Sypris Solutions, Inc. (SYPR) Q3 2012 Earnings Report, Transcript and Summary

Please stand by. Good day, everyone, and welcome to the Sypris Solutions Incorporated Earnings Conference Call. As a reminder, today's presentation 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.

Thank you, Doris, and good morning, everyone. Brian Lutes, Tony Allen and I would like to welcome you to this call, the purpose of which is to review the trends reflected in the company's financial results for the third quarter of 2012. 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 through the first half of our presentation this morning, starting with an overview of the highlights for the quarter, to be followed by a brief discussion of each of our 2 business segments. Brian will then provide you with a more detailed review of our financial results for the quarter. Now let's begin with an overview on Slide 4. Without question, the third quarter turned out to be a real challenge as the headwinds of uncertainty from the looming fiscal cliff, events in Europe and the continuing resolution impacted production levels in the commercial vehicle market and delayed funding for purchases in the Aerospace & Defense sector. The company reported sales of $78.8 million compared to $91.2 million for the prior year period, reflecting shipment levels that were 18% below our internal expectations for our Industrial Group at the beginning of the quarter. Our gross profit, however, came in at $9.4 million or 11.9% of revenue, resulting in a 60-basis point increase in margin from the third quarter of 2011. The margin expansions, generated in both business segments, reflecting our continuing efforts to reduce cost, improve product mix and eliminate waste. In addition, our Industrial Group did an outstanding job in reacting to the sudden change in schedules that commenced in August, thereby minimizing the inevitable inefficiencies associated with the lower levels of production and making certain that inventory metrics for turnover and days were maintained within desired ranges. Earnings from continuing operations at $0.03 per diluted share reflected our expanding margins and disciplined cost containment, but were clearly well below our expectations going into the quarter. The good news is that the company's free cash flow of $0.22 per share exceeded our internal outlook for the quarter and was especially positive in light of the deceleration of shipments that took place during the period. In summary, we believe that the company's ability to increase margins during the quarter in the face of the current headwinds serve as an important testimony to the underlying strength and nature of the advancements that have been and continue to be made in both segments. On a year-to-date basis, please note on Slide 5 that sales have increased 8.8% to $274 million, driven by a $29.5 million or 14.6% increase in sales from our Industrial Group. Gross profit increased 32.4% to $35 million, far outpacing the company's growth in sales, while gross margin expanded 230 basis points to 12.8%. We're pleased to note that each business segment contributed to this positive performance with increases of 780 basis points and 150 basis points respectively, for each of the A&D and Industrial sectors. Earnings per share from continuing operations increased 57% to $0.55 per diluted share, up from $0.35 per share for the first 9 months of 2011. As we look to the future, our sense is that the current state of uncertainty will remain with us until such time as the election and the fiscal matters confronting our nation are addressed. In the interim, we believe that we are well positioned to look for opportunities to expand our businesses on a selective basis both through acquisition and through joint venture. Now let's advance to Slide 6 and take a quick look at our Aerospace & Defense business. The market outlook remains uncertain at best with the continuing resolution and fiscal cliff impacting program funding. Most of the major prime contractors, including Lockheed Martin and Northrop Grumman have already announced major realignments of their organizations well in advance in any budget resolutions. The potential for sequestration, that is the unilateral across-the-board funding cuts to the services that is slated to take effect in April of 2013 should Congress not otherwise agree upon a solution before then, would, by most accounts, be a disaster. As such, we feel the likelihood of such an outcome to be low. The bright spots remain cyber and information security, 2 areas of clear priority for our nation that will continue to receive increased levels of funding even under the least attractive of outcomes. There is a silver lining to this story with opportunities for those who are agile and have the ability to move quickly. The rightsizing of the primes may lead to the outsourcing of non-core production, which is exactly the course of action they followed in the late 1990s. In today's market, however, that the company is also certified as a trusted source, the commercial opportunity will be further enhanced and may make the outsourcing decision easier. We are finding that nation states around the globe are in need of U.S. military-grade solutions and services, especially during these times of growing tension and uncertainty. We have spoken before about the need to adopt common platforms and technology, to consolidate many functional capabilities into a single unit, so that the services can still achieve mission-critical outcomes, while spending less. The cyber threat is real, growing and certain to be persistent. Needs such as critical infrastructure protection, a good example of which is our smart grid project with the Department of Energy, identity and asset authentication and resiliency testing must all be addressed with new technology and solutions. It is open terrain at the moment with no clear market leaders. Our sense is that this will not be true 3 years from now. Our strategy for addressing these opportunities remains clear and focused. By turning to Slide 7, please note that we will continue with our efforts to expand our manufacturing services for the production of high-reliability, space-grade electronic assemblies for Lockheed Martin and others. These are primarily commercial-grade activities such as weather satellites and are not subject to DoD funding. In a similar vein, we plan to expand our business with TE SubCom and other telecommunications systems providers, for assemblies to be incorporated into severe environments such as deep sea telecom systems. Earlier this year, we received our certification as a trusted source by the federal government, which included a 1A microelectronic design and manufacturing certification. We also recently became a member of the Defense Industrial Base, or the DIB, as it is commonly known, which will provide us with important visibility into the ongoing and ever-changing cyber security threat to our industrial base and the nation. These events should help us to build our book of business for Lockheed Martin, Northrop Grumman, L-3 and others. We will continue to expand our product sales with NATO and the Five Eye countries both to meet their demand and to diversify our customer portfolio beyond that of the U.S. government. And we will continue with our efforts to develop a common platform utilizing Android technology to deliver encryption keys and other important functions for our men and women in uniform. We're scheduled to deliver our first cyber range during the fourth quarter, and we are in the process of developing a patent for embedding identity authentication in silicon, which, if successful, will represent an important transformation from threat identification to threat prevention. In short, we have a lot going on, with the short-term government funding issues making it all the more interesting, but we remain optimistic about the long-term prospects of this business. Now let's take a quick look at our Industrial Group beginning Slide 8, where order activity continues to reflect the economy's uncertain future course. The major change since the time of our last call has been the decision by the OEMs to reduce the production of commercial vehicles midway through the third quarter in an effort to bring growing inventory balances in line with demand. The method of choice has been to maintain line rates, while periodically taking weeks out of production. Our sense is that by so doing, they will be able to increase output in the future without having to go through the inefficiencies of recruiting and training new employees. At the current time, somewhere between the fourth quarter of this year and the first quarter of 2013, is expected to be the market trough before growth once again resumes. The long-term market fundamentals remain positive with all key metrics flashing green. In a recent conversation with an industry executive, we were told that in excess of 70% of the current class 8 trucks were placed in service prior to 2004. And as a result, the demand for replacement vehicles is expected to be solid for years to come. The first model year 2014 trucks, which are expected to be much more fuel-efficient will begin to ship in March of 2013 and may serve as the basis for a return of demand from the fleets. And finally, the long-term fundamentals continue to improve for housing and automotive demand both of which bode well for the future of the commercial vehicle industry. Advancing now to Slide 9, we will continue to focus our efforts on 3 key strategic initiatives: the continuous elimination of waste, investing to relentlessly drive efficiency, and selectively pursuing strategic opportunities to expand our customer and market share. With regard to the continuous elimination of waste. In the short-term, it goes without saying that we will vigorously pursue cost containment until such time as volumes return. But we must also continue to layer in the programs that can change our fundamental cost structure on a permanent basis. One such program will be with the help of Toyota, where we plan to be under contract shortly to engage Toyota's expertise to accelerate the deployment of Lean tools in our factories. We believe that significant additional opportunities exist to improve our processes and eliminate waste, thereby further increasing our competitiveness and margins. With regard to the second strategic initiative, investing to drive efficiency. We will continue to invest extensively in automation to increase efficiency, quality and reliability. We now have more than 60 robots in operation in our Louisville, Kentucky facility and we will now begin the process of automating our plant located in Toluca, Mexico. We will increase our investments in preventive maintenance to reduce expensive downtime and repairs. And we will expand our investments in employee training and education for all the right reasons. And finally, we will utilize our strong balance sheet liquidity to take advantage of growth opportunities that may become available in our current market environment. We've already had the opportunity to evaluate several such candidates for both segments of our business but have yet to find the right fit. As we proceed, we will continue to be patient and selective to make certain that any transaction that we complete is both strategic and accretive to earnings. This concludes my segment of our formal presentation. It is now my pleasure to turn it over to Brian Lutes. Brian will lead you through the balance of our deck this morning.

