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Richardson Electronics, Ltd. (NASDAQ:RELL)

F2Q 2014 Earnings Conference Call

January 09, 2014, 10:00 AM ET

Executives

Edward J. Richardson - Chairman, President, CEO and COO

Kathleen S. Dvorak - EVP, CFO and CSO

Wendy Diddell - EVP, Corporate Development and General Manager, Canvys

Analysts

Mark Zinski - 21st Century Equity Research

Dax Vlassis - Gates Capital Management

Operator

Good day, ladies and gentlemen, and welcome to the FY14 Second Quarter Earnings Call. My name is Chrystal and I will be your operator for today. At this time, all participants are in listen-only mode. Later, we will conduct a question-and-answer session. (Operator Instructions). 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 and CEO of Richardson Electronics, Ltd. Please proceed, sir.

Edward J. Richardson

Good morning and welcome to our second quarter 2014 conference call. Joining me today are Kathy Dvorak, Chief Financial Officer; and Wendy Diddell, Executive Vice President, Corporate Development and General Manager of Canvys. 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.

Second quarter revenues were $35.2 million, a 3.2% decrease compared to net sales of $36.6 million in the prior year. Sales for EDG were flat while sales for Canvys were down 10.9% compared to the prior year's second quarter.

We're not satisfied with these results; however, we saw some increasing changes in the second quarter of our fiscal year. Sales in November were the highest revenue month of FY14 which makes us optimistic that the balance of FY14 will show increases over the prior year.

We're seeing signs that global economic conditions are improving. The Asia-Pacific region was up 6.5% from the prior year. We're also seeing growth in several key markets including the industrial and automotive markets which utilized CO2 laser cutting equipment as well as the marine market, textile wood and industrial manufacturing.

During the quarter we continued to evaluate potential acquisitions in the diagnostic imaging replacement parts market. We remain convinced that the demand for high quality replacement parts will increase as healthcare reform makes it more critical than ever for hospitals to focus on reducing costs in the face of declining diagnostic reimbursements.

We firmly believe we can play a significant role as an independent parts supplier in the healthcare market in the future.

Now I'll turn the call over to Kathy Dvorak to present the details of our second quarter financial performance.

Kathleen S. Dvorak

Thank you, Ed, and thank you for taking the time to join us this morning. Sales in our second quarter were 35.4 million, down 3.2% from the prior year. Gross margin increased to 31.1% of net sales from 29.3% of net sales in the prior year's second quarter. The improvement in gross margin reflects a reduction of unabsorbed labor and overhead costs within our manufacturing operations as well as a shift in customer and product mix by geography.

Operating expenses were 10.5 million for the second quarter of fiscal 2014 compared to 10.2 million in the prior year. This increase includes expenses related to strategic initiatives such as support for our new IT platform and an investment in a new product development team. Operating income for Q2 was 534,000. As I mentioned before, our challenge is to find opportunities to reduce costs which allows us to strategically invest in materials of growth.

Interest income for the quarter was 255,000 and FX was a slight gain of 14,000. Income from continuing operations before tax was 788,000. Our tax provision from continuing operations for the quarter was $157,000 or a 20% effective tax rate. For the total year, our cash tax requirements will remain low while our effective tax rate will be around 36%, excluding any discrete tax events.

So, income from continuing operations for the quarter was 631,000 or $0.04 per diluted common share. Sales for the first half of fiscal 2014 were 69.7 million, down 3.5% compared to 72.3 million during the first half of last year.

Gross margin increased to 30.4% compared to 29.6% during the first half of fiscal 2013. Operating income was 0.7 million compared to 1 million last year and our income from continuing operations was 2.6 million compared to 1.3 million during the first half of fiscal 2013.

Turning to the balance sheet, cash and investments at quarter end were 134.1 million. Our increase in inventory since the beginning of our fiscal year of 1.3 million includes approximately 700,000 of inventory related to the WBS acquisition and another 500,000 increase due to foreign currency translation related to the recent strengthening of the euro relative to the U.S. dollar.

Also, cash from operating activities during the second quarter was a source of cash of 249,000, which is cash flow net of any effects from foreign currency exchange and acquired businesses.

