Nn Inc Q1 FY2020 Earnings Call

Good day, and welcome to the NN, Inc. First Quarter 2020 Earnings Conference Call. Today's conference is being recorded. At this time, I'd like to turn the conference over to Mr. Mark Schuermann. Please go ahead.

Thank you, operator. Good morning, everyone, and thanks for joining us. I'm Mark Schuermann, Vice President, Treasurer and Investor Relations. I'd like to welcome you to NN's first quarter 2020 earnings conference call. Our presenters this morning will be President and Chief Executive Officer, Warren Veltman; and Tom DeByle, Senior Vice President and Chief Financial Officer. If anyone needs a copy of the press release or the supplemental presentation, please contact Abernathy MacGregor at (212) 371-5999. Before we begin, I'd ask that you take note of the cautionary language regarding forward-looking statements contained in today's press release, supplemental presentation and in the Risk Factors section in the company's annual report on Form 10-K for the fiscal year ended December 31, 2019, and when filed, the company's quarterly report on Form 10-Q for the 3 months ended March 31, 2020. Same language applies to comments made on today's conference call, including the Q&A session as well as the live webcast. Our presentation today will contain forward-looking statements regarding sales, margins, foreign exchange rates, cash flow, tax rate, acquisitions, synergies, cash and cost savings, future operating results, performance of our worldwide markets, the impacts of the coronavirus pandemic on the company's financial condition and other topics. These statements should be used with caution and are subject to various risks and uncertainties, many of which are outside the company's control. Presentation will also include certain non-GAAP measures as defined by SEC rules. A reconciliation of such non-GAAP measures is contained in the tables in the final section of the press release and the supplemental presentation. Warren and Tom will provide a business update and review our results, and then we will open up the line for questions. At this time, I will turn the call over to Warren Veltman, President and CEO.

