Earnings Call Transcript - MEI Q1 2023

Operator, Operator

Good morning, everyone, and welcome to the Methode Electronics First Quarter Fiscal 2023 Results Call. It is my pleasure to introduce your host, Robert Cherry, Vice President of Investor Relations. Robert, you have the floor.

Robert Cherry, Vice President of Investor Relations

Thank you, operator. Good morning, and welcome to Methode Electronics fiscal 2023 first quarter earnings conference call. For this call, we have prepared a presentation entitled Fiscal 2023 first 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.

Don Duda, President and CEO

Thank you, Rob, and good morning, everyone. Thank you for joining us for our fiscal 2023 first 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 $282 million, helping our sales by $11 million with successful spot buy in premium freight cost recovery efforts. Working against us was foreign currency, which had a negative $14 million impact on sales. Additionally, we faced market headwinds in our automotive segment in Asia and Europe. In Asia, the COVID-19 lockdowns in China impacted the end of our fourth quarter, as well as the beginning of our first quarter. In Europe, we observed continued weakness in the auto market due to macroeconomic conditions. Helping to offset the weaker auto sales was a record quarter of sales in our Industrial segment. The surge in industrial sales was driven by power distribution, both through data center and EV applications, and by commercial vehicle lighting. This aligns with our strategic direction to grow our Industrial segment. During the quarter, we continued to face ongoing supply chain challenges. Our team is diligently working to mitigate their impact, which requires remedial actions such as spot buys and expedited shipping. We have worked relentlessly with our customers to share in the absorption of these increased costs. These costs include inflation in material, labor, and freight. Our ability to obtain reimbursement to offset these costs will lag as a matter of process as long as inflation continues. On the order front, we had another very strong quarter with over $90 million in program awards. As we will see later, these awards were in a variety of applications, once again led by EV programs. Focusing on EV, like last quarter, EV sales were 17% of consolidated sales. This percentage, which was 19% two quarters ago, was again directly impacted by the COVID-19 lockdowns in China. With those lockdowns seemingly behind us and given the ongoing momentum in our EV activity, we still expect EV sales to reach a record 20% of our total sales in this fiscal year. During the quarter, we achieved positive free cash flow and purchased approximately $12 million of Methode stock. As of the end of the first quarter, we now have approximately $117 million of capacity in our buyback authorization, which expires in June 2024. Furthermore, our debt is at its lowest level since the Grakon acquisition. Moving to Slide 5, Methode had another strong quarter of business awards. The awards identified here represent some of the key wins in the quarter, and represent over $90 million in annual sales at full production. As a reminder, the full launch timing of most of these programs could range anywhere from 1 to 3 years from now. While most of the dollar value of these awards are for new programs, some awards are for extensions or volume increases on existing programs. At the top of the list are EV programs representing over 40% of the total dollar value. The awards are mostly for power products from all of the additional big three U.S. automakers. The EV growth engine continues to roll on, and our exposure to it remains robust. In non-EV automotive applications, we were awarded programs for all four of Methode's core technologies: user interface, power, sensor, and lighting applications. Notably, we have solid awards for applications in motorsports and e-bikes, along with good award diversity in lighting, sensor, and power products. Overall, it was a successful quarter for awards that will drive organic sales growth in future years. To conclude, we continue to be cost-challenged by inflation, which has yet to stabilize. However, our team is working every day to mitigate the impact, and we expect more progress as the year continues. Looking forward, I am confident that Methode is positioned to mitigate these pressures and deliver sales and earnings growth for fiscal 2023. This confidence has enabled us to affirm our sales and earnings guidance for the year. At this point, I will turn the call over to Ron, who will provide more detail on our first quarter financial results and outlook for the full year. Ron?

