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Edited Transcript of SYPR earnings conference call or presentation 15-May-18 1:00pm GMT

Thomson Reuters StreetEvents

Q1 2018 Sypris Solutions Inc Earnings Call

LOUISVILLE May 17, 2018 (Thomson StreetEvents) -- Edited Transcript of Sypris Solutions Inc earnings conference call or presentation Tuesday, May 15, 2018 at 1:00:00pm 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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* James Andrew Ricchiuti

Needham & Company, LLC, Research Division - Senior Analyst

* Joel Cahill

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Presentation

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Operator [1]

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Good day, everyone, and welcome to the Sypris Solutions First Quarter Earnings Call. Today's call is being recorded.

At this time for opening remarks, I'd 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, Laura, and good morning, everyone. Tony Allen and I would like to welcome you into this call. The purpose of which is to review the company's financial results for the first quarter 2018.

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 at 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 to 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 a walk through our financial guidance for 2018.

Now let's begin with the overview on Slide 4. We're pleased to report that revenue for the quarter came in at just under $20 million, which represented a 9.7% increase from the prior year period. Sypris Technologies led the way, with shipments during the quarter increasing almost 14% on a year-over-year basis, driven by new contract awards and positive market conditions.

Gross margin on a consolidated basis increased to 10.2%, up from a loss of 3% for the prior year period and up 320 basis points sequentially from the fourth quarter of last year. The improvement was once again driven by continued gains at Sypris Technologies, where gross margin increased to 14.5% during the quarter, up from a loss of 5% for the same period in 2017, and up from 11.3% for the fourth quarter of last year.

The continued expansion of gross margins at Sypris Technologies resulted in another profitable quarter for the business, with operating margins and income rising materially during the period on an adjusted basis.

Our improved cost profile and operating performance, when combined with an expanding top line and improved mix, is expected to result in further margin expansion during the year.

Shipments from Sypris Electronics continued to be impacted during the quarter by component shortages that are becoming increasingly pervasive throughout the industry. It appears to be a perfect storm. Electronic content is up significantly in a variety of products, including automobiles and consumer electronics.

Simultaneously, demand has increased across most market segments, including automotive, industrial, military, aerospace and telecom, a situation that historically has been rare.

Suppliers, in turn, have been reluctant to add capacity, and in some cases, have chosen to exit certain legacy commodity products completely. Overbuying has further exacerbated the problem, thereby resulting in escalating prices, longer lead times and component shortages.

At Sypris, we began to feel the impact during the latter part of 2017. We've been working since that time with our large customers to approve alternative suppliers, qualify substitute parts, secure long lead-time funding and otherwise use the substantial leverage of our customers to secure components.

The results have been impressive and reflect the tremendous effort of our supply chain team and the much appreciated support of our customers. We now expect shipments to return to historical levels for the second quarter, which will position the business for the further expansion of shipments during the second half of this year.

Having said this, our sense is that we will need to maintain an aggressive and closely coordinated approach with our customers to successfully resolve supply chain issues as they arise. We expect the market to remain extremely dynamic for the foreseeable future, until such time as demand and capacity are balanced.

Orders for Sypris Electronics continued to be robust during the first quarter, up 84% when compared to the prior year period, thereby continuing the positive trend established during 2017, which culminated with the 83% year-over-year increase in orders during the fourth quarter of last year.

Of particular note, orders from the Department of Defense and Deep Sea Communications customers have been trending very positively.

Turning to Slide 5. The outlook for each of our major markets remains encouraging. Demand for heavy trucks continues at record levels, and fleets are still attempting to add capacity as fast as possible in this market.

North American Class 8 orders for the past 12 months have now totaled 368,000 units. Orders for Class 8 trucks in April were up 50% on a year-over-year basis, while orders during the past 3 months were up 75% to 121,200 units. The positive outlook for the economy and freight demand, coupled with rising freight rates, appears to be underlying the increase in orders.

