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Edited Transcript of SYPR earnings conference call or presentation 12-Nov-19 2:00pm GMT

Q3 2019 Sypris Solutions Inc Earnings Call

LOUISVILLE Nov 29, 2019 (Thomson StreetEvents) -- Edited Transcript of Sypris Solutions Inc earnings conference call or presentation Tuesday, November 12, 2019 at 2:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Anthony C. Allen

Sypris Solutions, Inc. - VP & CFO

* Jeffrey T. Gill

Sypris Solutions, Inc. - Chairman, President & CEO

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Conference Call Participants

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* Joel Cahill

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Presentation

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Operator [1]

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Good day, and welcome to the Sypris Solutions, Inc. conference call. Today's conference is being recorded. At this time, for opening remarks, I would like to turn the call over to the President and Chief Executive Officer, Mr. Jeffrey Gill. Please go ahead, sir.

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Jeffrey T. Gill, Sypris Solutions, Inc. - Chairman, President & CEO [2]

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Thank you, Tracy, and good morning, everyone. Tony Allen and I would like to welcome you to this call, the purpose of which is to review the company's financial results for the third quarter of 2019. For those of you who have access to our PowerPoint presentation this morning, please advance to Slide 2 now.

We always begin these calls with a note that some of what we might discuss here today may include projections and other forward-looking statements. No assurance can be given that these projections and statements will be achieved, and actual results could differ materially from those projected as a result of several factors. These factors are included in the company's filings with the Securities and Exchange Commission. And in compliance with Regulation G, you can access our website, sypris.com, to review the definitions of any non-GAAP financial measures that may be discussed during this call.

With these qualifications in mind, we'd now like to proceed with the business discussion. Please advance to Slide 3. I will lead you through the first half of our presentation this morning, starting with an overview of the highlights for the quarter to be followed by an update on the outlook for each of our primary markets. Tony will then provide you with a more detailed review of our financial results for the quarter as well as walk you through our forward-looking financial guidance.

Let's begin now with the overview on Slide 4. Revenue for the third quarter of 2019 increased 5.5% to $22.3 million, reflecting the positive growth in each of our business segments. Sales for Sypris Technologies increased 5.4% on a year-over-year basis primarily reflecting the growth of shipments of energy-related products when compared to the prior year period. Sales in our energy business, in particular, continue to expand on a year-over-year basis, reflecting the positive combination of the strong backlog and improved supply chain delivery performance.

Sales to our electronics customers increased 5.7% on a year-over-year basis but were less than our internal forecast as a result of 2 supply chain issues that impeded shipments during the quarter. Importantly, these issues have since been resolved. Tony will address these issues in greater detail momentarily.

Gross margin for the quarter increased to 10.5% of revenue, up from 5.7% last year. The improvement, while certainly positive, was impacted by the lower-than-expected top line during the quarter as well as the charges incurred at Sypris Electronics to reflect the results of the physical inventory that was completed at quarter end.

Within our segments, gross profit for Sypris Technologies increased 89.4% from the third quarter of 2018 on a 5.4% increase in sales driven by strong operating performance and margin expansion across the business. Looking forward, we expect margins for Sypris Technologies to expand further, reflecting the positive impact of higher energy-related product shipments during the fourth quarter of this year. For 2020, we expect the successful launch of new programs, when coupled with the reduction of the costs that were incurred to support the launch of these programs, to result in further margin expansion on a year-over-year basis.

Gross profit for Sypris Electronics was roughly even with that of last year, despite lower-than-expected shipments during the period as a result of the supply chain issues I mentioned a moment ago and which I have said have since been successfully resolved. With our solid backlog, the commencement of shipments under our new contract and improved component availability, we expect margins for Sypris Electronics to expand significantly during the fourth quarter. As we look forward into 2020, we expect margins to stabilize at rates that are consistent with our guidance.

Before moving on to our new business awards, it is important for us to note that while our financial performance improved during the quarter on a comparable period basis, we did not achieve the results we had forecast or had expected internally. We believe that we've addressed the root causes of these surprises, and we will certainly continue to work hard to mitigate any such issues in the future.

Turning now to Slide 5. We have recently announced the award of several important new multiyear contracts across the business. For Sypris Electronics, we announced the receipt of a multiyear contract award from Northrop Grumman to manufacture a variety of mission-critical electronic assemblies for a large Department of Defense program.