Thanks, Mark, and good morning, everyone. As everyone is aware, there have been substantial changes in the world since our last conference call 2 months ago. At that time, the coronavirus threat had not significantly impacted our businesses outside of China, but today, all of our operating segments and geographies have been adversely impacted by the COVID-19 pandemic. I'm proud to say that NN's employees have risen to meet one of the greatest challenges of our generation. Our employees have adapted to numerous workplace changes required to combat the spread of the coronavirus and have maintained a safe working environment for all. As a team, they continue to meet our customers' volume requirements while adhering to the high-quality standard that is the trademark of all NN facilities. So before I start my prepared remarks on the quarter, I want to express my sincere thanks for their collective efforts over the last 3 months. Thank you. We'll start with an overview of the first quarter on Page 4. Given this economic uncertainty caused by COVID-19, we took immediate action to react to what we viewed would be a threat to the health and safety of our employees and a substantial and potentially prolonged reduction in our sales volumes. Our plan is focused in 4 major areas: one, keep our employees safe; two, meet our customer requirements; three, flex variable costs and reduce fixed costs; and four, fortify our liquidity. From a cost containment standpoint, our operating groups are focused on reducing variable costs commensurate with our sales volume reductions. These costs would primarily include material and perishable tooling, direct labor and outsource-related costs. Unfortunately, to accomplish this objective, we have furloughed both direct and indirect employees where customer volumes have been dramatically reduced. We have also taken action to reduce some fixed manufacturing and SG&A expenses. I will review a summary of those actions later in the presentation. Fortifying our liquidity is of supreme importance. To that end and prior to the end of the first quarter, we drew down $60 million under our revolving credit facility, and we held $79.2 million in cash at March 31, 2020, including $57.2 million in the United States. We will also review other actions we are taking to retain as much liquidity as possible during the balance of 2020 later in the presentation. Moving on to financial performance in the first quarter. Our sales were $199 million for the quarter, down $13.5 million or 6.3% from the prior year after consideration of foreign exchange differences. Our Life Sciences group reported sales of $84 million, down $2 million or 2.3% from a year ago. This decrease is a result of reduced customer demand within the orthopedic end market driven by the timing of product launches and the impact of the COVID-19 pandemic. Mobile Solutions sales were $69.9 million, a year-over-year reduction of $8.2 million, primarily due to lower demand within the global automotive markets resulting from the COVID-19 pandemic, especially during March. Our Power Solutions group reported sales of $46.4 million in comparison to sales of $49.7 million a year ago. Our reported EBITDA, excluding the goodwill impairment for Q1, was $16.2 million and adjusted EBITDA was $30.4 million. Adjusted EBITDA was slightly down from the first quarter a year ago due primarily to the year-over-year decline in sales, offset by fixed cost and SG&A reductions. Our Life Sciences group reported EBITDA, excluding goodwill, of $17.8 million, while Mobile Solutions and Power Solutions each reported $6.2 million for the quarter. The first quarter operating loss of $245 million is primarily due to the write-off of $239.7 million of goodwill during the quarter. This action resulted in a write-off of 100% of the Power Solutions goodwill and $146.8 million of goodwill associated with our Life Sciences group. This write-off also adversely impacted our reported EPS as we reported a loss of $5.96 per share versus a loss of $0.47 per share a year ago. Tom will discuss the accounting rationale associated with the goodwill impairment later in the presentation. Our free cash flow for the first quarter was a use of $1 million, an improvement of $15.7 million from the first quarter a year ago. As we discussed last quarter, we expected an $8 million benefit in the first quarter due to having maintained our trade payables in a better aged position at December 31, 2019, versus December of 2018. The remaining improvement is due to cost reductions we have implemented, lower capital expenditures and improved working capital management. Lastly, we previously announced a strategic review where the company will evaluate a broad range of operational, financial and strategic options with the goal of reducing leverage and enhancing shareholder value. This process is ongoing, and it is clear to us that despite the current economic environment, there continues to be a substantial number of potential buyers for high-quality assets and businesses. As we have said before, we have a great company and really good businesses. And moreover, our organizational structure allows for good flexibility as we continue our strategic review and look to enhance shareholder value. This is the extent of our disclosure and comments regarding this process. As always, we appreciate your understanding and patience as we continue to pursue alternatives associated with this important initiative. Circling back to our overall COVID-19 plan, Page 5 summarizes some of the action regarding maintaining a safe work environment for our employees. We have taken measures to enhance employee communication and education surrounding the coronavirus and employee-driven preventative actions. We have also coordinated a standard response protocol with local health officials based on CDC recommendations and are conducting daily temperature screening of on-site personnel and visitors. We're issuing appropriate personal protective equipment and performing frequent and responsive workplace cleaning and disinfection. On Page 6, we have presented a summary of our efforts to further reduce costs and improve liquidity. All of these actions are in addition to our previously announced goal of improving cash flow by $32 million annually. That goal has been achieved. Given the uncertainty regarding the COVID crisis, we feel that immediate action was required to reduce additional costs and preserve our liquidity. We have already implemented cost reductions that include temporary salary reductions for all executive management team members of 20% to 25% and temporary reductions for other salaried personnel of 5% to 15%. Other significant cost reductions include reductions in employee benefits, including the suspension of the 401(k) matching employee and gainsharing programs, suspension of noncritical travel and further streamlining of our indirect and SG&A labor costs. These new cost reductions exceed $20 million annually. As it relates to the liquidity enhancement measures, we have reduced our capital expenditure expectation to below $35 million with an extreme bias towards authorizing only maintenance CapEx items going forward. We also expect to benefit from certain provisions under the CARES Act. The ability to increase depreciation and interest expense deductions in 2018 and '19, along with new carryback provisions will allow us to carry back 2018/'19 losses back to 2017 to recover taxes paid in those years. In addition, we will be deferring the employer portion of FICA tax until 2020 and '22, including the cost actions we have or in the process of implementing actions that should provide over $45 million in cash savings from our pre-COVID business plan. Turning to Slide 7, which details our first quarter by segment. On a consolidated basis, total revenue decreased 6.3% versus the prior year due primarily to issues associated with the coronavirus pandemic. Our China operations for Life Sciences and Mobile Solutions were impacted throughout most of the quarter, and the Mobile Solutions operations in Europe and North America were adversely impacted in the latter part of the first quarter. Now, I'd like to turn it over to Tom DeByle so he can provide a more in-depth review of our financial performance for the quarter.

