Transcat Inc (TRNS) Q3 2020 Earnings Call Transcript

Greetings and welcome to the Transcat Inc. Third Quarter Fiscal Year 2020 Financial Results. At this time, all participants are in listen-only mode. A question-and-answer session will follow the formal presentation. Please note, this conference is being recorded. I will now turn the conference over to your host, Craig Mychajluk, Investor Relations. Craig, you may begin.

Yes. Thank you and good morning, everyone. I certainly appreciate your time today and your interest in Transcat. With me on the call today, we have our President and Chief Executive Officer, Lee Rudow; and our Chief Financial Officer, Mike Tschiderer. After formal remarks, we will open the call for questions. If you do not have our news release that crossed the wire after markets closed yesterday, it can be found on our website at transcat.com. The slides that accompany today's discussion are also on our website. Please refer to slide two. As you are aware, we may make forward-looking statements during the formal presentation and Q&A portion of this teleconference. Those statements apply to future events, which are subject to risks and uncertainties, as well as other factors that could cause the actual results to differ materially from where we are today. These factors are outlined in the news release, as well as with documents filed by the company with the Securities and Exchange Commission. You can find those on our website where we regularly post information about the company, as well as on the SEC's website at sec.gov. We undertake no obligation to publicly update or correct any of the forward-looking statements contained in this call, whether as a result of new information, future events or otherwise, except as required by law. Please review our forward-looking statements in conjunction with these precautionary factors. I would also like to point out that during today's call, we will discuss certain non-GAAP measures, which we believe will be useful in evaluating our performance. You should not consider the presentation of this additional information in isolation or as a substitute for results prepared in accordance with GAAP. We have provided reconciliations of non-GAAP to comparable GAAP measures in the tables accompanying the earnings release. So with that, let me turn the call over to Lee to begin the discussion.

Thank you, Craig. Good morning, everyone. Thank you for joining us on the call today. To kick off this morning's call, I'll provide an overview of fiscal 2020 third quarter results, then turn things over to Mike to provide a closer look at the financials. I'll return to wrap things up with an outlook for the fiscal year and beyond before we open up the line for questions. We had solid growth in the third quarter, generating $43 million across both segments. While growth was solid, the third quarter was atypical. October and November 2019 started out very strong with double-digit organic growth similar to what we generated in the second quarter. That momentum gave way to a very slow December, which we believe was negatively impacted by holiday timing that drove an unusually high number of extended plant shutdowns. The positive news is, as we mentioned in our release, sales in both our service and distribution segments bounced back as we moved through January and into early February, providing confidence in our belief that December was an anomaly. Fiscal year-to-date, we've generated $8.2 million in cash, up 13.6%. With an active organic and acquisition pipeline, the strong cash generation is expected to continue to fund growth and growth opportunities. Turning specifically to our service segment. In the third quarter, where industrial demand was reported to have weakened and we experienced a drag from the holiday schedule, our service business continued to grow at a rate of 7.8%. The growth demonstrates the effectiveness of and focus on the highly regulated life science and aerospace and defense markets. The third quarter represents our 43rd consecutive quarter of growth. That's almost 11 straight years. While the service business grew 7.8% in the third quarter, the month of December actually declined year-over-year, and the lower-than-expected revenue was unable to fully offset the largely fixed costs related to the service business. In fact, this was particularly true this past December as we strategically built additional capacity into our operation throughout the year. Still, service margins improved by 10 basis points, which we see as a very good sign under the circumstances. There are two primary drivers of the increase in service gross margins. The first driver is the tangible improvement in many of our service processes as we continue to drive operational excellence throughout our lab network. While there's much work to be done, we are pleased with the noticeable progress. The second driver is the net increase of 37 technicians, which represents a 12% increase over the prior fiscal year period. Our technicians today are more seasoned than this time last year and we believe we're well-positioned to handle double-digit growth. Technology continues to play an important role across many fronts. An important technology component is the development of faster and more effective acquisition integration tools. Some tools have been created, others are still in the works. The calibration industry remains fragmented and continues to provide a real opportunity for Transcat to expand geographically and leverage additional capabilities and synergies. Improved data analytics is another technology component. Timely and predictive data is key to continuous process improvement and a competitive advantage in the market. And of course, driving automation into our calibration process remains high on our list. The acquisition of Infinite Integral Solutions in the second quarter of fiscal 2020 continues to position Transcat nicely for the future. IIS specializes in calibration automation software. At present, we're making our way through the programming stage for initial implementation, which we anticipate to launch in the next three to four months. Moving to Distribution, revenue increased 3.5% in the quarter. Our higher margin instrument rental business also increased 3.5% to $1.2 million in the quarter. This represents a lower growth rate than what we've seen recently, so we saw less favorable impact on Distribution margin. A similar story here is with Service. We believe the lower rental growth rate in the quarter was an anomaly and we expect more typical growth rates for rentals moving forward. The Distribution business and the segment continues to differentiate our unique value proposition, generate gross profit dollars, solid cash flow and perhaps most importantly provide leads to foster strong organic service growth. With that, I'll turn things over to Mike.

