Spectrum Control, Inc. F1Q10 (Qtr End 02/28/10) Earnings Call Transcript

| About: Spectrum Control, (SPEC)

Spectrum Control, Inc. (NASDAQ:SPEC)

F1Q10 (Qtr End 02/28/10) Earnings Call Transcript

March 25, 2010 4:45 pm ET

Executives

Dick Southworth – President and CEO

Jack Freeman – SVP and CFO

Analysts

Ted Kuntz – Needham & Company

John Peterson [ph]

Operator

Welcome to Spectrum Control, Inc.’s 2010 first quarter conference call. Representing the company today, we have Dick Southworth, President and Chief Executive Officer and Jack Freeman, Senior Vice President and Chief Financial Officer. Their discussion of the company's operating performance for the first quarter and the February 28, 2010 should take about 20 minutes. They will then try to answer as many questions as reasonably possible. We expect to conclude this conference call at approximately 5:30 p.m. Eastern time.

As a reminder, the following discussion will include certain forward-looking statements which reflect management's current views with respect to future market conditions and operating performance. These forward-looking statements are subject to certain risks and uncertainties which could cause actual results to differ materially from historical results or those anticipated. These risks and uncertainties are described in detail in the company's most recent quarterly and annual SEC filings.

The words believe, expect, anticipate and similar expressions identify forward-looking statements. Listeners are cautioned not to place undue reliance on these forward-looking statements. Such forward-looking statements speak only as of the date on which they are made and the company does not undertake any obligation to update any forward-looking statement to reflect events or circumstances after the date of this call.

I would now like to introduce Mr. Dick Southworth, President and Chief Executive Officer of Spectrum Control.

Dick Southworth

Thank you, Joe, and we’d like to welcome you to Spectrum Control's 2010 first quarter conference call. I will briefly review some key operating and financial highlights for the period after which Jack Freeman will review our financial performance in more detail. We will be happy to take any questions after that.

For the first quarter of 2010, we reported net income of $2.4 million or $0.19 per share on sales of $37.9 million compared to net income of $2.2 million or $0.17 per share on sales of $33.1 million for the same period last year.

We are pleased to report 2010 first quarter financial results that are really consistent with our previous guidance, as current revenues were up 14% and earnings per share increased 12% from the comparable period of last year.

Our military business continues to grow, generating $23.2 million or 61% of our overall revenues during the first quarter; and that’s an increase of $3.5 million or 18% from the first quarter of 2009. In addition, for the first time since the worldwide recession began in late 2008, shipments of our products into our commercial markets increased over the comparable period a year ago.

In the first quarter of 2010, our commercial product sales were $14.7 million; that’s up $1.2 million or 9% from the same period of 2009. During the current period, we commenced the integration of our most recent acquisition generating $3.1 million of Micro Networks product sales in the first quarter. We also continued our strong cash flow, which has already enabled us to repay $3 million of the $7 million we borrowed to finance the acquisition last November 30th.

Total customer orders received in the current quarter were $35.3 million, an increase of $3.8 million or 12% from the first quarter last year. And for us that’s very encouraging, and we expect to build upon that throughout the remainder of 2010.

These are just some of the highlights and accomplishments of the first quarter of 2010. At this point, I would like to introduce Jack Freeman, our Chief Financial Officer and ask Jack to review our first quarter results in greater detail. When Jack has completed his presentation I will conclude with some final comments and we will open the floor to questions. Jack?

Jack Freeman

Thanks, Dick. Our consolidated net sales were $37.9 million in the first quarter of fiscal 2010, an increase of $4.8 million or 14.4% from the comparable period last year. This increase does reflect a $3.1 million of Micro Networks product shipment that Dick mentioned as well as additional shipment volumes for many of our products using military and defense and communication equipment applications. These shipment increases were partially offset by a $1.2 million reduction in sales for sensors and controls primarily associated with our precision positioning sensors and related assemblies.

Sales of our advanced specialty products were $11.7 million in the current quarter compared to $10.6 million in the first quarter of fiscal 2009. Our advanced specialty products are used in numerous industries, including military and defense, medical equipment and instrumentation, industrial controls and communications equipment. Shipments of our advanced specialty products increased across virtually all of our key markets during the current quarter.

