Earnings Call Transcript - THR Q2 2023

Operator, Operator

Greetings, and welcome to the Thermon Group Holdings Second Quarter Fiscal 2023 Earnings Conference Call. At this time, all participants are in a listen-only mode. A question-and-answer session will follow a formal presentation. Please note this conference is being recorded. I will now turn the conference over to our host, Ivonne Salem, Vice President, FP&A and Investor Relations. Thank you. You may begin.

Ivonne Salem, Vice President, FP&A and Investor Relations

Thank you, Diego. Good morning, and thank you for joining today's fiscal 2023 second quarter conference call. Earlier this morning, we issued an earnings press release, which has been filed with the SEC on Form 8-K and is also available on the Investor Relations section of our website. Additionally, the slides for this conference call can be found in our IR website under News & Events, IR Calendar Earnings Conference Call Q2 2023. During the call, we'll 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. I would like to remind you that during this call, we may make certain forward-looking statements regarding our company. 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, and we undertake no obligation to publicly update any forward-looking statements, whether as a result of new information, future developments or otherwise, except as may be required by law. Now I would like to introduce Bruce Thames, our President and Chief Executive Officer, for his opening remarks.

Bruce Thames, President and CEO

Well, thank you, Ivonne, and good morning, everyone, and thank you for joining us today. I wanted to begin today by setting the stage with a quick overview of Thermon. As a 68-year-old company, we've been tested and proven resilient across many economic cycles. We're a world leader in providing safe, reliable and innovative mission-critical industrial process heating solutions to customers in 85 countries from facilities on four continents. Our over 1,300 employees have an industry-leading safety record and are dedicated to creating value for our customers by executing our strategic long-term plan, which I will discuss in more detail in the next few slides. I'd also like to thank and recognize our Canadian team for being an excellence awardee as one of Canada's safest employers in 2022. Thank you all for your commitment to safety. Turning now to Slide 4. You can see our strategic pillars. In order to create value for our shareholders over the long term, we're focused on three key areas. First, profitably growing our installed base. Second, diversification, digitization and developing markets. And third, disciplined capital allocation. We benefit from a very large global installed base, which provides significant opportunity to capture recurring revenues while driving growth across our traditional end market verticals. We're driving additional growth through diversification into attractive adjacencies, such as commercial, rail and transit, food and beverage and other end markets. Our solutions also help enable the long-term transition towards sustainable energy sources. We're expanding our solutions in the area of digitization with products that utilize the industrial Internet of Things and support customer demand for productivity, reliability, efficiency and safety enhancements. We're also seeing growth in the developing markets, driven by a rising middle class, and localization has become increasingly important, particularly with ongoing supply chain challenges to meet price point, lead time and content requirements for our customers. Finally, we're committed to disciplined capital allocation with inorganic growth through bolt-on acquisitions and debt pay down to maintain balance sheet strength as our current priorities. Turning now to Slide 5. We're increasingly focused on enabling the transition to sustainable energy and decarbonization. As the world moves towards carbon neutrality in 2050, we are seeing a wide range of opportunities emerge. You can see here that our portfolio offers a wide variety of products and services that are critical for the transition to renewable energy sources as well as for decarbonization efforts. Our heating applications support renewable energy sources such as wind farms, solar plants and battery power. Our products and services also