Thermon Group Holdings' (THR) CEO Bruce Thames on Q1 2017 Results - Earnings Call Transcript

| About: Thermon Group (THR)

Thermon Group Holdings, Inc. (NYSE:THR)

Q1 2017 Earnings Conference Call

August 03, 2016, 11:00 ET

Executives

Sarah Alexander - General Counsel

Bruce Thames - President and CEO

Jay Peterson - CFO, SVP, Finance and Secretary

Analysts

Scott Graham - BMO Capital Markets

Charlie Brady - SunTrust

Jeffery Hammond - KeyBanc

Bhupender Bohra - Jefferies

Brian Drab - William Blair

Jon Braatz - Kansas City Capital Markets

Operator

Welcome to the Thermon First Quarter 2017 Conference Call. [Operator Instructions]. I would like to turn the call over to Sarah Alexander, General Counsel. Ma'am, you may begin.

Sarah Alexander

Thank you, Taqia [ph]. Good morning, everyone, and thank you for joining us for today's earnings conference call. We issued an earnings press release this morning which has been filed with the SEC on Form-8K and is also available on the Investor Relations section of our website at www.thermon.com. A replay of today's call will also be available via webcast after the conclusion of this call.

This broadcast is property of Thermon. Any redistribution, retransmission or rebroadcast in any form without express consent of the company is prohibited. During this conference call, our comments may include forward looking statements, these forward-looking statements are subject to risks and uncertainties and our actual results may differ materially from the views expressed today.

Some of these risks have been set forth in the earnings press release and in our annual report on Form 10-K filed with the SEC in May. We would also like to advise you that all forward looking statements on today's call are intended to fall within the Safe Harbor Provisions of the Private Securities Litigation Reform Act of 1995.

These statements may include, among others, our outlook for future performance, revenue growth, profitability, leverage ratios, acquisitions, acquisition synergies and various other aspects of our business. During the call, we will also discuss some items that do not conform to generally accounting principles. We have reconciled those items to GAAP measures in the tables at the end of the earnings press release. These non-GAAP measures should be considered in addition to and not as a substitute for measures of financial performance reported in accordance with GAAP.

And now it's my pleasure to turn the call over to Bruce Thames, our President and Chief Executive Officer.

Bruce Thames

Thank you, Sarah. Good morning everyone. Thank you for joining our conference call and for your continued interest in Thermon. Today, I have Jay Petersonn, our CFO joining me on the conference call. Jay will follow me and present the financial details of our fiscal 2017 first quarter.

To begin with a brief overview of our Q1 results, revenue and earnings both fell short of our expectations for the first quarter. Revenues at $63 million were below our expectations and 3% below prior year due to timing projects and lower MRO/UE business. Gross margins remain under pressure and were below expectations and 6% below prior year for several reasons. First, Greenfield projects represented 43% of revenues versus MRO/UE 57%, relative to a historical ratio of 40% Greenfield, 60% MRO.

Secondly, our most recent acquisition, industrial process insulators had a very strong first quarter, generating $5.5 million in revenue that diluted margins by 2% on a consolidated basis during the quarter. Finally, we also continue to see near term pricing pressure as the number of large projects declined and there's available capacity in the industry. Jay will cover margins in more detail during the financial results. It is also important to remember that the first quarter is historically our weakest quarter in both revenue and margins. We typically see margins improve in late Q2 and Q3 during the heating season as MRO/UE sales increase. We do expect margins to move closer to our historical level of 45% in Q3, but anticipate weaker margins to continue in Q2 as the mix will be unfavorable during the first quarter.

Let's now turn to discuss our three primary end markets, oil and gas, chemical and power. The oil and gas market remains weak with upstream being the hardest hit. Downstream refining projects tied to environmental regulations are proceeding at a slower pace. Maintenance activity continues to be delayed due likely due to lower refining margins and earnings pressure on integrating oil companies. Of our three primary ends markets, the chemical sector has some of the best macro-economics and is anticipated to exceed GDP by 1% through 2040 with ethane demand growing by 4% through 2020. Currently this sector remains solid and has represented the bulk of backlog growth, but has begun to show some signs of weakening. Projects that are currently underway are proceeding albeit at a slower pace. Power projects continue to generate opportunities driven by conversion of coal to cleaner natural gas bioplants, as well as increases in emissions monitoring. As a result, we continue to see strong revenues and a solid backlog in our tubing bundled product line.

