Greetings. Welcome to the Twin Disc, Inc. Fiscal Second Quarter 2022 Earnings Conference. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. Please note, this conference is being recorded. I will now turn the conference over to your host, Stan Berger. You may begin.

Thank you, Shamali. 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 2022 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 statements that represent 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 a copy to you. Hosting the call today are John Batten, Twin Disc's Chief Executive Officer; Jeff Knutson, the company's Vice President of Finance, Chief Financial Officer, Treasurer and Secretary. At this time, I will now turn the call over to John Batten. John?

Thank you, Stan, and good morning, everyone. Welcome to our fiscal 2022 second quarter conference call. As usual, we will begin with a short summary statement and then Jeff and I will be happy to take your questions. Before we go over the results, I'll touch on some of the operational highlights from the quarter. Looking at demand; as we mentioned in the press release, demand improved nicely across most of our markets. The biggest impact we saw was in our North American operations where our orders improved in industrial and transmission product lines. Our global marine demand for our North American-produced models remained flat at the factory as we still work through some of the inventory at our distributors'. But the market activity in our marine product line improved nicely in the quarter and we saw significant new orders at our European operations for those models. We also noted continued elevated high demand in the Australian marine market, particularly in pleasure craft, with nice unit orders for our marine transmissions and some other product lines that they sell into the market. As I mentioned, we had a growing number of projects in the Asian, European, and North American workboat markets. There was continued application growth for our Veth product line, primarily in new markets, especially for expedition-style mega yachts. That activity increased notably. The one market that remains a bit slow is the inland passenger vessel market. However, as COVID-19 wanes, we should see that market start to pick up in the calendar year. We also saw some initial inquiries for offshore vessels into Asia; that would be the first time in a long while that we've seen new project activity in any offshore markets. As expected, there was a steady flow of hybrid and electric electrification projects for our marine transmissions. With respect to oil and gas, we received good unit orders from Asia for both the 7600 and the 8500 models, along with a significant amount of aftermarket parts orders for the North American fleet. Quoting activity for new units also improved in December and January, and we believe that new rig construction should improve this calendar year. Our operation in Lufkin has weathered significant supply chain issues concerning parts coming from India and has turned around their past due amounts. We have continued to see significant growth in demand for new unit orders for our industrial products based in Lufkin. The supply chain continues to be a challenge. Lead times have extended significantly, but they're more predictable now. In this quarter, we saw significant inflationary cost increases from our suppliers, particularly in castings, forgings, and machine parts. Steel prices have continued to rise in the second quarter. The momentum of these increases continued throughout the quarter. We had previously announced a 4.5% price increase effective July 1, 2021. This fall, we announced a 5.5% increase effective January 1, and we've also implemented a 4.9% surcharge on product shipping after January 1 to combat some of these inflationary increases that we've seen. In this quarter, we will be evaluating inflationary input costs and deciding on future increases to be implemented in the fourth quarter. One of the other challenges we faced, as did everyone in the quarter, was the impact of COVID. We certainly had a demand impact from some of our customers, but it was also significant in terms of supply chain. Many parts were delayed due to labor shortages, and we had a noticeable impact in December due to illnesses and quarantines. Fortunately, this situation has improved in January, and we are hopeful that this trend will continue throughout the remainder of the calendar year. And now I'll turn it over to Jeff to discuss the financials.

