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Edited Transcript of TWIN earnings conference call or presentation 6-May-19 3:00pm GMT

Q3 2019 Twin Disc Inc Earnings Call

RACINE May 10, 2019 (Thomson StreetEvents) -- Edited Transcript of Twin Disc Inc earnings conference call or presentation Monday, May 6, 2019 at 3:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Jeffrey S. Knutson

Twin Disc, Incorporated - VP of Finance, CFO, Treasurer & Secretary

* John H. Batten

Twin Disc, Incorporated - President, CEO & Director

* Stanley Berger

SM Berger & Company, Inc. - President

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Conference Call Participants

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* Noah Duke Kaye

Oppenheimer & Co. Inc., Research Division - Executive Director and Senior Analyst

* Timothy Ronald Wojs

Robert W. Baird & Co. Incorporated, Research Division - Senior Research Analyst

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Presentation

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Operator [1]

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Good day, and welcome to the Twin Disc, Inc. Fiscal Third Quarter 2019 Earnings Conference Call and Webcast. Today's conference is being recorded. At this time, I would like to turn the conference over to Mr. Stan Berger of SM Berger. Please go ahead, sir.

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Stanley Berger, SM Berger & Company, Inc. - President [2]

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Thank you, Sandy. On behalf of the management of Twin Disc, we're extremely pleased that you have taken the time to participate in our call, and thank you for joining us to discuss the company's fiscal 2019 third quarter and 9-month financial results and business outlook.

Before I introduce management, I would like to remind everyone that certain statements made during this conference call, especially those that state management's intentions, hopes, beliefs, expectations or predictions for the future, are forward-looking statements. It is important to remember that the company's actual results could differ materially from those projected in such forward-looking statements. Additional information concerning factors that could cause actual results to differ materially from those in the forward-looking statements are contained in the company's annual report on Form 10-K, copies of which may be obtained by contacting either the company or the SEC.

By now, you should have received a copy of the news release, which was issued this morning before the market opened. If you have not received a copy, please call Annette Mianecki at (262) 638-4000, and she will send the copy to you.

Hosting the call today are John Batten, Twin Disc’s President and Chief Executive Officer; and Jeff Knutson, the company's Vice President, Chief Financial Officer, Treasurer and Secretary.

At this time, I will turn the call over to John Batten. John?

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John H. Batten, Twin Disc, Incorporated - President, CEO & Director [3]

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Thank you, Stan, and good morning, everyone. Welcome to our fiscal 2019 third quarter conference call. As usual, we will begin with a short summary statement and then Jeff and I will be happy to take your questions.

Before Jeff goes over the quarterly results in detail, I will touch on some of the operational highlights from the quarter. In many ways, the fiscal third quarter was frustrating, and that represented the amount of work and effort that was put into it. Sales for the quarter easily could have been $6 million to $8 million higher than what we achieved. Some of this was due to order pushouts, particularly in oil and gas; continued supply issues in critical components like outsourced gears, castings, forgings and heat treat furnaces, all caused certain delays during the quarter. Additionally, we had internal inefficiencies with new employees in training and much higher turnover than we have historically experienced, all which led to increased internal capacity issues within the quarter. Things have started to improve, but more of our oil and gas has been pushed into fiscal '20 Q1. On a positive sign, our marine backlog is growing globally and we're starting to see signs of life and inquiries in the offshore space.

Our demand remains at historic highs and we enter into our fourth quarter in fiscal '20 with an extremely strong backlog in this market. The Veth backlog is growing in North America, and we couldn't be happier with the progress that we're making there. And we'll know more after the offshore conference in Houston this week, but our oil and gas projects as far as applications for new rigs are also growing. We also added over $2 million in CapEx during the quarter. These will come online in the fiscal fourth quarter and into next year, but they should help add capacity, particularly in our gear manufacturing space.

Our Lufkin facility got under construction in the quarter and we're currently moving this week our aftermarket business to its new facility. Both of these will allow for more assembly space and more machining space in our Racine operation. Lufkin will also tap into a completely new labor market for us, which will be critical for our next up-cycle.

