Transcat Inc Q2 FY2023 Earnings Call

Greetings and welcome to Transcat, Inc. Second Quarter 2023 Financial Results. 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, Tom Barbato, Chief Financial Officer. Thank you. You may begin.

Thank you, operator, and good morning everyone. We appreciate your time and your interest in Transcat. With me here on the call today is our President and CEO, Lee Rudow, and our Chief Operating Officer, Mark Doheny. We will begin the call with some prepared remarks and then we'll open up the call for questions. Our earnings release crossed the wire after markets closed yesterday and can be found on our website, transcat.com, in the Investor Relations section. If you would please refer to slide number two, as you are aware, we may make forward-looking statements during the formal presentation and Q&A portion of this teleconference. These 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 in the documents filed by the company with the SEC. 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. Additionally, 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've provided reconciliations of non-GAAP to GAAP measures in the tables accompanying the earnings release. With that, I'll turn the call over to Lee.

Thank you, Tom. Good morning everyone, and thank you for joining us on the call today. Yesterday, we announced our fiscal 2023 second quarter results that included significant revenue growth, solid earnings, and strong cash generation. Consolidated revenue for the quarter was up 12% to $56 million, service revenue grew 19% with organic service revenue growth of 9.3%. Consolidated gross margin expanded 70 basis points to 29.7%, driven by expansion in our distribution and rental business margin. Distribution margin was slightly offset by a 30 basis point decline in our service segment gross margin, primarily the result of startup costs associated with several new client-based labs and a significant number of new technicians onboarded and trained to support future service growth. Adjusted EBITDA grew 6% from the prior year to $7.5 million in the second quarter. Turning to a closer look at the service segment. As expected, we generated strong service revenue growth despite macroeconomic uncertainty. We continue to benefit significantly from a value proposition targeted to service the highly regulated life science and aerospace and defense industries. Both industries, among others, inherently have a high cost of failure, which makes them an ideal fit for Transcat. Our reputation for delivering consistent, reliable services and solutions remains stellar across North America. Service gross profit in the second quarter grew 18.3% or $11.5 million on a service gross margin of 32.6%. Strong organic growth continues to be fostered by inherent recurring revenue streams, while strategic acquisitions have increased our capabilities, adjacent markets, and expanded our geographic footprint. Our acquisition strategy continues to outperform and is foundational to our strategy as our focus on integration ensures that Transcat's portfolio of acquired companies becomes one entity over time. This allows for uniformity, consistency, and continuous process improvement for our customers, regardless of which Transcat lab or operation they're engaged with. Our focus on integration also allows Transcat to capture the anticipated synergies, both from a cost and a sales perspective. In the second quarter, we continued the successful operation of our new Transcat calibration training center. The center has produced an impressive number of new technicians to support both our current service organic growth, as well as our new service pipeline that includes a significant number of traditional and client-based lab opportunities. New technicians coming out of the Transcat training center have gotten off to a great start and we expect they will continue to achieve higher levels of productivity as they gain experience in the field. A trained technical workforce is a critical component of our business, and we believe the new training center provides clear differentiation relative to our competition. Moving on to our distribution segment, revenue grew 2% to $21.2 million despite vendor lead times and supply chain shortages that continue to make it challenging to convert open customer orders. Order backlog is up 18% from the prior year's second quarter. Distribution gross margin expanded 140 basis points to 24.9%, and as we progress through the third quarter, distribution demand continues to be strong. Acquisitions are an important part of Transcat's long-term growth strategy, and we closed two deals right after the close of our second quarter. Complete Calibration, located in Cork, Ireland, is a small but very strategic acquisition. It provides Transcat with a local calibration capability and presence to support the robust life science market in Ireland and also brings expertise in the field of calibration robotics. Our ultimate vision is to leverage this promising robotic technology in both Ireland and throughout North America. When taken together with automation, we have the potential to drive additional differentiation, efficiency gains, and improvement in our customers' instrumentation uptime. E2B Calibration, located in Cleveland, Ohio, specializes in calibration services related to the aviation industry. We believe that we can leverage our national footprint and infrastructure to further accelerate the growth in E2B's capabilities across the US and Canada. In addition, there is an attractive life science market in the Greater Cleveland area, which we are now well positioned to capitalize on. All in all, we are pleased with our solid performance in the second quarter of fiscal 2023. We continue to see strong levels of demand for our calibration and asset management services that support our longer-term growth objectives. Our balance sheet remains strong with a leverage ratio of just over 1.8 times. We are well-positioned to effectively execute our acquisition strategy and work through our currently very strong acquisition pipeline. With that, I'll turn things over to Tom for a deeper look into our second quarter financials, and I’ll return upon completion of Tom's narrative to discuss our outlook.

