Mayville Engineering Company, Inc. Q4 FY2020 Earnings Call

Good morning and welcome to the Mayville Engineering Company Fourth Quarter 2020 Earnings Conference Call. All participants will be in a listen-only mode. After today’s presentation, there will be an opportunity to ask questions. Please note this event is being recorded. I would now like to turn the conference over to Mr. Nathan Elwell of Investor Relations. Please go ahead.

Thank you. Welcome, everyone, and thank you for joining us on today's call. A few quick items before we begin. First, please note that some of the information you will hear during this call will consist of forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934 as amended. Such statements express our expectations, anticipations, beliefs, estimates, intentions, plans and forecasts. Because these forward-looking statements involve risks, assumptions and uncertainties, our actual results could differ materially from those in the forward-looking statements.

Thank you, Nathan. Good morning, everyone. As we look back at 2020, we're pleased with the way we’ve responded to the pandemic challenges we faced. Not only did we effectively adapt our operations to continue working throughout the year to support our customers, we were still able to focus on optimizing our cost structure through facility and process improvement and strengthen our financial position. I give credit to our leadership groups throughout the company for being creative and quickly formulating improvement plans and our entire team for their resilience and diligently implementing those plans and continually adapting to the changing environment. Agility, adaptability and realignment are strengths of our business culture at MEC. The fourth quarter provided a positive end to a challenging year. In short, we did exactly what we told you we would do last quarter. All things considered we're pleased with our performance for the quarter and our progress for the year. We continue to maximize the efficiency of our manufacturing operations. And we are seeing the positive impact of these initiatives in our results. For the fourth quarter of 2020, we delivered net sales of $95.3 million, slightly lower than the fourth quarter of 2019, but a sequential increase from the third quarter of 2020. Most importantly, we've produced adjusted EBITDA and adjusted EBITDA margin of $9.3 million and 9.8% for the fourth quarter respectively, both of which are significantly higher than the same period last year, as we are now more efficient and have reacted to the changes that occurred late in 2019.

Thanks, Bob. I'll begin with the highlights of our full year financial performance and then discuss our fourth quarter and provide commentary on our balance sheet liquidity and our thoughts on guidance. As noted in our press release, we’ve recorded full year 2020 net sales of $357.6 million, as compared to $519.7 million for the same prior year period, a decrease of 31.2%. The decline was driven by volume reductions related to de-stocking activities and market demand changes mostly driven by the pandemic. Despite the lower volumes, our customer relationships and manufacturing programs remain intact. Adjusted EBITDA and adjusted EBITDA margin percent for the full year 2020 finished at $32.8 million and 9.2% as compared to $54.7 million and 10.5% for 2019, resulting in a decremental margin of 13.5% as compared to our historical average of 17.5%. The improved decremental margin percentage is attributed to our effective implementation of cost reduction activities, including the Greenwood, South Carolina closure, a full year of DMP synergies, and leveraging our recent investments in new technologies and automation. It is important to note that these cost adjustments are permanent, providing a clear path and a 15% adjusted EBITDA margin expectation when manufacturing volumes return to pre-pandemic levels in the coming years. Despite the challenges posed by the pandemic, we generated strong cash flow, resulting in a significant debt pay down of approximately $28 million, resulting in an ending debt balance of $47.9 million and the leverage ratio of approximately 1.5 times as of year-end. Now I'll provide guidance on the financial performance for the fourth quarter. We recorded fourth quarter net sales of $95.3 million as compared to $102.3 million for the same prior year period, a decrease of 6.8%. The decline is due to market-related manufacturing volume reductions, again mostly driven by the pandemic. Manufacturing margins are $11 million for the fourth quarter of 2020 as compared to $4 million for the same prior year period, an increase of 174%. Prior year manufacturing margins were adversely impacted by sudden declines in market demand, customer-related labor union issues and de-stocking activities, resulting in an unusually high amount of under absorbed manufacturing expenses during the period.

Thank you, Todd. We're pleased with our recent results and the progress we're able to make during the difficult year, while not back to pre-pandemic levels. As Todd mentioned, we are seeing volumes improve across many customers and end markets. And most of the commentary from our customers about the future is positive. In the fourth quarter, we did exactly what we said we would do and I'm pleased we're able to end the year on a positive note. Assuming the economy continues to stabilize and improve, we are bullish about our prospects in 2021 and beyond as we pursue further productivity gains through new technologies and automation and explore important internal and external growth opportunities. On behalf of the Board and our Management team, I want to thank each and every MEC employee and shareholder for the dedication they have shown during very trying circumstances over the past year. We continue to be vigilant regarding the pandemic, and believe our employees are now used to operating with these restrictions in place. Despite the disruption, their persistence and consistent strong performance have ensured we have maintained all of our customer relationships and manufacturing programs and now are in a position to respond as customers ask us to ramp up volumes. With our current business as well as opportunities on the horizon, we are well positioned to drive growth in the years ahead. With that said, operator, we'd like to open up the call for questions.

