Daktronics' (DAKT) CEO John Kapoor on Q3 2016 Results - Earnings Call Transcript

| About: Daktronics, Inc. (DAKT)

Daktronics, Inc. (NASDAQ:DAKT)

Q3 2016 Earnings Conference Call

February 23, 2016 11:00 AM ET

Executives

Sheila Anderson - CFO

Reece Kurtenbach - Chairman, President and CEO

Analysts

Jim Ricchiuti - Needham & Company

Tristan Thomas - Sidoti

Operator

Good day ladies and gentlemen and welcome to the Daktronics Third Quarter 2016 Financial Results Conference Call. [Operator Instructions] As reminder, this call maybe recorded.

I would now like to introduce your host for today’s conference, Sheila Anderson, CFO. Please go ahead.

Sheila Anderson

Thank you, operator. Good morning everyone. Thank you for participating in our third quarter earnings conference call. I would like to review our disclosure cautioning investors and participants that in addition to statements of historical facts, we will be discussing forward-looking statements reflecting our expectations and plans about our future financial performance and future business opportunities.

All forward-looking statements involve risks and uncertainties, which may be out of our control and may cause actual results to differ materially. Such risks include changes in economic condition, changes in the competitive and market landscape, management of growth, timing and magnitude of future contracts, fluctuations of margins, the introduction of new products and technology, and other important factors as noted and detailed in our 10-K and 10-Q SEC filings. Fiscal 2016 is a 52-week year and fiscal 2015 was a 53-week year. The extra week of fiscal 2015 fell within the first quarter resulting in a year-to-date results in comparison to be 39-week versus 40-week comparison.

At this time, I would like to introduce Reece Kurtenbach, our Chairman, President and CEO, for a few comments.

Reece Kurtenbach

Thanks, Sheila. Good morning everyone. Our backlog was solid as we entered into the third quarter. While a portion of backlog is for projects we don’t plan to convert into sales until FY17, we had a large book of sports business ready to build and we are able to convert nearly $22 million of this backlog to sales during the quarter.

You may remember, we had delayed some of this build from second quarter since these projects had flexible lead times, we could then take advantage of new product enhancements in our module designs, while still meeting our customer commitments. This allowed us to achieve 4% increase in sales for the quarter as compared to last year.

Our third quarter remains historically lighter for sales and profit due to the seasonality of our business in sports, impact of weather on construction cycles, and the decrease in production days available due to holidays in the quarter.

Profitability is also historically impacted during the third quarter because of the cost of the capacity we carried through the quarter, yet still need to meet demand for the remainder of the year.

Our order bookings in our business are inherently volatile due to our project-based and large account based businesses. This creates unevenness in order flow creating difficulties in making comparisons over the short-term. Order bookings were down for the third quarter with the biggest decrease in our commercial business unit. For the quarter, orders in our billboard niche were down over 50% causing the decline in commercials compared to last year. Orders in our on-premise segment of commercial remains strong.

Year-to-date, orders are down 4% overall. Commercial orders are down $30 million due to the decrease in orders in out-of-home advertising and in the spectacular niche offset by the increase in orders in our on-premise segment. Our billboard business has been down this year across our major customer accounts and local independent billboard operators. We believe this lag is partially due to customer capital allocation decisions and due to high overall satisfaction with our product lifetime, leading to increased product replacement cycle.

We continue to maintain strong relationships with key national billboard companies and expect demand to pickup in the coming months as deployment activities pickup again in the spring. We focus on large multimillion dollar projects in our spectacular niche and have seen many projects were shelved in this segment. Many of the projects, we expected to be completed by now have not yet been awarded and we continue to see delayed decisions from customers due to the complexities and design permitting or obtaining capital needed.

International orders for the year are down nearly $12 million. While some difference is due to the natural volatility of our projects, we suspect that the volatility in the world economy, regional, political relationships and the US dollar is also having an impact. We are down primarily in out-of-home and spectacular niches internationally, while the transportation niche has been quite successful. Live Events orders continued to exceed last year on a year-to-year basis.