Thanks, Lee. I'll start on slide number four of the earnings deck, which provides detail regarding our revenue on a consolidated basis and by segment for the second quarter. Consolidated revenue of $56.4 million was up 12% versus the prior year, driven primarily by strength in our services segment. Services segment revenue growth remained very strong at 19.4%, with 9.3% of the growth coming organically and the other roughly 10% from acquisitions. Turning to the distribution, revenue of $21.2 million was up 1.6% versus the prior year. We continued to see strong demand for our products, which is reflected in our open order backlog of $9.1 million, which is up 18% versus the second quarter of the prior year. Turning to slide five, our consolidated gross profit of $16.8 million was up 15% from the prior year, and our gross margin expanded 70 basis points to 29.7%. Service gross margin declined 30 basis points from the prior year. As Lee mentioned earlier, this is primarily the result of start-up costs associated with several new client-based labs and a significant number of new technicians onboarded and trained to support future service growth. Distribution segment gross margin of 24.9% was up 140 basis points from the prior year on continued strength in our rental business and a favorable sales mix. Turning to slide six, consolidated operating income of $3.6 million was up 1% from the prior year. Increases in operating income in the distribution segment were partially offset by declines in the services segment. Turning to slide seven, Q2 net income of $2.4 million decreased $700,000 from the prior year, and our diluted earnings per share of $0.31 per share were down $0.09 per share. When comparing net income and diluted earnings per share to the second quarter of the prior year, increased interest and tax rates accounted for all of the year-over-year decline of $0.09 per share. We expect our full-year fiscal 2023 tax rate to be in the range of 22% to 24%. Flipping to slide eight, where we show our adjusted EBITDA and adjusted EBITDA margin. We use adjusted EBITDA, which is a non-GAAP measure, to gauge the performance of our segments because we believe it is the best measure of our operating performance and ability to generate cash. Additionally, as we continue to execute on our acquisition strategy, this metric becomes even more important to highlight as it does adjust for one-time deal-related transaction costs, as well as the increased level of non-cash expenses that will hit our income statement from acquisition purchase accounting. With that in mind, consolidated adjusted EBITDA of $7.5 million was up 6% from the prior year. As always, a reconciliation of adjusted EBITDA to operating income and net income can be found in the supplemental section of this presentation. Moving to slide nine, cash flow from operations was in line with expectations for the quarter, apart from strategic inventory buys that were made to counteract both vendor price increases and ongoing supply chain lead time challenges. This inventory is expected to largely sell through during the balance of the fiscal year. Year-to-date capital expenditures through the end of the second quarter were $4.8 million compared to $3.8 million year-to-date in the prior year, continuing to be centered around service segment capabilities and technology, including automation and future growth projects. Slide 10 highlights our strong balance sheet. At quarter end, we had total debt of $50.8 million with a leverage ratio of 1.81 times. We had $36.7 million available from our revolving credit facility. Lastly, we expect to file our 10-Q later this week. With that, I'll turn it back to Lee.

Thank you, Tom. Looking forward, we expect our unique differentiated value proposition to continue to drive long-term sustainable competitive advantage for Transcat. In the short term, amidst a fair amount of economic uncertainty, we are well-positioned to deliver strong performance and to demonstrate the continued resiliency of our business model. Longer term, we expect rigorous execution of our strategy to drive consistent growth in revenue, margin, cash flow, and ultimately shareholder value. At the heart of our strategy is strong organic service growth. We expect organic growth in the high single-digit range for the balance of the 2023 fiscal year. We will continue to capitalize on the strength of our acquisition pipeline as we target additional capabilities, broaden our geographic footprint, and expand our addressable markets. We believe the combination of these acquisition drivers will increase the trajectory of our business. Operationally, we will continue to leverage continuous process improvement and automation to generate sustainable margin improvement over time. The team has done a terrific job driving service margin improvement into the operation, still there's work to be done, and we have a great plan to continue margin expansion over time. As I mentioned earlier, Transcat's ability to perform well and grow in moderated economic conditions has been a hallmark of our business model over the years. With the acquisition of NEXA Asset Management last year, we now have another suite of services that inherently deliver strong performance in both growing and moderated economic environments. Our strong balance sheet, supported by healthy cash flow, has facilitated both organic and acquisitive growth. We expect this to continue as we make our way through the back end of the 2023 fiscal year and into the future. And with that, operator, we can open the line for questions.

