Transcat Inc Q4 FY2021 Earnings Call

Greetings, and welcome to Transcat, Inc's Fourth Quarter and Full Fiscal Year 2021 Conference Call and Webcast. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Craig Mychajluk, Investor Relations for Transcat. Thank you. You may begin.

Yes, thank you. And good morning, everyone. We certainly appreciate your time today and your interest in Transcat. With me here on the call today, we have our President, Chief Executive Officer, Lee Rudow; and our Chief Financial Officer, Mark Doheny. After formal remarks, we'll open the call for questions. If you don't have the news release that crossed the wire after markets closed yesterday, it can be found at our website at transcat.com. The slides that accompany today's discussion are also on our website. If you would, please refer to Slide 2. 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 the 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'd like to point out as well 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, I'll turn the call over to Lee to begin the discussion. Lee?

Thank you, Craig. Good morning, everyone. We appreciate you joining us today. Our team is very pleased with the fourth quarter results and the overall performance for the full fiscal 2021 year. We achieved record revenue, operating income, service margins, and cash flow in both the fourth quarter and for the entire fiscal year. Our company has navigated the challenges of the pandemic, showcasing the resilience of our business and the adaptability of our committed team. This performance highlights the value of our services and confirms the investments we've made in technology, infrastructure, and the talent necessary to successfully implement our strategic plan, particularly this past year. Our Service segment continues to be the main driver of growth, showing strong expansion across all financial metrics. In the fourth quarter of fiscal 2021, we saw a return to double-digit organic revenue growth, marking our 48th consecutive quarter of growth in services and enabling Transcat to surpass $100 million in annual service revenue for the first time. Alongside the growth in service revenue, we also achieved exceptional service margin performance, with gross margins increasing by 500 basis points in the fourth quarter to 33.9%. For the first time, our full-year service gross margin reached 30%. Operating margin increased by 470 basis points to 15.1% in the fourth quarter, driven primarily by technician productivity, operational leverage on organic service revenue growth, and the strategic acquisitions of pipettes.com and BioTek. While distribution has been affected by the lasting impacts of the pandemic, we are encouraged by the improvements in the business, which delivered its best quarterly results of fiscal 2021. The rental business also performed well, growing 11% in the fourth quarter. Overall, our fourth quarter operating income surpassed our expectations, reaching $4.5 million, a 21% increase. Despite the pressures from the pandemic, full-year operating income set a record at $11.1 million. We generated record cash flow of $23.6 million throughout the year, primarily allocated to support our acquisition strategy, technology investments, and to reduce debt by $10.7 million. Our current leverage ratio is below 1, providing us with flexibility to seize future organic growth opportunities and to integrate margin-enhancing technology for automation and process improvements in our operations. Additionally, our solid balance sheet will support the implementation of our next-level acquisition strategy. Before I pass it to Mark, I want to announce an acquisition we made on April 29. We acquired Upstate Metrology, a small acquisition near our headquarters in Rochester, New York. Upstate Metrology has annual revenue of about $1 million, but as a bolt-on acquisition, it will be quickly integrated into our Rochester-based calibration lab, allowing us to fully utilize our existing infrastructure.

