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API Technologies (NASDAQ:ATNY)

Q3 2013 Results Earnings Call

October 10, 2013, 10:00 AM ET

Executives

Tara Flynn Condon - Vice President, Corporate Development & Marketing

Phil Rehkemper - Executive Vice President and Chief Financial Officer

Bel Lazar - President and Chief Executive Officer

Analysts

Mike Crawford - B. Riley & Company

Operator

Good morning and welcome to the API Technologies Corp Fiscal Year 2013 Third Quarter Earnings Call. All participants will be in listen-only mode. (Operator Instructions) After today's presentation there will be an opportunity to ask questions. (Operator Instructions) Please note this event is being recorded.

I would now like to turn the conference over to Tara Flynn Condon, Vice President, Corporate Development and Marketing. Please go ahead.

Tara Flynn Condon

Thank you, Chad. And good morning, everyone and thanks for joining us today. With us from management are Bel Lazar, President and CEO and Phil Rehkemper, Executive Vice President and CFO.

Before starting the call, I'd like to read the Safe Harbor statement. This conference call will contain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. The words anticipate, believe, estimate, expect, intend, may, plan, project, will, would and similar expressions are intended to identify forward-looking statements, although not all forward-looking statements contain these identifying words.

Forward-looking statements are subject to risks and uncertainties, which could cause actual results to differ possibly materially from what the company now anticipates. Management has outlined the risk about the company's business in the section titled Risk Factors and Management Discussion and Analysis of financial conditions and results of operations in the fiscal year report on Form 10-K and quarterly report on Form 10-Q. These reports are on file with the Securities and Exchange Commission, and they should be reviewed with great care, because all forward-looking statements that management makes during this conference call or otherwise should be interpreted in light of the risks appraised in those reports. API Technologies is not under any obligation to update any guidance or any other statements discussed on this conference call and investors should not assume that the company would update any of these statements.

With that, I'll turn the call over to Phil Rehkemper, who will discuss the company's financial results. Bel Lazar will discuss API's overall business and operations. Please go ahead, Phil.

Phil Rehkemper

Thanks Tara and good morning, everyone. Before I review our financial results, I’d like to remind you of our previously announced sale of our Data Bus product line on July 5th, which we discussed on last quarter's earnings call as a subsequent event. We sold the Data Bus product line for $32.5 million. As part of the sale transaction, we recorded a $350,000 reduction in proceeds due to a working capital adjustment.

Net proceeds of $28.8 million from this transaction were used to pay down our term loan during the third quarter. Beginning in the quarter ended August 31, 2013, we began reporting our Data Bus product line previously included as part of our system, sub-systems and components or SSC segment as a discontinued operation. All comparable historical periods for the Data Bus product line are now recorded as discontinued operations. The financials I will be discussing do not include the Data Bus product line unless I’m specifically commenting on discontinued operations.

As you’ll recall, we began reporting our historical Sensors business as a discontinued operation last quarter. But beginning this quarter, our historical comparative financials include both Data Bus and Sensors' financial results reported in discontinued operations.

In our Q3 earnings press release issued yesterday, we published tables that recap our historical FY13 and FY12 quarterly revenue and adjusted EBITDA by business segment, excluding our Data Bus product line and Sensors businesses. The Data Bus and Sensors divestitures were part of API Technologies' Board of Directors' previously announced and ongoing strategic review process. As has been our practice, we will not release information on any results of this process until the Board has approved a specific course of action.

Earlier today, we filed a Form 8-K announcing that we entered into an amendment to our term loan credit agreement with Guggenheim Corporate Funding, LLC. The amendment modified the financial covenants in the credit agreement to adjust the minimum interest covered ratio and increased the maximum leverage ratio.

Additionally, the amendment reduced the interest rate on loans under the credit agreement and modified the terms of the prepayment premium, which we are required to pay upon making voluntary prepayment and certain mandatory prepayment. With this amendment, the effective interest rate on the term loan was reduced from 11% to 9%.

Now I would like to review our Q3 financial results. For the quarter ended August 31, 2013, API Technologies reported revenue of $62.6 million. Third quarter revenue declined $1.6 million from the prior quarter revenue of $64.2 million due to a quarterly revenue decline in the Electronic Manufacturing Services or EMS and Secured Systems and Information Assurance or SSIA segments, offset by revenue growth in our SSC segment. Bel will comment more on our revenue trends in a moment.

