Twin Disc Inc (TWIN) Q1 2023 Earnings Call Transcript

Greetings. Welcome to the Twin Disc, Inc. Fiscal First Quarter 2023 Earnings Conference. 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, Andrew Berger of Investor Relations. Thank you. You may begin.

Thanks Latania. 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 2023 first quarter 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 the news release which was issued this morning before the market opened. If you have not received a copy, please call our office at 262-638-4000 and we'll 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'll now turn the call over to John Batten. John, go ahead.

Thank you, Andy, and good morning everyone. Welcome to our fiscal 2023 first quarter conference call. We will start with a brief summary and then take your questions. In the fourth quarter of fiscal 2022, we experienced a lot of positive momentum, and we had hoped that it would continue into the first quarter of this year. Our global operations team worked hard to manage the supply chain, but we encountered various shortages and delays, including issues with chips, wiring, harnesses, gears, forgings, castings, and a new concern with heat treat capacity. The trend of reshoring to North America is significant and is causing considerable delays due to capacity constraints and consistently high prices, despite a decrease in scrap prices over the past six months. The European supply chain also faced challenges, including high utility costs, significant wage increases due to the rising cost of living, and a general labor shortage. It is disappointing not to see higher revenue this quarter since the demand remains strong. We plan to address the cost structure of our European operations promptly, given the ongoing inflation and our inability to reflect real-time pricing. While European governments can raise wages quickly, manufacturers must honor the prices quoted at the time. The unexpected increase in living costs that we witnessed this summer and fall has added to our challenges. Considering our revenue for the quarter, we anticipated gross margins to be at least 300 to 400 basis points higher, and we are committed to achieving that improvement in the second and third quarters. Part of the reason for the lower margins is related to the propulsion products we quoted 12 to 18 months ago, before the rapid inflation of 2021-2022. These products shipped late in the fourth quarter and into the fiscal first quarter, and while we managed to mitigate some margin loss due to inflation, we could not recover all of it. Future project margins look better and will continue to improve as the fiscal year progresses. Furthermore, we are facing challenges with shipments from larger propulsion projects in Europe due to supply chain issues linked to the shipyards, particularly concerning diesel engines, electric motors, hulls, and other prefabricated components sourced from China. The backlog remains the highest it has been since our acquisition in 2018, but we are confident in our potential for margin and revenue growth throughout the year. We see strong demand in Asia for oil and gas, improving demand in global marine markets, steady industrial demand in Europe and North America, and increasing demand in domestic oil and gas markets. This quarter, we saw a rise in new unit orders for the domestic pressure pumping fleet, and parts demand remains very high. We have orders for the 7600 and 8500 transmissions produced in Racine, and our team is working diligently to handle suppliers, internal capacity, and other delays to meet this demand. In Lufkin, our team effectively managed supply chain challenges from India and is operating very efficiently. Our hydraulic PTOs are currently in production and should be shipping this quarter and throughout the fiscal year. Last quarter, we mentioned our hybrid application with Hinckley Yachts, which has been well-received at recent boat shows. We are collaborating with numerous customers on marine and hybrid electric projects, and many more are on the horizon. Recently, our distributor Sewart Supply and their partner Grizzly launched an e-frac solution using our 7600 frac transmission, and the response has been very positive. We see many opportunities here for new unit construction as well as potential refits for older Tier 2 applications. The number of hybrid and electrification projects is on the rise, although growth may be limited by existing supply chain challenges, including motors and inverters. While the situation is complex, we remain optimistic about our hybrid and electric future. Now, I will hand it over to Jeff to discuss the financials.