Thanks, Lee, and good morning, everyone. I will start on Slide 4 of our earnings deck, which provides detail regarding our revenue for the fourth quarter and the full year. For the fourth quarter, consolidated revenue of nearly $49 million was up 7% on strong service revenue and sequentially improving distribution revenue. Turning to the segments. As we mentioned, we were very pleased with Service segment revenue growth of approximately 16%, with 10% organic growth and 6% coming from acquisitions. The strong organic growth was mainly driven by improving order trends and continued market share gains, and to a lesser degree, by an easier comparison to the prior year quarter as the service business began to feel the impact of the COVID-19 pandemic towards the second half of March 2020. With regard to the acquisition growth, we have now lapped the 1-year anniversary of our acquisition of pipettes.com, which was acquired in February 2020. With that in mind, beginning in the first quarter of fiscal 2022, pipettes.com will fully become part of our base business. Turning to Distribution. Segment sales of $19.8 million were down approximately 5% from the prior year, the best quarterly comparison of fiscal year 2021. Sales improved 3% sequentially from our fiscal third quarter on modestly improving incoming trends, especially for products sold into the wind power generation market. As a reminder, we did not feel the impact of the COVID-19 pandemic on distribution revenue until early April of last year as we continue to ship out of our backlog through the end of March 2020. Finally, on a full year basis, we were very happy to set a new revenue record of $173.3 million, which was up slightly from the prior year. Our service business was up a healthy 9%. And as Lee mentioned, surpassed the $100 million milestone revenue mark. This more than offset the distribution decline of approximately 10%. Turning to Slide 5. Our fourth quarter consolidated gross profit was up 16% from the prior year, and our gross margin expanded 230 basis points to 28.6%. Service segment gross margin was up 500 basis points to 33.9% on continued traction from our technician productivity initiatives, operating leverage from organic growth, and accretive margins from our recent acquisitions. Fourth quarter distribution gross margin was down 220 basis points from the prior year on lower levels of co-op advertising and rebates from our vendors. For the full year, our consolidated gross profit increased 9% to $46.1 million. And also, as Lee mentioned earlier, we achieved an important milestone of over 30% gross margin on our service business for the year. We believe this level of gross margin is largely sustainable as the majority of the year-over-year improvement we saw in fiscal 2021 has been driven by technician productivity and operating leverage on our fixed costs. Turning to Slide 6 and our overall operating performance. Fourth quarter consolidated operating income of $4.5 million was up 21% from the prior year and exceeded our expectations. Service segment operating income increased $1.8 million, and operating margin increased 470 basis points as a significant portion of the gross profit increase fell through to operating income. Distribution operating income was down approximately $1 million, largely on lower gross profits. Operating expenses for the fourth quarter included incremental expense from our recent acquisitions, higher technology spend as well as approximately $300,000 in severance expense. Turning to Slide 7. Q4 net income increased 29% to $3.2 million, and our diluted earnings per share of $0.42 were up $0.11 from the prior year, a result of the strong operating performance. For the full year, net income was down 3% and diluted earnings per share were down $0.05. The fiscal 2021 tax rate of 21.9% was up 470 basis points from the fiscal 2020 tax rate, which was aided by higher discrete income tax benefits. Moving to Slide 8, where we show our adjusted EBITDA and adjusted EBITDA margin. Among other measures, we use adjusted EBITDA, which is non-GAAP to gauge the performance of our segments because we believe it is a good measure of our operating performance and ability to generate cash. A reconciliation of adjusted EBITDA to operating and net income can be found in the supplemental section of this presentation which, as a reminder, is posted on our website. Fourth quarter consolidated adjusted EBITDA was up 30%, and our adjusted EBITDA margin increased to 15%. We were especially pleased with the Service segment’s increase of $2.4 million, which drove EBITDA margin up to 21.7% in the quarter. For the full year, adjusted EBITDA was up 12% and driven by Service segment EBITDA margin expansion to a healthy 16.8%. Moving to Slide 9 and our cash flow. Full year net cash provided by operations doubled from the prior year to $23.6 million and was a function of our improved EBITDA and reductions to working capital. Full year CapEx was $6.6 million, and was largely focused on technology infrastructure, Service segment capabilities and rental pool assets. For fiscal year 2022, we anticipate our CapEx to be in the range of $7.5 million to $8.5 million, with investments focused on technology infrastructure, rental pool assets and operational capability and efficiency projects, including calibration automation. Slide 10 highlights our strong balance sheet. At quarter end, we had total net debt of $19 million, which was down $10.8 million from fiscal 2020 year-end. With this reduction, our leverage ratio also came down and was slightly below 1 at quarter end. This is calculated as the total debt at the end of the period divided by the trailing 12 months adjusted EBITDA, including giving credit for any acquired EBITDA. And finally, we had $31.1 million available under our revolving credit facility at the end of the quarter. One more thing, we expect to file our Form 10-K on or around June 7. With that, I'll turn it back to you, Lee.

Okay. Thank you, Mark. We entered fiscal 2022 with a strong balance sheet, strong organic sales pipeline and a very active acquisition pipeline. Operationally, we expect our fiscal 2021 gains in service gross margin to be largely sustainable. From a directional perspective, we like what we see when we look ahead. Our confidence is high that we have both the right strategic plan in place and the ability to execute it. We expect both operating segments to have a strong start to the new year. For the first quarter of fiscal 2022, we expect service organic growth to be similar to what we just achieved in the trailing 2021 fourth quarter. We believe we can continue to improve service margins, albeit at a more moderated level as the fiscal year progresses and technician productivity comparisons become more challenging. Moving forward, automation will be a key focus. And we expect to gain more traction over the next 12 to 24 months. Distribution has progressively improved since the pandemic started over the last year, and we believe the trend will continue. For the first quarter of fiscal 2022, we expect distribution growth to be in the high teens on improving trends and an easy comparison to the first quarter of fiscal 2021, which was heavily impacted by the onset of COVID-19. All in all, Transcat enters fiscal '22 well positioned. We remain focused on continuous improvement and leveraging technology as a competitive advantage to drive sustainable differentiation. In combination with improved macroeconomic indicators, vaccine rollouts and accelerated expansion, we expect to enhance shareholder value in 2022 and beyond. With that, operator, please open the line for questions.

