Mayville Engineering Company, Inc. Q3 FY2022 Earnings Call

Good morning, and thank you for attending today's Mayville Engineering Company 2022 Earnings Conference Call. My name is Daniel, and I will be your moderator for today's call. I would now like to pass the conference over to our host, Nathan Elwell. Nathan, please proceed.

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 that you will hear during this call will consist of forward-looking statements within the meaning of Section 21(a) 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 events. For more information regarding such risks and uncertainties, please see our filings with the Securities and Exchange Commission, including our filings on Form 10-K for the period ended December 31, 2021. 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 Jag Reddy, President and Chief Executive Officer; Todd Butz, Chief Financial Officer; Rand Stille, Chief Operating Officer; and Ryan Raber, EVP of Strategy, Sales & Marketing. Jag will begin with his thoughts on the quarter and the end markets we serve, new business and future plans, followed by Todd, who will review the financial results and guidance. Please note that accompanying slides are available via the webcast and on the Investors section of the company's website at mecinc.com. With that, I'll hand the call over to Jag, please go ahead.

Thank you, Nathan, and good morning, everyone. I'm on Slide three. Our team executed effectively this quarter, producing strong improvements across the board. Net sales grew approximately 25%. Adjusted EBITDA increased approximately 61% and our net income increased significantly when compared to the third quarter of 2021. The improvements were primarily driven by volume growth, commercial pricing increases, and better absorption of manufacturing costs. I am pleased to report that we commenced production at our state-of-the-art facility in Hazel Park, Michigan during the quarter as planned. Additionally, I am excited to announce that we launched MEC Business Excellence, or MBX, to drive operational and commercial excellence. I believe this will be a game changer for MEC and we'll discuss this in more detail. We are refining our full year guidance that was originally provided in February, which Todd will discuss later. After 100 days, I wanted to share some of my observations and reflections as summarized on Slide four. I had the opportunity to visit all 18 of our manufacturing plants and have met with hundreds of our team members across the organization. I have also met with many of our customers and learned more about how vital MEC is to their ongoing success. It is clear to me that we are an integral part of our customers' future expansion plans. Through my site visits and meetings with our customers, I have identified the following observations as key to our future success. Our company culture is a direct result of our hard-working employees taking great pride in their work to support our customers' needs. This has deepened relationships with customers and enabled us to grow profitably in recent years. Additionally, the secular trends of reshoring and outsourcing have been confirmed by our customers. Our investments in automation will support cost reductions, volume productivity, and quality to meet the increased demands driven by macro trends. MEC capacity utilization can be improved as we average two shifts per day, four days a week with some weekend work. Although some of our sites present hiring challenges, we see a recent improvement in labor availability. We see the potential for significant growth over the next five years with continued trends of reshoring and outsourcing. Our focused expansion into emerging technologies and adjacent spaces will help MEC maintain and expand our leadership position. We have more room for margin expansion through continued value pricing even beyond the pricing actions taken during 2022. We also have significant opportunities to improve our operations through standardization, lean manufacturing, and automation. Today, I am pleased to outline the strategic priorities that will help us achieve our profitable growth aspirations. I am now on Slide 5. Regarding profitable growth over the next five years, we need to capture the opportunities with current customers while also diversifying into markets and applications such as electric vehicles and renewables. We can expand our design, prototyping, and aftermarket services to better support our customers' needs. EBITDA margin expansion beyond 15% can be achieved through commercial and operational excellence through strategic and value pricing, productivity improvements, capacity utilization, and purchasing and supply chain improvements. In terms of capital allocation, starting in 2023, we will return to normalized CapEx spending levels of $20 million to $25 million per year. We plan to focus our M&A activities on targets in adjacent markets, specifically lighter weight materials such as aluminum, plastics, and composites and design and prototyping services. I remain confident that we have the team and expertise to execute the strategic initiatives and to drive long-term profitable growth at MEC. Now I would like to turn your attention to our industry outlook and recent customer wins. I'm on Slide six. We currently serve five major end markets, all of which continue to forecast positive near-term demand outlooks. The commercial vehicle market is our largest market and continues to forecast strong demand through the first half of 2023. The industry is predicting a slowdown in the second half of 2023 due to expected emissions regulation change in 2024. The emissions change will again drive increased demand in subsequent years. Current ACT forecast predicts 310,000 units in 2022, followed by 296,000 units in 2023. While supply chain constraints have continued to impact some CT customers, we expect to see sequential increases over the next couple of quarters due to sizable backlogs at OEMs. We continue to monitor weakening freight fundamentals and forecasted sequential declines through the second half of 2023 and remain ready to adapt to any market changes. Powersports continue to be an important market for us, while showing some signs of softening; retail demand remains generally positive. Low dealer inventories will continue to drive consistent volumes for the products we deliver. We believe our customers will continue to fulfill retail demand and restart the dealer channel into 2023. Of course, the powersports market is sensitive to discretionary spending and interest rates, and we are keeping a close eye on this industry. As mentioned on our previous