Our revenue in Q3, 2012 was $58.8 million resulting in a year-over-year revenue growth of 6.6%. Bookings in Q3 were $56.8 million, resulting in a book-to-bill ratio of 0.9 to 1 due to timing of certain programs and summer seasonality.

GAAP gross margin for the third fiscal quarter of 2013 increased to 23.9%, up from 22.8% in the second quarter versus 21.9% in the third quarter last year. Quarter-over-quarter, GAAP gross margin improved primarily due to higher gross margins in our SSC business segment. SSC gross margins improved by 2.3 percentage points from the prior quarter, due primarily to favorable product mix and lower manufacturing overhead on higher revenue.

Our SSIA segment gross margin percentage in Q3 was flat to Q2 at 34.6%. Our EMS segment gross margin percentage declined by 4.7 percentage points from Q2 to 4.9% in Q3. This quarter-over-quarter decline in EMS gross margin was due primarily to lower revenue, which increased our fixed cost as a percentage of revenue.

In Q3, we recorded total restructuring cost of approximately $0.1 million compared to $0.4 million in Q2 and $2.2 million in Q3 of 2012. The company reported GAAP operating income of $2.3 million in Q3, a $1.2 million increase over Q2 operating income of $1.1 million, versus an operating loss of $1.2 million in fiscal Q3 of last year.

For the third quarter of 2013, the company’s effective income tax rate was 212% compared to a blended U.S. Federal and State statutory income tax rate of about 37%. The primary difference between the Q3 effective tax rate and the blended statutory tax rate is due to the existence of valuation allowances for deferred tax assets and income from foreign subsidiaries taxed at rates lower than the U.S. statutory rate.

Income tax expenses allocated between continuing and discontinued operation with an income tax benefit recognizing continuing operation associated with the current year operating losses and income tax expense from discontinued operations primarily related to gain on the sale of the Data Bus product line.

We reported income from discontinued operations of $5.3 million in Q3 compared to $11.0 million of income in Q2 versus a loss from discontinued operations of $2.1 million in last year’s Q3. Included in the Q3 income from discontinued operations was a gain on the sale of the Data Bus business of $10 million and a tax expense of $4.9 million.

The company posted net income of $7 million in Q3. During Q3, we recorded $0.4 million of dividends on preferred stock that were paid in kind resulting in net income attributable to common shareholders of $6.6 million. Our Q3 net income declined by $0.5 million from a Q2 net income of $7.5 million. The quarter-over-quarter net income decline was due to a $5.7 million decline in net income from discontinued operations, mostly offset by a $5.2 million improvement in net income from continuing operations.

The decline in discontinued operations' net income was due primarily to a lower gain on the sale of the Data Bus product line net of income tax in Q3, compared to the gain on sale of Sensors, net of income tax in Q2. The improvement in net income from continuing operations was due to higher pretax income and lower taxes in Q3 compared to Q2.

In last year’s third quarter, we recorded a $27.7 million net loss due primarily to the write-down of $24.3 million of goodwill, mostly associated with the restructuring of our EMS segment; $2.2 million of restructuring cost from amortization of approximately $0.9 million of discounts and deferred financing cost related to our old term debt.

Adjusted EBITDA for Q3 was $8.4 million. This adjusted EBITDA and all of our references to adjusted EBITDA by segment include allocations for net corporate expenses. Net corporate expenses, which recently have been approximately 3% of continuing operations' revenue, are allocated to the business segment based on revenue as a percentage of total revenue each quarter.

Moving on to the balance sheet as of August 31, 2013, the company had $14 million of cash and cash equivalents including $1.5 million of restricted cash and a $110.2 million in total debt obligations net of discount. During Q3, we paid down our term loan by $30 million primarily from the net proceeds from the Data Bus product line sale.

Cash provided by operating activities was $1.9 million for Q3 driven primarily by higher operating income. Our cash capital expenditures for the August ending quarter were $1 million. DSO or days sales outstanding was 64 in Q3, compared to 61 days in Q2. At the end of Q3, inventory was $61.6 million versus $59.6 million in Q2. Days of inventory were 119 in Q3 compared to 111 in Q2.

And with that, I’ll turn the call over to Bel. Bel?