Excluding the impact of our current period Micro Networks product sales of $3.1 million, sales of our microwave products grew $684,000 or by 5% from the same quarter of last year. This increase reflects additional shipments of our microwave products in support of numerous military and defense programs including applications and secure communications, radar systems, as well as counter measures for improvised explosive devices.

Sales of our power management systems increased by $1.1 million or nearly 39% the sales of $3.9 million in the current quarter versus $2.8 million in the comparable period last year. Shipments for these power products were particularly strong in applications for data storage and networking systems.

Sales of our sensors and controls amounted to $4.5 million in the first quarter of fiscal 2010, down $1.2 million from the same period a year ago. In the first quarter of this year, shipments of our custom position sensors were negatively impacted by the late order releases under certain military/defense as well as some commercial aerospace programs.

Overall, our average selling prices throughout all of our four businesses remained relatively stable during the first quarter.

Also in the first quarter of fiscal 2010, our gross margin was $8.9 million or about 23.4% of sales compared to about $8.3 million or 24.9% of sales for the same quarter last year. The decrease in gross margin percentage principally reflects increases in certain overhead costs associated with the Micro Networks acquisition, which I will try to explain a little bit further in a moment.

As a percentage of sales, our material and labor costs actually decreased during the current period, primarily reflecting changes in sales mix. Our aggregate material and labor costs were about $13.3 million or just a little bit above 35% of sales in the first quarter of fiscal 2010, and that compares to $11.8 million or almost 36% of sales for the same period a year ago.

Out total manufacturing overhead was $15.6 million or about 41.4% of sales in the current quarter, and that compares to about $13 million or 39.3% of sales for the comparable period of fiscal 2009. This increase, as a percentage of sales, principally reflects inventory charges upon the sale of acquired Micro Networks’ inventory, which had previously been written up for manufactured cost to fair value in accordance with generally accepted accounting principles associated with purchase accounting, as well as certain non-recurring manufacturing costs and inefficiencies from the initial integration of Micro Networks into our Microwave Components and Systems Business.

With certain of these costs being non-recurring, we expect our gross margin in the second quarter to return to a more normalized level of 25% to 26% of sales. In the second half of this year, we would anticipate further improvements in our gross margin percentage as we leverage our fixed manufacturing costs over expected additional sales volume and complete the integration of the Micro Networks acquisition.

At the end of the current quarter, we had a total workforce of about 1,400 employees, which is up about 6% from the end of last fiscal year. And as always, we are continuously reviewing our organization and cost structure to make sure that we maximize the efficiencies, while maintaining flexibility for additional production requirements.

During the current quarter, selling expense amounted to $2.8 million or about 7.3% of sales, compared to $2.9 million or 8.8% of sales for the same period last year. The reduction in our selling expense primarily reflects changes in sales mix and related decreases to our effective sales commission rate associated with the changes in sales mix.

Our aggregate general and administrative expenses were about $2.4 million in the first quarter of this year, versus about $2 million in the comparable period of fiscal 2009. The slight increase in our G&A expense reflects higher personnel costs and numerous other operating expense increases generated or related to our additional business activity.

With lower interest rates and reduced short-term borrowings, our interest expense decreased in the current quarter compared to the same period last year. During the current quarter, our weighted average borrowings under our domestic line of credit amounted to about $6.9 million, with an average interest rate of 1.23% on those borrowings.

During the first quarter of last year, our weighted average borrowings under our domestic line of credit were about $8.8 million with an average interest rate of about 2.44%.

For the first three months of fiscal 2010 as well as 2009, our effective income tax rate was approximately 35% compared to an applicable federal and state statutory income tax rate of approximately 40%. Differences between the effective tax rate and the statutory tax rate continued to primarily arise from domestic production activity deductions, state tax provisions and foreign income tax rates.

