Earnings Call Transcript - THR Q1 2020

Operator, Operator

Greetings and welcome to the Thermon Group Holdings Inc. First Quarter Fiscal Year 2020 Earnings Conference Call. As a reminder, this conference is being recorded. It is my pleasure to introduce your host, Kevin Fox, Vice President of Corporate Development. Thank you. You may begin.

Kevin Fox, Vice President, Corporate Development

Thank you, Donna. Good morning, and thank you for joining today's conference call. We issued an earnings press release this morning, which has been filed with the SEC on Form 8-K and is also available on the Investor Relations section of our website at ir.thermon.com. A replay of today's call will also be available via webcast after the conclusion of the call. This broadcast is the property of Thermon and any redistribution, retransmission or rebroadcast in any form without the expressed written consent of the company is prohibited. During the call, we will also discuss some items that do not conform to generally accepted accounting principles. We have reconciled those items to the most comparable GAAP measures in the tables at the end of the earnings press release. These non-GAAP measures should be considered in addition to and not as a substitute for measures of financial performance reported in accordance with GAAP. Before I turn this call over to Bruce and Jay, I'd like to remind you that during this call, we may make certain forward-looking statements regarding our company and business that are not historical facts because forward-looking statements relate to the future; they are subject to inherent uncertainties, risks and changes in circumstances that are difficult to predict. Please refer to our annual report and most recent quarterly report filed with the SEC for more information regarding our forward-looking statements, including the risks and uncertainties that could impact our future results. Our actual results may differ materially from those contemplated by these forward-looking statements. We caution you, therefore, against relying on any of these forward-looking statements. They are neither statements of historical facts nor guarantees or assurances of future performance. Any forward-looking statement made by us during this call speaks only as of the time at which it is made. Factors or events that could cause our actual results to differ may emerge from time to time, and it is not possible for us to predict all of them. We undertake no obligation to publicly update any forward-looking statement whether as a result of new information, future developments or otherwise, except as may be required by law. And now it's my pleasure to introduce Bruce Thames, our President and Chief Executive Officer for his opening remarks.