Bel Lazar

Thank you, Phil. Hello to everyone joining us today. Just a quick note that all the numbers that I will discuss, including the end market estimates exclude the Data Bus product line and Sensors business.

Let's talk about our business performance. I am very pleased to report strong results this quarter with adjusted EBITDA expansion, year-over-year revenue growth, record revenue for our SSC segment and additional term debt pay down. We delivered our highest adjusted EBITDA in five quarters at $8.4 million for Q3, up $1.1 million from Q2 and up $1 million from last year's Q3.

We continue to execute on our business strategy, improve our operational efficiency and develop innovative technologies to meet the requirements of defense and commercial customers worldwide.

Now let me speak to our segment results and end market. I’ll start with the SSC segment. Our SSC segment set a record high revenue number for this quarter, posting $45.7 million of revenue in Q3, compared to $42.9 million in Q2, up more than 6%, with the increase due to healthy shipments in our U.S. RF Microwave and Power Systems Solutions product line.

Adjusted EBITDA for our SSC segment increased as well, moving from $5.6 million or approximately 13% of revenue in Q2 to $7.5 million or approximately 16% of revenue in Q3. Book-to-bill was 0.9 in line with last year’s Q3. Products on the segment hold key design end positions in over 300 U.S. DoD and international military program.

The diversification of our defense program footprint is complemented by a robust and growing portfolio of new products. These include innovative Active Antenna Array Units for AESA, Datalink and Satcom applications; our line of advanced GaN-based power amplifiers and a new suite of mobile power solutions for command and control applications. These solutions deliver competitive advantage and a compelling return on investment and we are pleased to see positive customer response.

Our Electromagnetic Integrated Solutions or EIS product and power solutions consistently have a solid foothold in the commercial end markets close to 60% combined. We are now seeing this being reflected in RF microwave product line, where we are seeing increasing customer adoption of these products for industrial and wireless applications such as smart metering and mobile communication.

In Q3, we booked $1 million order with a Fortune 100 wireless carrier for our microwave product that will be used in its cellular broadband network. We are leveraging our RF and microwave engineering heritage, next generation design and award-winning product portfolio to solve technical challenges for communication and industrial customers, which opens up new end markets and additional pathways for revenue growth.

In addition, we continue to leverage our cost efficient manufacturing capabilities in Mexico, enabling us to be price competitive in cost conscious markets, while delivering strong margins. By combining our innovative designs with market priced product, we are well positioned for continued growth within the commercial non-defense sector.

Moving on to our SSIA segment, our SSIA segment revenue was $3.7 million in Q3 versus $5.1 million in Q2. As I have explained before, revenue in this segment is lumpy. Adjusted EBITDA was $0.6 million or approximately 17% of revenue in Q3, compared to $1 million or approximately 21% of revenue in Q2, with the adjusted EBITDA decline due to lower revenue, which increased our fixed cost as a percentage of revenue.

Book-to-bill for our SSIA segment came in strong at 2.8. Key bookings included a $3.3 million win for secure systems in support of the U.K. Ministry of Defense ASTOR Program and $3.5 million of the recently announced $15 million contract win with the Canadian agency for our secure communication products.

Our SSIA products have a strong and loyal following. U.S. and international governments' continued interest and investment in cyber security matches well with our product mix, which features secure communication, remote management and secure access products.

Moreover there is a continued interest by the U.S. government for more competition in the TEMPEST market, which bodes well for our continued expansion in the U.S. TEMPEST market going forward. These factors -- these factors combined position in the SSIA segment, well for continued growth in Europe and North America.

Moving on to our EMS segment; revenue for Q3 was $13.3 million compared to $16.2 in Q2 with a book-to-bill of 0.5 due to the prior quarter’s strong bookings and timing of certain programs. Adjusted EBITDA for Q3 was $0.3 million or approximately 2% of revenue compared to a $0.7 million or approximately 4% in Q2 with the adjusted EBITDA decline due to lower revenue, which increased our fixed cost as a percentage of revenue.

A year ago we restructured our EMS business with the aim of improving profitability. As our results demonstrate, over the last three quarters, we have delivered adjusted EBITDA profitability and our plan is to continue to drive efficiencies and profitability within the segment.

