Earnings Call Transcript - MEI Q4 2022

Operator, Operator

Good morning, ladies and gentlemen. Thank you for standing by. Welcome to the Methode Electronics Fourth Quarter Fiscal 2022 Results. At this time, all participants are in a listen-only mode. After management’s prepared remarks, there will be a question-and-answer session. I would now like to turn the call over to the host, Vice President of Investor Relations, Robert Cherry. Sir, please go ahead.

Robert Cherry, Vice President of Investor Relations

Thank you, operator. Good morning, and welcome to Methode Electronics fiscal 2022 fourth 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 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 fourth 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 $289 million, increasing our sales by $7 million with successful spot buy and premium freight cost recovery efforts. However, our Automotive segment encountered demand headwinds in North America and Europe due to program roll-offs and the ongoing global supply chain disruptions. Also in Europe, the extent of the weakness in the auto market, due to the conflict in Ukraine, was worse than expected. Also unexpected were the COVID-19 lockdowns in China, which led to weaker-than-forecasted sales in Asia. While the overall sales for the quarter were in our expected range, sales could have been better, reducing the effects of other headwinds. We continue to face ongoing supply chain challenges in the quarter. Our team worked diligently to mitigate these challenges, which required 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. You may recall that we had made solid progress on this front in the third quarter. However, in the fourth quarter, we saw even more acceleration in our material, labor, and freight costs. Our ability to obtain reimbursement for or to offset these costs is likely to lag as a matter of process as long as inflation continues. In addition, the demand weakness in Europe resulted in an unfavorable product sales mix. All of these factors, along with some unanticipated expenses, significantly changed the landscape from the time that we provided guidance until the quarter closed at the end of April. Going forward, we will work to mitigate the cost increases and product mix impacts as we have successfully done in the past. Ron will elaborate further on this later in the call. On the order front, we had another very strong quarter with over $100 million in program awards. Of these awards, approximately 90% were EV applications with a variety of products, customers, and regions. I will provide more color on our awards in a moment. Focusing on EV, last quarter, we reported that sales in the EV applications were 19% of the consolidated sales. This quarter, EV sales were 70% of consolidated sales; the lower percentage was directly related to the COVID-19 lockdowns in China. Nonetheless, it was our second-best quarter ever for EV sales. Given ongoing momentum in our EV activity, we're expecting sales to reach 20% of our total sales in fiscal 2023. In the quarter, we further reduced debt and now have the lowest debt levels since the Grakon acquisition. We also made progress on reducing working capital and delivered strong free cash flow of $34 million. Last Thursday, in addition to our quarterly dividend, we announced a $100 million increase to our existing stock buyback authorization. As of the end of the fourth quarter, we now have approximately $129 million of capacity in the authorization, which expires in June of 2024. Moving to Slide 5. Methode had another very strong quarter of business awards. The awards identified here represent some of the key wins in the quarter and account for over $100 million in annual sales at full production. As a reminder, the full launch timing of most of these programs could be anywhere in the range of one to three years from now. Also, some of these awards are notable volume increases on existing OEM programs. As you can see, the list is dominated by EV programs representing 90% of the dollar value. What’s also clearly noticeable is the rich variety among the awards. They include power, lighting, and sensor products that cover the top hat and skateboard of an EV. They are with seven different auto OEMs and they are in our three main geographic regions: Europe, the U.S., and Asia. The EV market growth trend and our exposure to it continues to be robust. In other applications, we were awarded programs for an e-bike sensor, an off-road vehicle control module, and a datacenter busbar assembly, all strategic and growing markets and applications for Methode. Overall, it was a very successful quarter for awards that will drive organic growth in future years. Turning to Slide 6 and our fiscal 2022 highlights, we delivered sales growth for the fifth year in a row and finished with record sales of $1.164 billion for the full year. Even excluding $22 million in cost recovery and a favorable impact on foreign exchange, we have over 4% year-over-year sales growth. Supply chain challenges and the market disruptions during the year took a toll on earnings. However, program awards were very strong, reaching almost $300 million. We had record sales in the EV application for the year, and they reached 70% of our total sales for the full year. As I already mentioned, we see that number reaching 20% in fiscal 2023. Our balance sheet story is one that we continue to be proud of, with our debt level now at the lowest level since the 2018 acquisition of Grakon. While our free cash flow generation was down year-over-year, it was still healthy and supported the purchase of over 1.4 million shares of stock as well as our ongoing dividend program. With a strong award pipeline for the past two years and the effort Methode made to diversify its product portfolio further into lighting, power and sensors, we’re now confident to announce a three-year organic sales compounded annual growth rate target of 6%. This target demonstrates that our business model is not just healthy, but it is prospering from the strategic steps that we've taken to grow the business. Turning to Dabir, we achieved over $4 million in sales for the year. The key factor to the success of this business has always been and will continue to be the ability to conduct product evaluations at hospitals. While the interest in the product has remained high in recent years, the COVID-19 pandemic has been a headwind over the last two-plus years to our ability to execute these evaluations, as sales generally lag evaluations. However, we remain confident in those prospects, but we're also exploring options to engage external mechanisms to help accelerate the growth of the business going forward. To conclude, it was a challenging year characterized by ongoing demand headwinds and supply chain challenges. However, our worldwide team still delivered organic sales growth throughout the year. Moving forward, I am confident with the team's experience and operational expertise that Methode is positioned to mitigate these pressures and deliver sales and earnings growth for fiscal 2023. Looking beyond 2023, we are confident in our strategy and our award pipeline continues to be robust. This firmly puts Methode on a path to deliver on our 6% compounded annual sales growth target over the next three years. At this point, I'll turn the call over to Ron, who will provide more detail on our fourth quarter and full year financials.