Thank you. Ladies and gentlemen, at this time we will be conducting a question-and-answer session. Our first question comes from the line of Greg Palm from Craig-Hallum. Please proceed with your question.

Yeah. Thanks. Good morning, everyone, and congrats on the good results.

Thanks, Greg.

I wanted to first dig into the recent acquisition activity. So maybe first, can you talk about the growth opportunity in Ireland, specifically with the opening of the new labs? So maybe start with organic and then from an inorganic standpoint, what's the opportunity used as a starting point to expand, obviously, within the region, but across other countries in Europe as well?

Okay, I'll take that. This is Lee. So good question and we look at Ireland in two ways. One, we will continue to build out that lab that we acquired, so that it becomes a really nice general-purpose lab. We have a lot of customers in the US that also do business in Ireland, and it's our ultimate goal to be able to service them in Ireland and in the United States, and we think that that will be a differentiator for us as we can work on some of our efficiency programs and continuous process improvement with our customers by virtue of that factor. But with the acquisition of Complete Calibration, we also pick up some robotics expertise and it's our goal also to work one discipline at a time so that some of the robotic capability there can be brought to the United States, and then ultimately help us with efficiency and margin. So we've kind of got a dual play there. As far as expanding beyond Ireland, I mean NEXA has over 40, 50 employees in Ireland, and ultimately they are able to provide their services really across Europe on a project-by-project basis. So in a sense, we're prepared for that today. We don't have any imminent or immediate plans for expanding our calibration activities; we're going to really focus on getting that lab up and running in the short term. That's really our focus.

Okay. Yeah, it makes sense, and that kind of dovetails into my other question, because the robotic technology and automation opportunity just seem so significant. So maybe help us understand how they incorporate that into everything? And I'm not sure if there are any efficiency metrics that you can give us, either what the margin profile is, how different it is, revenues by employees, but my guess is, they're probably able to become a much more efficient organization when you incorporate that kind of technology into the business. So I don't know, anything you can expand upon that would be really helpful.

I'm not going to be able to expand much in terms of data like you've requested, but I will say that robotics in general have a couple of benefits, right? It always improves the quality of the calibration versus human calibrations, and really at the end of the day, it allows us to use more operators, if you will, versus calibration technicians, which drives the cost of labor down over time and increases the availability of labor. So you've got a lot of benefits from quality to labor savings to efficiency. Even the time we are doing calibration can be run 24 hours a day. These are all potential benefits. And you're right, over time, in theory, they should have a significant impact on margins, and we would anticipate getting some of that over time, but it's not going to happen overnight. And it's early days, and we're just beginning to understand some of the potentials. So I would say, Greg, to stay tuned with respect to robotics; it is very small, almost theoretical today, but we absolutely will be driving that over the long term into our operation. That's our goal.

Let me ask you maybe in a different way. I mean, is there any sort of structural reason why you couldn't incorporate at least some or all of that technology into calibration centers here in the States?

No, it's our goal to develop the technology, enhance the technology that's already in Ireland, and bring it to the United States. That is our express goal over the next couple of years, and we will be doing that.

Yeah. Okay. It sounds pretty interesting. And I guess just the last one, just a quick update on the CBLs; any way to quantify what the impact on margins were in the quarter? How many are currently ramping up? And just any expectations for the go-forward period too? Thanks.

We won't specify a number, but between the first quarter and the second quarter, we had several new CBLs of significant size that caused some material impact on short-term margins, which is to be expected. Given the high lifetime value of these CBLs, the effort is worthwhile, and we want to highlight that. The CBL pipeline is also strong, which is positive for us. Coming out of the COVID environment, we anticipate picking up and continuing the momentum we had before COVID, but landing several in one quarter will result in some margin drag that typically takes about a quarter or two to resolve. We're on track with our timeline.

Yeah. Makes sense. Okay. Best of luck going forward. Thanks.

Okay, Greg. Take care.

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

Hey, good morning, Lee, Mark, and Tom, thanks for taking my call.

Hey, Gerry.

Hey, Gerry.

You addressed my question regarding the CBL and how long it will take to resolve. However, I'm also curious about the service sector doing well, with hiring and a solid pipeline for CBLs, while we're hearing mixed signals about the economy. Are you noticing any of these issues, or is it just that everyone is concerned about rising interest rates and being cautious about the economy?