Now let me provide some color on our end markets and trends. The following data represents our best estimate of end market percentage breakout. Our U.S. defense and market revenue was $33 million or 53% of quarterly revenue, down slightly from $34.4 million or 54% of revenue in Q2.

Even in the current challenging defense environment, we were able to maintain and defend our revenue levels due to our differentiated product and outstanding customer support. Primary revenue drivers include solutions for radar, weapons, missiles, defense, mil aero and electronic warfare programs.

Shifting to our government and security end markets, as a reminder, this end market includes U.S. non-DoD government agencies and foreign government. Q3 revenue was $7.7 million or 12% of revenue compared to $9.7 million or 15% of revenue in Q2, primarily due to some seasonality in our SSIA segment.

Moving on to our medical, industrial and commercial end market, quarterly revenue was relatively flat, $11.5 million or 18% of revenue in Q3 versus $11.9 million or 19% of revenue in Q2.

Lastly in our communications and consumer end markets revenue increased from $8 million or 12% of Q2 revenue to $10.3 million or 17% of revenue in Q3, with the increase primarily due to demand increase from communications end market customers.

Now let me talk about our overall business operational accomplishments and goal. With the Q3 sale of Data Bus product line, we completed approximately $84 million in product line divestitures this fiscal year. Since February 2013, we have paid down nearly $77 million in term debt. While doing so, this quarter we delivered adjusted EBITDA at the highest percentage and dollar level for the past five quarters and year-over-year revenue growth of 6.6% in an atmosphere of sequestration and macroeconomic uncertainty.

Furthermore, we have curated the company's offerings and in doing so, created an even more desirable portfolio of products for our target customers that positions us well for further expansion within our target markets.

Our facilities have some of the highest level of industry qualifications. As an example, there are 19 facilities worldwide that have a MIL-PRF-38534 Class K or space level for microelectronic certification. Two of those facilities are ours. There is a high barrier of entry into this specialized high reliability market and only certain providers offer the product and capabilities to address it. We have heritage in many high reliability applications and programs including defense and satellite. And given our differentiated product portfolio, we have plenty of headroom to grow within the satellite and other end markets.

We continue to identify and implement judicious cost reductions resulting in margin expansion. By leveraging our offshore manufacturing capabilities in Mexico, we are able to provide market leading product of exceptional quality that are at right priced for our diverse customer base. And we continue to explore opportunities for mindful consolidation, including the recently announced consolidation of our Canadian [filtering] operation into other API manufacturing sites.

Notwithstanding our judicious cost reductions, we continue to make necessary investments in CapEx and R&D to fuel our profitable revenue growth. As a result of our R&D investment and effective execution on our technology roadmap, we continue to see new product revenues to be north of 25% of total product revenue as was the case in Q3.

Our fully funded backlog is healthy at $136 million complemented by reliable book and ship business and a robust sales tunnel of $327 million of which close to 50% are in the RF and microwave product line.

In Q3, we continued to demonstrate success on many fronts including continued adjusted EBITDA expansion, year-over-year revenue growth, significant debt pay down and the launch of innovative and differentiated new products that address the growing technological demands of our diverse, domestic and international customer base. I look forward to what's ahead.

With that, we will turn the call over to questions. Please go ahead, operator.

Question-and-Answer Session

Operator

Thank you. We’ll now begin the question-and-answer session. (Operator Instructions) Our first question comes from Mike Crawford with B. Riley & Company. Please go ahead.

Mike Crawford - B. Riley & Company

Thank you. Bel, you said that the light book-to-bill and EMS in the quarter was, to some extent, attributable to the strong bookings in that segment in the prior quarters. Is that -- why would that be, and should that imply that we should expect lighter bookings in, say, SSIA in this quarter?

Bel Lazar

From an EMS perspective, the May quarter we had about 1.2 book-to-bill ratio and it was due to certain programs coming in during that quarter. For the August quarter it was 0.5. So really if you look at both, we were like 1.7. So in a way, it’s slightly less than two, it's less than two. We expect the bookings to continue, actually we expect the bookings to grow in the future quarters. It was timing, Mike. Now what was the question on the SSIA?

Mike Crawford - B. Riley & Company

Well, you implied a relation between the Q2 and Q3 bookings in EMS, why one was weak, the prior being strong, so now you had quite strong bookings in SSIA. Does that imply that there would be a same relationship where we should expect it to be weak in terms of bookings in that segment in this quarter?

