Transcat Inc (TRNS) Q1 2024 Earnings Call Transcript

Greetings and welcome to the Transcat, Inc. First Quarter Fiscal Year 2024 Financial Results. At this time, all participants are in a listen-only mode. A brief 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, CFO. Please, sir, you may begin.

Thank you, operator, and good morning, everyone. We appreciate your time and interest in Transcat. Joining me on the call today are our President and CEO, Lee Rudow, and our Chief Operating Officer, Mark Doheny. We will start with some prepared remarks before opening the call for questions. Our earnings release was issued after the markets closed yesterday, and both the earnings release and the slides we will reference can be found on our website, transcat.com, in the Investor Relations section. Please refer to Slide 2. As you know, we may make forward-looking statements during the formal presentation and Q&A, which pertain to future events that carry risks and uncertainties, among other factors that could lead to actual results differing significantly from our current outlook. These factors are detailed in the news release and in the documents filed with the SEC, available on our website and at sec.gov. We do not undertake any obligation to publicly update or correct any forward-looking statements made in this call, unless required by law. Please review our forward-looking statements alongside these cautionary factors. Additionally, we will discuss certain non-GAAP measures today, which we believe will help in evaluating our performance. This information should not be considered alone or as a substitute for results prepared in accordance with GAAP. We have provided reconciliations of non-GAAP to GAAP measures in the tables accompanying the earnings release. I will now hand the call over to Lee.

Thank you, Tom. Good morning, everyone. Thank you for joining us on the call today. I'd like to start with Transcat's overall performance in the first quarter of fiscal 2024. We delivered better-than-expected revenue, margins and earnings across our entire business portfolio. Consolidated revenue was up 11% to $61 million, driven by strong demand from our unique suite of diverse complementary services including calibration, instrument rentals, and NEXA’s cost control and compliance services. Consolidated gross margin expanded 150 basis points to 30.9% and was driven by margin expansion in both our Service and Distribution segments. Adjusted EBITDA, a key metric for us given our successful acquisition strategy, grew 16% to $8.5 million and expanded 60 basis points over the prior year. Turning to our Service segment. First quarter service revenue totaled $40 million, up 18% from the prior year. Organic growth was up 11% as we continue to benefit from recurring revenue streams in highly regulated markets, our unique and differentiated value proposition, and growth synergies between our combined business channels. The service growth in the first quarter represents our 57th consecutive quarter of year-over-year growth. That's every quarter year-over-year for a little over 14 years. We also reported a service gross margin of 32.5%, which represents a 50 basis point increase over the prior year. The margin expansion, which exceeded our expectations, was a result of double-digit organic growth combined with increased productivity in our lab operations. Lab operations continue to drive automation and continuous process improvement throughout our traditional and client-based lab network. Moving to distribution. First quarter gross margins expanded 270 basis points from the prior year, driven in part by 15% growth in the high-margin rental business. We continue to see strong demand for our rental offering, which is an important differentiator as it enhances Transcat's ability to offer solutions to challenges our customers face. Our distribution segment, including our rental channel, continues to foster organic service growth by generating a significant number of leads and strengthening our overall value proposition. Looking at the entire business portfolio in the first quarter fiscal 2024, we benefited from our differentiated value proposition that is resonating throughout our expanded addressable markets. We also demonstrated the inherent operating leverage in our service business as we generated strong incremental gross margins from our double-digit organic service growth. The NEXA business continues to see good growth benefiting from synergies with Transcat's core calibration business. And the pipeline of synergistic opportunities is compounding at an impressive rate. While the traditional calibration service market continues to be fragmented, we're seeing similar market attributes in the spaces where NEXA competes. Early in July, we were able to capitalize on the opportunity to acquire SteriQual who specializes in instrument commissioning, qualification and validation services to pharmaceutical, medical device, and diagnostic manufacturers. SteriQual also provides process engineering, quality assurance, and project management to recent clients like Pfizer and others. We view the acquisition of SteriQual as another important differentiator, as NEXA delivers our single-source solution platform, which complements Transcat's calibration services. At the start of the first quarter, we also acquired the bolt-on acquisition of St. Louis based TIC Metrology Services. The newly acquired calibration operation will be integrated with our current lab in St. Louis within the next year, and we anticipate the operation will support solid revenue growth and the realization of various cost synergies as we consolidate the labs into one. Overall, our balance sheet remains strong and our current leverage ratio is 1.5 times. We've done an excellent job managing our working capital. And in the first quarter, we generated $7.5 million of free cash flow. Over the course of fiscal 2024, we expect to continue to deploy capital to margin and revenue-enhancing initiatives, along with the execution of our ongoing acquisition and integration strategy. And with that, I'll turn things over to Tom for a more detailed look at the financials for the first quarter.

