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Executives

Don Duda – President and CEO

Doug Koman – VP, Corporate Finance and CFO

Analysts

Jeremy Hellman – Divine Capital Markets

Keith Schicker – Robert W. Baird

Methode Electronics, Inc. (MEI) F2Q2011 Earnings Call Transcript December 9, 2010 11:00 AM ET

Operator

Greetings and welcome to the Methode Electronics fiscal 2011 second quarter earnings presentation. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. (Operator instructions) As a reminder, this conference is being recorded. This conference call does contain certain forward-looking statements, which reflects management’s expectations regarding future events and operating performances and speak only as of the date hereof.

These forward-looking statements are subject to the Safe Harbor protection provided under the securities laws. Methode undertakes no duty to update any forward-looking statements to conform the statement to actual results or changes in Methode’s expectations on a quarterly basis or otherwise. The forward-looking statements in this conference call involve a number of risks and uncertainties.

The factors that could cause actual results to differ materially from our expectations are detailed in Methode’s filings with the Securities and Exchange Commission, such as our annual and quarterly reports. Such factors may include, without limitations, the following

dependence on a small number of large customers, including two large automotive customers; dependence on the automotive appliance, computer and communications industries; seasonal and cyclical nature of some of our businesses; dependence on the availability, price, and risk of substitution or counterfeit of components and raw materials; ability to compete effectively; customary risks related to conducting global operations; ability to keep pace with rapid technology changes; ability to avoid design or manufacturing defects; ability to protect our intellectual property; ability to successfully benefit from acquisitions; currency fluctuations; unfavorable tax laws; and the future trading price of our stock.

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

Don Duda

Thank you Kristine, and good morning everyone. Thank you for joining us today for our fiscal 2011 second quarter financial results conference call. I am joined today by Doug Koman, Chief Financial Officer; and Ron Tsoumas, Controller. Both Doug and I have comments today and afterwards, we will be pleased to take your questions.

This morning, I am pleased to report that the second quarter of fiscal 2011, Methode continued to post strong net sales, which improved 8.2% year-over-year, and 8.5% sequentially over the first quarter, led by improved sales in our Asian automotive and power product segments as well as in our North American and European semiconductor segments.

We achieved this revenue improvement despite the loss of the Delphi business, which represented 6.6 million in sales in the second quarter of last year, and planned lower legacy automotive products sales of 3.9 million. Excluding these two items from the year-over-year comparison, second quarter fiscal 2011 sales increased 18.6 million or in excess of 21% over the last year, which I believe reflects the true measure of our success.

For the first six months of fiscal 2011, net sales increased 8.8% compared to the same period of fiscal 2010. Excluding the loss of 14.1 million in sales to Delphi and planned lower legacy automotive products sales of 10.2 million, sales increased 40.9 million or almost 25%. As we announced this morning, Methode recorded an expense of 3.8 million in the second quarter for unsecured claims Methode had filed against Delphi in Delphi’s bankruptcy proceedings, which we sold to Credit Suisse in 2006 and they subsequently assigned to Blue Angel.

We recorded this expense as mandated by accounting rules, although we believe we have defenses to the complaint. This expense adds a considerable negative impact in earnings in the second quarter of fiscal 2011 and as a derivative of the unusual manner in which Delphi filed and served the preference complaints.

Additionally, we had several other charges and costs in the second quarter that makes an apples-to-apples comparison a little difficult. Doug will expand upon these in his discussion, but let me give you a brief overview.

Consolidated gross margins were 22.1% in both the fiscal 2011 and 2010 second quarters. Even though our sales increased year-over-year, gross margins in the second quarter remained constant due to the loss of sales to Delphi, which was a higher margin business line for us, and our negotiated program termination charge, which was part of the negotiations on a recent major program reward. For the same reason, consolidated gross margins were down 1% early in the first half of fiscal 2011.

Moving on to the segment results, in the second quarter, automotive segment sales were down 2.5% year-over-year, again mainly due to the loss of sales to Delphi and the planned lower legacy automotive product sales. If we take these two items out of the second quarter, automotive segment’s net sales increased almost 20%. Again excluding Delphi and legacy automotive, sales in six-month period, net sales increased over 25% year-over-year.

If we also exclude the planned transfer of manufacturing with the (inaudible) China, North American automotive segment sales increased 40% and Asian sales increased 63% in the second quarter. This was primarily the result of the upturn in the U.S. automotive market. Sequentially, the second quarter automotive sales were up more than 11% over the first quarter.