calls, we have had many project wins with existing and new customers, which will provide a buffer to potential market softness. The construction and access equipment end markets are now starting to see the impact of rising interest rates and softening of the housing market. However, non-residential, infrastructure, and oil and gas markets are seeing some improvement as we look towards 2023. The need to restock fleets, given fleet age and low dealer inventories continues to drive near-term volumes and are expected to offset weakness in the residential construction market. We continue to see strengthening demand in the ag market; low global stocks, strong crop prices, and low new and used machine inventory will maintain volume growth in the near-term. And finally, though the smallest of our end markets, our military segment remains stable. Our customers have solid backlogs for U.S. government contracts, and we continue to see good volumes based on new vehicle introductions. While supply chain disruptions have continued to persist throughout our customer base, we anticipate these supply chain constraints to ease as we move into 2023. Importantly, our new business pipeline remains strong. We have continued to pursue and convert opportunities with our current customer base while focusing on new customers and new markets to drive further diversification. Let me walk through a few of the exciting opportunities on Slide seven. We recently won a large family of parts for an electric side-by-side that will make up the battery enclosure on the vehicle. Production of this side-by-side model will fully launch in 2023 and was a great example of using our manufacturing expertise to design a cost-effective solution for a brand-new product for an existing customer. Last quarter, we made significant progress in working with a new potential customer that focuses on thermal management of electric vehicle batteries and battery enclosures. The family of parts work coding will be used in multiple applications and provide us with a great opportunity to expand into the EV space. Recently, we were awarded a high-value takeover project for a current ag customer, supporting a product family for high horsepower tractors. Based on our history of quick-turn products, MEC won the business for this exciting project. Building on our earlier win in the light-duty truck market, we have continued to engage with a market-leading engine manufacturer to develop additional opportunities on this new product platform. We have been able to win incremental business as this project reaches the conclusion of its design phase and shifts into production. Opportunities for reshoring projects continue to grow, and I'm pleased to report that we closed out a project for a commercial vehicle customer in the last quarter. We are scheduled to start production in early 2023, bringing production to the U.S., replacing an Asian supplier. We also are able to expand with a new customer in the industrial infrastructure space to supply structural components and enclosures. While this relationship is new, we have been able to quickly support urgent product needs and expect to grow this business in the years ahead. Overall, it is clear that both our business with current customers and our pipeline of projects with both existing and new customers remains strong as we look towards 2023. As I said when I joined, my initial focus will be on accelerating our use of innovation, technology, and lean manufacturing initiatives to help drive profitable growth. The launch of MEC Business Excellence, or the MBX program is an important first step in that process as summarized on Slide eight. The focus of MBX is to drive operational and commercial excellence across the company, and it will be a vital product of achieving our profitable growth potential in the years ahead. While MEC has consistently used lean tools within our operations for many years, the dedicated MBX program will significantly accelerate our efforts and drive exponential improvements across all our processes. Led by a newly appointed team, the program will focus on strategy deployment, operational excellence, commercial excellence, and talent management. This will include value stream mapping, lean daily management, and productivity Kaizen events led by MBX lean engineers in all facets of our business. As demonstrated on Slide nine, each quarter, the MBX team will lead a special event known as the President's Kaizen. These events will include members of the executive team to further illustrate company-wide commitment to our lean journey. In September, we held our first President's Kaizen in Mayville. While targeting a specific role centered process, the team applied several lean tools to significantly improve throughput, reduce labor hours, reduce inventory, enhance safety, and drive meaningful cost reductions. We are pleased with the results of our initial events and launch of MBX and look forward to the team developing in 2023 and beyond. I also want to provide an update on the situation with our former fitness customer. Despite our best efforts, the company was unable to reach an amicable resolution with its former fitness customer, and therefore, filed a breach of contract lawsuit in the Supreme Court of the State of New York in August. The company remains confident in the protection supported by the contract provisions. The total amount of damages claimed is substantial, but the amount and the timing of the ultimate recoveries is uncertain. As a result, any recovery from this litigation or settlement of these claims is a contingent gain and will be recognized if and when realized or realizable. At this point, there isn't much more we can say on this subject, except that we will provide updates as and when we can going forward. Our Hazel Park, Michigan facility is an important part of our future, and I am proud to report that we commenced production as planned during the quarter. The ramp-up in production will continue in the coming quarters. The team has done a remarkable job of launching on-time and in line with our plans, providing us with the capacity and the state-of-the-art operations in a market with solid labor availability. In conclusion, I want to thank all of our team members for embracing the change and helping to channel ideas into our updated strategy for profitable growth. It's been an important quarter for the company in which we began a critical journey to build on our proud history, implement new initiatives, and expand our horizons to ensure we obtain our full potential in the years ahead. Now I will turn the call over to Todd for a review of our financial results.