Looking to the third quarter, we are expecting sales to be in the range of 34 million to 36 million, up slightly from the prior year. The current market dynamics remain challenging and therefore we are cautiously investing in growth initiatives. We are diligently working on our long-term objectives which are to identify opportunities to grow sales, to cut costs, and to create shareholder value.

Now, I'd like to turn the call over to Wendy to discuss the operating performance of Canvys.

Wendy Diddell

Thanks, Kathy. Good morning, everyone. Canvys finished the second quarter with sales of $9.3 million. This was slightly better than the first quarter but 11% below second quarter last year. Gross margin was 27% which was up from 26.6% during the first quarter and flat with second quarter last year. The team's done an excellent job reducing in-bound trade costs as a percent of sales through better planning and a reduction in expedited freight requirements.

Within our custom OEM display segment, which designs and sells customer-specific display solutions, our European business continued to show improvement in the second quarter. Sales were higher than the first quarter and better than last year's second quarter sales on significantly improved margins. New business played a critical role in sales growth. The North American OEM segment was down compared to the second quarter of fiscal year 2013. The decrease is attributable to the relocation and temporary suspension of purchases by one of our key accounts.

The volume of quotes for new business continues to strengthen and backlog remains steady. During the second quarter, we began shipping several new displays to high profile customers in both the medical and industrial markets. Margins continued to be solid indicating that our customers see value in our engineering and other services we provide. While cost reduction pressure from our customers is tough and ongoing, the team has done an excellent job selling the benefit of customized solutions but also working through options to lower costs. We are constantly balancing costs, new technologies, features and benefits with our customers and our suppliers.

With our ongoing focus on our two flat displays, we anticipate that margins will continue to hold steady or improve, and we expect to reduce our turnaround time on delivering new production requirements. We are also investing time and resources in developing unique display solutions which we can tailor to our customer requirements. Consolidating margin demand around core components allows us to improve our purchasing power and control our own destiny, while increasing our value on perception as a technology leader to our customers.

In our healthcare segment, which includes the sale of picture archiving into new patient systems or PACS displays directly to hospitals, we continue to be challenged with tight capital expenditure measures and compliance issues associated with new healthcare legislation. In 2013, IHS, a leading provider of critical information, which focuses on the healthcare industry reported that hospital spending reached historic lows with purchases increasing less than 2% over prior year. This was evident at the RSNA Show in November.

Attendance was on par with 2012, but in 2012, attendance was down 12% versus 2011. However, on a positive note, it is anticipated that many displays are at the end of their warranty periods and will need to be upgraded. This coupled with economic improvements is driving cautious optimism that the demand for medical grade displays, particularly those used by radiology and surgical segments will rise significantly over the next three years.

In spite of market conditions, revenues in our healthcare segment improved during the second quarter. While sales were still below the second quarter of last year, sales were much stronger than we reported in the first quarter of FY14. Our backlog in healthcare is building and we've enjoyed several nice project wins in the quarter. Two of the largest PACS software companies, McKesson and [Sectra] (ph), recently announced they are opening up their software such that hospitals may select and buy hardware through sources other than the PACS software provider. This is a good opportunity for us as it expands the size of this available market. We will begin shipping our new 6 megapixel displays this week which will further help us grow revenues in the quarter.

We further believe that if Richardson Electronics expands its footprint in the diagnostic imaging replacement parts market, our opportunities to sell PACS monitors will expand as our reputation as a high quality replacement products provider coming into the market. Our expanding healthcare strategy will improve our potential to sell in new geographical regions such as China and Latin America where healthcare facilities are just transitioning to digital technology, but it's also an opportunity for us to revisit the PACS display market in parts of Southern Europe which have been notably slow in adopting PACS.

We will continue to closely manage Canvys expenses and look for ways to improve working capital efficiency. We currently have excess capacity but we do not want to negatively impact our ability to grow revenues in light of economic improvements and changes in our corporate strategy.

Ed will now provide an update on EDG.

Edward J. Richardson

Thanks, Wendy. EDG sales in the first quarter were 26.2 million, the same as the prior year. Gross margin increased to 32.5% from 30.3%. We saw signs of global economic improvement as the Asia-Pacific region sales increased 6.5% and Europe finally stabilized.

Demand for industrial products in the textile, wood and plastic industry has continued to improve and as a result our industrial heating business increased approximately 15% in the quarter. CO2 laser tube business and associated consumable parts also performed well. On a year-to-date basis, our marine and vacuum capacitor businesses as well as Powerlink, our satellite amplifier repair business are also up.

