MSA Safety Inc Q2 FY2022 Earnings Call

Good day, and welcome to the MSA Q2 2022 Earnings Conference Call. Please note, this event is being recorded. I would now like to turn the conference over to Chris Hepler. Please go ahead. Thank you, Chad. Good morning, and welcome to MSA’s Second Quarter 2022 Conference Call. This is Chris Hepler, Executive Director of Corporate Development and Investor Relations. I’m here with Nish Vartanian, Chairman, President and CEO; and Ken Krause, Senior Vice President, CFO and Treasurer. Before we begin, I’d like to remind everyone that matters discussed during this call may include forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements include, but are not limited to, all projections and anticipated levels of future performance. Forward-looking statements include a number of risks, uncertainties and other factors that may cause our actual results to differ materially from those discussed today. These risks, uncertainties and other factors are detailed in our SEC filings. MSA undertakes no duty to publicly update any forward-looking statements made on this call, except as required by law. We have included certain non-GAAP financial measures as part of our discussion this morning and the non-GAAP reconciliations as well as our second quarter press release are available on our Investor Relations website at investors.msasafety.com. Moving on to today’s agenda. Nish will discuss key highlights of the quarter and then turn the call over to Ken to discuss our financial performance. Nish will then provide closing remarks. Following our prepared remarks, we will open the call for questions. With that, I’ll turn the call over to Nish.

Thank you, Chris, and good morning, everyone. Before getting into the details of the quarter, I’ll start today’s call by sharing some information that has all of us at MSA very excited. Within the past several weeks, we were able to finalize significant breathing apparatus contracts with two of the most recognized fire departments in the world. As you may have read in our recent press release, the Los Angeles County Fire Department has selected the G1 SCBA as its new respiratory protection system. Following up that exciting news, we learned that the London Fire Brigade selected the MSA M1 SCBA as its new breathing apparatus of choice. You can find more information on that contract in our press release issued Tuesday. Today, the MSA brand is a global leader in the firefighter safety market, and we’re grateful for the trust that LA County and the London Fire Brigade continue to place in us. Both wins are excellent examples of cross-selling to existing customers who already know MSA from fire protective clothing and helmets. A key element of our strategy is to 'protect the firefighter' from head to toe. Through a combination of product development initiatives and inorganic investments in well-established brands like Globe and Bristol, our team continues to advance that strategy. When we look at our business more broadly, overall demand continued to be very strong in the quarter across most of our core products and markets. Orders were up 15% in the quarter on a constant currency basis and 10% organically. Book-to-bill continued to trend well above 1x again this quarter, and in July, we continue to see good growth in orders over the prior year. Our quarterly revenue, which continues to be restrained by supply chain issues, was $373 million, up 9% from a year ago on a reported basis and 12% on a constant currency basis. Currency translation was a 3% headwind in the quarter. Ken will discuss this in more detail in his remarks. Backlog at quarter end was again at a record level of over $400 million as a result of strong demand and ongoing supply chain issues. Backlog has increased steadily over the past 1.5 years and is up across all product categories. Supply chain and inflation continue to be factors, and we expect this to persist in the near term. As anticipated, supply chain issues were most pronounced in electronic components in our gas detection business. Our teams are working on a number of initiatives to address these challenges. We continue to build supply chain resiliency, especially for electronic components, by engineering redesigns to increase flexibility for high-risk components, as well as qualifying alternative components and suppliers, and we’re using more technology to get better visibility to future availability of components. We’re also considering greater insourcing for certain key components, and we’re consciously building select inventory to serve our customers in high-demand areas. Building inventory is a good use of our strong balance sheet in this challenging environment to ensure we can respond to our customers’ expectations. All things considered, I remain very optimistic around the fundamentals of our business and the durability of customer demand for MSA products and solutions. Shifting gears a bit, in June, we published our annual Corporate Social Responsibility report. As I’ve said on many occasions, Corporate Social Responsibility is at the heart of what we do at MSA. Our mission is to keep the world’s workers safe each and every day so they may return home safe to their families. As I reflect on our progress, I’m energized about both our vision for the future of worker safety and the next steps in our CSR journey. We continue to make investments in products, services and connected worker solutions that reimagine the next generation of worker safety. We also continue to enhance our programs around environmental sustainability and talent, as well as various risk reduction programs such as the supply chain resiliency programs I just talked about. We do this because at MSA, we know these are the kind of investments that help us to build a better business model in these times. Our people continue to bring passion for our mission, which inspires us to design, develop, and manufacture the world’s best safety solutions that protect people who put their trust in the MSA brand. While I’m very pleased with our results this quarter, our journey continues to make our company, our associates and our customers fit for the future. With that, I’ll now turn the call over to Ken for his comments.