Thanks, John. Good morning, everyone. I'll briefly run through the fiscal 2022 second quarter and year-to-date numbers. Sales for the quarter were just under $60 million, up $11.3 million or 23.3% from the prior year second quarter, and up $12.1 million or 25.4% from the previous quarter. This sales increase reflects continued growth in demand across our markets, as John mentioned, with shipment performance limited somewhat by supply chain challenges across all locations. As noted last quarter, we've experienced a significant increase in lead times from our suppliers, unpredictable vendor delivery performance and difficulty in obtaining shipping containers. Despite these supply chain challenges, strong demand and improved operational performance resulted in a 46% increase in industrial product shipments, a 14.5% increase in marine and propulsion shipments, and a 13.4% increase in off-highway transmission sales for the second quarter. By region, sales into North America were up 30%; sales into Asia Pacific were up 17%; and sales into Europe were up 5%, while foreign currency exchange resulted in a net negative $1 million impact to sales in the second quarter. Through the first half, we are now 13.6% or $12.9 million ahead of the prior year. The second quarter margin percentage was 22.5% compared to 18.3% in the prior year second quarter. The improved margin in the current year is a result of increased revenue and a more profitable mix of products, partially offset by the impact of inflationary pressures on cost, as we have seen significant price increases across our supply base. We have taken action, as John detailed, to implement price increases and surcharges to offset inflationary pressures going forward. We will continue to monitor this area closely to identify any additional required pricing actions. Spending on marketing, engineering, and administrative costs for the fiscal 2022 second quarter increased by $1.9 million, or 14%, compared to fiscal 2021. The increase in the quarter is primarily due to increased salaries and benefits, the return of a global bonus program, professional fees, marketing expenses, and other inflationary increases, essentially a return to a somewhat normalized level of spending in areas that had been dormant for some time. These increases were partially offset by the favorable impact of a Dutch COVID relief subsidy recorded in the quarter. As a percent of revenue for the second quarter, marketing, engineering, and administrative expenses were 25.5% compared to 27.5% in the prior year second quarter. For the first half, these expenses were 26.3% of revenue compared to 27.2% in the first half of fiscal 2021. We recorded restructuring charges of $1.2 million during the quarter, primarily related to the final negotiated settlement concerning the Belgian restructuring program announced this past June. The total cost of this program is now approximately $3.3 million and is expected to drive annualized savings of approximately $1.6 million once complete. Including the restructuring charge, the operating loss for the quarter was $3 million compared to an operating loss of $4.6 million in the prior year second quarter. For the first half, operating income of $200,000—which includes a $2.9 million gain on the sale of our Swiss facility recorded in the first quarter—represents nearly an $8 million improvement from the fiscal 2021 first half. The effective tax rate for the first half of fiscal 2022 was negative 131% compared to 30.3% in the prior year first half. The current year rate is quite unusual and was impacted by the domestic full valuation allowance which results in no tax benefits being recognized on current domestic losses. The net loss for the second quarter of fiscal 2022 was $3.8 million or $0.29 per diluted share compared to a net loss of $4.3 million or $0.33 per diluted share in the prior year first half. EBITDA for the quarter was $200 million, improved from a loss of $3.6 million in the prior year second quarter. For the first half, EBITDA improved by $10.4 million from the prior year, from an EBITDA loss of $5.2 million to positive EBITDA of $5.2 million in the current year. Turning to the balance sheet, inventory was up $9 million in the first half, driven primarily by supply chain imbalances. Despite a significant increase in inventory, operating cash was only slightly negative at $1 million. Capital spending at $1.8 million for the half is well behind schedule, impacted by the lead times on machine tools. Given the slower start in capital spending, we now anticipate that we will invest in the $7 million to $10 million range in fiscal 2022. And with that, I'll turn it back to John for some final comments.

Thanks, Jeff. And now I'll just spend a quick moment on the outlook. Obviously, our backlog and project activity has improved significantly, both year-over-year and sequentially compared to the first quarter and the end of the prior fiscal year. We are also anticipating improving conditions in North American oil and gas. Our challenge will be to match our internal and supply chain capacity to meet this improving demand. We have the inventory to meet the improving oil and gas trends in North America, and we will be building in advance when possible to get ahead of this wave. Hopefully, in one of the next calls, we can highlight more hybrid and electrification applications that we've been working on with our customer base as they are testing it in their prototype process. The R&D and engineering activity has continued in earnest this fiscal year, and we are extremely excited about the future developments in all our markets regarding hybridization and electrification. That concludes our prepared remarks. And now Jeff and I will be happy to take your questions. Shamali, can you open up the line for questions now?

And our first question comes from Josh Chan with Baird. Please proceed with your question.

Good morning, John and Jeff. Thanks for taking my questions.

Thanks, Josh.

I guess first question on oil and gas. Clearly, the backdrop has improved. But I think this CapEx discipline is kind of the phrase for the industry in this cycle. And so I guess I was wondering, John, if you could talk about sort of the conversations that you're having with the customers, and how you think about the trajectory of when you might see orders within this calendar year?

Yes. So the conversations and quoting activity with the OEMs is ongoing. Historically, before we've had new rig construction, there's been a rebuild phase in every cycle. I would say that activity has clearly picked up in the last couple of months. If I go by empirical evidence from prior cycles, that would suggest that new unit orders and building should occur in the next three to six months. I expect to see new unit orders this fiscal year for us. Whether or not they come quickly enough for delivery or if the units will go to Asia this fiscal year, I definitely foresee improvement in orders within a quarter or two.