We're seeing many, many inquiries for new applications for both RF and microwave generators across various markets and applications including mining, industrial heating, cooking, drying and plasma. We've recently booked substantial orders for microwave generators in China with additional significant projects in the pipeline. The initial prototype order for one project exceeded $1 million in revenue. The customer has the potential for more than 100 of these systems to be installed over an extended period of time.

As mentioned in the first quarter, we now establish a new product development team to support this growth led by Ted Staub, former engineering manager of Microwave Cavity Labs. MCL was recently acquired by CPI and the manufacturing facility has been relocated to California and Canada. Several of the MCL engineers have now joined Richardson Electronics as part of our product development team under Ted's management. They will focus on high voltage power supply used in microwave generators and other high powered amplifiers.

We've also added technical support resources in key countries to provide superior customer assistance and drive our sales of more sophisticated engineered solutions such as microwave generators and power supplies. Our goal is develop our own intellectual property which we believe will not only create growth to the company but also give us more control over our future. We will develop standard products which can be modified to specific customer applications.

We're also quite pleased with the progress of the engineering firm that we acquired in July in Germany to expand our activity into the power capacitor market. We estimate the power capacitor market to be 200 million annually. The additional resources have helped expand a number of products that we now offer to the power capacitor market. We are also strengthening our ability to offer solutions to the OEMs.

Historically, our focus has been on the replacement market. With our expanded engineering resources we're developing unique products and expanding our product range with new partnerships. This strategy also requires more training at the sales level to ensure we bring value to our customers.

As a result of our investment and effort, our revenue and backlogs of power capacitors is increasing. As we look to the future of Richardson Electronics, we've continued to build a line of replacement parts for the diagnostic imaging market. Our initial focus is on glassware which includes flat panel detectors as well as CT and X-ray tubes. We're heading a line of flat panel detectors and other high value components and subassemblies to accomplish our objective through a combination of acquisitions, strategic partnerships, organic growth programs.

Retail [ph] is the major opportunity to become an independent supplier to the healthcare industry of high quality replacement parts at price levels well below the OEMs. We're confident that our sales in the diagnostic imaging replacement parts market will expand substantially in the balance of FY14 and more significantly in FY15 and beyond which will gradually expand Richardson Electronics position from the legacy power grid 2 provider to a key player in the healthcare industry.

We repeat our commitment to our shareholders that we'll use the funds received from the sale of RFPD in March 2011 to make strategic acquisitions, invest in growth strategies and repurchase stock. Today, we spent approximately $6 million on acquisitions which have provided additional resources, customers and knowledge-space support to EDG.

We're investing in resources to develop our own intellectual property and to support more sophisticated sales in the field. We've spent $56 million on our stock buyback program which has reduced the number of sales outstanding to 14 million. We're confident that our acquisition program will expand substantially in the near future which will ultimately result in increased revenue and earnings growth.

While our economic conditions have made sales growth challenging, we do see the global economy slowly improving. At the same time we worked hard to improve efficiencies throughout the company and reduce costs within the business wherever possible.

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

Question-and-Answer Session

Operator

(Operator Instructions). Your first question comes from the line of Mark Zinski representing 21st Century Equity Research. Please proceed.

Mark Zinski - 21st Century Equity Research

Good morning, everyone.

Edward J. Richardson

Hi, Mark.

Mark Zinski - 21st Century Equity Research

Ed, just wanted to start off with kind of a higher level question, just ensuring our phenomenon with some manufacturing moving from Asia to Mexico, I'm wondering if you've seen any impact from that on your business, and given your pretty wide geographical network, are you pretty much able to accommodate that?

Edward J. Richardson

I guess we've seen some of it. We've seen more manufacturing moving from China to countries like Vietnam and possibly India and things of that nature. And certainly we have 25 foreign subsidiaries all over the world, and so it's not an issue to us wherever the customer wants to buy product, we can handle that efficiently. We can move product from anywhere in the world to anywhere in the world in one to three days.

Mark Zinski - 21st Century Equity Research

Okay, so there's no real impact on your cost structure from any of these geographical shifts in your …?