Great. Thanks, Jeff. Good morning, everyone. I'd like to go through the highlights of our third quarter and year-to-date results with you briefly and, that this time, ask you to advance to Slide 10. You'll see, starting from the top there, our A&D segment revenue for the quarter was down about $4.9 million from the prior year period, primarily due to the completion of EDMS, as well as manufacturing and engineering programs. Additionally, as you heard, Jeff mention the quarter was impacted by the budgetary and funding challenges we've been discussing with you for quite some time. However, despite the lower revenue, we did expand gross margin by 260 basis points versus the prior year quarter, again reflecting the strength of execution as we move to a more favorable product mix and a testimony to the team's relentless focus on building a culture of Lean. With respect to our Industrial Group, we did experience decelerating commercial vehicle demand during the quarter. This resulted in about a $7.5 million revenue decrease from the prior year quarter. And once again, as you heard Jeff mention, the team did a great job managing the downside conversion on lower volume resulting in gross margins that expanded by 60 basis points. Finally, on the consolidated view, despite the revenue overall at $12.4 million, we did realize overall margin expansion of 60 basis points. Obviously, the challenges during the quarter were a result of lower volumes, especially within our Industrial Group. Everything -- if you look at this, everything being equal within the Industrial Group, assuming Q3 revenue to be equal to Q2 revenue when viewed on a sequential basis, we estimate the volume decline impact on earnings per share to be approximately $0.11. Again, really concluding here, both segments did a very good job managing execution in a quarter that was marked with lower volumes. In terms of our year-to-date performance, let me touch briefly on that and ask you to advance to Slide 11. Really calling your attention to the bottom of the page, you'll see our consolidated gross profit summarized. This increased 32.4% to $35.1 million, far outpacing the sales growth that we had, which was around 8.8%, while gross margin expanded 230 basis points to 12.8%. What's important to note, you did hear Jeff mention this earlier, but of particular importance is that each business segment contributed to the positive performance with increases of 780 basis points within A&D and right at 150 basis points there in our Industrial Group. Before I conclude with our brief summary and view of the financial performance in the quarter on lower volumes, largely driven by the macro-environment that continues to fluctuate, we maintained cost discipline in managed conversion very efficiently in the factories, and again this drove the margin expansion that you see here on Page 11. Let me summarize as we close out the Q3 call with you today. As we've discussed for quite some time, Sypris is sustaining strong operational performance. Third quarter gross margin expanded 60 basis points. This was despite the softening revenue and driven by 260-basis-point increase in our A&D segment. Free cash flow was really fine, frankly and exceeded our expectations. It increased sequentially to $0.22 per share. And finally, the year-to-date gross profit has increased 32%, while gross margins are up 780 basis points for A&D and again 150 for industrial segment, reflecting the strength of operational execution. For us, middle of the page, volatility provides opportunities. And as a result, the long-term fundamentals continue to remain positive for both the Industrial Group and the Aerospace & Defense segment. We believe that an estimated 70% of the class 8 trucks that were placed into service prior to 2004, as a result, this will create future demand for replacement vehicles for years to come. The increasing and persistent cyber threat will create significant opportunities within our Aerospace & Defense segment, working closely with our customers, enable us to provide timely, cost-effective solutions that meet their specific needs. And finally, post the September 2008 economic turmoil, we did take the necessary steps, as we've talked about over the past few years, to reduce the cost structure and build a strong balance sheet. And we believe this is truly a great asset for the times that we're in right now. It continues to provide us the important ability to maintain internal investments in our process improvement, automation and R&D during this short period of the headwinds. Further, we continue to be proactive in evaluating an array of opportunities to selectively expand our strategic footprint to increase customer and market share. At this time, I'd like to thank you for joining this morning. And at this time, we'll turn it over to Doris for any questions you might have.