Automotive segment gross margins in the second quarter and first half were negatively impacted by the loss of the higher margin sales to Delphi as well as other charges and costs in the quarter. As we launch more programs, margins should improve.

As we have said in previous calls, we expect the MyFord Touch Center Console Program will ramp in the third quarter. We expect the lead-frame business to continue to do well. As such, we expect second half automotive sales to mirror the first half.

Interconnect connect sales increased almost 20% in the second quarter and nearly 29% in the first six months. This was attributable to solid growth in the interface solutions and data solutions businesses. Sequentially, second quarter Interconnect sales were up 5.7% over the first quarter. However, Interconnect sales may be flat to slightly down sequentially in the second half, as we are expecting some softening in appliance sales. Interconnect margins in the second quarter and first half exceeded our target margins for this business, due primarily to higher sales volume and a good sales mix.

Power Products sales were up almost 28% in the second quarter and nearly 15% in the first half, driven mainly by higher demand for busbar products in Asia and North America. Sequentially, second quarter Power Products sales were up over 4% over the first quarter. Gross margins decreased year-over-year in the second quarter due to a customer program cancellation and associated expenses, which we are seeking to recover, as well as from higher costs related to new products development.

As we said last quarter, the majority of power business awarded in the last six to 12 months that will launch in fiscal 2012 is higher margin business and as such, we expect the segment’s margins to improve overtime.

On to new business wins and ongoing solutions development for our customers, in the third quarter of last fiscal year, we told you about several opportunities in our North American automotive business, which represented significant future revenue potential, more than $100 million annually.

Thus far, in this fiscal year, we have been awarded three of these opportunities, with the remaining three still evolving. First, as we announced last month, we were awarded a next-generation center stack program for multiple General Motors vehicle platforms, starting in model year 2013, with an expected five-year program life.

This program is expected to represent over 57 million in fiscal 2013 revenues, and over 100 million in revenues per year, starting fiscal 2014. Additionally, we were awarded small center console programs for Kia and have produced a prototype center console for Hyundai [ph]. Methode won these programs because of our innovative work with Ford on the center consoles in its MyFord test platforms and because of the unique touch screens we developed for our premium appliance customers. Methode’s technology and solutions in both the automotive and appliance markets allowed us to provide a complete solution for these automotive OEMs.

Second, we booked additional transmission lead-frame business with our current customer. This award represents more than 17 million in revenue, beginning in fiscal 2013, peaking to 21 million in fiscal – for 2012, peaking to 21 million in fiscal 2013. We continue to pursue additional lead-frame opportunities for other domestic and European OEMs.

Third, we were awarded a prototype program for a major Asian OEM, utilizing our biometric sensor for driver identification to authorize telematic transactions. The other three opportunities we discussed in North American automotive which are still evolving all utilize our MDI technology. We will keep you apprised of these opportunities.

Beyond those opportunities and also on MDI, we are launching a sensor to be used on e-bikes for Bosch in Europe. E-bikes are traditional pedal bikes with an electric motor, which provides electronic pedal-assist, but can still be ridden on bike paths in Europe. Our MDI sensor determines how hard the biker is working, which allows the optimum amount of mechanical support.

For instance, if a wind comes up, the e-biker must pedal harder to maintain the same speed. The sensor reacts to this and extra power from the motor supply. This program could represent in excess of $2 million in revenue in fiscal 2012 and demonstrates the versatility of the MDI technology.

In user interface, Methode was contracted by a leading worldwide manufacturing welding equipment to develop a concept for multi-featured UI panel to be used across a wide range of welding machines. Already Methode UI and power customer, we approached this customer to demonstrate the rest of our technology toolbox. It turned out that our touch sensor technology – touch screen technology was of key interest for this customer, because of its robustness for the environments in which welders must operate.

Also in user interface, we are pursuing two opportunities, utilizing our multispectral imaging biometric sensors. One with a forklift company as part of their operator identification system and the other for a company involved in fleet management. Both companies have commented that our Lumidigm biometric sensor is the most robust they have seen.

Finally in power, we are working with a military contractor on an auxiliary power unit, which utilizes several products from our power solutions group. It is important to note that the majority of these awards we received in this fiscal year won’t get our revenue line until fiscal 2014, as it takes 18 to 24 months from the date of an award to the launch of a program, and about 36 months to reach full production of volume.

