Twin Disc Inc (TWIN) Q4 2021 Earnings Call Transcript

Good day, and welcome to the Twin Disc's Fiscal 2021 Fourth Quarter Conference Call. Today's call is being recorded. At this time, I'd like to turn the call over to Stan Berger. Please go ahead. Thank you, Katie. On behalf of the management team 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 fourth quarter and full-year financial results and business outlook. Before introducing management, I would like to remind everyone that certain statements made during the 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. At this time, I will turn the call over to John. John?

Thank you, Stan, and good morning, everyone. Welcome to our fiscal 2021 fourth quarter and year-end conference call. As usual, we'll begin with a short summary statement, and then I will be happy to take your questions. Most of you will notice that Stan did not mention Jeff Knutson as a host today. Unfortunately, Jeff was involved in an unfortunate incident earlier this week, which will require him to be on leave for the next few weeks. He is doing well and is most likely listening to the call right now. The good news is that we are expecting a full recovery. The bad news is you just have me for the numbers. But joining me today are Jim Feiertag, our President and Chief Operating Officer, and Tim Batten, our Vice President of Sales. Before I go over the quarter and year-end results, I'll just touch on some operational highlights from the quarter. As I've been mentioning in the past, the number of hybrid projects and electrification projects continues to grow, as does our product development in that area. Once our customers are ready to release their products, we will share them with you. As I've mentioned in the past, the development cycles for these applications are not short ones. The COVID-related supply chain issues that we were seeing in the first half of the year continued throughout the fourth quarter, but we have seen some easing, particularly from supply coming from India. Shipments from our new facility in Lufkin are hitting full steam. They've been hampered a little bit by the supply chain issues from India, but they are hitting full stride, and all of our mechanical clutches and PTOs that were once in production in Racine are now being produced in Lufkin. Orders in the fourth quarter were strong and driven by robust aftermarket demand, including parts for North American oil and gas rebuilds. While the six-month backlog is down versus our third-quarter backlog, the overall backlog increased nicely. The shift out passed our six-month window as a combination of customer requirements for those days and the realization that we are going to still have some supply chain issues. We continue to work through our inventory with our distribution partners, and we are confident that as they get new orders, those new orders will improve our factory output. This inventory is being sold off, and projects in our global marine markets are driving this, and those projects remain strong. We should see new orders on marine continuing to improve in the coming quarters. New oil and gas shipments to Asia continue to be very steady and should increase later in this calendar year. Looking at the numbers, the fiscal 2021 fourth quarter and full-year numbers are as follows: Sales of $66.2 million in the fourth quarter were up $6.8 million, or 11.5% from the prior year fourth quarter. The quarter's improvement from the prior year was a result of a strengthening global economy as the ongoing effects of the COVID-19 pandemic began to ease. Compared to the prior year fourth quarter, transmission sales were up 28.9%, industrial sales were up 21.1%, and marine and propulsion sales were down 3.8%. By region, sales into North America were up 9%, sales into Europe were up 11%, and sales into Asia Pacific were up 5%. Foreign currency exchange was a net positive $4.1 million impact on sales in the fourth quarter. For the full year, sales are down $28.2 million or 11.4%. Foreign currency translation contributed a positive impact of $11.6 million compared to the prior fiscal year. The fourth quarter margin percentage was 27.7% compared to 23.3% in the prior year fourth quarter. Similar to the third quarter, the fourth quarter benefited from the Employee Retention Credit, which contributed $1.2 million to gross profit. Adjusting for this benefit, gross profit would have been 25.8%, still a significant sequential year-over-year improvement, reflecting a more favorable sales mix driven by aftermarket activity in the North American oil and gas market and the positive impact of targeted cost-reduction activities. Gross profit for the fiscal year finished at 23.3% compared to 22.6% for fiscal 2020. Spending on marketing, engineering, and administrative costs for the fiscal 2021 fourth quarter increased by $1.6 million, or 11%, compared to fiscal 2020. The increase in the quarter is primarily due to the partial achievement of global incentive