Ron Tsoumas, Chief Financial Officer

Thank you, Don and good morning, everyone. Please turn to Slide 7. First quarter net sales were $282.4 million in fiscal year '23 compared to $287.8 million in fiscal year '22, a decrease of $5.4 million or 1.9%. Fiscal year '23 sales included $11.1 million of spot buy and premium freight cost recovery and an unfavorable currency impact on sales of $14.2 million. Excluding the spot buy in premium freight cost recovery and the foreign currency impact, sales decreased by $2.3 million or 0.8%. Sales declined in the Automotive segment but increased in the Industrial segment. The Automotive segment saw a sales increase of $19.2 million or 9.8%. Net sales were negatively impacted by foreign currency exchange of $8.9 million but benefited from stock spot buy and freight recovery sales of $9.1 million. In North America, the $4.4 million decrease in the first quarter sales included the full impact from the roll-off of a major automotive program. In Asia, Automotive segment sales decreased by $9.1 million or 23.4%, primarily due to China's COVID-19 zero tolerance lockdown and the shutdown of a large customer's facility in July. We anticipate recovering a portion of the lost sales in the first quarter in our second quarter. In Europe, sales declined by $5.7 million or 9.9%, largely due to foreign exchange headwinds of $7.7 million, partially offset by cost recoveries of $1.2 million. In addition to foreign exchange, sales were impacted by general economic uncertainty in the region. The weakness in the Automotive segment was partially offset by record sales in our Industrial segment, which experienced a sales increase of $13.6 million or 17.3%, resulting from strength in our commercial vehicle lighting and industrial non-EV power-related product offerings. EV product applications amounted to 17% of sales in the quarter. This figure was adversely impacted by the lockdown and shutdown activity in China. Currently, we expect recovery in the next several quarters and still anticipate HEV and hybrid electric vehicles to represent 20% of our full-year fiscal '23 consolidated sales. First quarter income from operations in fiscal year '23 decreased to $21.8 million from $34.1 million in fiscal year '22, mainly due to lower product sales and lower gross margins, primarily due to higher costs from material cost inflation, spot buys, and other unreimbursed costs. The impact of overhead absorption due to the roll-off of a major automotive program also played a role, as did modestly higher selling and administrative expenses. From a gross margin perspective, cost recovery actions did not keep pace with the accelerated inflation and other increased costs. It will take time to catch up on cost recovery, but actions are in process for recovery in future periods. These factors were partially offset by higher other income in the form of international government COVID-19 assistance, which increased from $1.9 million in the first quarter of fiscal year '22 to $4.1 million in the first quarter of fiscal year '23. The other income spiked in the first quarter; we do not expect this elevated level of government assistance during the remainder of the fiscal year. First quarter net income in fiscal '23 decreased by $7.6 million to $21.5 million or $0.58 per diluted share from $29.1 million or $0.76 per diluted share in the same period last year. Sequentially, from the fourth quarter of fiscal year '22, diluted earnings per share increased by $0.15 per share from $0.43 to $0.58 per diluted share. Please turn to Slide 8. Fiscal year '23 first quarter gross margins were 21.9% compared to 24.9% in the first quarter of fiscal year '22. A contributing factor in the decline in the consolidated gross margin profile was the increase in pass-through cost recovery sales at zero margin, which led to lower net product sales. If these sales are removed, fiscal year '23 first quarter consolidated gross margins would have been 22.8%. Automotive segment gross margins decreased to 33.7% in the quarter of fiscal year '23, down from 36.3% gross margins in the first quarter '22, mainly due to decreased sales in North America and Asia. Industrial segment gross margins decreased to 33% in the first quarter, down from 36.3% gross margin in the first quarter of fiscal '22. Of the overall segment gross margin decrease, approximately 75% was due to material costs inflation, increased freight and logistics costs, and 25% was related to inventory items, unfavorable absorption due to China's lockdowns, and increased profit in ending inventory eliminations and other items. The 33% in Industrial segment gross margins are more in line with historical norms, and barring any substantial change in commercial vehicle or EV production levels, we anticipate opportunities for modest improvement in the Industrial segment margin for the remainder of the current fiscal year. Fiscal year '23 first quarter selling and administrative expenses as a percentage of sales were 12.5% compared to 11.4% in the first quarter of fiscal year '22, mainly due to increased wages, along with other general and administrative expenses and travel. Our selling and administrative expenses as a percentage of sales are reasonably consistent from a cost structure perspective and should yield an efficient flow-through from gross margin to income from operations. Please turn to Slide 9. Net income was negatively impacted by the operational items noted