We continue to rebuild our revenue stream by serving large growth markets by providing solutions that deliver genuine value for our customers and higher margins for our shareholders, and by focusing on innovation and integration of patent and technologies. Our goal is to reach our historical revenue high of 551 million in fiscal 2014, which includes all the new business wins we discussed today. In summary, we are encouraged by ourselves improving in the first half of fiscal 2011, and at this point, expect similar results in the second half.

Now, I will turn the call over to Doug, who will provide further details regarding our financial results. Doug?

Doug Koman

Thank you, Don, and good morning everyone. I am glad to keep my comments brief today, since we provided detailed information about our consolidated and segments’ results in both our earnings release and 10-Q filings. Don mentioned that we had some significant items in both the current and last year’s results that makes for our difficult apples-to-apples comparison.

Let me walk you through some non-GAAP adjustments. For the second quarter, we reported a net loss of $0.5 million or $0.01 per share. This compares to net income of 2.1 million or $0.06 per share in last year’s quarter.

Excluding the 3.8 million Blue Angel charge and the negotiated program termination charge of 1.3 million, the current quarter’s net income would be 4.6 million or $0.12 per share. In last year’s results, if we excluded the negative effect of the 3.2 million of restructuring charges and the offsetting favorable effect of reversing a 1.7 million one-time pricing accrual, then last year’s second quarter net income would have been 3.5 million or $0.10 per share, therefore, on an adjusted non-GAAP basis, net income was 4.6 million this quarter compared to 3.5 million last year’s quarter or $0.12 per share this quarter versus $0.10 last year.

For the six-month period, we reported net income of 3.6 million or $0.10 per share. This compares to 2 million or $0.06 per share in last year’s six-month period. Excluding the $3.8 million Blue Angel charge and the negotiated program termination charge of 1.3 million in the current six-month period, net income would be 8.7 million or $0.23 per share. If last year’s results excluded the negative effect of 6.8 million of restructuring charges and the favorable effect of reversing a $1.7 million one-time pricing approval, then last year’s six-month period net income would have been 7.1 million or $0.19 per share. So, on a non-GAAP basis, net income was 8.7 million in the current six-month period compared to 7.1 million last year or $0.23 versus $0.19.

Just some comments on cost of products sold. In the current quarter, as a percentage of sales, it was 78.9% compared to 79% last year. The comparison would have been better this year except for a few unusual items in the current quarter, such as the negotiated program cancellation charge of 1.3 million. We had some vendor supply issues on a new product launch that was about 600,000. We had a customer cancellation charge of 400,000, and we incurred slightly higher environmental charges this year of about 300,000. So, those negatively impacted the cost of products sold as a percent of sales this year.

Likewise, in the six-month period, cost of products sold as a percent of sales was 79.5% this year compared to 79% last year. And again, the comparison would have been better except for the negotiated program cancellation charge, vendor supply issues on the new product launch which were about 700,000 in the six-month period, the customer cancellation charge, and about $0.5 million of additional higher environmental charges this year versus last year’s six-month period.

Looking at selling and administrative expense, in the quarter, selling and administrative as a percent of sales was 19.9% compared to 16.6% last year. If you just remove the Blue Angel charge, then selling and administrative this year would drop to 16.3%, which is slightly below last year’s 16.6%. This is encouraging especially since we are incurring slightly higher selling and administrative costs in the automotive segment to support some of the future growth.

For the six-month period, selling and administrative expense as a percent of sales was 18.3%. This compares to 17.2% last year. Again, if you exclude the Blue Angel charge in this year’s six-month period, as a percent of sales, selling and administrative would be 16.4% compared to 17.2% last year.

I wanted to point out that in the quarter, we did borrow 18 million under our credit facility. Currently, most of our cash is located outside of the U.S. And while we expect to generate cash in the U.S. through future domestic operations, and through the collection of refundable income tax and other cash repatriation methods, it may be necessary to borrow from our foreign affiliates or to borrow again under the credit facility for the near term.

In the quarter, we recorded a foreign exchange loss of approximately $2 million. This was primarily the result of the weakening of the Dollar versus the Euro. During the second quarter, the U.S. Dollar to Euro went from a high of 0.79 to a low of 0.71, about a 10% swing, so that’s significantly impacted the results.