Finally, we couldn't be happier with the Veth acquisition so far. We've seen great results both in Europe in their business in general, but particularly in North America, and we've brought a salesman over from The Netherlands to oversee this market development. Additionally, the added engineering capacity and capability is dramatically speeding up our marine hybrid activities, both with the Veth product line of thrusters, but also our conventional marine transmission. We also announced recently last week the hiring of Jim Feiertag as our new President and Chief Operating Officer. For the last 5 years, Jim has been the CEO of Bemis Manufacturing and some of you will remember that he was our Chief -- that he was our Executive Vice President of Operations up until 2014. We've also announced the retirement of Mac Moore who was our Chief Operating Officer, and Jim will be able to hit the ground running, knows our facilities, knows our people well and knows our markets. So we couldn't be happier with the transition from Mac to Jim.

With that, I'll turn it over to Jeff for some comments on the financials.

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Jeffrey S. Knutson, Twin Disc, Incorporated - VP of Finance, CFO, Treasurer & Secretary [4]

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Thanks, John. Good morning, everyone. I'll briefly run through the third quarter numbers. Sales of $77.4 million for the quarter were up $12.1 million or 19% from the prior year third quarter. The quarter results include the impact of the acquisition of Veth Propulsion, which closed on July 2. Excluding the impact of that, sales were actually down 5% compared to the prior third quarter. The primary driver for the decline in revenue in the quarter is reduction in North American aftermarket demand, primarily related to oil and gas product following an historically high level of aftermarket demand in fiscal '18. The quarter was also impacted, as John referenced, by continued supply chain challenges, resulting in some delayed shipments and excess inventory in the quarter. We continue to see strength and positive momentum in nearly all of our markets, including the global industrial, commercial marine and petrol craft markets.

Through the first 3 quarters, sales are now up $63.3 million or 38%. Adjusting for the Veth acquisition, the organic increase is over 12%. While much of this growth was driven by oil and gas demand, industrial product sales have increased nearly 16% compared to the prior year first 9 months and marine transmission sales increased nearly 3%. Our gross margin performance for the quarter was hampered by an unfavorable product mix with lower aftermarket demand being the primary driver. The third quarter margin percent was 29.9%, a decline of 200 basis points from the prior year third quarter. This result includes the impact of the Veth acquisition and related purchase accounting amortization. Excluding the Veth noncash purchase accounting amortization, gross profit was approximately 31.2% for the third quarter.

Spending on marketing, engineering and administrative cost for the fiscal 2019 third quarter increased $2.8 million or roughly 19% compared to the prior year. This entire increase can be attributed to the addition of Veth and the related amortization of acquired intangibles. We also had some increased spending on professional fees, salaries, stock comp, travel and marketing compared to the prior year. These increases were essentially offset by a reduced global bonus expense and a foreign exchange impact. As a percent of revenue for the fiscal 2019 third quarter, ME&A expenses were essentially in line with the prior year third quarter at 22.4% compared to 22.3% for the prior year.

Through the first 9 months, ME&A expenses fell to 24% of revenue compared to 25.8% in the first 9 months of fiscal '18.

Included in the third quarter results are 2 other operating items totaling $1.4 million. These relate to a $900,000 gain on the sale of the Mill Log business and related assets and $500,000 adjustment to an accrual associated with the Veth Propulsion acquisition.

With the improved volume impact, reduced restructuring spending and the other operating income items just noted, our operating results improved by $1.2 million from $5.8 million operating profit in the prior year third quarter to $7 million operating profit this year.

Through the first 9 months, operating improved -- profit has improved by $11 million to $18.5 million in fiscal '19 compared to $7.5 million in the prior year.

The effective tax rate for the third fiscal quarter was 23.9%, reflecting the continued impact of the new tax legislation, compared to the prior year rate of 20.7%. The change from the prior year rate is reflective of the jurisdictional mix of earnings with no significant or material discrete items recorded in the quarter of either year.

Net profit for the quarter of $4.6 million or $0.34 per diluted share reflects a slight increase from the prior year fiscal third quarter net profit of $4.3 million or $0.37 per share.

Through the first 9 months, the bottom line has improved by $7.9 million to a profit of $11.5 million or $0.90 per share compared to a profit of $3.6 million in the prior year.

Positive EBITDA of $10 million for the quarter reflects $2.8 million improvement over the fiscal '18 third quarter. On a trailing 12-month basis, we are now at $37 million of EBITDA, which includes restructuring charges of $1.6 million.