For Sypris Technologies, we announced the receipt of significant orders for Tube Turns branded closures for use in large natural gas transmission projects in Kazakhstan and British Columbia. These orders are planned to begin shipment during the current quarter and continue into next year.

We also announced the award of a long-term contract to supply certain transmission components for use in a new automotive dual-clutch transmission that was designed for high-performance applications. Shipments under this contract will begin during the current quarter and are expected to reach full production levels during the first quarter of next year. In addition, we announced the award of a long-term contract to supply transmission components for use in one of the leading all-terrain recreational vehicles. These last 2 contract awards are important, both in terms of their anticipated contribution of the company's future financial performance as well as to our efforts to further diversify our customer, product and market portfolios.

Turning now to Slide 6. North American demand for heavy-duty trucks reached an all-time high during the 2018 and 2019 years driven by strong freight growth, tight capacity and an expanding economy. Looking forward, customer demand is forecast to return to historical norms in 2020, which, if accurate, will result in an estimated 25% year-over-year reduction in demand for Class 8 trucks. In past years, such a reduction would have been expected to have had a material impact on the revenue and profit of our business. But as we sit here today, we believe that recent contract awards in the automotive, ATV, commercial vehicle and industrial markets will materially offset the reduction in revenue associated with the Class 8 cycle. Furthermore, the substantial cost that we have incurred during 2019 to develop tool up and launch these programs is not expected to carry over into 2020, thereby contributing to further margin expansion when compared to the prior year's performance.

I would like to pause here for just a moment for this outlook represents a significant transformation for Sypris. If our forecast proves to be accurate, we should expect to actually improve our profitability during the forecasted down cycle in the Class 8 market. This would represent a first for Sypris and would certainly be reflective of the hard work that everyone has put forth during the past several years.

As we discussed during previous calls, demand for oil and natural gas continues to outpace domestic consumption, thereby supporting the forecast that the U.S. will become a net exporter of energy within the next year. The conversion of power generation to natural gas as well as the construction of pipelines and LNG terminals to support export activities is also serving to bolster the market outlook.

Production in the Permian Basin continues to outpace current pipeline capacity, while the growth in pipeline gathering systems and the aging of existing transportation infrastructure bodes well for the future demand of the company's closures, insulated joints and other such products. DoD spending also continues to remain solid, with U.S. military spending expanding especially with regard to key long-term strategic programs that are expected to run for many, many years.

Turning to Slide 7. As we discussed during our prior call, these positive market conditions, when combined with recent contract awards and our lower cost profile, provides us with a solid base for optimism when looking forward. Our initial outlook for 2020 lays the groundwork for additional growth and margin expansion during the year.

From a gross margin standpoint, we are targeting to be in the range of 15% to 17% of revenue for the year, with both business segments posting solid margin performance for 2020. The combined effect of new program revenue, reduced start-up costs, improved material availability and solid backlog is expected to have a positive impact on the company's financial results going forward. Our journey continues. And needless to say, we are looking forward to the coming year.

Turning now to Slide 8. Tony Allen will lead you through the balance of our presentation this morning. Tony?

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Anthony C. Allen, Sypris Solutions, Inc. - VP & CFO [3]

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Thanks, Jeff, and good morning, everyone. I'd like to discuss with you some of the highlights of our third quarter financial results. Please advance to Slide 9. Q3 consolidated revenue was $22.3 million, an increase of 5.5% from the third quarter of last year. Consolidated gross margin was 10.5% for the third quarter which is a 480 basis point improvement from the prior year.

Revenue for Sypris Technologies increased 5.4% to $15.7 million from $14.9 million a year ago, and gross profit nearly doubled to $2.5 million from $1.3 million. We began to experience order board reductions for commercial vehicle products during the third quarter, a trend we expect to continue into Q4 and 2020. This accounted for a slight decline in year-over-year revenue in this market and a sequential decrease of about 10%. Offsetting the commercial vehicle market decline was increased revenue from our energy products and shipments on new programs for automotive, all-terrain vehicles and refrigeration valve customers.

Energy product shipments increased about 19% year-over-year but were down slightly from Q2. Gross margin was 16.1% for Sypris Technologies in the third quarter which compares to 8.9% in the prior year period. The year-over-year improvement in gross margin for technologies reflects operational improvements on our legacy programs partially offset by costs incurred on the launch of new programs. We expect costs to bring equipment up to OEM specifications in order to minimize equipment downtime as this equipment is repurposed for the new programs. Additionally, labor productivity was lower during the ramp-up phase as we design and train our workforce on the manufacturing processes for the new programs.