Okay, that's encouraging. I think you mentioned in the press release that you have some completed products, right? So I guess would you be able to serve some demand immediately? Or how does that work?

Yes. For the first few dozen, we would be able to react very quickly because we have a well-balanced inventory. After that, although lead times won't extend to 12 months, it may take a couple of months once we get past the initial quantity. As orders improve in China, our ability to react quickly in North America will also be significant. Lead times will be dictated by our internal capacity for assembly and testing, along with some parts we need from suppliers, but we are on top of it.

Yes, absolutely. No, that's encouraging. I guess on the price increase and the surcharge side, historically, we haven't talked too much about it. So could you just talk about how that works? Is it broadly across your portfolio? Does it hit immediately? And then maybe if you could include how much impact you think that can have on your gross margin improvement in the second half that you kind of alluded to?

Historically, for smaller price increases, we have typically implemented one annual price increase. Going back to the early '80s, we saw similar trends when raising prices multiple times per year. We typically announce a price increase about two months in advance, and this year we did so for a price uplift effective July 1. Although we anticipated that this would be satisfactory, it became obvious in August and September that inflationary pressures exceeded that initial increase. Consequently, we announced another price increase for January. In the October-November time frame, we experienced significant rises in costs from our suppliers, especially based on the escalating steel prices. The timing of this additional price increase will influence our second quarter outcomes. The surcharge should start impacting shipments as of January 1. Admittedly, implementing these increases is a response to the inflationary pressures we are facing in castings and forgings. Our goal is to maintain our gross margin levels in light of these pressures.

Right. Right, that makes sense. So the 4.5% surcharge, does that mathematically get you back to the sort of mid- to high, maybe 20% gross margin in the back half? Is that a reasonable guess?

Yes. That’s what we are aiming for, Josh. We expect to be above 25% for the remainder of the year. Of course, inflationary pressures will continue, but we are looking to definitely position ourselves above that mark, potentially in the 26% to 28% range as we progress through the year.

Yes. Some of the increases we're implementing are broad-based across our product lines, but we will be taking a closer look at specific products as some have seen more severe price increases than others.

All right, great. Thanks for the color and thanks for your time.

Thanks, Josh.

Our next question comes from Noah Kaye with Oppenheimer. Please proceed with your question.

Thanks for taking the questions. So just following up on price/cost commentary. You look at the six months backlog; what is the price cost for that? Is that a headwind to margins? Is it about neutral? And if you assume that sort of pricing initiatives you put in place are generally retained throughout the year, when does price cost turn positive?

What’s in the backlog doesn’t reflect the price increase we’ve implemented. However, when these products are shipped, they will be billed at these higher prices. So, generally, our current backlog should positively influence margins as we get into shipping.

Right. And steel prices are elevated year-over-year. It started to back off a little bit. When would you start to see, potentially, based on what we're observing with commodity indices, some relief or at least, stability on key input costs? Given other supply constraints, it may be hard for suppliers to cut prices, but if raw input prices start to decline a bit, what would happen with your pricing profile?

I’m hopeful that the price increases have stabilized, and that we are at a flat rate. What I have been reading suggests that there is a chance that steel prices and fuel could ease somewhat. However, I haven’t seen any actual evidence of price decreases or surcharge easement for us yet. Hence, we opted for a surcharge this time, recognizing that inflation may ease in calendar 2022. If that occurs, we can ratchet back our surcharge as needed; however, we have yet to see definitive improvements in cost thus far.

Great, helpful. And then, I guess, John, some historical context around tax spending in the North American oil and gas market would be helpful. You've seen varying mixes of new build versus repair versus replacement in the field. Given the improving activity levels, how do you see the mix of spend trending compared to past periods?

Anecdotally, our customers tell us they typically like to rebuild about 25% to 30% of their fleet. For example, if they are planning to build 100 rigs, they want to repair roughly 25 to 30 of them. This has happened as we have seen new rig construction following after rebuilds. It's a positive sign to observe a rapid increase in aftermarket parts, indicating that many rigs that had been idle are being brought back to operation. Historically, quick rebuild activities often do not meet the immediate demand for what is needed and I sense that a similar pattern could occur again this time. The rebound in aftermarket parts orders is often an indicator of forthcoming new rig orders.

Great. That's helpful. Thanks so much.

Thanks, Noah.

And our next question comes from the line of Robert Fitch, who is a private investor. Please proceed with your question.

Hi, good morning. If you can just elaborate on that last comment, what is your content per new rig, just in general ballpark?