Edward J. Richardson

We're well represented in each one of those countries with sales engineers and we can handle the move seamlessly.

Mark Zinski - 21st Century Equity Research

Okay, great. Next, I've got a few questions for Kathy. Kathy, gross margin bumped up nicely on EDG, and I am just wondering if there were any kind of permanent actions taken to improve that, and is this gross margin sustainable at all?

Kathleen S. Dvorak

Let me take that in pieces and then I'll let Ed comment as well. One of the biggest pieces as I mentioned in my commentary was the fact that previously we had lower capacity and manufacturing, so we had unabsorbed overhead which impacted EDG's margins. Things have improved in that area and as a result, it has contributed to the improvement in margins. From a product standpoint, I'll turn it over to Ed.

Edward J. Richardson

Well, if you’ve watched the fluctuations in our inventory levels, we're inclined to take advantage of buying at old prices and we see price increases from our major vendors, and we've seen some of that and you saw the inventory bump off in the first quarter of the year and now start to level off in EDG, and that was taking advantage of old prices which have increased the margins to some extent, but we do that on a perpetual basis whenever we can.

Mark Zinski - 21st Century Equity Research

Okay, great. And then Kathy, do you have any visibility on FX volatility for next quarter? I know it was – the euro strengthened a bit but have you guys done anything strategically in terms of moving cash around?

Kathleen S. Dvorak

We try very hard to keep currencies in the base currency in those countries. I think we've done as much as we can to mitigate holding U.S. dollars in our foreign entities. Other than that, I don't have a lot of visibility into foreign currency.

Mark Zinski - 21st Century Equity Research

Okay. And then was there any one-time costs in SG&A this quarter?

Kathleen S. Dvorak

Not one time, just as I described again in my commentary, there were additional costs related to the investments in building the new product development group.

Mark Zinski - 21st Century Equity Research

Okay. Would you be able to quantify that at all or was it material?

Kathleen S. Dvorak

400,000

Mark Zinski - 21st Century Equity Research

Okay. And then I guess lastly for Wendy, I'm just wondering what the sentiment is with your customer base regarding the Affordable Care Act? Are they still – are folks still kind of nervous and unsure what the impact is going to be or any comments there would be helpful?

Wendy Diddell

Definitely. We're seeing that at the hospital level where again money is tight. They are very conscious still trying to take cost out of their organizational structures and out of their operational costs, and so we see them kind of holding back for as long as they can on hardware purchases. I think that they're still investing what available resources they have more in electronic medical records and that side of the business, so I would say definitely they are still waiting to see exactly how all the rules are going to play out and how much money they're going to get in reimbursement.

Mark Zinski - 21st Century Equity Research

Okay, so then really – we still really haven't seen any beginning effects from the Affordable Care Act yet per se?

Wendy Diddell

Not in a positive way if you're saying not in terms of increased demand for new equipment purchases.

Mark Zinski - 21st Century Equity Research

Okay. And then – I'm sorry, one more question, Ed, on the acquisition front, are the multiples looking any better? Any color you can provide on how the acquisition strategy is going would be appreciated.

Edward J. Richardson

Okay, I wouldn't say the multiples have changed a whole lot. It depends on what segments you're looking at. Obviously, the three little acquisitions we've done were primarily in the tube distribution business and the service business and those multiples are pretty reasonable. We're working hard on several acquisitions. The problem is it takes a willing buyer and a willing seller, so we don't have control over a portion of that equation. We're hopeful that we'll see something rather substantial here in the next six months or so.

Mark Zinski - 21st Century Equity Research

Great. Okay, that's it from me. Thank you.

Edward J. Richardson

Thank you.

Operator

Your next question comes from the line of Roman [ph] representing Gates Capital. Please proceed.

Dax Vlassis - Gates Capital Management

It's actually Dax. Ed, I was wondering on the share repurchase program this quarter, were there points where you were restricted from buying stock during the negotiation on acquisition?

Edward J. Richardson

Yes, we obviously had some insight information for sure, and so we were rather cautious during the quarter.

Dax Vlassis - Gates Capital Management

Okay. And on the acquisition side, you’ve talked about potential for some acquisitions and they kind of fell through and for whatever reason, we're not pointing fingers that you should have done them or shouldn't have done them, but kind of hearing a similar line of thinking hopeful of substantial acquisitions coming up, are these different than the ones you were discussing before? Have those traded and these are totally new companies or is this re-engaging with some of those potential acquisitions, and if we're starting off fresh from new ones, why do you think something will happen soon?

