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Edited Transcript of LDL earnings conference call or presentation 2-May-18 2:00pm GMT

Q1 2018 Lydall Inc Earnings Call

Manchester May 3, 2018 (Thomson StreetEvents) -- Edited Transcript of Lydall Inc earnings conference call or presentation Wednesday, May 2, 2018 at 2:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Brendan Moynihan

Lydall, Inc. - VP of Financial Planning and IR

* Dale G. Barnhart

Lydall, Inc. - President, CEO & Director

* Randall B. Gonzales

Lydall, Inc. - Executive VP & CFO

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Conference Call Participants

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* Edward James Marshall

Sidoti & Company, LLC - Research Analyst

* Matthew Butler Koranda

Roth Capital Partners, LLC, Research Division - MD & Senior Research Analyst

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Presentation

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Operator [1]

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Good day, and welcome to the Lydall Announces First Quarter Financial Results Conference Call and webcast. (Operator Instructions) Please note, this event is being recorded. I would like to turn the conference over to Brendan Moynihan, Vice President Financial Planning and Analysis and Investor Relations. Please go ahead, sir.

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Brendan Moynihan, Lydall, Inc. - VP of Financial Planning and IR [2]

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Good morning, thank you, operator. Good morning, everyone and welcome to Lydall's First Quarter 2018 Earnings Conference Call. Joining me on today's call are Dale Barnhart, President and Chief Executive Officer; and Randy Gonzales, Executive Vice President and Chief Financial Officer. Dale will start the call with comments about the continued progress we are making in executing our long-term strategy as well as provide an overview of current business conditions. Randy will follow with a review of our financial performance and discuss the key drivers by segment. At the end of our remarks, we'll open the line for questions. Our quarterly earnings press release and form 10-Q were released yesterday. So that you can follow along with today's call, please reference to the Q1 2018 Earnings Conference Call presentation, which can be found at lydall.com in the Investor Relations section. As noted on Slide 2 of this presentation, any comments made on this conference call that may constitute forward-looking statements are made available pursuant to the Safe Harbor provision as defined in the securities laws. Please also refer to the cautionary note concerning forward-looking statements within Lydall's Form 10-Q for further information. In addition, we will be referring to non-GAAP financial measures during this conference call. A reconciliation to GAAP financials can be found in the appendix of the presentation I just referenced.

With that, I'll turn the call over to Dale.

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Dale G. Barnhart, Lydall, Inc. - President, CEO & Director [3]

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Thank you, Brendan. Good morning, everyone, and thanks for joining us. I'm pleased to report strong above market sales growth in all segments with organic sales growth of 4.2%. Compared to last year's strong first quarter, adjusted operating margin was down 240 basis points. As expected, gross margin was negatively impacted by increased commodity cost and reductions in select customer pricing in the Thermal Acoustic Solutions segment. In addition, the Thermal Acoustic Solutions business also saw the incremental manufacturing costs, which negatively impacted gross margin. These gross margin reductions were partially offset by favorable leverage on SG&A expenses, adjusted earnings per share for the quarter were $0.67 compared to $0.74 in the first quarter of 2017.

Slide 3 outlines our recently published financial results for the first quarter of 2018. I will briefly cover the key highlights and Randy will take you through the first quarter results in detail when he provides a summary of our financial performance. First quarter 2018 net sales increased 15.8% from the same period in 2017 to $191.7 million. Organic growth of 4.2% was led by Technical Nonwoven segment, organic growth of 7.8% resulting from continued strength in Industrial Filtration markets coupled with robust demand in Advanced Materials applications.

