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Methode Electronics (NYSE:MEI)

Q2 2013 Earnings Call

December 06, 2012 11:00 am ET

Executives

Donald W. Duda - Chief Executive Officer, President and Director

Douglas A. Koman - Chief Financial Officer, Principal Accounting Officer and Vice President of Corporate Finance

Analysts

Jimmy Baker - B. Riley & Co., LLC, Research Division

Joseph D. Vruwink - Robert W. Baird & Co. Incorporated, Research Division

Gregory M. Macosko - Lord, Abbett & Co. LLC

Operator

Welcome to the Methode Electronics Fiscal 2013 Second Quarter Earnings Conference Call. [Operator Instructions] As a reminder, this conference is being recorded.

This conference call does contain certain forward-looking statements, which reflects management's expectations regarding future events and operating performances and speak only as of the date hereof. These forward-looking statements are subject to the Safe Harbor protection provided under the securities laws. Methode undertakes no duty to update any forward-looking statements to conform the statements to actual results or changes in Methode's expectations on a quarterly basis or otherwise. The forward-looking statements in this conference call involve a number of risks and uncertainties. The factors that could cause actual results to differ materially from our expectations are detailed in Methode's filings with the Securities and Exchange Commission, which is our annual and quarterly report. Such factors may include, without limitations, the following: Dependence on a small number of large customers, including 2 large automotive customers; dependence on the automotive, appliance, computer and communications industries; further downturns in the automotive industry or the bankruptcy of certain automotive customers; ability to compete effectively; customary risks related to conducting global operations; dependence on the availability and price of raw materials; dependence on our supply chain; ability to keep pace with rapid technological changes; ability to improve gross margins due to a variety of factors; ability to avoid design or manufacturing defects; ability to protect our intellectual property; ability to withstand price pressure; the usage of a significant amount of our cash and resources to launch new North American automotive programs; location of a significant amount of cash outside of the U.S.; currency fluctuations; ability to successfully benefit from acquisitions and divestitures; ability to withstand business interruptions; income tax rate fluctuations; ability to implement and profit from the newly acquired technology; and the future trading price of our stock.

It is now my pleasure to introduce your host, Don Duda, President and Chief Executive Officer for Methode Electronics. Thank you. Mr. Duda, you may begin.

Donald W. Duda

Thank you, Kevin, and good morning, everyone. Thank you for joining us today for our fiscal 2013 second quarter financial results conference call. I am joined today by Doug Koman, Chief Financial Officer; and Ron Tsoumas, Controller. Both Doug and I have comments, and afterwards, we will be pleased to take your questions. Methode's second quarter sales grew 12% to $130 million, and in the first six months of fiscal 2013, net sales increased nearly 10% to $249 million. In both periods, improved volumes are driven mainly by increased sales of the Ford center console program and lead frame assembly products, new product launches in our European Automotive business, torque-sensing products sales for e-bikes, motorcycles and ATB's, as well as higher appliance and data solution sales. These sales improvements were partially offset by softness in our Power Products segment. As we announced this morning, we received half of the fund coming [indiscernible] the other half in January of next year. We recorded the entire gain in the second quarter in the income from settlement section of the income statement. Including the impact of [indiscernible] second quarter net income is $5 million or $0.13 per share from, $0.01 last year and its first-half net income is $8.8 million or $0.23 per share compared to $0.05 last year. The earnings improvement was driven by higher overall sales volume, lower selling and administrative expenses, the one-time reversal of accruals related to a customer bankruptcy, higher other segment income, commodity pricing adjustments and lower legal expenses. Second quarter earnings were negatively impacted this year by higher cost related to the design, development, engineering and launch of the General Motors center console program, higher income tax expenses, absence of the gain on the acquisition of AMD, from which we've benefited last year, cost related to the delayed launch of the laundry program, as well as manufacturing efficiencies, lower sales and an unfavorable product mix within the Power Products segment. Loss related to the design, development and launch of the General Motors center console program for their next-generation truck platform lowered second quarter net income by approximately $2 million or $0.05 per share and lowered first half net income by $3.4 million or $0.09 per share. In fiscal 2013, we anticipate approximately $4.5 million in total launch cost for the program, with the majority of those cost having already occurred in the first half. Consolidated gross margins fell about 1% in the second quarter and less than 1% in the first 6 months compared to the same periods of last year. The decrease was due primarily to increased design development and engineering cost for the General Motors center console program, as well as increased sales of the Ford center console program, which carries a higher prime cost due to the high purchase content. Additionally, the delayed launch of the laundry program in the Interconnect segment, as well as manufacturing inefficiencies and an unfavorable product mix in the Power Products segment negatively impacted our second quarter and first half gross margins. The development launch cost for the General Motors center console program lowered Automotive second quarter gross margins by 2.5 percentage points and first 6 months gross margin by 2.2 percentage points. As I mentioned last quarter, we are successfully producing all of the decorative components for Ford's D Car platforms. However, due to higher-than-anticipated volumes of the U Car, we continue to utilize the outside suppliers to supplement our production in the second quarter. While our charges for inspection and freight were lower this quarter over last year, we anticipate incurring charges in the third quarter as we ramp up to meet towards demand.