We will now begin the question and answer session. We'll pause momentarily to assemble the roster. First question comes from Mig Dobre, Baird. Please go ahead.

Thank you. Good morning, everyone.

Good morning Mig.

Hi, Mig.

I appreciate the ranges that you've given us by end market in terms of your mix for '21. Just a quick question on 2020, can you give us a sense for commercial vehicles and how much that contributed to your revenue in 2020?

Yes, that was in the 33% range, I think, right around 33.

Okay, thank you for that. And your reference consensus is generally in line with kind of how you're thinking about 2021 at this point. 2021 is likely to be a year of good volume growth. So I guess my question is, as you're looking at your operations currently, what do you see as your ability to be able to meet that higher demand? Do you see any challenges ramping up production, either related to your own operations or your own supply chain in this regard?

Yes, I'll take the comment about supply chain first. I guess, there have been some steel shortages in the marketplace that we are aware of. Obviously, steel pricing has increased significantly. But most of our contracts are passed through on the material costs. On the availability side, we've actually done very well, probably better than most. So we've worked very hard at that all the time, Mig. And as far as there are some very modest imports that come into our product before we ship it, and we're working on those things as well. It's almost immaterial to talk about. On the internal side with the equipment and investments that we've made, that helps mute some of the people requirements that otherwise would have to be taking place. We still have pockets; it's different locations, different geographies have different challenges. But again, I think our investment in automation is showing that we did the right thing and will continue to do the right thing with those investments. So we won't be without challenges, but I think we're continuing to work at minimizing them.

Okay, it sounds to me, and I don't want to put words in your mouth here. But it sounds to me that you're fairly confident that you're going to be able to essentially keep up with your customer demand in 2021. And I suspect that not all your competitors are going to be able to do that. And even your own customers, the ones that are having internal fabrication operations are probably going to struggle to some extent ramping up. As you look back at the prior industrial downturn or recession, is there an argument to be made that you will be able to gain some share or incremental business just given your ability to ramp your own production higher and hopefully take some share that way? What if you in this regard?

Right, I think history is one thing, but we were less automated at those times. Hopefully, with our additional automation, we have more leverage potential there. But we're going to be very careful about it. We want to look at that opportunistically. And it's not just about share. It's about profitable share. So that's what we're focused on and doing the right things overall for the business.

I see. And that actually, this is my second line of questioning which is surrounding margin. You talked about the fact that raw material costs are generally a pass through, but I know that some of this is embedded in your own business, right? I mean, if I'm thinking about consumables on the welding side, that's something that you have to deal with, that I presume, and it's not something easily passed through to the customer. So how do you think about the impact of that on your financial model in 2021? Should we expect you to adjust pricing accordingly? And do you think you can be at least neutral from a price cost perspective?

We're making significant efforts toward that goal. When we consider automation, some of the equipment actually proves to be more energy efficient in relation to the consumables used in welding, such as weld wire and gas. The usage remains consistent compared to less automated processes. Additionally, we are implementing continuous improvement initiatives at our sites, managed on a corporate-wide level, which allows us to share the best practices and ideas among locations. This is a major focus for us, and we are dedicated to it. If we experience notable increases in overhead or perishable costs, we might observe some reductions. However, as we evaluate our work backlog, if adjustments are needed, we will engage in discussions with our customers.

I understand. For my last question, you mentioned your goal of achieving a 15% margin and stated your confidence in reaching that target. I'm interested in your perspective on the manufacturing margin and what factors contribute to that expectation. If I recall correctly, your previous peak manufacturing margin was just below 15. Should we anticipate that number to exceed past levels? Additionally, considering our earlier discussion, how should we view the manufacturing margin for 2021? Thank you.

Yes, as I mentioned in the script, we anticipate that once we return to normalized or pre-pandemic levels, the manufacturing margin percentage will exceed historical averages. Considering the peak was around 15%, we expect that when we return to pre-pandemic levels, it will be higher, likely in the range of 16 to 18 percentage points. I believe that in 2021, we will see an improvement compared to 2020. However, because of lower volumes compared to 2019, I don't expect to reach that 15% this year. Moving forward, as we begin to leverage our investments and overhead with volume levels akin to pre-pandemic, we do foresee it exceeding 15%. Additionally, we aim to achieve that 15% adjusted EBITDA margin.