Balance sheet remains healthy as we closed out the third quarter of '19 with the impact of the $61 million Veth acquisition and subsequent $32 million follow-on offering remaining the headlines for the year so far. We finished the third quarter with $33.5 million of debt, debt-to-total capital of 20.9% and a debt-to-EBITDA ratio of 1.3x.

The slight decrease in inventory during the third quarter didn't meet expectation, but we feel like we have a positive momentum and processes in place to drive a meaningful improvement in the fourth quarter. Backlog finished the quarter at $114 million, which is down $24 million from the Q2 level. We did experience some additional order cancellations in Q3 as we proactively validated backlog levels to ensure we weren't bringing in unnecessary inventory.

While incoming order levels softened in Q3, market activity and inquiry levels remained strong, and we're encouraged by positive trends in our end markets.

Operating cash flow is negative $8.4 million and free cash flow is negative $10.6 million in the third fiscal quarter, impacted by a ramp-up in capital spending, limited improvement in inventory levels and temporary payment delays from a few key customers. Significant payments have been received in early Q4 and inventory reduction efforts remain a high priority. We look for improved cash flow results as we finish fiscal '19 and move into fiscal '20.

And now I'll turn it back to John for some final comments.

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John H. Batten, Twin Disc, Incorporated - President, CEO & Director [5]

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Thanks, Jeff. And now I'll spend a quick moment or 2 on the outlook. Looking at Q4 and beyond, we feel that we have the backlog and demand to achieve quarters like our third fiscal quarter. Oil and gas for both new units and aftermarket continues to be a bit unpredictable as far as quarterly timing for improving trends, but we do not think we're seeing anything like 2015. And as Jeff mentioned, our other markets remain stable, and we enter the fourth quarter and going into fiscal '20 with a very good backlog in all of our other markets.

Our main operational focus remains improving our internal capacity, primarily here in Racine, and getting our Lufkin facility operational by January 2020. New product development continues to be a priority as we look beyond marine, hybrid and the electrification of our other product end markets and as we develop and take what we've learned with Veth in our marine markets and apply it to our other product end markets.

That does conclude our prepared remarks. And now Jeff and I will be happy to take your questions. Sandy, could you please open the line for questions.

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Questions and Answers

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Operator [1]

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(Operator Instructions) We'll take our first question now. It is from Noah Kaye at Oppenheimer.

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Noah Duke Kaye, Oppenheimer & Co. Inc., Research Division - Executive Director and Senior Analyst [2]

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John, you called out a couple of different factors as drags on the operating efficiency in the quarter. You mentioned supply chain, labor, just the space constraints. How we kind of parse out which of those are relatively bigger factors? And then how -- can you talk about the actions you're taking to kind of ease each of the bottlenecks?

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John H. Batten, Twin Disc, Incorporated - President, CEO & Director [3]

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Sure. I would -- know to be fair, I would put them roughly at 50-50, and it's -- what we're seeing, we went from a few years of 0 oil and gas and then had to ramp up very quickly. So we're taking capacity away from our suppliers. And then when the other markets ramped up, we're trying to get all of this hyper demand through people who are supplying us gears, castings, forgings, and they have labor issues. So as the bubble in oil and gas slowed a little bit, it's getting better to get stuff for our marine transmissions and aftermarket those supply through them. What was new in the quarter, I would say, is one of our primary heat treat suppliers for gears had some furnace issues continually through the quarter. So that was the new whack-a-mole issue that came up in the quarter that hindered us. So it should be roughly half to that, but half also to just trying to hire and find -- we've had continued retirements throughout the fiscal year, and we're bringing in new younger employees and people are moving up and stepping up, but they have long ways to go to get to the capability that there are guys that we're retiring ahead. But we've also seen, I would say, a much higher turnover rate than what we're used to seeing. So we're having to hire more and having to train more. And the key part there, Noah, is not that they can't. Training them on, just for instance, one machine tool or another or assembling marine transmissions versus oil and gas, it's just that the guys that are retiring that were here 35, 40, 45 years, they could assemble all of the transmissions or work multiple machines. So it's been a challenge this year with the surging oil and gas demand. The other market is improving to get the headcount up, but get the headcount that is well trained as the headcount that was leaving. Does that answer your question?

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Noah Duke Kaye, Oppenheimer & Co. Inc., Research Division - Executive Director and Senior Analyst [4]

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Yes. It does. And then just kind of a follow-on to that. You commented that you expect the June Q to have kind of comparable results, financial results to the March Q. Would that include on the gross margin line as well?