Thanks, Lee. I'll start on Slide 4 of the earnings deck posted on our website, which provides detail regarding our revenue on a consolidated basis and by segment for the first quarter of fiscal 2024. First quarter consolidated revenue of $60.6 million was up 11% versus the prior year on service segment strength and solid revenue performance in our distribution business. Looking at it by segment, service revenue growth remained very strong at 18% with 11% of the growth coming organically and the other 7% from acquisition. As Lee mentioned, demand in our service business remained strong in the quarter. Turning to distribution, revenue of $20.7 million was consistent with the prior year. Within the Distribution segment, we continue to see excellent performance in the high-margin rental business. Turning to Slide 5. Our consolidated gross profit for the first quarter of $18.7 million was up 17% from the prior year. And our gross margin expanded 160 basis points to 30.9% in the first quarter. Service gross margin expanded 50 basis points. The service margin increase further demonstrated our ability to leverage higher levels of technician productivity and our differentiated value proposition, which continues to drive high levels of demand. Distribution segment gross margin of 27.7% was up 270 basis points, driven by strong performance in the previously mentioned rental business. Turning to Slide 6. Q1 net income of $2.9 million decreased 4% from the prior year, and our diluted earnings per share came in at $0.38. Net income was negatively impacted by a shift in stock-based tax benefits from Q1 of last year to Q2 of this year, as well as higher interest expense. The combined year-over-year impact of these two items was $0.11 per share. We report adjusted diluted earnings per share as well to normalize for the impacts of upfront and ongoing acquisition-related costs. Q1 adjusted diluted earnings per share was $0.52. Flipping to Slide 7, where we show our adjusted EBITDA and adjusted EBITDA margin. We use adjusted EBITDA, which is non-GAAP to gauge the performance of our business because we believe it is the best measure of our operating performance and ability to generate cash. As we continue to execute on our acquisition strategy, this metric becomes even more important to highlight as it does adjust for related transaction costs as well as the increased levels of noncash expenses that will hit our income statement from acquisition purchase accounting. With that in mind, first quarter consolidated adjusted EBITDA of $8.5 million was up 16% from the same quarter in the prior year, and adjusted EBITDA margin expanded 60 basis points. Both segments had adjusted EBITDA growth compared to last 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 8. Operating cash flow was $7.5 million in the first quarter, which was up significantly year-over-year. Q1 capital expenditures were $400,000 higher than the prior year and continue to be centered around Service segment capabilities, technology, including automation and future growth projects. At quarter end, we had a total net debt of $46.2 million with a leverage ratio of 1.5 times. We had $37.5 million available from our credit facility as previously announced, we acquired SteriQual for $4.25 million just after the end of the first quarter, paid 100% in the company stock. Lastly, we expect to file our Form 10-Q on August 2 after the market closes. With that, I'll turn it back to you, Lee.

