Earnings Call Transcript - MEC Q2 2021

Nathan Elwell, Investor Relations

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 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. For more information regarding such risks and uncertainties, please see our filings with the Securities and Exchange Commission, including our filing 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 is Bob Kamphuis, Chairman, President and Chief Executive Officer; Todd Butz, Chief Financial Officer; and Ryan Raber, EVP of Strategy, Sales and Marketing. First, Bob will provide an overview of our performance, then Todd will review our financial results and guidance. With that, I'll turn the call over to Bob. Please go ahead.

Robert Kamphuis, Chairman, President and CEO

Thank you, Nathan. Good morning, everyone. I'm pleased to report that many of the positive trends we discussed last quarter carried over into this quarter. Thanks to the hard work of our team, we achieved net sales of $120.2 million this quarter, nearly doubling the amount from the second quarter of 2020. Our adjusted EBITDA was $14 million, leading to an operating income of $4.8 million, both showing significant improvement compared to the same period last year. The second quarter of 2020 was the most challenging time during the pandemic for MEC, but as conditions have improved in 2021, we've surpassed nearly every metric on a year-over-year basis. Our end markets are strengthening, and volumes are steadily increasing as we move back to normal operations. Based on our current visibility, we remain optimistic about the future. We ended the quarter with an adjusted EBITDA of 11.7%, which exceeded last year's figures and met our expectations. However, our bottom line has been somewhat affected by the usual delay in adjusting contractual raw material prices and by general inflation. As volumes keep rising, we expect to make further progress towards achieving our goal of 15% adjusted EBITDA margins. Todd will elaborate on this later. Looking ahead, we are dedicated to investing in technology and automation to boost our productivity and manage the growing demand from our customers, especially with the launch of our business in Hazel Park, Michigan. Although COVID cases are low in many of our operating areas, we are remaining vigilant about the health and safety of our workforce, which is a top priority. As I've mentioned, the markets we focus on today show a positive outlook. The commercial vehicles market is now much healthier than it was a year ago, with a strong backlog for Class 8 trucks that aligns with our order flow through the quarter. Since freight demand remains robust, we believe this market will continue to thrive. Demand for power sports remains strong as outdoor recreation products continue to be sought after. We expect retail demand to remain high, and our customers will likely rebuild their dealer inventories in the upcoming quarters to meet this demand. The construction and access markets are improving, especially in residential construction, particularly for equipment related to housing and equipment rental. While the non-residential and oil and gas markets have not fully recovered yet, we believe they have stabilized and are beginning to show positive signs. With the infrastructure bill, the start of dealer restocking, and rising oil prices, we see a brighter future for these sectors. Additionally, improving crop prices and low crop inventories give us confidence about the agricultural market, and we anticipate stable to rising volumes here in the near to mid-term. In our military segment, we continue to experience stability, with our clients holding solid backlogs for U.S. government contracts. There is also potential for increased revenues due to updates to vehicles being implemented by our customers. However, while demand trends remain positive, supply challenges continue to limit our customers' growth. We are experiencing various degrees of supply chain disruption that are temporarily affecting the volumes they require from MEC. We expect these issues to persist for the foreseeable future. Like many companies, we are facing inflationary pressures on raw materials, labor availability, and component prices. MEC has mechanisms in place to mitigate these impacts on our bottom line quickly, such as passing along contractual raw material price increases to our customers, balanced by ongoing investments in new technologies and automation. We are also actively working to reduce the potential impact on our customers. Additionally, one of our major customers faced union labor issues during the second and into the third quarter, including a brief strike. Although this issue has been resolved, it has caused some