Ron Tsoumas, CFO

Thank you, Don. And good morning, everyone. Please turn to Slide 8. Fourth quarter net sales were $288.7 million in fiscal ‘22, compared to $301 million in fiscal 21, a decrease of $12.3 million or 4.1%. Fiscal ‘22 sales include a $7 million of spot buy in premium freight cost recovery, partially offset by an unfavorable foreign currency impact of sales of $5.7 million. Excluding the spot buy premium freight cost recovery and foreign currency impact, sales decreased by $13.6 million or 4.5%. Sales declined in the automotive and industrial interface segments, but increased in the medical segment. The decrease in the fourth quarter sales was mainly due to program roll-offs in North America, supply chain issues in North America, and weakness in Europe due to the conflict in Europe. While year-over-year sales in Asia were higher in fiscal ‘22 as compared to fiscal ‘21, the lockdown in China due to the zero COVID policy impacted our fourth quarter results, especially with respect to our March guidance issuance. This weakness was partially offset by higher sales of EV product applications, which amounted to 17% of sales in the quarter and for the full year. We now expect EV sales to represent over 20% of our full year fiscal ‘23 consolidated sales. Income from operations decreased to $14.6 million from $33.7 million, mainly due to higher costs because of material cost inflation, spot buys, increased unreimbursed freight that accelerated during the quarter and our ability to fully recover the increased costs from our customers was hampered from a timing perspective. Also, reduced sales and unfavorable product mix contributed to the decline in operating margin. Fourth quarter net income decreased $14.9 million to $16.2 million or $0.43 per diluted share from $31.1 million or $0.81 per diluted share in the same period last year. Please turn to Slide 9. Fiscal ‘22 fourth quarter gross margins were 19% as compared to 25.1% in the fourth quarter of fiscal ‘21. A key factor in the decline of the consolidated gross margin profile was the sharp decline in the industrial segment margin profile, which is our highest margin segment by far. Industrial segment gross margins decreased to 24.4% in the fourth quarter, down sharply from the 40% gross margin in fiscal ‘21 4Q and the fiscal ‘22 third quarter year-to-date gross margins of 34.3%. Of the overall margin decrease in this segment, approximately 50% was due to material cost inflation and premium freight and related issues, and 25% was related to inventory-related items such as unfavorable absorption due to the China lockdown, increased profit, and ending inventory eliminations and other year-end inventory adjustments. While some of the items may recur in fiscal ‘23, we anticipate the impact to be noticeably less than what was incurred in the fourth quarter. In the automotive segment, the margin decrease was due to higher costs from material inflation and premium freight spot buys, lower sales volumes, and unfavorable product mix. 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 place in process for recovery in future periods. Our inability to pass along premium costs to our customers amounted to $3.4 million, or approximately $0.07 per diluted share in the fourth quarter. We do anticipate cost inflation and supply chain disruptions to continue in our fiscal ‘23. Fourth quarter selling and administrative expenses as a percentage of sales was flat at 12.3% in both relevant quarters. Our selling and administrative expenses percentage of sales is consistent from a cost structure perspective and should yield an efficient flow-through from gross margin to income from operations. Please turn to Slide 10. Net income was negatively impacted by the items mentioned prior and lower other income, partially offset by a lower tax expense. The effective tax rate in the fourth quarter of fiscal ‘22 was 5.8% as compared to 15% in the fourth quarter of fiscal ‘21. Most of the effective tax rate difference was due to a mix of jurisdictional earnings and the impact of US GILTI tax on foreign earnings. Shifting to EBITDA, a non-GAAP financial measure. Fiscal ‘22 fourth quarter EBITDA was $30.8 million versus $50.8 million in the same period last year. Even though it was negatively impacted by higher costs of material, cost inflation, spot buys, premium freight, lower sales volumes, unfavorable product mix, and lower other income. Please turn to Slide 11. Full year net sales increased $75.6 million to $1.164 billion, which is a record and the fifth consecutive year of increased sales. Sales included $22.1 million of spot buy and premium freight cost recovery and $5 million attributed to foreign exchange. Without the cost recoveries and foreign exchange, sales increased approximately $48 million or 4.4%. For the full year, income from operations was $111.7 million, a decrease of $16.2 million or 12.7% from the $127.9 million of income from operations in fiscal ‘21. Income from operations was negatively impacted by lower gross margins and increased selling and administrative expenses, mainly due to increased stock compensation expense, as fiscal year ‘22 had 12 months’ worth of expense compared to seven months in fiscal ‘21. Fiscal ‘22 diluted earnings per share was $2.70, compared