Bel Lazar

Not necessarily, no. Actually we are expecting to have good booking for SSIA segment in the future quarters.

Mike Crawford - B. Riley & Company

And a couple of the wins that you’ve been able to press release in SSIA; were those -- were any of those booked in the current Q4?

Bel Lazar

Some of them we have booked for example on the Canadian win, we booked out of that $15 million contract, we booked $3.5 million.

Mike Crawford - B. Riley & Company

In November quarter?

Bel Lazar

In the August quarter.

Mike Crawford - B. Riley & Company

Right. So my question was, were any of these booked in the November quarter yet?

Bel Lazar

Some of it, yes, some of it has and we will report that when we report our November quarter.

Mike Crawford - B. Riley & Company

Okay. Thank you. Congratulations on the Credit Agreement Amendment; lowering your borrowing costs at 200 basis points. Why would the leverage ratio be increased given that it does not appear to be much of a problem given your profitability in cash flow generation?

Phil Rehkemper

Yeah Mike, so we took an opportunity with reviewing the credit agreement to look at all of the key terms and so Guggenheim was basically willing to adjust the covenant ratios as well, but there was no risk hitting those under the old agreement.

Bel Lazar

Yeah Mike, we were very comfortable with the covenants in the old agreement and the amended agreement. The main purpose of the amendment was to lower the interest rate.

Mike Crawford - B. Riley & Company

Right. So with a greater leverage ratio does that mean that you might be looking to even do some bolt-on acquisitions even at the same time as you are looking to divest existing businesses as part of your strategic process?

Bel Lazar

You know, as we have stated before on the strategic process, well, first of all, we have no acquisitions in the funnel, but as we stated regarding the Board process is that we do not intend to discuss or disclose development unless the Board has approved a specific course of action.

Mike Crawford - B. Riley & Company

So you might be willing to do bolt-on acquisitions even while you are looking to sell some or all of the businesses?

Bel Lazar

We have nothing lined up.

Mike Crawford - B. Riley & Company

Okay. Two more questions please. One, the gain on the Data Bus sale; initially, you thought that was going to be $26 million to $27 million. It ended up being $10 million, and as disclosed in the Q, so what was the…

Phil Rehkemper

Yeah, the difference Mike was the goodwill. We had to allocate a portion of the goodwill associated with the Data Bus product line of $15 million.

Mike Crawford - B. Riley & Company

Okay. And then, the last question is probably a bit more lengthy to answer. So you have restated all prior quarters in terms of revenue and EBITDA margins, so now of you have these three segments with different margin profiles, and can you please, once again, walk through with a new look ATNY your margin targets by segment, the timeline you would hope to achieve these EBITDA margins in those segments, as well as the likely revenue range you would need to achieve those margin targets? Thank you.

Bel Lazar

Yeah, thanks, Mike. I followed up on the last quarter's question regarding at what revenue levels we need to get to that 20% target. And it's about $72 million and higher. We would need to have EMS to be about 20% of that total revenue and the target bill for the whole company is 20% EBITDA. For the non-EMS, EBITDA target we need to be at 23% to get to overall 20%, that assumes 10% EMS -- 10% EBITDA for EMS.

Mike Crawford - B. Riley & Company

Right. And so, Bel, that's really more of a revenue timeline. Like if your revenues were there you could be there today, or is there some more restructurings that need to occur to enable you to achieve those profitability levels at those revenue levels?

Bel Lazar

No at these revenue levels we can probably get there today, Mike. There are some more work to be done on the EMS side. But in general, we’ll be close to it, because remember the -- for the non-EMS, the incremental margin is pretty high. So we would -- so once we get to that $72 million in revenue, we’ll probably get very close to that number today.

But that doesn’t mean that we have stopped or ended our cost reduction. We continue to consolidate factories. We continue to take cost out, so that will be a plus.

Mike Crawford - B. Riley & Company

Okay. Thank you very much.

Bel Lazar

Sure.

Operator

(Operator Instructions) There appears to be no further questions in the queue. I would like to turn the conference back over to management for any closing remarks.

Bel Lazar

Thank you. We appreciate your time today and thank you all for joining today's call. Thanks.

Operator

Thank you very much. The conference is now concluded. You may disconnect your line. Thank you.

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