The encouraging news is that based on the recent strengthening of the Dollar to the Euro, since the end of the quarter, the USD to Euro has come back to as high as 0.77. So, we will be looking to be opportunistic and lock in those gains when appropriate during the second half of the year.

Just finally a comment on operating cash, during the first six months, we generated 3.8 million cash from operating activities. However, this was about an 11.8 million less than we generated in last year’s six-month period. This was primarily due to the change in working capital and again, the change in working capital was primarily attributable to the higher sales activity. So, we saw an increase in accounts receivable, in inventory, this was partially offset by increase in accounts payable.

Additionally, the increase in inventory was also occurred because we were carrying some higher inventory for certain components that had been in short supply in the marketplace.

Don, that concludes my remarks.

Don Duda

All right. Thank you, Doug. Kristine, we are ready to take questions.

Question-and-Answer Session

Operator

(Operator instructions) Thank you. Our first question is from Jeremy Hellman with Divine Capital Markets. Please proceed with your question.

Jeremy Hellman – Divine Capital Markets

Hi, good morning guys. Congrats on a nice quarter.

Don Duda

Thanks Jeremy.

Jeremy Hellman – Divine Capital Markets

And thanks also for putting out that 10-Q earlier, I like that, makes my job easy. A number of things on my end. Just trying to get to what is, if you will normalize SG&A expense level, if you back up Blue Angel, that gets it down to 17.5 million for the quarter, and then there was program termination costs and write-downs and vendor supply, that’s another 2.6 [ph] or so, am I right? And thinking that will be backed out getting me down to about 15 million or so for kind of a base SG&A level?

Don Duda

Jeremy, just didn’t quite hear you, what were you backing out in Blue Angel?

Jeremy Hellman – Divine Capital Markets

Blue Angel, then 1.3 million of program termination costs, 0.7 –?

Don Duda

Yes, Jeremy, those are in cost of products.

Jeremy Hellman – Divine Capital Markets

That’s simple. That’s right, yes. So, I actually had my question upside down, and if I back those out of cost of products sold, that comes out to about 4.7% of revenues. So, for the auto gross margin, let me say, it’s going to pick up anyway based on what you have got coming down the pipe, but that gets it up to around 22 in change is kind of a go-forward basis for gross margin, is that, I am thinking about that right?

Don Duda

I think we have said that we were in the – going forward, probably the high teens. Yes, I don’t know that I would go as high as that – what you have taken out there, but I don’t think we would see that, I think high teens is a little bit –

Jeremy Hellman – Divine Capital Markets

Okay. And then, kind of thinking about the margins, again, when you mentioned your 2014 goal of hitting that $551 million revenue target, do you have any kind of framework around where you would like margins to be with that revenue level?

Don Duda

I would refer you to the – you are talking about gross margins?

Jeremy Hellman – Divine Capital Markets

Whichever margins you would care to comment on, EBITDA margins, gross margins, that margins, if you want to go that far.

Don Duda

I will let you go from a gross margin line down, but I would use what we put out recently on the gross margin ranges by segment.

Jeremy Hellman – Divine Capital Markets

Okay. Legal expense, I think in the Q, you mentioned that, that has come down a bit, how much was legal expense in the quarter?

Doug Koman

There is 600,000.

Jeremy Hellman – Divine Capital Markets

Okay. Legal?

Doug Koman

I am sorry, it was 600,000 less I think – I am sorry, it wasn’t 600,000, it was 600,000 less than last year.

Jeremy Hellman – Divine Capital Markets

Okay, last year.

Doug Koman

And as we commented, that will (inaudible).

Jeremy Hellman – Divine Capital Markets

So, is there anything in this quarter that’s currently scheduled that you would look to skew it in this quarter?

Don Duda

No, it’s hard to predict.

Jeremy Hellman – Divine Capital Markets

Okay.

Don Duda

No.

Jeremy Hellman – Divine Capital Markets

All right. One last one from me, and then I will jump back. Have you seen anything that would cause you to change your assumptions with Ford in the MyFord Touch with about 12 million second half this year, ramping to 40 next year and beyond.

Don Duda

We had a good launch with them from a standpoint of them filling their pipeline. They had a delayed launch. So, they picked it in the high gear recently. We are probably going to be into the mid-teens. I think we said 12 million, I think we will be in the mid-teens for the year, so that’s going to update slightly in the second half.

