Mayville Engineering Company, Inc. Q4 FY2021 Earnings Call

Hello and welcome to today's Mayville Engineering Company's Fourth Quarter and Full Year Earnings Call. My name is Bailey, and I'll be the operator for today’s call. I would now like to pass the conference over to Nathan Elwell, Investor Relations. Nathan, please go ahead.

Thank you, Bailey. 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 that you will hear during this call will consist of forward-looking statements, within the meaning of Section 21E of the Securities and 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. For more information regarding such risks and uncertainties, please see our filings with the SEC, including our filings on Form 10-K for the period ended December 31, 2020. We assume no obligation and do not intend to update any such forward-looking statements, except as required by Federal Securities laws. Second, this call will involve a discussion of certain non-GAAP financial measures. Reconciliation of these measures to the closest GAAP financial measure is included in the earnings press release, which is available at mecinc.com. Joining me on the call today are Bob Kamphuis, Chairman, President, and Chief Executive Officer; Todd Butz, Chief Financial Officer; and Ryan Raber, EVP of Strategy, Sales & Marketing. First, Bob will provide an overview of our performance, then Todd will review our financial results and guidance. With that, I’ll hand the call over to Bob. Please go ahead.

Thank you, Nathan. Good morning, everyone. I'm going to start with 2021. We’ve effectively executed throughout ’21 and produced significantly better results than the previous year despite the inflationary pressures and labor challenges that we all experienced, compounded by labor and supply chain disruptions affecting our customers' production schedules. As we look back at 2021, we are pleased with the way we navigated through these challenges and continue to see strong medium and long-term demand trends across all the end markets we serve. We have added new takeover business and new customers in the powersports end market. We look forward to delivering on the 2021 deferred customer volumes in 2022 and stand ready to successfully execute on the strong demand for our services for the current year and beyond. For the fourth quarter, we produced net sales of $113 million. The 19% increase of $17.7 million was primarily driven by contractual raw material prices and pass-throughs to customers, improved volumes, and commercial pricing increases. We delivered adjusted EBITDA of $9.2 million as supply chain disruptions impacted our customers’ schedules during the quarter and led to some of our volumes being deferred into 2022. Our fourth-quarter performance internally was particularly impacted by significant supply changes from Class A Truck OEMs, which stem from their supply chain issues and microchip shortages. For us, this also resulted in operational choppiness and efficiencies impacting our profitability. As we navigate these challenges, it was important to maintain our skilled labor force so we are ready to address the strong demand as supply chain issues start to improve. Although recruiting quality employees remains a challenge, we have been able to cost-effectively grow our capacity through investments and flexible redeployable automation and process improvements. We also expect to recover general inflationary pressures on raw materials, labor, and other product content through contractual material price adjustments and increased commercial pricing. As volumes have only been deferred from ‘21, we are confident that our volumes will increase as the customers' supply chain issues start to subside during 2022. Additionally, MEC's supply chain is 98% concentrated in the U.S. We have maintained our supply of raw materials and components and are prepared to effectively execute as our customers step up their volumes. The end markets we serve continue to forecast strong demand outlooks over the mid and long term. More specifically by market, the commercial vehicle market continues to show strong demand but has seen the most impact from supply chain disruption, which is predicted to continue during 2022, particularly during the first half of the year. However, the ongoing strong freight demand and strong backlogs at the OEMs lead us to believe this will continue to be a strong market for MEC over the medium to long term. Turning to powersports, it continues to be a strong and growing end market for MEC with elevated volumes due to the overall strength of retail demand for outdoor recreational products, coupled with low dealer inventories that we expect to be restocked over 2022. The construction and access end markets have continued to show strength in residential construction with non-residential starting to see some signs of improvement. We believe that we'll continue to see further signs of volume improvement, and with low dealer inventories, further demand requirements to restock fleets. The agricultural market continues to see low machine inventory, strengthening demand, advancements, and equipment productivity combined with low global crop inventories and strong crop prices will continue to drive improving volumes over the mid to long term. Concluding with our military segment, which continues to be a stable market for us with customers having a solid backlog for U.S. government contracts. We continue to see potential for increased revenues due to vehicle