contribute to the process of decarbonization through electrification, carbon capture and storage and recycling amongst others. Our technology and controls in communication, high temperature and harsh conditions make Thermon uniquely qualified for many of these applications. This year, we have secured over $16 million in orders in these applications with a growing pipeline of over 150 opportunities. Our team of technical experts is dedicated to delivering solutions that help our customers achieve their sustainability and decarbonization objectives. Moving now to Slide 6 on our end markets and the external environment. I would like to again emphasize the progress that we've made against our end market diversification strategy. At the end of fiscal year '22, approximately 60% of our revenue came from non-oil and gas end markets compared to roughly 50% in fiscal year '21. In fiscal year '23, we're currently seeing a strong recovery in the oil and gas sector outpacing other end markets that is largely focused on maintenance combined with efforts to increase throughput and reliability on the installed base. However, we are also seeing continued success in our efforts to diversify and will diligently work toward our long-term goal of targeting 65% to 70% non-oil and gas revenue by the end of our fiscal year 2026. We continue to see strength across the majority of our other end markets. We believe that the strong maintenance environment in chemicals and petrochemicals, combined with customer demand for end-use plastics enables those markets to grow over the longer term. The headwinds from margin pressures and increased European energy prices are partially offset by the cheaper and abundant feedstock here in the U.S. In the power sector, we expect growth going forward to be driven by the transition to electric power and renewable energy, along with the rise of the middle class in Asia. Several of the verticals that make up the strategic adjacencies category continued to experience growth, including renewables, such as hydrogen, biofuels and nuclear power. As mentioned earlier, we have secured over $16 million in orders this fiscal year. Overall, while we're not immune to the impacts from ongoing macroeconomic turbulence, we believe the breadth of our solutions, combined with our diversification across a wide variety of both geographic and end markets continues to serve us well. Turning now to our results for the second quarter of fiscal year 2023 on Slide 7. Thermon had another quarter of outperformance driven by our team's outstanding execution despite ongoing macroeconomic challenges, including supply chain disruptions and softening of revenue and incoming orders in Europe. We achieved record second quarter adjusted earnings per share due to strong performance in North America, which benefited from the ongoing recovery in the oil and gas industry. We've also been able to offset increased material and transportation costs with strong price realizations, while diligently managing controllable costs and continuing to make strategic investments to grow our business over the longer term. For example, the integration of our Powerblanket acquisition announced during the first quarter is on track and produced over $3 million of revenue during the second quarter. Revenue of $100.6 million was up 24% year-over-year. Adjusted EBITDA nearly doubled year-over-year to $22 million, with a margin of 21.8%, an increase of 770 basis points. Free cash flow of negative $1.3 million for the quarter was impacted by short-term investments we made in inventory to address global supply chain constraints. Nonetheless, adjusted EPS was a record $0.38 a share, an increase of more than 200% from the prior year period. While global macroeconomic turbulence is ongoing, we're raising revenue and EPS guidance for the full fiscal year, given our robust performance in the first half and a continued strong backlog in the business. On Slide 8, you can see that our orders and backlog continue to remain strong. Year-over-year, orders were up 3%, excluding a one-time labor contract, while bookings grew 18% on a trailing 12-month basis. Book-to-bill was 0.95x. Our backlog of $160.8 million was up 3% year-over-year, excluding FX impacts. With that, I'd like to now turn the call over to Kevin for a more in-depth review of our financial results.