In our release today, we announced that we anticipate sequentially lower sales in earnings in our third quarter compared to the second quarter due to weakening demand over the last few weeks in our European Automotive segment, as well as reduce sales in the Power Products segment. As such, we now expect third quarter earnings per share to be breakeven to modestly profitable. Additionally, based on what we are seeing in Europe, we now anticipate sales and earnings for fiscal 2013 to be at the low end of our guidance range of sales of $470 million to $500 million, and earnings per share in the range of $0.45 to $0.60. This guidance excludes the income from a litigation settlement. This would indicate that we are anticipating a strong fourth quarter, which is based on the initial launch of the General Motors K2XX program, new launches in European Automotive, which are being delayed by the customer from our third quarter now launching in the fourth quarter. Our fourth quarter is a full 13 weeks with no holidays. And generally, we see strong OEM demand in our fourth quarter. That said, there is considerable volatility in the European market.

Now turning to review of our individual segments. Automotive segment sales increased nearly 19% in the second quarter, and grew 16% in the first half with a higher sales of the Ford center console program and our transmission lead-frame product, as well as new product launches in Europe. Automotive segment gross margins decreased in the second quarter and first half, impacted by the higher prime cost for the Ford center console program, as well as cost related to the launch of the General Motors program, partially offset by lower costs related to third-party inspection cost premium freight and overtime expenses, and a commodity price adjustment. In our third quarter, we believe our European Automotive segment will be impacted by several factors. First, the economic conditions in Europe; second, the delayed launches; and finally, reduced volumes on the new EV programs.

Moving to Interconnect sales, increased almost 6% in the second quarter and nearly 2% in the first half, attributable mainly to improved appliance and data solution sales, partially offset by lower sales of radio remote controls, as well as the planned exit of our product line at our Asian operation. Appliance sales improved in the first half due mainly to the successful launch of the first phase of the laundry program in October. However, due to a customer-driven delay, the remaining 3 phases of launch are now expected to occur in the first quarter of fiscal 2014. We anticipate this program to be at a full run rate in the second half of our fiscal 2014.

As I mentioned last quarter, radio remote control sales decreased in Europe, partially due to lack of sales to a financially distressed distributor. To remedy the situation in September, we acquired certain assets of the distributor and we'll operate this business under the name Hetronic Italy. Additionally, an overall ongoing weakness in the European economy impacted second quarter Hetronic sales, but several of our customers saw a softer demand in their end markets. Interconnect's gross margins were relatively stable in the second quarter and first half, due mainly to higher sales for appliances and data solution products, offset by development cost for the laundry platform. Our Power Products segment saw a 9% and 7% lower sales in the second quarter and first half, respectfully, due mainly to significant reduced military spending, major project with Cisco going end-of-life sooner than we anticipated, as well as the delay of new programs such as domestic EV programs. And in general, much lower volumes than we originally anticipated.

However, our design and success with Power Products on data center servers has offset some of the weakness in industrial and military accounts due to the economy and government budget cutbacks. At this point, we anticipate continued softness in the second half for the segment.

Power Products' gross margins decreased in the second quarter and first half, mainly as a result of manufacturing inefficiencies, lower sales and an unfavorable product mix. Without the new product development cost for E-Trucks, gross margins would had been 18% and 19% in the second quarter and first half, respectively. Now let me summarize some of the product development and new business awards and opportunities occurred in the second quarter. In our North American Automotive segment, we have been awarded the capacitive touchscreen for a portion of General Motors K2XX, as well as all of the vehicles in the 31XX platforms, replacing the 8-inch resistive touchscreen we are currently purchasing from a third party. This will be a running change for the K2XX platform, beginning at July of 2014, and 31XX will launch with our capacitive touchscreen. This is Methode's first major award with a capacitive touch screen and should improve the margins for the General Motors center console program. We are utilizing this award to discuss additional capacity business opportunities with General Motors, as well as opportunities with other OEMs. This is another example where our technology developed by another Methode division, in this case, Touch Sensors has been successfully marketed in Automotive, as well as being refined to meet stringent Automotive specifications.