Thanks, Jag. I'll begin with a look at our third quarter, which is summarized on Slide 10. We recorded third quarter net sales of $136.3 million, which is a 25% increase year-over-year. The increase was primarily driven by improved volumes due to the overall strengthening of the business, commercial pricing increases, and contractual raw material price pass-through to our customers. Manufacturing margins were $15.5 million for the quarter as compared to $10.9 million in the prior year period. The increase was driven by improving demand, improved absorption of manufacturing costs, and commercial pricing increases. These improvements were partially offset by a downward shift in scrap income, Hazel Park launch cost, and continued customer supply chain issues during the quarter. Manufacturing margin percentages were 11.3%, which is a 130 basis point improvement over the 10% recorded in the prior year period, despite some of the challenges previously mentioned. SG&A expenses were $6.5 million as compared to $5.3 million for the same prior year period due to higher consulting and professional fees, CEO transition costs, as well as continued inflationary pressures on wages and benefits. For the third quarter, income tax expense was $1.5 million on pretax income of approximately $8.1 million. Our federal net operating loss carryforward was approximately $18.5 million as of quarter end, which was driven by pretax losses incurred in prior years. The NOL does not expire and will be used to offset future pretax earnings. We continue to anticipate our long-term effective tax rate to be approximately 27% based on current tax regulations. Adjusted EBITDA increased to $16.1 million versus $10 million for the same quarter last year. Adjusted EBIT margin percent increased by 260 basis points to 11.8%, representing an incremental margin of 22.5%, which is consistent with our historical average. If we remove the impact of customer supply chain issues and raw material price pass-through, our incremental margin would have been 25.6%, which is above our historical average. Basic earnings per share were $0.32, a $0.31 increase over last year, as the improvements I've already mentioned dropped through to the bottom line, as well as the one-time positive impact of updated guidance that totaled $0.11 per share, which includes stock forfeitures from our former CEO's third-quarter retirement. Now let me address our capital expenditures and balance sheet liquidity. Year-to-date, capital expenditures were in line with our expectations at approximately $38.8 million as compared to $26.6 million for the same prior year period. The increase relates to the planned ongoing build-out and repurposing of our Hazel Park, Michigan facility and our continued investments in technology and automation. As shown on Slide 11, our total outstanding debt was $74.1 million at September 30, 2022, as compared to $56.9 million at the same point last year. The increase in debt relates to capital spending, but our balance sheet remains strong with a leverage ratio of 1.3 times at the end of the quarter. We continue to see a solid pipeline of M&A opportunities and are focused on new markets, new materials such as aluminum, plastics, and other lightweight materials and new customers to continue to diversify our business. Strategic fit and rational valuation remain our top considerations as we refocus our M&A efforts. Now I'd like to discuss the 2022 guidance, which is shown on Slide 12. We are refining the financial outlook we first provided in February and have adjusted our expectations as follows: Net sales of between $480 million and $530 million has been updated to between $520 million and $540 million. Adjusted EBITDA between $58 million to $70 million has been updated to between $58 million and $65 million. As it stands today, our revenues are expected to be at the high end of our original range due to raw material price pass-through. However, due to falling scrap income prices, increased legal costs, and continued near-term inefficiencies related to customer supply chain issues, we expect EBITDA results to be between the midpoint and the low end of the range. This forecast also assumes no major supply chain disruptions with our customers or other unusual events in our end markets as well as any recovery associated with the former fitness customer. We continue to expect our capital spending to be between $55 million and $65 million for the full year of 2022. The primary focus is on investment in technology and automation, the addition of equipment building to new programs with existing customers, and costs associated with production at our Hazel Park facility. We are nearing the end of the unusually high CapEx cycle and expect 2023 to return to more normalized spending levels of approximately $20 million to $25 million per year. In summary, our third-quarter results continue to reflect steadily improving volume trends, which, in conjunction with commercial pricing increases, has helped deliver improved results. While the supply chain disruptions affecting our customers and inflationary pressures persist, near-term end market demand remains generally solid. That concludes my comments, and I'll now turn the call back over to Jag.