We expect the rate of comparable period growth to cool as we move forward through the year, with build slots for 2018 reaching capacity, thereby pushing the production of any additional orders into 2019.

The outlook for the automotive and light-truck markets remain solid, while the price of oil has risen approximately 40% over the past year. 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 4 years.

The conversion of power generation used in natural gas as well as the construction of pipelines and LNG terminals to support export activities is expected to reinforce the future demand of the company's products.

Department of Defense spending is also on the rise, with the recent approval of the National Defense Authorization Act for fiscal year 2018, providing nearly $700 billion in funding for the Department of Defense. Within this budget, spending has been increased for missile defense, weapons programs and the Joint Strike Fighter, which should bode well for our business.

Even more importantly, the bill should provide for the continuity in funding of major multiyear programs that have been disrupted in the past by continuing resolutions and other short-term budgetary issues. The combination of these positive market conditions, when combined with the recent contract awards and our lower-cost profile, provides us with a solid base for optimism when looking forward.

Turning to Slide 6. We expect both Sypris Technologies and Sypris Electronics to be solidly profitable for 2018, reflecting the benefits of top line growth, improved mix and growing operational efficiencies.

Revenue for 2018 is forecast to increase 13%, at the midpoint of our guidance on a year-over-year basis, while our gross margin is expected to increase to 16%, at the midpoint for 2018, up from 4% for 2017. The effective reduction of our cost profile by $26 million since 2016 has certainly played an important role in this transformation. As we look to the future, however, the acceleration of top line growth will be the key factor that carries us forward.

Much work certainly remains. We must make certain that we have the materials we need in order to meet customer commitments. But by working in close partnership with our customers, we will have a much better chance of navigating these issues successfully.

In summary, the combination of revenue growth, improved mix and the significant reduction in our expense profile is expected to open up a new, very positive chapter in our journey here at Sypris, with a return to profitability for 2018.

Turning now to Slide 7. Tony Allen will lead you to 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. Good morning, everyone. I'd like to discuss with you some of the highlights of our first quarter financial results.

Please advance to Slide 8. Q1 consolidated revenue was $19.9 million, an increase of 9.7% from the first quarter of last year. We're pleased with the year-over-year increase in revenue, particularly given the headwinds faced by our electronics segment on component availability.

The revenue split between Sypris Technologies and Sypris Electronics was $14.5 million and $5.4 million, respectively. On a segment basis, this represents an increase over the prior year period of 13.7% for Sypris Technologies, while Sypris Electronics remain flat.

The demand drivers for Sypris Technologies are primarily strong market conditions for our customers serving the commercial vehicle, automotive and energy markets. The volumes in Q1 were comparable with those in Q4 of '17, although with a slightly different mix in revenue. We see further upside in these markets as we enter the second quarter.

As Jeff discussed earlier, the supply chain team for Sypris Electronics is working closely with our customer base to resolve the challenges of component availability in the market that are impacting our programs, and we are beginning to see signs of improvement as we aggressively pursue solutions.

By partnering with our customers, the momentum is starting to shift in our favor. However, component shortages are an industry-wide problem, so we must remain persistent and keep everyone in our organization focused on problem solving and paying attention to details every day.

We expect to see an improved flow of components for the second quarter, which will enable us to drive revenue back to the levels we reported in the last 3 quarters of '17.

Consolidated gross margin improved significantly in Q1 to 10.2% compared to negative 3% in Q1 of '17. A little over a year ago, we announced our plans for transferring production from Broadway and the actions to reduce our costs by an estimated $26 million in 2018 compared to 2016. These actions were completed over the course of 2017, and the benefits are now being reflected in a more material way in our cost of sales following the closure of the Broadway Plant in December.

The technology segment reported gross margin of 14.5% for Q1 compared to negative 5% in '17. This also represents a sequential improvement of 320 basis points from Q4 '17.

The reduced fixed cost structure achieved by closing the Broadway Plant and the lower variable cost for this segment primarily attributable to lower employment costs are 2 of the key drivers for the margin improvement. Another factor is that we had year-over-year growth in our energy-related product sales, which further expanded margins.

