Earnings Call Transcript - NDSN Q3 2020

Operator, Operator

Ladies and gentlemen, thank you for standing by and welcome to the Nordson Corporation Third Quarter Fiscal Year 2020 Conference Call. At this time, all participants are in a listen-only mode. After the speakers’ presentation, there will be a question-and-answer session. Please be advised that today's conference is being recorded. I would now like to hand the conference over to Ms. Lara Mahoney. Please go ahead.

Lara Mahoney, Vice President of Investor Relations and Corporate Communications

Thank you. Good morning. This is Lara Mahoney, Vice President of Investor Relations and Corporate Communications. I'm here with Sundaram Nagarajan, our President and CEO; and Joseph Kelley, Executive Vice President and CFO. We welcome you to our conference call today, Thursday, August 20, 2020, to report Nordson’s fiscal year 2020 third quarter results. Our conference call is being broadcast live on our audio webpage at nordson.com/investors and will be available there for 14 days. There will be a telephone replay of the conference call available until September 3, 2020. During this conference call, references to non-GAAP financial metrics will be made. A complete reconciliation of these metrics to the most comparable GAAP metric has been provided in the press release issued yesterday. Additionally, forward-looking statements may be made regarding our future performance based upon Nordson’s current expectations. These statements may involve a number of risks, uncertainties, and other factors as discussed in the company's filings with the Securities and Exchange Commission that could cause actual results to differ. After our remarks on the quarter, we will be happy to take your questions. With that, I'll turn the call over to Naga.

Sundaram Nagarajan, President and CEO

Good morning, everyone. Thank you for joining Nordson’s fiscal 2020 third quarter conference call. With me today is Joe Kelley, the new Chief Financial Officer of Nordson. I'm pleased to welcome Joe to the call this morning. Joe joined Nordson on July 6 and brings over 25 years of financial and operational expertise to Nordson, most recently serving as Chief Financial Officer of Materion, a global advanced materials company. I'm very excited to have him on board. He's already bringing great energy and perspective to our leadership team. First, I want to thank our Nordson employees for their continued flexibility, resilience, and commitment as we have navigated 2020. They remain focused on protecting the health and safety of our employees and responding to the needs of our customers. Nordson products serve a very diverse set of end-markets, including medical, electronics, consumer non-durables, and general industrial. This diversity has helped drive the relative stability of our results to this point in the year. By maintaining new safety measures, our team has risen to the challenge and continues to meet the needs of our customers who depend on us to help them drive efficiencies, enhance innovation, and continuously supply aftermarket parts and consumables that keep their manufacturing lines running smoothly. While we remain focused on managing this dynamic environment, the Nordson leadership team and I are equally committed to making progress towards our strategic priorities of accelerating organic growth, diversifying through acquisitions, leveraging the Nordson Business System, and building winning teams. On June 1, we announced the acquisition of Fluortek, a precision plastic extrusion manufacturer in the medical device industry. Fluortek brings highly differentiated PTFE medical tubing expertise, which is complementary to our current value-added component offerings for minimally invasive therapies such as heart valve replacement. Growing our Nordson Medical business continues to be a priority of our capital deployment strategy. We're pleased to have the Fluortek employees as part of the Nordson team. Also during the quarter, we continued to develop the next generation of the Nordson Business System, which we're calling NBS Next, Nordson's growth framework. Our new segment realignment, which unleashes an owner mindset at the division level, allows our teams to make decisions as close to the customer as possible. Using critical insights created by segmentation tools in NBS Next, our division leaders were empowered to prioritize investments and simplify non-value-added tasks to deliver best-in-class product quality and delivery. Staying invested in what makes Nordson strong, our customer-centric business model and precision technologies will position us to accelerate profitable growth when the economy recovers. I'll speak more about the business in a few moments, but first I'll turn the call over to Joe to introduce himself and provide a more detailed perspective on our financial results for the quarter.