Thank you. Appreciate it.

Thank you. Next question from Andy Kaplowitz with Citi Group. Please go ahead.

Hey, good morning, guys.

Hi, Andy.

Good morning, Andy.

Maybe I could ask Mig’s question one other way on the margins. You guys have said in the past that given the cost out and footprint consolidation that you've done, that you might be able to average high 20% incremental sales recover. Is that possible in '21? I know you said you're comfortable with consensus. But obviously, there's price versus cost and all that kind of stuff you just talked about. So is that possible in '21?

Yes, 22.5% as our historical average, we do believe that is still achievable in 2021. Now, you won't see the 30% and 40%, you don't even 100% type incremental that you saw when you compare it to 2020 to some of the 2019 fourth quarter, but we will still be above the 22.5% in my mind given the cost reductions we've made.

Got it. That's helpful Todd. And then Bob, maybe just for a little more clarity and maybe Todd can answer this also. So if we look back at Q4, I mean, you talked about not yet reaching pre-pandemic levels in '21. But if we look back at 2020 in Q4, I would assume some of the businesses in some end markets are already above pre-pandemic levels given you're only down 6%, or whatever it was, and power sports has been relatively obvious, maybe military but any sort of more commentary on the end markets themselves and sort of what's already recovered if you may versus what's not recovered.

Sure. Well, when we say pre-pandemic, there are a couple of definitions. 2019 was one year and pre-pandemics is kind of the first quarter of last year. Obviously, the commercial vehicle market was in a downturn going into 2020 and has since bottomed and it's coming back. So that one, we've seen that begin in the third quarter and strengthen in the fourth and we think it will continue to improve throughout '21. So that's what we're talking about, that's one example of what we're discussing when we say pre-pandemic. Other markets, likewise, we've seen the inventory de-stocking become complete during the second quarter, third quarter period of time. And those markets have bounced back. So when it comes to the recreational products, obviously, they were not essential manufacturers, so they ate their inventory during the second and third quarter and now are replacing inventory and trying to keep up with demand. So everything has been moving pretty much in a very positive direction. So that gives the color I can put around that.

And Bob, maybe just following that, like in terms of restocking powersports, sure, and you said maybe that sort of levels off at some point in '21. Is that still your thinking? And then for end markets like small ag, for example, and there was de-stocking that seem to end? Do you think that any markets will really need restocking in '21 besides powersports?

I guess I'm going to ask Ryan if he has a more close impression on that one. But I guess I'll start by saying we'd agree that there will come a point where inventory is restocked on the recreational side. And then the other markets, yes, Ryan, do you have some comments?

Yes, I guess you mentioned small ag and definitely there was a quick depletion of inventory kind of in the middle of 2020. That has led to a little bit of restocking there. We would also see it a little bit in the construction market as Bob noted in his remarks, the housing market has been strong. We've seen a lot of the rental companies increase CapEx year-over-year, in certain pockets of equipment tied particularly to more of the housing sector. There is a little bit of restocking activity that has taken place there in the construction market.

Thanks Ryan. And then maybe one more for me, can you give us an update on where you are in terms of acquiring new customers and entering new verticals? I know you talked about it a little bit, Bob, in the prepared remarks. But you've been talking about opportunities in the past like warehousing, packaging, how are you thinking about new potential business contribution to '21? I know it's sort of in the other segment, but anything that really excites you in '21 and beyond?

We can discuss it further if and when it happens, but we are quite optimistic about the opportunities and potential available. That's my comment on that. Once we are able to report on it, we will do so.

And Bob, are you seeing any evidence of existing customers re-shoring at all, or maybe pushing outsourcing more?

Sure. And that's part of that story and creates those kinds of opportunities. So absolutely, that's part of the piece behind that.

Great, thanks, guys.

You're welcome.

Your next question comes from Stephen Volkmann of Jefferies. Please go ahead.

Hi guys…

Good morning Steve.

Hi, this is for Steve. I just had a quick question on any temporary cost coming back in '21 and just probably cadence on it. I know you mentioned that travel expense and related expenses were down this year. Any guidance on what we can expect in 2021?

