Methode Electronics Inc Q2 FY2022 Earnings Call

Good morning, ladies and gentlemen, and welcome to the Methode Electronics Second Quarter Fiscal 2022 Results. It is now my pleasure to turn the floor over to your host, Robert Cherry, Vice President of Investor Relations of Methode Electronics. Sir, the floor is yours.

Thank you, operator. Good morning, and welcome to Methode Electronics Fiscal 2022 Second Quarter Earnings Conference Call. For this call, we have prepared a presentation entitled Fiscal 2022 Second Quarter Financial Results, which can be viewed on the webcast of this call or found at methode.com on the Investors page. This conference call contains certain forward-looking statements, which reflect management's expectations regarding future events and operating performance and speak only as of the date hereof. These forward-looking statements are subject to the safe harbor protection provided under the securities laws. Methode undertakes no duty to update any forward-looking statements to conform the statement to actual results or changes in Methode's expectations on a quarterly basis or otherwise. The forward-looking statements in this conference call involve a number of risks and uncertainties. The factors that could cause actual results to differ materially from our expectations are detailed in Methode's filings with the Securities and Exchange Commission, such as our 10-K and 10-Q reports. At this time, I'd like to turn the call over to Mr. Don Duda, President and Chief Executive Officer.

Thank you, Rob, and good morning, everyone. Thank you for joining us for our fiscal 2022 Second Quarter Earnings Conference Call. I'm joined today by Ron Tsoumas, our Chief Financial Officer. Both Ron and I will have opening comments, and then we will take your questions. Let's begin with the highlights on Slide 4. Our sales for the quarter were $296 million. We had a significant headwind in our automotive segment due to the ongoing supply chain disruptions, particularly the semiconductor shortage. That shortage led to auto OEM production slowdowns and in some cases, production shutdowns. This, in turn, led directly to lower sales in our Automotive segment, especially in North America. Helping to offset that auto headwind were near record sales in our Industrial segment. There was strength in sales across all our industrial product categories, but in particular, we saw growth in electric vehicle busbars, commercial vehicle lighting, and radio remote controls. Respectively, these products are benefiting from the macro growth trends in electrification, e-commerce, and automation. The industrial sales in our portfolio relative to our automotive sales continue to grow. As I mentioned, our team continued to face supply chain challenges. These include the ongoing semiconductor chip shortage, pandemic-related supply chain disruptions, and port congestion, all of which are increasing costs and consequently negatively impacting margins. Our team has worked diligently to mitigate these challenges, which, in many cases, require remedial actions, such as expedited shipping and premium component pricing. In addition, we are working relentlessly with our customers to share in the absorption of these costs. The timing of these cost recoveries is not certain. At this point, our expectation is that these conditions will last until the end of our fiscal year. This extended period of demand recovery and margin pressure is a driver of our revised guidance for the full fiscal year. The situation is fluid, and our mitigation efforts are ongoing, but we are confident that we will continue to execute and meet our customers' requirements. Ron will provide more detail on our guidance later in the call. On the new order front, we were encouraged by the diversity of awards across key applications. In addition to our traditional automotive market, we secured awards in cloud computing, commercial vehicle, and EV applications. Focusing on EV, last quarter, we reported that sales in the EV applications were 16% of the consolidated sales. This quarter, EV sales were again 16% of consolidated sales. However, on a dollar basis, they were higher and in fact were a record for Methode. Our expectation for that percentage for the full year continues to be in the mid-teens. Our EV activity is being fueled by growth in our power distribution offerings where we leverage over 40 years of expertise to supply power products to various EV OEMs. In the quarter, we further reduced debt, generated positive operating cash flow and continued to return capital to shareholders. Our free cash flow was positive even though we invested in inventory to support our deliveries to customers and to help mitigate supply chain disruptions. While our debt was down, we did have an increase in net debt as we utilized a portion of our available cash to execute a $35 million share buyback in the quarter. We have now executed half of the $100 million stock buyback authorization since it was announced last March. Before I provide detail on our business awards, I want to provide some information on an existing program. I can now share with you a little more detail on our largest truck center console program. We expect a small portion of the sales from this program to start to roll off late this fiscal year, which was included in our original full year guidance. Then in fiscal 2023, we expect the bulk of the remaining truck program sales to roll off in the range of $90 million to $100 million. The fiscal 2024 impact is negligible. As I've mentioned in recent quarters, our business awards over the last couple of years have put us on track in aggregate to replace the sales from the roll off of this truck program. Moving to Slide 5. Methode had another solid quarter of business awards. These awards continue to capitalize on key market trends like cloud computing and vehicle electrification. The awards identified here represent some of the key business wins in the quarter and represent $25 million in annual sales at full production. In non-EV automotive, we were awarded programs for lighting and user interface applications. In cloud computing, we saw demand for our power distribution products and data center applications. In commercial vehicles, where signs of an upcycle continue, we were awarded programs for exterior lighting solutions. In EV, we won awards for switch, lighting, and power distribution programs. Overall, our business awards are delivering on our strategic priority to drive customer, product, and geographic diversity. To conclude, despite the ongoing demand fluctuations and supply chain challenges, we are still in a position to deliver solid organic growth sales for fiscal 2022 while generating positive free cash flow. At this point, I'll turn the call over to Ron, who will provide more detail on the second quarter financial results.

