Twin Disc Inc Q2 FY2021 Earnings Call

Thank you, James. On behalf of the management of Twin Disc, we are extremely pleased that you have taken the time to participate in our call and thank you for joining us to discuss the company's fiscal 2021 second quarter and first half financial results and business outlook. Before introducing management, I would like to remind everyone that certain statements made during this conference call, especially those that state management's intentions, hopes, beliefs, expectations or predictions for the future are forward-looking statements. It is important to remember that the Company's actual results could differ materially from those projected in such forward-looking statements. Information concerning factors that could cause actual results to differ materially from those in the forward-looking statements are contained in the Company's Annual Report on Form 10-K, copies of which may be obtained by contacting either the Company or the SEC. By now, you should have received a copy of the news release, which was issued this morning before the market opened. If you have not received a copy, please call Annette Mianecki at 262-638-4000 and she will send the copy to you. Hosting the call today are John Batten, Twin Disc's Chief Executive Officer; and Jeff Knutson, the Company's Vice President of Finance, Chief Financial Officer, Treasurer and Secretary. At this time, I will turn the call over to John Batten. John?

Thank you, Stan, and good morning, everyone. Welcome to our fiscal 2021 second quarter conference call. As usual, we'll begin with a short summary statement and then Jeff and I will be happy to take your questions. Before Jeff goes over the quarterly results, I'll touch on some of the operational highlights or headwinds that we faced in the quarter. Again, in the fall timeframe of our second quarter, we faced a lot of our distributors and end-customers working down inventory that was in the pipeline. And we've seen that trend start to reverse, and orders in the backlog improved in the quarter. I thought our team did an excellent job navigating the continuing COVID pandemic and ongoing staffing issues due to quarantines. Obviously, having people out in the plant, we’re seeing 15% to 20% of the staff out, but there are a lot of increased efficiencies and some extra overtime for people who were not in quarantine. Half of the topline miss that we faced in the second quarter was due to aftermarket, and obviously, aftermarket parts come at a higher margin. A lot of that miss was due to decreased activity, specifically the ability to do rebuilds in the market, and we've seen that trend reverse as of late regarding incoming orders in the quarter and that continued into January. Our facility in Lufkin did come online in late November, early December, and we started producing and shipping some of our mechanical clutch line. All of the rest of the mechanical clutches and PTOs were transferred there over the holiday shutdown. Orders in the quarter did show some improvement, and as you've seen in the press release, our backlog did increase during the quarter. We saw strong orders at our Veth subsidiary, good orders in Asia and Australia, and in many of the U.S. and European core markets. Obviously, activity in North American oil and gas remained extremely low, but we did see some aftermarket demand in orders at the end of the quarter, and we are seeing some rebuild activity at some of our customers starting in January. We did have a nice increase again, in projects for hybrid and electrification, and our application and engineering teams are very busy with projects in most of our core markets, whether it's industrial, marine, or oil and gas, and we expect to receive more orders as these projects come to completion. With that, I'll turn it over to Jeff for some comments on the financials before I come back for an outlook.