updates and new opportunities for service-related demand. While supply chain disruptions persist, pandemic-related problems have stabilized and declined somewhat, and we anticipate volumes will gradually improve as 2022 progresses. Furthermore, our new business pipeline remains very strong. We continue to build relationships and convert on new opportunities to expand our customer base and the markets we serve. During 2021, we expanded business opportunities with new and existing customers looking to expand capacity to support strong end market demands. These came through new product and new model launches, takeover business with several top powersports customers, aftermarket programs, and new product line offerings by customers, as well as reshoring and outsourcing by OEMs. I'll walk through some of the more exciting and noteworthy opportunities we see today. The commercial vehicle market has continued to launch new products, which has led to market share gains for us. We have been focused on cross-selling our products during the model changeovers, and we expect to continue to grow as customers launch their next generation of products. The powersports market continues to be a very active space for us. We are growing our market share with current customers by adding new programs and with new and takeover programs with new customers, which has led to powersports accounting for 20% of our 2021 revenues. Our expansion in powersports means we now work with all the major players in the UTD powersports market. In the military end market, our market share on tactical wheeled vehicles continues to expand with our customers launching their next generation of products, plus expansion in the service parts, demand and new product development activities that have the potential to bolster revenues in the coming years. Overall, our new business pipeline remains robust with numerous products being actively pursued. We're excited about all of the avenues of growth with current and potential new customers. And we'll keep you updated on the latest developments over the coming quarters. Turning to our fitness customer, as you probably saw on February 9, we provided a business update that included commentary regarding our new customer in that fitness market. In that update, we noted that due to circumstances beyond our control, we would not go into production for this customer on the original plan date. We have, however, remained on track with the investment and build-out for this fitness customer and would have been ready to begin production when originally planned. As you saw in our earnings release from last night, there have been some new developments. On February 18, we received an update from the customer, which informed us that it does not forecast any demand for any products or parts that are subject to our agreement for the remainder of the agreement's term, which ends in March of 2026. Needless to say, we are disappointed with how this has unfolded in recent months. As such, we have taken and will continue to take steps to reduce operating costs and capital investments for this project, where appropriate. From an accounting standpoint, this update also resulted in an impairment charge recorded in the fourth quarter 2021 results of $16.9 million. Todd will be covering this topic in more detail in his segment. But it's important to reiterate that we remain confident in the protections provided by our agreement with the customer and will vigorously pursue this matter to ensure that terms are honored. Our new facility in Hazel Park, Michigan has other important activities going on beyond those related to the fitness customer. As mentioned in our last quarterly earnings call, we are putting in place additional state-of-the-art flexible redeployable automation and capacity to support the growth of our base business. We will be ramping up in the second half of this year and into 2023 to support meaningful volume for new projects and market growth with customers in the markets we already serve. Hazel Park will continue to be an important part of our future growth story. The location allows us to hire the technology’s skilled workforce we need in an excellent location in Southeast Michigan, while leveraging our experience and world-class process know-how, and continuing to demonstrate MEC's agility, adaptability, and realignment for serving these market-leading customers. As we look further into '22 and beyond, we continue to see a good pipeline of M&A opportunities and focus on analyzing potential targets that could open new end markets, develop new relationships with potential new blue-chip customers, and possibly add new geographies. Strategic fit and rational valuation are the top considerations when considering opportunities, and we continue to review and pursue logical potential leads. In summary, our fourth quarter performance reflected the supply chain challenges faced by our customers, but we are seeing very positive demand signals across all end markets and significant potential new business opportunities, and we will remain ready to increase our production volumes as needed. We have invested in the right technologies, facilities, and workforces that allow us to successfully address this demand, and our 2022 outlook, which Todd will talk through shortly shows we are rapidly working back towards exceeding our record 2019 performance. I'd now like to turn the call over to Todd to discuss our financial results in more detail. Todd?