Joe Kelley, Executive Vice President and CFO

Thank you, Naga, and good morning to everyone. I am very pleased to join Nordson, which has a long-established reputation as a high-quality company that consistently delivers top-tier financial results. I look forward to partnering with Naga and the leadership team to drive the next chapter of profitable growth for Nordson. We have an extremely solid and rich foundation on which to build, and I am honored to be part of the team. With that in mind, let's turn our attention to the fiscal third quarter financial results. Third quarter 2020 sales decreased 4% compared to the prior-year third quarter. The decrease was primarily related to organic volume as unfavorable currency effects were offset by the benefits from the Fluortek acquisition. The company's diverse end market and geographic exposure, as well as broad product applications contributed to the relatively strong commercial performance in these challenging times. Our combined Asia region led the way by delivering 3% growth in the quarter. Gross margins totaled $281 million or 52% of sales in the quarter compared to $303 million and 54% of sales in the prior year. The 200 basis point decrease in margins is attributable to $1.2 million of inventory step-up amortization related to the Fluortek acquisition, unfavorable sales mix, and COVID-19 manufacturing inefficiencies. As our factories addressed employee safety needs in this challenging time with precautionary quarantining of employees, implementing social distancing, rotational staffing, etc., a combination of these three factors contributed to the lower gross margin percentage in the quarter. We anticipate the majority of these headwinds to be temporary in nature and forecast returning to our historical gross profit margin levels. Operating profit in the quarter was $112 million or 21% of sales, excluding nonrecurring items in the quarter related to cost reduction actions and the acquired inventory step-up amortization, adjusted operating profit totaled $120 million, a 9% decrease from the prior-year adjusted operating profit. EBITDA for the third quarter was $148 million or 28% of sales, which is 7% below the prior year EBITDA of $159 million. Looking at nonoperating expense, net interest expense decreased $4 million or 37% from the prior-year levels, associated primarily with the lower effective borrowing rate. Other net expenses increased $10 million associated with an unfavorable $5 million year-over-year swing in currency gains and losses and a $5 million increase in pension cost. $3 million of the pension increase was related to a noncash pension settlement charge associated with the prior CEO. Tax expense in the quarter totaled $9 million or an effective tax rate of 9% in the quarter. The rate was driven lower by a $12 million discrete tax benefit associated primarily with non-recurring levels of stock option exercises and deferred equity compensation. Excluding these discrete items within the quarter, the effective rate would more closely reflect the company's long-term tax rate of 20% to 22%. Net income in the quarter totaled $87 million or $1.49 per share. Excluding non-recurring adjustments to operating profit, the non-cash pension settlement charge, and discrete tax benefits, adjusted earnings were $83 million or $1.42 per share. This represents a 12% decrease from the prior year adjusted earnings reflective of the 4% decrease in sales volumes. Cost reduction actions taken in the quarter to structurally lower the ongoing cost profile of the company totaled $6 million and primarily related to severance payments. These actions are forecasted to deliver annualized savings of approximately $11 million to $12 million. Looking at the segment performance, Industrial Precision Solutions’ sales decreased 6% compared to the prior year third quarter. Stable demand from product lines serving consumers in non-durable markets were offset by weakness in sales of product lines serving industrial markets. Asian markets appear to be recovering from the lower COVID-19 demand levels. Operating profit for the quarter was $75 million or 26% of sales. Excluding $3 million in structural cost reduction and simplification actions, EBITDA was $86 million or 30% of sales, a decrease of 200 basis points compared to the prior year third quarter. Advanced Technology Solutions sales decreased approximately 2% compared to the prior year third quarter. This change included a decrease in organic sales volume of 3% and an increase of approximately 2% related to the Fluortek acquisition. Currency impact was minimal. Sales volume increases in test and inspection product lines serving the electronics end-markets and stable demand in medical product lines were offset by weakness in fluid dispense product lines serving industrial end-markets. The stable demand in medical reflects strength in some product lines offset by meaningful softness in the other product lines, more closely tied to elective surgery. It's important to note that the definition of elective surgery has been broadened during the early months of this pandemic, particularly in the US. However, we are starting to see market signs that elective medical procedures are beginning to ramp back up. Within the Advanced Technology Solutions segment, reported operating profit was $50 million or 20% of sales in the quarter. Excluding one-time charges associated with the cost reduction actions and inventory step-up amortization, EBITDA was $71 million or 29% of sales, in line with prior year profits despite the 2% decrease in sales. Finally, turning to the balance sheet and cash flow. We ended the quarter with a strong balance sheet and plenty of available borrowing capacity. Cash totaled $222 million and net debt was $1 billion, ending the quarter with a 1.8 times leverage ratio based on the trailing 12 months EBITDA. Free cash flow in the quarter was $82 million, which brings the year to date free cash flow conversion rate to net income to 119%. Investing activity in the quarter totaled $135 million driven by the $125 million acquisition of Fluortek. Dividend payments were $22 million in the quarter and the company's board approved a 3% increase in the annual dividend effective in the fourth quarter of 2020. This marks the 57th consecutive year the company has increased its dividend. We remain very confident in the cash flows of the company and are committed to returning a portion of the cash to shareholders in the form of a consistently increasing dividend. In summary, our top line has held up well considering the challenging macroeconomic environment. While we benefit from the diversity of the end markets we serve, the team has responded in a great way in supporting our customers and delivered solid performance while controlling costs in the quarter. We continue to maintain a strong balance sheet with sufficient liquidity to allow us to stay focused on long-term strategic initiatives to drive organic and inorganic growth. I'll now turn the call back to Naga.

