Twin Disc Inc (TWIN) Q4 2023 Earnings Call Transcript

Good day, and welcome to the Twin Disc Fiscal Fourth Quarter 2023 Conference Call. All participants will be in a listen-only mode. After today's presentation, there will be an opportunity to ask questions. Please note, this event is being recorded. I would now like to turn the conference over to Jeff Knutson, Vice President of Finance, CFO, Treasurer and Secretary. Please go ahead.

Good morning, and thank you for joining us today to discuss our fiscal 2023 fourth quarter and full year results. On the call with me today is John Batten, Twin Disc's CEO. I would like to remind everyone that certain statements made during this conference call, especially statements expressing 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. Any forward-looking statements that are made during this call are based on assumptions as of today, and the company undertakes no obligation to publicly update or revise these statements to reflect subsequent events or new information. During today's call, management will also discuss certain non-GAAP financial measures. For a definition of non-GAAP financial measures and a reconciliation of GAAP to non-GAAP financial results, please see the earnings release issued earlier today. By now, you should have received a 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 will send a release to you. Now I'll turn the call over to John.

Good morning, everyone, and thank you for joining us today. Let's start today's call with some highlights. During the quarter, we saw strong demand for our products across various markets, along with easing supply chain constraints and increased shipments. This resulted in a 10.5% rise in sales year-over-year for the fourth quarter and a 14% year-over-year increase in sales for fiscal 2023. Our gross margin was 29.5% for the quarter, which marked a 236 basis point decrease from last year's historically high margins but a 340 basis point improvement from the previous quarter. We generated $22.9 million in operating cash flow and $14.9 million in free cash flow for the year, which is a positive change compared to the cash outflow in fiscal 2022. Earlier this year, we implemented several actions to address challenges related to supply chain constraints and rising costs. Our team has continued working with key vendors to source components that are in short supply or are currently sourced from a single supplier. We also made significant progress in streamlining our global operations and expect to see further benefits in fiscal 2024 as we enter the next phase of our plans. The Veth business finished fiscal 2023 with a record-high six-month backlog, largely due to its expansion beyond core Northern European markets into North America and Asia Pacific. In terms of our product segments, Marine and Propulsion Systems remains our strongest area and has seen very healthy demand, with sales for the quarter up 22% year-over-year. We're receiving increased inquiries from the US and Canada, and our production facility in Belgium is operating at full capacity with solid projects in the pipeline, now booking into August 2024 and beyond. Propulsion continues to drive our success, with the partnership between Veth and Rolla making notable strides in product performance and project design. A prime example is our Elite Drive offering, which integrates Rolla's in-house CFD capabilities with Veth's hybrid expertise to design and produce advanced hydrodynamic propellers and the most efficient azimuth thruster, creating a comprehensive hybrid system for the mega yacht market. This collaboration continues to provide Twin Disc with a competitive edge, opening new opportunities and markets. In our Land-Based Transmissions segment, reduced oil and gas investment in recent years has led to increased demand for rebuilding and/or replacing fleets. Customers are facing challenges with new engine availability from third parties, resulting in delayed orders for new transmissions. Instead, we've seen sustained demand for the refurbishment of existing transmissions. While refurbishing transmissions is part of our regular offering, the frequency of rebuild requests has increased. Typically, a transmission would be rebuilt two or three times before replacement; however, due to delays in third-party engine manufacturing, we are now seeing some transmissions come in for their fifth or sixth rebuild. Our e-frac testing is progressing well, and we've received positive feedback thus far. We expect to start receiving orders in the United States in fiscal 2024. Within the Industrial group, we have experienced stable demand across various markets and have been able to maintain our volumes. In the fourth quarter, we encountered some sourcing challenges, but our team worked swiftly to address them. We have sourced a new vendor for the component in short supply and anticipate resolving any outstanding backlog in the first quarter of fiscal 2024. Our team is also making progress in several hybrid and electrification projects with different OEMs, though these have longer development timelines of a year or more for field tests and trials. We will keep you updated as we hit key milestones. Looking forward, we are exploring opportunities to foster innovation, enhance execution, and accelerate our growth. Although the year started with challenges, supply chain issues have eased over time, allowing us to improve shipments significantly. This progress has enabled us to clear a substantial portion of our past due orders. Although inventory levels as a percentage of backlog increased slightly from the third quarter, the overall trend is moving toward historical levels. We continue to experience shortages of certain components and materials, but the alternative measures we have implemented to mitigate these constraints have been effective and will benefit Twin Disc in the long run. Most of the supply chain challenges we faced in previous quarters, particularly regarding treatment capacity constraints, have subsided, and we believe this trend will persist. However, we recognize the uncertainties we are operating under and are prepared to confront future challenges proactively. As we assess each opportunity, we need to consider various aspects, including how our actions align with our commitments and long-term strategy. Throughout fiscal 2023, our team has made significant progress on both fronts. We are continuously modernizing and optimizing our legacy facilities, equipment, processes, and geographic presence. This work has already started delivering improved shipments, lower inventory, shorter lead times, and reduced costs, all contributing to better results for Twin Disc and enhanced value for our shareholders. As we transition into fiscal 2024, I am particularly excited to launch our e-frac offering. I am also optimistic about our partnership with Veth and Rolla, the potential opportunities in the Marine and Propulsion systems area, and the advancements our Industrial group is making with OEMs on various electrification and hybrid systems projects.