metrics resulting in a bonus expense of $2.3 million in the quarter, along with a positive currency translation impact. These increases were offset by the ME&A portion of the Employee Retention Credit and the ongoing focus on cost containment having a favorable impact on global discretionary spending. As a percentage of revenue for the fourth quarter, ME&A expenses were 25.3% compared to 25.4% in the prior year fourth quarter. For the fiscal year, ME&A spending is down $7.5 million or 11.8%, finishing at 25.5% of revenue compared to 25.6% for the prior fiscal year. We recorded restructuring charges totaling $6.6 million in the fourth quarter. This is comprised of a $2.3 million charge for a restructuring program at our Belgian operation, which will result in the elimination of 23 positions and drive annualized savings of approximately $1.6 million. This charge represents the legal minimum cost of the action. Negotiations are ongoing, and we anticipate a final charge will be recorded in the first half of fiscal 2022. We also recorded a $4.2 million impairment charge related to the write-down of our corporate office building to an estimated fair value as this asset is currently held for sale. During the fourth quarter, we received notification of full forgiveness of our $8.2 million PPP loan from the Small Business Administration, resulting in an other operating income benefit of $8.2 million reported in the quarter. Including the significant impacts of restructuring and PPP forgiveness, operating income for the quarter was a positive $3.2 million compared to a $1.5 million operating loss in the prior year. The effective tax rate for fiscal 2021 was negative 110.4% compared to 9.5% for fiscal year 2020. During the current fiscal year, the company received full forgiveness of its PPP loan, which resulted in an increase to the effective tax rate of 17.5%. In the prior year, the company determined that the carrying value of certain goodwill and intangibles exceeded the fair value, and a $27 million impairment loss was calculated, which resulted in a decrease to the prior fiscal year effective tax rate of 13.8%. During the current fiscal year, the company was able to take advantage of the newly enacted high tax exception regulations. The company filed its federal tax return utilizing this exception and had no GILTI inclusion, increasing the current rate by 12%. Due to continued historical domestic losses and uncertain future domestic earnings, the company recognized a full domestic valuation allowance reducing the effective tax rate by 158.6%. The net loss for the fourth quarter of fiscal 2021 was $12.7 million or $0.96 per diluted share, largely due to the $15 million deferred tax valuation allowance recorded in the quarter compared to a net loss of $1.8 million or $0.13 per diluted share in the prior year fourth quarter. For the fiscal year, we reported a net loss of $20.9 million or $1.58 per diluted share compared to $39.8 million or $3.03 per diluted share in the prior year. EBITDA of $4.9 million for the quarter improved from $1.3 million in the prior year fourth quarter. For the year, EBITDA of $3.6 million was nearly $34 million improved over the prior year. Turning to the balance sheet, inventory was down $1.7 million in the quarter and $5.6 million for the year despite the $3.4 million currency translation-driven increase. With a focus on liquidity and cash flow, we were able to generate $1.5 million of operating cash flow in the quarter, bringing free cash flow to positive $2.1 million for the fiscal year. Capital spending at $0.6 million for the quarter and $4.5 million year-to-date has been focused on the new Lufkin facility and modern machine tools and testing equipment. As we work through a very challenging fiscal year, we focused on preserving liquidity and deferred all non-essential capital spending. This will result in some catch-up spending in fiscal 2022, where we expect to invest $10 million to $12 million during the fiscal year, while monitoring the ongoing market recovery for any pauses or setbacks. As for our outlook, obviously in the fourth quarter, we were very encouraged by the improvements we are seeing in the markets and our order trends. This should continue throughout fiscal 2022, and we are expecting a much improved fiscal 2022 compared to fiscal 2021. We mentioned on the last call that we've been analyzing our global footprint and how we do business. You saw some of those actions that we took in the fourth quarter to make us more profitable. It's basically a realization of rightsizing our operations to the size of what we manufacture inside versus what we outsource on the outside. Finally, we are continuing to invest in our electrification efforts both in systems and data security, and we are very optimistic about our ability to bring competitive solutions to our markets. That concludes my prepared remarks. Now Jim, Tim, and I will be happy to take your questions. Katie, could you open the line for questions?