Edward J. Richardson

It's sort of a mix. We saw some of the acquisitions that we weren't willing to pay up for, the unsuccessful as far as being sold somewhere else and some of those have come back to take a second look as to what we might be able to do and some of them are new acquisitions as well.

Dax Vlassis - Gates Capital Management

How would you define substantial?

Edward J. Richardson

$50 million in revenue.

Dax Vlassis - Gates Capital Management

Okay. And then on the operations side, I think you mentioned something when you're talking about the microwave in Asia, you said you had one order of $1 million for one order and did I hear you right? You said that there could be the need for up to 100 of these over time?

Edward J. Richardson

Yes, it's a very exciting application and we don't want to go into a lot of detail because it started late on our roadmap for some of our competition, and at this juncture we have an exclusive position on this particular project. But we're excited about it. We had the opportunity to visit the prototype system just before Thanksgiving and it's working very well. They've processed a very substantial amount of material through this system and they've proven the prototype works. This particular industry is government owned and regulated and the government has now approved this system, so we're really positive that this could be something for the future that's quite substantial. It's going to take a long time. This first prototype system took six months to install. Fortunately, the company that's doing the installing work is backed by a major company within China. They have lots of cash resources, so if this takes off it will staff up to facilitate the process.

Dax Vlassis - Gates Capital Management

When you said up to 100 over time, did you mean like within a couple of years or are you talking about a longer timeframe?

Edward J. Richardson

I'd say three or four years into that nature. The problem right now is the length of time that it takes to install the system, the system is – to give you some idea it's in a building that's probably 240 feet long and 75 feet wide. It's a rather complex system that these generators are used in multiple conveyors and three different phases. Fortunately the prototype engineering is completed and it works well and we're just about to receive an order for a second system right now, but it's just going to take time to get these installed.

Dax Vlassis - Gates Capital Management

Would these be at similar gross margins to the overall segment?

Edward J. Richardson

Yes.

Dax Vlassis - Gates Capital Management

Okay, thanks a lot.

Edward J. Richardson

Thank you.

Operator

(Operator Instructions). You're next question comes from the line of Michael Collis [ph]. Please proceed.

Unidentified Analyst

Hi, Ed, Mike Collis. I was just wondering having followed up on a lot of this, how is any of the Avnet services from that acquisition a few years back, I know you did some of that and that (indiscernible)?

Edward J. Richardson

Mike, it's Arrow and Arrow and Avnet are always confused. We do it too. Yes, they still – they have leases on the office facility and some of the warehouse here that's five years and we're three years into that program, so there are two more years to go and we continue to provide them services.

Unidentified Analyst

And I was just wondering what kind of return do you get on investing for cash?

Edward J. Richardson

Yes, Kathy I'll let you work with that on.

Kathleen S. Dvorak

It's a balancing act because our cash is distributed and it's around the world and we need to have liquidity in the event we are able to pursue some of these acquisitions. Obviously at this point a return on cash is measured in basis point.

Unidentified Analyst

Is there anything that precludes it from extending the curve out because if we have the cash, maybe it seems like there will be some 2% or something like that two or three years out and you could still borrow against the funds if you do make an acquisition or need it?

Kathleen S. Dvorak

That is a possibility and yes, we have invested in certain – even CDs. I mean we've been able to go out a year or two and get higher returns, but unfortunately it's nothing like what we would like.

Unidentified Analyst

Okay. Well, I hope you'd address that in the future because it seems like the opportunity for the last three or four years would have about doubled the bottom line if we get some better interest. Thanks for answering my questions.

Edward J. Richardson

Thank you.

Operator

(Operator Instructions). At this time, there are no further questions. I would now like to turn the call back over to Mr. Ed Richardson for closing remarks.

Edward J. Richardson

Well, thank you again for joining us and for your ongoing support of Richardson Electronics. We look forward to discussing our fiscal 2014 third quarter results with you in April. Wish you all the best for a happy, healthy and prosperous New Year. Thanks a lot.

Operator

Thank you for your participation in today's conference. This concludes the presentation. You may now disconnect and have a great day.

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