Thanks John and good morning everyone. I'll briefly run through the fiscal 2023 first quarter results. Sales of just under $56 million for the quarter were up $8.2 million or 17% from the prior year's first quarter. The sales increase reflects the improved demand in the company's global oil and gas, industrial and marine markets. Shipments in the quarter were somewhat limited by ongoing supply chain constraints mentioned in previous quarters. Electronic components remained the most challenging area to find reliable and predictable supply. With help from improving North American demand for pressure pumping equipment compared to the prior year first quarter, our transmission product sales improved by 30%. Sales of industrial products increased by 15%, while marine propulsion product sales grew by 10%. By region, sales in North America were up 33%; Asia-Pacific up 8%; while sales into Europe were up just 2%. The strengthening of the US dollar has begun to impact our competitiveness when selling US produced goods into the European market. Foreign currency exchange had a net negative $4.8 million impact on sales in the quarter, and on a constant currency basis, first quarter sales increased 27.2% from the prior year. The first quarter margin percentage was 23.8% compared to 28.2% in the prior year first quarter. The prior year's result included several one-off benefits, including a domestic ERC credit, a Dutch COVID subsidy, and a favorable adjustment to the warranty reserve. Adjusting for these non-recurring items, the prior year's gross profit would have been 22.9%. The small increase in the current year then is a function of improved volume and a favorable product mix, partially offset by the negative impact of inflation, primarily at our European operations. Spending on marketing, engineering, and administrative costs for the fiscal 2023 first quarter increased $2 million or 15.2% compared to fiscal 2022. The increase in the quarter is primarily due to the impact of prior year COVID subsidies in the US and the Netherlands totaling $800,000, along with inflationary impacts and a return to more normal spending activities in areas such as marketing, travel, salaries, professional fees, and the global bonus program, those items totaling $2.1 million. These increases were partially offset by a foreign currency translation impact of $900,000. As a percent of revenue for the first quarter, ME&A expenses were 23.8% compared to 28.2% in the prior year first quarter. During the prior year first quarter, we recorded a $2.9 million non-operating gain related to the sale and leaseback of our Swiss facility. The effective tax rate for the first quarter of fiscal 2023 was 26.3% compared to 16.2% in the prior year first quarter with a mix of foreign earnings by jurisdiction driving the increase in the effective tax rate. The net loss for the quarter of $2 million or $0.15 per diluted share compares to a net profit of $2 million or $0.14 per diluted share for the fiscal 2022 first quarter. EBITDA was breakeven for the quarter, down $5.4 million compared to the prior year, driven by the prior year COVID subsidies and the gain on the sale of this facility in the prior year. Turning to the balance sheet, inventory was up $1 million for the quarter impacted by a significant currency-driven decline of $4.5 million. The significant increase excluding the translation impact is the result of supply chain imbalances, customer delayed shipments, and the timing of shipments through our distribution operations. We anticipate significant improvement in our second fiscal quarter as we continue to focus on and refine inventory planning and sourcing strategies that will drive progress. With the increase in inventory and lower operating results, operating cash was slightly negative for the quarter. Capital spending at $2.2 million for the quarter was focused on the modernization of our machine tools. We expect a similar quarterly run rate in capital spending for the remainder of the year, totaling between $10 million and $12 million for the year. And now, I'll turn it back to John for some final comments.

Thanks, Jeff, and I'll spend a quick moment on our outlook. Despite our first quarter results, we still feel very good about fiscal 2023. Like last year, we think the quarters will build throughout the year. We will have to address some local cost structures due to local conditions, whether that's inflation we can't pass on, supply challenges, et cetera. But in general, our markets are much more optimistic than they were a year ago, and we are too. The challenges that manufacturers are facing are coming in waves, and we will continue to deal with them. As Jeff mentioned, the additional challenge right now in the past few months has been the strengthening of the US dollar. And while it helps our European operations selling into North American markets, it is a concern going forward on our US-based products, primarily marine transmissions, which are sold into Europe. That concludes our prepared remarks, and now Jeff and I will be happy to take your questions. Latania, please open the line for questions.

Thank you. We will now conduct a question-and-answer session. Our first question comes from Noah Kaye with Oppenheimer. Please proceed.