disruptions to production schedules, affecting our volumes. While we anticipate ongoing supply chain issues, we do not expect them to worsen significantly, and we are managing the challenges we encounter proactively. While our margins are temporarily affected by the delay in passing contractual price increases to customers, we expect to recover these costs soon. Another nationwide challenge is the tight labor market. Our innovative recruiting strategies and HR initiatives are progressing well, but finding skilled employees will remain a concern in the latter half of the year. This is another reason we are focusing on investing in flexible and redeployable technology and automation. I would like to revisit our new strategic partnership with a prominent U.S.-based fitness company that we announced last quarter. They sought to expand their U.S. production capabilities, and as the largest fabricator in the U.S. with an exceptional reputation for quality and service, they chose to partner with MEC. With a long-term agreement in place, we will spend the latter half of this year getting our operations ready to begin producing key components as planned in the first quarter of 2022. As you're aware, we also announced in June our plans to open a significant new manufacturing facility in Hazel Park, Michigan. This facility will boost our production capacity to meet the demand from our new customer, and we plan to bring on nearly 400 skilled employees in Michigan over the next few years. After considering several sites and states, we selected Hazel Park for its available skilled manufacturing workforce. We signed a 10-year lease for a 450,000 square foot facility, which is larger than our original plan for a 287,000 square foot facility due to increasing demand. As part of this arrangement, we also received a $2.5 million incentive from the state of Michigan. As stated, we see 2021 as an investment year, with plans for $35 million to $45 million in automation and technology projects in the second half of the year. This new partnership won't impact our 2021 revenue, but we anticipate it will become a significant top 10 customer in 2022. This aligns perfectly with our long-term strategic priorities for market diversification. We expect to see more opportunities for product localization in the coming years. While we cannot provide specific details about this customer or the agreement, we are excited to be developing a strong relationship with this new blue-chip client. Alongside this major development, we are consistently building relationships and seeking to expand our customer base and the sectors we serve. We are currently pursuing new projects and opportunities. For example, in addition to our recent award, our new customer in the fitness market is exploring other product support opportunities with us. We are also growing our market share with one of our commercial vehicle clients as they introduce new models, allowing us to deepen our collaboration through quick responses to design changes. We have also expanded our market share for next-generation tactical wheeled vehicles that we will launch over the next couple of years. Activity in current programs is strong, and we anticipate further market share growth in the coming quarters. The power sports market remains active for us, with new programs launching next year alongside initiatives with newly added clients. In the construction market, we have noticed our customers enlarging their product ranges, enabling us to secure additional volume for our current products. Overall, our new business pipeline is strong, with many projects actively being pursued. We are enthusiastic about these growth opportunities and will keep you updated on new developments in the coming quarters. Regarding capital allocation, this continues to be a focus and remains consistent. Our balance sheet is robust as we've reduced our debt load in recent years. We are positioned to make essential investments for long-term growth and explore external investment opportunities. Currently, our M&A pipeline is stronger than it has been since before the pandemic, and we are focused on evaluating potential targets that could open up new markets, provide complementary product expansions, develop relationships with esteemed customers, and possibly enter new regions. The strategic fit and rational valuation are our primary considerations when evaluating opportunities, and we continue to explore logical potential deals. Overall, our recent performance and outlook for the business are very positive. As we navigate supply-related challenges and address the strong demand trends across nearly all our markets, we expect these positive trends to persist in the second half of this year.

