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Richardson Electronics Ltd. (NASDAQ:RELL)

Q3 2013 Earnings Call

April 11, 2013 10:00 am ET

Executives

Edward Richardson – Chairman, Chief Executive Officer, President

Kathleen Dvorak – Chief Financial Officer

Wendy Diddell – Executive Vice President, Corporate Development

Sandeep Beotra – Executive Vice President, Mergers and Acquisitions

Analysts

Charles Frischer (ph) – (unknown)

Mark Zinski – 21st Century Equity Research

David Tomell – Berthel Fisher

Operator

Good day ladies and gentlemen and welcome to the fiscal year 2013 third quarter earnings conference call for Richardson Electronics. At this time, all participants are in a listen-only mode. Later, we will conduct a question and answer session. If at any time you require operator assistance, please press star followed by zero and we will be happy to assist you. As a reminder, this conference is being recorded for replay purposes.

I would now like to turn the conference over to your host for today, Mr. Ed Richardson, Chairman, Chief Executive Officer and Chairman. Please proceed.

Edward Richardson

Good morning and welcome to our third quarter 2013 conference call. Joining me today are Kathy Dvorak, Chief Financial Officer; Wendy Diddell, Executive Vice President of Corporate Development and General Manager of Canvys; and Sandeep Beotra, Executive Vice President, Mergers and Acquisitions. As a reminder, this call is being recorded and will be available for audio playback on our website.

During the call, we may make forward-looking statements, and based on certain risk factors our actual results could differ materially. Please refer to our press release and SEC filings for an explanation of our risk factors.

Net sales for the third quarter of fiscal 2013 were $33.6 million, down 12.3% from net sales of 38.3 million during the third quarter of last year, reflecting sluggish demand relating to continued uncertainty in the global marketplace. Sales in the quarter were down the most in Asia. The year-over-year decline is also attributable to continuing slow demand for displays in Canvys’ European segment as well as for PACS monitors in the healthcare segment.

Gross profit for the third quarter of fiscal 2013 was $9.9 million or 29.5% of net sales compared to 11.3 million or 29.5% of net sales during the third quarter of fiscal 2012. Gross profit during the quarter was up slightly over Q2 but continued to be negatively impacted by under-absorbed manufacturing labor and overhead. During the second quarter, we reduced headcount and working hours in our manufacturing group to reflect the decline in demand. While we continue to be under-absorbed, our manufactured products generate higher margins than our distributed products. They also fill a need for products which cannot be sourced from other vendors and continue to be a positive contributor to our operating margin.

Selling, general and administrative expense during the quarter was $9.3 million compared to 9.5 million during last year’s third quarter. We also generated nearly $5 million of cash from operating activities through the first three quarters of the fiscal year. This reflects our continued attention to expense control and working capital efficiency as we anticipate economic recovery and keep ourselves well positioned to take advantage of pent-up demand.

As a result of our lower revenue, income from continuing operations for the third quarter of fiscal 2013 was $600,000 compared to income from continuing operations of 1.6 million during the third quarter of last year. The month of February was the strongest month in North America that EDG has seen in two years and one of the highest billing months overall for EDG during the same time frame. We remain cautiously optimistic that the economy is stabilizing on a global basis and we’ll see a return to normal purchasing patterns in the coming months.

Now I’ll turn the call over to Kathy Dvorak to share the details of our third quarter performance.

Kathleen Dvorak

Thank you, Ed, and good morning everyone. Sales in our third quarter of fiscal 2013 were 33.6 million, representing a 12.3% decline in sales volume compared to the third quarter of fiscal 2012. While we were disappointed that we did not see sales demand pick up during the third quarter as we had expected, we anticipate that our sales volume during the fourth quarter should be up about 10% from our third quarter, reflecting more normal purchasing patterns.

Operating expenses were 9.3 million in the quarter compared to 9.5 million in the prior year’s third quarter. Operating income for the third quarter of fiscal 2013 was 600,000 or 1.8% of net sales compared to 1.8 million or 4.8% of sales in the third quarter of last year. We continue to monitor expenses and are committed to taking costs out of the organization as appropriate, of course keeping in mind our long-term growth objectives.