Thanks, Lee and good morning, everyone. I'll be referring this morning to the slides that we did post. I'll start on slide 4, which provides detail regarding our revenue on a consolidated basis and by segment. As a reminder we have two reportable business segments: Service and Distribution. As Lee mentioned, we had another solid quarter with consolidated revenue of $43.2 million, which represents a record level for a fiscal third quarter with an increase of nearly 6% on a consolidated basis. The reported revenue for both segments was negatively impacted by the timing of the holidays in December, especially with Christmas falling on a Wednesday. This mid-week holiday impacted customer operations and working hours more than we would expect to see if the holiday was at the beginning or last day of a work week. Service segment revenue increased 7.8% to $22.1 million, which was all organic. This increase in Service revenue reflects new business from the highly regulated life science sector and includes new and ramping-up multiyear client-based lab contracts; growth in the FAA-regulated aerospace and defense sector; and in general industrial manufacturing. Distribution sales were up 3.5% to $21.1 million. This growth rate was generally in line with our overall revenue growth expectations for Distribution. Service segment gross margin improved 10 basis points over the prior year third quarter, as Lee mentioned, but that progress has been muted by December as our service costs, especially our technician workforce, which we have been growing to meet the double-digit growth we have been experiencing, was under-absorbed as essentially a fixed cost. However, as Lee described, hiring, retaining, and training our technicians has been and will continue to be a major focus for us. The Distribution gross margin was impacted by the 3.4% growth in our higher-margin rental business. The growth in rentals is less than what we have seen in recent quarters, although we do expect a stronger growth rate in the fourth quarter of fiscal year 2020. Rental revenue was $1.2 million in the quarter. Slide 5 shows the drop-through to operating income and operating margin lines. We are encouraged with the start of our fiscal fourth quarter and when combined with our focus on service productivity metrics, we expect to see improvements in our various profit margins going forward. Slide 6 shows our bottom line results. Despite the softness in the quarter, we are still generating earnings at a record pace, as depicted on a trailing 12-month basis. Our effective income tax rate was 22.1% in the third quarter and continues to be aided by the increased discrete income tax benefits related to share-based awards due to stock option exercise activity. As a result, we have adjusted our full fiscal year 2020 income tax rate expectations down slightly to range between 17% and 18%. Looking at Slide 7, we show adjusted EBITDA and adjusted EBITDA margin. Among other measures, we use adjusted EBITDA, which is a non-GAAP measure to gauge the performance of our segments because we believe it is a good measure of operating performance and is used by investors and others to compare and evaluate performance of core operations from period to period. I encourage you to look at the provided reconciliation of adjusted EBITDA to the closest GAAP measures, which for us are operating income and net income. As one would expect, the fiscal 2020 third quarter segment and consolidated adjusted EBITDA results reflect our early commentary around December's impact on revenues and margins. Slide 8 provides some detail regarding our balance sheet and cash flow. Year-to-date, net cash provided by operations increased $1 million or nearly 14% to $8.2 million and was used for funding capital investments, acquisition-related payments, paying down debt, and covering tax withholding obligations for netting of share awards, which are shown as a repurchase of common shares. Over the trailing 12 months, we have generated $13.6 million in cash from operations. At quarter end, we had total debt of $19.7 million with $23.4 million available under our revolving credit facility. Our debt level is down $1.3 million since the end of fiscal year 2019. Our leverage ratio at quarter end also declined to 1.07 and is calculated under the credit facility as the total debt on the balance sheet at period end divided by the trailing 12 months adjusted EBITDA, including giving credit for any acquired EBITDA. Other companies may calculate such a metric differently. Year-to-date capital expenditures were $5 million and primarily focused on technology infrastructure, funding organic growth opportunities, and for the purchase of additional rental pool assets. As noted in the press release and on slide 9, we have lowered our CapEx spend expectation for fiscal 2020 to a range of $6.8 million to $7.1 million from the previously provided range of $7.8 million to $8.2 million. This change is largely due to the timing of certain projects not having to spend as much on service lab replacement assets as first estimated. We continue to believe we have sufficient liquidity for any investment opportunities that meet our strategic criteria. Lastly, we expect to timely file our Form 10-Q after market closing today. With that, I'll turn it back to you, Lee.