Our recent performance and current outlook of the business remains positive. As we manage the demand trends, we are seeing across our end markets. However, we are monitoring market changes, staying in constant communication with our customers and will be ready to adapt as needed. We are maintaining and expanding the relationships we have with some of the best blue-chip companies in the world and are pursuing numerous opportunities with potential new customers and new end markets. We're focused on profitable growth into new platforms, margin expansion with lean initiatives, and innovation to drive competitiveness. We are off to a great start, and I'm very excited about the future of MEC. With that, operator, we would like to open the call for questions now. Thank you.

Thank you. The first question comes from Vlad Bystricky from Citigroup. Please proceed.

Good morning, guys. Thanks for taking the call. Nice quarter-end results and thanks for some of the strategic outlook or update, I should say, around some of the long-term priorities and what you're doing with MBX. I guess just thinking about MBX, can you maybe give us more color on how you're going about implementing MBX, whether you have the talent and skill you need to sort of drive this more focused approach and wider approach it seems to lean, and just how you're thinking about the runway for MBX-driven improvements to manifest?

Yes, sure. I'll take that. I'll start with my comments, Vlad, and then I'll pass it on to Ryan to expand on our implementation. MBX is critical and vital for our profitable growth future. Even though, as I mentioned in my prepared remarks, MEC has historically used lean tools. The MBX program, with this dedicated team across our network, will bring sustainable implementation of our programs. We're going to accelerate the number of Kaizens. We have dedicated teams in the plans right now that are going to drive these Kaizens, and we're utilizing not only internal but also some external resources to offset short-term strength for the MBX team. I'm going to pass on to Ryan to expand on implementation.

