appreciate the underpinning of the American-made built here, US manufactured, and the people that are making our products are the people that are using them also. All of that is working very well for us. I do believe, to your comment that there is a shift where people are looking and saying, 'Listen, I don't want, okay – I don't want a broad portfolio. That's okay. I'd rather pick the best in class that serves particular or specific markets well,' and that's really resonated with our customers. Our customers are saying that back to us, and I believe that's key to our improvement. It's all underpinned by what we're doing. We're doing what we said we were going to do, and I think folks appreciate that.

Craig Irwin, Analyst

Great, and then if we could just lastly, touch on petroleum. This has been a long-term social strength for LSI. You announced in the release that you picked up another important customer there. Can you maybe scope out for us how many of your large programs you're executing on for petroleum at the moment and what portion of the revenue in the company is actually coming from petroleum these days? How is this evolving?

Jim Clark, CEO

Well, Craig, we are engaged in five large projects right now. These projects tend to be multi-year projects. We don't typically break up the Graphics piece of petroleum – what we do for branding and stuff like that. But those five projects represent about 30% of what we're doing – Lighting and Graphics combined.

Craig Irwin, Analyst

Understood, great. Well, congratulations on the progress with the balance sheet, and fingers crossed, maybe we can get to net debt zero in the next couple of months. I'm really looking forward to that. Thank you again for taking my questions.

Jim Clark, CEO

Thank you, Craig, and I do – we're on the same page, I do think we can get to zero. But I also want to comment that there wasn't a race to zero, as much as it's a race to having that dry powder and being able to look at opportunities that may come in front of us or opportunities that we're developing. I'm not – I mentioned this before. I'm very much willing to use debt to help fuel our company and help build it. But as I mentioned a few minutes ago, I always felt the management team felt too that we needed to have a good solid foundation to work from – a better business before we became a bigger business.

Rich Fearon, Analyst

Hey, Jim. Jim, thanks for taking my call.

Jim Clark, CEO

Good morning. Thank you.

Rich Fearon, Analyst

Yeah. Good morning to you all and congrats on a really nice quarter. The margin improvement is very impressive as is the $40 million year-over-year debt reduction, and it just speaks to really smart decisions you're making in reallocating the assets towards higher margin and growth opportunities both internally organically as well as hopefully there's some things you can scout out there in what remains a somewhat fragmented industry and perhaps offer some acquisition opportunities. So I guess, just my one quick question relates to that. This unlevered balance sheet is a phenomenal tool to have. It's nice in a somewhat cyclical industry not to be run with a lot of leverage. But if there are some opportunities out there that are cash flowing and may help counter some cyclicality or just provide long-term growth that can be bought at a good price, do you have anything in the near term or medium term sort of in mind or any direction that you'd like to take the company with respect to deploying some of the strong balance sheet towards acquisitions?

Jim Clark, CEO

Well, let me answer that in a couple of ways. First, the simplest answer is yes, we are out there looking for opportunities. They could range from partnerships to acquisitions to technology in a number of different areas we are looking at. I don't want to really comment specifically on who or what we're looking at just for general business sake, but we have been actively out there looking. We have had conversations with a few people that have advanced to the point where we're trying to figure out how they would best fit in. We will continue to do that. Probably the only thing that was holding us back was making sure that we were organizationally ready and had the organizational maturity to bring on a partner or an acquisition to expand our product offerings or whatever it was. So much in the acquisition world, so much value is destroyed by poor integration. Knowing that we were ready, we had a good solid foundation we were standing on was necessary before we could go and credibly say we can do an acquisition and integrate it in a way that's meaningful to our business.

Rich Fearon, Analyst

Yeah, you've built a really strong team, Jim, and it's impressive, and it sounds like a smart way of going about it. If there's anything that any of your shareholders or others can do to help with respect to contacts, please don't hesitate to reach out. I'd love to see you really leverage what you have built now. I don't mean with debt, but seeing how you can grow the business and do that in a really smart way, the way you have already, in terms of improving margins and finding good value-added businesses that have long-term sustainability. So congrats on the nice work, and thanks for all the hard work.

Jim Clark, CEO

Well, thank you, thank you for those comments.

Operator, Operator

Thank you. Ladies and gentlemen, at this time, I'd like to turn it back to Jim Clark for closing comments.

Jim Clark, CEO

I just want to say thank you, everybody for participating and joining in. I hope that you find these calls informative. As we've mentioned before, we're always available, myself and Jim Galeese, if anybody wants to follow up comments or conversations on specific, as Rick brought up, certainly we are continuing to look for opportunities and hopefully on the next call we will have even more to talk about. Thank you and good afternoon.

Operator, Operator

Thank you. Ladies and gentlemen, this concludes today's teleconference. You may disconnect your lines at this time. Thank you for your participation.