Our Thermal Acoustics Solutions business grew organically at 3.6% on strong market demand and expansion to new platforms. In particular, Thermal/Acoustic, while China operations saw sales growth of 50% compared to prior year period. Finally, Performance Materials grew organically at 1.3%, led primarily by increased filtration sales, particularly in the fluid power applications. On a volume basis, Lydall grew with or in excess of its applicable end markets in all segments. With respect to profitability, 2018 adjusted gross margin declined 420 basis points to 20.8%, negatively impacted by incremental manufacturing costs in Thermal Acoustical Solutions, higher commodity cost, reduced customer pricing and mix. This decline was partially mitigated by improved leverage of SG&A expenses, which on adjusted basis decreased by 180 basis points as a percentage of net sales compared to the first quarter of 2017. The resulting adjusted operating margin of 7.7% was 240 basis points lower than prior year period including a 20 basis point headwind for increased intangibles, amortization from the Texel and Gutsche acquisitions. First quarter results include a tax rate of 16.1% driven by the reduction of the U.S. corporate tax rate from 35% to 21% under the tax Reform Act enacted in December, 2017, compared to an effective tax rate of 17.6% in the first quarter of 2017. Resulting EPS was $0.67 per share. In our Thermal Acoustics Solutions segment, as discussed in prior earnings calls, we have been addressing underlying operational issues in our automotive operations, but in Q1, this segment incurred incremental manufacturing cost as a spike in demand coupled with equipment downtime and related inefficiencies led to cost increases to satisfy customer delivery schedules. These costs included expedited freight, excess overtime and scrap. We have seen significant improvement in these items beginning early in the second quarter. In the Technical Nonwovens business, we continue to make progress in executing on our Technical Nonwoven's integration activities to consolidate existing sites in Europe and China. Finally, the previously announced formation of the new Thermal Acoustic Solutions segment is complete. The resulting streamline organizations [indiscernible] us to leverage a unified global sales force to drive commercial and operational synergies going forward.

Turning to Slide 4. This is an overview of our long-term growth strategy, which includes 4 drivers, new product development, Lean Six Sigma, geographic expansion and M&A. With respect to new product development, I would like to highlight a significant achievement for the Thermal Acoustic Solutions team, which was recently recognized by General Motors with their prestigious Supplier of the Year award. This award recognizes suppliers that have consistently exceeded General Motor's rigorous performance, criteria in quality, execution, innovation and cost metrics. The award recipients are selected by a global team of GM purchasing, engineering, quality, manufacturing and logistic executives. General Motors recognized the Lydall Thermal Acoustic Solutions leadership team on April 20 at their 26th Supplier of the Year award ceremony. The award represents a significant time and effort that Lydall team has invested in building positive supplier relationships providing outstanding products and exceeding customer expectations.

Moving on to geographic expansion. We have executed well on this component of our strategy with 1/3 of our sales now generated internationally. In particular, our Thermal Acoustic Solutions operation in China continues to ramp-up profitably with sales growth of over 50% compared to the first quarter of 2017. We remain focused on the previously announced restructuring initiatives in Technical Nonwovens, and have made progress in consolidating our capabilities and manufacturing footprint in Europe and China. These initiatives will better leverage our business, to be more efficient and further strengthen our scale and positioning in these markets. We continue to estimate the total restructuring expense to be approximately $5 million with run rate synergies benefits of $5 million by 2019. 2017 results included $900,000 of expense, the majority of the remaining spend of approximately $3.5 million will occur in 2018 with limited spend in the first half of 2019.

Finally, with respect to M&A, both Texel and Gutsche integration efforts continue to be on track. Both businesses saw strong sales activity in the first quarter and continue to build a very healthy backlog in line with our expectations. In terms of new opportunities, we continue to build a pipeline of potential acquisitions and are actively pursuing new prospects. Given the ongoing integration activities in Technical Nonwovens, we are continuing to focus our efforts on opportunities in the Performance Materials segment.

Turning to Slide 5 with respect to business conditions. Overall, we believe underlying fundamentals of our business remain favorable. On the supply side, we continue to see elevated price levels for certain raw materials, particularly aluminum. Market prices for aluminum was roughly flat sequentially from fourth quarter 2017, but increased approximately 10% to 15% from the first quarter of 2017, representing a headwind of approximately 150 basis points for the Thermal Acoustic Solutions business. As a reminder, Lydall does have pass-through arrangements in place for approximately one half of the affected business volumes. There is typically a 3- to 6-month lag on recovery. Finally, we are seeing some moderate upward pressures on polyester fiber pricing, the key input across all Lydall business units. On the demand side after solid performance in 2017, the domestic automotive market continued to show favorable results in the first quarter of 2018. With U.S. light vehicle seasonal adjusted annual rates ramping-up through Q1 to a high of 17.4 million units in March. Current forecast indicate that 2018 will likely see light vehicle production levels flat to slightly down, Western Europe volumes are forecasted to be flat to marginally up, while China production are to grow at mid-single digits. Given this global outlook and the mix of applications and platforms in our product portfolio, we expect to slightly outpace the market on a volume basis.