Okay. Thanks, Tom. I'll wrap things up by pointing out that Transcat has continued our track record of consistent performance over many, many years and over various economic cycles. We generated profitable growth and have proven to be a very resilient business model. And perhaps most important, we've assembled a very skilled leadership team, which we believe is the ultimate competitive advantage. As we look forward, we expect to deliver strong performance throughout the balance of fiscal 2024. We expect organic service growth in the high single-digit to low double-digit range, and the gross margins will continue to increase over time. We will continue to execute our acquisition strategy to add capabilities and expertise, expand our geographic footprint into important regional markets and bolt-on opportunities that leverage our current lab infrastructure. From both an organic and acquitive perspective, our focus will remain on our diverse strategic channels, including calibration, pipettes, instrument rentals, and NEXA suite of cost control and compliance services. As in the past, we will leverage the highly regulated markets where the cost of failure is high and our unique value proposition resonates the most. Our go-to-market strategy remains the same, that is to demonstrate to our demanding regulated customer base that Transcat can be trusted as their risk-mitigating service partner. We do this by leveraging our core competencies, which allows them to focus on theirs. In other words, we win together. As we work our way through the second quarter of fiscal 2024, our acquisition pipeline remains strong and our initiatives designed to drive organic service growth and margin improvement continue to gain traction. Effective allocation of capital has always been a hallmark of Transcat and at the heart of our growth strategy. We expect our balance sheet to remain strong and supportive as we drive sustainable long-term shareholder value. We like the trajectory of our business and the leadership team calling the shots. In many ways, as we discuss internally amongst our leadership team, we feel like we're just getting started. And with that, operator, please open the line for questions.

Thank you. We will now be conducting a question-and-answer session. Our first question comes from Greg Palm with Craig-Hallum Capital Group. Please go ahead.

Awesome. Thanks. Congrats on the great results, everyone.

Thanks, Greg.

I want to just maybe start with the quarter. It wasn't that long ago, quite a couple of months ago since you gave an update; you nicely exceeded expectations. But more surprisingly, you raised the outlook for the full year, at least on the service side for organic growth. So I'm just curious, did you see an uptick in June specifically? Or what are you seeing in July that makes you confident that one quarter out of the gates you raised the outlook for the year?

Okay. Yes, Greg, I appreciate where that question is coming from. We talk a lot about it internally, as you can imagine. It's really quite simple. We've had three consecutive quarters of double-digit growth. We like the pulse going into the second quarter or at least we're almost halfway through the second quarter. When we just look at our pipeline and look at the business activity, in general, we think the pulse supports being in the range that we stated. So not a major change, more of a subtle one, but I think appropriately timed.

Yes, makes sense. Any specific end markets or areas that are maybe outperforming relative to what your expectations were a couple of months ago?

I wouldn't point to anything specific other than to say, we like the way some of the synergies are working between NEXA and Transcat. I think these two businesses continue to complement one another. And by complement, I'm referring to the business activity levels that are on the increase as a result of working together versus working separately or before the acquisition. So I think that's gained traction and momentum probably as much or more than anything.

Okay. And then just shifting gears to distribution, what really caught us by surprise in a positive way was the gross margin there? And I guess it’s somewhat a byproduct of strength in rental. So any way you can give us a sense of what rentals growth was and maybe ballpark where rentals is in terms of mix as a part of distribution overall?

Yes, Greg, it's Tom. I would characterize the rental growth as being stronger and at a higher level than what we are experiencing in the service sector of the rental business. It continues to perform well, and as we've mentioned previously, the margins are significantly better than those in the overall distribution business. Additionally, we have managed to continue with some advanced purchases, which benefit both the overall margins and the distribution side. So, while rentals are performing well, we anticipate a moderation as we move into the second half of the year.

Okay. But just to be clear, I mean, that margin in distribution specifically was, I don't know if it was a record, but certainly one of the best that we've seen since we've been tracking the company. I'm assuming that's not sort of a normalized rate going forward, but maybe you can help us figure out what the normalized run rate is, just given rentals is a bigger part of the mix because we used to think of it as kind of a low to mid-20s, but obviously, you had a good year in fiscal 2023 and really an outsized result here in fiscal Q1.