Yes, Vlad, thanks for the question. Again, many of these tools we've been using for quite some time, but it's the acceleration that Jag talked about. And so with that acceleration, we've dedicated a team fully committed to MBX. So we have a team of lead engineers led by our Vice President focusing on making sure we're driving across all aspects of the company. So it's just an acceleration, and I'll say hyper-focused on what we are doing in the past. And so we do have those skill sets, and we have those capabilities. So we feel very confident about the impact that this is going to have across the organization.

Okay, that’s helpful. And then maybe just a follow-up for me. I know you're not guiding to '23 yet. But as we think about the outlook into '23 here, if I just look at sort of the end market industry outlook, obviously, some mix trends there and obviously concerns about the macro. So, I guess, can you just talk about given your work on new wins and reshoring opportunities, et cetera, how you're thinking about the potential or the likelihood of being able to drive growth if we are going into sort of a broader macroeconomic slowdown here in '23?

Sure. Let me address that and then let Todd add his thoughts. Generally, we view the business in two aspects: the base business we currently have and the new growth opportunities that will start in 2023. Before I delve into that, I want to clarify that we are not providing any guidance for 2023 at this time. We will share that guidance when it's appropriate. Given the uncertain environment, it helps to frame our thoughts this way. Regarding the base business, nearly all of our customers are signaling volume growth for next year. Many of these customers are publicly traded companies that you are familiar with, and we have access to the same publicly available information. This suggests there will be some growth next year from our base business. However, we are also considering external factors. If we anticipate even a slight decline in demand in the base business, we believe the new business coming in 2023 can compensate for that potential decline. Unless there is a significant market shift or a deeper downturn, which we can discuss separately, we feel optimistic about next year, thinking in terms of our base business versus new business.

What I would add is certainly that we're not providing guidance at this point, right. We will when the time's appropriate. But to Jag's point, as it stands today, volumes in markets generally look solid for next year. And with that, with the MBX launching, the pricing carryover, and activities that happened in 2022, hopefully, supply chain kind of balancing and getting corrected at our customers will lead to a higher net income. Our expectation for next year would be bettering income, better EBITDA. And along with that, significantly improving the free cash flow. When Jag spoke earlier, $20 million to $25 million in normalized CapEx, and inventory levels because the supply chain issues are a little high right now, so we would expect turns to get better as we move into 2023. And as the steel pricing has come down. So in a general sense, we feel very positive about next year. We're really not ready to provide guidance at this time.

That’s understandable. So, really helpful, thank you guys. I get back in queue.

Next question comes from Mig Dobre of Baird. Please proceed.

Thank you for taking the question. Good morning, everyone. Sticking with this last comment maybe as we're looking at margins, and Todd, I appreciate that you expect improvement here. But if we're looking at the fourth quarter, can you comment at all as to how you see the manufacturing margin, your gross profit evolve sequentially? And as I'm thinking about 2023, if we're in an environment in which volumes are at least stable and it sounds like some of the cost pressures are at least starting to moderate, if not outright reverse in some cases, is it fair to expect the manufacturing margin to recover to more normalized levels, something like, call it, 2019 type levels?

I expect that to exceed 2019 levels. The low end of our guidance is already a record compared to 2019. Even with slightly lower volume this year due to material price increases compared to 2019, we are achieving record EBITDA. This is why we outperformed in 2019 by more than 10%. I anticipate that our margin profile will continue to improve compared to 2019. As we consider Q4 and the reasons for narrowing our guidance, we are facing rising interest rates, ongoing supply chain issues with our customers, and potential legal costs in Q4. Additionally, the holiday season may cause customers to adjust their schedules due to supply chain challenges. However, as we move into 2023 and these issues ease, we are confident in our ability to deliver improved results and achieve our goal of 15% adjusted EBITDA.