Looking to our Filtration and Engineering Materials businesses, Performance Materials end markets continue to show stability across all regions. Strong demand for filtration products in 2017 continued into the first quarter of 2018, and we expect that to continue for the balance of 2018. Fluid power filtration applications will continue to be a growth area for Lydall, buoyed by strength in agricultural and construction end markets. The Specially insulation business saw mid-single digit growth in 2017, led by higher sales of cryogenic insulating products. We expect demand in this area to remain stable going forward. Finally, in our Technical Nonwovens segment, we are experiencing stable demand for both our Advanced Materials and Industrial Filtration products. In North America and China, the power generation markets remain healthy and while we anticipate this to continue, we don't expect the double-digit growth rate seen in 2017 driven by the 2016 contraction in these markets. Gains in the Advanced Materials market in 2017 were fueled largely by Texel and Gutsche acquisitions and even when adjusting for this, we still see healthy demand in end markets, evidenced by our robust backlog at the end of the first quarter of 2018.

With that, I will now turn the call over to Randy.

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Randall B. Gonzales, Lydall, Inc. - Executive VP & CFO [4]

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Thank you, Dale. Turning to Slide 6, I'll briefly cover our consolidated results and then provide an overview of our operating segment results. In the first quarter of 2018, the company achieved net sales of $191.7 million, an increase of 15.8% over the first quarter of last year. This increase was driven by organic growth of 4.2%, with growth in every segment. Tooling sales of $13.3 million in Thermal Acoustical Solutions, an indicator of future parts sales were up $10.3 million compared to first quarter of 2017, contributing 5.8 points of growth. Favorable foreign exchange contributed an additional 5.8 points of growth. Note that $6.3 million of sales growth in the first quarter of 2018 is related to the new accounting standard, which impacts the timing of revenue recognition. In the quarter, $6.2 million of this increase was in tooling sales for Thermal Acoustical Solutions. Under the new standard, Lydall predominantly recognizes tooling sales as costs are incurred over time in contrast to the prior practice of recognizing tooling revenues upon acceptance and delivery to the customer.

The resulting impact to gross margin and operating income was $300,000. Reported gross margin in the first quarter was down 390 basis points from prior year to 20.6%. Excluding acquisition related inventory step-up and severance charges in Q1 '17, and restructuring charges in Q1 '18, adjusted gross margin of 20.8% was down 420 basis points. As Dale noted, gross margin was negatively impacted by higher manufacturing costs in Thermal Acoustical Solutions, impacting consolidated Lydall margins by 160 basis points in the quarter, of which we estimate the majority is nonrecurring. Higher commodity costs, particularly aluminum with an additional headwind of 70 basis points. Pricing pressure and unfavorable mix, particularly the increase in low-margin tooling sales in Thermal Acoustical Solutions made up the remaining reduction. Consolidated operating margin for the first quarter was 7.3% including $500,000 of expense related to restructuring activities and $100,000 of expense related to strategic initiatives.

Adjusted for these items, operating margin in first quarter was 7.7%, down 240 basis points from prior year. Lower gross margin was offset by leveraged SG&A spending, which improved 180 basis points in the quarter and included 20 basis points of increased intangible amortization expense. The effective tax rate for first quarter 2018 was 16.1% compared with the same period in 2017, which was 17.6% due to a lower U.S. statutory tax rate. Note that the tax rate in first quarter 2017 included 11.4 percentage points of favorability related to stock compensation expense. For the full year 2018, we now expect the consolidated ordinary tax rate to be in the range of 18% to 20%. First quarter 2018 earnings per diluted share were $0.64 compared to $0.68 of earnings in the prior year. When adjusting for the strategic initiatives expense, inventory step-up, restructuring and severance expenses, adjusted earnings per share of $0.67 was down $0.07 or 9.5% compared to adjusted EPS of $0.74 delivered in the first quarter of 2017.