Thanks, John. Good morning, everyone. Before I jump into our results, I want to make sure you're all aware that Twin Disc's pension accounting method changed to modified mark-to-market during the fourth quarter of fiscal 2023. The change in accounting method has been applied retroactively with fourth quarter and full year results discussed today. The modified mark-to-market adjustment for fiscal year 2022 resulted in a $2.4 million gain. Turning to our financial performance, we delivered sales of $83.9 million for the quarter, up $8 million or 10.5% from the prior year as shipments improved substantially in the quarter. Supply chain headwinds continue to ease as a result of the mitigating actions taken earlier in the year. Our teams are also able to clear much of our past due orders from backlog, an important step to laying the foundation for fiscal 2024. Sales for fiscal 2023 increased 14% to $277 million from fiscal 2022. Net income attributable to Twin Disc for the fourth quarter was $8.6 million or $0.62 per diluted share compared to $10.2 million or $0.75 per diluted share in the fourth quarter of fiscal '22. The year-over-year decrease was primarily the result of higher income tax expense. For the fiscal year 2023, the company generated net income attributable to Twin Disc of $10.4 million or $0.75 per diluted share, a decrease of 0.8% and 3.8%, respectively, from fiscal 2022. Each of our product groups delivered continued growth sequentially with both Marine and Propulsion systems and Land-Based Transmissions reporting another double-digit quarter and the Industrial Product Group delivering another quarter of sales in line with expectations. Across our business, quarterly sales growth remained fairly consistent across geographies, further implying robust global demand. In addition to strong end market demand, our product groups are also benefiting from continued geographic expansion and strategic partnerships. For example, the Veth partnership with our high-end propeller design and manufacturing firm, Rolla, continues to deliver results that demonstrate one plus one can equal more than two. Gross margin decreased approximately 236 basis points from the prior year period, primarily driven by inflation as well as mix. However, we continue to make sequential progress with gross margin of 29.5%, increasing approximately 340 basis points from Q3. The quarter-over-quarter improvement was driven by increased volume, favorable product mix and a full quarter realization of our prior pricing actions as supply chain headwinds continue to ease. Similarly, we continue to see commodity pricing trend down, which has resulted in some improved pricing for our raw material inputs and components as we negotiate supply contracts up for renewal. In fiscal 2024, we expect to implement low single-digit pricing actions to mitigate any remaining headwinds. Over the course of fiscal 2023, we continue to strengthen our balance sheet. Twin Disc has reduced net debt by approximately $19 million and improved EBITDA by 7.6% to $25.8 million. At the end of the fiscal year, we had a cash balance of $13.3 million, 5.9% higher than the prior year, generated positive free cash flow of $14.9 million and achieved a leverage ratio of 0.2x. As John mentioned, we faced geopolitical and macroeconomic uncertainty as we consider how fiscal 2024 may unfold. Our balance sheet is a credit to our team's discipline and effectiveness. We can look at this new fiscal year from an enviable position of strength and opportunity. We continue to pursue bolt-on and transformational M&A opportunities and are making further investments in innovation and improving the operational efficiency of Twin Disc. To best deploy our balance sheet, we need to take a measured approach to capital allocation. This includes establishing a track record of cash flow generation before resuming any dividends as a means to return capital to shareholders. We will continue to make investments within our business to fuel growth through research and development, geographic diversification and expansion, and our marketing efforts. We will also continue to evaluate and pursue bolt-on and/or transformational acquisitions that align with our strategic and financial fit characteristics as well as other considerations. As we shift to a new fiscal year, I think it is important to confirm our medium-term targets. Over the next three to five years, we believe the execution of our long-term strategy will deliver revenues of approximately $400 million with gross margins of 30%. We also expect to deliver consistent free cash flow conversion of 60%. In summary, the demand strength and sales momentum we've experienced in Q4 provides a solid foundation as we transition to fiscal 2024. We delivered our strongest free cash flow since 2014 and expect inflation to improve slightly in fiscal 2024. Substantial progress has been made to release supply chain challenges that surfaced in fiscal 2022 and '23. We will take necessary and prudent steps to mitigate any challenges brought on by the macroeconomic and geopolitical uncertainties that remain. Finally, our balance sheet gives us confidence and enables us to manage the business and evaluate growth opportunities for the long term. That concludes our prepared remarks. John and I will be happy to answer your questions.