I understand. The industry outlook slide you shared is quite helpful. I am looking to clarify something, and I apologize if I missed it, but regarding your 2023 market outlook, is the information on this slide your assessment of how these end markets will evolve in terms of either growth or decline? As for production levels, you are not yet observing any reductions from your customers in sectors like powersports and construction equipment, correct? Is my understanding accurate?

Yes. That's exactly right, Mig. This is absolutely, the 2023 outlook here is our interpretation of how it might turn out. But as I said earlier, most of our customers are not indicating any declines. They're all being reasonably stable or bullish in their outlook so far. But we're being realistic and that we're internally saying that, hey, if the market softens, that's in our base business. This is how it would look like and where the areas might be soft. That's what we're trying to communicate here. But having said that, also when I add that even in powersports, we have new business that we're going to be producing next year, new customers, and new programs. So even in an industry that might be softening, we feel like we have new business to offset the potential softness. And I'm going to ask Ryan to chime in.

Yes. I think, Jag, generally, right now, we still see a macro trend of the majority of the industries having relatively low inventory compared to retail demand. And certainly, in the short-term, there is some refilling of the pipeline that needs to take place. As we look out into '23, certainly, the rising interest rates have had an impact on residential construction and other things affecting the construction and access equipment. We also see things like strong rental CapEx and good signals from our customers about aged fleets that are in rental fleets and other things that I'd like to think could provide some potential tailwinds, but still too early to call that into '23. Powersports, like Jag said, certainly new business coming online. We generally feel like we'll be playing the powersports more in the high-end premium product, which has some independence from interest rates when you think about the interest rates affecting that discretionary income, those buyers might have. So as we look to next year's interest rates, we believe, will have an impact. It's hard to quantify that inventory and the need to restock. But going back to the initial comment, customers are generally sending strong demand signals that year-over-year, we believe, would be flat to up. We'll continue to monitor that as we go into '23, and we remain very in our ability to convert new business and show some incremental growth as we go into next year.

Understood. That makes sense. Last question, maybe one on M&A and capital deployment. You mentioned some new technologies here that are of interest to you, plastics and aluminum. And I'm kind of curious if you can expand on that. I mean, are you looking to get into things like injection molding and the like? And I guess I'm curious also in terms of what you perceive to be sort of the competitive edge or core competency of Mayville. I, for one, have always thought of it as metal fabrication. But Jag, it seems to me like you're thinking more broadly than that, which obviously has strategic location for the company.

Thank you, Mig. When I first joined, we examined what we excel at. We assist our customers in producing top-quality products at competitive prices and have the necessary infrastructure and supply chain capabilities to provide quick turnarounds. With that foundation, we consider how else we can assist our customers and identify their current challenges. We are now looking to engage in product design while also forming design partnerships with our customers as they transition from design to manufacturing. Our design for manufacturing services are a crucial part of what we offer, although we don't currently commercialize those services. Many customers I’ve spoken with have expressed difficulties in securing engineering talent and facing long lead times to market. We aim to help our customers accelerate their design to manufacturing processes and enhance their speed to market. Providing prototyping services is another significant way we can assist them. As we consider the energy transition and the shift to electric vehicle platforms, lightweighting continues to be vital, even for internal combustion engines. Most of our work has been in steel fabrication, but some customers are seeking our assistance in other areas, especially aluminum fabrication, which we have yet to heavily focus on. This presents an opportunity for us to expand into aluminum fabrication long-term. Additionally, I've learned that we also engage in subassemblies and cable assemblies, combining metal and plastic components. This knowledge has encouraged us to explore more value-added services, including in-house production of certain plastic components instead of sourcing from third-party suppliers. This is part of our strategy to diversify our offerings and better support our customers' growth, justifying our entrance into adjacent markets and guiding our M&A efforts.

Very interesting. Thank you for that.

There are currently no additional questions registered at this time.

Okay. Well, thank you, everyone, for your time today and your continued interest in MEC. We look forward to speaking with some of you at the upcoming Baird and Sidoti conferences.