Cash flows used in operations in first quarter was $4 million, compared with positive cash flow of $12 million in first quarter of 2017. While net income was relatively flat, working capital increased, particularly in accounts receivable, driven by higher sales, partially offset by favorable accounts payable. As it relates to capital expenditures, Lydall spent $7.7 million in first quarter of 2018, $1.9 million less than in first quarter of 2017. We continue to invest in capacity and automation in Thermal Acoustical Solutions and expenditures related to the Technical Nonwovens site consolidation activity will ramp through 2018. We continue to anticipate the 2018 capital spend to be in the $30 million to $35 million range, with strategic growth and productivity spending in each of the 3 segments. Our liquidity remained strong. At the end of the first quarter, cash was $49.1 million, total outstanding debt from the credit facility at quarter-end was $76.6 million for a net debt ratio of approximately 0.3x adjusted EBITDA, positioning us well for future acquisition growth.

Moving to Slide 7, I'll discuss our segment results. I'll start with our Thermal Acoustical Solutions segment. This is our global automotive business, which specializes in providing an engineered thermal and acoustical solutions for vehicle under hood, underbody, powertrain and exhaust applications. First quarter sales in this business were $101.4 million, up 19.6%. Net parts sales of $88.1 million were up $3 million or 3.6% organically, compared to last year led by strong growth in China and Europe with more moderate growth domestically. Tooling sales of $13.3 million grew by $10.3 million in support of customer product launches, including $6.2 million related to adoption of ASC 606 revenue recognition. Favorable foreign exchange primarily the stronger euro, added 4.7 points to sales growth. Adjusted operating margin declined 590 basis points from first quarter 2017 to 12.4%. Increased cost from expedited freight, scrap and overtime to support customer volume increases and equipment downtime impacted margins unfavorably by 310 basis points. In addition, higher aluminum pricing, up about 15% from the prior year period, contributed another 130 basis points headwind with price and unfavorable mix accounting for the remaining drop. While we have seen meaningful progress in the second quarter to address the ramp in customer volumes and equipment issues, we anticipate some of these issues will persist into Q2. Commodity pricing remains uncertain for the remainder of 2018, but we continue to work on mitigating this impact through sourcing, customer negotiations and other initiatives.

Moving to Slide 8. I'll cover our Performance Materials segment. This business provides specialty filtration and insulation solutions to a variety of end markets globally. Sales grew organically by 1.3% in the first quarter to $30.7 million, led by higher filtration sales, primarily from strong gains in fluid power applications, leveraging cyclical strength in underlying markets and the introduction of new products. Specialty insulation sales were relatively flat with gains in low-temperature cryogenic insulation products, offset by reductions in other categories. Life Sciences sales were flat. Foreign currency translation provided a favorable tailwind of 5.5% in the quarter. First quarter operating margin expanded by 280 basis points to 8.6%, with select pricing pressures more than offset by lower SG&A expenses, primarily the lack of an $800,000 noncash asset impairment expense incurred in the first quarter of 2017. As you may recall, this charge related to a chronically underutilized legacy product line in North America.

Slide 9 covers our Technical Nonwovens segment. This segment produces air and liquid filtration media as well as other engineered products for use in various commercial applications such as geosynthetics, automotive, industrial and medical among others. For the first quarter of 2018, sales of $67.5 million were up $8.6 million including $4 million of favorable currency translation. Organically, sales grew 7.8% or $4.6 million on improved demand from Industrial Filtration customers in Europe and to a lesser extent, China and North America. Increased sales of Advanced Materials were driven primarily on higher demand for automotive and geosynthetics applications. From a profitability perspective, adjusted operating margin for the first quarter declined by 110 basis points to 8.2% compared to the same period in 2017, driven by unfavorable mix, and higher variable overhead expenses.

As a reminder, adjusted operating income excludes $500,000 or 80 basis points of expenses related to ongoing restructuring activities in the quarter, but does include $300,000 or 50 basis points of increased intangibles amortization versus the same period last year. As Dale noted earlier, with respect to the acquisitions, the performance and integration of both businesses continues to be on track, and we remain confident in the strategic supply and demand side leverage to be gained by the industry-leading market position that we now enjoy. That concludes our review of the first quarter results. Top line growth exceeded 15%, driven by generally healthy demand in end markets we serve. Moving forward, we remain focused on improving operational performance in Thermal Acoustical Solutions, executing our integration and restructuring in Technical Nonwovens and driving organic and inorganic growth across all business segments. Leveraging these improvements on continued strength in our end markets positions us to deliver solid performance in 2018. With that, I'll turn the call back to the operator to begin our question-and-answer session.

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Questions and Answers

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Operator [1]

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(Operator Instructions) The first question is from Matt Koranda of Roth Capital Partners.