Interest income for the quarter was 260,000 and FX was a $460,000 loss. The loss on FX primarily reflects the strengthening euro over the U.S. dollar. In some of our foreign subsidiaries where the euro is the base currency, we need to hold U.S. dollars to operate. We also have the inter-company balances in different currencies that affect our FX gain/loss through revaluations.

Income from continuing operations was 389,000 before tax. We had a tax benefit from continuing operations for the quarter of 197,000; so income from continuing operations was $586,000 or $0.04 per share.

For the first nine months of fiscal 2013, sales were 105.9 million and gross profit was 31.3 million or 29.6%. SG&A was 29.7 million and operating income was about 1.6 million or 1.5% of net sales.

On the year-to-date basis, our tax rate from continuing operations was 2.1%. Our tax calculations are complex and reflect a number of variables, including our geographic distribution of taxable income as well as our forecasted cash available to distribute back to the U.S. from each of our foreign jurisdictions. Our tax rate also includes certain discrete tax adjustments reported during the fiscal year. While our projected tax rate is difficult to estimate, we currently believe that our tax rate for the fiscal year will be under 10%, given our current assumptions.

Cash and investments as of the third quarter were 148 million. During the first nine months, we generated 4.9 million of cash from operations. This includes 2.9 million of cash generated from working capital. The 2.9 million source of cash reflects a decrease in our inventory of $2.2 million, a decrease of receivables of 600,000, and an increase in payables of 200,000. To clarify, this is cash flow net of any effects from foreign currency exchange in acquired businesses.

While our current global economic environment in the markets we serve continues to present numerous challenges, we are focusing on opportunities for growth that will allow us to leverage our global infrastructure and core capabilities. Our outlook for the fourth quarter is for sales to be in the range of 36 to 38 million, or an increase of about 10% from our third quarter.

In conclusion, we continue to be challenged by the macroeconomic environment but remain confident in our ability to reduce our costs, which should allow us to achieve our operating margin target in the future. We look forward to reporting our fiscal 2013 results in July.

And now, I would like to turn the call over to Wendy, who will discuss Canvys.

Wendy Diddell

Thank you, Kathy, and good morning. Canvys sales for the third quarter were 9.3 million versus 11.5 million in the third quarter of FY12. Sales in all three segments were negatively impacted by continued economic concerns both here and in Europe, which has caused a decrease in capital expenditures. Sales were also negatively impacted by ongoing pressures regarding healthcare regulations and the financial impact on both manufacturers of medical equipment and hospitals.

Gross margin in the third quarter for Canvys was 26.9% versus 28% during the third quarter of FY12. The decline over prior year was due to the higher percentage of low margin sales to key OEM customers and the significant drop in healthcare sales. The difference is also attributable to an increase in provisional costs relating primarily to higher freight expense in FY13 and more favorable manufacturing variances in FY12.

Given the lack of revenue growth, we continually evaluate our resources and remain committed to reducing expense. Canvys headcount is 87 today versus 96 at the end of the first quarter of the fiscal year. The sales teams in all three segments continue to focus on new business acquisition within the medical and industrial markets. Booking new business with new customers, as we’ve previously mentioned, is taking longer than we anticipated, and with the onset of touch in greater displays in brand name vendors, competition is increasing. We still believe there are a vast number of opportunities for customized displays which we are uniquely positioned to provide. As such, we will continue to work closely with EDG to find existing Richardson Electronics customers who make equipment which utilize displays, attend and participate in trade shows and industry events, and take advantage of social media to find leads.

We are still validating the opportunity to sell our Image Systems branded PACs displays and surgical monitors throughout Latin America. As Richardson Electronics expands its presence in the healthcare market, which Ed will tell you about shortly, we believe this will also have a positive impact on our healthcare segment sales.

Ed will now provide an update on EDG.

Edward Richardson

Thanks, Wendy.

EDG’s third quarter sales continued to be impacted by uncertain economic conditions, particularly in Asia and in Europe. Sales in the quarter were $24.3 million, down 9.4% from 26.9 million in the third quarter last year. Gross margin in the quarter was 30.4%, which was an improvement over 30.1% in the prior year. Gross margin continues to be impacted by under-absorption in manufacturing associated with a drop in demand for semiconductor wafer fabrication components.