[Operator Instructions] And our first question comes from Jim Ricchiuti from Needham & Company.

First of all, are the test and measurement arbitration issues completely behind the company at this point?

Yes, they are completely resolved.

Okay. And it looks like your legal expense in the June quarter was about $0.5 million or so. Was it all associated with this? And what were -- Brian, I don't know if you can give us a number for Q3.

The Q2 expense that you referred to is accurate. I think for Q3, it's about $6 million.

$600,000.

$600,000 in Q3.

Okay, so that largely goes away Q4?

That is correct.

Okay. So we should assume, I guess, your SG&A, expense some decline in that line item?

That's -- yes.

Okay, great. And if we look at the current slow growth environment, is it fair to assume that your -- the revenues, the quarterly revenues from your industrial segment can remain around these levels, or do you still see some potential downside as some of your customers adjust their production?

Jim, this is Jeff. I think we'll see probably some additional downdraft in Q4. Not of a material nature, but we've got the holidays and all sorts of things going there, so there's some also natural cycle down that takes place then. And then we're anticipating that Q4 into Q1 will be somewhat flat, and then we'll see where it goes from there.

Okay. And I guess the impressive -- really, the impressive part is the way you've been able to maintain some pretty attractive margins in the business just given the falloff. Apart from the operational improvements that you've made, were there any unusual issues, with respect to mix that contributed to the margins in the quarter in the industrial business?