Thanks, Bob. I'll start with a review of our full year financial performance, then discuss our fourth quarter before providing commentary on our balance sheet, liquidity, and thoughts on guidance. As we noted in our press release, we recorded full-year net sales of $454.8 million as compared to $357.6 million for the same prior year period. The 27% increase was driven by increased volume due to improved market conditions and commercial pricing increases implemented in the fourth quarter to combat inflationary pressures. These increases were slightly offset by customer supply chain issues and the timing related to contractual raw material pricing pressures to our customers. Manufacturing margins were $51.4 million for the year ended December 31, 2021, as compared to $31.5 million for the same prior year period. The improvement of approximately 63% was primarily driven by production volume increases, higher scrap income, improved absorption of manufacturing overhead costs, as well as efficiency gains in the closure of the Greenwood, South Carolina facility in 2020. These favorable impacts were partially offset by the timing of raw material pricing passed to our customers and inflationary pressures on wages, benefits, materials, and other general manufacturing supply during the year. Additionally, the company incurred approximately $2.9 million in launch costs and $700,000 in inventory write-off related to the agreement with the new business customer during 2021. The prior year period was impacted by customer shutdowns related to COVID-19 pandemic along with lower demand and related destocking activities particularly in the commercial vehicle, agricultural, construction, and access equipment end markets. Manufacturing market percentages increased 250 basis points from 8.8% in 2020 to 11.3% for 2021 based upon improved operating conditions and other factors already mentioned. Profit-sharing bonus and deferred compensation expenses were $11.5 million for the year ended December 31, 2021, as compared to $8.3 million in the prior year. The increase of $3.2 million was principally driven by the return of normal life, discretionary 401(k), and bonus accrual as business activity and sales volumes improved in 2021. Other selling, general and administrative expenses were $20.4 million for the year ended December 31, 2021, as compared to $19 million for the prior year, stemming from higher salary, travel, and entertainment expenses, which were artificially low in the prior year due to the pandemic. EBITDA tax benefits were $1.9 million on a pretax loss of $9.4 million for the full year 2021, as compared to a tax benefit of $2.1 million on a pretax loss of $9.2 million for the same prior year period. Our federal net operating loss carryforward was $18.5 million as of December 31, 2021. The NOL does not expire and will be used to offset future pretax earnings. We continue to anticipate our long-term reflected tax rate to be approximately 26% based on current tax regulation. 2021 adjusted EBITDA finished in line with our prior guidance at $46.2 million. After adding back the recent impairment charge recorded for the quarter, this was well above the prior year of $32.8 million. Adjusted EBITDA margin percentage increased by 100 basis points to 10.2% in the current year, as compared to 9.2% for the same prior year period. Our adjusted EBITDA margin and margin percentages were favorably impacted by increased sales but negatively impacted by the timing of raw material pricing pass-throughs, inflationary pressures, and stock outstanding during the year. I will now provide an update on the financial performance of our fourth quarter. We recorded fourth quarter net sales of approximately $113 million, as compared to $95 million for the same prior year period. The 19% increase was primarily driven by contractual raw material pricing pass-throughs, increased volumes, and commercial price increases compared to prior years. Manufacturing margins were $9.4 million for the fourth quarter 2021 as compared to $11 million for the same prior year period. The decrease was driven by continued inflationary pressures along with the timing of contractual raw material price increases passed to our customers in the current period. The company also incurred $2 million in launch costs and $700,000 of inventory write-off related to the agreement with the new fitness customer during the fourth quarter. These items were moderately offset by increased production volume, commercial price increases, higher scrap income, and improved absorption of manufacturing overhead. Manufacturing margin percentages were 8.3% for the fourth quarter of 2021 as compared to 11.6% for the three months ended December 31, 2020, a decline of 