Kevin Fox, CFO

Thank you, Bruce. Turning to revenue on Page 9. First, I would note that we are very pleased with our overall performance this quarter as the global Thermon team continued to drive profitable growth, while meeting strong customer demand. Revenue in the second quarter was $101 million, up 24% versus prior year and exceeding internal expectations. Sales growth in the Western Hemisphere was a result of continued deferred maintenance activity in upstream and downstream, oil and gas and chemical end markets and investments driven by sustained commodity prices and global demand. While maintenance spending in the oil and gas markets is growing considerably, we are still focused on executing against our long-term goal of market diversification. By the end of fiscal '26, we expect that at least 65% of total revenues will come from diversified markets other than oil and gas. We continue to see progress in those markets with rail and transit up 67% and food and beverage up 122% year-over-year. FX negatively impacted revenue by $3 million due to the stronger U.S. dollar, which we expect to continue to impact our business in the quarters ahead. Reported results also include the full quarter of Powerblanket financials worth $3 million in revenue. Thermon's revenue growth, excluding acquisitions and on a constant currency basis was 24% year-over-year. We are pleased that our integration of the Powerblanket acquisition is progressing smoothly with commercial integration activities completed on plan and in advance of the winter heating season. Point-in-time revenues grew 24% in the quarter and 29% in the trailing 12 months, which underscores the strength and maintenance spending across our global installed base. As a reminder, point-in-time revenues are aligned with our product or material sales, while overtime revenues, which were up 24% in the quarter and 34% on a TTM basis are representative of project work where we have engineering and installation services. Over time, revenue growth was driven by increased activity in smaller design and supply projects, particularly in downstream oil and chemical end markets. Over time, our project revenues represented 38% of total revenue this quarter versus point-in-time or material revenues of 62%. Now for gross margins and SG&A on Page 10. Reported gross margins in the quarter are 46% versus a reported 39% last year, with a few items we'll call out to provide context on the improved performance. In the second quarter of fiscal '23, volume contributed an increase of 630 basis points driven by both the strong point-in-time sales in the Western Hemisphere and the mix in overtime sales towards the design and supply projects mentioned earlier. We continue to be able to manage the price/cost equation with favorable pricing impacting this quarter of 200 basis points, offset by global supply chain headwinds of 400 basis points. Operational efficiencies contribute an additional 110 basis points in the quarter. Please note that the trailing 12 months and prior year quarter data includes the impact of the large one-time labor contract we discussed on our previous calls and for which on-site work was completed in May of 2022. As a quick reminder, we deduct depreciation from the SEC reported selling, general and administrative expenses to arrive at the SG&A on the slide. In the quarter, SG&A was $25.2 million or 25% of revenue versus the prior year of $20.4 million or 25% of revenue. On a trailing 12-month basis, SG&A was almost $90 million or 23% of revenue, up from $77 million and compared to 25% of revenue in the prior year, demonstrating our ability to increase efficiency as we grow the business. We remain diligently focused on managing the controllable spend, while continuing strategic investments in our business to drive profitable growth over the longer term and our aggregate SG&A dollars will increase during the balance of fiscal '23 because of those factors. We've continued to proactively manage spending to ensure we are directing capital towards the highest returning investments that will help us to scale and diversify the business. With ongoing macroeconomic challenges, most notably in Europe, we want to ensure we are positioning the business for success and attractive profitability through the cycle. Moving on to Page 11 for adjusted EBITDA and earnings per share. The combination of higher volumes, carefully managing the price/cost equation in a volatile environment and continuing our pursuit of operational excellence, has yielded very positive bottom line results this quarter. This is the strength of the Thermon business model and representative of the execution we expect from the team as we deliver on our strategic objectives. Adjusted EBITDA was $21.9 million or 22% of sales in the quarter. Adjusted EBITDA has almost doubled, up over $11 million from the prior year, along with margin expansion of 770 basis points. On a trailing 12-month basis, adjusted EBITDA is now up to $78 million, along with margins of 19.4%, an expansion of 500 basis points. Powerblanket's business is quite seasonal and is not expected to meaningfully contribute to adjusted EBITDA growth until the heating season begins in the third quarter. Given the strong performance in the first half of the year, we are now projecting a 300 to 400 basis point expansion in adjusted EBITDA margins from fiscal '22's 16.4%. GAAP EPS in the second quarter was $0.33 per share, a significant increase compared to $0.01 per share in the prior year, and adjusted EPS was $0.38 per share versus last year's $0.12 per share. For the trailing 12-month period, GAAP EPS was $1.11 and adjusted EPS was $1.31. On Page 12, we'll cover the updated balance sheet. We ended the quarter with cash at $32 million. We paid down $4.6 million of total debt during the quarter, resulting in a net debt to adjusted EBITDA ratio of 1.4x, an improvement of 0.9x versus the prior year. We'll continue to look at additional M&A opportunities as an attractive capital allocation option, which we believe will play a key role as we continue our strategy of diversifying the business over the next few years. Working capital results were mixed as we invested in our inventory, particularly raw materials to buffer disruptions we've seen in the global supply chain, secure supply of key raw materials and prepare for the seasonality of our higher-volume winter season. We anticipated our working capital would increase due to the robust demand and shipped volumes in the quarter, and we expect inventory turns, in particular, to normalize as supply chain challenges subside and volumes increase in the second half of the year. Historically, Thermon has been able to generate positive cash flow through the cycle. And as a reminder, we had generated positive free cash flow in the previous 15 consecutive quarters. On the right side of the page, we had negative quarterly cash flow due to the strategic investments in inventory with free cash flow of negative $1.3 million in the quarter. CapEx was $2 million and predominantly focused on maintenance. We expect to deploy over $10 million in CapEx this year as we continue to invest in our strategic initiatives and conclude some maintenance activities. This quarter built upon last quarter's positive performance with significant margin expansion. While the outlook in Europe continues to be an area of concern and supply chains are nowhere near the pre-COVID levels of cost or lead times, the Thermon team continues to execute against its short- and long-term plans, and we see opportunity ahead to continue to drive strong results and create value for shareholders. Many thanks to the Thermon team for the great work and commitment that enables us to deliver for our customers, shareholders and our communities. And with that, I'll ask Bruce to provide an update on the fiscal year '26 plan.