Todd Butz, CFO

Thanks, Bob. I'll begin with a look at our second quarter financial performance before providing commentary on our balance sheet, liquidity and guidance. As we noted in our press release, we recorded second quarter net sales of $120.2 million as compared to $62.6 million for the same prior year period. The approximate 92% increase was primarily driven by higher sales volumes due to the strengthening market conditions in 2021 versus the prior year. In addition, the lack of operational shutdowns and issues related to the COVID-19 pandemic, which impacted our customers most heavily in the second quarter of 2020. Manufacturing margins were $16.3 million for the second quarter of 2021 as compared to a loss of $1.2 million for the same prior year period, an increase of approximately 1,500%. The increase was driven by the aforementioned sales volume improvements, the utilization of investments in new technology and automation, and the permanent cost reduction in overhead costs and related prior year restructuring costs of $1.8 million following the closure of our Greenwood, South Carolina facility. These improvements were slightly offset by the lag in contractual raw material price increases incurred in the current period, which we expect will be recovered in the near term. Additionally, the company incurred $0.1 million of the expected $3.5 million to $5.1 million of launch costs related to the new Hazel Park, Michigan facility for our new customer in the fitness equipment market. Manufacturing margin percentages were 13.5% for the second quarter of 2021 as compared to a negative 1.8% for the 3 months ended June 30th, 2020, an increase of approximately 1,500%. In line with the higher sales volumes and permanent cost reductions associated with our cost optimization initiatives, incremental quarter-over-quarter manufacturing margins were 30.3%. The profit-sharing bonus and deferred compensation expenses were $3.2 million for the second quarter of 2021 as compared to $1.2 million for the same prior year period. The increase was primarily driven by the return of discretionary retirement benefits and bonus accruals, as business activity and sales volumes continue to move towards pre-pandemic levels. Other selling, general and administrative expenses were $5.4 million for the second quarter of 2021 as compared to $4.6 million for the same prior year period. The increase is due to higher salary and payroll expenses, in addition to higher travel and entertainment expenses, which were artificially low in the prior year period due to the COVID-19 pandemic. Interest expense was $0.5 million for the second quarter of 2021 as compared to $0.6 million for the same prior year period. The modest decrease is due to lower borrowings in the current period and comparable interest rates for the prior year. For the second quarter of 2021, income tax expense was approximately $1 million and pretax income of $4.3 million. Our federal net operating loss carryforward was approximately $12 million at quarter end, which was driven by pretax losses incurred in prior years. The NOL does not expire and will be used to offset future tax earnings. We continue to anticipate our long-term effective tax rate to be approximately 26% based on current tax regulations. Adjusted EBITDA was $14 million for the second quarter of 2021 as compared to $2.3 million for the same prior year period. Adjusted EBITDA margin percent increased by 810 basis points to 11.7% in the current quarter as compared to 3.6% for the same prior year period and represented an incremental margin of 20.4%. Our adjusted EBITDA margin and margin percentages were impacted by the lag in contractual raw material price increases passed along to our customers. Removing this effect of the contractual lag, our incremental quarter-over-quarter adjusted EBITDA margin percentage would have been 30.6% as compared to our historical average of 22.5%. Now let me address our capital expenditures, balance sheet and liquidity figures. Capital expenditures were $11.4 million for the second quarter of 2021 as compared to $1.3 million for the same prior year period. The increase, which was in line with our 2021 budget, was driven by our continued investment in new technology and automation and $5.3 million of spending to support the production ramp-up for our new strategic customer in the fitness equipment market. We continue to expect our full year capital spend to be in the range of $55 million to $65 million, which includes the $35 million to $45 million of investment needed to support the Hazel Park addition. As of the end of the second quarter of 2021, total outstanding debt, which includes bank debt and capital lease obligations, was $46.2 million as compared to $77.5 million at the end of the second quarter of 2020. The nearly $31.3 million debt reduction resulted in our leverage ratio dropping to 1x based upon a trailing adjusted EBITDA of only $46.1 million, which is substantially lower than the 2.4x in the second quarter of 2020, and significantly lower than our covenant threshold of 3.75x. Now I'd like to discuss 2021 guidance. Based on our recent performance, the overall economic climate and the broader industry and market trends, we are slightly modifying our guidance provided last quarter. Due to the impact of increased material price pass-throughs, the company now expects sales to be between $470 million to $490 million, up from the previous range of $450 million to $470 million. While adjusted EBITDA is expected to be between $48 million and $52 million, which has narrowed from the $46 million to $52 million and continues to include the $3.50 million to $5.1 million one-time launch costs related to our expansion into the fitness equipment market. The momentum we have built in the recent quarters appears set to continue in the second half of this year. With that said, please remember that our outlook assumes our end markets remain stable, supply chain constraints do not dramatically worsen, and that business activity as a whole continues to trend positively. In addition, please note that our manufacturing and adjusted EBITDA margin percentages may be diluted upwards of 150 basis points due to the impact of contractual raw material price increases that contribute to our top line sales but provide no margin dollars and they are simply passed through to our customers. Despite this short-term impact, we remain confident in our ability to deliver 15% adjusted EBITDA margins when production volumes return to pre-pandemic levels. Finally, we couldn't be more pleased with our current financial health. And I'd like to thank everyone on our team for working diligently to ensure we are positioned to succeed going forward. We are focused on making the right investments and building out the Hazel Park, Michigan facility, so we are ready to ramp up production for our new strategic customer as planned in early 2022.