Thanks, John, and good morning, everyone. I'll briefly run through the fiscal 2021 second quarter numbers. Sales of $48.4 million for the quarter were down $11.1 million or 18.6% from the prior year second quarter. The decline from the prior year is a result of the continuation of the generally weak global economy due to the ongoing effects of the COVID-19 pandemic. Compared to the prior year second quarter, transmission sales were down 28.7%, industrial sales were down 8.2%, and marine and propulsion were down 18.1%. By region, sales in North America were down 35%, in Europe were down 17%, and in Asia-Pacific were actually up 11% due to improving Australian market demand and relatively stable demand for oil and gas transmissions in China. Foreign currency exchange had a net positive impact of $2.1 million on sales in the quarter. For the first half, sales are down $24.2 million or 20.4%, with currency translation contributing a positive impact of $3.6 million compared to the prior year first half. The second quarter margin percentage was 19.6%, compared to 26.4% in the prior year second quarter. The decline in margin percentage was primarily a function of the reduced volume and a very unfavorable product mix, with a significant decline in aftermarket volume and shipments in the North American oil and gas market. Gross profit for the first half finished at 20.9%, compared to 21.3% for the fiscal '20 first half. Spending on marketing, engineering, and administrative costs for the fiscal '21 second quarter decreased $2.4 million or 15% compared to fiscal '20. This decrease is primarily the result of reduced payroll costs, bonus expenses, corporate travel, amortization expenses, and marketing activities. Additionally, North American wages would continue to aggressively pursue cost reduction opportunities to compensate for the decline in gross profit. As a percent of revenue for the second quarter, ME&A expense was 28.8%, compared to 27.6% in the prior year second quarter. For the first half, ME&A spending is down $5.8 million or 17.6%, finishing at 28.5% of revenue compared to 27.6% in the fiscal '20 first half. Our restructuring charge of $120,000 was recorded in the second fiscal quarter, primarily related to actions to adjust the cost structure at our domestic operation, and ongoing cost reduction and productivity actions at our European operation. With the reduced second quarter volume and a challenging product mix, we reported an operating loss of $4.6 million in the quarter compared to a loss of $5 million in the prior year quarter; this is despite improvements due to the prior year impairment charge, partially offset by the volume decline and unfavorable mix impact. For the first half, the operating loss of $7.8 million reflects a $4 million improvement over the fiscal '20 first half. Significant other expenses of $1.7 million for the quarter and $2.9 million for the first half are primarily due to translation losses on euro-denominated liabilities caused by the weakening of the U.S. dollar. The effective tax rate for the fiscal '21 second quarter was 38.1% compared to a negative 19.2% for the same period last fiscal year. The current year rate benefited from newly enacted regulations related to the GILTI provisions of the Tax Cuts and Jobs Act. The net loss for the second quarter of fiscal '21 was $4.3 million or $0.33 per diluted share, compared to a net loss of $6.5 million or $0.49 per diluted share in the prior year second quarter. Through the first half, we reported a net loss of $8.3 million or $0.63 per share compared to $12.8 million or $0.98 per diluted share in the prior-year first half. EBITDA was negative $3.6 million for the quarter, reduced from the negative $2 million in the prior year second quarter. For the first half, EBITDA was negative $5.2 million, which is $1.5 million better than the prior year first half. As we worked through the second quarter with little market improvement, we determined there was a high likelihood that we would not meet the minimum fuel cumulative EBITDA covenant for the quarter. As a result, we have entered into a forbearance agreement with BMO that relieves us of the EBITDA covenant through September 30, 2021. This agreement also reduces our maximum capacity to $42.5 million from the current $45 million for the forbearance period and includes additional reporting requirements which are detailed in an 8-K filed earlier today. Turning to the balance sheet; inventory was up $1.6 million due to a $4.9 million currency translation-driven increase, partially offset by a significant reduction at the North American operation. With a focus on liquidity and cash flow, we were able to generate $3.5 million of operating cash flow in the quarter, bringing free cash flow to essentially breakeven through the first half. Capital spending at $1.4 million for the quarter was focused on the new Lufkin facility and modern machine tools and testing equipment. As we remain in a very challenging market environment, we will continue to defer all non-essential capital spending and continue to expect to invest $5 million to $7 million during the fiscal year. Now, I'll turn it back to John for some final comments.

Thanks, Jeff, and I have just a few comments on the outlook. As we've mentioned, orders and backlog improved in the second quarter, and we saw that across most markets including oil and gas and some spare parts orders, and we expect our core markets to improve throughout the year; oil and gas may improve a little bit towards the latter half of the year. But we are seeing, as I mentioned, much better demand in our aftermarket spare parts orders. The order rates in January were double what they were throughout the summer, so that gives us a lot of optimism heading into calendar 2021. Our focus remains diversification through the growth of our other markets outside of oil and gas, primarily industrial, with our new products coming out with the HPTOs and RPTO line that will be produced at the Lufkin facility. Again, our focus is on how we can participate in supplying the complete system in hybrid and electrification or how we can provide the key components that work in the general systems. We will continue with those product development efforts throughout the year and rationalize our investment in bricks-and-mortar, whether in North America or in Europe. That concludes our prepared remarks. With that, James, we'll turn it over for questions.

Hey, good morning, John and Jeff. Can we start with the transition and ramp up of Lufkin? So first I want to understand how the transition is going, how you see revenue capacity ramping at Lufkin, and if you can remind us of the revenue you think that can support and how much of that is incremental. And then just to clarify, did you have any production slowdowns or lost revenue in the quarter from the transition, or do you expect any? Thanks.