Thanks, Warren. Please turn to Slide 8, which includes our first quarter results on a GAAP, non-GAAP, excluding special items, and a total adjusted non-GAAP basis. We break down our adjustments into 2 categories: one category is special items, which are one-time unusual expenses; and the second category is transition and integration expenses the company has historically captured due to the number of acquisitions and integration activities made over the past few years. A couple of points on this slide. First, GAAP operating profit was impacted by a non-cash charge for the write-off of goodwill of $239.7 million. This was driven by a decline in our market capitalization that was less than our net book value of our shareholders' equity. The decline in market capitalization of roughly 75% was a triggering event that caused us to perform a goodwill impairment analysis as of March 31 and a write-off of the goodwill. Second, sales were down $13.5 million or 6.3%. Historical variable margins are approximately 42% to 45%. Therefore, expected operating profit decrease would be about $5.7 million to $6.1 million down. Operating profit on a non-GAAP, excluding special items, was only down year-over-year $800,000 circled on the right side of the page. This shows that the business is flexing results on lower volumes through cost cuts and managing production levels. Let's go to Slide 9, which provides a bridge with more granularity between reported GAAP, non-GAAP, excluding special items and total adjusted non-GAAP. There are a few moving parts on this page that I would like to discuss. First, let's focus our attention on the upper portion of the bridge. The tax-affected asset write-down of $3.8 million primarily related to the elimination of the lease obligation for a major portion of the corporate headquarters building. As previously mentioned, there was a non-cash charge for the impairment of goodwill of $239.7 million, impacting the results. The discrete tax item of $11.9 million primarily relates to the tax rate impact of the goodwill impairment as well as the impact of the CARES Act legislation. In the prior year, the large tax-affected special items consisted of $2.1 million related to the write-off of unamortized debt issuance costs and a discrete tax item of $6 million related to the toll charge for the repatriation of foreign earnings through 2017. Now, let's turn our attention to the lower section of the bridge. In Q1 2020, the tax-affected non-operational adjustments relating to capacity and capabilities development, professional fees and integration and transformation were down $2.4 million year-over-year. Tax-affected foreign exchange on intercompany was up $0.9 million, and the amortization of intangibles was down $0.6 million year-over-year. Turning to Slide 10. Net working capital at the end of the first quarter was $187.6 million compared with $199.4 million in the prior year, a decrease of $11.8 million. Working capital turns were 4.3 turns in both years. DSO improved versus the prior year by 4.3 days. Inventory turns were the same in both years, and the accounts payable decreased as less inventory was brought in. Please turn to Slide 11. Net debt at the end of the first quarter was $768.9 million versus $848 million in the prior year, a decrease of $79.1 million. EBITDA measured by the credit agreement to fund a debt was 4.89x versus 5.1x in the prior year. During the quarter, we drew $60 million on our revolver for liquidity purposes. Our credit agreement leverage ratio steps down from 5.25x at the end of the first quarter '20 to 5x for the remaining quarters of calendar year '20. Due to the uncertain economic environment related to the COVID-19, we are in constructive discussions with our banks. They have been supportive of our efforts as we continue our strategic review process. Although we have taken tangible steps to improve our liquidity and implement cost reductions, given the uncertainty of the economic environment, our 10-Q for the first quarter will show us as a going concern. Slide 12 shows our free cash flow for the quarter. Free cash flow showed a cash use of $1 million during the first quarter of 2020 compared with a cash use of $16.8 million in the prior year, a significant improvement. It is worth noting that the first quarter of 2020 represents the fourth consecutive quarter of positive net cash provided by operating activities as shown on the graph. Slide 13 summarizes our capital spending, depreciation and amortization trends. Cash capital expenditures were approximately $11.3 million in the first quarter compared with $14.1 million in the prior year. For the quarter, the company's capital spending was 5.6% of sales, down from the prior year's percentage of 6.6%. The company has cut its capital spending forecast from $45 million to $35 million in response to COVID-19. With that, I'll turn the call back to Warren.