I wanted to quickly mention that the changes you're observing in our margins are deliberate on our part. We've focused on directing funds toward areas where we want to see growth. As we continue to invest in higher-margin segments over time and shift our focus towards them, we may observe an improvement in our margins, moving from the low 20s to the high 20s. We're already beginning to see some of this progress in the last quarter, and I don’t believe it’s a one-time occurrence. As we strategically change our mix and invest in higher-margin channels, we can expect to see further increases. Tom, do you have a different perspective?

No. I would like to add that we are intentionally moving away from some of the lower-margin traditional distribution business. The growth in rentals is providing us the opportunity to step back from some of that less desirable business.

And we're in a nice position to do that now, Greg, versus a couple of years ago.

Yes. Understood. All right. Well, congrats again. Best of luck. Thanks.

Take care.

Our next question comes from Gerry Sweeney with ROTH Capital Partners LLC. Please go ahead.

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

Hi, good morning.

I wanted to spend just a little bit of time on NEXA and strategy isn't the right word, but maybe I want to see if you could talk a little bit more about the opportunity behind NEXA and sort of that entire market. I'm not sure market size opportunity, acquisitions, it's been a great purchase for you. Obviously, you're following it up with SteriQual. But just wanted to get a better feel for what really lies out there on that side of the business.

Right. Well, first, I mean, just to take one small step back to describe the different models. On the traditional Transcat side, we do calibration services. On the NEXA side, they don't perform calibration services at all, but they do everything around that, around the calibration process, they are in the calibration ecosystem. And we use the words cost control and compliance because most of their work is done in large life science companies where they're doing CMMS work, where the data is being consolidated from one system to the next, where they're looking at ways to be more efficient to lower their costs over time through anything from efficiencies of usage of the instruments, uptime, reliability could be interval adjustments involved. So they essentially improve calibration programs, we do the calibration work. And so you can see the natural complementary nature between the two. We can bring them into our clients, which we have over 30,000 when we see an opportunity to where cost is a factor or efficiency is a factor, they can bring us into opportunities when they see a problem at one of their clients because the calibration vendors are not performing effectively. So there's just a natural good fit and when we go together, sit at the same table, and this is probably the biggest point, Gerry. When we're pitching our value prop to a customer together, it is really effective. It's difficult to compete against us when all the stars align in that way. And that's where we're seeing the growth both from an organic Transcat perspective and also from NEXA perspective, it just kind of working well, and we think it's going to continue.

And certainly get that, and I apologize, maybe it wasn't 100% clear. But I was curious how big of a market maybe that cost control and outsourcing efficiency market that is NEXA. How big is that opportunity?

That's something we're working on to try to come up with a range that would be meaningful to our shareholders. I'm not going to be able to give you that size of the market today, other than to say it's significantly larger than just calibration. The calibration world is a $1.5 billion to $2 billion market in North America. It's going to be significantly larger than that because their business is driven — well, in a sense, now that SteriQual, in particular, as part of the NEXA value proposition, you get commissioning, you get startups in plants and so on and so forth. And so as capital spend to build facilities around the country, and there are certain estimates about life science capital spend that we take a close look at. But while that market is getting bigger and bigger for us as we expand the services within that ecosystem. So we'll try to work on a figure, but I will say it could be significantly larger — it could be 10 times larger in that range from the traditional calibration business. So they'll help us gain share and then we'll gain share inherently by the nature of their business and the channels that they serve.

So it suffices to say, it dramatically expands your addressable market and while you're pretty small nascent in that market, a lot of runway, lots of synergies and strength in both sides of the house.

Yes, we think so. And then we're doing business in Ireland as well, but the nature of their business is, it's not that difficult on their side of the equation to scale their business, even beyond some work. I think we said last quarter, in Belgium and Germany because you have the same customer as another facility in Europe and in different country, it's not a big leap to service them to do an on-site visit, go back to Ireland, do 80% of the work behind the computer, so to speak, and periodic visits. So it's unlike calibration, which we will scale and have scale, it's a little bit easier as you cross borders. So that's another attribute of the business that we like.