Thank you. We'll go to Noah Kaye with Oppenheimer.

Hi. Good morning. Thanks for taking the questions. First, best wishes to Jeff. Hope he is back and well soon. Although, John, I will say you handled that stress with great efficiency.

Hi, Noah. Before you ask a question, I just realized that I printed the wrong version of the script and that the forgiveness of the PPP loan is not included in operating income. It is, as in the press release, income from the extinguishment of the loan. So that was my mistake, but it's hard to stop once you're actually reading it.

Yes. Thank you for the clarification. Can we just start with maybe a little bit more detail in terms of your electric product development and pipeline? Specifically, we understand these are relatively long product development cycles. However, I would love to understand the potential revenue magnitude of what you're working on and bidding on. Is this a $10 million, $20 million, or $30 million pipeline? I think it will help folks understand where this opportunity may be headed.

So that is a great question. And I ask it; the Board asks it, we all ask it. Just to give you an idea on an industrial application, where we used to sell a $15,000 or a $20,000 pump drive, a hybrid system can be anywhere from $130,000 to $180,000. That shows you the multiplier on your content is huge. The gross margin is roughly the same; it might be a little bit less because we're not producing everything. We're not manufacturing everything in the complete system. So we won't have the same margin on all the components. The issue that you face is that we have NDAs and we’ve got applications looking at our VP of Sales in pretty much every market segment that we operate. The challenge is that it takes a year to develop the product, a year to test, and then there’s market acceptance. If we could move from the first inning to the ninth inning where everything is hybrid, you would see our revenues increase dramatically. It's just a ramp-up of how quickly we will prove these products out in the field, meaning us and the OEM, and then how quickly there’s market acceptance for those products. So, it's a huge opportunity, Noah. It's just a question of how quickly will it happen. I sound like a broken record, Noah; it'll happen much quicker in automotive because the car companies control everything, and it's been in production and testing for a while. The off-highway markets are scrambling to catch up, but there are so many different applications and variations. Everyone is trying to figure out what combination will work. So I'm really optimistic because the projects that we're involved in are going to be accepted very well in the market. The big question remains: how quickly will it happen?

Yes. That's very helpful, John. It sounds like a fair characterization to say we're sort of at the top of the second tier, if you want to use your baseball analogy.

Yes.

Okay. Let's move on to oil and gas. Given the extremely low rig counts, particularly the live rig counts, it feels like the table could be setting up for an uptick in activity. Could you talk a bit about your pipeline and your expectations for that market over the next year?

I would expect Asia to show some—I don't want to say significant improvement—but noticeable improvement in the demand for the units that we ship there. In North America, we've had kind of the first two markers for new spending, which have been aftermarket demand, ordering spare parts for rebuilds, and requests for quotes and lead times. We've reached that point, so I think at some point in the next couple of quarters, we'll actually see new unit orders for the North American market. However, they are being much more cautious on CapEx spending right now. I still think there are some deals out there for idle equipment; used equipment that hasn’t been used much in some of the larger players, whether they’re public or independent, are snapping up some used equipment.

Okay. Lastly, at this point within the portfolio, where are you actually capacity constrained and still working to catch up with demand? Is it less of an issue?

I'm going to ask Jim to respond too. I think all of the supply chains are still constrained. The most challenging has been many of our industrial products that we produced in Lufkin, which have a supply chain coming from India, that has been a constraint. We’re seeing relatively long lead times and delays, but for products that have shorter lead times to customers, we're seeing long lead times for other products, especially marine transmissions and power-shift transmissions, which generally have better lead times. So the impact as a percentage hasn’t been as great, but I'll let Jim answer a bit as well.