Thanks, Tom. We have shared more details about each of our operating groups, beginning with Life Sciences on Page 15. Despite a decrease in sales compared to the previous year, our Life Sciences group is still performing well, as indicated by the growth in operating profit, EBITDA, and adjusted EBITDA as a percentage of sales. EBITDA, excluding goodwill impairment, increased by $1.9 million from last year due to our ongoing process improvement initiatives and effective cost management. Our backlog is at $163 million, reflecting a $15 million increase from Q4 of 2019. However, we remain cautious about future demand due to significant declines in elective orthopedic surgeries resulting from the coronavirus pandemic. In Q2 and Q3, our emphasis will be on productivity and cost control, as we anticipate a substantial drop in customer demand compared to first quarter levels. The Mobile Solutions business summary can be found on Page 16. As noted, the Mobile Solutions group was severely impacted by the coronavirus pandemic in the first quarter, with sales down 10.5% year-over-year. EBITDA decreased from $10 million in Q1 2019 to $6.2 million in the first quarter of 2020 due to reduced sales and operational inefficiencies stemming from a sharp decline in volume in mid-March. We predict that volumes will remain significantly lower over the next couple of quarters due to OEM shutdowns initiated in mid-March and expected to last until mid-May. Once production restarts, it is likely to operate below normal capacity for some time. If recovery patterns in Europe and North America mirror those in China, OEMs may take up to two months to return to standard production levels, contingent on consumer demand recovery. Our focus in Mobile Solutions will be on managing capital expenditures, working capital, and productivity. Moving to Power Solutions on Page 17. Power's first quarter sales fell 6.6% year-over-year primarily due to decreased sales from COVID-19 uncertainties and delayed customer approvals linked to production relocations due to a facility closure. Reported EBITDA, excluding goodwill impairment, was adversely affected by $1.4 million because of the sales decline and changes in the sales mix. Power has shown some resilience to the coronavirus impact. We expect Q2 sales to be negatively impacted, given the full quarter of COVID-19 effects, but we believe it will be less severe than the impact on our Mobile Solutions and Life Sciences groups. Similar to the other groups, our Power management team will prioritize productivity, working capital management, and cost reductions. Normally, I would finish my comments by providing guidance for the upcoming quarter and year. However, as you know, we have withdrawn our sales and earnings guidance for the year due to COVID-19 and will not reintroduce any guidance until we have a clearer understanding of the recovery in our industries and global economies. Nonetheless, I want to share additional insights on our outlook for the rest of the year. Given its focus on orthopedic products, our Life Sciences group is reliant on elective surgeries, such as joint replacements. There has been a significant reduction in elective surgeries over the past two months, and they are just now beginning to resume. Consequently, we expect our Life Sciences group to experience decreased sales from Q1 levels over the next two quarters, with a recovery anticipated afterward and continuing into the first quarter of 2021. We believe the recovery for our Mobile Solutions group will take longer than for Life Sciences. We anticipate that European and North American automotive OEMs will gradually increase production over the next 8 to 10 weeks, with consumer demand ultimately dictating overall production levels. Given the high levels of recent unemployment and uncertainty about economic growth, coupled with the substantial cost of purchasing a vehicle, we expect a return to pre-COVID production levels will not occur until the latter half of 2021. As previously mentioned, I believe the path for Power Solutions will fall somewhere in between, more influenced by economic growth and an increase in consumer confidence. We expect that the volume reductions in Q2 and Q3 will not be as severe as those in Life Sciences or Mobile, and the recovery trajectory will likely be less steep than in Life Sciences but quicker than that of Mobile Solutions. As a reminder, my comments regarding market trends and revenue estimates are not guidance and are meant solely for illustrative purposes, given the uncertainties surrounding the impact of the COVID-19 crisis on demand and revenue. That wraps up our prepared remarks, and I will now hand the call back to the operator for questions.

And we'll go to our first question from Dan Moore with CJS Securities.

This is Lee Jagoda standing in for Dan this morning. You did a good job outlining the outlook for the various segments. Considering the cost-cutting measures you've implemented, how should we view the levels of EBITDA? Are we looking at flat EBITDA or potential growth in EBITDA, given the costs you've already eliminated and your outlook for these segments?