Sundaram Nagarajan, President and CEO

Thank you, Joe. I'm pleased with the performance the team delivered in a very challenging environment. I’d like to make note of few areas. First, I appreciate the strong performance of our teams in Asia Pacific and Japan. They successfully managed through the challenges of COVID-19 earlier this year. Through it all, they remained focused on serving the customer. As a result, they delivered growth in the quarter. Revenue in the Asia-Pac region increased 3% compared to prior year. We had a very productive virtual review of our Asia businesses several weeks ago. Taking our executive team on a virtual tour of the facilities and new product pipeline, it is clear that the regional team is making meaningful progress in broadening in-country new product application and service expertise and resources to serve our customers in the region. Second, I'd like to acknowledge the strong results of our test and inspection product lines, which are up double digits year-over-year. Test and inspection has been a focus area of our acquisition strategy, and we have built a robust offering of T&I product lines including X-ray, acoustic imaging, bond testing, and automated optical inspection capabilities. As advanced electronic components and semiconductor technology for 5G, AI, and memory applications are becoming increasingly sophisticated, the need for T&I equipment is growing. Nordson’s diverse portfolio of solutions and technical expertise is making us a go-to partner for global customers. In fact, our matrix inline automated X-ray, offline DAGE X-ray and bond testing, and SONOSCAN acoustic imaging product lines had direct sales in the fiscal third quarter. As I mentioned earlier, I'm encouraged that our teams are beginning to use a data-driven approach with NBS Next Segmentation Tools to prioritize investments to position their businesses for profitable growth as their recovery begins. In July, I participated in a progress review of the four pilot businesses who are currently deploying NBS Next. I'm pleased with the curiosity and experimentation in how our teams are beginning to apply data-centered insights to enhance customer service levels. Nordson’s geographic and end market diversity is one of our greatest strengths. In this period, our Test & Inspection, Consumer Non-Durable, and Medical end markets are helping balance the weakness of industrial end markets that are still under pressure. Our recurring revenue of aftermarket parts and consumables contributes to our relatively stable performance in these dynamic times. Looking at the fourth quarter, our order entry rate has come off of the lows experienced early in the quarter. The trailing four-week order entry as we enter the fourth quarter is approximately 93% compared to prior-year levels; and the 12-week order entry is approximately 90% compared to the same period last year. Backlog has decreased approximately 3% compared to the prior year. Based on these data points, we expect our fiscal fourth quarter revenue to be comparable to slightly better than the third quarter 2020 revenue. We also expect low single-digit sequential growth in earnings. I want to thank our colleagues around the world for their incredible commitment to our customers. This is an uncertain time for many, and the team’s strong execution is commendable. As always, I want to thank our customers, employees, and shareholders for their continued support. With that, I'll pause and take your questions.