A large impact to profitability in the quarter was warranty expenses. In the past year, we have experienced failures on modules installed in certain outdoor environments used in 24/7 applications. While we have deployed a firmware update to mitigate this issue at a number of that risk sites, we continue to experience failures and have our planned repair modules for certain locations. We believe we are taking appropriate preventative measures and corrective actions to deliver to our customers, the quality experience we promised while minimizing the cost impact of the company. However, the issue is complex and could be more prevalent when these estimates entail. While we have reserved all probable warranty claims, we are unable to estimate total claims where there is reasonable possibility of further expenses due to the complexities and uncertainties and the failure rates. We believe this could lead us to incur additional warranty expenses in future quarters.

We are continuing to refine our reliability models to better predict future performance and the impacted population of installation. While these models are helpful in our analysis, we are few months away from having enough data to create a reserve for the remaining life of our displays operating under these conditions in the field. Because of this, I suspect we may have similar warranty charges in future quarters. We have qualified our new designs to higher levels of long term reliability to avoid these issues in the future. For more details on the financial results, I will turn it back to Sheila.

Sheila Anderson

Thank you, Reece. Sales for the third quarter of fiscal 2016 increased to $123 million as compared to $118 million last year. As on previous years, due to the seasonality within our business, the third quarter is generally the lightest quarter for revenues. This past quarter, sales were up primarily in our Live Events business as we continue to build-out the backlog from prior quarters. We were able to make great progress on the Vikings Stadium, the Cleveland Indians and the Las Vegas Arena, for example. The increase in live events offsets the declines in the commercial and international business units.

For the third quarter, gross profit was 17.8% this year and down as compared to 21.2% last year. Gross profit was impacted by the number of multimillion dollar projects in the quarter which was profitable capital or less profitable than orders due to the competitive nature and bid process in that market. The warranty impact was approximately $2.3 million which caused a decrease in gross profit percent of 1.9%.

Total warranty as a percent of sales was 4% for the quarter. As Reece discussed, we will continually monitor our warranty claims and provide a reserve for estimated cost upon initial sales recognition which is determined with respect to claims that we needed to increase the reserves in this quarter for the probable cause we know today. We will continue to monitor and adjust reserves as necessary.

Gross profit improved in Transportation and High School Park and Recreation business units due to increased volumes and higher margins on the sales mix. Gross profit decreased in the commercial business units for the warranty impact, decrease in utilization of a fixed cost infrastructure due to lower sales and in live events due to the mix of lower margin projects realized into sales.

Operating expenses for the third quarter were $27.6 million as compared to $26.6 million last year. The increase relates primarily to information technology maintenance costs in the general and administrative areas. We are entering the fourth quarter with $177 million backlog, approximately $50 million of this backlog relates to projects with customer needs beyond the fiscal year and we expect to convert sales beyond fiscal 2016 into 2017 primarily in the live events and transportation markets.

In addition, we have experienced a lagging of orders in our uncertain order volumes in commercial and international business units. This lag and the current planned scheduled for production of booked orders cause us to expect revenue to be slightly lower than last year fourth quarter. Gross profit predictions also remain dynamic pending the conversion of sales, but we expect gross profit to be similar to slightly down from last fiscal year fourth quarter as well. We anticipate operating expenses in dollars to be up slightly as compared to the fourth quarter of fiscal 2015, the general increases in personnel costs, information technology maintenance cost and increased design and development activities.

Our overall effective tax rate for the third quarter was a benefit of 64% due to our operating loss and due to the reinstatement of the research and development credits. Going forward, the research and development credit was made permanent which will avoid these catch-ups we have historically had due to the law changes.

We forecast an effective annual tax rate of approximately 36%. Our tax rate can fluctuate depending on changes in tax legislations and the geographic mix of taxable income. We reported negative free cash flow of $10 million for the first nine months of fiscal 2016 compared to positive free cash flow of $16 million for the same period of fiscal ‘15. The cash usage was primarily due to lower net income levels and timing increases in working capital due to project cash receipt and payments for inventory.