above, partially offset by higher income, lower tax expense, and lower net interest expense. The effective tax rate in the first quarter of fiscal '23 was 17% compared to 16.4% in the first quarter of fiscal year '22. The minor change in the effective tax rate was due to a mix of jurisdictional earnings. Shifting to EBITDA, a non-GAAP financial measure, fiscal year '23 first quarter EBITDA was $38.2 million versus $48.5 million in the same period last fiscal year. EBITDA was negatively impacted by the higher costs from material inflation, spot buys, premium freight, lower product sales volumes, and unfavorable product mix, partially offset by other income. Please turn to Slide 10. In the first quarter of fiscal year '23, we reduced gross debt by $3.3 million. Since our acquisition of Grakon in September of 2018, we have reduced gross debt by $150 million. Net debt, a non-GAAP financial measure, increased by $16.3 million to $54.8 million in the first quarter of fiscal year '23 from $38.5 million at the end of fiscal '22, mainly due to the share repurchases of $11.9 million and unfavorable working capital changes, especially related to inventory, which increased significantly due to ongoing supply chain-related challenges. We ended the first quarter with $152.4 million in cash. Our debt to trailing 12 months EBITDA ratio, which is used for bank covenants, is approximately 1.3, well below our covenants threshold of 3.5. Our net debt to trailing 12 months EBITDA ratio was approximately 0.4. Please turn to Slide 11. Fiscal year '23 first quarter free cash flow, a non-GAAP financial measure, was $3.1 million compared to the use of cash of $6.2 million in the first quarter of fiscal year '22. The increase of $9.3 million was due primarily to favorable changes in net operating assets and liabilities. Lower net income of $7.6 million was offset by a favorable change of $10.6 million in working capital and $6.3 million less in capital expenditures. We expect free cash flow to improve for the remainder of fiscal year '23 as we target reduced inventory levels and other positive working capital initiatives, combined with increased net income while supporting increased CapEx. Regarding capital allocation, on June 16, we announced a $100 million increase to our existing stock buyback program. During the first quarter of fiscal year '23, we bought back 317,000 shares for $11.9 million, bringing the total purchases to date of nearly 1.9 million shares totaling $83 million, which leaves approximately $117 million of remaining capacity available for purchases as of the end of the first quarter. The current authorization expires in June 2024. Investing for future organic growth and vertical integration remains a key priority from a capital allocation strategy perspective, especially as we rationalize our global footprint for the future, including expanding our EV capabilities to better support our build where we sell strategy and continue to position ourselves to capitalize on the EV mega trend. We have a strong balance sheet and will continue utilizing it by investing in businesses to grow them organically. Additionally, we will pursue opportunities for inorganic growth with a measured return of capital to shareholders. Please turn to Slide 12. Regarding fiscal '23 guidance, it is based on management's best estimates, including the impact of the COVID-19 pandemic, particularly in China, the headwinds from the ongoing semiconductor shortage, other supply chain disruptions, inflation, economic instability in Europe, and both short and long-term supply chain rationalization and restructuring efforts and the related impact on our financial results. All of these items, individually and collectively, still pose ongoing challenges in this macroeconomic environment. While we have experienced some success in recouping some cost recoveries, we expect these headwinds will likely persist for the remainder of fiscal year '23. The revenue range for the full fiscal year '23 is between $1,160 million to $1,210 million. The anticipated growth at the midpoint of our range considers the full year impact of a large automotive program roll-off, which had sales in fiscal '22 in excess of $100 million. The diluted earnings per share range remains unchanged at $2.70 to $3.10 and contemplates the continued headwinds from supply chain inflation and other macroeconomic events. Our estimated annual effective tax rate remains between 16% and 18% without any discrete items. We continue to anticipate CapEx of between $40 million and $50 million as we expand our capabilities to support growth in EV sales and strategically position our global footprint to support production of our significantly increased order backlog built over the last 2 years. Estimated depreciation and amortization expense remains between $54 million and $58 million. In summary, the first quarter met our expectations, and our current view of the remainder of the fiscal year remains unchanged. Based on the strong bookings we realized over the past two fiscal years, much of which is for the EV market, we announced a 3-year organic compounded annual growth rate of approximately 6%. This CAGR continuously considers the anticipated roll-off of relevant programs and reinforces that our organic growth strategy is placing the company on a solid path for future growth. The strong bookings momentum continued in the first quarter of fiscal '23. Don, that concludes my comments.