Moving on now to discuss our four geographic markets. Timing on projects and lower MRO/UE sales resulted in year-on-year organic revenue declines in the U.S., in Europe, Middle East Africa by 14% and 16% respectively following difficult comps to record years in fiscal 2016. The Canadian business was also down 23% year-over-year on an absolute basis, but we began to see stabilization and growth in backlog at the end quarter. The fires in Alberta MRO sales for five weeks and delayed approximately 1 million shipments from backlog during the quarter.

During Q1 we have continued to right-size the cost structure in our Canadian business while positioning to better serve our customers and the large install base there. Asia-Pacific is off to a very strong start with revenues up 28% and a growing backlog -- over prior year with visibility to a number of additional project opportunities in the pipeline. Although timing is shifting, our project pipeline remains strong with over 800 identified opportunities, representing approximately $1.2 billion in potential revenue over the next three to five years. While the number of opportunities have increased, we see the average size of the projects decreasing due to the lack of very large upstream projects on the horizon.

On a positive note, we saw quotations increase sequentially over the prior quarter. In addition we’re very pleased to see the order intake improve by 21% over the prior year, and 7% sequentially with a book to build ratio of 122%. As a result, our backlog increased to 95.4 million, an increase of 25% over the prior year, and 17% over the prior quarter. Excluding the large projects, backlog grew by respectable 7% over the prior year and 1% sequentially. This increase in activity and backlog are characteristic of a bottom but we do expect it to remain volatile for the next several quarters. Accurately predicting the timing of recovery is proving very difficult.

Our commitment to new product development remains steadfast and we continue to invest during the cycle. In April, we announced the release of our new TraceNet command software. The three significant product introductions that we noted during the last call remain on track to be launched through the balance of the year. We'll talk more about that in future earnings calls.

Our M&A pipeline has become more actively and we are expanding the universal targets consistent with the revised strategy to grow our addressable market by 2 to 3 times over the next five years.

Looking forward, our core business model remains resilient, our balance sheet remains strong, and our cash conversion allows us to operate from a position of strength. Based upon the increase and backlog we hold to our revenue guidance for the year of flat to low single-digit growth. Based upon the project timing we see in backlogs, we see the year being back-end loaded. Given the environment we do anticipate margin pressure to continue due to an unfavorable mix and pricing pressure. A modest recovery of maintenance spending during the heating season, combined with effective cost management will be key in achieving our profit objectivities for the year.

Thank you again for joining us today. Jay Petersonn, our CFO will now address the details of our financial performance for Q1, 2017. Jay?

Jay Petersonn

Thank you, Bruce. Good morning, I would like to start off by discussing our Q1 financial results and then conclude with high level guidance for the balance of fiscal year 2017. First off in terms of revenue this past quarter, in totaled $63.4 million and that's a decrease of 3% over the prior year's quarter. Relative to the prior year quarter, our organic revenue declined by $7.3 million. FX currency fluctuations impacted revenue by a negative $700,000, and M&A revenue contributed $5.5 million in the quarter. This last quarter, we continue to experience erosion with our Canadian business, which was down 23% on an absolute currency basis, with both Greenfield and MRO revenues declining. As Bruce mentioned, we are continuing to aggressively manage costs in Canada, such that our spending in this geography is in alignment with current levels of demand. Our MRO/UE mix for Q1 was 57% of revenues, whereas Greenfield totaled 43%, and this lower mix of MRO was the leading driver of our reduced margins for the last quarter. Orders for the quarter totaled 77.5 million versus $64 million in the prior quarter for a growth of 21%.and we saw ordered growth of 57% in the United States and nearly 10% in Europe this last quarter.