We expect employee benefits and retirement benefits to return to more normal levels this year. As Todd mentioned, we contributed significantly to the 401(k) for our employees in the fourth quarter. We anticipate that this contribution will be at full levels in 2021, which will lead to higher amounts alongside other incentives. Regarding travel costs and related expenses, we've learned a lot this past year about conserving costs and saving time, not just in production but also in administrative areas. We will be closely monitoring these expenses. I do not foresee travel and entertainment spending returning to 2019 levels, although it may increase slightly from 2020. We have all gained valuable insights this past year, and we intend to leverage those to use our time more effectively.

That's helpful. Thank you.

You're welcome.

Thank you. Next is a follow-up question from Mig Dobre of Baird. Please go ahead.

Thanks for taking the follow-up. Just a quick one, Bob, you talked about the M&A environment. And I think I heard you say that it was kind of slow. So I guess my question is, I know before the pandemic, you guys had a pretty active and fairly full pipeline and you operate, obviously, in a very fragmented industry. What are all the puts and takes here in terms of when some of these deals would become maybe available? And you'd start converting on that? Then I'm also kind of wondering if now that we've been through this sort of big shock, if your own thinking in terms of the things that you'd like to add to your portfolio changed, right? I mean, if you're either looking for sort of new geographies around the country or new verticals that you might not have examined before, or even sort of new manufacturing capabilities that extend beyond the core of what Mayville Engineering has been known for?

I guess, Mig, I'll take a couple of pieces here. Those prospects that we had are still there. And some of them have retrenched and are waiting for a better day to present themselves for sale. I think that's both from a PE standpoint and from a private owner standpoint. But we still have those contacts, and it just doesn't seem as robust today as it had done. I think that will change over time. As people figure out the end of COVID and all the other risks and issues that are out there. With regard to what we're looking for, our definition is still the same – product line expansion, product line extension, geographic expansion, and then looking for the markets to serve. So now, between doing that through M&A or through internal growth, if we can do it in a meaningful way with internal growth, it seems like a more cost-effective way to do it. And we will always try to prioritize the best return opportunities and achieve all those investment criteria. And so it can be both.

Well, if opportunities don't avail themselves to you. Based on just my own modeling, it looks to me like your leverage ratio will exit 2021 close to zero. And I'm wondering if that's the case at that point. Would you consider some form of returning capital to your shareholders either in a special dividend or something like that?

Yes. We are focusing on three areas for investment. First, we are exploring additional internal ROI opportunities to reduce our reliance on personnel through re-deployable automation. Second, we are pursuing internal growth opportunities, maximizing automation wherever feasible. Third, we are looking into M&A opportunities as another way to utilize our cash. All these activities will take place this year, but I can't predict the specific mix at this time. I don't expect our balance sheet to be debt-free by the end of the year, but we see potential for growth and are actively pursuing it.

All right, fair enough. Thank you, guys.

Thanks, Mig.

Thank you. The next question is from Chip Rewey of Rewey Asset Management. Please go ahead.

Good morning, everyone. I have a few quick questions, more focused on one-on-one topics. I'm aware you have the raw material pass through, but with the recent increase in steel prices, I wonder if there is any lag on those contracts, such as a 90-day delay. Also, regarding the construction side, could you separate the residential and commercial top lines? For the commercial vehicle sector, are you involved in the engine, tractor, or trailer, and specifically, how much visibility do you have regarding short-term projections or longer-term forecasts for the next 6 to 12 months?

I'm going to ask Ryan Raber to address those more details on that.

Yes, we primarily deal with heavy duty and medium duty trucks, with not much involvement in trailers. We rely on long-range forecasts from industry publications, but we generally have 3 to 12 months of visibility from our customers. Regarding the construction market, we don't have a top-line breakdown; instead, we analyze it by sub-sector, so there is nothing significant to mention there. Could you please remind me of the first question you asked?

Sure, just on the raw material pass through, do you guys have a 30-day, 60-day, 90-day lag that we have to just think about?

Yes, all those tend to be a little bit different based on who the customer is. We have some that are kind of more real-time where you're looking on monthly. There's others that look at quarterly. So it really depends on which customer. They each kind of run their own individual program consistent over time. So if there is any lead lag that always kind of works its way out as you go up and down through the cycles.

Very much on that topic or what I should say.

This concludes our question and answer session. I'd like to turn the conference back over to Mr. Bob Kamphuis for closing remarks. Thank you.

Thank you all. Thank you for your time today and your continued interest in MEC. We look forward to talking with you at conferences, whether they're in person or electronic and roadshows throughout the year. Thanks again for your time and interest.

Conference is now concluded. Thank you for attending today's presentation. You may now disconnect.