Earnings Call Transcript - MEI Q3 2022

Operator, Operator

Good morning, ladies and gentlemen, and welcome to the Methode Electronics Q3 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.

Robert Cherry, Vice President of Investor Relations

Thank you, operator. Good morning, and welcome to Methode Electronics Fiscal 2022 third quarter earnings conference call. For this call, we have prepared a presentation entitled Fiscal 2022 third 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 2022 third 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 $292 million, helping our sales by $9 million, as we were successful in premium freight cost recovery efforts. However, our Automotive segment encountered demand headwinds in Europe due to the ongoing supply chain disruptions, particularly the semiconductor shortage, leading to various European auto OEM production slowdowns. In our Industrial segment, we saw strength across all our product categories, particularly in power and lighting products. In particular, this segment saw growth in electric vehicles, busbars, commercial vehicle lighting, and radio remote controls. These products continue to benefit from macro growth trends in electrification, e-commerce, and automation. As such, our industrial sales again outgrew our automotive sales, a trend we expect to continue. As I mentioned, our team continues to face ongoing supply chain challenges this quarter. They have worked diligently to mitigate these challenges, requiring remedial action such as expedited shipping and premium component pricing. We have worked tirelessly with our customers to share in the absorption of these increased costs, particularly related to premium freight. Additionally, we've taken proactive steps to consolidate operations into another existing facility in response to these logistical challenges. We are confident this action will help reduce some supply chain risk, improve customer service, and ultimately drive margin expansion. Rob will provide more details on this restructuring later in the call. On the order front, we had a very strong quarter with over $100 million in new program awards, approximately 70% of which were for EV applications. Among these new awards, a large majority were for power distribution products. Focusing on EV, last quarter we reported that sales into EV applications comprised 16% of consolidated sales. This quarter, EV sales grew to 19% of consolidated sales, a record for Methode. Given our year-to-date performance with EV sales, we now expect that percentage will be in the high teens for the full fiscal year, up from our previous mid-teen guidance. Our EV activity continues to be fueled by growth in power distribution, where we leverage over 40 years of expertise to supply power products to various EV OEMs. In the quarter, we further reduced debt and continued to return capital to our shareholders. While our debt reached the lowest level since the Grakon acquisition, we did experience an increase in net debt as we utilized a portion of our available cash to execute a $21 million share buyback in the quarter. We've now executed over $70 million of the $100 million stock buyback authorization since it was announced last March. Moving to Slide 5, Methode had a very strong quarter of business awards. The awards identified here represent some of the key business wins in the quarter and represent over $100 million in annual sales at full production. As a reminder, the full launch timing of some of these programs could be anywhere in a range of one to three years from now. As you can see, the list is dominated by EV programs, representing three quarters of the dollar value. Within those EV awards, power products were the main focus with several busbar programs and a battery disconnect unit program. One of those busbar programs was a significant first win for Methode with a large established German automotive OEM. These EV awards, which are part of the skateboard of the electric vehicle, are expected to have a longer program life than traditional internal combustion engine programs, as the OEM will leverage their investment over multiple EV platforms and model refreshes. In non-EV automotive, we were awarded programs for several user interface applications, including HVAC switch bars, overhead consoles, and parking brake switches. We also won awards for motorsport headlamp and a micro DPU for a telecommunications company. Overall, it was a very successful quarter for new programs that will drive organic growth in future years. To conclude, it was a well-executed quarter by a worldwide team. And despite some ongoing demand headwinds and supply chain challenges, we are still expecting to deliver strong organic growth for fiscal 2022. Looking beyond this fiscal year, our award pipeline remains strong, as evidenced by this past quarter, putting Methode on a path to deliver long-term results. At this point, I'll turn the call over to Ron, who will provide more detail on our third quarter financials.