Don Duda, President and CEO

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

Operator, Operator

Our first question is coming from Luke Junk with Baird. Please go ahead.

Luke Junk, Analyst

To start, I was hoping you could help us understand the two factors behind the continued margin decline in the automotive segment. Can you explain how we should consider the relative impact of the major customer roll-off affecting cost absorption and the China-related impacts this quarter, especially regarding the persistence or potential reduction of these challenges on auto margin going forward?

Don Duda, President and CEO

Sure. When I look at the roll of the program, what we've anticipated for quite some time, I don't attribute a lot of weight to that. Several years ago, we booked EV programs that we already see from revenue that will replace that. The impact, even though we did recover some of our costs during the quarter, was primarily from ongoing supply chain issues—both inflation and logistics. If those issues didn’t exist in the quarter, I don't think we would be discussing the roll-off of public programs. So those are mutually exclusive factors. What impacted auto is the macroeconomic conditions in Europe, which are a higher margin territory for us than in the United States, so the combination of the logistics and inflation, along with European sales and mix, contribute to our marginal decline. Ron, do you have anything to add?

Ron Tsoumas, Chief Financial Officer

Yes, I think we will recover— we anticipate recovering what was lost in China for the rest of the year. As for the stickiness of the items Don mentioned, we will continue to pursue them.

Luke Junk, Analyst

Thank you for that. My second question is regarding the shape of the fiscal year. You're clearly starting to see some improvement in earnings relative to where the fourth quarter shook out from here. If I do the math, taking the midpoint of guidance and what you reported this quarter, that results in approximately $0.77 per quarter in EPS to get to that midpoint. Can you just comment on how you see that progression internally, or any key factors we should consider regarding that anticipated progression on a quarterly basis?

Don Duda, President and CEO

Sure. I'll start off and then Ron can comment. As I mentioned in our prepared remarks, we were impacted in the first quarter by the lockdowns in China as well. If those had not occurred, we would have reported improved results. As I would say, we've anticipated some momentum coming out of this quarter, particularly in terms of the China lockdowns and some of the other programs we will bring to launch. We anticipate progression throughout the year in terms of EPS growth.

Ron Tsoumas, Chief Financial Officer

Yes, we are confident in the improvement we expect in each of the upcoming quarters. Historically, our third quarter tends to be slightly weaker than some of our other quarters, but we are seeing momentum coming out of this quarter in terms of China lockdowns and various programs coming to launch. You should expect to see progression throughout the year regarding EPS growth.

Don Duda, President and CEO

We'll provide quarterly guidance, but we didn't establish math indicating that achieving that average per quarter is feasible. We are confident going forward, barring another lockdown in China.

Luke Junk, Analyst

Thanks for that. One last question, if I can, Don: could you comment on the trends in medical this quarter, and perhaps zooming out, more importantly, your aspirations and outlook for that business as we look over the rest of fiscal 2023? Thank you.

Don Duda, President and CEO

Sure. In the last quarter, we had a very strong quarter with $1.6 million, and this quarter was $0.7 million. I don't read too much into that; the fourth quarter had a very large order, along with another mid-size order. The completion of evaluations by hospitals had been impacted by COVID, with orders typically following in the next quarter. So that was largely what happened in the fourth quarter. The first quarter we didn't complete any major evaluations. I'm anticipating that the pace for medical orders will pick up now that we've had those evaluations done. We remain confident in this business, with our list of customers continuing to grow.

