Spectrum Control, Inc. F2Q08 (Quarter End 05/31/08) Earnings Call Transcript

Jul. 3.08 | About: Spectrum Control, (SPEC)

Spectrum Control, Inc. (NASDAQ:SPEC)

F2Q08 Earnings Call

July 2, 2008 4:45 pm ET

Executives

Richard A. Southworth - President, Chief Executive Officer and Director

John P. Freeman - Chief Financial Officer, Senior Vice President and Director

Analysts

Theodor Kundtz – Needham & Company

Jason [Raynovich] – Paradigm Capital

Operator

Welcome to Spectrum Control, Inc.’s second 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. (Operator Instructions)

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 Dick Southworth, President and Chief Executive Officer of Spectrum Control.

Richard A. Southworth

Welcome to Spectrum Control’s 2008 second quarter conference call. First I’ll briefly review some key operating and financial highlights for our second quarter after which Jack Freeman will review our financial performance in more detail. Then we will be happy to take any questions.

For the second quarter of 2008 the company reported net income of $2.2 million or $0.16 per share on sales of $32.6 million. That compares to net income of $2.8 million or $0.20 per share diluted on sales of $33.6 million for the same period last year. On a sequential basis our sales were up over $1.4 million and diluted earnings per share increased $0.03. More importantly though our total customer orders for the quarter were a record $42.4 million that’s an increase of $10.8 million or 34% from the first quarter of 2008 and up $7 million or 20% from the same period a year ago.

Certain military and defense orders which had previously been delayed were released in the current quarter. Major military and defense orders received in the second quarter included applications for secured communications, land and amphibious combat systems and munitions systems.

Our strong order rate generated a positive book-to-bill of 1.3:1 while our sales order backlog grew to $58.3 million as of the end of the current quarter up $10.3 million from the end of last year. Unlike orders for our commercial products which usually have a very short lead time orders for military and defense applications often have extended delivery dates. Accordingly a significant portion of our recent orders were not required to be shipped to our customers until later this year or early into 2009. As a result of this mix of orders our shipments and profitability for the current quarter fell slightly below our previous expectations.

With our record second quarter order rate and the strong sales order backlog we have made the decision to maintain our production capacity and infrastructure to enable us to respond quickly and efficiently to expected increases in business levels. In the short term this means we have to absorb additional manufacturing overhead costs which is temporarily suppressing our gross margins. On a longer term basis we believe this investment strategically positions us for future dynamic growth and enhanced shareholder value.

At this point, I’d like to introduce Jack Freeman, our Chief Financial Officer and ask Jack to review our second 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.

John P. Freeman

Our operations are conducted in four reportable segments, signal and power integrity components, microwave components and systems, power management systems and our sensors and controls. Currently approximately 85% of our microwave product sales are in military and defense applications. Although our signal and power integrity components business serves many different end markets more than 35% of these products are sold to military and defense customers with another 20% sold to the telecomm equipment industry.

Early in fiscal 2008 customer orders for certain military and defense programs were delayed and demands throughout portions of our telecomm equipment markets was soft. These market conditions contributed to lower shipment volumes during the current quarter for our signal and power components as well as our microwave products. However overall market conditions have recently improved as reflected in our strong second quarter order rates.

Shipments of our signal and power integrity components were at $13.7 million in the current quarter that’s down about $1.1 million from the second quarter of last year. Sales of our microwave components and systems amounted to $10.4 million in the second quarter of fiscal 2008 that’s down about $1.4 million from the same period a year ago. More importantly though we think customer orders received for signal and power integrity components totaled $19.6 million that’s up $6.8 million or 53% from the first of quarter this year and it’s up $3.1 million or 19% from the comparable period of last year.