Ron Tsoumas, Chief Financial Officer

Thank you, Don. And good morning, everyone. Please turn to Slide 7. Third quarter net sales were $291.6 million in fiscal year '22 as compared to $295.3 million in fiscal year '21, a decrease of $3.7 million or 1.3%. The year-over-year comparison includes $8.6 million of premium freight cost recovery, partially offset by an unfavorable currency exchange impact on sales of $2 million. Excluding the premium freight cost recovery and the foreign currency impact, sales decreased by $10 million or 3.5%. The decrease in third quarter sales was mainly due to lower automotive sales in Europe. This sales decrease was partially offset by higher sales of electric and hybrid vehicle products, which amounted to 19% of sales in the quarter, higher than our previous communication that electric and hybrid vehicle sales would comprise a mid-teens percentage of our fiscal year '22 consolidated sales. We now expect electric and hybrid vehicle sales to represent the high teens of our full year fiscal '22 consolidated sales. Additionally, stronger commercial vehicle and power product sales contributed to the industrial segment's growth. Income from operations decreased by $5.6 million, mainly due to marginally lower gross margins and marginally higher selling and administrative expenses. Third quarter net income decreased $2.5 million to $29.4 million, or $0.78 per diluted share from $31.9 million, or $0.83 per diluted share in the same period last year. Please turn to Slide 8. Third-quarter gross margins were lower in fiscal '22 as compared to fiscal year '21, due to lower sales volume, unfavorable product mix, and higher restructuring costs, partially offset by premium freight cost recovery. Fiscal year '22 third-quarter margins were 23.7% as compared to 24.6% in the third quarter of fiscal year '21. Additionally, we do anticipate a degree of cost inflation in the remainder of this current fiscal year and into our fiscal year '23. Fiscal Year '22 third-quarter selling and administrative expenses as a percentage of sales increased to 11.8% as compared to 11% in the fiscal year '21 third quarter. The minor fiscal year '22 third-quarter percentage increase was mainly attributable to restructuring costs. This quarter's selling and administrative expenses percentage was in line with our historical norm, which should yield an efficient flow-through from gross margin to operating income. Please turn to Slide 9. Net income was negatively impacted by decreased sales, higher restructuring costs, unfavorable product mix, and higher selling and administrative expenses, partially offset by premium freight cost recovery, higher other income, and lower tax expense. In addition to the gross margin and selling and administrative items previously mentioned, there was one other non-operational item that significantly impacted net income in the third quarter of fiscal year '22. As mentioned, other net income was up by $2 million, mainly due to success in securing higher amounts of international government assistance between the comparable quarters and lower foreign exchange losses from re-measurements. The effective tax rate in the third quarter of fiscal year '22 was 12.2% as compared to 12.6% in the third quarter of fiscal year '21. The fiscal year '22 full-year estimate of between 16% and 17% includes the impact of the $2.2 million of discrete items recorded in the third quarter and is lower than a previous range of 17% to 18%. Shifting to EBITDA, a non-GAAP financial measure, fiscal year '22 third-quarter EBITDA was $47.9 million versus $51.3 million in the same period last year. EBITDA was negatively impacted by lower operating income, mainly due to increased restructuring costs and unfavorable product mix, partially offset by premium freight cost recoveries and higher other income. Please turn to Slide 10. In the third quarter of fiscal year '22, we reduced gross debt by $7.5 million and ended the quarter with $153.1 million in cash. During the first nine months of fiscal year '22, net debt, a non-GAAP financial measure, increased by $55.6 million, mainly due to share purchases of $63.9 million and unfavorable working capital changes, especially related to inventory, which increased by nearly $45 million due to supply chain-related challenges. Regarding capital allocation, on March 31, 2021, we announced a $100 million share repurchase program, of which we executed $21.3 million in purchases during the third quarter of fiscal year '22. Since the authorization's approval, we have purchased $71.2 million worth of shares at an average price of $44.72. 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 third quarter, free cash flow was $11.8 million, compared to $82.2 million in the third quarter of fiscal year '21. The decrease was mainly due to negative working capital changes, especially from inventory resulting from difficult logistics and accounts receivable, which had a significantly favorable impact in the third quarter of fiscal year '21 compared to the third quarter of fiscal year '22. Additionally, CapEx was $8.3 million in the current quarter as compared to $4.9 million in the third quarter of fiscal year '21. We do anticipate continuing a proven history of consistently generating reliable cash flows, which allow for ample funding of future organic growth, inorganic growth, and return of capital to shareholders. 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 $35 million to $45 million range, lower than our previous guidance of $45 million to $50 million. The decrease is simply the result of the timing of cash outflows of approved projects rather than any concerted effort to slow or reduce the cadence of our capital investment. Investing for future organic growth and vertical integration remains a key priority for our capital allocation strategy. We have a strong balance sheet and will utilize it by continuing to invest in our businesses for organic growth. In addition, we will continue to pursue opportunities for inorganic growth and measured return of capital to shareholders. Please turn to Slide 12. Regarding guidance, it is based on management's best estimate. External events such as headwinds from the ongoing negative impact from the chip shortage, logistical challenges, and other related items can potentially impact our future results, and these headwinds remain an ongoing challenge. While we have experienced increased success in recouping some incurred costs, we expect these headwinds will likely persist for the remaining three months of the current fiscal year. We increased our previously issued annual revenue guidance, mainly due to revenue from cost recoveries, which are considered non-product sales. The revenue range for the full fiscal year '22 is now between $1.16 billion and $1.17 billion, up from a range of $1.14 billion to $1.16 billion, largely due to the mentioned premium freight cost recoveries, which amounted to $8.6 million in the third quarter. The diluted earnings per share range has been tightened to $3.05 to $3.15 from the prior range of $3 to $3.20. The midpoint of our EPS guidance remains unchanged. Higher costs for materials, freight, and labor are a constant dynamic battle, and we remain uncertain as to when things will fully stabilize. Don, that concludes my comments.