Okay. Thank you, Mike. As many of you know, the fourth quarter historically is the most impactful quarter for Transcat. We got off to a good start in January and early February and we expect to have record revenue and profits for fiscal 2020 year. We believe the increased service capacity we created throughout the year is a differentiator and provides a competitive edge moving forward. With an increase in capacity, we are well-positioned to support double-digit service growth. Our new business and acquisition pipelines are healthy and active. We expect operational excellence and technology initiatives to continue to drive improvements in productivity. Improvements in productivity are expected to benefit gross and operating margins this fiscal year and into the future. Our confidence in our strategic plan and overall direction is high, and we have strong momentum and high expectations heading into fiscal 2021. With that operator, we can open the line for questions.

Thank you. At this time, we'll be conducting a question-and-answer session. Our first set of questions comes from the line of Gerry Sweeney of Roth Capital. Please proceed with your question.

Good morning, Lee and Mike. Thanks for taking my call.

Hey Gerry. Good morning.

So, one question maybe two parts to start off with. I wanted to see, is the bounce back in revenue that we're seeing in January and early February sort of on par with the growth that you're seeing in October and November? And then, the follow-up to that would be the slowdown in December, was there any chance that's just companies being a little bit more proactive earlier in the quarter and just prepping for a longer seasonal or holiday shutdown?

This is Lee. It's challenging to say for sure. We had a very strong October and a robust second quarter, which continued into October, making it one of our best months ever. November was also solid. While there could have been some anticipation by customers, I haven't seen definitive data on that. I believe it's a matter of taking the average daily revenue impact for our service and factoring in that a mid-week holiday could have resulted in losing a few days. It's not overly complex, and we didn't dwell on it. We anticipated a softer month, and while it ended up being a bit softer than expected due to a few additional days, it didn't surprise us. January started very well, performing in line with or slightly better than expectations. We understand our typical January trends, and usually, our business scales up towards March, which is our strongest month of the year. We were pleased with the way we began the quarter, and everything aligns with our expectations for the start of Q4.

Okay. And then one more question. Again, a little newer covering you guys. But back I think earlier last year you added a bunch of capacity. And then in the press release, you talked about 37 techs on a year-over-year basis. Did you add any techs in the last one or two quarters? Because I know, I think selling costs were up a couple of hundred thousand quarter-over-quarter and I do know it takes a couple of quarters to get them going. So is this just – one, did you add any in the last one or two quarters? And should I just anticipate sort of a gradual uptick every quarter in techs?