to $3.19 in fiscal ‘21, mainly due to the impact from higher costs from material cost inflation, premium freight spot buys, higher selling and administrative expenses, and a higher effective tax rate of 13.8% as compared to only 9.3% in fiscal ‘21, which benefited from a significant amount of foreign investment tax credits. Please turn to Slide 12. In fiscal ‘22, we reduced gross debt by $29.6 million. Since our acquisition of Grakon in September of 2018, we have reduced gross debt by $147 million. Net debt, a non-GAAP financial measure, increased by $31.6 million to $38.5 million in fiscal ‘22, from $6.9 million at the end of fiscal ‘21, mainly due to the share repurchases of $64.5 million and unfavorable working capital changes, especially related to inventory which increased significantly due to supply chain-related challenges. We ended the fourth quarter with $172 million in cash. Our debt-to-trailing 12 months EBITDA ratio, which is used for our bank covenants, is approximately 1.19, well below our covenant threshold of 3.5. Our net debt-to-trailing 12 month EBITDA ratio was 0.22. Please turn to Slide 13. Free cash flow, a non-GAAP financial measure, is defined as net cash provided from operating activities minus CapEx. Fiscal year ’22 fourth quarter free cash flow was $33.6 million as compared to $31.2 million in the fourth quarter of fiscal ‘21. Improvements in working capital allowed for the higher generation of cash in the quarter. For the full fiscal ’22, we generated net cash provided by operating activities of nearly $99 million as compared to $180 million in fiscal ’21, with lower net income of $20 million and a nearly $77 million unfavorable swing and changes in working capital accounting for most of the difference. For the full fiscal ’22, we generated free cash flow of nearly $61 million as compared to $155 million in fiscal ‘21. CapEx was higher by $13 million in fiscal ‘22 as compared to fiscal ‘21. For fiscal ‘22 cash generation was solid but trailed the following year, mainly due to fiscal ‘21 working capital reductions which were noted at the time as not being likely repeatable in fiscal ’22. We expect free cash flow to improve in fiscal ‘23 as we target reduced inventory levels and other positive working capital initiatives. The strengthening of the USD in fiscal ‘22 costs a nearly $12 million unfavorable swing in the FX on cash and cash equivalents and the cash flow statement year-over-year. Regarding capital allocation, on June 16, 2022, we announced a $100 million increase to our existing stock buyback program, of which approximately $29 million remains, bringing the total amount available for purchases to approximately $129 million. The 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 so we can better support our 'build where we sell' strategy and better position ourselves to capitalize on the EV megatrend. We do have a strong balance sheet, and we'll continue to utilize it by continuing to invest in our businesses to grow them organically, pursue opportunities for inorganic growth, and measure the return of capital to the shareholders. Please turn to Slide 14. Regarding fiscal ‘23 guidance, it is based on management's best estimates, including the impact of the COVID-19 pandemic, the headwinds from the ongoing semiconductor shortage, short and long-term supply chain rationalization, other logistic challenges from the conflict in Ukraine, and the latest impacts on our financial results, which remain an ongoing challenge. While we have experienced some success in recouping some cost recoveries, we weren't as successful in the fourth quarter as we were in the third, and we do expect some of these headwinds will likely be with us for the majority of fiscal ‘23. The revenue range for full fiscal ‘23 is between $1,160 million to $1,210 million. The anticipated growth at the midpoint of our range considers the impact of the GM T1 program rolled off, which had sales in fiscal year ‘22 of over $100 million. We expect EV sales to be at least 20% of consolidated sales in fiscal ‘23, up from 17% in ‘22. The diluted earnings per share range is $2.70 to $3.10, unchanged from the June 14 pre-announcement, and contemplates continued headwinds from supply chain inflation and other macroeconomic events. We are expecting softer earnings in the first quarter of fiscal ‘23, with EPS improving as the fiscal year progresses. Our estimated effective tax rate is between 16% and 18% without any discrete items. We anticipate increased CapEx of between $40 million and $50 million as we expand our capabilities to support the growth in EV sales and strategically position our footprint to support production of our significantly increased order pipeline that we have built over the last two fiscal years. Depreciation and amortization expenses are expected to be between $54 and $58 million. Lastly, based on the strong bookings we have realized over the past two fiscal years, much of which is for the EV market, we announced the organic compounded annual growth rate target of 6%. This CAGR takes into account the anticipated roll-off of the relevant programs and reinforces our organic growth strategy that's putting the company on a solid future organic growth trajectory. Don, that concludes my comments.