Our cash and marketable securities positions remain positive at $56 million at the end of the quarter. We expect our capital usage to be approximately $20 million for fiscal year 2016. Use of capital expenses is for manufacturing equipment for new or enhanced product production, expanded capacity investments in quality and reliability equipment, demonstration equipment for new products and continued information system infrastructure investments.

With that I'll turn it back to Reece for additional comments on our outlook.

Reece Kurtenbach

Thank, Sheila. The world economy remains dynamic with oil prices, uncertainty in interest rates, currency fluctuations, regional political unrest, the China’s growth or lack of growth rates. It appears that this volatility has created some uncertainty in our marketplaces. In addition, we continue to compete in a dynamic competitive environment with each company working to find their niche in this growing market. While these challenges may have some short-term impacts on orders, we have faced similar competitive challenges in our history and we believe the long-term outlook is still good. Our strategy is to continue to focus on things we can control, serving our customers in the growing market with high quality and reliable solutions which means their business needs over the long term.

In the coming year, the economic environment may have an impact on large projects or opportunities in commercial and international business. However, we continue to work with our customers to help them realize their visions for successful use of their video systems. We also continue to refine and enhance our global transportation products and see opportunities in Europe and the Middle East as those projects can take time to close and then delivery schedules can extend when revenue is recognized. We continue to see strong demand in our Live Events, High School Park and Recreation, and Transportation businesses. And compete strongly in our product offerings by providing full solutions to our customer’s desire.

Transportation quoting in the North America is also strong due to the recent passing of the US Transportation Bill. This allows for longer term planning at the state DOT levels and more availability of projects for the foreseeable future. Seasonal availability and the influence of large projects in our business will continue to affect individual quarters and fiscal years. As the order of picture for the short term becomes clearer we continue to monitor and limit the amount of cost added to personnel, our largest non-inventory cost. We also continue our strategies for continuous improvement in operational excellence, all of which will lower our overall cost to serve customers in the future.

We also will continue to utilize and improve our capabilities on quality and reliability during design and manufacturing of our products due to lower overall cost of warranty. Our market outlook over the coming year is positive, we see continued adoption of our products in all of our major markets. Our on-premise and out-of-home customers continue to turn to digital messaging solutions to advertise or communicate information to their audiences. Unique projects such as seen in Times Square or Las Vegas continue to be considered by developers and venue owners to help attract large sustained audiences. Our solutions in these markets have natural replacement cycles as the products have a known end of life. This provides us the outlook to continue to investment in customer centric solutions to meet the demands of the market.

With that, I would ask the operator to please open it up to questions.

Question-And-Answer Session

Operator

[Operator Instructions] Our first question is from the line of Jim Ricchiuti of Needham & Company. Your line is open.

Jim Ricchiuti

Hi, good morning, sure I missed your - I think you gave some broad guidance for revenues for the quarter, upcoming quarter Q4?

Sheila Anderson

We are anticipating slightly down from last year compared to last year's fourth quarter.

Jim Ricchiuti

So if we can maybe drill into that a little bit more. I would assume given the backlog you would expect live events to be up and some of the other businesses notably commercial, international and I guess possibly transportation down, is that how we should think about it?

Sheila Anderson

Yeah, I think live events will be similar as compared to last year depending on the project cycle; some of that backlog I spoke about is a little bit of a longer lead time. And then you’re right, the commercial market and international maybe a bit down from last year during the same quarter.

Jim Ricchiuti

And regarding margins, so if we take out this warranty charge, your gross margins are somewhere around 19.8%?

Sheila Anderson

Right.

Jim Ricchiuti

So, what obviously there was some of it volume driven but to what extent are some other issues in work. I mean how negative was the mix for you this quarter, I mean, I think what we are all struggling with is where do your gross margins bottom. We’ve just been seeing a steady downtrend in margins and it sounds like you're guiding to lower year-over-year gross margins again in Q4? So my question is how do we - how should we think about your margins going forward? I mean, at what point do we see some bottoming potentially some at least year-over-year improvement?