The first quarter included costs incurred on a major maintenance project for a manufacturing asset in our Toluca plant that will benefit future periods but also affected our margin percentage for the quarter. We are continuing to implement operational improvements following the transfer of production and expect these actions will contribute to increased margin performance beginning in Q2.

Our gross margin for Sypris Electronics was dampened during the quarter by the lower revenue base. The results were similar to the first quarter of '17, in which we were slightly positive in gross margin with an equivalent level of revenue.

Our labor productivity was down in the quarter as we managed through various component shortages on certain programs. And although we were able to reduce variable spend in certain areas, an increase in revenue will ultimately lead us back to our targeted margins in this segment.

The good news is that the backlog is in place to support a return to our recent revenue run rate for the balance of the year. And as we resolve our component issues, we expect to achieve our top line and margin targets.

At the adjusted operating income line, we reported a $1.1 million loss, which represented an improvement of 71.9% compared to Q1 of '17. We are continuing along the path of our return to profitability, but the revenue impact on our electronics segment prevented us from getting there in Q1.

As expected, Sypris Technologies reported its second consecutive quarter of profitable results. Given all of the changes within this segment over the past 3 years, this is a remarkable achievement and one that we expect to build on in future periods.

Please advance to Slide 9. I'm going to begin the outlook discussion by breaking down our 2018 targets into the first and second half of the year. After which, we will drill further into the first half.

Our outlook for 2018 is consistent with the view we discussed on our Q4 earnings call. We expect revenue for the year to be in the range of $90 million to $96 million. At the midpoint of the range, this represents an increase of 13% over 2017. We expect to see revenue grow sequentially from the first half to the second half of the year, increasing from $43 million to $45 million in the first half to $47 million to $51 million in the second half.

We are maintaining our margin target at 15% to 17% for the year. And similar to the revenue profile, we expect our second half performance will exceed the first half.

SG&A is expected to follow within 13% to 14.5% of revenue for the year, with the percentages between the 2 halves tracking the revenue change. The net result is top line growth for the first time in 4 years and, most importantly, a return to profitability.

Please advance to Slide 10. With Q1 in the books, we're going to deviate from past practices with regard to our outlook discussion on this call and drill further into the segment level for the second quarter. We believe this is necessary to highlight the shifts taking place in the business as we move beyond Q1 on our path to profitability.

Going from left to right. The first column includes our Q1 actual results followed by our outlook for Q2 to arrive at the first half outlook we discussed on the previous slide. I'll start the discussion at the segment level and build up to the consolidated results.

First, Sypris Technologies. We were pleased with the first quarter performance, both at the top line and the gross margin. On a sequential basis, our revenue was flat with Q4 of '17, but we drove an expansion in gross margin from 11.3% to 14.5%. The margin improvement in Q1 and our outlook for Q2 reflects the cost structure now in place following the closure of the Broadway Plant in December.

Our team has done a remarkable job over the past year to successfully launch all transferred programs at our Toluca plant to get us to this point, and we have confidence that we can further improve margins as the workforce continues up the learning curve.

As I mentioned earlier, we performed a major maintenance procedure on an asset in our forging area during the first quarter. This impacted our margin performance in 2 ways. First, we recognized the expense directly related to the maintenance procedure; and second, our labor productivity reflected the downtime while the work was completed.

With this event behind us, we are positioned to increase our margin through lower variable spend in the second quarter.

We are also bringing up a new machining line that was transferred from our Broadway facility to provide additional capacity for revenue growth and to add flexibility to how we schedule our lines. We are projecting top line growth of just under 14% based on the midpoint of our revenue range for Q2. This growth is primarily based on programs currently in-house, so our main challenge is to execute on our existing book of business as opposed to needing a high percentage of book in turn to achieve our target.

The conversation on this additional revenue is expected to enhance our margins as we are able to absorb the volume without increasing our fixed cost structure, allowing the incremental margin to flow directly to the bottom line. As a result, we expect margins to grow from 14.5% in Q1 to 18% to 21% in the second quarter.