Don Duda, President and CEO

Thank you very much. Kelly, we are ready to take questions.

Operator, Operator

Certainly. The floor is now open for questions. Your first question is coming from Luke Junk with Baird. Please pose your question. Your line is live.

Luke Junk, Analyst

Good morning. Thanks for taking the questions today.

Don Duda, President and CEO

Good morning, Luke.

Luke Junk, Analyst

For starters, I want to start on the top line. Hoping you could help us unpack the lower sales and power distribution that you said in the quarter. Should we read that as purely a reflection of the market and the weakness that you called out in China? And I would assume probably Europe to some extent as well, or is there anything else that we should be aware of there?

Don Duda, President and CEO

I would say, there's nothing unusual. This is the way the orders flow. Ron, do you have any additional comments? It was the slowest quarter and the last of several, but nothing particularly notable. Ron?

Ron Tsoumas, CFO

Yeah. Luke, I think the lockdown that we experienced in China negatively impacted our ability with our products as well. As that has lifted, we would expect that to relieve that pressure in the first quarter of this year after the lockdown is lifted.

Luke Junk, Analyst

Okay, thank you for that. And then switching to margins, but staying with industrial, maybe a question for you, Ron. Can you just help us better understand the earnings bridge versus last year in the segment? If I look at the top line down to a few million dollars, but income from operations off more than $10 million. And what I'm wondering is, how much of this is timing-related or temporary in terms of things like mix or whatnot, as opposed to something that you'll need to ultimately recover from your customers and could have more of a lasting impact as we look into the first half of next year, I’d say?

Ron Tsoumas, CFO

I focused specifically on the industrial segment because it has the highest margins. You're correct in noting the margin mix compared to our year-to-date, which was a 40% margin last quarter. About 50% of that margin was affected by factors like material costs, excessive freight, and spot buys, but we expect to see some recovery in the future. Additionally, some of the inventory-related issues I mentioned, including adjustments and profit eliminations based on the inventory in transit, contributed to this. We don't expect these costs to persist, and they are more difficult to predict. Therefore, we anticipate that our industrial gross margins in fiscal year 2023 will align more closely with our historical performance rather than what we saw in the fourth quarter.

Luke Junk, Analyst

Okay, thank you for that clarification, especially the last comment there. And then the last thing I wanted to ask is a related question, but in the auto business. And just want to make sure we're reading the $7 million of spot buy and premium freight cost recovery in the quarter correctly. Specifically, I don't know if you can disclose how much of that pertained to the current quarter, i.e., offset to the cost of the experience in the quarter versus some kind of clawback of cost that you had incurred in prior quarters?

Ron Tsoumas, CFO

Probably half and half; look at a high level 50% each.