Our first question comes from the line of Greg Palm with Craig-Hallum.

I guess, just to start off on services. I'm curious, what are you seeing in terms of growth by end market? 10% organic was a pretty solid number. And what I'm trying to figure out is that is it broad-based? Is it driven more by certain end markets like life sciences, what are you seeing?

Really, I would characterize it, Greg, as broad-based. We are seeing some recovery in the industrial markets, which is always good for us. Life science has been consistent for years now. And so that's certainly playing a role. But overall, I would say that the double-digit growth is based upon recovery across the industrial marketplace, more than anything else from previous quarters.

Is that fair to say then that most of your end markets now are at or exceeding kind of that pre-pandemic level? Or do you still feel like there's some pent-up demand out there?

It's hard to tell with certainty, but I think most have recovered somewhat. I think there probably is some pent-up demand. We'll see some of that throughout the year. I don't think oil and gas, for example, has fully recovered. I think it's taken steps in that direction. So a little bit of pent-up demand, some recovery, it's kind of a mix.

Okay. Got it. Makes sense. And then specifically on the margin, I just wanted to kind of clarify some comments. I thought Mark had said something about gross margins in service being sustainable, but the guidance kind of is vague in terms of expecting year-over-year improvement, but not to the same degree experienced last year. So can you just help us understand exactly what you mean by the comments there?

Yes. Mark and I both believe that the company will continue to enhance our margin. We're coming off a year with a significant 500 basis point improvement, so we approach this with caution. We don't want to give the impression that we expect the same level of improvement again. However, we do anticipate further enhancements. As I've mentioned before, and Mark has as well, these improvements won’t always be evident on a quarterly basis. Nevertheless, we have measures in place, including investments in technology and automation aimed at boosting margins. We are committed to achieving these goals. While we temper expectations based on the previous year's performance, we do foresee improvements ahead, which is what we want to communicate.

Is the improvement commentary based on what you observed in last year's quarter or is it based on the entire fiscal year? I'm trying to understand the benchmark we're using. Are we considering a 30% improvement level or the 26% change you noted last quarter a year ago?

Yes. I think you've got to get closer to the 30%. And like I said before, it could dip down 100 basis points here and there. We're in the 30% range, and I expect to stay there. And again, we alluded to the sustainability of the improvements we made. I think you're going to see that apparent in this upcoming year. So I think I'd guide you closer to the 30% than going back this time last year to 26?

Yes. Just to be clear, that's for the full year. We achieved a full year of 30%. We expect improvement for the full year. Regarding the Q1 guidance, we also expect improvement there. While we consider 500 basis points to be an excellent year, we anticipate progress in both the quarter and the full year, though perhaps not to that same extent.

Our next question comes from the line of Scott Buck with H.C. Wainwright.

It seems like a little bit of a slower start to M&A this calendar year. I'm curious, is that a reflection of the pricing environment? Or you get a little bit of a deer in the headlights from COVID with some of the potential targets?

Yes, I wouldn't make too much of the slower start to the calendar year. About two quarters ago, almost three now, we appointed a VP of Corporate Development specifically to take advantage of what we anticipated would be a favorable time in the market for acquisitions. Additionally, we were ready as a company to move to the next level, and that hasn't changed. We’ve developed a strong pipeline, which I mentioned in our script, and I expect to see an increase in activity as the year progresses. The first few months of the year are just that—a period where we have a well-constructed pipeline, and I am looking forward to seeing the results from it.

Okay. Good. I appreciate that color. Second one for me, how should we think about margin in distribution longer term? I mean, can they be maintained at these levels? Or are we likely to see some compression over time?

Our aim is to achieve stability in distribution, both in terms of revenue and margin. We launched our rental program around four or five years ago to help maintain stable margins. While distribution isn't as strategically important as it was a decade ago, it still generates numerous leads and provides significant opportunities to sell services to customers who purchase our products. Therefore, we are looking for this business to remain stable over the next few years, as we have made investments to support that stability. We do not anticipate significant margin increases; we find the current situation acceptable.