Thank you, Don, and good morning, everyone. Please turn to Slide 7. Second quarter net sales were $295.5 million in fiscal year '22 compared to $300.8 million in fiscal year '21, a decrease of $5.3 million or 1.8%. The year-over-year quarterly comparisons included a favorable foreign currency impact on sales of $2.8 million in the current quarter. Sequentially, sales increased by $7.7 million or 2.7% from the first quarter of fiscal year '22. The decrease in second quarter sales was mainly due to lower automotive sales, especially in North America as compared to the same period in fiscal '21, which benefited from the rebound from the depths of the impact of the COVID-19 pandemic experienced in our first quarter of fiscal year '21. The sales decrease was partially offset by higher sales of electric hybrid vehicle products, which amounted to 16% of sales in the second quarter of fiscal '22, which was in line with our previous communication that electric and hybrid vehicles sales would comprise a mid-teens percentage of our fiscal year '22 consolidated sales. In addition, stronger commercial vehicle sales contributed to the robust industrial segment sales growth. Second quarter net income decreased $11.1 million to $27.5 million or $0.72 per diluted share from $38.6 million or $1.01 per diluted share in the same period last year. Net income was negatively impacted from decreased sales, the impact of higher materials and logistics costs and other operating costs and the efficiencies due to the global supply chain shortages and logistics challenges, higher stock-based compensation costs, and lower other income, partially offset by lower restructuring costs and favorable foreign currency translation. Please turn to Slide 8. Second quarter gross margins were lower in fiscal year '22 as compared to fiscal year '21, mainly due to higher material and logistics costs, including freight and supply chain shortages and unfavorable product mix. Fiscal year '22 second quarter margins were 23.4% as compared to 26.9% in the second quarter of fiscal year '21. The negative impact of supply chain disruption and higher logistics costs, including freight on the second quarter fiscal year '22 gross margin was approximately 250 basis points. Unfavorable product mix also impacted gross margins. These higher costs that were experienced in the second quarter are expected to continue and further into fiscal year '22. In addition, we had anticipated a degree of cost inflation in the remainder of the current fiscal year. Fiscal year '22 second quarter selling and administrative expenses as a percentage of sales increased to 10.6% compared to 10.2% in the fiscal year '21 second quarter. The minor fiscal year '22 second quarter percentage increase was attributable to higher stock-based compensation, partially offset by lower professional fees and restructuring costs. The second quarter fiscal year '22 selling and administrative expenses percentage is in line with our historical norm, which should yield an efficient flow through from gross margin to operating income. Please turn to Slide 9. In addition to the gross margin and selling and administrative items mentioned above, one other nonoperational item significantly impacted net income in the second quarter of fiscal year '22 as compared to the comparable quarter last fiscal year. Other income net was down by $1.7 million, mainly due to lower international government assistance between the comparable quarters and increased foreign exchange losses from remeasurement. The effective tax rate in the second quarter of fiscal year '22 was 16.7% as compared to 16.5% in the second quarter of fiscal year '21. The fiscal year '22 full year estimate, which does not include any discrete items, is estimated to be between 17% and 18%, tightening the high end of the range down from 19% to 18%. Shifting to EBITDA, a non-GAAP financial measure, fiscal year '22 second quarter EBITDA was $47.4 million versus $60.2 million in the same period last fiscal year. EBITDA was negatively impacted by lower operating income and lower other income. Please turn to Slide 10. In the second quarter of fiscal year '22, we reduced gross debt by $12.3 million, and we ended the second quarter with $177.2 million in cash. During the first six months of fiscal year '22, net debt, a non-GAAP financial measure, increased by $39 million, mainly due to the share repurchases of $42.4 million and unfavorable working capital changes, especially related to inventory, which increased by nearly $26 million due to the supply chain-related challenges. Regarding capital allocation on March 31st, we announced the $100 million share repurchase program, which we executed nearly $35 million of purchases during the second quarter of fiscal year '22. Since the authorization approval, we purchased nearly $50 million worth of shares at an average price of $44.04. Please turn to Slide 11. Free cash flow, a non-GAAP financial measure, is defined as net cash provided from operating activities minus CapEx. For the fiscal year '22 second quarter, free cash flow was $21.6 million compared to $36.7 million in the second quarter of fiscal year '21. The decrease was mainly due to negative working capital changes, especially from the inventory items we discussed prior. We experienced sequentially improved free cash flow in the second quarter of fiscal '22 as compared to the first quarter of fiscal '22. We anticipate our proven history of generating reliable cash flows, which allows for ample funding of future organic growth, inorganic growth, and continued return of capital to the shareholders. In the second quarter of fiscal year '22, we invested approximately $5.4 million in CapEx as compared to $3.6 million in the second quarter of fiscal '21. The higher CapEx is in line with our expectation that CapEx in fiscal year '22 would be higher than the investment in the prior fiscal year. We now estimate fiscal year '22 CapEx to be in the $45 million to $50 million range, which is lower than the prior estimates for the current fiscal year of $50 million to $55 million we provided earlier. The decrease is simply the result of the timing of the cash outflows of approved projects as opposed to a concerted effort to slow or reduce the gains of capital investment. Investing for future organic growth and vertical integration remains a key priority from a capital allocation strategy perspective. We do have a strong balance sheet and we'll continue to utilize it by continuing investment in our businesses to grow them organically. In addition, we continue to pursue opportunities for inorganic growth and a measured return of capital to the shareholders. Please turn to Slide 12. Regarding guidance, it is based on management's best estimates. External events and the related potential impact on our financial results remain an ongoing challenge. As Don mentioned in his remarks, we lowered our previously issued revenue and earnings per share guidance, largely due to the persistent headwinds from the ongoing negative impact of the chip shortage and logistics challenges. As you recall in our September conference call, we noted that the persistent headwinds could call our performance to be below the midpoint of the ranges of our original guidance as the situation was fluid and would likely remain challenging. These headwinds continue to adversely impact our second quarter results and will likely be with us for the remaining six months of our fiscal year. The revenue range for full fiscal year '22 is between $1.14 billion and $1.16 billion, down from a range of $1.175 billion to $1.235 billion. Diluted earnings per share range is now between $3 per share and $3.20 per share, down from $3.35 to $3.75 per share. The range is due from the uncertainty from the supply chain disruption for semiconductors and other materials on both Methode and its customers. From a sales perspective, lower sales could result from a supply disruptions to us or our customers which could result in lesser demand for our products or our ability to meet customer demand. Continued supply chain disruption would also negatively impact gross margins due to additional costs incurred from premium freight, factory inefficiencies, and a lesser extent other logistic factors such as port congestion. Higher costs for materials, freight and labor are a constant and dynamic battle, and we remain uncertain as to when things will stabilize. Don, that concludes my comments.