Our book to bill for the quarter was a solid 122%. Our backlog of orders, ended June at $95.4 million versus $76.4 million at the end of June 2015. That's an increase of 25%. Also, note that foreign currency fluctuations negatively impacted our backlog by $3 million. In terms of gross margins, margin dollars this past quarter were an uncharacteristic 41.2% of revenue, versus the prior year quarter, our margins decreased by 590 basis points due to several factors, including a decline in MRO/UE margins, due to softened maintenance spend in the western hemisphere, an unfavorable product mix, and an increase in lower margin construction revenue. In terms of operating expenses, core operating expenses for the quarter, and this excludes depreciation, amortization of intangibles and any transaction related expenses, totaled $17.4 million in the quarter, and that's essentially flat from the prior year level. This level of spending comprehends the continued investments we're making in new product development for products that will be released later this fiscal year.

Our operating expense as a percent of revenue was a competitive 28% and again this excludes depreciation and amortization. The number of full-time employees at the end of June was 984 versus 965 as of calendar June 2015. And excluding headcount from recent activity, our organic headcount declined by '16 over the prior quarter. GAAP EPS for the quarter totaled $0.08 compared to a prior level of $0.14. Our adjusted EBITDA totaled $9.6 million this past quarter and adjusted EBITDA as a percent of revenue was 15.1% and this is well below our historical levels.

In terms of our balance sheet, our cash balance ended at $72.6 million this past quarter, this $12 million cash reduction over the last 90 days was due to the pay out of the earn out to the former owners of the Sumac business that we acquired last year, plus a reduction of the accrued liabilities and accrued taxes.

On a net debt to EBITDA basis, this ratio ended the quarter at 0.3 and we anticipate to be debt free on a net debt basis this current fiscal year. Lastly, 2017 guidance, we reiterate our previous guidance of flat to low single-digit growth for fiscal year '17 and point to our strong Q1 bookings and backlog growth as validation of this guidance. We believe the revenue will be more skewed to the second half of the year and we anticipate another quarter of compressed margins due to product mix.

I would now like to turn the call over to Taqia to moderate our Q&A session.

Question-and-Answer Session

Operator

[Operator Instructions]. And the first question comes from Scott Graham at BMO Capital Markets. Your line is open.

Scott Graham

Just wondering, really two questions. The bookings have obviously been quite strong, yet obviously this quarter's gross margin was below what everyone was expecting both internally and externally. Could you give us a feel for what the gross margin of the backlog is right now? I mean assume is it -- I assume it's declining situation, but order of magnitude, is it as bad what we just saw in the first quarter?

Bruce Thames

As you know, historically, mix has had a big impact overall in our consolidated margins, and gross margins. And so the backlog as we see it, the snapshot at the end of any given quarter, is heavily weighted towards projects business, and so those margins tend to be lower. And I think the biggest thing that we see is risk around the MRO/UE -- in the coming quarter, and it being lower because customers have really not been spending those maintenance dollars. And so, based upon that, we expect the mix to have a much greater impact than just the margins and backlog, and the fact that we were seeing Greenfield revenues higher than MRO sales, what you would think in this type of cycle, in the reduced capital spending would be inverted, but that’s not occurred because our customers are really holding onto those maintenance dollars.

Scott Graham

Right, and I appreciate that, that was a comprehensive information, Bruce, thank you. The question I'm trying to drive at here is, yes, the backlog is typically loaded with more Greenfield, but is that Greenfield margin, let's say we have this quarter's mix factor related to MRO/UE because that is obviously has nothing to do with the Greenfield. Our Greenfield margins in the backlog weaker because of pricing or is there maybe just not a lot of business out there, and you're booking business that's lower margin than you would not have booked before?

Bruce Thames

The bigger impact in backlog is the mix of construction within Greenfield and it's largely contributed to our IPI business and the construction activity in the Gulf coast. So we noted it had about a two point impact in the first quarter, and we do see that mix continuing. The advantage of having that business, it allows us to bid more competitively and it positions us to win more work which pulls through our core product sales. Does that answer your question?