Bruce Thames, President and CEO

Kevin, thank you. I'd like you to now turn to Slide 13 and our long-term revenue goals. Our goals for fiscal year 2026 remain unchanged, and we're very pleased to be progressing well toward these objectives. This chart shows the impact of COVID-19 on the business in fiscal year '21, which is the base year of our five-year strategic plan. Subsequently, we saw growth in fiscal year '22 that was driven by the early stages of recovery in our end markets and successful execution of our strategic initiatives. With our strong performance in the first half of this fiscal year, we've revised our fiscal year '23 revenue estimate to $405 million to $420 million, which will put Thermon in line with our peak revenues established in fiscal year '19, and we believe puts us on track to achieve our fiscal year '26 growth objectives. We will continue to drive execution of organic growth, strategic initiatives and acquisitions across the entire enterprise to achieve our goals. We continue to place a high priority on diversifying our end market exposure, specifically targeting industrial markets outside of the oil and gas sectors to represent 65% to 70% of revenues by the end of our fiscal year '26. Last but not least, we expect operational excellence combined with leverage on our fixed costs to yield EBITDA margins in the low- to mid-20% range over that same period. Turning now to Slide 14 and our updated guidance for the fiscal year 2023. We are very pleased with Thermon's strong performance in the first half of this fiscal year. In spite of the number of areas of uncertainty in the current macro environment, the positive momentum we are seeing in quotations, bookings and backlog gives us confidence to raise our fiscal year '23 full year revenue and EPS guidance. We're raising fiscal year '23 revenue to $405 million to $420 million, which represents roughly 16% growth over the prior year at the midpoint of the range. GAAP EPS guidance for the full year is being raised to $1.08 to $1.17 a share, an increase of roughly 90% at the midpoint over the prior year. We are also raising adjusted EPS guidance to $1.30 to $1.39 a share for the full year, an increase of 62% over our fiscal year '22 on top of the 150% growth delivered in the prior fiscal year. Finally, wrapping up on Slide 15. As we've detailed today, Thermon is a world leader in providing safe, reliable, and innovative mission-critical industrial process heating solutions. This is a high-value niche market with high barriers to entry, which is a significant competitive advantage. Our outstanding global team, our diversification across a variety of end markets, our large installed base, our aftermarket business that generates recurring revenue and our low capital intensity combined to create a business that is resilient across economic cycles. We believe that Thermon is truly well positioned to deliver profitable growth through the remainder of '23 and beyond and to create long-term value for our shareholders. I'd like to now turn the call over to our moderator, Diego, for the Q&A portion of this call.

Operator, Operator

Our first question comes from Brian Drab with William Blair.

Brian Drab, Analyst

Can we go back to Slide 5 just for a second and talk about these projects in the pipeline? First of all, can you just clarify, did you say how much revenue did you say that you generated and over what time period related to these categories?

Bruce Thames, President and CEO

I had noted the bookings in Slide 5. So I don't have a revenue number for this quarter. But I can say that...

Brian Drab, Analyst

If you could just repeat whatever you did say, I missed the number.

Bruce Thames, President and CEO

Yes, it was $16 million in bookings year-to-date. That's roughly equivalent to what we booked in all of last fiscal year. So we are seeing significant growth in these areas. This slide illustrates the various opportunities we have in this emerging economy and the shift in our energy markets towards decarbonization by 2050.