John's comments are correct. The issue with the Suez Canal set us back; however, that has been rectified. We're seeing a supply increase, so we're looking at a much better fall than we struggled with when the Suez Canal was down. I think that’s going to clear up; with regard to oil and gas, we have the inventory on hand to support the market. With Marine, the issue is not obtaining parts from our suppliers. We are working closely with all of our suppliers, and we do not foresee that being a problem as we move forward over the next 12 months. The biggest issue we have is electrical connectors, which is the same challenge faced by the automotive industry and others worldwide, but we are getting what we need to continue our shipments.

Okay. That was extremely helpful. Thank you, and good luck to all.

Thanks, Noah.

Thank you. We'll take our next question from Josh Chan with Baird.

Hey, good morning. Hope for a speedy recovery for Jeff, if he's listening.

Thanks, Josh.

I guess my first question, John, is on the backlog. Your six months backlog was down a little, but the total backlog went up. What that means to me is that you had some longer-term projects booked in the quarter. I would have thought that would be oil and gas, but it doesn't sound like that's coming back as quickly yet. Could you explain what you booked farther out beyond the six months?

Sure. The biggest driver was some military transmissions; you asked about domestic and some oil and gas for Asia, which drove backlog outside the six-month window. There’s also realization that, as I’ve mentioned, going through our sales and operation planning, we’re putting discipline on the factories, especially the one here in Racine, and scheduling for capacity and not over-committing. So, in general, things have been scheduled according to when we’re going to get inventory and when we have capacity. But the two drivers are the transmission business, XT-1410, and some other components along with oil and gas in China.

Okay. That makes sense. Thanks for the clarification. On the gross margin side, could you give us the pluses and minuses you see? Hopefully, you get better volume and hopefully a better mix as well if oil and gas picks up in the second half. How do you see gross margin trending?

Gross margin should be trending up. One of the biggest advantages that I saw during the fiscal year was the focus on gross margin improvement at a product level, cost reduction, and finding new suppliers. Remember from calls in prior quarters, during the last oil and gas run-up in 2018, we actually had a couple of suppliers go bankrupt, and we were forced to scramble to find new suppliers primarily for castings and forgings. We’ve been able to source new suppliers and recognize some cost reductions. Overall, we’ve reduced variable costs, and in addition, we implemented fixed cost reductions during the year. These gross margins have been improving, including bringing Lufkin online. I’ve been very pleased to see the improvement in gross margins within industrial. With some actions we announced in Belgium and the sale of the corporate facility, we still have some costs in the gross margin line. Once we finalize the sale on this facility, it will take some fixed costs out. I expect gross margins to continue to improve nicely through fiscal 2022, and volume will certainly help.

Okay. Yes, that's good to hear. Lastly, could you talk about your capital expenditures, and what you plan to spend the CapEx on this year, along with any thoughts on free cash flow given that the CapEx is higher?

We’re still expecting positive free cash flow for the year. For the CapEx, we have some big machine tools on order; a gear grinder for Belgium, some test stands for the hydraulic PTO product line for Texas, and there are some other items—I’ll let Jim add some more big ticket items for Racine.

There are a few test stand upgrades we want to do to improve our efficiencies and reduce our test time. In addition to that, we have ancillary products going on in our core manufacturing cells for gear grinding and shafts, and we’ll be adding specific pieces of equipment to improve our efficiencies there.

We also have some noticeable engineering CapEx on electrification and hybrid test stands, along with equipment for that. There's a lot of development there, and we’re excited about it, but the development is not without costs.

Absolutely. Well, thanks for the insight and your time; best of luck into 2022.

Okay. Thanks, Josh.

With no additional questions in queue at this time, I'd like to turn the call back over to our speakers for any additional or closing remarks.

All right. Thank you, Katie, and thank you for joining our conference call today. We appreciate your continuing interest in Twin Disc and hope that we've answered all of your questions. If not, please feel free to call, email, or reach out to me, and I will get—I'm sure there were a question or two that wasn't asked because Jeff wasn't here, but if you send them to me, I will get an answer to you as quickly as possible. We look forward to speaking with you, including with Jeff, again at the close of our fiscal 2022 first quarter. Katie, now I'll turn the call back to you.

Thank you. That will conclude today's call. We appreciate your participation.