Thanks, Nish, and good morning, everyone. On today’s call, I’ll provide a recap of our second quarter financial performance and review key balance sheet and cash flow metrics. Quarterly sales were $372 million, up 9% on a reported basis. On a constant currency basis, quarterly sales were up 12% and 8% organically, driven by both price realization and improvements in volume. Currency translation impacted consolidated sales by 3% this quarter, largely due to euro and British pound exposure in our International business. Orders were very strong in the quarter across the portfolio, up 15% on a constant currency basis over last year. Organic orders also showed double-digit improvement, reflecting healthy trends across both price and volume. Quarterly book-to-bill was in excess of 1.1x, and we saw double-digit year-over-year growth in orders each month throughout Q2 and continue to see a robust order pace into July. While we saw strong sales and order growth in the quarter, supply chain issues continue to constrain our growth and drive up our backlog. As Nish mentioned, we finished the quarter with record backlog, driven by robust customer demand and ongoing supply chain challenges. Backlog was up by another $50 million from the first quarter. The increase was primarily attributable to SCBA, firefighter protective clothing and gas detection. Now turning to profitability, gross profit was 44.2% of sales in the quarter. Acquisition-related intangible asset amortization impacted gross margin by 60 basis points in the quarter. Adjusting for amortization in both periods, quarterly gross margin was down slightly on a year-over-year basis. This was driven by higher inflationary pressures and product warranty charges, offset by improved pricing, especially in the Americas segment. Pricing remains at the top of our agenda, and our team is focused on managing the price/cost equation. SG&A expense in the quarter was $86 million or 23.1% of sales, up $3 million from the prior year. The increase was largely attributable to higher employee wages and costs associated with increased business activity. As a percent of sales, we realized strong leverage in SG&A on the double-digit sales growth, which offset the gross profit headwinds I mentioned previously. Reported operating margin was 16.5%, up 620 basis points over the prior year. On an adjusted basis, operating margin was 17.6%, up 40 basis points on margin accretion from Bacharach. With that, I’ll provide a closer look at our segment performance. In our Americas segment, we had strong growth in sales, up 16% or 10% organically. Adjusted operating margin was 22.6%, in line with the prior year. In our International segment, sales were down 3% on a reported basis but up 5% in constant currency, or up 2% in organic constant currency terms. The quarterly currency translation headwind was significant at 8% on the weaker euro and pound that I mentioned previously. Adjusted operating margin was 14.3%, down 220 basis points from last year due to unfavorable currency headwinds, large orders and higher input costs impacting gross profit, offset partially by improvements in SG&A performance. We continue to see very good leverage in international SG&A from our restructuring programs that we’ve executed over the past couple of years. GAAP net income was $48 million or $1.21 in earnings per share, compared to GAAP net income of $25 million or $0.64 in earnings per share in the prior year. On an adjusted basis, adding back in both periods, product liability expense, restructuring and similar items, net income was $51 million or $1.29 in adjusted EPS, a 22% increase over the prior year on the 9% increase in reported sales. Just over a year ago now, we completed the acquisition of Bacharach. Bacharach expanded our gas detection business into new applications and expanded our addressable market. The business is performing very well. Demand is strong and backlog is robust. Margin performance has been very strong, quite frankly, ahead of our expectations with adjusted operating margins trending just under 30% for the quarter and year-to-date periods. Turning to cash flow and the balance sheet. Quarterly free cash flow was $4 million. Free cash flow was impacted by an increase in working capital, notably inventory and receivables, in response to strong customer demand and ongoing supply chain bottlenecks and receivables associated with strong shipping at the end of the quarter. Inventory is up approximately $60 million from year-end on the over $100 million increase in backlog. Given the dynamic nature of the supply chain and availability of certain components, we are investing in inventory to help deliver our backlog. We do expect to see improvements in inventory as we expect to see sequential strengthening in the second half revenue performance versus the first half. Quarterly CapEx was $12 million. We paid $18 million of dividends to shareholders and deployed $28 million to repurchase shares during the quarter. At the end of the quarter, we had cash of $134 million and net debt of $489 million or 1.6x adjusted EBITDA for the trailing 12 months. Our second quarter performance demonstrated the strength of our diversified business. As we navigate through an increasingly uncertain economic environment, our teams continue to focus on getting product out the door and managing the price/cost equation. We entered the second half of the year with solid underlying demand in our end markets and a robust backlog. Our strong balance sheet positions us well to invest in our business and provides good optionality as we continue to focus on execution and driving long-term, profitable growth for our shareholders. Before wrapping up, I just want to comment on our outlook. Despite the dynamic macro environment, our end markets remain very healthy. Funding in the fire service is healthy. The OGP market is supported by strong commodity prices, and construction and utilities are performing well. That said, there are increasing risks of a recession in many of our key regions. As such, our internal planning continues to consider a range of economic scenarios, and we are prepared to take actions in the event we see a softening in our business.