Scott Graham

Yes, that’s actually a great answer to the question. In the past, we have seen other companies, this actually out there and just book that business in weaker times, and while I'm hearing you say that that’s not the case here. The other question I had was that it's always difficult to extrapolate much from one particular core or otherwise, but I was just kind of wondering how the progression of orders were in the quarter and by extension, you had a couple of real terrific quarters of bookings. You know, A, where is that coming from, how did that progress in the quarter as I’ve already asked and I guess the other question would be, are you sensing that there are push backs of deliveries in front of you?

Bruce Thames

We do see timing moving out on execution, so a lot of the projects that we have seen booked are -- customers are taking longer to execute those and so we have seen that, that is continuing. The nature of the projects, the orders that we're getting that we still see the chemical, petrochemical sector is very strong. We have won a number of key projects there. I have noted we’ve actually have had some very good orders in the Eastern Hemisphere as well both in EMEA as well as in Asia Pacific, those that have contributed the backlog growth but we have had some real major project wins in the U.S. that have contributed to that as well.

Canada remains slow, capital spending is certainly depressed but we have seen some activity, which I noted was stabilization of the backlog and slight growth we saw during the first quarter of this year.

Operator

And our next question will come from Charlie Brady at SunTrust. Your line is now open.

Charlie Brady

And to piggyback on that last question, Scott, can you talk about the duration of the backlog and how much does that current backlog goes out the door, and I know the timing of the project is a little squishy on that but maybe a best estimation, how much of that backlog today goes out at this fiscal year, how much falls beyond the fiscal year?

Jay Petersonn

Historically, the great majority of that backlog, let's say 95% or so, would be billed within the next 12 months. And as Bruce mentioned, we are seeing some extension with shipments and the associated revenue. I can't give you an exact figure, but I'm guessing we have seen maybe a 90-day increase in the turn of that backlog.

Charlie Brady

Can you also talk about the margin outlook in the second quarter, or I guess I'm trying to get a little more granular on that. Are you expecting Q2 gross margin to be below Q1?

Jay Peterson

No.

Charlie Brady

Okay. And then can you speak to the cost takeouts that you guys have underway? Can you give a little more granular, what you're doing on that, it doesn’t sound it has a whole lot of headcount reductions, but maybe just speak to the actions internally you’re taking to right-size the cost structure.

Bruce Thames

Yes we're looking primarily at areas that are underperforming, relative to the fiscal year plan, and to historical levels of performance. Most of the efforts at present are in Canada, and we are looking at rationalizing our facility footprint. We're looking at the spend between employees and contractor mix, primarily within engineering. We're looking at headcount within the organization, we're looking at possibly consolidating certain functions. So it's pretty pervasive in terms of what we're doing, and a lot of these activities are currently underway. So a lot of these activities are currently underway. So to give you the exact magnitude might be a little premature.

Charlie Brady

And one more for me. Just on the pricing environment right now, can you give me a sense on the order intake that you’re seeing out there with your pipeline of orders -- I guess what's the ballpark headwind on margin relative to what you would consider a normalized environment. Is it a 400 basis point headwind, is it six? And there is some variability on types of job, maybe in general terms to get a sense of kind of what the pricing pressure really is you guys are facing?

Bruce Thames

I would really have a hard time -- this is Bruce. I really have a hard time giving you an exact -- it would just be an estimate as to what we're seeing. So I really don't have a good answer for that.

Operator

And our next question comes from Jeffery Hammond at KeyBanc. Your line is now open.

Jeffery Hammond

So just on the pricing pressure, can you clarify, is that solely tied to the upgrade in project business, or are you also seeing pricing pressure on the after-market side?

Bruce Thames

We have seen both the after-market is largely been related to Canada, but as you see renewals on large multiplier agreements, we certainly have seen competitive bidding pressure there as well.

Jeffery Hammond

Okay, and then just on the -- I think you've called out a large project or a couple of large projects, assuming from your order of commentary, that's in the U. S, but I'm just trying to understand kind of what you're trying to signal there in terms of what's in the orders and backlog, and how that large project kind of flows through in the year and into next year.

Bruce Thames

So typically, larger projects, project execution is more protracted and I think we probably already covered that with some of the questions that have been asked about backlog and how that's changed maybe over the turns in backlog maybe has been extended another 90 days, but certainly what we're trying to project is that that will be executed over multiple fiscal years.