Revenue for Sypris Electronics increased 5.7% to $6.6 million in Q3, and gross profit was essentially flat with the prior year. This performance was well below our expectations for the quarter, and I would like to spend a little time discussing the 2 discrete material issues that contributed to the shortfall. The first issue involves a third-party value-add supplier that provides a coating process that assures the functionality of an integrated circuit component on the printed wiring board of one of our highest volume programs. As our volume on this program was ramping up, the supplier was experiencing low-yield rates on the coating and was struggling to meet our required delivery schedules. A process change was proposed by the supplier to improve the yield and throughput of product in their factory. This proposed change required first article sample builds and tests for approval by both Sypris and our customer. The process took close to 60 days to complete. After approval, the supplier coating process yield has improved significantly to over 95% from the previous 50%, and Sypris is back on track to our full run production rate.

The second issue centered around the approval of a component that was sourced to an alternate supplier after our original supplier notified us that shipments of the component were going to be delayed from Q3 until Q1 of 2020. Once notified, we worked diligently with our customer to qualify an alternate source and was successful in identifying a vendor that could begin deliveries within the quarter. However, the alternate source for the component was not a previously approved broker. And therefore, the components were required to undergo a counterfeit mitigation test process before our customer could approve the components for use on the program. The component successfully passed the test and customer approval was received, allowing production to resume to full run rates as we close September.

In addition to the revenue and related contribution margin associated with the delayed production on these 2 high-volume programs, we were not able to fully offset the impact of the lower direct labor and overhead absorption levels, which impacted our margins in the quarter.

As we look at the current state of electronic component availability on a broader level for our programs, we believe the conditions have improved, and our outlook of the market is considerably better than it has been at any point this year. Additionally, the advanced funding by our customers for long-lead components on certain of our programs has enabled us to procure these components and mitigate that element of risk on future shipments.

We conducted a physical inventory at Sypris Electronics at the end of September, which was our first physical inventory since we implemented our new ERP system at the beginning of the year. Our knowledge and use of the system as a business tool has improved on almost a daily basis since the implementation. The results of the physical inventory provided another learning opportunity to target specific process improvements we can make to improve inventory accuracy.

We incurred a charge of approximately $300,000 as a book to physical adjustment for the quarter, which approximates 2% of our net inventory balance for Sypris Electronics. We were not pleased with this result as our previous cycle counting of raw materials was at a much higher accuracy rate. Our investigation of the variance resulted in actions to improve the processing of materials on the manufacturing floor to ensure accurate and timely reporting, beginning with kitting through each manufacturing and test operation until shipment to the customer.

In addition to the book to physical adjustment, we increased our E&O reserve on a specific program by $100,000 during the quarter. Our consolidated SG&A expense was $3.1 million for Q3, a year-over-year increase of approximately $200,000 and a reduction of about $450,000 sequentially. The consolidated operating loss for the quarter is clearly a disappointment. However, we remain confident the factors contributing to the setback have been addressed to put us back on track in Q4.

Please advance to Slide 10. Consolidated revenue for the first 9 months was $66.3 million, an increase of 3.5% from last year. Consolidated gross profit was $7.2 million, an increase of $1 million from the prior year. And gross margin was 10.8% for the first 9 months of 2019, which is 120 basis points above the comparable period of 2018.

Revenue for Sypris Technologies increased by $4 million or 8.9% to $48.7 million, and gross profit increased by $2.4 million to $7.8 million. Gross margin for Sypris Technologies for the first 9 months was 16%, an increase of 400 basis points from 2018.

Coming into 2019, Sypris Technologies targeted a number of cost reduction initiatives, and the margin improvement reflects our success in the categories of supply spend and utilities in particular. Management focus and controls over consumable tooling and other variables supply spend resulted in a year-over-year 290 basis point reduction in supply expense as a percent of revenue. Additionally, avoiding production on certain high electrical consumption machinery during peak periods at our Toluca facility drove a year-over-year 60 basis point reduction in utility expense as a percent of revenue. The combined effect of these 2 initiatives alone generated approximately $1.5 million of year-over-year cost reductions.

These improvements were partially offset by pre-production and ramp-up costs on new programs being launched as we continue to diversify our markets and customer base. We estimate that approximately $1 million in incremental costs and labor inefficiencies incurred in 2019 will not repeat in 2020 as these programs move from start-up to full-rate production.