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John H. Batten, Twin Disc, Incorporated - President, CEO & Director [5]

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Yes. We think -- I mean, the gross margin, I'd say the -- for what's been happening as far as supply issues, I'd say the gross margin for the next couple of quarters that's a fair estimation going forward for the next 2. Although that once we get to fiscal '20, the purchase accounting drops off. So we lose that anchor. But I would say right now, like what we have in available backlog, the shift looks fairly constant for the next 6 months.

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Noah Duke Kaye, Oppenheimer & Co. Inc., Research Division - Executive Director and Senior Analyst [6]

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Okay. Very helpful. And turning to the backlog. Just wanted to understand, last quarter, you were pretty explicit that a lot of what happened with the backlog was you guys really shaking out and making sure you didn't have any kind of duplicative or soft orders in there. How much of kind of the step down this quarter was the same versus kind of any actual softness in the market?

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John H. Batten, Twin Disc, Incorporated - President, CEO & Director [7]

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I would say -- I would -- yes. Noah, this time, I think this was just -- this was oil and gas shipping and not being replaced. So we're waiting -- we have some new orders for oil and gas, but we shipped more than we took in orders.

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Jeffrey S. Knutson, Twin Disc, Incorporated - VP of Finance, CFO, Treasurer & Secretary [8]

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I think the cancellations were around in the $6 million range, if I remember right, Noah.

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Noah Duke Kaye, Oppenheimer & Co. Inc., Research Division - Executive Director and Senior Analyst [9]

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Okay. All right. Perfect. And maybe if I could just squeeze one more in here. You commented on the strength and the continuing strong interest on the marine propulsion side sort of specific to Veth. Can you give us a sense of what kind of development synergies you're actually seeing here on the hybrid products? You mentioned like a benefit not just for the thrusters, but for the transmissions. Can you elaborate on that a little bit, please?

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John H. Batten, Twin Disc, Incorporated - President, CEO & Director [10]

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Yes. So Veth, the engineers in Rotterdam have a lot more experience in dual inputs into the gearbox for the propulsion system, so electric motor and diesel direct, so which is where we're going with our marine transmissions. We are developing master clutches for our standard marine transmissions to have that dual input. So the engineers there have been doing this for a few years on the software, but they also have the hardware developed, so the screens and the controls handles that let it all happen from the helm. So it has jump-started our hybrid activity for our standard marine transmission. So we've seen -- we're so much farther ahead just after a year of integration of where we were before the acquisition. Our engineers in Racine have designed the master clutch module to go on our marine transmission, and we're able to utilize the expert team from Veth on the control system. So could not be happier about where we are there. And it's just taking the same philosophy of controlling the gearbox, whether it controls the propeller, steers the thruster or controls the output of a vehicle transmission like ARFF or oil and gas. We are well on the way to understanding the software of how to do it, but also the hardware to make it happen.

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Operator [11]

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(Operator Instructions) We'll take our next question from Tim Wojs of Baird.

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Timothy Ronald Wojs, Robert W. Baird & Co. Incorporated, Research Division - Senior Research Analyst [12]

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So I guess, maybe I'll start on free cash flow. Just how much of the working capital drag that you saw in the third quarter maybe reverses in the fourth quarter? And is it enough to get free cash flow to slight positive for the year or do you think that's going to be a little bit of a stretch?

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Jeffrey S. Knutson, Twin Disc, Incorporated - VP of Finance, CFO, Treasurer & Secretary [13]

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I think positive for the year at this point of the stretch, to be honest. I think we have a good chance of having very positive cash flow in the quarter, but I don't think we reversed the 3 quarters that we've had so far. I think we will continue to have -- there's a good chunk of CapEx spending that will be flowing through -- at least we anticipate flowing through in Q4 as well.

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Timothy Ronald Wojs, Robert W. Baird & Co. Incorporated, Research Division - Senior Research Analyst [14]

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Okay. And as we look at kind of 2020, you should see some further progress on the inventory drawdown and then I would imagine that CapEx would step down into 2020 from '19 levels?

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Jeffrey S. Knutson, Twin Disc, Incorporated - VP of Finance, CFO, Treasurer & Secretary [15]

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I think we still have a fair amount of investment that we'll be doing with the new Lufkin facility. So I think it might come down some, but I think it will still be at historically at a slightly higher than average level.