Operator, Operator

First question comes from Matt Summerville with D.A. Davidson.

Matt Summerville, Analyst

Thanks. A couple of questions. First, on the medical side of the business, can you talk about how much of that is being driven by what is now being defined as elective versus non-elective? I guess I was under the impression that the elective portion was pretty minimal.

Sundaram Nagarajan, President and CEO

Yeah. Thanks, Matt. As we entered the quarter, the definition of what is elective and what is selective, as you know, continues to broaden. And so, because of that, we did have some impact in our businesses. But if you look at our medical portfolio product offering, you have a fairly broad and diverse offering that not only serves the minimally invasive surgeries such as heart replacement or stent placement. We also have a number of surgical as well as fluid management product offerings. And so, what we saw really was a surge in demand for our fluid management product offerings, like pulmonary treatments. It certainly helped us come in flat to last year in the medical business, less than what we have experienced, historically, 4% to 5% growth. So, it was lower than that, but it was flat to last year. And to put it in context, what I’ll tell you is if you take a look at medical device manufacturers, many of them in this environment are down mid-teens. Therefore, we're really pleased, and it is slightly lower than our expectation, but very pleased that the team was able to come in on a flat year-over-year basis for medical.

Matt Summerville, Analyst

Got it. Thank you for that color. And then just as a follow-up, can you provide an update on what you're seeing in fluid dispense as it pertains to consumer electronics, 5G project activity, and what the outlook is there? Thank you.

Sundaram Nagarajan, President and CEO

What we see is the early stages of project activity. We had a good quarter last quarter, if you remember on the fluid dispense side for our electronic businesses. What we see is continued project activity. In the electronic side, we're finding a lot of applications for these new complex components that go into AI applications, a number of advanced 5G-related products, be it out of electronics or mobile devices, where you have increased antenna requirements, increased camera modules, increased numbers of microphones as well as micro speakers. So, a lot of advanced components and we are seeing a lot of project activity on that. But primarily on the electronics side, where we see strength and had a really strong quarter, was in our test and inspection, which is more geared towards the semiconductor side of the business rather than the components side.

Operator, Operator

Next question comes from Jeff Hammond with KeyBanc Capital Markets.

Jeff Hammond, Analyst

Hey, I just want to really understand, kind of the order trend through the quarter, and you kind of gave some different numbers, you know, 12-week trend, 4-week trend. Just kind of, really get a better sense of, you know, kind of what the true trend is in terms of, you know, things getting sequentially better. And maybe where particularly you're seeing things get sequentially better. Thanks.

Sundaram Nagarajan, President and CEO

No, thank you, Jeff. To clarify, we feel given the dynamic environment, it was important for us to provide you with more color than we normally do. As we entered the third quarter, if you looked at the 12-week order rate, we think of the 12-week order rate as a little more longer-term and stabilizes the near-term environment. Given the current dynamics, we felt that it was important for us to take a look at something shorter term so that we can gauge what is happening. The best way to think about the current environment is to think about it more sequentially. As we navigated through the third quarter, sequentially the order trends for the total company were starting to improve. We entered the quarter with six-week order trends being more in the range of 11% down. As we exit the quarter, we begin to see that order trend is closer to down 7%. So that's the sort of framing to help you.

Jeff Hammond, Analyst

That's helpful. Where do you think you are seeing the best sequential improvement?