Revenue for Sypris Electronics decreased 9% to $17.6 million from $19.3 million in the prior year primarily reflecting the low shipment levels for Q1 of 2019. We expected to have sequential revenue growth in Q3 that would have improved this variance to the prior year. However, the revenue shortfall related to the material issues we discussed limited our progress. The material issues were resolved as we exited Q3, allowing revenue for the month of September to meet expectations. And our run rate for the month of October continued at a consistent level.

We have the backlog in place to support our forecast for Q4. And while we anticipate routine supply chain challenges will require us to proactively manage production among our programs in the near term, we can successfully balance this out to meet our shipment targets.

Our consolidated operating loss for the first 9 months was $3.4 million, which was $760,000 favorable compared to last year, reflecting the growth and profit improvements in our technology segment partially offset by the impact of lower volume for Sypris Electronics and increased SG&A expense.

Please advance to Slide 11. Revenue for Q4 is expected to be in the range of $23 million to $25 million, with gross margin returning to our target range between 15% and 17%. Our revenue outlook includes reduced demand from the commercial vehicle market, offset by revenue from new programs at Sypris Technologies, increased energy product sales and the growth expected for Sypris Electronics based on improved material availability across its programs. The anticipated mix of revenue for the fourth quarter drives targeted margins back into the range we set earlier this year.

Our preliminary outlook for 2020 has revenue growing approximately 11% and gross margin continuing in the 15% to 17% range. We believe we have the opportunity to further improve the margin performance for Sypris Technologies in 2020, as we eliminate the costs associated with new program launches during 2019. We recognize we are facing headwinds in this segment as industry forecasts are calling for a reduction in North American Class 8 production up to 25% next year, which highlights the need to efficiently ramp production on our new programs beginning in Q4.

We also anticipate favorable market conditions will continue in the energy markets and provide growth opportunities for this higher-margin product line in the coming year. Our existing backlog, coupled with follow-on opportunities on certain programs, are expected to produce an increase in revenue for Sypris Electronics in 2020.

As noted earlier, we believe the electronic component availability has improved. And while specific components may present challenges from time to time, we can navigate those effectively to achieve a more consistent production plan in future periods.

The revenue growth we anticipate for 2020 is expected to deliver contribution margins in line with quoted levels. We are balancing our direct and indirect workforce to optimize labor and overhead absorption beginning in the fourth quarter. We are targeting SG&A expense as a percent of revenue in the fourth quarter in the 12% to 14% range and continuing in that range in 2020.

Although it isn't noted on this slide, I would like to briefly discuss our effective income tax rate as that question has been raised from time to time on our calls. Our tax expense in 2019 and 2018 generally consists of currently payable income taxes on our Mexico operation and domestic state and local income taxes. We also maintain a valuation allowance on our domestic deferred tax assets and the majority of our foreign deferred tax assets. We review the valuation allowance quarterly. And as the profitability of Sypris Technologies' Mexican operations has improved in recent periods, we believe there is a reasonable possibility that sufficient positive evidence may become available in the next 12 months that would support a release of some or all of the $3.5 million valuation allowance on our foreign deferred tax assets. Any future release of the valuation allowance would result in a recognition of a tax benefit and would favorably impact our effective income tax rate in the period released.

Please advance to Slide 12. Slide 12 provides a view of consolidated revenue and gross margin performance for the 3 most recent years and our outlook for 2019 and 2020 based on the midpoint of the ranges we just discussed. With Q4 revenue expected to land between $23 million and $25 million, we would finish 2019 with a slight increase from the prior year. The midpoint of our 2020 forecast reflects 11% growth over 2019. The midpoint of our gross margin outlook results in an expected increase of 340 basis points to 12% in 2019 before expanding another 400 basis points to 2016 or -- to 16% in 2020. Two of the key factors to improve margins in Q4 and for the full year 2020 include increased volume for Sypris Electronics and a reduction in new program launch costs for Sypris Technologies in 2020.

Please advance to Slide 13, and I will offer a few takeaways. Revenue for Q3 increased $1.2 million to $22.3 million, an increase of 5.5% from the prior year. Gross profit nearly doubled to $2.3 million or 10.5% of revenue. Sypris Technologies increased revenue to $15.7 million and posted $2.5 million in gross profit. Gross margin for Q3 of 16.1%, 720 basis points above the prior year margin. Sypris Electronics increased revenue to $6.6 million from $6.2 million a year ago, but revenue was impacted during the quarter by lower-than-expected shipments on 2 of its higher running programs. These issues were resolved by quarter end and positions the segment for growth in revenue and profit beginning in Q4.