Bruce Thames, President and CEO

Thank you, Kevin, and good morning, everyone. Thank you for joining our conference call and for your continued interest in Thermon. Today, we have Jay Peterson, our CFO, joining me on the conference call. Jay will follow me and present the financial details of our fiscal year 2020 first quarter. To begin with Q1 results. After an overachievement in revenue in Q4 of fiscal year 2019, we were pleased with the revenue generation the team delivered in Q1. We saw revenues of $91.7 million meet our expectations for the quarter, an increase of 3.2% over the prior year. Organically, this represented the sixth consecutive quarter of growth. While we anticipate the mix to shift toward a more historical distribution between Greenfield and MRO/UE, we continue to see a heavy mix of turnkey projects at lower gross margins that have been dilutive to the margin profile of the business. Although we did see an improvement of 111 basis points sequentially, gross margins declined by 419 basis points from the prior year quarter. While we welcome the growth in the installed base, we are taking actions to drive margin improvements in the areas we control. First, we passed on a price increase in June that ranged from 3% to 5% and is anticipated to positively impact margins in the second half of the year by 100 to 150 basis points. Secondly, we have continuous improvement initiatives underway that we expect to reduce cost of goods sold by 1% in the fiscal year. Those actions have already begun to have an impact but will be back-end loaded to the second half of the year. In addition, our new product development efforts are focused on creating differentiated value for our customers while protecting and expanding the margin profile of the business. Finally, we're focused on serving the installed base to grow the MRO/UE segment of our business through our direct relationships with owners and operators and through our channel partners. We did also see margins and backlog improve by 100 basis points for the second consecutive quarter on incoming order growth of 12% over the prior year. This represents the second consecutive quarter of double-digit order growth. The book-to-bill was 90% for the quarter and backlog ended at $111.5 million. The business delivered adjusted EBITDA of $13.1 million in the quarter, a decline of 26.7% from the prior year. Adjusted EPS was $0.15 per share for the quarter, down $0.09 per share year-over-year. Turning now to an overview of our markets and geographies. From a market perspective, upstream activity is flat to declining on lower oil prices. Both the chemical and petrochemical sectors remain the most robust of our end markets as the outlook for global demand growth remains positive. The project pipeline continues to improve, led by opportunities in North America and the Middle East. In midstream, we are well positioned to capitalize on an expanding pipeline of LNG investments that will increase global capacity by an estimated 100 million tons per annum valued at approximately $85 billion through 2028. This represents a compounded annual growth rate of 5% to 7% in the market. We've seen a few of these projects that could be awarded in fiscal year 2020, but will not begin to materialize until fiscal year 2021. We believe that this trend will provide a significant tailwind through 2025 and beyond. Combined cycle power projects are trending positively, showing low single-digit growth, particularly in the U.S. and Latin America. The transportation sector in North America continues to create opportunities to diversify end markets for Thermon. We anticipate several large infrastructure projects in Eastern Canada and the U.S. will contribute to bookings in fiscal year '20. Our installed base and associated approvals in the nuclear sector position us well to capitalize on a steady flow of refurbishments planned in the coming years. Geographically, the Western Hemisphere shows continued strength in Q1, which we anticipate will continue through the balance of the year. In the Eastern Hemisphere, the outlook in Asia remains positive but is offset by weakness in Europe, the Middle East, and Africa that we expect will continue through the balance of our fiscal year 2020. Overall, we're pleased with how well the business is positioned for future growth. Since fiscal year 2015, our opportunity pipeline has virtually doubled in size, consistent with our efforts to expand the addressable market. This is augmented by the recent stream of new product introductions, driven by advancements in smart technology and material science. These new product introductions are beginning to have a positive impact on results, and we are on track to announce five more new product launches in this fiscal year. We remain committed to developing technology that differentiates Thermon in the marketplace to create sustainable value for both customers and shareholders over the long term. We're also investing in the globalization of the Thermon Heating Systems business line by leveraging our existing footprint. We have seen several examples where the initial thesis on delivering an expanded process heating solution is being validated by our customers. This expanded solution set, along with the associated increase in our addressable market, is anticipated to provide opportunity for growth over the next several years. Our M&A pipeline remains robust. We have some significant opportunities on the balance sheet to improve our cash position in the coming quarters that will create additional capacity for the right strategic opportunity. Looking forward, we maintain our revenue forecast of 2% to 4% organic growth for fiscal year 2020. I'd like to take this opportunity to thank our Thermon employees around the globe for their unwavering commitment to serving our customers and creating value for our shareholders. Thank you, again, for joining us today. Jay Peterson, our CFO, will now address the details of our financial performance for Q1 fiscal year 2020.