It's interesting that we would typically anticipate feeling the effects of an economic slowdown first in our distribution business, as it's a leading indicator for us and almost real-time based on my experience over the past 20 to 25 years. I'm somewhat surprised that the distribution business has remained strong so far; it has grown and seen expanded margins. Additionally, we might eventually notice some softness in the service business with a lagging effect, which we haven't experienced yet. Even in a scenario where economic conditions worsen enough to impact our service business, the effect is usually minimal due to the inherent resilience of our model. This sector operates in a regulated environment in life sciences, encompassing medical devices, pharmaceuticals, and aerospace, areas that are not typically influenced by standard economic downturns. This understanding is foundational to our business and model. While some softness in the service business might be expected, its impact has historically been limited, making us somewhat resistant to recession.

And then the other thing I'd add, Lee. This is Mark, Gerry, is the NEXA business. Now that we have owned it for 13, 14 months, we're getting a lot of inquiries there as you might have heard some of our customers heading into more uncertain economic times. We have that, which has also held up well going into what could be another macro uncertainty, I guess, is ramping up.

It’s a great point. The whole business model that NEXA operates is to increase efficiency and decrease the cost of calibration programs. So inherently in a sort of tightening environment, their services become more valuable and sought after. So I think that will play well as well.

Got it. And I know you've talked about life sciences, aviation, et cetera, but a bigger emerging theme is sort of a manufacturing renaissance in the United States. We're seeing semiconductor chips plants being announced, et cetera, one up in Syracuse. Is this an opportunity for you longer-term as well? How do you look at that?

I think anytime manufacturing output increases in the United States, that's going to be good for our business. Through regulated and less regulated environments, that can only be good news. So we'll be prepared for any growth in manufacturing for sure.

Got it. And then final question, how much has rentals become a part of the distribution business? It's been growing. I think you even called out some very good growth in that area. Can you break that out? Or will you break that out? Or give a little bit of view towards that?

Well, I won't break out the numbers specifically as a percentage of our growth in the distribution segment. However, rentals have done very well and it has done well for a number of years now. I think it was back in maybe 2016 timeframe when we launched that business to stabilize the distribution business over time. That was the first goal. The second goal was to create a bridge between distribution and service. And so I think rentals has accomplished both of those initial goals. It continues to be strong, it continues to do well in a variety of economic conditions, and so we're going to continue to fund that business, and it's an important part of our value proposition. It also makes us unique; it’s a differentiator as well.

Got it. I appreciate it. Thanks for taking my question.

No problem. Take care, Gerry.

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

Hi, good morning, guys. Thank you for taking my questions. We talked about the service segment gross margin a lot, but I'm curious about the distribution side. What's the ceiling on the gross margin? Because we've seen it come up here the last few quarters versus a year ago. I just wonder if you can get this into the kind of higher 20% range.

Hey, Scott, it's Tom Barbato. I would say that we're probably at or near the ceiling on the distribution margins. I mean, as I mentioned in my commentary, we're able to do some strategic buys over the past six to nine months that allowed us to kind of get ahead of some of the vendor price increases, which is giving us a little bit of a boost to margin as well, but that's going to kind of dry up a little bit over time as things moderate. We'll be able to continue to leverage the growth in the rental, but I think you should think of where we are now kind of as the ceiling.

All right. Thanks, Tom. That's helpful. And then on the rental business, I don't think I saw this anywhere, but what are you guys spending in terms of annual CapEx in terms of keeping that business growing?

Yeah. I mean, we generally target $2 million to $2.5 million of our annual budget toward rentals.

Okay. Great. Thanks. And then last one, if you could give us a little more color on the acquisition pipeline in terms of what kinds of deals you're looking at now? Are there some larger opportunities out there, or are the opportunities in Europe more attractive than in the US? I mean, just kind of any color there would be helpful.

Our acquisition pipeline is strong. We have a variety of opportunities that we're currently exploring, all based in the United States, aligning with our ongoing strategy. These opportunities range from small to large, and we are always on the lookout for transformative possibilities for the business. If such an opportunity comes up, we will be prepared to act. Meanwhile, we are focused on increasing our capabilities, expanding our geographic footprint, and broadening our addressable markets, similar to what we accomplished with the NEXA business. We see potential in picking up services related to our core calibration. We have three main drivers, primarily within the US, and I can confidently say that we have a very strong pipeline of acquisition opportunities.

Okay. Great, Lee. I appreciate the time, guys. Thank you.

All right. Take care, Scott.

Our next question comes from the line of Ted Jackson with Northland Securities. Please proceed with your question.

Good morning and congratulations on a solid quarter.

Thank you.