Customer orders received for our microwave products were at $13.5 million in the current quarter that’s an increase of $5.5 million or 68% from the first quarter of this year and it’s up $1.9 million or 17% from the same period last year. Our sensors and controls business which designs and manufactures rotary and linear precision sensors, temperature sensing probes, thermistors, resistance detector sensors and related assemblies. Shipments of our sensors and controls amounted to $5.6 million in the second quarter of fiscal 2008 up $446,000 or about 9% from the same period a year ago. Customer orders for these products totaled $6.9 million in the current quarter that’s up $1.2 million or 21% from the second quarter of last year. In particular demand for our custom position sensors which are used in numerous applications including robotic surgical equipment, commercial weather instruments as well as military aircraft and vehicles continues to be very strong.

Our power management systems business designs and manufacturers power distribution units, breaker infused interface panels, custom power outlet strips as well as our Smart Start Power Management systems. Shipments of our power management systems increased by about $1.1 million or 57% with shipments of about $2.9 million in the current quarter versus about $1.9 million in the comparable period last year. Customer orders for these systems amounted to $2.4 million in the second quarter of fiscal 2008 that’s an increase of 42% from a year ago. Demand for these products has been particularly strong in applications for servers, data storage, optical networking equipment, voice over internet protocol equipment, switching gear as well as various defense related systems.

During the current period our overall sales by industry remained relatively unchanged. For the second quarter of fiscal 2008 consolidated sales by major end markets were 47% for military and defense, 24% for medical and industrial instrumentation, 19% for communications equipment and 7% for commercial aerospace. Throughout the current quarter as well as the current year no single customer was more than 10% of our total consolidated sales.

For the first half of fiscal 2008 our total consolidated sales have amounted to $63.7 million that’s down about $2.7 million from the first six months of last year. All of this shortfall of $2.7 million can be attributed to reductions in shipments under our various [PRU] programs. [PRU] related shipments were about $2.1 million in the first half of this year down $6.1 million from the comparable period of 2007. So excluding [PRU] related shipments our total consolidated sales are actually up about $3.4 million or 6% during the first half of this year compared to last year.

In the current quarter our gross margin was $8.1 million or about 25% of sales compared to $9.1 million or about 27% of sales for the same quarter last year. The decrease in gross margin percentage solely reflects the impact of additional manufacturing overhead costs and certain operating efficiencies from lower than expected production volumes. In subsequent quarters if our sales volumes increase as we expect we will be able to better leverage our fixed manufacturing costs and our gross margin percentage would be expected to significantly improve.

With our state college ceramic facility continuing to set aside all of our ceramic component needs our prime margins continue to improve. Material and labor costs were about 36.5% of sales in the second quarter of fiscal 2008 compared to about 37% of sales for the second quarter of last year. At the end of the current quarter we had a total work force of 1,459 employees which is down about 9% from the end of last fiscal year. As always we expect to continuously review our organization and cost structure to enhance operating efficiencies while maintaining flexibility for additional production requirements.

Selling, general and administrative expense remained relatively stable throughout the period. During the quarter selling expense amounted to $2.7 million or just over 8% of sales compared to $2.6 million or about 7.8% of sales for the same period last year. This slight increase in selling expense primarily reflects some additional travel and advertising costs. Aggregate general and administrative expense was $2 million in the second quarter of fiscal 2008 as well as the second quarter of 2007. During the current period increases in certain legal and professional fees were substantially offset by lower incentive based compensation and other reductions in certain discretionary expenditures.

Compared to a year ago our interest expense continues to decrease principally reflecting lower average short-term interest rates and reduced borrowings under our domestic line of credit. In the second quarter of this year our weighted average short term borrowings were $4.6 million and they were at an average interest of 3.8%. In the second quarter of fiscal 2007 our weighted average short-term borrowings were $7.6 million with an average interest rate of about 6.6%. Our domestic line of credit continues to be in place and our current agreement runs through December of 2010.

For the first half of fiscal 2008 our effective income tax rate decreased slightly to 35.7% compared to 37% for the comparable period a year ago and an applicable Federal and state combined statutory income tax rate of about 40%. Differences between our effective tax rate and the statutory tax rates primarily arise from various state tax provisions, US deductions for domestic production activities as well as foreign income tax rates.