Net cash provided by operating activities was $2.5 million in the first three months of fiscal 2010; that’s an increase of over $700,000 or 41% increase from the first three months of fiscal 2009. In the current period, net cash provided by operating activities was positively impacted by improved inventory turnover rates which resulted in a $2 million reduction in our inventories.

In the first three months of fiscal 2010, our positive operating cash flow and our existing cash balances enabled us to repay $3 million of our short-term bank borrowings as well as fund capital expenditures of about $1.2 million.

At the end of the first quarter, our ratio of current assets to current liabilities was about 4.50 to 1.00, and our total bank borrowings were only $4.5 million for a bank debt to equity ratio of 0.04 to 1.00.

So as of the end of the first quarter, our total stockholders' equity was nearly $116 million, which reflects a book value of about $9.11 per share. We continue to believe that our strong cash flow and financial position provide a solid foundation for our expected future growth and enhanced shareholder value.

So with that, Dick will now make some concluding comments.

Dick Southworth

Thanks, Jack. Based on our current assessment of business conditions and our customers demand we presently anticipate our 2010 second quarter revenues to be between $38.5 million to $39.5 million, with earnings of $0.22 to $0.23 per share. If this operating performance is achieved it would represent an increase of between 15% to 17% increase in revenues year over year and a 22% to 28% increase in earnings per share year over year.

With our positive first quarter performance, a commercial marketplace that’s showing signs of the beginning of a rebound from the global recession, and operating margins that should improve during the second half of the year as we leverage our fixed operating costs and consolidate our recent acquisition, we remain very optimistic about the current year and beyond.

So at this point, we would like to open the discussion for any questions you may have.

Question-and-Answer Session

Operator

(Operator instructions) The first question is from the line of Ted Kuntz with Needham & Company. Please go ahead with your question.

Ted Kuntz – Needham & Company

Good afternoon, Dick and Jack.

Dick Southworth

How are you doing Ted?

Ted Kuntz – Needham & Company

Good, doing fine. Thanks. Couple questions for you. Could you go back over the gross margin again, what happened in the quarter exactly with Micro Networks? It sounds like you wrote off some inventory, did you write it down? I was a little confused as to what the inventory charge was. And was that the total extent of the shortfall?

Jack Freeman

Sure. Let me try to explain that a little clear. As you know, we consummated the acquisition of Micro Networks the last day of our last fiscal year, November 30. And in accordance with GAAP fair value accounting for business acquisitions, for inventory, particularly the work-in-process and finished goods inventory, those inventories have to be valued at fair value; and the part of the allocation of the overall purchase price has to be allocated to those inventories at fair value, which is not the same as their normal manufacturing costs. And so for example, when you acquire finished goods as part of a business acquisition the fair value really is not their manufactured cost, but their selling price less whatever direct selling expenses may remain in order to sell that product, plus you’re allowed to reduce it by a normal profit just on the selling activity.

So what happened and this was the first acquisition we’ve had in quite some time where we had some significant work-in-process and finished goods inventories that we acquired, we had to value those not at a normal manufacturing costs that would lead to a normal gross margin. So we had to write those up as part of the acquisition to that higher fair value. And so as a result, those products had – those work-in-process that [ph] we completed during the quarter and shipped as well as some of the purchased finished goods items, they carried about a $600,000 additional value or write up for manufacturing costs to fair value.

It was about $800,000 in total for all the inventories we acquired; $600,000 roughly or three-fourth of that inventory end up being converted in full during the quarter. So that added $600,000 to our manufacturing overhead and that all by itself, which will not recur as we go forward except for the –

Ted Kuntz – Needham & Company

The balance of the two.

Jack Freeman

The balance of the two.

Ted Kuntz – Needham & Company

Right.

Jack Freeman

That additional markup of inventory that ended up being charged to cost of sales in the first quarter as we sold the product. That increased our cost of sales as a percentage of sales by about 1.6% all by itself. So we would have been at a 25% gross margin if it hadn’t been for that. That’s a single biggest item that drove the – that impacted gross margin during the quarter. We also had some other items of a non-recurring nature that’s related to our initial operations of Micro Networks after the acquisition that also contributed to margins staying below expectation or below normal, but as we go forward with most of that acquired inventory now having been converted and sold and with the initial integration of the operations behind us for Micro Networks, we would expect our gross margin in the second quarter to revert to a more normalized level.