Hi, Noah. It's John. So, Lufkin will probably be for the first 12 plus months about $1 million to $1.5 million of shipment a month as we transition the units that were being produced here in Racine. Depending upon what units go there, we have the brick-and-mortar there; phase 1 is 50,000 square feet. We could easily go to $30 million to $50 million depending on the value of the units that are produced there, so we have considerable room for growth. So, the incremental business, I wouldn’t say there is much incremental business there; it's moving business from Racine. However, given the extra room and capacity there and the team focused, we are determined to grow our industrial business in a way that we could not have done it in Racine given the constraints here. So, part of the plan with Lufkin is to move the industrial production there. We’ll move the inventory and free up room here in Racine. We have three facilities currently in Racine County: corporate headquarters, 21st Street which is our main manufacturing plant, and an aftermarket warehouse out on the Interstate. The plan is that once Lufkin is up and running, we can consolidate some of the facilities we have in Racine for further savings. So, the long-term plan is the growth of our industrial business in Lufkin, which will then allow us to consolidate some of our facilities here in Racine.

Yes. And I would say that run rate has a lot of untapped markets you can play, but can you talk about your strategy for growing industrial sales and market applications, regions where you think you have relatively low partners?

So, our biggest potential for growth is in the industrial markets and it’s with the clutches in the PTO lines. We're doing a lot of projects and a lot of development on being able to plug into hybrid and electrification efforts. Many of these require gearboxes with motors and control systems. Whether it's expanding our hydraulic PTO, typically used for larger horsepower than the mechanical PTOs, or remote control activated mechanical PTO lines, or pump drives and gearboxes. So a pump drive or an AM line basically in a hybrid application connects behind the diesel engine to provide inputs, whether it's a hydraulic pump or an electric motor. As more applications shift to hybrid and electrification, we are well-positioned to supply the necessary components. It's about growing our core, as well as the internal combustion engine part of industrial, and we see a lot of growth in hybridization and electrification areas across all markets, which could include recycling, construction, biomass, and some oil and gas applications. We're really looking to grow and focus on the capacity of a facility that is not on different cycles; the Lufkin facility will be solely dedicated to the industrial business.

Hi, good morning, John and Jeff. Just dovetailing on the prior question about the sort of strategy to grow industrial. I guess what’s required to work with newer OEMs that you haven’t worked with in the past? Are these usually with OEMs that you already have a relationship with, and how are you approaching those?

Yes, Josh, it's both and all of the above. It is working with our existing customers, who are venturing into hybridization and electrification, and it's working with new OEMs that we haven't engaged with before. Moreover, a lot of it is working with partners because, as I mentioned in previous calls, it’s rare that one company can provide all the necessary components and solutions. We often find ourselves collaborating with electric motor manufacturers, people who handle the inverters, and other controlling companies. It is not a one-size-fits-all solution. What we’re trying to do is look at our traditional customer base and other customers that we don’t yet engage, and work with them on the solutions that they need. We can provide all of that, part of it, or we have the products that integrate nicely into a hybrid solution or an electrification solution provided by another company. It’s all of the above; our main effort, my effort, and the management team is to focus on the solutions that provide the best return in the near-term. We have to sharpen our focus, and that's what we've been concentrating on in the last years—working with key long-term customers and exciting new partners.

Okay, that’s good to hear. I guess my next question is on the oil and gas business. Does the backlog improvement also include some of the improvement that you expect to see over the next couple of quarters, and broadly, with respect to the replacement cycle, how do you expect the pace of that to unfold? I know that in the past, both cycles have been sort of all at once, but will the replacement come at a more gradual pace?

Yes, Josh. The improvement in the backlog indicates unit demand improvements for Asia, along with some spare parts demand improvement here in North America, which has seen slightly stronger demand from some of our distributors. They’ve been able to clear excess inventory, and hopefully, soon we will see the replacement orders. I don’t see any large unit demand for new construction like we experienced in 2017, 2018, or 2011, 2012. We might see that towards the end of the second half of this calendar year. However, I do expect to see steady improvements in some rebuild activity. We are primarily waiting for the transportation demand to recover to pre-pandemic levels, which will drive production and make companies more comfortable about investing in rebuild activity.

That makes sense. Lastly, can we expect to see leverage in the ME&A line as we presumably move back to more normal conditions next year? Will some new expenses come back, or how should we think about that?