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Matthew Butler Koranda, Roth Capital Partners, LLC, Research Division - MD & Senior Research Analyst [2]

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I just wanted to start by honing in on the operational issues in Thermal Acoustical. Could you just clarify that, that the 310 basis points that you mentioned is on the metal side of that business? And then if you could quantify the drag in a little bit more granularity or detail from sort of, I guess, the downtime that you mentioned, the overtime, the expedited freight too, would like to break out of that if possible. But I'm trying to get a sense for is sort of, when I isolate what has been challenging for you guys in terms of fixes to that side of the business, it seems like its lingered for the better part of the last year and just looking for sort of more color on sort of the issues behind us, or at least, we've got a trajectory to improvement here.

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Dale G. Barnhart, Lydall, Inc. - President, CEO & Director [3]

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Sure. It's not all in the metals business, so it's across TAS, but significant portion is related to the metal product line. Again, related to about 160 basis points of the drag was due to the inefficiencies in TAS. The most significant of that in the first quarter was expedited freight. As we had a lot of new products launching, and volume spiked on a couple of applications, to keep up with demand, and we had a lot of expedited freight and overtime. And the good news on that particular aspect, Matt is through April there has been very little expedited freight and overtime. So as we put our processes in place, it's early in the second quarter, but we do anticipate those controllable issues will show significant sequential improvement from Q1. About 70 basis points was really the commodity, aluminum pricing, as 10% to 15% higher than the first quarter of last year. Sequentially, it was flat with the fourth quarter of 2017. But for the balance of year, there's just a lot of uncertainty. Half of our business, we do have pass-through, but it's a 3- to 6-month drag -- lag. So for the balance of the year, we probably anticipate still some headwinds on the commodity side there. And then we did have a little bit of mix in the automotive business as it relates to the new revenue recognition. And we recognized the significant amount of tooling in the first quarter, which you know the good news is it's an indication of new parts going to be launched, but again, pretty much at a breakeven point on the operating margin line.

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Matthew Butler Koranda, Roth Capital Partners, LLC, Research Division - MD & Senior Research Analyst [4]

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Okay. So it sounds like the majority of it was product launch issues and some volume that -- some incremental volume that you were dealing with, you won't necessarily prepared for. So going forward, with incremental launches, how do you get confidence that you're going to launch programs more cleanly? What changes have you made there to sort of ensure that we don't incur these overtime and expedited freight costs in the future?

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Dale G. Barnhart, Lydall, Inc. - President, CEO & Director [5]

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We have taken 2 senior engineers in the group that are clearly focused just on the product launches that we have going forward with us, and they have a dedicated team to ensure that we've learned from our experiences and that we schedule everything appropriately. It goes beyond just the tooling and running the initial part. It's also making sure we schedule our production volume accordingly, so we can break in at an appropriate time and run these PPAPs, which are run on our production line, so we've got a lot smarter in how we are scheduling our products going forward. So some of the interruption and expedited freight was due to the fact that we had to break into a production line to run PPAPs and that got us behind in what we had in our production line. So the good news is we didn't shut down any customers. The bad news is, we absorbed a lot of cost, which we think most of that is behind us as it relates to expedited freight and overtime.

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Matthew Butler Koranda, Roth Capital Partners, LLC, Research Division - MD & Senior Research Analyst [6]

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Got it. In terms of the tooling revenue, just to hone in on that a little bit more, I mean, I guess -- even surfing out the accounting change you guys mentioned, it's a pretty lumpy amount of tooling and I think you alluded to the fact that typically that's indicative of new business, but could you give us a little bit of color around sort of, is that all for new programs? Is there any sort of tooling replacement in there and any color on sort of the programs that you'd be launching on later this year?

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Dale G. Barnhart, Lydall, Inc. - President, CEO & Director [7]

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The majority of them are for new parts. Some of them are replacing parts on a new platform we're already on it and some of them are new. We mentioned the GM award. By the end of 2019, we'll probably be on every vehicle that GM produces, with our metal shields. The advantage we have there is we get on engine platforms and engine platforms go across various models. So we've done a very nice job in growing that business there. So it's a blend of both. We do have some new fiber products coming on towards the end of the year. Some wheel wells we've won in some of the foreign transplants that are producing SUVs here in United States.