In our European Automotive segment, we booked several new programs, including an electric park brake assembly, as well as hidden window lift and tailgate switches for various European OEMs. Together, these programs represent approximately $8 million to $10 million in new annual revenue beginning in fiscal 2015. Hetronic's exposed improved market penetration continues to expand with the addition of a new major customer in Brazil, who ordered their first systems. Further, Hetronic received several European industry certifications for various products, including its new explosion-proof battery, and most importantly, for railway products in Europe. So to quickly summarize, although we had a strong first half of fiscal 2013, the third quarter will likely be weaker as the impact of the economic turmoil and downturn in Europe begins to impact us. However, we do expect an improved fourth quarter over third quarter with the General Motors center console program launching and other European Automotive programs moving to full launch. On an aside, our launch and production teams continue to do an excellent job of managing all our projects under development and moving those towards a successful launch. We commend them for their very fine efforts. Now I will turn the call over to Doug, who will provide further details regarding our financial results. Doug?

Douglas A. Koman

Thank you, Don. Good morning, everyone. Let me add just a few additional comments to those Don has already made. Effective tax rate for the second quarter was 12.2%, which resulted in an income tax expense of $3.3 million for the second quarter. If the Delphi settlement were excluded from the second quarter of pretax income and from the tax rate calculation, effective tax rate would have been 25.1% and would have resulted in an income expense of $1.7 million for the quarter.

Looking at CapEx, in the first 6 months, we spent $23.6 million. As we have said previously, most of our capital spending would be in the first half of the year. For the full year, we now expect capital spending to be between $28 million to $31 million. Depreciation and amortization expense in the first six months was $8.8 million. In fiscal 2013, we expect full year depreciation and amortization to be between $18 million to $20 million as we place a significant amount of assets in service in the last quarter of the fiscal year.

As Don mentioned, consolidated net sales were up $13.9 million or 12% this quarter versus last year. However, sales were negatively affected by $2 million or 1.5% due to currency fluctuations, primarily due to the weakening of the euro against the dollar. For the 6-month period, sales were up $21.8 million or 9.6% over last year. Likewise, the 6-month sales were negatively affected by about $2.4 million or 2%, also due primarily to the weak euro. Operating cash was $22.7 million for the 6 months compared to $1.7 million last year. We had higher net income, which included $20 million from the Delphi settlement. However, $10 million of that is yet to be collected. We also saw improved working capital management in the first 6 months of this year compared to last year. We brought bank debt down $10.5 million in the quarter to $46 million at the end of the second quarter. You should recall that in the fourth quarter of fiscal 2012, we identified $38 million of undistributed foreign earnings from repatriation as a dividend. The cash was repatriated to the U.S. in the last week of our second quarter of fiscal 2013. A portion of this was used to reduce borrowings in the second quarter, and it will also reduce the amount of borrowing required for the remainder of the year and will otherwise be used for operating and capital needs. Don, that concludes my comments.

Donald W. Duda

Doug, thank you very much. Kevin, we are ready to take questions.

Question-and-Answer Session

Operator

[Operator Instructions] Our first question is coming from Jimmy Baker from B. Riley & Co.

Jimmy Baker - B. Riley & Co., LLC, Research Division

The inefficiencies that dinged your Power Products margins here in the quarter, along with mix. Can you maybe talk about your expectation for continuation of those dynamics for the balance of the year? Or should we see more significant margin improvement in that business come fourth quarter?

Donald W. Duda

At this point, -- let me back up, our military and aerospace products, in general, carry a much higher margin than our other products in Power, the data center products, as well as some of the telecom. So at this point, we're going to see that mix probably stay more towards the lower margin products. So for the duration of the year, I think we're going to see really more of the same. I think we've said that in the prepared remarks. And then we're taking a look at what steps do we need to take to adjust that business for what we think is going to be a continued downturn in the military spending going forward. Now we've got new products coming out, but I think this is a general softness that, that business is going to have a headwind for at least the next 6 months, maybe even 12 months.

Jimmy Baker - B. Riley & Co., LLC, Research Division

That's helpful. And then just maybe more generally, your guidance obviously implies a pretty healthy fourth quarter. Can you maybe just talk about your comfort level with your European business there in April quarter? Just trying to get a handle on what level of visibility you have there and how conservative you've been?