Luke Junk, Analyst

Okay, great. Well, I will go ahead and leave it there. Thank you.

Don Duda, President and CEO

Yes. And Luke, I just want to clarify on your first question when we were talking about power and actually the effect. I agree with Ron, the EV power was certainly affected by the shutdown in Asia. But also our non-EV power had a slower quarter than in the past. Again, there's nothing special there, perhaps a little bit affected by the lockdown, but more just the order rate. But I just wanted to clarify that, that was really two areas of our power group.

Operator, Operator

Your next question is from John Franzreb with Sidoti & Company. Please go ahead with your question. Your line is open.

John Franzreb, Analyst

Good morning, guys, and thanks for taking the questions. Take a step back, you've carved out freight, labor, and material as the reasons for the margin degradation. For the company as a whole, how much either dollar values or percentages did that impact the fourth quarter on either relative or sequential basis?

Ron Tsoumas, CFO

So, in the fourth quarter, we had about $3.5 million net impact.

John Franzreb, Analyst

On all three of those categories.

Ron Tsoumas, CFO

Yeah. So what we billed as price recovery and what we incurred as price recovery was a net negative of about $3.5 million.

John Franzreb, Analyst

Okay. And would you look at the slope of clawing back those costs, is it something that's going to take time for any specific reason? Or could you get that back relatively quickly?

Don Duda, President and CEO

Let me address that. First, I've never had to approach a customer more than once in a short period for price increases or expedited requests, which is quite rare in the auto and commercial vehicle sectors. We have been able to recover those costs, and the team performed well up until the third quarter. However, in the fourth quarter, we encountered more resistance due to the duration of these discussions. As I've mentioned before, this process can take six to twelve months. If we present a scenario to the customer where we can ship parts but need to incur extra overtime or face unusual costs, and the customer agrees or adjusts their purchase order, all of that will happen in the same quarter. Generally speaking, when it comes to material price increases or freight cost recovery, it is a lengthy process, and customers are facing similar pressures as we are. We experienced significant resistance in the fourth quarter. While I believe we will ultimately succeed, as we have historically, this remains a challenge that I mentioned in my opening remarks, and it will persist until inflation decreases. Do I believe we will recover the costs we incurred in the fourth quarter during this new fiscal year? Yes, but the timing is somewhat uncertain.

John Franzreb, Analyst

Okay. Regarding the GM T1 program. Are you supplying? Is there any more revenue from that program that's going to be hit in the first quarter of this year?

Ron Tsoumas, CFO

On the GM T1 lightweight truck program that has rolled off, we will have zero revenue this quarter, and it’s fully rolled off fourth quarter.

John Franzreb, Analyst

Right. Just make sure that. And you've referenced that you expect the first quarter EPS to be soft. I'm just wondering if you're comparing to a year ago, or you're comparing it to the fourth quarter?

Ron Tsoumas, CFO

For the full fiscal year, we expect to see a gradual pace from quarter to quarter, and we anticipate some softness in the first quarter as a continuation of the trends from the fourth quarter.

John Franzreb, Analyst

Okay. So in cadence-wise it's the softest. But you're not suggesting that it's going to be down versus the fourth quarter.

Ron Tsoumas, CFO

That's correct.

John Franzreb, Analyst

Perfect. Okay. And just I guess one last question regarding your CapEx? Are there any significant programs you plan on initiating that we should be aware of in the coming year?

Ron Tsoumas, CFO

Well, a fair amount of our CapEx is going to be increased capacity for our EV grants that we've won. It's going to be a significant amount of CapEx to do that. So I don't know that there's any particular program that will be CapEx intensive that is rolling on this year. But overall, with the two years of robust bookings that we've had, especially in the EV space and the power side, especially, we're going to have to increase our CapEx to accommodate that growth.

John Franzreb, Analyst

Okay, thank you very much for taking my questions. I appreciate it.

Don Duda, President and CEO

Thank you.

Operator, Operator

There appear to be no further questions in queue at this time. I would now like to turn the floor back over to Donald Duda for any closing remarks.

Don Duda, President and CEO

Thank you, Kelly. Well, thank everyone for listening and their questions. I wish everyone a very safe and pleasant summer. Good day.

Operator, Operator

Thank you. Ladies and gentlemen, this does conclude today's conference call. You may disconnect your phone lines at this time. Have a wonderful day. Thank you for your participation.