Ted Kuntz – Needham & Company

Okay. So basically the core margins from the core business are fine?

Jack Freeman

Yes, absolutely.

Ted Kuntz – Needham & Company

It’s just a particular impact and you will only have couple hundred thousand more of that to go through the system?

Jack Freeman

That’s correct.

Ted Kuntz – Needham & Company

Okay. At those lower margins that will be done. Okay. Perfect, thanks. And then, what did surprise me a little bit, maybe (inaudible) the SG&A was – you kind of made up to the numbers there, and I was surprised that’s lower than I was looking at because I was looking more of a fourth quarter run rate going forward. What’s your – given the higher volumes, I thought the SG&A would be a little higher, but it was not. So what can we expect from that line going forward?

Jack Freeman

Yes, I guess a couple of things just to take a step back and you mentioned comparing the current period SG&A to the fourth quarter run rate. You may remember that there were two or three non-recurring items that increased our SG&A in the fourth quarter, a settlement of an outstanding litigation related claim, as well as some employee and other relocation expenses that drove up SG&A in the fourth quarter.

Going forward, we continue to expect our SG&A as a percentage of sales to be around 14% to 14.5% of sales.

Ted Kuntz – Needham & Company

Okay.

Jack Freeman

But it is significantly – that run rate is significantly lower than the fourth quarter run rate and that’s because the fourth quarter had those –

Ted Kuntz – Needham & Company

Had those things. But I was thinking the acquisition would have added to it as well. But it didn’t?

Jack Freeman

No, really didn’t –

Ted Kuntz – Needham & Company

Add that much.

Jack Freeman

Right. And the other thing we did have a favorable – the change in sales mix did favorably impact our selling expenses in that our overall commission or our effective commission rate decreased in the current quarter with the mix of products that we sold that did not require any sales commissions; and that mix going forward that we incurred during – or realized in the first quarter, we believe that that is a fairly normal mix going forward. So we expect to continue to get some benefit from reduced effective commission rate.

Ted Kuntz – Needham & Company

Got it. Okay, great, terrific. Could you comment a little bit on each of the specific areas, just looking at the current order trends you are seeing in them? And maybe if you took them one at a time like in advanced specialty products you had a good book to bill there, and just give your thoughts about that business going forward. Microwave components book to bill is below one and then power management did drop off a bunch in terms of book to bill. So maybe you could address each of those areas for us and give us a little more color around the current business tone.

Jack Freeman

Ted, let me try to really summarize that. I think overall, our orders were really right on where we had planned, and our power orders were – even though our revenues were up significantly year over year, our orders were right to the planned levels that we had expected. We had a strong backlog; we ended with a strong backlog. Our backlog was over $70 million. And you may remember that we had a very strong book to bill in 2007, which was a plus $3 million and then we had $10 million plus in 2008 right before the recession started. And we had a 1-to-1 book to bill last year and then we had the backlog from each of our last two acquisitions.

So we’ve got a strong backlog going into the year and continue with a very strong backlog. Typically, first quarter we always have a sub – we usually have about a 0.95 book to bill.

Ted Kuntz – Needham & Company

Okay.

Jack Freeman

So our book to bill this quarter was no different. When we go into each of the product lines, we have – there is nothing alarming in any of them and typically our second quarter is our strongest quarter.

Ted Kuntz – Needham & Company

Great. That’s current [ph] bookings. Yes, it is, yes.

Jack Freeman

And we certainly expect that trend to be there for the second quarter.

Ted Kuntz – Needham & Company

Okay. So you see the business coming, and you’ve got a good sense that it will be a strong quarter booking wise?

Jack Freeman

Yes.

Ted Kuntz – Needham & Company

Okay. So that keeps you pretty much on track where I think we have you. And okay, that’s good. And let’s see if I had any – tax rate, do you expect for the year, Jack, is it really around the 35%, now 36%?

Jack Freeman

Yes, 35% is what it was in the first quarter and that’s what our expectation going forward.