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John H. Batten, Twin Disc, Incorporated - President, CEO & Director [16]

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Just given Veth too.

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Jeffrey S. Knutson, Twin Disc, Incorporated - VP of Finance, CFO, Treasurer & Secretary [17]

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And Veth, right, that's adding to that mix. I think working capital-wise, we have a good opportunity, again through the fourth quarter and also in fiscal 2020.

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Timothy Ronald Wojs, Robert W. Baird & Co. Incorporated, Research Division - Senior Research Analyst [18]

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Okay. And then on the marine business, John, I mean, you sound a little more positive there and I know probably over the 6 years, maybe that business has kind of bumped along the bottom a little bit. I mean, are you seeing kind of a notable improvement in kind of the discussions you're having with your marine customers now? I mean you mentioned offshore, which I don’t think you've mentioned offshore in a couple of years.

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John H. Batten, Twin Disc, Incorporated - President, CEO & Director [19]

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No, we're just starting to see some, and I'm very interested to see what happens. OTC, they arrived today. So I'm interested to see what comes out of it, but I've seen a little bit more signs of life in discussion of projects. And it helps, because Veth -- I mean, Veth doesn't have any market share there. So this is a growth opportunity on a certain size class for Veth, but continued activity here in Racine. No just -- again, it's being driven by the North American market, honestly Gulf Coast up through the inland river. But we've also seen some new orders from Asia, which has been a long time coming. So that's kind of what's changed a little bit even since the last quarter. So slightly stronger orders and improving trends from Asia.

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Timothy Ronald Wojs, Robert W. Baird & Co. Incorporated, Research Division - Senior Research Analyst [20]

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Okay. And then on oil and gas, how did orders kind of progress through the quarter, because I know it had some kind of bottlenecks in the Permian? Has that kind of extended into the summer? Or how do you -- how are your customers kind of talking about what's going out down there?

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John H. Batten, Twin Disc, Incorporated - President, CEO & Director [21]

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Trying to remember, I mean, we didn't get a lot of cancellations early in the third quarter at all. I would say it was more in that late February, March time frame with some pushouts into late this fourth quarter, but they're going international. So they will fall into next year. But everyone that I talk to, they want to go on record, but kind of things that it would be late summer/fall when we -- but we have a lot of projects going, both domestic and in China. We should see some improving trends in the second half of the year as far as orders and results. And Tim, we have inventory to show.

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Timothy Ronald Wojs, Robert W. Baird & Co. Incorporated, Research Division - Senior Research Analyst [22]

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Yes. Okay. Got you. Got you. Okay. And then the Veth business in the quarter, was there a way to give us what the revenue dollars were for Veth in Q3? And then just curious what the reversal was. Was that just an accounting thing?

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Jeffrey S. Knutson, Twin Disc, Incorporated - VP of Finance, CFO, Treasurer & Secretary [23]

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The -- in other operating income, that's what you're referring to?

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Timothy Ronald Wojs, Robert W. Baird & Co. Incorporated, Research Division - Senior Research Analyst [24]

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Yes.

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Jeffrey S. Knutson, Twin Disc, Incorporated - VP of Finance, CFO, Treasurer & Secretary [25]

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Yes. So what that was, we had an accrual as part of the acquisition, there was an earn-out provision. That earn-out was to be paid either in cash or Twin Disc stock at our discretion. So we made the determination within the quarter that we would be paying that in stock. And therefore, there was a sort of a mark-to-market adjustment because of the change in the stock price from the timing of the agreement to the end of Q3.

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Timothy Ronald Wojs, Robert W. Baird & Co. Incorporated, Research Division - Senior Research Analyst [26]

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Got you. Okay. And then was the revenue $14 million or so in the quarter?

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Jeffrey S. Knutson, Twin Disc, Incorporated - VP of Finance, CFO, Treasurer & Secretary [27]

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A little over $15 million.

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Operator [28]

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(Operator Instructions) It appears there are no further questions at this time. I would like to turn the conference back to John.

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John H. Batten, Twin Disc, Incorporated - President, CEO & Director [29]

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We can close, Sandy.

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Operator [30]

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

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John H. Batten, Twin Disc, Incorporated - President, CEO & Director [31]

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Thank you, folks.