Ron, thank you very much. Matt, we are ready to take questions.

Your first question is coming from Luke Junk from Baird.

So first question I want to ask is on guidance. So I know you're not giving third quarter guidance, just wondering at a very high level, if there are any factors that you could discuss that we should be thinking about from a modeling perspective, 3Q versus 4Q in your fiscal year, especially be interested in your perspective on underlying auto and commercial vehicle trends? And also just want to make sure there's nothing that's sort of one-off in nature that we should be aware of. Ron, you mentioned the FX remeasurements in the current quarter, for example, I just want to make sure there's nothing that we should be looking for in the back half of the year that could be impactful like that?

I think the primary factor that will influence our performance in the second half is the holiday production shutdowns, which typically affect operations in both the US and Europe. Historically, Q3 has been a lower revenue quarter, so that will be a significant consideration. The remaining factors related to supply chain disruptions are uncertain. It seems that the situation in the US may have stabilized, although this is not certain. Conversely, Europe has experienced more disruptions recently compared to past quarters. So, one region may be improving slightly while the other could be facing additional challenges. Ron, do you have any insights?

Clearly, I mean, historically, our third quarter due to, as Don mentioned, the holiday shutdowns and simply less shipping days tends to be our weaker quarter and our fourth quarter tends to be stronger, and we would expect that to follow through that type of cadence.

Second question would be in terms of the state of your supply chain. Obviously, a number of comments in the prepared remarks on that. I'm hoping we can maybe discuss sequentially what you saw in the second quarter versus the first quarter of the year, sort of where you exited the previous fiscal year, especially wondering where you're seeing incremental challenges right now from a supply chain and material standpoint? And as we zoom out and look at what this might look like going forward, how much permanence do you see in costs that are in the P&L right now versus things that might be, say, less permanent in nature over a subject to potential customer recoveries, let's say?