I would look at it as more gradual. We add techs all the time. If the question is, did we add techs in the third quarter? Yes we did. We hire for a couple of reasons. If we land a new large account or a new client-based account, we'll hire employees to service that new work. So there's new work that we gear up for. And then there's planned hiring throughout the year that's more gradual and keeps pace with where we think sales are going and trying to get ahead of it. And that's a timing game. In the past we've fallen behind. And I would say this year we've done a really nice job of staying ahead of things and being more predictive, more accurate in our predictions and I think it's played out well. If the volumes that we anticipate in Q4 come through you're going to see good margin enhancement because we got ahead of it.

Got it. Perfect. That’s what I needed. Thank you very much.

Thank you.

Our next set of questions come from the line of Mitra Ramgopal of Sidoti & Company. Please proceed with your question.

Yes, hi, good morning. Thanks for taking the questions. First, just wanted to follow-up on the last question, as it relates to adding techs, if you could give us a sense as to the labor market and the ability to continue to add if necessary?

So I would say, it's been a positive encounter in the last 60, 90 days, Mitra. We've really done a nice job. It starts with us increasing our recruiting staff here the year before and having that team be more experienced and effective. In the last 60 to 90 days we've had our – we've not had a difficult time finding the people we need to support our growth. I wouldn't have said that a couple of quarters before that but I think the process has turned for us, and we've done well.

I think the other thing we've also seen in addition to those improvements in the hiring and the onboarding is the retention of those techs through the various training and development plans that are now in place for that piece of the workforce. Turnover is expensive, so if we can hire the right people and then keep them, it helps our productivity going forward.

Yes, that's a really good point. So turnover is a by-product of better training and better management. I think we've accomplished a lot on both fronts.

Okay. And then on the question of training and productivity. Typically how quickly would you say someone is up to where you'd like them to be on being hired?

So, if you're hiring someone that's new to the industry and is not a calibration technician, let's just put that aside for a moment. We'll get to that. But if you hire someone that has some calibration experience, the learning curve is dependent upon their ability to pick up our systems, and that usually takes about 30 to 60 to 90 days. So, a good quarter for them to get productive, an experienced person, by the second quarter and third quarter they're up and running. I'd say the process takes two to three quarters before they're doing what we expect and reaching the expected levels. If you're new to the industry and we're breaking in people on the lower-end disciplines that don't require the experience level, it's a good six months before a technician starts, let’s call it, breakeven meaning they're doing enough work to pay for themselves. It takes a good year for them to get profitable. The duration varies depending on the level of technician we bring in, anywhere from a quarter or two, to three or four quarters and it sort of runs the range.

No, that's great. It's very helpful, thanks. And then switching on the acquisition opportunities, I know you said you have a pretty strong pipeline there. And I'm just wondering if there's any incremental call you might add in terms of just the environment and things like pricing, et cetera, if that has changed.

Right. So from a multiple perspective, we're seeing things in line with our historic trends in terms of acquiring. Maybe some of the deals we're looking at have a turn or two more. Instead of four to six times, we might be looking in some cases at seven. We will see even eight. But all these deals are extremely accretive for us. So, we're going to keep an open mind in terms of multiples in that range. Generally the same, maybe a little bit of escalation there. I would characterize the pipeline, if I were to use a word that I'm comfortable with, it would be active. It's a big part of our strategic plan to grow through acquisition in addition to our strong organic growth, and we have an active pipeline.

And Mitra, just kind of following up on the valuation and the multiples that we're seeing, it's not like there are deals that we're losing to others. It's been pretty quiet. We've talked in the past that it really is Trescal, the only other third-party provider that's buying any companies. They've been pretty quiet in the U.S. over the last quarter. So, it's not like we're seeing big multiples that we are losing in bidding contests. There are still a lot of good companies out there for very accretive prices.

Okay, that's great. I know you mentioned the addition of new lab-based contracts. I'm curious if these are wins coming from competition, or if it's a situation where a client is now choosing to outsource something they previously handled in-house.