Now to Sypris Electronics. As Jeff discussed earlier, component shortages began to impact our business late in '17. This put pressure on our Q1 shipments as our supply chain team, with the support of our customers and vendors, work to alleviate constraints and identify solutions that will enable us to increase the flow of product going forward.

We've accomplished a great deal in this area, but more work remains ahead of us as the market dynamics aren't expected to change substantially in the near term. However, the collective efforts of our team provide us with confidence that we will begin to see enough improvements during the second quarter to return to a normalized run rate.

Our supply chain team will have to continue to manage this area aggressively and leverage the support we are getting from our customer base to maintain or improve our position in this competitive market.

In addition to improvements in component availability, our Q2 outlook includes the ramp-up on shipments on the development phase of a defense program. We expect our performance on this development contract will lead to follow-on awards as we complete the initial phase.

We are also increasing shipments during the second quarter on 2 other defense programs that in the past 2 years, it required lower shipments in Q1 compared to the balance of the year.

We expect the combined impact of program growth and improved component availability will allow us to generate a sequential increase in revenue for the second quarter of just under 40%.

As our revenue increases, you will note that we expect a significant improvement on our gross margin performance. Program mix plays a role in this, but the key factor in returning to a double-digit gross margin is going to be volume.

At quarterly run rate of $7 million or more, we expect to be profitable at the operating income line, and the leverage we can get from increasing our revenue provides upside to our margin performance in the second half of the year. We have the backlog in place to support our outlook for both the second quarter and the second half of the year. We will continue to team with our customers to ensure we are able to procure components at levels to support our customers' requirement during this unstable period of component supply.

At the consolidated level, this brings us to an outlook for Q2 of $23 million to $25 million of revenue, with gross margin in the range of 16% to 18%, driven by the increase in volume in both segments and the absence of major maintenance expenses incurred in Q1.

Please advance to Slide 11. This is a chart we've used on recent calls, showing gross margin performance for periods back to 2014 when our annual revenue was over $350 million with approximately 70% generated from sales to the heavy truck market.

In 2014, we had gross margin of just under 11% with a cost structure and footprint that were significantly greater than today's levels. As we managed through 3 years of change, we experienced a significant drop in margin performance as we realigned our cost profile to meet our new top line, but we started to see an upward trend on our performance beginning in the first and second halves of '17. We expect to continue this trend in the current year with sequential improvement in both the first and second half periods.

Reaching 10.2%, gross margin in Q1 of this year takes us another step in this direction, but we must continue to meet our top line goal and drive the operational improvements throughout our business to meet these targets.

As we look beyond 2018, we expect to leverage our cost profile with new business awards and follow-on business opportunities to create further margin expansion opportunities.

Please advance to Slide 12, and I will offer a few takeaways. Our first quarter revenue increased 9.7% from Q1 of '17. Gross margin improved to 10.2% in the first quarter compared to negative 3% in the prior year, an improvement of over 1,300 basis points.

SG&A declined 7.7% from Q1 of '17 and represented 15.8% of revenue for the quarter. The improvement in gross margin at Sypris Technologies to 14.5% for Q2 resulted in a positive operating income in this segment for the second consecutive quarter.

We are confirming our outlook for revenue at $90 million to $96 million for the year and gross margin of 15% to 17%. We provided additional detail for our Q2 outlook, which shows revenue coming in at $23 million to $25 million and gross margin of 16% to 18%.

The revenue outlook is supported by our current backlog and the strong market conditions for our heavy truck, energy and aerospace and defense programs. We expect to be cash flow positive for the year, and we have the opportunity to generate upside to our forecast from the sale of excess assets. And finally, we expect to return to profitability for 2018.

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

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Questions and Answers

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Operator [1]

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(Operator Instructions) We'll turn first to Jim Ricchiuti with Needham & Company.