We expect headwinds in revenue from the commercial vehicle market as it cycles down to normal Class 8 production levels in 2020 from the above-average levels of the last 2 years. Our new program launches, existing backlog and growth in the energy markets are expected to offset the reduced demand for truck components. We provided our outlook for revenue in Q4 of $23 million to $25 million, with gross margin in the 15% to 17% range. We also provided our preliminary outlook for 2020 that shows a quarterly run rate for revenue continuing slightly above the Q4 level for a full range of $95 million -- full year range of $95 million to $105 million with margins stabilizing in the 15% to 17% range.

The opportunity to increase revenue and margins in the face of the Class 8 down cycle represents a first for Sypris, reflecting the impact of our recent diversification efforts and the cost reduction initiatives taking place throughout the business in recent periods. We believe that we are prepared for the projected downturn in the class 8 market and believe that we are well positioned to face this cycle and target a return to profitability in the year ahead.

This concludes our call today. And at this time, I'd like to turn it back over to Tracy to answer any questions you might have for us at this time. Thank you. Tracy, are you still available?

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Questions and Answers

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Operator [1]

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(Operator Instructions) We will now take our first question from Joel Cahill from The Jameson Companies.

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Joel Cahill, [2]

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So it hasn't been kind of a disappointing run for period here, kind of looking at -- just last quarter, we were looking at $95 million to $105 million of revenue for 2019. And now we're calling for 2020 to be that same level and calling as if it's an up year. It seems like we just keep getting pushed back. How do I look at this as an investor thinking not losing confidence in you guys and being able to forecast adequately and maintain whether it's supply chain or otherwise?

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Jeffrey T. Gill, Sypris Solutions, Inc. - Chairman, President & CEO [3]

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Well, that's a good question, Joel, and certainly a fair one. When we look forward, the opportunity to be in the $95 million to $105 million range for 2020, I think, is positive in the sense that the headwinds that are taking place in the commercial vehicle market now, which I think there's a consensus around about a 25% drop. This is the first time really in our history where we've been able to have an outlook that anticipates growing through the down cycle. And the other element that I think is important in the outlook is the fact that we anticipate expanding our margins as we go forward despite the down cycle in the Class 8 market.

When you look at our track record recently of being able to forecast accurately and to have confidence in our outlook, certainly, the track record hasn't been great, hasn't been what we wanted. We have repeatedly thought that we had control of the material side in our electronics business, and the ball just seems to shift. And in this last quarter, Tony went through the 2 events, which weren't just the availability of components, but one coating issue and the other customer approval issue, which were of a different nature than the issues we've had earlier in the year. So we clearly have to prove ourselves. We believe that the business is well positioned going forward. And it's our job to make sure that we bring the results in within our guidance.

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Joel Cahill, [4]

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I appreciate that candor. Does it start to get concerning on some of the SE side as far as like size and cloud to maintain that supply chain? Is really the smaller size an issue? You've got a lot of great specialty products and things, but is that where we're running into some of those headwinds?

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Jeffrey T. Gill, Sypris Solutions, Inc. - Chairman, President & CEO [5]

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No, I don't think so. Our customers have been very supportive and have used their size and weight to help us get components. And that's why, during our last call, we really felt we were out of the woods on the issue. And the issue of the coating and the issue of customer approval on a supplier change caught everyone by surprise. And as we look forward into 2020, as Tony indicated, we believe that the backlog that we now have on the electronics side, assuming that the material issues or versions of it don't rear their head again, we're looking at strong double-digit growth going into the coming year in that side of the business. And -- so as we get larger, I think it will be a benefit, clearly. But I also think the side benefit of growth will be that when we have small hiccups or something, we can make them more opaque, if you will, in terms of their impact than when we're a smaller business.

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Operator [6]

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(Operator Instructions) There appears to be no further questions in the queue. (Operator Instructions) It appears there are no further questions at this time. Mr. Gill, I'd like to turn the conference back to you for any additional or closing remarks.

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Jeffrey T. Gill, Sypris Solutions, Inc. - Chairman, President & CEO [7]

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Well, thank you, Tracy. Tony and I would like to thank you for joining us on the call this morning. We welcome your continued interest and, of course, your questions about our business. We want to thank you, and have a great day.

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Operator [8]

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This concludes today's call. Thank you for your participation, ladies and gentlemen. You may now disconnect.