Luke Junk, Analyst

Okay, thank you. I'll leave it there.

Don Duda, President and CEO

Thank you.

Operator, Operator

Our next question is coming from John Franzreb with Sidoti. Please go ahead.

John Franzreb, Analyst

Good morning, guys, and thanks for taking the questions.

Don Duda, President and CEO

Good morning.

John Franzreb, Analyst

I would like to start with the industrial business. Record revenues; was there anything unusual regarding timing in the quarter that helped achieve those revenues? What's your outlook for the cadence in the industrial business for the balance of the year relative to the first quarter?

Don Duda, President and CEO

Sure, John. A couple of things: the commercial vehicle sector was strong and continued to grow, which was good for us. Our power products, which serve data centers, can be lumpy, and we experienced some nice revenue recorded during the quarter. So a combination of both of those elements likely contributed to the increase in sales. John, I’m confident in the continued growth of our business. It was affected by logistics and inflation, but not to the same degree. Our commercial business remains strong, and our customers have continued to pursue business with us.

John Franzreb, Analyst

In the last quarter, you expressed concern about having to return to customers repeatedly for price increases due to being behind the cost curve of inflation. Has that abated in the first quarter, or are you still finding yourself needing to return multiple times, elongating your recovery process?

Don Duda, President and CEO

That situation still exists. It's a delicate conversation with customers. We are careful in how we approach it, but it is a necessity. As I mentioned in my prepared remarks, as long as inflation continues, we will remain behind the curve in any given quarter. You recover from maybe the previous two quarters, but now you face another increase that you must go back for. It feels like a hamster wheel, and until inflation subsides, we'll continue to navigate these challenges. Customers understand this, but they do not typically grant anticipatory price increases based on inflation; we wouldn't either. So, yes, this challenge continues.

John Franzreb, Analyst

Regarding the lockdowns in China, can you: a) hit your 20% EV target without China returning to some normalcy? and b) considering the additional lockdowns we just heard about, is that factored into your outlook, or were you surprised by them?

Don Duda, President and CEO

I wouldn’t say we were surprised; we anticipated some impact in our review of the balance of the year. However, the unknown factor is if next week Shanghai gets locked down or some other location; that would certainly affect us. To what degree, I can't specify, but we do have inventory and products on the water, which is unfortunate and contributes to our inventory. It is a significant factor, even more so than general macroeconomic conditions in Europe.

John Franzreb, Analyst

Regarding your 20% EV target, do you need China to return to normal operations to achieve it?

Don Duda, President and CEO

I think we can achieve it. If the situation stays as is, can we meet the target? Our projections indicate yes, although if there are dramatic changes, that will have an effect.

John Franzreb, Analyst

Great, and one final question on capital allocation. Can you discuss your decision to buy back shares versus reducing debt further or pursuing M&A? What are your thoughts at this point?

Ron Tsoumas, Chief Financial Officer

Sure, John. We are actively continuing to look at inorganic growth targets, as we have in the past. Yes, we reduced debt by only $3.1 million during the quarter, but that was a conscious choice; we prioritized share buybacks. If we pay down our available debt, we cannot borrow against it. We believed it was the right time to act on share repurchases, especially after announcing the additional $100 million back on that program.

Don Duda, President and CEO

Regarding acquisitions, we continue to explore opportunities. Several acquisitions on our radar are being evaluated, and we want to observe how the world economy evolves, which will influence the valuations of those companies. The M&A market seems to be pausing to gauge interest rates and economic conditions, particularly in Europe right now.

John Franzreb, Analyst

Got it. Thank you for the insights, and I appreciate you taking my questions.

Don Duda, President and CEO

Thank you.

Operator, Operator

As there are no more questions in queue, I will hand it back to Mr. Duda for any final comments.

Don Duda, President and CEO

Ellie, thank you. Thanks everybody for listening, and I wish everyone a safe and enjoyable Labor Day weekend. Goodbye.

Operator, Operator

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