And then are you guys having any challenges in sourcing inventory in distribution to meet some of this pickup in demand?

Yes, we actually are. Mark, do you want to address that?

Yes, I believe what you're hearing and reading from other companies reflects a similar situation, nothing unique to us. However, we are facing container shortages and challenges related to COVID that make ramping up production in certain areas difficult. Additionally, driver availability is an issue. As a result, our backlog in the distribution business is higher than usual. We have received some good orders recently, but the lead times are longer, meaning it takes us more time to receive what we need from our vendors. We hope this situation improves, but we are not unaffected by the current global circumstances.

Our next question comes from the line of Gerry Sweeney with ROTH Capital.

I want to start with revenue. Just this is more out of curiosity, I guess, than anything. But how much of this jump is maybe we talked about a little bit of pent-up demand in the past versus maybe just general economic expansion?

I believe it's a mix of both factors. We are witnessing a recovery in the industrial markets that has contributed positively to our growth, and we anticipate this trend to persist. Additionally, there is undoubtedly some pent-up demand at play. Therefore, it's a combination of influences. We will continue to project our service business towards mid- to high single-digit organic growth, and we feel confident in that forecast.

Got it. That's fair. And then just on the margin side, not to beat a dead horse, but any way you could maybe bucket out your maybe mix price versus productivity enhancements. I know in the past, we talked about software calibration being a longer-term driver of margin improvement. And just want to see where here...

For the quarter, technician productivity year-over-year was a significant factor. We achieved more standard hours with fewer overall hours. Additionally, when we see organic growth of 10%, as previously mentioned by Lee and the team, we gain substantial leverage on our fixed costs. These two factors contributed largely to the improvements we experienced this past quarter and throughout the full year. This is what I would emphasize moving forward.

Got it. I don't want to assign specific numbers to anyone, but for some reason, the long-term gross margin of 35% is a figure that has stayed in my mind. I'm not sure if that's the exact figure. Additionally, I believe software calibration and automation significantly contribute to that. Is that what we can expect in the medium to long term?

When we think about margin enhancement and margin growth, we started this, call it a journey, for lack of a better word, back when we hit around 24 some odd percent. And we had a pretty good plan in place, Gerry, to get us to 30. We got there probably earlier than we expected. And so that's good news. But we're not done. And so the question is, what's achievable? And how long is it going to take? I think we're going to stick to the idea that we're going to have improvement over time. It's going to be really consistent. And I don't think it's unrealistic or unachievable to get into the mid-30s. I think that's a conversation that we're having internally. It's not going to be quarter-to-quarter. We don't have time frames on it, whether it be a year or 2 or 3, but at some point in the future, I anticipate that we'll be having that conversation. And so you probably heard mid-30s as something that was mentioned in the last meeting, during one of the Q&A sessions. And it's part of the conversation.

Understood. That's reasonable. I prefer not to specify any numbers, but that's the figure that comes to mind. Regarding labor, there seem to be some challenges in obtaining it as conditions are tightening everywhere. It's been a great quarter, and I believe there's a lot of potential ahead. I'm trying to emphasize that, as you pointed out, it's better to look at things on a yearly basis rather than quarterly. In the past, you've had periods where you brought in larger groups of technicians, which affected margins. I'm just curious if that might happen again so that everyone is prepared.

Yes. So it's a great question. And anyone who has studied this company knows that when we have to hire a lot of people at one time, there can be short-term deflation in margins, that could be a quarter or two. It takes a couple of quarters to get a tech up and running. The more growth you achieve organically, the more you're going to need technicians. Technicians are never easy to find. So there's always going to be those training periods as you hire a large number of technicians. But that shouldn't take our eye off the ball, which is longer term, efficiency in the operation and automation and margin enhancement. So that's why we always say, let's not look at this quarter-to-quarter. High rates of growth do sometimes have a short-term dampening effect on margins. Now as we get better at what we do and put more technology to our operation, we should be able to offset that better than we've been able to do in the past. So that will be a factor as well that we would look to achieve.

Got it. And again, great quarter, and I actually look at hiring as a positive so...

Yes, exactly.

Our next question comes from the line of Mitra Ramgopal with Sidoti & Company.

First, just on the higher CapEx and investments in technology infrastructure, if you can give us a sense in terms of where that might entail and in terms of helping you facilitate expansion via M&A and also overall improving margins further?