Don Duda, President and CEO

Thank you very much, Matt. We're ready to take questions.

Operator, Operator

Certainly. Your first question is coming from Chris Howe from Barrington Research. Your line is live.

Chris Howe, Analyst

Good morning, everyone. Thanks for taking the questions. Starting first off, two questions here. With the new business wins, you mentioned approximately 70% of the applications going to the EV market. Can you talk about these new business wins in a little bit greater detail as far as how you anticipate the potential or maturation of these new business wins, as we move further out into the future over the next several years? I would imagine that we're just at the kind of initial stages of this and the potential for additional EV application wins should only increase from here?

Don Duda, President and CEO

Yes, I would agree with that. The EV awards will get their full launch as soon as 12 to 15 months from now. The major ones are at least 24 months out to maybe even 30 months until you achieve full launch. Just because it launches doesn't mean you're running at full rate, and they run the usual launch cycle similar to our internal combustion engine awards—there's nothing unusual there. As for the potential, as you launch these programs, you may see that carry over onto other platforms. For example, a $20 million annual program might increase to $30 or $35 million as you progress through the launch. So we do anticipate some of that occurring. A little more color: a lot of those are on the skateboard, which is exciting for us. It's hard to predict the duration of the programs; the contracts are four to five years, with some even longer. However, we are in uncharted territory regarding how long these programs will last. I believe it will be similar to a transmission program where our lead frame program extends over ten years or more. So, we expect to see longevity in the skateboard awards since there are not as many refresh cycles occurring. Moreover, I would emphasize that the majority of the awards, particularly the larger ones, are with established OEMs. This offers more confidence in the volumes as opposed to some of the startups we deal with, which makes it simpler to predict future revenues.

Chris Howe, Analyst

Perfect, very helpful. And next about the semiconductor situation. We're still undergoing the situation, and I think you believe it will go into fiscal year '23. As we think about that challenge, and perhaps also the challenges you're seeing in Europe, on a directional basis, how do you think that plays out in the first half of fiscal '23 and the second half of fiscal '23? When we glance at that compared to how the past year is unfolding.

Don Duda, President and CEO

If you take the approach that it takes about two years to add capacity, and that might be a little conservative, we are about a year into it—maybe a little longer depending on what was happening prior to the shortage in terms of capacity addition by the suppliers. So a conservative way of looking at it is to expect this to persist throughout this calendar year. Some people have predicted improvements in the second half, but we're gearing up for this challenge until capacity has sufficiently improved. That’s really how we view our guidance. And this is how we anticipate our fiscal '23 will pan out too.

Ron Tsoumas, Chief Financial Officer

Yes, I would say there is still a lot of uncertainty not only for us in securing components for shipping to our customers but also for the OEMs we serve—they’re still dependent on how well they have navigated this shortage. We expect this uncertainty to continue. One area where we have improved is in our success with cost recovery and in establishing more cost-sharing arrangements than we did earlier this year. We are certainly navigating the negative impacts as well as we can, but there remains significant uncertainty regarding how this will ultimately affect our customers and the demand for our products.

Chris Howe, Analyst

Okay. Many industrial companies are optimistic about the second half thesis, but in my opinion, that just means it's not going to be like the first half. We'll see how the second half unfolds. As a follow-up on some of your earlier comments, Q4 is typically your strongest quarter. Q3 is usually weaker. Are there any considerations or factors you see at this point regarding how this will play out in fiscal year '23, or is it too early to assess, and will the typical seasonality of the business run its course?

Don Duda, President and CEO

I agree; our fourth quarter is generally our strongest. However, as Bob has noted, supply chain issues can impact that. Looking ahead, we are like everyone else—there is significant uncertainty, so it’s hard to predict. On paper, our organic outlook looks solid, but we really need to see how the situation evolves in the second half of the year. It can be really challenging. Traditionally, this seasonality has been quite predictable, but the past two years have challenged that notion. So, it is difficult to share precise expectations for June or July.