Jay Peterson, CFO

Thank you, Bruce. Good morning. First off, I'd like to start by discussing our Q1 financial results, then finish with guidance and a discussion on margin enhancements for the current fiscal year. Our revenue this past quarter totaled $91.7 million, an increase of 3.2% over the prior year's quarter and a record start for Thermon. The legacy revenue mix between MRO/UE and Greenfield was 51% and 49%, respectively, with the Greenfield mix significantly higher than in the past. FX decreased total revenue by approximately 2% and in constant currency, our top-line revenue grew by over 5%. We continue to experience positive signs of a recovery with our legacy business revenues showing growth for the sixth consecutive quarter. Orders for the quarter totaled $82.8 million versus $73.8 million in the prior quarter for a growth rate of 12%. Our backlog of orders ended June at $111.5 million versus $144 million as of June of fiscal year '19, and that's a decrease of 23%. Margins and our backlog improved by 100 basis points over the last 90 days. Our book-to-bill for the quarter was negative at 0.90. Turning to gross margins. Margins were 40.5% of revenue, and gross profit declined by 490 basis points. The legacy mix shift to Greenfield revenues was the significant driver of the lower-than-typical corporate margins due to their higher content of engineering and construction labor and third-party buyout items. We believe it is important to win these lower-margin projects, understanding there is a near-term dilution to our gross margins due to the margin-rich maintenance business that will occur as soon as 36 months from now. Margins from Thermon Heating Systems were accretive to our corporate margins, and we continue to be on track for this acquisition to provide a return on capital in excess of our weighted average cost of capital by fiscal year 2021. Gross profit declined by $2.6 million or 6.5% versus the comparison period. While we have experienced cost increases attributable to the tariffs, we have largely been able to pass these increases along to our customers, and we have not seen any material impact to our gross margins due to these tariffs. Moving to operating expense. Core operating expenses for the quarter, that is SG&A, excluding depreciation and amortization of intangibles, totaled $25.1 million versus $23.4 million in the prior year, and that's an increase of 7.3%. The drivers behind this increase included a 13% growth in research and development spending and other incremental personnel costs specific to achieving our fiscal year '20 strategic initiatives. Our operating expense as a percent of revenue was 27.4%, again, excluding D&A, and that's an increase of 100 basis points from the prior year level of 26.4%. Turning to earnings. GAAP EPS for the quarter totaled $0.04 a share compared to the prior year quarter of $0.09, a decrease of $0.05 per share. Adjusted EPS, as defined by GAAP EPS, less amortization expense and any one-time charges, totaled $0.15 a share relative to $0.24 a share in the prior year quarter, and we will continue to communicate this adjusted EPS construct going forward due to the high level of non-cash amortization expense running through our income statement. At present, we are expensing $4.4 million per quarter or $0.09 per share or approximately $0.36 a share on an annual basis after-tax for non-cash amortization. Note that the total amortization expense will decrease in May of fiscal year '21 to approximately $10.5 million per year due to the roll-off of certain assets related to the 2010 private equity acquisition of Thermon. EBITDA declined by 27% versus the comparison period, and EBITDA as a percent of revenue was 14.3%, with EBITDA totaling $13.1 million this past quarter. Moving to the balance sheet and our capital allocation philosophy. Our cash and investments balance at the end of June improved to $35.3 million, and our CapEx spend for the first quarter totaled $1.7 million or 1.9% of revenue. Recall our net debt-to-EBITDA ratio was 3.4x at the time of the October 2017 CCI acquisition and it is presently at 2.4x with additional deleveraging anticipated this fiscal year. Our capital allocation priority, in the absence of any near-term M&A transaction, is to continue to reduce our debt through optional debt repayment. In terms of taxes, our tax rate for the first quarter was 3%, positively impacted by the release of a tax reserve relating to the CCI acquisition. We continue to work with our tax advisers on potential strategies to optimize our income tax structure. It is possible our tax rate will be exposed downward later this fiscal year. Fiscal year 2020 guidance. We are holding to our previous revenue guidance of 2% to 4% growth relative to our current margin performance. Various activities are in process to improve our margins, including $4.5 million in cost reductions with an anticipated realization of $2.5 million in savings this current fiscal year, announced price list increases with an expected 2% margin impact for our maintenance-related products, and recent and planned product announcements that we anticipate will yield accretive gross margins. As we head into the heating season, we typically see a seasonal uptick in margins due to the increased mix of MRO activity. Finally, due to growth in cash and trailing 12-month EBITDA, and continued reduction in our net debt, we expect to improve our net debt-to-EBITDA leverage to approximately 1.5x at the end of this year, excluding any M&A transaction.

Operator, Operator

Our first question is from Brian Drab of William Blair.

Brian Drab, Analyst

So first, just to clarify a couple of things. So when you give the Greenfield-MRO legacy, that's excluding THS, right?

Jay Peterson, CFO

That is correct, Brian.

Brian Drab, Analyst

What was the year-over-year growth or decline in the MRO/UE business on a like-for-like basis for the legacy business?