Jeremy Hellman – Divine Capital Markets

But and then looking into next year, any –?

Don Duda

I don’t know if I want to go that far. Let’s see how those products receive in the marketplace.

Jeremy Hellman – Divine Capital Markets

Okay, thanks.

Doug Koman

Thanks Jeremy.

Operator

(Operator instructions) Our next question is from David Leiker with Robert W. Baird. Please proceed with your question.

Keith Schicker – Robert W. Baird

Hi, good morning. It’s Keith Schicker on the line for David.

Don Duda

Hi Keith.

Keith Schicker – Robert W. Baird

If I step back, it looks like the quarter came in better than what you guys were initially looking for and an outlook provided in the last 10-Q, could you just comment on just indeed that is the case, how the results are compared with what your initial expectations were and what the swing factors were one way or another that push it higher or lower?

Don Duda

Certainly in automotive, we benefited from the uptick in the U.S. automotive business and then that drove in our Asian sales, T-76 Lead-frame sales were very good, (inaudible) sensor business, which all comes out of the Asians was quite good. So, that really helped us interconnect, which is a little harder to forecast, was stronger. So, I think this kind of a, maybe than expected takeaways from our customers across the board certainly benefited us.

Keith Schicker – Robert W. Baird

Okay. And then if I look at some of the items, the vendor supply agreement and the customer cancellation, a, if I want to back those out of the number, should I or is there any tax effect that I need to consider there, and, b, are those things that you would expect to continue going forward or are those just one-time items during this quarter?

Doug Koman

The customer cancellation, those kind of happen all the time. We just commented on that, because it did happen in fact year-over-year. The negotiated program charges, it was different, because that was kind of a quick pro quote as Don mentioned in his comments in order to win some new business. So, that one, we consider that’s more one-time, I think we have seen that before. As far as the tax front on that, that happened to be business in Malta, and in Malta, there is no tax impacts of both pre and post-taxes, the same amount likewise on – you are going to ask about the Blue Angel in the U.S. because of our situation with net operating losses, we have taken full evaluation allowance from that. And so, there is no tax benefit to be recorded on that.

Keith Schicker – Robert W. Baird

And then vendor supply agreement, is this component shortages, maybe we have heard other supplies talk about some electronic component shortages, is that what the issue is there?

Doug Koman

No, in that case, it was really a capacity issue at the supplier. They ran into problems, we incurred premium freights and significant overtime. You can treat that as one-time, but every couple of years, you have something like that. That’s not something that you have routinely. But occasionally, supplier has a problem, and last one was about five years ago, maybe with Setco [ph] when they went under. So, I will leave that to the side.

Keith Schicker – Robert W. Baird

Okay. And then if I look at the legacy business and the Delphi business, are we through the point now where that’s out of the prior-year comparison right now and that’s not going to be something that depresses the year-over-year revenue growth comparison as there is still a little bit more to roll off?

Doug Koman

Yes, going into third quarter, fourth quarter, it will be a good comparison, but obviously the year-to-date will have a little bit in it.

Keith Schicker – Robert W. Baird

Okay. And then Don, I got caught up with one of our comments before. The new T-76 lead-frame business, is that something that’s just newly announced this quarter, or was that just about the last quarter when you reported earnings as well?

Don Duda

We discussed it last quarter.

Keith Schicker – Robert W. Baird

Okay, so that’s –

Don Duda

I wanted to update from third quarter of last year where we had listed out the opportunities. (inaudible) Those are all included in the numbers you saw at the Baird Conference.

Keith Schicker – Robert W. Baird

Okay. And so, it looks like that revenue opportunity went up a little bit, though you are talking about $38 million now. I thought we had written down to 20 million last quarter? That, maybe I need to follow-up offline?

Don Duda

Let us follow up on that. It may just be the difference in the fiscal years, so let’s look that.

Keith Schicker – Robert W. Baird

Okay. That’s all I had for now. Thank you.

Don Duda

All right. Thanks Keith.

Operator

Mr. Duda, there are no further questions at this time. I would now like to turn the floor back over to you for closing comments.

Don Duda

Thank you, Kristine. That will conclude the call, and we wish everyone very pleasant and safe holiday season. Thank you.

Operator

Ladies and gentlemen, this does conclude today’s teleconference. You may disconnect your lines at this time. Thank you for your participation.

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