330 basis points. This decrease was driven primarily by the material price pass-throughs, launch inventory costs related to the new Hazel Park facility, labor variances caused by production disruptions related to customer supply chain issues and increases in the cost of labor. When the impacts of these temporary items are removed, our normalized manufacturing margin percentage would have been 12.8%. Profit-sharing bonus and deferred compensation expenses were $3.5 million for the fourth quarter 2021, which is in line with the $3.4 million reported for the same prior year period. Other selling, general and administrative expenses were $5 million for the fourth quarter of 2021 as compared to $4.4 million for the same prior year period. The increase was principally attributable to higher salary, travel, and entertainment expenses, which were again artificially lower in the prior year due to the pandemic. Adjusted EBITDA after adding back the impairment finished at $9.2 million for the fourth quarter of 2021, as compared to $9.3 million for the same prior year period. Adjusted EBITDA margin percentage declined by 170 basis points to 8.1% in the quarter, as compared to 9.8% for the same prior year period, representing a negative incremental margin of 1%. Again, if we remove the information and temporary items, our adjusted EBITDA would have been approximately $12.5 million. Our incremental margins would have been in line with a historical average of 22.5%. Now let me address our capital expenditures, balance sheet, and liquidity figures. Overall capital expenditures for 2021 were $39.3 million, as compared to $7.8 million during 2020. The increase is primarily due to the $19.7 million investment in the new Hazel Park facility, with the remainder being for the continuing investment in technology and automation affected by the pandemic. As of the end of 2021, total outstanding debt, which includes bank debt and capital lease obligations, was $68.8 million, as compared to $48 million at the end of 2020. The increase in debt relates to working capital increases due to the rising steel prices, higher production levels, which have rebounded from the pandemic closures in 2020, and increased capital expenditures related to the new Hazel Park facility. Turning to the impairment charge related to the business customer, given the recent communication with the customer that Bob outlined earlier, U.S. generally accepted accounting principles require us to assess whether the assets specifically purchased lease obligations under the agreement with the customer were impaired. As a result, we recorded an impairment charge of $16.9 million. This impairment comprised of $700,000 of inventory, which was recorded as cost of goods sold, and $16.2 million of leasehold improvement and equipment-related assets. Additionally, in accordance with U.S. GAAP, we have not met all the requirements at this point necessary to allow us to record a loss recovery or a gain contingency. It's important to reiterate that we remain confident in the protections provided by our agreement with the customer, and we will rigorously pursue this matter. Now I'd like to discuss our 2022 guidance. As Bob talked earlier, our goal is to manage through supply chain uncertainty continuing. We anticipate volume to gradually improve as we go through 2022. Our new business pipeline remains strong as we continue to build relationships and convert on new opportunities with new and existing customers looking to expand capacity and support robust end market demand. As a result of the end market dynamics, we currently expect net sales between $480 million and $530 million with generally stable material pricing and adjusted EBITDA between $58 million and $70 million. Additionally, based on a recent event with our fitness customer, we are still assessing our full-year capital plan, and as thus, are not in a position to offer updated capital guidance for the year at this time. What we can say is that 2022 capital expenditures are expected to be above 2021 levels, as we make the final payment for capital commitments previously made to meet contractual obligations related to our business customer, as well as our continued investments in new technology and automation in our base business. These items will enhance our production capabilities and allow us to take on more business in the years ahead. Please note this outlook assumes no revenue associated with our business customer and that our end markets remain stable, and supply chain constraints do not worsen as business activity continues to turn positive. On a positive note, we do expect to return to a record year of adjusted EBITDA performance in 2022. I will now turn the call back over to Bob.