Yes, this is Jeff, Josh. As we recover to more normal market conditions, ME&A expenses will increase. We've made a lot of permanent reductions, and some of those reductions, such as the wage reductions and elimination of the bonus program, will return to normal levels. However, we believe we have made sustainable reductions in our cost structure on the ME&A line.

Hi, guys. I guess some people have a bit of a feeling here in the next couple of quarters in the top off perspective. Can't avoid them, so I just wanted to sort of the free cash neutrality environment, ensure that the working capital will kick back in. What’s your position that we can sort of maintain out of the cash burn in the second half?

As we've discussed in the first couple of quarters, that's our focus. We're happy with where we are. I think we have the ability to continue to sort of stay neutral. Any activity in North American oil and gas will help us as we have inventory to support that demand which can turn into cash very quickly. As John pointed out, we are starting to see some of that aftermarket demand, so I believe we are still focused on staying neutral and not leaving cash in this fiscal year.

Most of the orders you're seeing most recently are those sort of book and ship. They're not going to reprice outside the year, fiscal year?

We have to do book and ship, essentially booked and shipped in the aftermarket.

Okay. Any update on the sale of Racine headquarters?

No. It's been relatively quiet; we’ve had one interested party, but nothing to report.

Okay. And what’s it listed for?

I think the list price is $4.3 million.

Good morning. The liabilities that you referred to that are Euro-based translated negatively into dollars; can you give me more details of what that is?

Sure, part of our revolver is Euro-based liability; it was debt taken on when we acquired that subsidiary a year and a half ago. It's denominated in Euros, that's the biggest piece of it.

Got it, thanks. And just to remind an application on the land transmission segment; how much of that is oil and gas specifically?

Yes, I mean, obviously that's our most cyclical piece. Right now, it's probably 20% oil and gas, essentially all in Asia, but it can exceed 50% oil and gas when it's at its peak.

And to what extent do you think progress on gross margin relies on North American natural gas recovery? Looking around the corner a bit, do you think North American oil and gas is a higher gross margin piece of that segment and is a driver for gross margin, or is that not the case?

It is a driver, and I think if you go back to some of our best quarters when we were in the mid-30s, that was largely driven by high North American oil and gas activity. I think we can certainly improve margins without a significant move in oil and gas, but to reach our desired margin levels—around 30%—will require some North American oil and gas activity in the near term. We're working on various aspects to drive improvement, including our cost structure and new product developments. However, North American oil and gas and the aftermarket component is a significant contributor to our mix impact and overall margin performance.

From a big picture perspective, do you think this oil and gas cycle is any different from prior cycles or do you expect activity to return as it always has?

It's John. I don’t disagree that the next wave will not be as big as those we saw five years ago. I suspect people will be more cautious with investments. Still, the long-term outlook is good; we need to generate electricity, and natural gas is a primary source; renewables are increasing each year. However, I don’t think we should overlook the crucial role of natural gas in electricity generation. This trend favors us since we cater to higher horsepower fracturing rigs, and our 8,500 transmission fits perfectly. Overall, I’m optimistic; while the market may not grow significantly, there will still be a need for equipment replacements and rebuilds. Geopolitical events could also influence OPEC’s decisions, so I think it’s essential for us to diversify our operations to weather different market dynamics. We would welcome steady demand over erratic fluctuations; this is what we are hoping for. We would prefer years of lower demand spread over time rather than a rapid boom and bust cycle.

So from your view, do you believe North American oil production may enter a slow decline due to changes in OPEC’s policies, as opposed to a rapid recovery?

I wouldn’t disagree. The market could see a steady-state decline in production. However, production still needs to be replaced and requires pressure pumping services, which remains crucial. We’ve seen reduced deepwater investments, and demand will likely shift to onshore. We expect that as demand returns, there will still be opportunities for rebuilds and retrofits. Furthermore, actions by OPEC could also lead to shifts in production dynamics, but we need to remain flexible as a business. We are prepared to adjust our offerings and grow in areas outside oil and gas to mitigate risks. Our planning reflects necessary corrections to stay resilient amidst these changes. Thank you, James. And thank you, everyone, for joining our conference call today. We appreciate your continual interest in Twin Disc and hope we've answered all your questions. If not, please feel free to contact Jeff or myself, and we'll try to get back to you as quickly as possible. We look forward to speaking with you again following the close of our fiscal '21 third quarter. With that, James, I'll turn the call back to you.

Thank you, sir. That will conclude today's conference. Thank you for your participation. You may now disconnect.