Brian Drab, Analyst

And just to clarify, you're saying 60 or 16, 1-6?

Bruce Thames, President and CEO

1-6, which is roughly 8% of bookings year-to-date are tied to these areas. And the other point is we've got over 150 opportunities in our pipeline now that's growing.

Brian Drab, Analyst

I wanted to ask about that. It sounds like a very substantial pipeline. A couple of questions on that. Are some of those projects larger projects? Do you expect to see the same competitors when you're bidding on these projects? Typically, with larger projects globally, you see Thermon and nVent, and that's pretty much it. Will it be the same situation here, or are there other competitors that you'll encounter in this space?

Bruce Thames, President and CEO

Well, it really depends on the opportunity. Certainly, when we think about certain product lines, nVent would be one of our largest competitors in our heat tracing business. But if you think about the breadth of our portfolio, whether that be process heating, emergent heating, environmental, tubing bundles, all of those things, our competitors do differ. And as you can see here, there's a pretty wide range of products and applications across all of these. So the competitive landscape will differ depending upon the opportunity. And Brian, I would add when you think about the size of the opportunities here, it runs the gamut. But I think I would tell you it skews towards the smaller side of things. And it's not your kind of large big heat tracing installs. I would kind of skew you more towards maybe the process heating engineered-type systems from a size standpoint. So hopefully, that helps give you a little bit of context there.

Brian Drab, Analyst

Yes, absolutely. One last question regarding the slide. Do you think that having a broad portfolio of solutions for these different categories gives you a competitive advantage in offering to various verticals?

Bruce Thames, President and CEO

Absolutely. It gives you an ability to really bring the right solution to solve the customer's problem. It gives you different touch points within the customer and the organization. So without question, it really gives us a real competitive advantage as we pursue and develop these types of opportunities.

Brian Drab, Analyst

Okay. Great. Yes, it will be interesting to see how this develops. Just moving to margins, please correct me if I wrote it down incorrectly, but I think you mentioned an expectation for a 300 to 400 basis points increase in EBITDA margin this year. If I understood that correctly, can you discuss what you expect for the rest of the year regarding gross margin? Additionally, for that 300 to 400 basis points, how much is attributed to gross margin compared to OpEx leverage?

Kevin Fox, CFO

Yes, Brian, this is Kevin. I think when we think gross margins specifically for the back half, you've got the advantage of the heating season, which generally skews a little more towards the material side of things, which is higher margin. I think when we look at the backlog, margins and backlog for the projects, I think, are consistent with what we've seen in the first half of the year. So that's what's part of driving the uptick here that you're seeing year-over-year. And then we certainly don't have the headwind on the big contract that we had in backlog last year. So I think if you put all that together, it feels like we're going to have gross margins in the range of that kind of historical, call it, 45% where we've seen in the past. But there's obviously puts and takes with the mix, realization with projects. Do you get it in the year versus just out? So I think we feel pretty good about delivering that gross margin consistent with where we've seen it in the first half of the year and the back half.

Brian Drab, Analyst

Okay. The 45.7% that you did here in the second quarter is very strong gross margin, do you expect to come off of that level somewhat? Or that's what I was wondering is now we're going in the heating season, you just put up 45.7% does it kind of go up from there possibly?

Kevin Fox, CFO

Yes. Keep in mind, Q1 was a little bit lower. So when we kind of mix in the year-to-date gross margins, you're not near that 46% level. On a TTM basis, gross margins would be about 44%, if we exclude that labor project as well. So I think the team has certainly been able to demonstrate that we can get into those mid-40s. But certainly, as you know, the mix within the mix is a factor and certainly, the timing around that can skew the margins a little bit in the back half. So I think we feel pretty good about that mid-40s range for gross margins in the second half.

Brian Drab, Analyst

So can you give that number again just to make sure I got it. You said excluding the large project, gross margin was 44% over what period?

Kevin Fox, CFO

That's a TTM number, Brian. So that's 44.1% on a trailing 12 basis.