Reece Kurtenbach

I appreciate the question Jim, we had eat up some designs ready to go into production in early to mid-summer and as we started to dive into this BGA issue that we have been having – we chose to stay with the design we had and make it more reliable because we at least knew what that product would do and that caused us to delay the release of a number of these products until early in our Q3 and so that pushed out a number of activities that we had planned for our fiscal year and the cost of our products, which would help us improve our margins. So we think we've made it through this hard period and are working to get these strategies in place for our product competitiveness.

Jim Ricchiuti

So, if -- but it sounds like there are going to be lingering issues on the warranty side and you had broken up a little bit earlier, I wasn't quite clear if you're saying, are these warranty issues going to linger for a couple of quarters in fiscal ‘17?

Reece Kurtenbach

There is certainly uncertainty in any estimate we make, but I'd say a couple of quarters is reasonable.

Jim Ricchiuti

Okay. And just curious about the competitive environment, how confident are you that you're not losing some share in the billboard business. Sounds like you're in touch with your larger customers and you're anticipating some orders, but has there been any share shift to your knowledge in that market, in the billboard market or more broadly in the commercial market?

Reece Kurtenbach

It's our understanding, Jim, that our share in the billboard market is relatively consistent and that there was a shift in capital spent at least in the last half of calendar 2015.

Jim Ricchiuti

Got it. Okay. I'll jump back in the queue. Thank you.

Operator

Thank you. [Operator Instructions] Our next question comes from the line of Tristan Thomas of Sidoti. Your line is open.

Tristan Thomas

Can we maybe just kind of get back to the billboards? Initially, the shift to capital spend, is that just maybe economic uncertainty, lengthened replacement cycles, just pushing back the orders or are they transitioning to other forms of that, I think you maybe -- help there to kind of get a handle on that?

Reece Kurtenbach

I think that worldwide, out of home companies, especially in the billboard space, are using LED technology and it's proved to be profitable for them and we don't see another technology out there. As I tried to indicate in some comments, some of our customers had planned to replace, but the products that we had in the field are still performing well and so they pushed out their replacement for a period of time. How long they choose to do that is still an uncertainty, but the LED technology is very positive in this business.

Tristan Thomas

Okay. Could you maybe just give kind of a rough estimate of kind of the life expectancy of an LED billboard?

Reece Kurtenbach

In a billboard application 24x7, it's 7 to 10 years.

Tristan Thomas

Okay. Maybe just going back to the warranty reserves, what specifically can you do internally to get that percentage of sales down?

Reece Kurtenbach

We are doing many things internally. As we indicated, there is a software upgrade we can do to these systems to give us better visibility and control and mitigate this attachment, the mechanical attachment and then we have different ways to implement changes in the field and we've worked on how to do those changes to keep our cost down if we would choose to do work in the field.

Tristan Thomas

Okay. Just one final question, train station was up nice in the quarter, can you talk to what really drove that and then what your expectation is for them looking forward, was the Data Display incorporated or what's the -- little more color there would be great.

Reece Kurtenbach

Certainly, Data Display has been a nice acquisition for Daktronics and that integration is going well and I think some of the growth has to do with, they have access to products that Daktronics has as well as Daktronics has access to do products and services that Data Display had. Also, the overall mood in that market is up as they passed the US transportation bill. So in North America at least, that's a real positive. As well as in some of our other markets, they're continuing to invest in infrastructure. I think all of that together gave us a positive look at transportation this year.

Tristan Thomas

Okay, thank you.

Operator

Thank you. [Operator Instructions] And that does conclude our Q&A session for today. I would now like to turn the call back over to Mr. Reece Kurtenbach for closing remarks.

Reece Kurtenbach

Thanks everybody for your time this morning. We appreciate your continued interest in what Daktronics does. We have realized this has been a hard year, but like we said, we're optimistic about the future of our business and our ability to continue to perform in it. So I hope everybody has a great week. Thank you.

Operator

Ladies and gentlemen, thank you for your participation in today's conference. This does conclude today's program. You may all disconnect. Everyone, have a great day.

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