Got it. And how is the market fragmented? Or similar to what calibration market is, I mean, in calibration there are a couple of larger players then a bunch of small players, but how does the market look from that perspective?

Well, we're learning more and more about the market as each quarter goes by, but my answer to that question is, we think so. And part of the script in this particular release was to say that we're discovering as we do our development work on the acquisition side that it is fragmented. It may be equal to or even more fragmented than the calibration business. So it lends itself to those acquisition and integration opportunities that we see with traditional Transcat. We like that, and that's why we mentioned it in the earnings script.

Got it. One last question. And I think this is all positive. This is what just trying to get by the way. Maybe I should notice, but what does the margin profile look like? You actually talked about it's easier to leverage. So there — it sounds like there are some either margin components or at least leverage opportunities on the NEXA side. Maybe just...

It's Tom. I mean what we've said in the past, right, is that the gross margins for NEXA are generally higher than they are for the overall services, we’ll just leave it at that.

Okay. Got it. Okay. Thanks a lot. Appreciate it.

You are welcome.

Our next question comes from Ted Jackson with Northland Securities. Please go ahead.

Good morning, guys. Congrats on the quarter.

Good morning, Ted.

Just I'm going to kind of keep it to two questions and let things go forward. One is, I want to talk a little bit about the customer-based labs. In the first half of the guess calendar year, we know there was some discussion about some impact with margin with regards to some of that new stuff coming online. So I'm curious what we could expect to see with regards to kind of an operating margin in the back half of this calendar year as we roll through and that moves behind and then tied into that is what the pipeline looks like with regards to new opportunities there? And then I've got a follow-up.

We have secured a few customer-based labs early this year and later last year. Typically, when we win a new lab, the first couple of quarters experience a slight decline in service gross margins due to reasons that are understandable, such as new staff getting accustomed to the lab processes. There are definitely a few quarters where we are not operating at peak efficiency, but this usually improves over time. Looking at the margin expansion in the first quarter, we didn't anticipate it coming out of the fourth quarter. Some of this can be attributed to the initial ramp-up of the labs over a quarter or two. This factor always exists, but we know how to address it relatively quickly, although there is still some margin pressure at the beginning. We have made progress in this area. Regarding the pipeline, it’s looking strong and as robust as ever. From a client-based lab perspective, this strength is a result of the difficulties the market faces in hiring technicians. Even clients that would typically run their own labs encounter challenges finding technicians, and they don’t have the same resources we do, like our technician school, Transcat University. They hire a few technicians annually while we bring on hundreds, which leads to a noticeable difference in proficiency. We have the manpower and the ability to adapt our staff as needed, which greatly benefits these client-based labs, even when they face challenges. This kind of labor environment will always support the growth of our client-based lab business, and we are seeing that continue this year.

Okay. So let me move on to my next question about NEXA and the M&A pipeline. The last time we spoke, it was evident that the M&A opportunities were plentiful, and there was considerable discussion about enhancing the NEXA portfolio through acquisitions. You've made the first acquisition in that area. What does the overall pipeline look like? How does it relate to consulting services? I'm particularly interested in that sector. Where do you see potential opportunities, and what specific areas within your NEXA business do you think are promising?