Robert Kamphuis, Chairman, President and CEO

Thank you, Todd. Thanks to the strong work ethic and focus on safety of MEC's employee shareholders. We are in a solid position today as our business and the world continues to rebound from the pandemic-related downturn last year. While demand trends are all showing green, we are being limited by the various supply chain, people constraints and price inflation that will continue to impact MEC and our customers and the overall economy for the rest of 2021. We are navigating through these headwinds and are well positioned over both the near and long term to drive improvements and expand our market-leading position. We are pleased with our results for the first half of the year, and our outlook bodes well for the second half of 2021 and beyond. With this said, I'd like to open the call for questions.

Mircea Dobre, Analyst

I guess I want to start with the discussion on supply chain and sort of what you're seeing from your customers, as you've highlighted disruptions to their production schedules, which, obviously, we've been hearing about that throughout earnings season. You don't expect things to get worse, but I'm sort of curious as to, first, is there a good way to kind of quantify what the impact on your business might have been in the second quarter from these changes and in production schedules? And then do you expect your customers to be able to make up production either in the third quarter or the fourth quarter?

Robert Kamphuis, Chairman, President and CEO

Sure. Regarding the first question, there was some impact on us, but it wasn't significant. It would have certainly improved our second quarter results had we not encountered some issues, and I believe our results would have been more pleasing to people. On the supply side, we think things are stabilizing, and we anticipate better days ahead, especially with employment as federal assistance for unemployment benefits wanes and schools and daycare services resume. We're optimistic about the future. I believe the most challenging times are behind us. On the supply side, this will enhance our domestic suppliers' ability to meet their commitments to customers. On the import side, our ports are improving for receiving products, but there's still room for progress. The situation remains uncertain. From a customer perspective, they are looking ahead and will want to recover the lost volume, but it will depend on the prevailing challenges they face.

Mircea Dobre, Analyst

Then in your updated outlook, I'm trying to figure out here if we should be thinking that revenue here is up sequentially and do you expect normal seasonality into the fourth quarter? Or sort of how do you have things kind of planned out for the rest of the year from a revenue standpoint?

Robert Kamphuis, Chairman, President and CEO

Yes. I would say we're anticipating a strong second half. I believe the resources and output we've demonstrated in the first half will continue and possibly increase slightly in real output, excluding price adjustments. Therefore, we expect our output to improve, largely due to material cost adjustments contributing to revenue growth. As a result, there will be a modest increase in earnings as well.

Mircea Dobre, Analyst

But are you able to maybe parse out the third versus the fourth quarter? I'm just trying to think as to how we should be thinking of revenue sequentially here. If it builds in the third quarter and then slows down into the fourth with holiday shutdowns? Or is there a different way that you might be thinking about this?

Robert Kamphuis, Chairman, President and CEO

So Mig, when you look at third and fourth quarters, really, it feels a little bit the same because of the price pass-throughs that happened in the third quarter. And so it really stabilizes. And really when you look at third and fourth quarters, they're very much very similar from a top line sales perspective other than when you take off the impact in the fourth quarter for the holiday shutdown. So really, that production is very much stabilized in the back half and very consistent. Yes. So on that $20 million lift, we would say about approximately two-thirds of that was related to price pass-through. Some of it is just strengthening market conditions.

Eitan Buchbinder, Analyst

This is Eitan Buchbinder on for Andy. Similar to your new fitness customer, have you seen further demand from both old and new customers to localize their supply chain during Q2? And how much runway would you say that a potential reshoring trend has to go?

Todd Butz, CFO

Yes, I believe we are seeing ongoing opportunities. Clearly, supply chain challenges, both at home and abroad, are prompting customers to reassess their situations. While I can't provide a specific figure regarding the impact, I can confirm that we are actively seeking out more opportunities, both domestically on an outsourced basis and in terms of reshoring for those utilizing an international supply chain.

Eitan Buchbinder, Analyst

And you've previously mentioned potential opportunities regarding warehousing and packaging. So what are you seeing in terms of that business potentially contributing to revenue over the coming quarters?