Ted Kuntz – Needham & Company

Is for the year, okay, terrific. Okay –

Jack Freeman

And Ted maybe I can add one more point from the business activity sense our quoting activity continues to be very vigorous and very demanding of our people that we had seen no softening in the quoting side, if anything we’ve seen even in the commercial side more opportunity.

Ted Kuntz – Needham & Company

Yes, nice to see that business coming back a little bit.

Jack Freeman

Yes.

Ted Kuntz – Needham & Company

Yes, and you expect that to be continuing to grow, continuing to show some decent growth?

Jack Freeman

And the first market segment in the commercial side is the communications, which has been down –

Ted Kuntz – Needham & Company

– really great, yes.

Jack Freeman

And we’ve seen some pretty good opportunities there so far.

Ted Kuntz – Needham & Company

Okay, terrific. One last question, then is there anything of size that you could be looking at this year in terms of either booking or hopefully shipping as well? But any orders that we should be looking out for? I know we always talk about the crew business and I don’t know what’s going on there at the moment. Could you give us an update on anything that’s of size?

Jack Freeman

Of size? But I would say we expect this year that crew business to be up probably 20% year over year.

Ted Kuntz – Needham & Company

From what level, last year, again, if you could just remind us?

Jack Freeman

Up [ph] 12.

Ted Kuntz – Needham & Company

Up 12 million last year?

Jack Freeman

Yes.

Ted Kuntz – Needham & Company

And you expect it to be up 20% this year?

Jack Freeman

Yes.

Ted Kuntz – Needham & Company

Okay. And you have – what kind of visibility do you have on that?

Jack Freeman

I don’t know how to describe it to you, but pretty good.

Ted Kuntz – Needham & Company

Well, pretty good? That’s good. I mean, it’s not just a hopeful thing down on a wish list that will (inaudible). You have a good sense that this could be real business coming?

Jack Freeman

Yes.

Ted Kuntz – Needham & Company

Okay, great. Perfect, thanks very much.

Dick Southworth

Thank you, Ted.

Operator

(Operator instructions) The next question is from John Peterson [ph], Private Investor. Please go ahead with your question.

John Peterson

Congratulations on a fine quarter Dick and Jack.

Jack Freeman

Thank you, John.

Dick Southworth

Thank you, John.

John Peterson

I have two questions. The first is when will Micro Networks become accretive? And the second question, what impact will recently passed health legislation have on Spectrum?

Dick Southworth

Let me try to answer at least the first one. We did generate $3.1 million of revenue from Micro Networks in the first quarter, and it was accretive to our earnings. As we go forward, and as we are able to eliminate some of those non-recurring acquisition-related expenses and when we combine that with, during the second half of the year, a physical consolidation of the Massachusetts operation that was part of that acquisition with our previously existing Marlborough, Massachusetts operation, we expect that the margins and the extent of the accretive nature of that acquisition to increase. But it was indeed slightly accretive during the first quarter.

John Peterson

Congratulations.

Jack Freeman

On the health benefits, John, right now there is a negative impact because of all the COBRA – the laws with COBRA for people that have lost their employment that maybe on their family, there’s just a whole group of that impact us. And those dollars we don’t – I hadn’t really added them up. We know they’re probably six figures for the first quarter. But the overall impact of the new health law, we don’t have really an idea if there is going to be an impact on Spectrum [ph].

Dick Southworth

And I guess, at this point the most I could say is that we’ve started the process of trying to understand and assess the new law and have not quantified that yet. But certainly based on what we know we expect that it will have some, we believe, a negative impact to our – it will increase some of our health related costs. But to the exact extent at this point, we don’t have a good estimate at this time.

Dick Southworth

I understand. Well, thank you.

Dick Southworth

Thank you, John.

Jack Freeman

Thanks, John.

Operator

There are no further questions in queue. I would like to turn the call back over to management for closing remarks.

Dick Southworth

Well, if there are no further questions we thank you for joining us today. We will end this call. Thank you.

Operator

This concludes today’s teleconference. You may disconnect your lines. Thank you for your participation.

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