Thank you, Ken. In closing, I want to highlight a couple of things. We certainly acknowledge the growing economic uncertainties from rising interest rates, high inflation and recession risks, but I remain very confident in the fundamentals of our business and our team’s ability to work through the challenges of today’s macroeconomic environment. Our end markets remain healthy, and robust underlying demand for our products and technologies continued in the second quarter and well into July. We entered the second half with a record backlog and a very healthy balance sheet, which we’re putting to work, building some inventory in high-demand product areas to better serve customers who put their trust in the MSA brand. I look forward to our team executing our plan in the second half to continue to bring strong results. I thank you for your interest in MSA. At this time, Ken and I will be glad to take any questions you may have.

We experienced growth in the second quarter and into July. As we move into the second half, we have a record backlog and a strong balance sheet, which we are utilizing to build inventory in high-demand areas to better serve our customers who trust the MSA brand. I am eager to see our team implement our plan in the second half to deliver positive results. I appreciate your interest in MSA, and Ken and I are now happy to take any questions you may have.

What are you observing in the Americas? The breathing apparatus is up 26% and head protection is up 18%. Is some of that due to the supply chain perhaps recovering a bit? I'm curious about how to consider this when thinking about the rest of the year.

The end-user markets are really strong. The oil and gas industry is performing well. The construction industry continues to do quite well for us, and our general industrial business is also good, alongside utilities. This drives a significant portion of our hard hat and portable gas detection business. We are seeing good demand for fixed gas and flame detection products, although we are currently facing some delays in getting them out. We expect that situation to improve in the second half of the year. The fire service business is well funded, and we have a robust opportunity pipeline. We are starting to secure some of that business, as seen with the L.A. County Fire Department and other sizable orders. We are also approaching the assistance to firefighter grant season, with funds being released in the second half of the year, which should lead to strong demand for breathing apparatus. Overall, the end-user markets are very positive. It is not just a case of distributors restocking; many of our products are made to order, and we do not see a significant backlog built into that. The general environment remains strong for us.

Looking at the financial performance with more detailed data, the Americas segment's book-to-bill ratio exceeded 110%, and despite a 26% growth in constant currency revenue for breathing apparatus, it also had a book-to-bill ratio above 1. The demand remains exceptional, with industrial head protection also above 1, which is generally not ideal since we prefer to respond to customers quickly. However, demand continues to be very strong as we manage through the quarter.