Thanks for taking the questions. John, I think you mentioned kind of margin expectations 300 basis points, 400 basis points higher than actual results was really reflecting the lag on price cost. So just help us understand, as you look at the backlog today, how does that look for subsequent quarters? Think about 2Q, 3Q? What does that 300 basis points, 400 basis points drag look like as we look in the next couple of quarters?

I'm going to let Jeff assist me with that. However, Noah, I can tell you that the trend looks promising moving forward. Our current backlog for the next three quarters appears better than it was at the end of the fourth quarter. We anticipated that the Veth projects would yield lower margins compared to inflation. First quarters are typically our toughest due to shutdowns, particularly in Europe, which tend to last longer than those in North America. Europe has been notably inefficient during the first quarter, affecting not only our operations but the region as a whole. We also faced significant cost of living increases, such as in Belgium, where we expected a 2% to 4% increase, but it turned out to be 8.5% effective immediately. This was unexpected and impacted the entire quarter. The cost of living increase in the Netherlands was also higher than we had forecasted. Overall, we are observing revenue levels in Europe and elsewhere lagging behind demand by 15% to 20%, indicating a significant gap due to a lack of available parts. We're closely examining how long this situation will last and whether we can adequately staff certain operations when revenue is so considerably lower because of the supply chain issues. This is a current focus for us. The frustrating aspect is that demand is present. We remain optimistic and our sales team, especially with Veth globally, has been successful in converting projects into orders. Our backlog is at its highest percentage of projects outside Northern Europe, aligning with our strategic goal of expanding beyond our home market. We just need to ensure we have all the necessary parts to ship. Overall, disregarding the quarter's specifics, our current position is much improved from a year ago. A year prior, we were grappling with rapid inflation and pricing issues, which we managed, and while we've seen improvements over the course of that year, we are again facing some similar challenges this year. Nevertheless, the backlog indicates a positive outlook, with much of our work extending beyond the six-month period. We are hopeful for improvements throughout the year, and I feel more content this year compared to 12 months ago.

That's helpful. And I guess just listening to that answer, there are a lot of companies in various industries that really had to change how they price, right, because we've been looking at some extraordinarily challenging times with respect to wrangling the inflation bear. So talk to us about how you price and how that may change. You mentioned the cost of living index. How do you price projects now? And what are you changing? And do you think that that allows you to better manage inflation going forward?

It does. The frequency of our price increases has been unprecedented, with price adjustments every quarter. Historically in North America, we priced at the time of shipment, which was challenging, but we managed to do it. We also implemented surcharges last year, and while I'm not ruling out returning to surcharges, we are now more focused on pricing at the time of the order. This means that if you order model XYZ today for $100, the price may increase in two months. We primarily price at the time of shipment because we have the ability to do so. In Europe, pricing is determined at the time of order, making it nearly impossible to price at shipment. Two years ago, we made annual price increases, but what's different now is that we plan to implement them more frequently and examine every order. We're optimistic that much of the inflation has stabilized at a higher level. Although we don't see significant material cost increases, prices aren't decreasing, even with declining scrap prices over the past six months. We feel more confident about some stability, but prices aren't coming down. To address your question, we are evaluating almost everything individually. When we provide a quote, we assess whether we're confident in the margin at that point, and if someone wishes to buy it a month later, the price may differ.

Okay. And if I could sneak one more in. I don't want to steal thunder from future project announcements, but you did mention that you've got some exciting projects in the hybrid and electric space apart from Hinckley. Can you just maybe give us an idea of what sort of applications or…?

Yes, there will be more projects in the commercial workboat sector. Hinckley made a significant impact as one of the top builders in the pleasure craft industry. We have additional projects planned that are more long-term. However, there are several upcoming vessels, including potential ferries or taxi systems. The commercial space is very busy as everyone seeks fuel-efficient, green solutions for revenue-generating vessels. We remain optimistic, but progress depends on obtaining all necessary components. Electric motor lead times have been extended, which is a challenge we are currently addressing while also making announcements. Much of our work requires testing for six to twelve months before release, but there will definitely be more developments throughout the year that we can discuss.