All the fun questions were asked, so most of my questions are going to be around your financials. So I'm going to start out, with regards to the services business, you typically have a little breakout in terms of like calibration, third party, and freight. Can you just give those percentages?

I think, Ted, you're probably referring to what we put into the Q and the K. I'm not sure if you have those handy right now for the quarter. Tom, I think...

Yeah, it'll be in the Q, which we're actually targeting to file at market close tomorrow afternoon.

But I wouldn't expect a huge change in the next from what we typically report in any given quarter, Ted.

Okay. And then what's your view for CapEx for the remainder of the year?

We're about halfway there. We were at $4.8 million, and we expect to be in the $9 million to $10 million range for the full year.

Okay. Now that you have a strong presence in Ireland and the opportunities in Europe, what investments are you making in your lab to enhance its capabilities for tackling the market there? What type of infrastructure will be necessary to grow that business, including personnel, equipment, and skills? It seems there’s a significant opportunity for a consolidation strategy in Europe similar to what you've achieved in the US. What kind of talent will you need for that? How do you envision your long-term investment in that business?

There's no reason why we can't establish a highly functional calibration lab in Ireland, connect that between our customers here and there, hire the right people, train them, and put some capital into the labs to increase the capabilities. I mean, that's kind of what we do, and we've done that in the US in the past, and we're pretty confident with our ability to be successful doing that in Ireland, which is really part of your question. The second part of your question is, what our long-term plans to expand beyond Ireland? I would say that, right now, I don't want to get too ahead of ourselves in laying out plans. I mean, clearly, once we're there and doing business, if there are opportunities to expand down the road, we will always be open to that; it is a foothold for us, but we're going to focus on getting that lab up and running. Remember also we have the NEXA business there. So between the services that they offer and the core calibration, we certainly got a lot of runway to focus our time and attention on. Longer term, I don't see any reason why we wouldn't be open to expansion beyond that.

All right. Well, I'm going to step out, and again congratulations on the great quarter.

We appreciate it. Thank you.

Our next question comes from the line of Mitra Ramgopal from Sidoti. Please proceed with your question.

Yes, good morning, and thanks for taking the questions. First, I was just curious about the service side. As we look at a potential recession next year, how much of the business or service revenue comes from life science, given that's probably your most stable or defensive business?

Today, it's in the 60% maybe 63% range, low '60s.

Okay. Thanks. And Lee, I believe maybe a quarter ago or even two quarters ago, labor shortages were sort of an issue for you. It seems so far from the commentary, it's not as much of a concern today, especially given the new CBLs and the influx of new tax, but I know you're still looking to hire employees to support future growth. So maybe if you can help how we should think about employee additions and investments there?

Having employees and technical staff is crucial to our growth strategy. That's why we established a training center and successfully trained 48 people in the first two and a half quarters. Out of those 48, 46 are now working in the field at their respective labs, which is great news. Their productivity might not match future levels, but they are active and contributing, and we have developed our own workforce, which is fantastic. In the long term, we will continue this approach, and we are also focusing on automation, which will require more operators than technicians, making it easier for us to find and hire at lower costs. We are tackling the technical labor issue from multiple angles, including automation, process improvement, and staff development. Additionally, we have a strong reputation in the industry, and we believe we are a desirable place for technicians to work due to our great culture. We have made significant efforts to be an attractive workplace for a technical workforce to grow and develop, so I feel confident about our position.

Okay. No, thanks. That's great. And again, looking out to next year, a lot of pointers to recession, companies concerned about labor, raw materials, cost inflation; you name it, that's something out there. But as a warning for you now, as you look out to next year, what do you see as maybe the biggest headwind for you, if any?

We have cautious optimism like everyone else. We recognize the same challenges that others are facing, but with 35 years of experience in this industry and various economic cycles, I believe our calibration business is well positioned for a potential economic slowdown, especially given our focus on regulated markets. Every business will feel the impact in some way, but our business model provides a solid buffer against the typical consequences of a slowdown. I appreciate the model we're currently pursuing, and I feel confident about our position if conditions begin to worsen.

That's great. Thanks for taking the questions.

No problem.

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

Thank you all for joining us on the earnings call today. We appreciate your continued interest in Transcat. Transcat will be presenting in person at the IDEAS Conference in Dallas on November 16 and at the Craig-Hallum Alpha Select Conference the following day in New York City, on November 17. Feel free to attend our presentation or sign up for one-on-ones if you'll be at those conferences. Additionally, you're welcome to check in with us at any time. We look forward to talking with everyone again after our third-quarter results. Thank you for joining us.

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.