Donald W. Duda

In general, we, at least a quarter in advance, we have pretty good visibility into the releases. And in normal times, those [indiscernible] are fairly reliable. You don't see much variation. Europe is not unlike what we saw in, say, 2008, 2009 in the U.S. Automotive business where there isn't quite a bit of variability in the market as OEMs adjusted to their demands. So we've looked at our releases, we know we are launching more products and work with -- although they're going to launch at a lower rate. And we feel confident that those are good numbers at this point. But if we see further declines in the European economy, well then, that confidence is -- of course, it's much less, as we're at the mercy of what the OEMs are going to take from us. So let's say there's a degree of caution, there's also a degree of conservatism. And as we look at Europe and those numbers, and we're also launching the initial launch of K2, which will ramp. We will be building inventory beginning in our fourth quarter, and then ultimately, selling product, I think, in the last month is scheduled. So -- and the fourth quarter is usually our strongest quarter, it's 13 weeks, no holidays and it's a strong OEM build season. So that, we know that the fourth quarter will certainly be well improved over what we're selling in the third quarter. Anyway, the third quarter has December in it and the holiday shutdowns.

Operator

Our next question is coming from David Leiker from Robert W. Baird.

Joseph D. Vruwink - Robert W. Baird & Co. Incorporated, Research Division

This is Joe online for David. I just want kind of circle back on what you're saying with Europe. Can you give us a better sense of when you're seeing the production cuts come? Is it December? Are they going to take a full 2 weeks of holiday downtime? Is it more January? And then I'm wondering, is this broad-based weakness across all the automakers, because I know you typically kind of supply more than normal share of the superpremium segment with like a McLaren or an Aston Martin or even a Jaguar. So maybe is it broad-based across the automakers or more customer-specific to Methode?

Donald W. Duda

It will be more customer-specific. We have Fiat, Renault, Peugeot. We're also seeing the volume on the Leaf vehicle, those are ramping at a slower pace. And the Volkswagen is up for us. I mean, really, if you look at quarter-over-quarter, what automakers in Europe, what the fact is we're tracking that almost one for one. If Fiat's down, we're down. The premium, that hasn't seen a large downturn. But I would -- the significant reductions are on Fiat and Renault and Peugeot. And I don't have [indiscernible] I don't have with me what that effect is on a monthly basis, but we certainly have that.

Joseph D. Vruwink - Robert W. Baird & Co. Incorporated, Research Division

Okay. And maybe I can circle back offline. Just thinking about, I understand your business is normally strong because Q1 production especially in North America is normally strong. I'm wondering, are there any concerns given that GM has very visibly built up a lot of inventory that you really can now be sitting on declines there at the GM, so your normal Q4 is a function of how strong Ford might be?

Donald W. Duda

That's a good question. But I would say, that will have -- a higher inventory will have an effect later on, GM, as well as Methode, will be doing a pipeline fill on the new pickup truck lines. So if there is an effect, I would think that would come later. And we're really in daily contact with GM and monitor -- I mean, we're nearing launch, so we're looking at volumes, we're looking at running rates. That could always change, but I think it would really affect maybe our first or second quarters of next year. And it's one month also.

Joseph D. Vruwink - Robert W. Baird & Co. Incorporated, Research Division

Sure. And then my last one. As you kind of think about the K2XX launch, so you're incurring cost right now without any revenues. As we head towards your Q4, you'll start to get some initial volume, but probably not enough to absorb all your overheads. So I'm just wondering, when do we really hit full stride in the launch cadence so that K2XX is additive to your profits? When would you envision that run rate happens?

Donald W. Duda

In the first quarter of fiscal 2014. At that point, truck is fully launched, and then later on in '14, SUV will launch. But truck will be fully launched. And again, that's all -- there's no take rate on that, it's all the trucks.

Joseph D. Vruwink - Robert W. Baird & Co. Incorporated, Research Division

And I guess, what would be the target margin by fiscal Q1 be kind of in line with the rest of your auto business or would you expect it to already be above given that, I guess, would you be doing the touchscreens on the initial truck volumes as well?

Douglas A. Koman

No. That touchscreens will be a running change. What did we say in...

Donald W. Duda

2014.

Douglas A. Koman

2014. So that won't have an effect on next year.

Joseph D. Vruwink - Robert W. Baird & Co. Incorporated, Research Division

Okay, got it. And then I actually just have a housekeeping item for Doug. Do you have a sense of what sort of tax rate you might expect towards the back half, given it seems like your income is going to be skewed more towards the U.S.?

Douglas A. Koman

Yes. I mean, we do take a look at what the full year effective for tax rate looks like. And based on where we sit today, I think we were at -- again, we had a couple of discrete items, but I think we were at 12.2%. So that's probably -- I get that would be the good rate for the full year to use.