Todd Butz, CFO

Yes, we have brought on new customers in that area over the past couple of years, and they continue to grow. While we haven't highlighted them in our recent calls, we are strengthening our position in the market. The changes in consumer spending on goods are beneficial for our commercial truck market, especially related to freight movement, which relies on docks and warehouses. We're pleased with our current customer base and see additional opportunities for growth, particularly in automation within conveyors, warehouses, and other areas. We remain optimistic that this growth will continue.

Eitan Buchbinder, Analyst

And one last one, if I can. Given the impact of lag price realization and ramping launch costs, how are you thinking about the cadence of margin in Q3 and Q4?

Robert Kamphuis, Chairman, President and CEO

Margins in the third and fourth quarters will experience a similar drag effect. We anticipate a dilution of around 150 basis points compared to our usual rate, which will create a slight dilutive impact in the second, third, and fourth quarters. I expect our margins to be somewhat lower than what we achieved in the second quarter, but I believe we may be able to improve on that with timing.

Larry De Maria, Analyst

You mentioned your target of a 15% adjusted EBITDA margin as sales are expected to return to pre-pandemic levels, likely next year. I would like to know how you plan to increase from approximately 11% this year to 15%, including your level of confidence in achieving those figures, as this is aligned with our expectations.

Robert Kamphuis, Chairman, President and CEO

Yes. I guess a couple of things, and I'll ask Todd to provide some further color, perhaps. But our margins will be better. Our direct margins and our overhead absorption will be better with that higher volume. So there should be two factors contributing to that improvement. It also depends on where raw material prices sit. If raw material prices remain high, we pass that along, but we don't pick up additional margin on that. So that has its own impact on that. It's had its impact in the second quarter and plus the lag, and we'll have the same ramifications in the second half.

Todd Butz, CFO

Yes. So as Bob mentioned, when you think about pre-pandemic levels, in 2019 we were at $520 million. And we've all talked about that 15% occurring once we reset sort of level of volume. And when we think of today's material pricing, if you were to push that back into '19, that would have created about $40 million of additional sales, right, with no further bottom line improvement. So really, it's that production volume. So when you look at our estimates this year at $470 million to $490 million, we're still well beneath our pre-pandemic run rate from a production standpoint when you think of that overhead absorption and that favorable impact. So this quarter, because of that lag, we had a very large step-up in material prices from Q1 to Q2. There'll be a modest increase in Q3, and the expectation is to stabilize or come down in Q4. We took the bulk of that kind of margin, I'd say, impact in the second quarter. And when you compare that back to 2019, we stabilized that. Again, it's a short-term impact. We're very confident when you couple material prices stabilizing with the overhead absorption and the cost reductions we've already done, we have that pathway to 15-plus percent.

Larry De Maria, Analyst

We're aiming for 15%, but that won't be achievable if material prices do not align with our expectations. Therefore, it may be wiser to target an absolute figure of $90 million or more for next year, given the potential instability of material costs.

Ryan Raber, EVP of Strategy, Sales and Marketing

If material costs stabilize and we avoid volatility from quarter to quarter, we can still aim for 15% adjusted EBITDA. Achieving this requires increased sales volume, as material costs are essentially a pass-through. For instance, if we reach $550 million in sales next year, we could maintain 15% EBITDA, even with higher material prices. However, consistent volatility can negatively affect our quarterly margins and has short-term consequences.

Robert Kamphuis, Chairman, President and CEO

I guess, first, we're focusing internally on our commitments to the schedule, to the cost to the preparedness. And we are right on path and on track with our expectations internally. The other things, when we look into those or try to look into those, we'll stay focused on what we're responsible for taking care of and certainly keep our eye on those things, but there's nothing really to report there either. It all appears to be going as expected.

Nathan Elwell, Investor Relations

Thank you. Thank you all for your time today and your continued interest in MEC. We look forward to talking with some of you later today at the Jefferies Conference. So with that, we'll say goodbye. But thanks, again, for your attention today. Appreciate it.

Operator, Operator

Thank you. The conference has now concluded. Thank you for attending today's presentation. You may now disconnect your lines.