Yes. I think our EBITDA clearly is going to be dependent on where the sales volume ends up. And as I indicated, it's really tough for us to provide guidance on that, given how uncertain it is at this point in time. So we're focused more on providing the guidance as it relates to overall sales and where we think directionally that's going to go at this point in time. I would encourage you to continue to use the rule of thumb that Tom indicated in his prepared remarks that typically, when sales fluctuate, we see a fall through a variable margin at about 42% to 45% of the sales change. And we expect that to continue going forward. I think our teams have done an extremely good job over the last couple of months of flexing our businesses consistent with the change in the sales volume.

Okay. And then just switching to the liquidity. Can you kind of give us a view of your current level of liquidity, remind us of any near-term debt maturities and then kind of give us a refresher on the piece of paper that you took out, I guess, late last year in that private placement? And how that impacts both interest expense and liquidity needs going forward?

Yes. I'll talk about the preferred stock that we issued in the fourth quarter. One of the primary benefits of that issuance was that it didn't create any demands on our liquidity or our cash position. The interest associated with that was minimal. And that's one of the reasons that we pursued that instrument is it gave us some flexibility from a liquidity standpoint. Tom, do you want to address some of the comments as it relates to where our cash and liquidity position is today?

Sure. So we have about $4.5 million due every quarter of principal payments. And so that's ongoing, as we speak. And right now, Warren had mentioned how much cash we had on the balance sheet that we show at March 31, and we have roughly $75 million of cash today, that includes overseas cash. Did that answer your question?

Yes, it does.

We'll go to our next question from Steve Barger with KeyBanc Capital Markets.

I'm trying to think about the magnitude of revenue decline in mobile in 2Q. We know China has restarted to some degree, but North American auto plants are going to be shut down for half the quarter, probably a slow ramp. Is down 50% a good proxy for how we should think about that revenue decline? Is that not enough to be extreme?

Steve, I want to share the performance data from April with you. In comparison to our first quarter results, Mobile Solutions group sales in April were at about 45% of the first quarter volumes; Power was around 80%; and Life was at 90%. This should give you an idea of what we've observed so far.

Right. No, that's really helpful. So if revenue is down whatever, pick a number, $30 million, $40 million in 2Q sequentially, what percentage of that revenue loss would be released from working capital? Could it be $10 million or $20 million?

Yes. When we do our modeling on that, we typically look at somewhere around 20% of the sales change that we should be able to pick up in working capital, which is between 15% and 20%.

Got it. So if you net out what you think happens in 2Q from a revenue standpoint versus a working cap and cost action standpoint, do you burn or generate cash in 2Q? And at what level?

We've explored a variety of scenarios, and if we experience a 30% decline from our planned targets on a company-wide scale, there will be a cash burn, even when factoring in potential increases in working capital.

Is there any way to frame the size of the cash burn in 2Q?

Yes. I would tell you that we look at our liquidity. We're very comfortable that with a 30% down case scenario over the next 2 quarters, with a slight recovery in the fourth quarter, our liquidity will definitely hold up through the end of the year. That's not an issue for us.

Meaning you continue shipping product and meeting your interest in other obligations based on what you can see through the year?

Correct.

One last question for me on the impairment. I'm no accountant, so I'm sure I don't understand this, but my thought is that impairments typically relate to the future value of cash flows falling below the carrying cost of goodwill. So does the Life Sciences impairment inherently suggest a lack of profitability in that segment? Or can you just talk through the mechanics of that?

Sure. I'll take that one, Warren. So it's all related to our market capitalization. I mean our share price went from, let's say, at year-end, our measurement time, below $7 down to $1.50 at March 31. And so it was just clearly a function of that our market capitalization went down below our book value of our shareholder equity, and we had to do a reconciliation of that. And the result is that with the market capitalization going down 75% or roughly $225 million, we had to write off goodwill. And otherwise, we'd have just such an extreme premium on our discounted cash flows out of our businesses that the market is not accepting. So it's an accounting situation; I don't agree with it, but it is what it is.

We'll go next to Rob Brown with Lake Street Capital Markets.

Life Sciences business, in particular. Obviously, it's a tough environment right now, but how much visibility do you have when things start to improve? How long does it take to sort of flow through into your business as procedures start to happen?