Sundaram Nagarajan, President and CEO

Yeah. Let’s break it down to regional perspectives and end markets. In the US, the order trends are stabilizing, albeit at a lower level that we talked about. In the Americas, particularly in Latin America and Mexico, we still remain challenged given all that is going on in Mexico and Brazil. In Europe, we see a meaningful pickup and a trend up sequentially compared to the third quarter. In Asia, as you've seen in our third quarter numbers, we reported growth in Asia, but when compared to last year, it remains flat. In terms of end-markets, what I would tell you is some of the industrial end-markets remain challenged. Businesses that have industrial exposure, like our ICS business or our fluid dispensing in EFD, they remain challenged. Our medical business continues to be flat, and order entry rates are flat and we feel good about that. Our fluid dispensing in non-consumer, non-durables is flat to slightly up. Our electronic business, as we talked about, and test and inspection had a strong quarter. So, this provides you a range of scenarios, but the essence is that we are managing to a very dynamic environment.

Jeff Hammond, Analyst

Thank you for the update, Naga. Regarding Fluortek, can you share its annual revenue contribution, its growth rate, and how its margin compares to the overall medical business or at least the Advanced Tech segment? Additionally, what new products or markets does this provide that you didn't have access to before?

Sundaram Nagarajan, President and CEO

I think let me give you some strategic color around how things are panning out in the first couple of months here. It’s a great little business; it's a niche business for us. It brings to the company PTFE tubing, the inner lubricious layer of the tube that is used to place stents or heart valves. It is a very niche product and a great complementary addition to our delivery mechanism in core component offerings. In terms of the integration, we really like the business. The technology is solid. As we've spent time within the business, it reaffirms our strategic thought about adding this. Let me turn it to Joe to provide some color around financials.

Joe Kelley, Executive Vice President and CFO

Jeff, just to give a little more color, the annual revenue on this business is approximately $20 million. From a margin profile standpoint, it is comparable to our current ATS business.

Operator, Operator

Next question comes from Christopher Glynn with Oppenheimer.

Christopher Glynn, Analyst

Thank you. Good morning. I just wanted to go into the medical piece for a little bit. I'm curious about how you're thinking about maybe pent-up demand for elective products. It’s obviously a pretty important business for you where it had great success over the past. I'm wondering how you're thinking about the prospects for pent-up demand, assuming it's not too late for some people in search of elective procedures.

Sundaram Nagarajan, President and CEO

Yeah. Chris, it's a great question. We fundamentally believe there is pent-up demand that we would enjoy as surgeries come up. We're beginning to see early signs of hospitals opening up and certainly trying to increase the number of surgeries. It will be a slow ramp-up. This environment is very dynamic. But in general, we feel very strongly about the growth drivers for medical. Even with those postponements, the team came in with flat revenue year-on-year, which is very strong performance.

Christopher Glynn, Analyst

That's great. Appreciate that. And then my follow-up is, just, kind of, an update on what you're seeing in terms of momentum. You touched on, kind of, the handset features and things like that. But for 5G, both for infrastructure and for handsets, compare contrast. Do you expect that ecosystem around 5G is likely to be your most robust vector in fiscal 2021 at this early juncture?

Sundaram Nagarajan, President and CEO

The 5G activity and project activity remain strong. There are lots of promises around 5G. We are invited to many different projects that we're working on. However, at the moment, 5G is not a needle mover for us. We are more excited about the base station infrastructure build-out, which is behind schedule. Also, we are looking at advanced components that will be developed—IoT devices will be a big player for 5G too.

Operator, Operator

Next question comes from Mike Halloran with Baird.

Mike Halloran, Analyst

A couple of margin questions here. So on the ATS, if you think about the sequential margins going into your fiscal fourth quarter, do you expect same mix pressures that were there in the fiscal third quarter?

Sundaram Nagarajan, President and CEO

Yes. I think, similar in ATS, the mix pressure will be there, and we assume it to be consistent into the fourth quarter.

Mike Halloran, Analyst

That makes sense. Then the inefficiencies you referenced for the Industrial Precision business, could you provide some context on those and how long do you think they linger?

Sundaram Nagarajan, President and CEO

Our factories initially responded during the COVID crisis with significant measures. While they remained open, we had to implement safety protocols that led to some inefficiencies. We've made progress during the quarter, and we anticipate as we adjust to the new normal, we will continue to improve throughout Q4.