On a positive note, sales of laser tubes and consumables to end users continued to improve every quarter as the sales and marketing teams focused on CO2 laser applications. In February, we sold the highest number of laser tubes in any month to date. We anticipate finishing the year up nearly 20% in volume and 18% in sales over the prior year. Over the past year, we’ve increased our customer base for laser tubes by more than 28%. Sales of laser consumables, which includes parts such as bellows, lenses, nozzles and other products which are replaced on a regular basis, have increase nearly 10 times compared to last year.

Powerlink, the service company we acquired at the beginning of the second quarter in FY12, continues to perform well, bringing incremental revenue and margin to EDG in both the satellite communications and industrial markets. We’re now able to repair critical driver stages which are used in CO2 laser equipment. This service provides our customers with tremendous value over buying a new driver stage directly from the OEM. Revenue from the aviation and marine market also improved compared to the third quarter last year. Demand for tubes in industrial applications such as textile manufacturing and wood treatment continued to be soft, and sales of cathode ray tubes declines as sources for CRTs become more and more difficult to find.

Overall, it’s been a challenging year for EDG as our customers logged fewer machine hours and reverted to cannibalizing unused equipment rather than purchasing new tubes. We continue to actively contact our database of more than 20,000 customers to understand their requirements and look for new products and services we can offer. Our incentive plan is structured to drive new business growth, whether it be from new customers or from existing customers with new products. We remain positive that EDG will continue to be a healthy and long-term contributor to our business.

Now let’s move on to what we’re doing to drive long-term profitable growth in Richardson Electronics. We’re actively pursuing several companies in the diagnostic imaging replacement parts and service market, which would provide a global platform for healthcare replacement part sales. We’ve found that although there are a number of small companies providing parts and service, the OEMs continue to dominate and control the market through high cost extended service agreements.

Many hospitals faced with reduced government reimbursements, cutbacks and service level requirements are bringing this service in-house or using more affordable third party options. We firmly believe there is a significant opportunity for Richardson Electronics to provide critical high quality replacement parts to support their needs. We’re taking our time to evaluate companies that can provide us with high quality parts as well as technical resources to help train the hospitals and third party service providers to maintain their own equipment. We’re also working with existing vendors on several critical replacement parts.

The key to our success and ultimately the value we bring to the market is our ability to make, source and supply only the highest quality parts. Through our existing global infrastructure, we believe that we can be one of the highest quality parts providers and deliver these parts anywhere in the world in a timely and cost effective manner. It’s an exciting time for the company and we look forward to sharing our detailed plans with you during our next fiscal year.

In summary, without a doubt it’s been a frustrating year for Richardson Electronics; however, we do expect sales in the fourth quarter will improve slightly over the third quarter. Based on the improvements we’ve seen in February and input from our customers regarding economic conditions in Asia and Europe, we’re optimistic that the global economy will recover and our core business will return to the levels achieved in fiscal year 2012.

At this point, Kathy, Wendy and I will be happy to take your questions. Operator, may we open the line for questions?

Question and Answer Session

Operator

[Operator instructions]

Your first question comes from the line of Charles Frischer of Richardson Electronics. Please proceed.

Charles Frischer

Good morning, Ed. How are you guys doing today?

Edward Richardson

I’m good, Charles. When did you join our staff?

Charles Frischer

That was the telephone operator. Sorry about that. I had a question—I don’t know if you can answer this, but on the replacement components that you sell, what do you guys think about the average life of those components? I’m trying to figure out where we are on that in terms of how that cycle is—where we are in the cycle.

Edward Richardson

Okay, well it depends upon the particular market that you’re speaking about. But when you look at the CO2 laser market or power grid tubes in general, the CO2 laser market, the tubes in constant service probably last about three years. You could look at that in terms of hours somewhere 5,000 to 7,000 hours, depending upon how they are operated. When you get into other markets like satellite communications where they are using traveling wave tubes, you are talking five years, seven years, sometimes longer; so it depends on the application.