Chris Howe, Analyst

Thanks for taking my call. I'll hop back in the queue to give others a chance. Thanks.

Operator, Operator

Thank you. Your next question is coming from John Franzreb from Sidoti & Company. Your line is live.

John Franzreb, Analyst

Good morning, everyone. And thanks for taking the questions. I'd like to start with the industrial business, which had a strong quarter year-over-year and grew sequentially despite the seasonal days off in the third quarter. What do January and February tell you about the recovery in the Class A truck market and how it’s looking for the balance of calendar 2022?

Don Duda, President and CEO

We view the commercial vehicle sector as a significant tailwind for us as we enter the second half of the year. Sales have been solid; last-mile vehicles, I think ACT has the numbers up, so we are very positive on that. That certainly contributed to a strong performance in Q3. The extent to which that is affected by shortages, we will need to monitor. Generally, we are optimistic about that segment moving forward.

Ron Tsoumas, Chief Financial Officer

We follow the ACT, and everything is looking pretty good. Unless something unexpected occurs, we would expect the fourth quarter to see further improvements.

Don Duda, President and CEO

Additionally, regarding restructuring, we moved our logistics out of Seattle due to port congestion and consolidated that into our Mexican logistics center. That will take some time to navigate, but we made this change to reduce inventory and improve our ability to service our customers more effectively. This decision is intended to mitigate some volatility in our operations.

Ron Tsoumas, Chief Financial Officer

And I would estimate that we will begin to see the results from that initiative in the first quarter of next year.

John Franzreb, Analyst

Got it. And just a little clarity on the premium freight recovery costs. It seems like in the press release, it was shown as having a zero impact on profitability. However, in the 10-Q, it appeared to have influenced the gross margin profile. Can you help me understand how this mechanism is working to clarify the overall concept here?

Don Duda, President and CEO

Sure, we are in a better position now compared to before. Before incurring any premium freight costs, we either contracted for cost-sharing, or we were recovering costs that had been incurred previously. The $20 million was a recovery for costs from the third quarter that we incurred in the first and second quarters when we faced significant negative impacts. Therefore, moving forward, we will continue to pursue recovery of any previously incurred premium freight or other costs. The success of these efforts could be seen in this quarter or the first quarter of next year. Those are the mechanisms we've put in place. We felt it was important to treat this as non-product sales and to highlight the significant success we've made. In the first two quarters, we achieved 240 basis points and recovered $7 million to $8 million each quarter, while in this quarter, it was negligible. We're making progress, and this is how we should generally think about this going forward.

John Franzreb, Analyst

That was helpful. One final question about the other income line—are there two items there? Is there a $2.2 million and $1.1 million? Is one a grant and the other a COVID recovery? How should I consider that line moving forward?

Don Duda, President and CEO

The other income line is made up of any government assistance, whether it's COVID-related or related to other funding opportunities we secure and the foreign exchange losses from re-measurements of our financial assets and accounts payable. These are the two main components, and we keep all government assistance in that other income line.

John Franzreb, Analyst

Are you still receiving government assistance since the fourth quarter? Is that part of your guidance?

Don Duda, President and CEO

In the fourth quarter, we will continue to pursue all forms of assistance. Success in that regard has been factored into our guidance.

John Franzreb, Analyst

Got it. Thank you for taking my questions.

Don Duda, President and CEO

Thank you.

Operator, Operator

Thank you. Your next question is coming from Nick Stephen from Baird. Your line is live.

Nick Stephen, Analyst

Hey, everyone. Thanks for taking my questions. My first one is that you updated 2022 guidance. Please walk us through the elements considered at the high and low ends of the guidance range and your perspective on the main swing factors for fiscal Q4.

Don Duda, President and CEO

So frankly, we need to focus on the 4Q guidance. Some factors influencing this are the pace and extent of recovery in European automotive relative to the significant $60 million decrease we had in the third quarter—from a product standpoint. Part of this also relates to recovery in some of our sensor products. Therefore, the cadence and extent of that recovery form the range of $10 million—these are the key elements we considered in tightening our guidance.

Nick Stephen, Analyst

Perfect, thanks.

Operator, Operator

Thank you. That concludes our Q&A session. I would now hand the conference back to Don Duda, President and CEO of Methode Electronics for closing remarks. Please go ahead.

Don Duda, President and CEO

Matt, thank you very much. We thank everyone for listening today and enjoy the coming weekend. Thank you.