Jeffery Hammond

Okay, and then just a couple on after-market. One, this million dollars or so that you lost around the wildfires, did you pick that up into 2Q, and then just broadly on the margins, I think you said in the second half, you expect to get back towards that 45, does that imply that we're still running below that 45 into the back half?

Bruce Thames

Jeff, that's going to be so dependent upon on what we really see happening in our maintenance spending, with customers in the coming year. A lot of that will depend on what type of winter we have, and just there has been a significant delay or just a reduction in maintenance spending at some point. We believe that will return, there is pent-up demand, predicting a timing of it is really difficult but those factors will have a big impact over margins, particularly in the third quarter.

Operator

And our next question will come from Bhupender Bohra at Jefferies. Your line is now open.

Bhupender Bohra

Just a housekeeping question, Jay, can you give orders ex-IPI?

Jay Peterson

Yes, ex-IPI, we saw significant order growth 12% for the organic business.

Bhupender Bohra

Okay, and the other question was, on the investment growth here, like in the last call you guys talked about the investment growth is going to be a little bit higher than the revenue growth, now with the margin pressure going forward and the pricing pressure. How should we think about, are you guys still going to invest -- I think Bruce talked about new products to be introduced this year how should we think about that SG&A line moving forward?

Bruce Thames

Bhupender, some of those investments are key to the future of the business and growing and so we’re holding a line in a number of those areas. Now what we’re doing is we're moderating the pace of some of those, so we'll slow the pace of those based upon the current environment and we'll also concurrently be looking at where we have lower volume, lower demand and managing our cost structure there. So we're really balancing investment in the future, and pace and timing with the current realities and managing our cost structure to the levels of incoming business.

Bhupender Bohra

Okay, and this is outside what Jay just mentioned about -- you know he gave a number of buckets where the cost has been reduced, right?

Bruce Thames

Well that would be inclusive of some of the comments that Jay made around, areas we’re looking to effectively manage cost.

Bhupender Bohra

Okay, and lastly on the EBITDA, I remember the last call, you guys commented on the EBITDA for the year can be slightly lower than last year, and now with all things said here on the margin pressure and the cost take out which you’re planning. How should we think about EBITDA for the year?

Jay Peterson

Yes, we are continuing to hold to the guidance that we provided earlier this fiscal year, Bhupender

Operator

And our next question comes from Brian Drab at William Blair. Your line is now open.

Brian Drab

You mentioned the book to bill, it was 122%. How much of that is held by the 1 million oil sands that didn’t ship and can you give us a frame of reference, what does that typically book to bill typically look like at the end of any first quarter?

Jay Peterson

Yes, the book to bill will really -- there's a lot of variability in that, Brian. We have seen negative book to bill at the end of Q1, we have seen positive book to bill. So it's really hard to say that there's a specific trend or specific expectation.

Bruce Thames

This is Bruce, just to give you a relative measure, we had an order intake of $77.5 million and revenue of 63.4. So you can see the $1 million swing would not have a huge impact on that shift.

Brian Drab

Yes, that helps. I would have thought that if I go back and look at the history, that we would see kind of good book to bill, with any particular quarter, your sales kind of ramp typically throughout the year, and you have a stronger back half of the year than the beginning of the year. That's not a fairway to look at it?

Bruce Thames

No, I think what you would see is a strong book to bill when we’re building back log, and then you would see a negative book to bill when we’re shipping more and orders begin to fall off.

Jay Peterson

Last year for example was positive, the year before that it was positive. The year before that, Brian, it was negative and the year preceding that, it was down. So there's a fair amount of variability at the end of Q1.

Brian Drab

Okay. And looking at IPI, so Bruce, you made the comment, I think it was a 250 basis point headwind, to gross margin, just 200?

Bruce Thames

Yes.

Brian Drab

Okay, is that business, I would imagine, is expected to kind be at the similar growing revenue run rate going forward and is this kind of a new normal for gross margin, 200 basis points below what we would have otherwise modeled.

Bruce Thames

When it represents, such a large percentage of the mix? Yes. We did have a very strong quarter. We had some nice change orders that came through, and revenues were up significantly within the quarter.