Charles Frischer

Okay. The reason I’m asking is I’m trying to figure out how close are we to where a lot of this equipment is going to start—you know, they’ve been cannibalizing or they haven’t been ordering, or they’re ordering as needed, not sort of stocking inventory – sort of where we are in that cycle. Any kind of thoughts about that?

Edward Richardson

Sure. That’s primarily industrial applications like CO2 laser, for example, and so I think the cycle time there is less than three years.

Charles Frischer

Okay. And this is also maybe a hard question, Ed, but over the last couple years with the slowdown in the global economy and our sales have slowed down a little bit, any sense of market share? Have we retained roughly the market share we’ve had, have we lost, have we gained? What would you say as you look at the business over the last year or two?

Edward Richardson

We’re gaining market share all the time. Unfortunately the tube business is such, we forecasted it’s declining about 5 or 6% a year in units, but basically there’s enough price increases in the industry that from a revenue point of view, it stays about flat. But certainly it’s like the CO2 laser market – we’re gaining market share all the time.

The other comment I’d add to the cycle time is that when they’re cannibalizing tubes from existing equipment, those tubes are used so they don’t have a full life on them when they start to use them, so possibly the cycle time as it relates to the cannibalized equipment is much less than three years.

Charles Frischer

That makes a lot of sense. When I sort of sit with a pro forma projected earnings from a business that you would buy at five or six times, my thought is—I don’t know whether five or six times EBITDA is the right number or not, but the returns really—if you were able to buy a business on those kind of multiples, it really does drive a lot of value considering that our cost of capital—not necessarily our cost of capital, but we have the capital earning essentially nothing. Is that how you think about it, or are my multiples kind of off by some factor?

Edward Richardson

No, I think you’re absolutely right. For example, we bought not a large distributor, a very small distributor, back in September and the performance there has been amazing and we’ll probably get a return on investment back out of the company in less than two years. So if we can find acquisitions of that nature, it’s certainly the best opportunity for growth.

Charles Frischer

Sure. Do you have any thoughts in the quarter about capital allocation? I see the company didn’t buy any shares back. Maybe could you share your thoughts about that, how you think about that?

Edward Richardson

Well, Kathleen can correct me, but we’ve spent about $45 million on stock to date and sort of our par was to stay under 50 million. I will tell you that we’re looking at some rather substantial acquisitions and so at the moment, we want to see if we can conclude those and see what our cash balances look like thereafter.

Charles Frischer

Oh, okay. That’s great. I know the acquisition business is—you don’t know what you’re going to get until you get it. Would you say that if you didn’t do a deal in the next six months or a year, you would be disappointed, or it could be longer, maybe a two or three-year period before a deal gets done?

Edward Richardson

I’d say we’d be very disappointed if we don’t have something done in the next six to 12 months.

Charles Frischer

Terrific, okay. Keep up the great work, guys. I appreciate it.

Edward Richardson

Thanks, Charles.

Operator

Your next question comes from the line of Mark Zinski of 21st Century Equity Research. Please proceed.

Mark Zinski – 21st Century Equity Research

Yes, good morning everyone. I guess I’ll continue with the acquisition theme. Just wondering if the regional economics in Asia and Europe, if they are kind of forcing you to maybe revisit your acquisition strategy in terms of geography. Just wondering if you’ve changed your thinking a little bit on the acquisition front strategically.

Edward Richardson

No, not really, Mark. The area that we’re particularly interested in right now is the diagnostic imaging portion of the healthcare market as far as aftermarket parts are concerned, and when you look at the global market, when you’ve got outside of the United States, the aftermarket is controlled possibly 95% by the OEMs who made the equipment, and many times the replacement parts cost is a multiple of what the OEM price is for that part. It presents, we think, a great opportunity for us to provide a high quality source of parts at a much lower price, particularly in international markets.

In the U.S., we think the market is probably still controlled 70% by OEMs. There is an opportunity here as well, but we think there’s more of an opportunity globally. So the economic conditions, I guess they have an impact. Probably where the economy is down, there is even more pressure on healthcare costs and there’s probably a greater need there as well.