Operator

Your next question is coming from Greg Macosko from Lord, Abbett & Company.

Gregory M. Macosko - Lord, Abbett & Co. LLC

Just with regard to some of the programs like the launch of the laundry, the laundry platform. I guess which has been delayed. Is that -- I mean, I would assume that would be affecting sales, primarily in the fiscal '14, is that right? Or is that how we'd look at it?

Donald W. Duda

Yes. The launch has been delayed at least the last 3 phases to our fiscal '14, and that should be ramping in our first quarter, then reaching its peak in the second quarter.

Gregory M. Macosko - Lord, Abbett & Co. LLC

Okay. And that was originally expected when?

Donald W. Duda

Really ramping now.

Gregory M. Macosko - Lord, Abbett & Co. LLC

Oh, okay.

Donald W. Duda

Launching now, ramping in the fourth quarter, so really shifted 2 quarters.

Gregory M. Macosko - Lord, Abbett & Co. LLC

I see. And that's just recent, I assume, right?

Douglas A. Koman

Right. I think we announced that in November 5.

Gregory M. Macosko - Lord, Abbett & Co. LLC

Okay. All right. Yes. Fine. And then with regard to the weakness in the Power Products, I guess that's primarily military-driven, right?

Douglas A. Koman

Yes. For the most part, but we also, we're providing Cisco a product for their high-end servers and that they took end-of-life sooner, but that wasn't anticipated and that was a good margin product as well. But it's really the military that is down. And we had an EV program that should have been fully ramped now, and that's much lower, and that's mainly because of the EV market not everybody anticipated. But again, the main factor is the military spending, but the other 2 certainly have an effect. And we're taking a look at what that business is going to be like over the next 6 to 12 months, and how do we position that so that we at least take into account what I think will be a slower spend in military for at least the next couple of years.

Gregory M. Macosko - Lord, Abbett & Co. LLC

So you're -- in other words, looking at the manufacturing and capacity and those kind of things for the next near-term?

Donald W. Duda

Yes. I mean, what we do, I think, fairly well is we adjust our expenses in line with the revenues that we expect, and the revenues aren't materializing as we once thought so we'll make the appropriate -- and then we've actually started to do that.

Gregory M. Macosko - Lord, Abbett & Co. LLC

Was the military a surprise? Or was that a...

Donald W. Duda

Well, I wouldn't say it was a surprise. The volumes in general were lower than we expected. But for months now, it's been in the process, these military spending cuts. And the new programs, which are funded, are ramping the volume much slower. I think we always talked about lessons learned in our business. I think as we go forward, we're going to look at these programs, and even though we certainly think we're conservative in what the volumes are going to be, we probably need to at least in our Power Products supply maybe even a lower factor or lower the adjustments we make and the volumes we get from our customers. Because across the board, we're seeing lower volumes. And a factory that's geared for a given volume, it doesn't take too much of a downturn to affect your income.

Gregory M. Macosko - Lord, Abbett & Co. LLC

Of course. And...

Donald W. Duda

We're certainly taking a look at that.

Gregory M. Macosko - Lord, Abbett & Co. LLC

And then you talked a fair amount about the development cost for General Motors, which makes obvious sense. I think you mentioned the Ford D program or something. Is that another -- is that a new development program, so some of the cost maybe from the GM will roll into that, the development cost?

Donald W. Duda

No. That -- we're fully launched on the 2 Ford platforms, D Car and U Car. We originally launched purchasing the painted bezel from a supplier. We had tremendous amount of issues with that supplier, incurred a lot of the premium freight overtime in our plants, and we've talked about that on several calls now. We chose to bring that manufacturing process in-house. We are probably about 80% complete doing that. However, Ford's volume is up, and so we've not been able to move away from the vendor completely. And that of course impacts our prime costs.

Gregory M. Macosko - Lord, Abbett & Co. LLC

Okay. When -- is there an anticipated time on that vendor will be gone?

Donald W. Duda

We are anticipating in probably in the next 12 weeks or so in this quarter, we soon should have it behind us.

Gregory M. Macosko - Lord, Abbett & Co. LLC

Okay, good. So that will help the margins a bit then.

Donald W. Duda

Yes.

Operator

[Operator Instructions] It appears we have reached the end of our question-and-answer session. I'll turn the floor back over to management.

Donald W. Duda

Thank you, Kevin. We will wish everyone a very safe and pleasant holiday season, and say good morning. There's a lot.

Operator

Thank you. This concludes today's teleconference. You may disconnect your lines at this time, and have a wonderful day. We thank you for your participation today.

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