We have been in constant contact with our customers in the Life Sciences sector regarding their expectations for demand through the end of this summer. As I mentioned earlier, the statistics for April showed that the business held up reasonably well despite the lack of significant elective surgeries over the past 6 to 7 weeks. This indicates that our customers have still been purchasing products. Currently, we are trying to assess their inventory levels and when they might reduce their orders. Customers believe, based on most of the data we have reviewed, that the recovery of elective surgeries will occur fairly quickly. They want to avoid being unprepared without sufficient inventory for an expected surge in volume. Therefore, they are likely in a good position at this time, planning their schedules for summer. We see a gap in the Life Sciences business more in the late May, June, and early July timeframe as customers work to ensure they have the necessary inventory for future demand, which they will adjust based on how the recovery unfolds. I wish I could provide a more definitive answer, but this is the current situation and the discussions we're having with our customers.

We'll go next to Young Kwon with Wellfleet Credit Partners.

I know you discussed this a little bit, but I was hoping maybe if you could give a little more detail as far as how the conversations are going with the revolver lenders. Certainly, it seems like you're getting pretty close against that covenant. So maybe if you could just share any more detail on that topic as far as getting a waiver and whatnot?

Tom, you want to take that one?

Sure. So we're in active discussions with our left lead bank, Truist. And they're very supportive of what we're doing. We've gone through all of our cost reduction actions. We've shared forecasts with them, and we're just working together. They want to see us through the strategic alternatives. We want to get through that process to delever the balance sheet as we've discussed before. And it's been productive.

Okay. As we think about these strategic alternative discussions, like, are those still active? It seems like this is a really tough time to pursue those opportunities. So how should we think about that?

I'll start by saying that we have three excellent businesses that are generating positive free cash flow. They are strong businesses and highly desirable assets. I'll let Warren provide additional comments, but it's important to remember that we possess valuable businesses.

Yes. I think the answer to that question is that certainly, it's a difficult time given where the debt markets are at, and we've had to be creative in the way that we're talking to people, and we're trying to evaluate opportunities. But I think the overriding point is that in spite of that and in spite of where the debt markets are today, we have had what we would consider to be reasonable success and continuing on with this process. So to answer your question, it is still ongoing. And we expect that it will continue on with that process in spite of what's going on in the markets today at this point.

Okay. Also like just going back to the fourth quarter, I remember there was some commentary about cash flow being a little bit weaker because you guys were ahead on your payables and that you expected that to benefit cash flow in 1Q, yet working capital was still negative. Did that actually flow through first quarter result?

Yes, please continue, Tom.

Go ahead, Warren. Please, go ahead.

Sorry, unfortunately, we aren't in the same room and can't see each other, so we're trying to make this transition as smooth as possible. In the fourth quarter, we mentioned that our accounts payable were significantly improved, and we anticipated that we would see benefits from this in the first quarter, which we believe we have. Looking at our performance in the first quarter last year, we had a cash usage of $16.8 million. This year, that figure was $1 million, so we're up by $15.8 million compared to last year. The improvement in our payables as of December 31 contributed to this result. Additionally, our cost-cutting measures and other actions taken to enhance liquidity have put us in a much better position today than we were a year ago, and we have met our expectations. If you review the guidance we gave regarding cash generation and free cash flow for the first quarter, we are essentially in the middle of the range we provided.

Okay. Great. And just one more for me. On the cost savings activities, is there going to be a cash component to that number? And is there a number you can provide?

The cash savings of the $20 million that we've itemized out is the cost reduction. That's all cash.

No, I guess, is there a cash component in that cash outlay that you're going to have to...

To accomplish those?

Yes.

There could be some minor severance amounts. The largest cash outlay we had was related to terminating our lease on nearly two full floors in Charlotte. This is already reflected in the $75 million cash figure that Tom mentioned earlier. That amount is after incurring a $4.4 million termination fee for the Charlotte office lease. This was the main challenge we faced in executing our cost reduction initiatives. Currently, the actions we are taking involve very minimal friction costs.

And at this time, there are no further questions.

Okay. I'd like to just thank everybody for their support and for their time this morning. Once again, a big shout out and thank you to the employees of NN. And everything that they've done for the organization over the last 3 months is really appreciated not only by me, but our whole management team. I am proud to be a leader of that group. And thank you, again, for your time today.

This does conclude today's conference. We thank you for your participation.