Our first question comes from Simon Wong with Gabelli Funds. Please go ahead.

Good morning, John and Jeff. How are you guys?

Good morning, Simon. Good, thanks.

Hey, quick question on your oil and gas business. In light of the lower rig count this year relative to the beginning of the year, what are you hearing from your frac customers?

I'm not certain about the final horsepower count at the end of our fiscal year, but I can say that the average age of the equipment is increasing, and they are consistently rebuilding it. Therefore, I anticipate that some of this equipment will be replaced in the coming months, or at least we will receive the orders for it. Despite the rig count being down, the active ones are being utilized extensively. Additionally, we are still shipping to China at higher rates compared to last year.

Okay. That's great. During the last quarter, how much of your business was related to oil and gas? And then within that, how much is consumable versus new equipment?

In the quarter, it's probably around 20% with about a quarter of that being aftermarket activity.

Okay. Thanks. Can you share how significant the opportunity is with the Rolla partnership?

It's a significant opportunity. We're just beginning to explore it. Rolla has been focused on designing and manufacturing propellers and performing computational fluid dynamics analysis for propeller design, choosing the appropriate gear ratio and horsepower, and assisting designers with hull design. This has primarily been in their traditional market, dealing with yachts up to 150 feet in length. Collaborating with Veth, which provides integrated L-drives and larger thrusters, allows us to enter the market for much larger vessels. While it may not be a drastic change for Rolla, their CFD technology and design capabilities, combined with Veth's input on mechanical products and electronics, represent a substantial advancement. This collaboration allows Rolla to engage with significantly larger vessels and assists Veth's customers in participating more actively in the vessel design process, including selecting horsepower and addressing hull-related questions to predict vessel handling. Overall, it's a major opportunity for us.

Okay. Great. A couple of housekeeping items. Are you anticipating a 30% gross margin in the medium term? It seems like you were close to that in the fourth quarter. Was there a one-time benefit contributing to that? Also, how should I view gross margin expectations for next year?

Yeah. No, the fourth quarter was pretty clean. Nothing really unusual other than it's the fourth quarter, which is usually our strongest quarter. So I think as we go forward into fiscal '24, we expect to have favorable comps to the prior year. But I would say Q1 starts with a favorable comp to Q4. So I think we'll build hopefully, to that 30% and beyond as we work through fiscal '24.

Yes. For us, any small trend that could impact demand is important. In general, we see an increase in revenue and gross margin quarter over quarter, and this is influenced by the number of shipping days. We have the fewest shipping days in the first quarter mainly because of shutdowns in Europe and holidays, which leads to a gradual increase in shipping days in the second, third, and fourth quarters.

Okay. Last question, what's the outlook for our capital expenditures next year?

Yeah, I think we'll be something a little bit higher than probably what we did this year. We're thinking in the $10 million to $12 million range, limited really by lead times again. We have an appetite for some of the machine tools to drive productivity. Some of them are already on order. But with extended lead times even beyond fiscal '24. So I think that's the limitation for next year, I think. But yeah, we should be higher than this year, again, in the $10 million to $12 million range.

Okay, great. Thank you.

As we have no further questions, this concludes our question-and-answer session. I would like to turn the conference back over to John Batten for any closing remarks.

Thank you, Vaishnavi. I'd like to thank our global teammates for another great year. This would not be possible without them. And please reach out if you have any further questions for Jeff or myself, and have a great day, and we'll look forward to talking to you after the close of our first fiscal quarter in October. Thank you.

The conference has now concluded. Thank you for attending today's presentation. You may all now disconnect.