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James Andrew Ricchiuti, Needham & Company, LLC, Research Division - Senior Analyst [2]

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I was just wondering, on the component shortages, Jeff or Tony, are we talking about just capacitors, resistors? What type of components are we talking about?

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

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Primarily, Jim, and it's the capacitors and resistors, and particularly the legacy commodities where apparently a number of Japanese manufacturers have just decided to quit making them. And so one of the issues that's affected us has been the fact that a lot of times, our source of supply and the components are specked in by our customers and a lot of times can be sole sourced. So we've been working to get that changed so that we can find alternative suppliers and/or alternative components to use in the manufacturing process.

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James Andrew Ricchiuti, Needham & Company, LLC, Research Division - Senior Analyst [4]

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Got it. So Jeff, in other words, you now have the ability to go to some alternative sources, and that's why you think this is -- this issue is largely going to be behind you over the next couple of quarters?

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

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You're making me hopeful, Jim. But I think this is the way we've characterized it is that we've been working closely with our customers. And a number of them, as you can imagine, have a lot more impact on getting allocation than we do. And so we've been working to classify or qualify new suppliers when looking at alternative components. We've been using their leverage to get more allocation. And so as we look at the near term, we feel we've got the material in house to ramp back up and -- but the outlook for the industry, to put it directionally, I think that some of the sources, you see demand rising 12% to 15% per year, and they're starting to add capacity in, now at a rate of anywhere from 10% to 25% per year, but there is a lag in this. And so depending upon who you're talking to, they see the situation is standing up 12 months to 18 months. And so in answer to your question, we want to -- we believe we have the material in house to handle our current performance, and we just want to stay on this thing very closely with our customers to make sure that we don't have a situation arise somewhere during the balance of the year.

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James Andrew Ricchiuti, Needham & Company, LLC, Research Division - Senior Analyst [6]

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Okay. Now that makes sense. That's a big increase in orders that you highlighted in Sypris Electronics, up 84%, is that concentrated? You highlighted a few contracts, but is this concentrated with just a handful of contracts? Or is it more broadly based?

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

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We're up generally, but there have been a couple of customers in particular where we've had some nice awards recently. And so that's contributing to it. The activity that we're seeing generally is up fairly materially over a year ago. A lot more porting activity, a lot more stuff being placed. As you probably know, Northrop Grumman and others are expanding their footprint. And depending upon who you believe, there are sources that say that we could be looking at an 8-year or 10-year run as the DoD side of things starts to reconfigure around new technology and things of that nature.

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James Andrew Ricchiuti, Needham & Company, LLC, Research Division - Senior Analyst [8]

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Sure. You're building, I assume, just based on what you're saying, you're building backlog now into next year. Is there any way to characterize the extent at which your backlog has been expanding, both -- actually in both businesses. It sounds like you're building backlog also in Sypris -- on both sides of the business.

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Jeffrey T. Gill, Sypris Solutions, Inc. - Chairman, President & CEO [9]

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Well, the order rates have certainly been good. And so I'll just say that we're looking for a good year in terms of top line performance this year, and we see that continuing into 2019. And so it's really going to be a matter of execution, material availability, those types of things, just to keep from stomping our toe.

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James Andrew Ricchiuti, Needham & Company, LLC, Research Division - Senior Analyst [10]

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And Tony, just a question for you on the unusual equipment expense that you incurred in Toluca. Is there any way to size the impact on that in gross margins?

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Anthony C. Allen, Sypris Solutions, Inc. - VP & CFO [11]

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I would say, in the technology segment, as we look at it at debt level, Jim, it's probably worth 1.5, 2 points of margin.

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Operator [12]

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(Operator Instructions) Next, we'll move to Joel Cahill with the Jameson Companies.

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Joel Cahill, [13]

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So I just wanted just a couple of quick questions off of Jim's questions regarding the supply chain issues. Are there competitive risks that start to come in to play in the event that we're not able to get -- to source these components? I mean, loss of the contract, really?