Mike Halloran, Analyst

Thanks for that. Lastly, on Fluortek, can you share your thoughts on the pipeline as it looks from here and what the ability to convert some of that pipeline looks like as we sit here today?

Sundaram Nagarajan, President and CEO

As you think about M&A, our focus is on scaling up medical and T&I. Our pipeline still has a number of opportunities, but given the environment, this is not the time that many companies want to transact. Opportunities remain, and we're cultivating them. If some of them come to market, we will certainly act on them strategically.

Operator, Operator

Next question comes from Andrew Buscaglia with Berenberg.

Andrew Buscaglia, Analyst

Good morning. I had a question on Industrial Precision. I was way off on modeling there, and my expectations were there because we have some tougher markets with auto, energy, and other exposures. I'm curious why did trends in those specific businesses surprise you, or is there resiliency in those tougher areas? Can you talk a little more about what you're seeing there and your outlook for the more difficult segments?

Sundaram Nagarajan, President and CEO

In IPS, this has traditionally been a strong part of the company focused on adhesive business that serves recession-resilient markets, such as food and beverage packaging. The aftermarket component is about 50% of the market, which has helped with stability and growth. However, industrial end markets remain challenged due to CapEx deferrals and shutdowns in the automotive industry. The diversity within the segment has helped us perform fairly well overall.

Andrew Buscaglia, Analyst

No, that's really helpful. I guess in a post-COVID world, are you thinking about any of these businesses differently? Or are there any pruning opportunities that you can make to some of your areas?

Sundaram Nagarajan, President and CEO

Our portfolio management entails consistent annual review of all product lines, looking through the lenses of growth potential and degree of differentiation. We make decisions based on our expectations. If things do not add up to our expectations, we will act on some product lines. This process has proven successful over the years.

Operator, Operator

Next question comes from Walter Liptak with Seaport. Walter?

Walter Liptak, Analyst

I wanted to ask a little bit more about the industrial. I wonder if you could help us understand any of the trends. We saw things getting better in May and June, but with virus cases going up recently, do you see things weaken again.

Sundaram Nagarajan, President and CEO

We don't seem to find industrial strength much. It seems to have stabilized at a lower level than our other businesses. It remains challenged but hasn't gone down further from where it was. It’s important to note that for major capital outlays, manufacturers will be cautious in this environment.

Walter Liptak, Analyst

Is it down because the customers are cautious on their CapEx spending, or is there difficulty with getting sales engineers out in the field?

Sundaram Nagarajan, President and CEO

Primarily, it is the larger CapEx spend where clients are cautious and aren't making major capital outlays especially when demand issues linger. However, we've found that, though there are some restrictions, communication with engineers and specifications have increased due to virtual engagements. Sales interactions are up, allowing for better customer connections.

Walter Liptak, Analyst

Thank you for that. And then I wondered about supply chain. We've heard about some parts shortages. How do you feel about your supply chain? And, also, you mentioned the segmentation work in MDS is a pilot project. Can you give us insights on which segments and what improvements we should expect over the next six to nine months?

Sundaram Nagarajan, President and CEO

We did not mention supply chain issues because we had none. Our strong supply chain team and risk mitigation plan helped avoid significant disruptions. Regarding NBS Next, we view it as a growth framework and have selected strong businesses to implement it. We anticipate improvements in customer metrics over the next 12 to 18 months with a focus on understanding top-tier growth opportunities for the company.

Operator, Operator

And at this time, I will turn the call over to Naga.

Sundaram Nagarajan, President and CEO

Thank you. While the near-term demand conditions stabilize at a reduced level, I remain excited about the future of Nordson. We have a solid foundation fortified by the diversity of our business and our strong customer-centric business model. We’ll continue to monitor this dynamic environment to ensure we're taking appropriate action to manage the business while staying focused on our long-term objective of making a strong Nordson even stronger by accelerating organic growth, diversifying through acquisitions, leveraging the NBS Next growth framework, unleashing an owner mindset, and focusing on building winning teams. Again, thank you for your time and attention on today's call.

Operator, Operator

This concludes today’s conference call. You may now disconnect.