No. No.

No.

And actually same is true, same question really for the Electronics business. Again, you had a pretty significant sequential decline in revenues and yet you were able to maintain pretty healthy margins. What's the outlook in terms -- from a margin standpoint over the next 1 to 2 quarters? Anything unusual that we should be thinking about?

I think that -- we expect margins to remain at or above where they are now. And so at the moment, we don't see a reason to believe that there'd be any diminishment of margins.

Okay, okay. And, Jeff, I don't know if this is a question you can answer or not, but I'm just wondering again just given the uncertain government spending environment, how might we think about your backlog as you enter 2013 versus 2012? Is this an issue where you're hoping to see some orders come in once the spending environment becomes a little -- there's more clarification on that? What kind of backlog would you anticipate entering the year with versus 2012?

Let me answer this way Jim. I think that what we're going to see, or what we expect to see at this point anyway, is to continue to trend about where we are at the moment going forward. And clearly, we'll all benefit once the spending priorities are addressed, and we have a new administration and Congress gets through the fiscal cliff. But at the moment, we see things being as pretty lumpy, and we certainly don't see growth opportunities at the moment.

Got it. And will fiber be meaningful for you guys in 2013 at this point? Or is it still something where it's really in the investment mode and you expect to see the benefits of that looking further out?

We're going to have to see. It depends. We're shipping our first -- targeted to ship our first cyber range this quarter. And we have a number of opportunities that we're working on in that area. And if that converts, then it could be. With regard to the other initiatives we're working on in cyber, they're a little bit longer term and less likely to impact 2013.

Okay. And final question, I'll just jump back. Brian, the partnership with Toyota, is there any upfront expenses associated with that and in terms of what we should think about that? And a question would be also when would you anticipate some of the benefits flowing in from that?

Well, those are both very good questions. We don't expect the cost of working with Toyota to have a negative impact on our margins. We expect that the cost and the benefits will time themselves out pretty closely with one another. But this is a very exciting opportunity for us to really take our organization to the next level with the intent, not only of certainly driving additional cost out and becoming more competitive and increasing our margins, but also the more important longer-term feature is embedding this type of thinking in our culture. And so we're very excited about that and look forward to participating with Toyota during 2013.

Jim, one clarification for you because I think this is important for the -- all of the other analysts joining us today. As we think about the arbitration and the settlement that's behind us on the comment referencing the expenses incurred in Q3, just as a reminder, those do flow through discontinued operations.

[Operator Instructions] And we'll go next to Tim Fronda with Sidoti & Company.

And as far as protecting margins, was it more about maintaining pricing discipline or -- and product mix or were you able to lower certain costs? Was it more on that side of it?

I think, Tim, largely, it was a quarter marked by execution. We had a very balanced revenue profile in our Electronics business. There was nothing that stood out in terms of driving the margin one way. It was really a quarter again marked by execution in both the segments.

And with the slowdown in orders in the commercial vehicle side, if the slowdown were to last a little longer than you expected, what are your plans to lessen the effects of that?

Well, I think we continue to rebalance and work closely with our key customers especially in the Industrial segment. I think we have a good 6-week view out. As Jeff mentioned to the earlier question, I think we will continue to see challenges in Q1, but it's really all about rebalancing to meet the demand criteria.

Tim, we have an excellent team that runs this side of the business for us. And just as a they did a great job of preparing for the upturn here over the past 18 months, they also responded very quickly maintaining direct labor, managing inventory, doing those types of things. And if the market continues to stay down or soften further beyond our expectations, we'll just -- we'll remain very aggressive in managing our direct costs.

Great. And final question. As far as strategic opportunities, are you more looking on the side of complementary products or maybe in another geographic area and growth market? What's the main focus there?

Well, we've been looking at several things quite frankly. One is we've been looking at expanding into some developing countries, primarily in South America and, to a lesser extent, India. And our objective there is to expand our footprint, not only with our existing customers, but add new customers and have the balance, if you will, of a different economic cycle. Here in North America, we've been looking at the opportunity to expand the number of touch points that we have with our customers by adding additional services and capabilities that we don't currently provide.

[Operator Instructions] And, Mr. Gill, at this time, there are no further questions. Sir, I'll turn the call back to you.

All right. Thank you, Doris. Brian, Tony and I would like to thank you for joining us on this morning, especially given it's historic day. And I'm sure a number of you have been out voting. We welcome your continued interest and, of course, your questions about our business. Thank you and have a great day.

And, ladies and gentlemen, that does conclude today's presentation.