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Jeffrey T. Gill, Sypris Solutions, Inc. - Chairman, President & CEO [14]

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Joel, no, I don't think so because this is an industry situation rather than a company-specific situation. And so again, since many of our components are specified as sole sourced by company, other than getting our customers to help us qualify another supplier, we're really without choice in certain circumstances.

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Joel Cahill, [15]

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Okay, sure. And then this likely means costs are going to be increased. Anything you can suggest for some of that? Did that come out of margins? Or are there adjustments that you're able to push through on contracts?

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Jeffrey T. Gill, Sypris Solutions, Inc. - Chairman, President & CEO [16]

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No. So far, our customers have been good to work with, and we haven't seen inflation coming through our cost of goods sold. And we've worked to prevent that because we are on a fixed price basis. And so -- but I think our customers get that. At least, so far, they do.

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Joel Cahill, [17]

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Good. So Tony, you mentioned some asset sales as a potential boost for cash flow into the end of the year. It looks like there was a $0.5 million taken for prepping the Broadway facility. I know last time we talked, you had said it's good building, but not necessarily going to generate a lot. Have you been able to put together some ideas on amounts that you can generate from asset sales?

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Anthony C. Allen, Sypris Solutions, Inc. - VP & CFO [18]

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We have some internal targets that we're working towards, Joel. The first item on the agenda is going to incur in, actually, in June. And we talked about the auction in our last call. So that would be for, what I would say, is the majority of the -- some of the smaller assets, manufacturing assets that we have in the Broadway facility. That will be part of that auction. That'll be completed in June. And so we'll have the results of that in our Q2 call. In terms of building itself, no, we haven't. We are taking actions today to start to look at alternatives as to how we prepare this property for sale, but we haven't set any targets in terms of our expected proceeds on that yet.

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Joel Cahill, [19]

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Okay, got it. So now just looking at the 2 businesses side-by-side, the FC is obviously generating some of the healthy margins off of much higher revenue. And I see, it's certainly being buffeted by some of these Department -- the DoD spending? One, I was going to ask, you mentioned the $700 billion for fiscal year 2018. How does that compare to previous? And then the next question is, what do we see for FC? Because low-single digits margins are somewhat tricky to justify for the business, it still seems.

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Anthony C. Allen, Sypris Solutions, Inc. - VP & CFO [20]

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On the margin question, what we -- as we return, Joel, to -- again, we referenced the run rate that we had in the last few quarters of '17. And as we get back to those levels, we expect to be in the double figures beginning in Q2. We're talking about 10% to 12%. And in the second half of the year, we believe we have some upside in our revenue run rates that will get us back into the mid to upper teens for that business. So we don't see it as a single-digit margin business. We see it as a firm double-digit number. But the volume is certainly important to us as we move through the year, and it certainly drives a lot of margin. You might recall at the beginning of '17 that we took significant piece of the fixed cost structure out when we relocated to a new facility. So our leverage on revenue today is pretty significant. So as we move into Q2, in the second half, we see those numbers getting back up in the double figures.

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Joel Cahill, [21]

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Okay, excellent. And then just from a macro environment.

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Jeffrey T. Gill, Sypris Solutions, Inc. - Chairman, President & CEO [22]

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Yes. The -- we don't have the figures here with us. But directionally, my memory is that the increase in spending year-over-year is somewhere in the $90 billion range, so that will make it 12%, 15%, [potentially].

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Operator [23]

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(Operator Instructions) And gentlemen, it appears there are no further questions. I'll turn the conference back to you.

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Jeffrey T. Gill, Sypris Solutions, Inc. - Chairman, President & CEO [24]

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Okay. Thank you, Laura. And Tony and I would like to thank you, guys, for joining us on the call this morning. We welcome your continued interest and, of course, your questions about our business. So thank you, and have a great day.

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Operator [25]

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With that, we'll conclude today's conference. Thank you, everyone, for your participation.

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Anthony C. Allen, Sypris Solutions, Inc. - VP & CFO [26]

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Thank you, Laura.