Great. Well, appreciate all the color. Thanks.

All right. Thanks, Noah.

Our next question comes from Simon Wong with Gabelli Funds. Please proceed.

Hey, John and Jeff.

Hey, Simon.

Hey, Simon.

Just some quick questions on the oil and gas side. How much of your sales this quarter was in oil and gas?

It's a good question, Simon. Let me do a quick calculation, and why don't you jump on your next question, and then I'll come back to you real quick.

Okay. My next question also related to oil and gas. How much of the orders came in related to oil and gas? Because you had a really nice order quarter; just wondering how much of that was due to the North American pressure pumpers coming back?

I guess, I can tell you it's a big part. I don't have the numbers. I'm not in the same room with Jeff, but it's a combination of equal parts about new unit orders as far as units, but also parts continue at a high level. So it was a pretty good quarter for oil and gas in North America.

No, are they related to the traditional diesel fleet? Or are we seeing orders for the…

The components are primarily for the traditional diesel fleet, but right now, it’s a small percentage. However, I expect that each quarter moving forward, the units for the e-frac fleet will increase significantly. I can envision a scenario in the next few quarters where you will ask about this, and we will be at 15%, 25%, or even potentially 50%. That milestone is not too far off.

Okay. So if a pressure pumper places an order for new equipment today, what is the lead time for transmission?

We could get to an 8500 for the traditional fleet probably in, I would say, three months, three to three months. And the reason I go to three months is because we're dealing with January and sorry, November and December are short months with holidays. But yes, if you ordered them today, we would have them early in the calendar first quarter of next year.

Okay. All right. And then last question.

One of the reasons I believe we haven't seen a larger increase is due to the ongoing challenges with lead times and engine availability for the fleet refit. Currently, we are observing customers securing engines, and we are receiving just enough transmission orders to meet the number of engines they have. As the supply of engines becomes more dependable and accessible, I anticipate an increase in our orders.

Okay.

The flip side is when they don't have engines, we get more spare parts orders because they rebuild, they're rebuilding.

Right, right. Okay. Great. Thank you, guys.

Thanks, Simon.

Our next question comes from Jim Dowling with Jefferies. Please proceed.

Yes. Good morning, fellows. Could you give us some color on the inventory breakdown between North America on the one hand and Europe and finished product versus work in progress and how that might skew by end market, energy and marine?

Yes. So, we've got, say, a little over half of our inventory is in what we would call salable, so either a finished part that could be sold as it is or assembled into a new unit or fully assembled units. Say, about 20% is work in process. And the remainder, 30%-ish, is raw material. A big component of that inventory, I would say, in terms of WIP and finished parts is in the oil and gas market here in North America. That would be the biggest component. In Europe, it's primarily marine. Europe is probably, I would say, just maybe 40% of our total inventory. 60% would be a little over 50% in the US and the remainder in Asia, Asia Pacific. In the US, like I said, it's industrial, it's marine, but the biggest component would be the oil and gas piece in that. That's what's allowing us I guess, from John's earlier point, to be able to deliver a very large and complex transmission within potentially eight weeks.

And one last inventory-related question, how much of your inventory has already been priced into a final product but can't be delivered because of other delays? And how much are still open where you can charge whatever the market will bear?

That's a good question. I don't think a large portion of our inventory is locked in. I would estimate that it's around 10% to 20% of the inventory that is committed to fixed price orders, but I acknowledge that I haven't fully considered this.

Yes, it may be a little bit higher, but it's not the majority, Jim. That's for sure.

At this time, I will turn the call back over to Mr. John Batten for closing comments.

Thank you, Latonya, and thank you, everyone, 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 reach out to either Jeff or myself. We look forward to speaking with you again at the close of our fiscal 2023 second quarter. And now, Latonya, I'll turn the call back to you.

Thank you. This does conclude today's teleconference. You may disconnect your lines at this time. And thank you for your participation, and have a great day.