During the second quarter we continued our stock buy back program with our Board of Directors authorizing an additional $5 million to be used for stock repurchases. Of this additional authorization $1.7 million was expended in the second quarter of fiscal 2008 to acquire approximately 199,000 shares of the company's common stock. In accordance with the terms of our stock buy back program acquired shares are purchased in the open market or through privately negotiated transactions at prevailing market prices. Funding for these repurchases comes from available cash reserves or borrowings under our revolving line of credit facilities. The amount and timing of future share repurchases if any will be based on our ongoing assessments of the company’s capital structure, our liquidity and the market price of the company's common stock. From the inception of our stock buy back program through the end of this second quarter we have now repurchased a total of 1.1 million shares at an aggregate cost of about $7.7 million all part of our Board’s current aggregate authorization of $11 million. All of these repurchased shares are held as Treasury stock.

Our operating cash flow continues to be very positive. Net cash provided by operating activities was $3.1 million in the first six months of fiscal 2008. Net working capital requirements increased slightly during the current period principally reflecting the timing and amounts of incentive based compensation payments as well as the timing and amount of estimated US corporate income tax payments. In addition to our operating cash flow we generated about $500,000 of cash during the first half of fiscal 2008 from the exercise of employee stock options. In the first half of this year we borrowed a net of $5 million under our domestic line of credit substantially to help us fund our stock buy back program.

Our overall financial position we believe remains very strong. At the end of the second quarter our current ratio was 3.6:1 and our debt to equity ratio was about 0.3:1 and we currently have as of today about $29 million of borrowing capabilities under our domestic line of credit which can be used to support our future growth as well as our acquisition opportunities. Our cash position at the end of the second quarter was up $8.2 million. With this solid financial position we certainly think we are strategically well positioned to support our future anticipated growth.

With that, Dick will make some concluding comments.

Richard A. Southworth

With uncertainty in the US economic and political environment and ever shortening lead times within our commercial markets developing short term business forecasts continues to be very difficult and even increasing in difficulty. But based upon our existing sales order backlog and our recent customer order trends and the forecast requirements for certain major customers and programs we currently expect shipments for the third quarter to be between $32.5 million to $34 million. If this sales level is achieved we anticipate generating earnings of $0.16 to $0.19 per share for the third quarter of fiscal 2008. On a longer term basis we will continue to build and diversify platform of products while strengthening our status as a key supplier to all of our major customers. As we broaden our product portfolio and participation in a wide variety of markets we will lessen the impact from a sustained weakness in any particular market sector.

As our sales volume increase we will be able to leverage our manufacturing overhead to enhance our operating margins and overall profitability. More than ever we believe this business strategy will deliver long-term shareholder value during all market cycles.

At this point I’d like to open the discussion to any questions you may have.

Question-And-Answer Session

Operator

(Operator Instructions) Our first question comes from Theodor Kundtz – Needham & Company.

Theodor Kundtz – Needham & Company

Could you talk a little bit about maybe what you’re seeing now in the order trends currently? Would you expect Q3 to have another positive book-to-bill ratio or can you tell that at this point?

Richard A. Southworth

It’s probably too early to tell but the trends continue certainly to be at the levels they were at, better than the average levels of last year.

Theodor Kundtz – Needham & Company

Which was what, if you could remind us? I’m not sure what that was.

Richard A. Southworth

I think the average last year was about $35 million a quarter.

Theodor Kundtz – Needham & Company

So you’re hoping to book something at or a little better than that? That’s kind of what your current sense is?

Richard A. Southworth

Yes.

Theodor Kundtz – Needham & Company

On the gross margin, Jack, you did certainly allude to it and you talked about the volume oriented thing here and what would take to kind of get these margins back into the higher 20% range, back into the 27%, 28% range? What kind of level of business would you need to do to get margins up to 28%?

John P. Freeman

Right now our model would indicate around $37 million per quarter. With the infrastructure we have in place and the production capacity that we maintain our incremental margins we think would be very, very strong for any additional revenue and so I think it would only take us to get back to say $37 million or so per quarter to get to that 28% gross margin level.