Well, I think we look at some of our growth — strategic growth opportunities across calibration. We'd say this from pipettes, rentals, we say it NEXA as well. And we're always looking for acquisition opportunities that meet our sort of stringent criteria. We're very disciplined, so we don't have a track record like we do in terms of success versus lack of success unless you're very disciplined at the outset in upfront. We remain disciplined in that way. We've got a great process and a great team that does this sort of work. So just having said that sort of a foundational comment, we are looking at the NEXA space, that cost control and compliance services space because we think it is a good fit. They are called an example of that. So I feel pretty comfortable saying SteriQual won’t be the last acquisition we ever made under NEXA, although the Transcat way is, let’s walk before we run. They want to prove this out. Let’s make sure that it is as well as we think it’s going to fit that their leadership team can integrate this as well as we pay on integrating. I like to see things proven. And so I get the question, yes, there will be more acquisitions likely in this space. We would expect that. But we're not going to rush it until the opportunity hits us that we think fits and that our leadership team has proven that on that side of the equation, they could do well with acquisitions. I have every reason to believe and every confidence that they will, but it's just the Transcat way to prove it before we jump in too far. So I kind of want to make that comment. But again, it's the same way with all of our acquisitions. Our pipeline is diverse because we want to be able to support all these areas, and it just made sense, SteriQual is the next fit and there will be others in time.

Thanks. Can I just sneak in one quick last one, which is around the distribution side of the business. And you clearly are seeing some really big growth in the rental side of the equation there. Probably as you mentioned answering the prior question on the equipment actual sales side, you're exiting some of the lower-end stuff where there is low margins, a lot of competition and stuff. Nothing of a secret there. How should we think about in kind of an aggregate going forward? In the past, we've kind of always been able to call it a GDP growth line item kind of — but I mean, as you're kind of sort of retooling that business and kind of walking away from things that you should walk away from, things where there's really not much of a profit margin in the squeeze. Does that change that calculus in terms of how we should think about the longer-term growth for distribution?

I'm not sure I would characterize it exactly the way you did, in that we're not directly exiting the distribution business. I think it's — I totally get it. I'm thinking more in line with allocation of future incremental capital. As we have capital spend and we look at both get the service business over here with recurring revenue streams and driven by regulations. We got the NEXA business with cost control and how that plays between some of our other channels. We've got rentals, which is kind of like a bridge to everything. When we look at how we allocate capital, the core distribution allocation is decreasing as a percentage on a go-forward basis. And by the way, it has for the last five years and we've had investors over time that have said, can you double the size of your distribution business? Can you make it $150 million? And we say, well, we could, but we won't, because that's not our strategy. And so as we go forward, think about we like the rentals mix more than the old line distribution mix because the margins are better and it has more of a recurring nature to it by customer. And so we incremental spent more dollars. And that's been for the last three, four, five years running, that's how we got these margins. That's why they're sustainable. This is not an overnight thing. This is something that's evolved over the last half a decade, and it continues to pick up momentum. That’s how I characterize it. So if we continue — if you kind of draw the line out, it continues that pattern of allocation, you're going to see similar growth results, I think, in that margin over time and that profile over time. Tom, would you straight away or Mark or ...

Yes. I mean, I think ultimately, Ted started with a question of is it GDP-like growth rate. What we should expect going forward. And I would just say yes. And again, there's — we expect to continue to perform well here. The only caution I would say is that, we have been getting some benefit from these advanced buys that we've been doing. And I think that's the piece of it that will kind of moderate as we get into the second half of the year and kind of change the trajectory on the margins a little bit. But still, I think we're talking about a mid-20s kind of market business versus a low 20s margin business that we had three or four years ago. It's more sustainable.

It's more sustainable.

Okay. And Tom, I did catch that comment regarding the advanced buys. So — but thanks for reiterating. And again, congrats on the quarter.

Thank you, Ted. Thank you.

There are no further questions at this time. I would like to turn the floor back over to Lee Rudow for closing comments. Please go ahead.

Well, thank you all for joining us on the call today. We certainly appreciate your continued interest in Transcat. We will be participating at the Oppenheimer Conference, which is on the 26th annual tech conference for them on August 9. We'll be participating there, feel free to call us or join us. If not, feel free to check in with us at any time. We look forward to speaking with everybody again at the end of next quarter. So again, thanks for participating.

This concludes today's conference call. You may disconnect your lines at this time. Thank you for your participation, and have a good day.