In most cases our success with client-based labs, we now have over 21 or 22 of them, has been a result of in-house labs, externalizing the work and outsourcing the work. We have positioned ourselves over the last couple of years, Mitra, to be the ideal company to take on that opportunity. So, we positioned ourselves to do a nice job with outsourcing and we continue to do that. It's not to say others can't do it, but when we do run into competition for some of these larger deals, we've had a very, very high success rate and win rate. I see that continuing. I think that we're still positioned to do really well in that space, and most of it tends to be outsourcing from what was previously in-house lab for manufacturing, particularly in life sciences and aerospace and defense.

Okay. That’s great. Thanks for taking the question.

Appreciate the effort.

Our next set of questions come from the line of Chris Sakai of Singular Research.

Chris, are you there?

Chris, please check your phone is on mute, please.

Operator, is there any other calls as we wait to see where Chris went?

Mitra has queued back up.

Okay. Maybe we'll take his and we'll wait to see what happened to Chris.

Yes, thanks. Actually I just wanted to follow-up a little on the Canadian market. I know you had highlighted that a little. And I was just wondering based on the recent acquisition you made, if you're sort of getting any additional traction as a result?

Well I'll start. Just to clarify the acquisition of IIS, which was a software company, was not a calibration service company like we've made other acquisitions for. So I'll just clarify that, that it wasn't that we bought a book of business and employees, it was a software play for that automation software.

Yes. We are quite satisfied with the performance of the Canadian market this year. In comparison to last year, which was a weak period for Canada due to fluctuating trade agreements and economic uncertainty, we are now seeing a rebound. There seems to be pent-up demand that is now entering the market. The previous year is behind us, and we have experienced strong quarterly results for Canada, returning to what we consider our typical expectations. We expect this positive trend to continue and have had a good start to the fourth quarter. I anticipate that Canada will finish the year on a strong note.

Yes. And it's been nice to see that it's kind of broad based, too, both in aerospace and defense, as well as in life sciences. So it's been an encouraging year for them.

Okay. And is there any impact or benefit for you as a result of the recent trade agreement?

I think just the lack of uncertainty, Mitra, is going to be a positive for us. We haven't gotten any direct feedback in terms of the particular elements of the agreement and the favorability it might provide. But I think overall just having the uncertainty behind this is going to be a plus.

Okay. That’s great. Thanks again.

Thanks, Mitra.

Our next set of questions come from the line of Chris Sakai of Singular Research.

Hi everyone. Sorry for the technical difficulties. Just a question, can you hear me?

Yes. Yes, Chris, we can hear you and go right ahead.

I just wanted to know how business in Canada was doing.

Business in Canada is doing very well. It's a recovery year for us. Each quarter has been better than the same quarter last year. We anticipate a strong finish. Much of the uncertainty from the previous year is behind us, and we're moving forward with optimism. We expect good results overall.

Okay. Great, and then how is the integration of IIS doing?

It's doing pretty well. IIS was a unique supplier/developer of automation software for the calibration process. We acquired them with the goal of taking a year or so and programming, developing onto their platform. We are doing that. In my presentation just a few minutes ago I mentioned that I think somewhere in the first quarter, in the next three to four months, we're going to launch our first set of automation protocols around pressure calibrations. That will be based on the IIS software. This will be our first time using it in the market, and I'm sure there will be some learning curve. But we're looking forward to it. We would expect to expand beyond pressure once we get that down.

Okay. Great, thanks. That's all the questions I had.

Thanks. Good, I appreciate it.

We have reached the end of the question-and-answer session. I will now turn the call back over to management for any closing remarks.

Okay. This is Lee. Thank you all for joining us on the call today. We appreciate your continued interest in Transcat, that's for sure. We'll be participating in the Roth annual conference in Dana Point, California on March 16. We'll also be participating in the Sidoti spring conference in New York City on March 26. So feel free to reach out to us at those events or really at any time. Otherwise, we look forward to talking to everybody again after the completion of our fourth quarter. Thanks again for participating on the call. Take care.

This concludes today's conference. You may disconnect your lines at this time. Thank you for your participation.