And basically, it sounds like demand is tracking ahead of expectation, but then you have the FX piece. So just kind of putting all those together. Help us with the wins. Very nice to see a lot of the investments you guys have made on the SCBA side. When should you start to see the flow through for either for L.A. or for London?

So the L.A. order will ship for the most part in the third quarter. We expect to start shipping those in late August, maybe September. So we should see most of that order go in the third quarter. Some of it may stray into the fourth quarter, based on the customer expectations and what they’re looking for. London will probably start to ship beginning in the fourth quarter, and that will extend into actually the second quarter. They have laid out a delivery schedule for us and continue to refine that. So we expect that to be spread out over 3 quarters.

And then lastly, we’re hearing concerns about manufacturing especially in Europe with energy cost, et cetera. How big of a concern is that for you all? Maybe some of the things you all can do to kind of help mitigate some of those higher costs over there?

So we continue to analyze the situation in Europe. We’re staying close to it, obviously, with some of the challenges that might arise due to pure economic impact of a recession in Europe. Secondly, the impact that might have on our supply chains and inflation. We continue to look at some alternative solutions to where we are sourcing some products out of Germany to have secondary resources, and we continue to look at strengthening and working with some of those suppliers. We’re not shy about building some inventory. We talk about building inventory and using the balance sheet to build inventory, where we have the opportunity to do that to offset some of those unknowns in the marketplace. We’ll certainly do that, Stanley.

The next question is from Larry De Maria with William Blair.

Nice job and outlook. A question, incrementals were a little bit below what we expected, but still, obviously, overall good performance given the choppy environment. But can you just talk to your ability to hit those mid-30s incrementals in the second half, which I think we’re all hoping for, but can you just give some color on that?

Yes, that's a great question, Larry, and I appreciate it. This is Ken. As we look toward the latter half of the plan, we see an opportunity to return to the level of incremental margin profile you mentioned. Our internal plans confirm this expectation, and we believe it is realistic. When considering the second half and the various drivers, we want to stress that we anticipate stronger revenue performance sequentially. If that materializes, which we are confident it will, we expect significant leveraging across our business, particularly in SG&A. We do not foresee major increases in SG&A sequentially between now and the second half. The additional revenue that comes in would certainly enhance our incremental margins significantly. Additionally, product mix will play a role. When we examine our backlog and our business, certain higher-margin products, like gas detection products, are currently facing supply chain challenges. Improvement in this area during the second half would provide a favorable boost to our incremental margin profile.

That’s very helpful. Should we consider it still an incremental margin build through 3Q to 4Q or hopefully hit those numbers both quarters? Or is it kind of fourth quarter heavy? I think last year, obviously, we had a good fourth quarter.

When you look at the business and you look at how the business profiles in terms of seasonality, Q3 is normally a pretty healthy quarter. We expect it to be healthy. However, Q3 also is impacted by European holidays and other sorts of events. We do have some confidence in our ability to see high mid-single-digit year-over-year growth to low double-digit year-over-year growth in Q3 versus last year. Q4 has historically been our strongest quarter of our year, so we expect that to be very similar again as we think about the second half of 2022. Summing it all up and looking at our business, it wouldn’t be unreasonable to expect a high single, low double-digit sort of increase in revenue in the second half versus what we saw here historically.

Perfect. Regarding the new contracts, you mentioned $9 million for London. Can you provide some context on whether this is just the beginning and if there’s potential for more revenue generated this year? Additionally, how is LUNAR performing? Is it a viable option? Please clarify if this is the start of more opportunities in London and L.A. or if this represents the total potential.