Thank you, Todd. With our solid balance sheet, ongoing operational improvements, solid customer relationships, favorable outsourcing and re-shoring trends, and encouraging demand dynamics in the end markets we serve, we have a positive outlook. Our business model is strong, resilient, and agile. We are well-positioned to execute our growth plans, which is demonstrated by the projected growth and record performance implied by our 2022 outlook. We believe our volumes will improve as the customers' supply chain disruptions continue to subside and they work to meet the vigorous demand in their respective end markets, particularly in the second half of 2022. With that, operator, we'd like to open the call for questions now. Thank you.

The first question today comes from Stephen Volkmann of Jefferies. Stephen, please go ahead. Your line is now open.

Great. Good morning, everyone. My first question, perhaps for Todd, is whether you could explain the difference in price versus volume in the fourth quarter. I apologize if I missed this, it's a bit hard to hear.

Well, for the fourth quarter, we were impacted by about $4,000 when you think of material lag. We did have some commercial pricing activity that went into place during the fourth quarter that was positive but on the flip side, we saw some inflationary pressures when looking at supplies, wages, benefits, and other factors. Really when you look at it, volumes were better than the fourth quarter, even if you strip out the commercial material pass-through. But again, we did have a little bit of a lag in the timing of commercial pricing.

I think the choppiness of the quarter and the commercial vehicle market also impacted our performance.

I was just trying to think about how much pricing continues to help us in ‘22 from a top-line perspective. But maybe that's enough, so I can back into it. Can you talk a little bit about the cadence of ‘22 in your plan? Like is each quarter a little better than the last one from a revenue and profit perspective, or is there some other different seasonality that you see?

Well, what we can say is, we come into the first quarter, and we assume the markets will be a little more robust and maybe finish in the fourth quarter. We believe supply chain issues will continue to get better. As you look at the rest of the year, we do expect to see a little lift in the second and third quarters as the market continues to improve, and the demand remains as robust as it is today. Then in the fourth quarter, just because of the timing of planned shutdowns by our customers, we wouldn't expect to see fourth-quarter down slightly. We think it's seasonality, but otherwise, we believe we come out of the first quarter probably with an 8% increase in volumes.

And then my final question, can you say anything more about the protections and recoveries that you've mentioned a couple of times relative to Hazel Park and this customer that is not going to end up buying anything? I'm trying to figure out what types of potential reimbursements might look like. Do you think this is something that will drag out for years, or can we kind of wrap this up in some point in 2022?

I'll answer a question on 2022 first. I believe that it will be resolved this year. We'll be in the midst of discussions with that customer, as this is new news. So we're confident in our contract and how it protects us, so I think we have to leave it at that.

The next question today comes from Mircea Dobre from Baird.

Thanks for the time here. I want to follow up on Steve's question. I just want to clarify that you expect revenue to be up sequentially in Q1 relative to Q4. So you think you're going to be able to ramp production in Q1 and how should we think about manufacturing margins in Q1 relative to Q4?

We do expect to see improvements here immediately in the first quarter. We put in some commercial pricing activity in the fourth quarter, but as we begin the year, a lot of those inflationary pressures will show up. There could be a little bit of lag with the higher steel prices we purchased in the fourth quarter. However, I expect we will have improvement in manufacturing margins over the fourth quarter. As we progress throughout the year, we expect those to generally increase sequentially.

You separated commercial pricing from the material sort of pass-throughs. Can you give us a sense of what's going on with commercial pricing relative to inflationary pressures you're facing?

As I mentioned in the fourth quarter, Ryan and his team implemented pricing strategies with our customers to compensate for much of the inflationary pressures. As we look into ’22, we’re assuming material prices won't increase dramatically from this point. We should be covered on our commercial pricing activities for the year, which is encouraging. The material pass-through that is neutral to EBITDA has a little impact on our EBITDA and margin percentages as steel prices should hopefully decline this year. We expect to see positive changes along with small percentage increases, but we want to remain consistent with our production levels.

My final question is on the Hazel Park facility. It sounds like you're continuing to invest, and while not providing an official CapEx guide for ‘22, it seems you're pushing forward with Hazel Park. Given that this customer is now out of the picture, what do you imagine this facility's purpose will be long-term?

When we look at Hazel Park, we see a solid workforce and higher technology equipment compared to our other facilities. We have good market growth within our existing customer base and markets to support a nice growth trajectory at that facility. While we may need to look at subleasing some of that space, I believe that facility will ultimately allow us to expand further than we initially thought.