Let me address that first. As I mentioned earlier, we are actively collaborating with customers to alleviate the supply chain challenges from a cost perspective. This process will take some time, and we anticipate it will persist throughout the fiscal year, with our expectations reflected in both the high and low ends of our guidance. COVID remains a factor in the supply chain issues; in some regions, it has eased, while in others, it continues to cause labor shortages and keep our inventory levels higher than necessary. We plan to reduce inventory as disruptions diminish, but predicting the timeline for this is quite challenging. From the first quarter to the second quarter, we observed a 250 basis point change. Unfortunately, the situation worsened rather than improved. I believe that’s about all I can convey on that front. Are we perhaps feeling a bit more confident in handling labor shortages and port congestion? Yes, but I expect these challenges to persist until the end of the fiscal year, with each day presenting new obstacles. Typically, in the automotive sector, production schedules are stable by the end of the quarter, but this year they have been fluctuating daily. Is there anything else, Ron?

As time progresses, we performed slightly better from a basis point perspective than we did in the first quarter. Moving forward, we will be better positioned to enhance our cost sharing and similar aspects. While one quarter does not establish a trend, we believe there is potential for improvement in the future, which is reflected in our guidance.

I would like to ask about the existing large truck center console program. The revenue numbers you provided are really helpful, and I’m trying to understand the margin implications related to that. I realize there will be an impact on gross margins due to the mix as that business transitions, as well as an effect from manufacturing overhead. Where do those two aspects converge? I don’t want to delve into fiscal '23 guidance specifically, but any high-level thoughts on margin progression would be appreciated.

The program has been quite beneficial for us, but as we've mentioned before, it doesn't offer the highest margins and is being replaced by a higher-margin electric vehicle program. Therefore, we anticipate that as the old program phases out and new programs come in, our margins will improve, though I won't specify exact timing. We're adept at evaluating programs and adjusting our factory overhead as necessary, considering factors such as floor space and labor. These adjustments are currently being implemented as we begin to phase out this program. Additionally, we're cautious about maintaining inventory levels as the program reaches its end, while also ensuring we meet our service obligations for the next three to five years. Overall, we're managing this situation well. We've successfully transitioned other programs in the past, adjusting our factory operations accordingly.

And then if I could just ask a last question, a little bigger picture. I noticed on the business awards that one of the awards that was interesting this quarter was busbars for charging. And just hoping you could expand on what that opportunity set might look like for Methode going forward?

That pertains to commercial vehicle charging, not to the charging stations you might find in a parking garage. I don’t have much more to add on that. It's a busbar specifically for commercial vehicles. For example, at a depot, those charging systems would be used to charge the vehicles overnight, and we provide the busbars needed for that.

Your next question is coming from Matt Sheerin from Stifel.

I just had a quick follow-up question regarding your comments on the cost headwinds and your ability or inability to pass them along to your auto customers? Some of your peers selling into auto appear to have more success. So I'm wondering, are you sort of locked into contracts that make it difficult, how are those conversations with customers going?

I believe things are progressing as expected in terms of our requests for price increases and logistics relief; this process does take time, and we have experienced it before. We are confident that we will recover our margin. While some competitors may have a head start, we monitor the situation weekly and are aware of ongoing discussions. The situation isn't hopeless; it primarily revolves around timing. Additionally, some tiers have automatic price increases due to material costs, which we don’t have in our standard automotive contracts. We do have such provisions in some of our EV or power distribution contracts, so those increases could happen automatically. However, in our case, it's not the norm. Our programs typically last four to five years and are contractually binding, making discussions more complex, especially in these unusual times. I would also emphasize that our discussions with the auto sector have been somewhat easier compared to those with the commercial vehicle sector. This is the first quarter where I can say we've made progress, but it's still been a challenging process across both sectors when it comes to negotiating price increases.

No, I was just going to mention on this EV space.

And just regarding the strength you're seeing on the EV side, it seems like you've got some good content gains. Are you also winning new programs and new logos in terms of customers?

Yes. It's important to highlight that some of this comes from both start-ups and traditional OEMs. We have been very satisfied with the bookings we've received, which will support our growth moving forward.

There are no further questions in the queue. I will now hand the conference back to Donald Duda, CEO, for closing remarks. Please go ahead.

Matt, thank you very much. We'll thank everyone for listening today and your questions, and we wish everyone a very safe and pleasant holiday season. Good day.

Thank you, ladies and gentlemen. This concludes today's event. You may disconnect at this time, and have a wonderful day. Thank you for your participation.