Mark Zinski – 21st Century Equity Research

Okay. And then in terms of the laser market, it continues to do very well for you. Any color on the market in North America versus Europe? Are your sales into Europe holding up okay there?

Edward Richardson

The OEMs, the laser equipment manufacturers are basically German companies. There are some elsewhere, but the two largest ones are in Germany, and I will say that they are strongest in controlling their aftermarket in Europe than they are in any other geography in the world. So we’ve had a more difficult time penetrating that market in Europe where we’ve done extremely well in North America. There’s also another difference – in the U.S., most of the companies know how to service their own equipment, and what we find in Europe is a much smaller percentage can service their own equipment, and then when you go to Asia probably 90% of the companies do not service their own equipment. So we’re having to develop a service capability to penetrate those markets, particularly in Asia and in Europe, and that just takes longer to build that base.

Mark Zinski – 21st Century Equity Research

Okay. And then also, I wanted to touch on your observations on the industry, particularly advertising. There’s been a player in your space that’s gotten a little more aggressive in their advertising and in terms of branding initiatives. I’m wondering if there’s any kind of paradigm shift in the industry to try to develop more brand recognition.

Edward Richardson

Hm. I’m really not familiar with what you’re making reference to.

Mark Zinski – 21st Century Equity Research

Okay, I’ll leave it at that without naming names.

Edward Richardson

All right. (Inaudible) brands, they’re pretty well recognized.

Mark Zinski – 21st Century Equity Research

Okay. And then lastly, I just wanted to get Wendy’s thoughts on the medical device tax and the level of burdensome-ness that folks are talking about, your customers. Do you see this as an ongoing significant barrier?

Wendy Diddell

Yes, we do. When some of our larger customers—I mean, they have had layoffs, they’ve pushed development of new equipment either out of the country or off of their roadmaps completely. Having said that, we have such a small market share that we believe that there is still a significant of customers out there that we can reach out to and work with and deliver customized displays. So yeah, it’s tough but there is still a lot of opportunity out there for us.

Mark Zinski – 21st Century Equity Research

Okay. Do you guys have any thoughts on fiscal ’14 in terms of where you think sales might come in at, or is there just too much uncertainty to feel comfortable with making any kind of estimates?

Edward Richardson

Well, we’re just working on budgets for next year – as you know, our year starts June 1, so it’s a little premature. But when we get into the next quarter, we can probably give you more guidance.

Mark Zinski – 21st Century Equity Research

Great, okay. That’s it for me. Thank you.

Operator

As a reminder, if you’d like to ask an audio question at this time, please press star, one on your touchtone phone. Your next question comes from the line of David Tomell of Berthel Fisher. Please proceed.

David Tomell – Berthel Fisher

Good morning. Quick question – what kind of potential do you see in Latin America?

Edward Richardson

Well particularly in the healthcare space and Brazil more than anywhere else, we see a lot of potential. Actually when you look at Brazil, it’s hard to believe but there are almost as many hospitals in Brazil as there are in the United States. I realize they are much smaller, but it presents a major opportunity there for replacement parts and for displays in the PACs environment, so we see that as a major opportunity.

David Tomell – Berthel Fisher

And how big of an effort is being made down there?

Edward Richardson

Our facility, we’re somewhere 6 or 8 million. I always have to qualify because when we had RFPD, we were much larger in Brazil. But I don’t know if we could actually quantify the diagnostic imaging market particularly in Brazil – we have those numbers somewhere, but I don’t have them on the top of my head.

David Tomell – Berthel Fisher

How many feet on the ground do you have down there?

Edward Richardson

About eight or 10, something like that.

David Tomell – Berthel Fisher

Okay. Thank you.

Operator

At this time, there are no further questions in the audio queue.

Edward Richardson

Okay. Thank you for joining us and for your continued support of Richardson Electronics. We have a solid base of business which we continue to generate cash from for years to come. We thank our employees and partners for being a key part of our ongoing success, and we’re hard at work on a very exciting growth strategy for the company. We look forward to sharing our progress with you in July. Thanks.

Operator

Thank you for your participation in today’s conference. This concludes the presentation. You may now disconnect. Have a wonderful day.

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