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Matthew Butler Koranda, Roth Capital Partners, LLC, Research Division - MD & Senior Research Analyst [8]

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Got it. And then on the poly fiber pricing headwind that you mentioned in the prepared remarks. I'm just curious, could you give us latest on sort of, how that's passed through in the TAS segments? And then maybe as well on the other segments since you are a kind of a big user of that across multiple segments here.

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Dale G. Barnhart, Lydall, Inc. - President, CEO & Director [9]

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In TAS, there are no contractual pass-through agreements. But in the past, where we've had significant increases, we've been able to get some relief. So if we see significant increases on the raw fiber, we'll have to see if we can negotiate some relief in TAS. In the other businesses, predominantly Technical Nonwovens, that's a business where as you know, most of our business is a bid business, so we can tend to pass-through commodities increases when we bid on new filtration projects that are out there.

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Matthew Butler Koranda, Roth Capital Partners, LLC, Research Division - MD & Senior Research Analyst [10]

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Got it. Maybe just last one for me. Given some of the dip in the stock here, have you guys revised any thought process around buyback and capital allocation strategy? I know obviously you guys have been chasing a fair bit of M&A and pipeline there, but any sort of rethinking around capital allocation?

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Dale G. Barnhart, Lydall, Inc. - President, CEO & Director [11]

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Well, our major -- we're still consistent with our theme, which is organic and inorganic growth, derisking our pension plan. We do not have a stock repurchase program available to execute on now, but it is -- that would be next in line as far as capital allocation. So yes, if it continues, obviously we have a lot of confidence in what we're going to do going forward and probably it would be a good time to buy.

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Operator [12]

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The next question is from Edward Marshall of Sidoti & Company, LLC.

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Edward James Marshall, Sidoti & Company, LLC - Research Analyst [13]

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So I wanted to ask, we last met on this forum about 6 weeks into the quarter. Was this an issue that crept up, kind of as you moved into the back half of the quarter? Because it looked like you were calling for flattish revenue and modest improvement on the margins on sequential basis. So kind of trying to get our arms around how this crept up on you as we moved into the first quarter?

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Dale G. Barnhart, Lydall, Inc. - President, CEO & Director [14]

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Well in the TAS business, the revenue and the expenses were very significant in the back half of the quarter.

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Edward James Marshall, Sidoti & Company, LLC - Research Analyst [15]

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Okay. So -- And you said by April, if I heard you correctly, you said the April that largely the inefficiencies were behind you. Is that what I heard?

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Dale G. Barnhart, Lydall, Inc. - President, CEO & Director [16]

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The expedited freight and overtime in April were less than 10% of what they were on the fourth quarter -- first quarter run rate. So the team has been working very diligently on focusing on the operational issues, as I stated earlier, we'll still be faced with some material commodity headwinds as we go through the year.

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Edward James Marshall, Sidoti & Company, LLC - Research Analyst [17]

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And you mentioned the equipment downtime. Was that a particular machine? Was that across multiple lines? What actually happened and then have you remedied the issue?

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Dale G. Barnhart, Lydall, Inc. - President, CEO & Director [18]

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There's a couple of them. One, some tooling issues we had, where we had to take tools out for maintenance, also the disruption we had again when we're running PPAPs. We've break into a high-volume production line and depending how well we run the PPAP. We're taking a high-value, high-volume asset out of production. So part of it was really not -- we didn't anticipate the spike in demand so therefore, we hadn't schedule the production quantities in line with to be in sync with what we were taking the line down for PPAPs. So we've gotten smarter in all of that. So the good news and bad news was significant top line growth on those new metal assets we have in Hamptonville. So the better news is as we go into the second quarter, you should see significant improvement on the operational efficiencies out of that facility.

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Edward James Marshall, Sidoti & Company, LLC - Research Analyst [19]

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Got it. Sounds like you're classifying it as a high-class problem with revenue surging leading to the inefficiencies.

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Dale G. Barnhart, Lydall, Inc. - President, CEO & Director [20]

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That's part of it. Part of it is we dropped the ball too, but we'll fix that problem.

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Edward James Marshall, Sidoti & Company, LLC - Research Analyst [21]

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Got it. I just wanted to get for better understanding around tooling as well. I know you spend a lot of time on that already. I know it's -- that it's a next to nothing margin for you, but is there -- with the change in recognition, is this a seasonal impact that will affect Q1 on a go forward basis? Or how do I view kind of the tool -- I know it's meant to smooth the business over time, but obviously it didn't do a good job in Q1.