Brian Drab

Okay. And where are we recording that revenue for IPI? Is it in MRO or greenfield?

Jay Peterson

It depends, it's definitional. If the customer were to have a $1 million over the preceding year in excess of a 1 million it's greenfield otherwise, it's in MRO/UE.

Brian Drab

Okay. So we’re just splitting it just like the other business. Okay, and the can you update us I don’t know if you’ve told us, Jay, CapEx expectations for the year and then also one other house-keeping item, you made the comment in the past that OpEx is expected to grow faster than revenue in fiscal '17. Is that comment still accurate?

Jay Peterson

I think a lot of it depends on performance of certain geographies and we’re looking at that as we speak. Okay? So right now, there really isn't any change in terms of that guidance, but a lot of it depends on how well our activity is in Q2, primarily with our maintenance business.

Brian Drab

And the CapEx?

Jay Peterson

CapEx for this fiscal year will be in the range of 2% to 3%of revenues, and the one significant variable there is how much rental business we have with our Sumac business in that we record that as capital and we would actually like to exceed the level last year of sumac leasing business, rental business, because it is a very, very high profitable business for us, both on gross margin and a net margin basis.

Operator

And our next question comes from Jon Braatz at Kansas City Capital Markets. Your line is now open.

Jon Braatz

Going back to the pricing pressures you've seen, and maybe this is a question for you, Jay. As you look back historically when your business turned down, are you seeing any different level of pricing pressures this year compared to prior downturns, and maybe a little bit on the duration of these pricing pressures? I guess historically, how does this downturn compare to prior ones?

Jay Peterson

I guess one of the things we are experiencing is that the tender process is more protracted, and with a greater number of iterations that there's less capacity at this point in time and it is a little bit more competitive than it was, let's say three years ago.

Operator

[Operator Instructions]. And our next question will come from Bhupender Bohra at Jefferies. Your line is now open.

Bhupender Bohra

Just one more question for the first quarter here. When you give the guidance, you were kind of like at the end of May, if I remember correctly. And you had April and May kind of in your books and we had just a month of June. Can you just give us the cadence of like month over month the things deteriorate like pretty bad like in the month of June or have you seen pricing pressure in the first two months when you came up with the guidance here? Just some color on the month of June or how it came from May to June. Thank you.

Bruce Thames

Really, quickly, we gave guidance -- I would like to again say that’s guidance for the year and not for the quarter, and beyond that, we did see the order intake during the quarter so we saw that, which gave us some level of confidence over the revenue numbers, although there's a big piece of our revenue, which is tied directly to MRO, which we have very little visibility on.

So as we looked at what happened in the first quarter and margins we did see a change order come through that really positively impacted our revenues and with the IPI business about a $1.5 million in revenue, and that changed the mix. And the fact that we had significantly more MRO sales in the Western Hemisphere than we have seen historically. We have factored that in due to the lower market cycle, but we actually saw the sales come in below our expectation.

So those things impacted the performance during the quarter, what I like to reiterate -- we gave revenue guidance for the year.

Operator

And we have a follow-up question from Charlie Brady at SunTrust. Your line is now open.

Charlie Brady

I mean on your expectation of what the mix will look like in Q2 given kind of where [indiscernible] today little more than the third through the quarter, I know the MRO stuff is short cycle stuff but do you think it's going to be around same as it was in Q1 or do you see a pickup in some of the MRO side as a percentage of the overall quarterly sales?

Bruce Thames

Charlie, due to historical seasonality, we would expect some increase, but we still are anticipating those maintenance sales to be weaker. We really typically don't see them begin to recover or begin to takeoff in the heating season until the last month of the quarter, and some of those will ship, some will still over into the following quarter. So we'll have a much better sense of how customers are going to be able to spend maintenance dollars at the end of this second quarter.

Operator

Thank you. I'm showing no further questions at this time. I would like to turn the call back over to Bruce Thames, President and Chief Executive Officer for closing remarks.

Bruce Thames

All right. Thank you again. Thank you everyone for joining us. Thank you all for your continued interest in Thermon. And we appreciate you joining us on the call today.

Operator

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

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