A new rig is approximately $1 million to $1.2 million, with a pressure-pumping transmission contributing $175,000 to $200,000 of that. It’s not quite 20%, but it remains a significant component, along with the engine and cooling system.

Okay. Can you talk also generally about the transition in your product lines, serving various end markets of the transition from diesel to electric and what the opportunity is there? Or is it cannibalizing some of the diesel products to a greater extent?

In the off-highway sector, transitioning to hybrid and electric powertrains involves significant engineering efforts due to the unique requirements of different OEMs. Unlike automotive manufacturers who can use a single hybrid design for multiple vehicles, we develop tailored solutions for each OEM, which can vary greatly. Despite its challenges, there is a massive opportunity for Twin Disc as our markets have utilized conventional systems unchanged for decades. The shift to hybrid and electric power presents a significant market opportunity for us, but it is essential to identify the right partners and to ensure that the cost recovery aligns with market acceptance. Developing supply chains for these new systems will also play a critical role in this transition.

Understood. With your broad customer base, do they pay you for the engineering for products that may be custom to their needs?

Yes, it varies per market. We’ve often been compensated for our engineering services. Currently, many initial applications are joint development projects, meaning we share the learning process with the OEM. In high volume scenarios, we amortize these engineering costs over what we deliver, but selecting the right customer is crucial. We need to identify partners that demonstrate success potential.

We've been working to maintain positive free cash flow. The second quarter fell a bit short of that goal. Year-to-date, we are slightly below our target, but we anticipate achieving positive free cash flow in the second half of the year, even with expected increases in capital spending as our orders start to come in.

I was going to say, working capital represents the greatest pressure on cash flow over the next 12 to 18 months?

Yes. The cash flow situation could significantly improve depending on demand levels for our fracking rigs and transmissions in North America. We have the ability to convert much of our inventory into cash if that demand surges.

And should you begin to approach a couple of turns of inventory annually again?

Yes. I believe as we exit this year, we should be able to achieve that goal.

And do you have a variable outlook related to your U.S. versus non-U.S. business?

They're very different businesses with varying market dynamics. The Asian oil and gas market has shown stability and consistency, while the Australian pleasure craft market has seen a 40% increase over the prior year. North American marine sales haven't yet rebounded to expected levels, but we anticipate that situation will improve.

Yes, that's good. Outside of oil and gas, what end markets do you feel most confident about as you look forward in the intermediate term?

Our global marine markets show significant order growth. Our industrial business in Lufkin has also seen a strong uptick in new unit orders. I'm optimistic about the North American oil and gas market recovering within this calendar year. Overall, everything is trending positively, even though some markets are moving faster than others.

Should we expect any growth in the next year to be principally or solely organic?

In this fiscal year, our growth will predominantly come from organic sources. By 'organic,' I mean recognizing the partners we engage with in hybrid and electrification systems, which we may procure from outside sources. More expansive M&A activity would likely be beyond this immediate timeframe.

On the labor front, are there constraints to your growth, either in manufacturing or at the administrative and engineering levels?

We do face challenges in growing our workforce here in Racine, particularly in Southeastern Wisconsin. There's considerable effort going on just to replace retirements. Adding to that, we encountered many supply chain difficulties linked to COVID, including labor shortages. In North America, it has had a significant adverse impact, but it has been somewhat more manageable in our global operations. I believe we’re beginning to see improvements, but ensuring our workforce availability is a critical area of focus.

Can your assets and staff sustainably support sales levels achieved previously over the last 10 to 15 years without significant capital expenditure?

To support growth back to previous levels, we do need to increase both our capital expenditures and our workforce. Our planned investments in machinery must be fulfilled to enable support for growth. Additionally, we are focusing on developing effective supply chain strategies with partners outside our organization to provide key components. We also have to increase our internal assembly and testing capacity primarily in North America.

I appreciate your frank responses. Thank you very much.

Thanks, Robert.

And we have reached the end of the question-and-answer session. I will now turn the call back over to CEO John Batten for closing remarks.

Thank you, Shamali, and thank you, everyone, for joining our conference call today. We truly appreciate your continuing interest in Twin Disc and hope that we have answered all your questions. If not, please feel free to call either Jeff or myself, and we'll get your question answered as quickly as possible. We look forward to speaking with you again following the close of our fiscal 2022 third quarter. Shamali, I'll turn the call back to you.

Thank you, John. This concludes today's conference and you may disconnect your lines at this time. Thank you for your participation.