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Dale G. Barnhart, Lydall, Inc. - President, CEO & Director [22]

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Ed, basically, it's no, it isn't reflecting. It isn't going to make it seasonal. What is it, it's just progress payments. Go back to the old ways, as we get a certain portion of the tooling project complete, we now do progress billing. Okay? And we record that as revenue and the cost and it all goes into -- it goes below the line as far as the profits from that transaction. So no, it won't be driven by any seasonality. It's really by the amount of work accomplished and when we bill it.

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Edward James Marshall, Sidoti & Company, LLC - Research Analyst [23]

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Got it. And so you don't think there'll be any particular seasonal issues with new model rollouts and the beginning of any particular year or at the end of a particular years you build tooling for those programs?

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Dale G. Barnhart, Lydall, Inc. - President, CEO & Director [24]

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No, I mean, a lot of it depends upon actually when the platform or new products are going to go into production. So you'll see tooling in the second quarter because we've got a lot of new parts that we're launching in the back half of the year. So we're in the process of designing and building that, having those tools built for us. And so it will be -- if anything, it may smooth it out, but there is no seasonal spike as it relates to tooling based just on seasonality. It's really on when these new parts are going to be going into production, and when we ran PPAP.

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Edward James Marshall, Sidoti & Company, LLC - Research Analyst [25]

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Got it. I wanted to ask on the pass-through as well. As you look at the commodity raw inflation, you talked about 50% of the business is through pass-throughs, 3- to 6-month lag. When we see rapid inflation like we have in some of the materials over the last year, does that kind of shift towards that 6-month range than the 3 months? Can you see it drift past that, maybe spend some time on that for a second.

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Dale G. Barnhart, Lydall, Inc. - President, CEO & Director [26]

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No, it's contractual. So the 3 month depends, whether it's 3 or 6 months just depends upon the contract we have with the given OEM. So that time period doesn't change. But if -- the challenge we have right now up until this quarter, which was pretty much flat with the fourth quarter of '17, we've been chasing an upward target. So we're always behind it. So it should be little catch-up or stability in the first quarter relative to the lag, but it's really a wildcard right now and where aluminum is going to end up this year.

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Edward James Marshall, Sidoti & Company, LLC - Research Analyst [27]

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Got it. And I guess, the other part of that question would be what about the 50% that's not under contractual agreement? How does the structure of that work, what's your ability to recapture those kind of price increases in the materials? And ultimately are you putting in any hedges, or maybe it's too late for that anyway, but, put in some hedges to offset some of the commodity risks?

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Dale G. Barnhart, Lydall, Inc. - President, CEO & Director [28]

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We don't hedge. We do some buy forwards though for a given period which gives us a little bit of protection. Really, again, what we would have to do there if the pressure gets -- continues to grow is to go back to individual customers on a given part and say we need relief because the raw material has had a negative impact. The other way is to do an engineering design that can take some cost out of the product that we share with the OEMs. So they get a portion of it, and we retain a portion of it. So those are our 2 avenues for the ones that we don't have material escalation.

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Edward James Marshall, Sidoti & Company, LLC - Research Analyst [29]

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Got it. So if I can just step back and look at big picture and talk about maybe the gross margin for the remainder of the year. It looks like operational efficiencies are slowed up, and will gradually will slowly subside as we kind of go through the year, commodity headwinds are also subsiding, with maybe a little bit of [triple through], but you should be catching up on half year business there. It seems like you should see a steady progress throughout the remainder of the year, assuming that volumes stays relatively consistent to up. Are you suggesting that Q1, or am I suggesting that Q1 is the low watermark for your gross margin for the full year?

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Randall B. Gonzales, Lydall, Inc. - Executive VP & CFO [30]

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I think that's fair, Ed. I think that's our view as well.

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Operator [31]

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(Operator Instructions) This concludes our question-and-answer session. I would like to turn the conference back over to the management team for any closing remarks.

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Dale G. Barnhart, Lydall, Inc. - President, CEO & Director [32]

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Thanks to everyone for joining the call, and we'll be talking to you at the end of the second quarter. Thank you, very much.

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Operator [33]

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