Jay Peterson, CFO

Yes. 1.3% versus the comp period, excluding THS.

Brian Drab, Analyst

So up 1.3%?

Jay Peterson, CFO

No, down 1.3%.

Brian Drab, Analyst

Down 1.3%. I believe you were anticipating solid, possibly even double-digit growth in MRO/UE for the year based on the last report. Am I remembering that correctly? If so, what occurred in this quarter? Also, do you still project MRO/UE will increase for the full year?

Bruce Thames, President and CEO

Yes. So Brian, this is Bruce. We do expect to see growth in MRO/UE during this year. As you know, the first quarter is off-heating season and is probably the most unpredictable for our MRO/UE business. It's the first quarter where we actually noticed a decline in MRO/UE business. We haven't observed any change in behavior from our customers. Therefore, we continue to believe that we'll see solid growth in our MRO/UE business this year, though it's more likely to be low to mid-single-digit growth rather than double-digit growth.

Brian Drab, Analyst

Okay. Got it. And can you be any more specific on where you think gross margin should be modeled for the balance of the year? It sounds like, clearly, some initiatives here will bring it up. But, I mean, could it be mid-40s again for the balance of the year or will we not get back to that level?

Jay Peterson, CFO

Yes. Brian, we've got a confluence of positive factors in our favor. However, if we have an inordinately large Greenfield mix, again, which is customer dependent, that could mitigate the cost reductions, pricing action and the seasonality that we see. It's really hard to give quarterly guidance.

Brian Drab, Analyst

Should I assume a model of 40% or 45%? I'm curious if it's closer to 40% or 45%, or if you can't provide that direction. Will we see an increase from this quarter?

Jay Peterson, CFO

Yes. I don't want to give you an exact number, but sequentially we are moving into the prime time for our legacy business.

Brian Drab, Analyst

Is there any way you can provide some insight into the Greenfield activity and its proportion? You mentioned that if Greenfield activity remains high, gross margin will face pressure. How much visibility do you have regarding that ratio for the rest of the year?

Bruce Thames, President and CEO

The situation we are currently observing aligns with our expectations for this year. Despite achieving strong order growth of 12% for the second consecutive quarter, we are experiencing a decrease in our backlog. This has led us to transition many larger projects that are becoming less prominent. As we progress through the remainder of the year, we anticipate a shift in our project mix towards what we have historically seen in the maintenance, repair, and operations sector compared to new developments. Additionally, it's worth mentioning that along with various initiatives aimed at enhancing gross margins within our existing business, we have witnessed improvements in margins and backlog for the second or third consecutive quarter, with a notable increase of 100 basis points this past quarter.

Brian Drab, Analyst

Okay. And then, Bruce, you mentioned the 90% book-to-bill. Does that imply a sequential decline in revenue in the second quarter?

Bruce Thames, President and CEO

No, we don't think there will be a sequential decline.

Brian Drab, Analyst

Can you provide more details about it? You recorded less than your billing. I believe the key point is that the backlog is at a healthy level, which will...

Bruce Thames, President and CEO

The backlog is healthy to support our revenue forecast, that's what I would say, for the balance of the year, which we projected 2% to 4% growth. We're right in the middle of that in the first quarter. I don't see anything going forward that would make us believe differently.

Brian Drab, Analyst

Got it. And then, just to clarify. You didn't change, Jay, how you're reporting adjusted EPS, right? You're just reminding us that, that's how you're reporting your adjusted EPS, correct?

Jay Peterson, CFO

That is correct, Brian.

Operator, Operator

We are showing no additional questions in queue at this time. I would like to turn the floor back over to management for any additional or closing comments.

Bruce Thames, President and CEO

All right. Thank you, Donna. Again, I would like to thank everyone for joining the call today and for your interest in Thermon. Enjoy the rest of your day.

Operator, Operator

Ladies and gentlemen, thank you for your participation. This concludes today's event. You may disconnect or log off at this time, and have a wonderful day.