Yes, we're forecasting that our spending will be in the range of $7.5 million to $8.5 million this year. We will continue to invest in technology and in rental pool assets, potentially even more than last year as that sector grows rapidly. I mentioned earlier that we will be investing in calibration automation, which will have a greater year-over-year impact than our investment from the previous year. Overall, nothing is unusual; the positive aspect is that these initiatives are aimed at supporting our long-term goals. This is how I would address that question.

Okay. Noted. And then, Lee, just a real big picture question. If you can give us a sense as to how much you think maybe the competitive environment has changed as a result of the pandemic and maybe opportunities that you have now from an M&A standpoint or even just maybe if you're seeing any willingness of some potential cost measures as it relates to sourcing that might have been existing before?

From an M&A perspective, we anticipated last year that the pandemic would impact the market and smaller competitors, potentially creating acquisition opportunities that we wouldn't normally have. We foresaw that small companies would face difficulties, and that has indeed happened. We have an active pipeline that we are currently pursuing. The increase in M&A activity is likely a result of these factors related to COVID. Additionally, we have appointed a VP to lead these initiatives. Therefore, it's a combination of timing, efforts, and investments, and I believe we will see an uptick in activity levels.

And then just on the perhaps increased willingness of maybe to customers now or clients as it relates to outsourcing the services to you?

Right. We haven't seen a major shift or change so far in the fiscal year or even in Q4 in terms of outsourcing. We'll always be well positioned to do what we call our client-based labs when there's a market for it. But we do expect to achieve our organic growth rates, whether it's from client-based labs, which is a byproduct of outsourcing or any of our other activities to achieve organic growth. So one way or the other. But I can't note a specific change in the last 60 days. That may occur later in the year, and I would certainly talk about it when that happens.

Our next question comes from the line of Dick Ryan with Colliers Securities.

Lee, as a follow-up to the CBL, how many of those are you operating now? And what kind of margin contribution do they bring in? Is it additive or dilutive to the core margins you see?

Dick, we've got about 20 of those going nationwide, which is the same number we had last year. We've not lost any of them in the 9.5 years I've been here, and we've gained some through the years, obviously. From a dilutive standpoint, the margins tend to be in range of our normal margins. I think it could be 100 basis points less, depending on the particular customer. But as you know, these are very sticky, and there's a high lifetime value of these customers. So sometimes, that's the benefit that you get. But yes, I would say that the number is in the 20 range.

Okay. So on the CapEx for the rental pool assets, it growing rapidly, small base. Any kind of ballpark of how you position that business and what rental could contribute 3, 5 years down the road? How big of a market is that you're trying to achieve?

Our narrative remains consistent with the past. We initiated this business in 2016 with the goal of stabilizing distribution and connecting our distribution segment with our service segment, aiming for several benefits. Nothing has really changed in that regard. Currently, we do not plan to become a $50 million revenue rental company. However, it is realistic to envision growth from our current standing of $5 million to $6 million in rental revenue to potentially reaching $10 million. This modest growth aligns with our strategy to stabilize the business, which in turn will help generate leads and cash flow to support the growth of our service business. This is the role rentals play in our strategy, and we believe it will continue.

Our next question comes from the line of Kara Anderson with B. Riley Securities.

Just one more on M&A from me. Just curious if there's an appetite for an availability of larger acquisition opportunities out there?

Thank you for the question, Kara. Our pipeline is quite different now compared to a year ago for two main reasons. Firstly, we have more opportunities to explore in terms of volume, thanks to the initiatives we've implemented. Secondly, within the pipeline, we are considering larger opportunities. Historically, our average deal size has been in the $3 million to $5 million range, but we are now looking at some larger deals. Currently, our pipeline includes similar deals to what we have done before, as well as larger deals that fall within the $8 million to $12 million range. While the opportunities vary, I believe we have some promising prospects, and we will see if these opportunities align well for us to close some deals.

Got it. And then just one last one on the guide for distribution growth in the high teens range. It implies a sequential decrease from the fourth quarter. Can you help me with that? Why would that be the case as you look more towards a recovery or seasonality offsetting it?

Yes, it's just the normal seasonality of the business. I would describe that as there are posted factors, but that's the normal seasonality of the business.

There are no further questions in the queue. I'd like to hand the call back to management for closing remarks.

Well, this is Lee. I appreciate everyone being on the call today. Thank you for joining us. Feel free to check with us any time. Otherwise, I guess we'll speak with everyone after we release our first quarter results. Thanks again for participating.

Ladies and gentlemen, this does conclude today's teleconference. Thank you for your participation. You may disconnect your lines at this time, and have a wonderful day.