Brian Drab, Analyst

TTM, got it. Okay. And then can I just ask one more? Can you elaborate a little bit further on Europe because this is obviously, I think, the first question I get on Thermon from investors at the moment going into the winter here and the gas situation, and can you just talk about the different dynamics there and how that connects potentially be a positive for Thermon? Or is it all risk? Or how do you look at that?

Bruce Thames, President and CEO

Yes. Brian, first of all, let's consider the short-term and mid-term opportunities. Europe's reliance on Russia for oil and gas presents significant challenges, and transitioning to new suppliers is necessary, opening up opportunities for Thermon. We see this particularly in the natural gas sector, including LNG liquefaction and LNG tankers. These developments are positive for us. However, higher energy costs in Europe are negatively affecting operations on the continent, which we have factored into our forecasts for the latter half of the year. We've accounted for this risk in our projections. That said, the elevated energy costs in Europe are making regions with lower energy costs more competitive, benefiting the U.S. market. This situation contributes to the strong performance we're observing in the U.S. chemicals and petrochemicals sector, despite global margin pressures. While there are both challenges and opportunities, we do expect near-term weakness due to high energy costs in Europe.

Operator, Operator

And our next question comes from Jon Braatz with Kansas City Capital.

Jon Braatz, Analyst

Bruce, in your comments, you talked about how strong this year, the oil and gas market has been in a lot of deferred maintenance. What kind of legs does that have, by definition, it's deferred and they're going to get caught up? How long does that last?

Bruce Thames, President and CEO

Yes. As I consider this, I am looking at several factors. First, we have seen maintenance spending being postponed for an extended time. Reflecting on COVID-19, it was the first major economic downturn where we couldn't access customer facilities, leading to a near halt in maintenance activities. Additionally, prior to that, since 2014, maintenance and underlying spending have generally been quite low. We are also experiencing a tighter supply environment, and regardless of a potential recession, I believe we will continue to see tight supply. The recovery isn’t really evident in capital expenditures; instead, it's in maintenance spending. This includes investments aimed at debottlenecking, enhancing productivity, and improving reliability. I think these investments can be sustained for a considerable time, likely another 12 to 24 months, as we catch up on maintenance and maximize the efficiency of existing assets. We are observing a shift in capital allocation strategy from significant capital expenditures by many oil and gas companies towards returning value to shareholders. Consequently, much of what we are witnessing is investment in the current asset base to optimize throughput and ensure ongoing reliability.

Jon Braatz, Analyst

Okay. Bruce, with the Inflation Reduction Act and the Infrastructure Bill, we have indications that spending may increase in 2023. Are you anticipating any benefits from the anticipated spending this year? Additionally, given the supply chain challenges that you, like many others, are facing, do you believe these issues will continue into 2023 despite the increased spending from these initiatives? How do you view this situation?

Bruce Thames, President and CEO

That's a great question. Let's start with the opportunities. We believe that some of the spending bills will create opportunities for our business, especially in power, rail, and transit. We are already seeing benefits in these areas, which are growing year-over-year. For example, power is up 24% this year after a 200% growth last year, and rail and transit have increased nearly 40%. We're observing continued strength in these sectors. Regarding supply chain challenges, we have seen improvements in several areas, but there are still some acute issues we need to manage. The unpredictability mostly stems from supply chains linked to China, where strict policies lead to factory shutdowns that are difficult to anticipate. Consequently, it's challenging to predict the future of supply chain issues. We have made numerous adjustments in our supply chain to enhance redundancy and resilience, which have positively impacted our operations. Additionally, we've raised inventory levels in certain areas to ensure we can supply our customers effectively. However, it’s still challenging to predict how much these issues will resolve in the next two to four quarters.

Operator, Operator

Thank you. There are no further questions at this time. I'll hand the floor back over to Bruce Thames for closing remarks.

Bruce Thames, President and CEO

All right. Diego, thank you. And thank you all for joining us on the call today. We appreciate your investment and interest in Thermon, and have a good day. Thank you.

Operator, Operator

Thank you. This concludes today's conference. All parties may disconnect. Have a great day.