I'm curious because you have previously highlighted the strategic location of these facilities around customers. When I look at Southeastern Michigan, I think automotive. Are you pursuing automotive business there or observing something else more consistent with your current end markets?

We have customers in Ohio, Iowa, and Illinois, so the logistics from that site are not that different than from where we are in Wisconsin. We've communicated with our customers about these changes and opportunities, and they seem excited as well.

Next question today comes from Andy Kaplowitz from Citigroup. Andy, please go ahead. Your line is now open.

Good morning, everyone. Can you give us a breakdown of your major end markets and what you anticipated for them at the end of '21? Given your low teens revenue growth forecast, do you expect the sales breakdown of any end markets to change significantly?

At a macro level, Andy, we don't see significant shifts year-over-year. We observe the greatest strength in commercial trucks as well as construction and access. As bottlenecks in the supply chain ease, we anticipate pent-up demand for commercial vehicles looking strong for '22 and carrying into favorable 2023 industry forecasts. Year-over-year, the access equipment market was down but showed growth in '21, particularly in the fourth quarter, and that's expected to strengthen, especially as non-residential projects ramp up. In our powersports market, we expect constraints at the dealer side due to production but anticipate demand for restocking given the strong retail environment.

That's good color. As a different way to ask, regarding your initiatives like new products and reshoring, how much of the projected low-teens growth in ‘22 do you expect to come from new customers or your existing customers expanding their businesses?

Much of the growth is linked to existing customer expansion. Over the last year, we've seen substantial model introductions and market share gains. We've made gains in the powersports market, adding new customers to fill our portfolio, and reshoring and customer outsourcing initiatives are in the quote phase with potential revenues likely late in the year, but these larger projects may not yield material revenue until 2023.

My last question revolves around cash flow in 2022. While you mentioned undefined capital expenses, could you speak on working capital? With current supply chain challenges, should we expect to see improvement in working capital flow?

It's challenging to comment on free cash flow without finalizing our plans on capital. I can say that working capital has been a detriment in '21 due to supply and fuel prices. As we begin this year, prices are modestly declining and we hope that trend continues as the supply chain stabilizes and production schedules normalize. This shift will likely boost our free cash flow generation this year. However, this will be offset by what we eventually spend on capital for future needs.

The next question today comes from Larry De Maria from William Blair.

I know you don't want to delve into the comprehensive aspects of the investment, but could you clarify expectations related to the recent impairment? Are we talking about a reimbursement amount equal to the $40 million invested?

The impairment charge considered several factors around whether there were specific used assets for the customer that they should be reimbursing us for. We also have commitments made regarding facilities or personnel that help mitigate these costs. It's fundamentally about the responsibilities established in our agreements. We’ll ensure that they fulfill their commitments as we're confident they'll work with us on this. We just need to wait until it all gets resolved.

That's helpful. Regarding Hazel Park, is there any special equipment being installed, or is everything contracted at this point?

The capacity is secured, as we develop that and proceed with the investments this year and likely into next year. The markets are favorable, and we have opportunities to fill that, and beyond, thus we're optimistic about it. We will approach this gradually and consider freeing up capacities at other locations that have more complex capabilities.

Lastly, regarding capacity utilization, how was it at year-end, and where do you expect to it to be by the end of ’22?

The fitness capacity will be removed, and our operational capacities will focus on existing customers in the markets we are already serving. While there will be a transition in technology, we expect regional capabilities to be dedicated to what we have previously handled.

There are no further questions waiting at the moment. So I'd like to pass the conference back over to Bob Kamphuis, Chairman, President, and CEO. Bob, please go ahead.

Okay. Well, thank you everyone for your time today and your continued interest in MEC. We'll be keeping you updated as things develop and the business continues to grow. Thank you for your time.

That concludes today's conference call. Thank you for your participation. You may now disconnect your lines.