The beauty of both departments. L.A. has been an MSA customer for turnout gear. They’ve been a user of Globe turnout gear for many years, which helped us to build our relationship in L.A. to win that business. That’s part of the cross-selling advantage we have with covering the firefighter from head to toe. So that’s what we saw in that. LA had ordered all their units with integrated thermal imaging cameras, the iTIC. They are evaluating and will continue to look at LUNAR as an opportunity. That would be a longer-term project with Los Angeles because of the size of the department and the magnitude. And putting that into their SOPs. They chose to go with the iTIC. The London Fire Brigade was also a Bristol Uniforms customer, and so again, able to leverage some of those relationships to help us with that business. They have their own type of unit that they use very specific to the London Fire Brigade. That million dollars is for all of the business from London. What we do anticipate is surrounding departments to follow London. This is our first major win in the U.K., and a number of departments are looking to London and what they did with their choice of breathing apparatus. We certainly expect that this is going to help us with our business profile in the U.K., probably Scotland, Ireland and some of the other countries in that region, just as the win with Boston helped us with the Northeast part of the U.S. It’s a pivotal win for us. A number of departments around the world look to that win. London is also taking a look at LUNAR and find the technology intriguing. But again, for a large department like that, that would be a much longer-term decision due to putting that into their SOPs and rolling out a major change in product like that. So those opportunities continue to be out there for us.

The next question is from Rob Mason from Baird.

I just wanted to see if you could update us on, I guess, your pricing plans for the second half of the year. You mentioned along with supply chain components still being a challenge at times, inflation as well. I’m just curious what you’re seeing on the inflationary front and whether it’s triggered any additional thoughts around adding price?

We noticed that inflation eased somewhat in the second quarter after being higher in the first quarter. In North America, we implemented a price increase in April and have another planned for June for our International division. We are continuously assessing the need for further price adjustments later in the year. We're still working to align with the pricing, and we anticipate that the increases from April and June will be effective in the upcoming quarters. If necessary, we will consider implementing additional increases later in the year. The North American division also executed an off-cycle price increase in November, which is under discussion based on the inflation trends and supply chain challenges we observe moving forward.

Just perhaps relatedly, Nish, you mentioned the AFG funding cycle about to get underway. Any prospects for inflation to be accounted for in some of the thresholds around products? I guess the funding levels themselves may be fixed. But could that help you on that front deal with the inflation or the customer deal with inflation as well?

A really insightful question. We are, in fact, working with the administration on pricing and increase in pricing. They have just recognized when we brought it to their attention the fact that all manufacturers are seeing inflation in the supply chain, and we are working with them to up the limits on the amount that the fire departments can spend on turnout gear, breathing apparatus, et cetera. They’re aware; we’ll probably see that work into the cycle for 2023, but they’re certainly aware of it. We’re working with them on it. There’s still room in the current funding pricing levels for them to purchase the breathing apparatus. A number of departments, municipalities will supplement some of those dollars with local dollars, so we are working on it.

Sure. Just a final question about the supply chain challenges and component availability. At one point, we were discussing fixed gas flame, all the gas detection products, and self-contained breathing apparatus. I’m not hearing as much about self-contained breathing apparatus now, and your volumes are increasing. Has the issue with self-contained breathing apparatus been resolved?

I wouldn’t say the issue is completely resolved. However, we are in a significantly better position with our SCBA situation. Our suppliers have consistently met their commitments through the second quarter and have provided us with components. The outlook for the third and fourth quarters is optimistic, but it's important to note that supply chains can be quite unpredictable, and we may encounter surprises along the way. Currently, the supply chain for breathing apparatus appears to be stable, and we hope it remains so for the remainder of the year since we have a substantial backlog to fulfill. Regarding fixed gas and flame detection, we have discussed our self-support initiatives and the qualification of alternative electronic components. We anticipate some volume production from what we refer to as the X&S 5000, which is a key product in our fixed gas and flame detection line. We believe we can start producing these in volume in the third quarter, with even larger quantities expected in the fourth quarter. This should improve as we continue through the year. However, we must remain mindful of the risks associated with supply chains and the need for suppliers to adhere to their commitments.

Ladies and gentlemen, this concludes our question-and-answer session. I would like to turn the conference back over to Chris Hepler for any closing remarks.

Thank you for joining us this morning. If you missed a portion of the conference call, an audio replay and transcript will be available on our Investor Relations website for the next 90 days. We look forward to speaking with you again soon. Thank you.

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