Theodor Kundtz – Needham & Company

From indication you sounded like the fourth quarter could be certainly stronger than the third given what you see now and in some of these orders it sounded like more related to the out quarters than the current one we’re in. Is that a fair statement? Do you think fourth quarter will be a stronger quarter given what you know now?

John P. Freeman

Yes, when we take a look at what our existing shippable backlog is already for the fourth quarter and compare that to historically what projecting out what our backlog would be at this point in time for projecting out to a fourth quarter we’re currently at the existing backlog is certainly much stronger than historical levels. So at this point we would think that that’s a precursor to a very good fourth quarter for us.

Theodor Kundtz – Needham & Company

Jack, a sense of a tax rate going forward.

John P. Freeman

The current tax rate which is about 35.7% we would think would fluctuate only in a very modest amount. For the year we would expect something anywhere between 35.5% to 35.7% effective tax rate.

Theodor Kundtz – Needham & Company

Maybe a couple more questions real quick, the Power Management Systems Business maybe you could talk a little bit more about that, I know it’s an area of excitement for you in the future however the book-to-bill there was the only area that was kind of below one, so is that something that you think could start ramping up or is that something for next year?

Richard A. Southworth

That business, our second quarter is always our weak period for orders and we believe that the second half of the year is going to be stronger than the first half of the year.

John P. Freeman

In total the first half of the year was quite strong. Our shipments with Power Management Systems were up just under $2 million and even though, as you mentioned, there was a something less than a 1:1 book-to-bill for the second quarter; on a year-to-date business their first quarter bookings were so strong that they have a significant positive book-to-bill on a year-to-date basis.

Richard A. Southworth

That’s for sure, that’s true. Yes.

Theodor Kundtz – Needham & Company

I just wanted to see if you thought that was going to ramp back up to that first quarter level which was very strong.

Operator

Our next question is from Jason Raynovich – Paradigm Capital.

Jason Raynovich – Paradigm Capital

I just wanted to get a better sense of, you’re talking in general terms related to order trends and what you’re seeing in the different segments, can you give more color related to, your first quarter was obviously weak for orders, your second quarter was better so you’re up 7% year-over-year. Is this just a seasonal pick up or are you seeing any strength related to new programs or new markets or new customers that’s going to sustain this trend going forward?

Richard A. Southworth

That’s a difficult question. I would say certainly in the first half of the year we’ve seen bookings from many new programs and remember our business, we’re custom application specific so we tend to be moving from program to program to program as the life of the programs are extinguished I guess. But the order rate that we see going forward I think will be strong with the military. We expect to telecomm to continue with very modest increases as we go through. We’ve seen the low parts of our telecomm at the end of last year and the first quarter of this year. Outside of that, we see some medical programs and some industrial type of programs especially in wind instruments and wind power management.

Jason Raynovich – Paradigm Capital

So would you characterize overall that the business, if you look compared to the end of the fiscal year a year ago, you’re healthier than you were or is that kind of at the same rate that it’s been at?

Richard A. Southworth

Certainly from the backlog we’re healthier. Our backlog is up I think about $10 million from the end of last year which really strengthens specifically our fourth quarter this year and our first quarter of next year. But we’re still dependent on book and ships during the quarter which for us typically is about 40% of our revenue stream.

Jason Raynovich – Paradigm Capital

You mentioned [PRU] $1 million versus $8.2 million in the first half of 07, so down $6 million year-over-year. What was that total for FY 07 and the aggregate and what would you expect for FY 08 based on what’s in your backlog.

John P. Freeman

For fiscal year 2007 it was about $14 million in total shipments for all the [PRU] related programs. Going forward we simply don’t have very good visibility, we certainly don’t expect the second half to be such a big pick up that we come in and we’re close to what those shipments were in 2007 but whether the second half remains at that $2.1 million level or increases slightly at this point we don’t have good visibility. For this year, we certainly expect it to be down significantly down from 2007. When we look beyond that we see tremendous opportunities for additional orders and shipments for [PRU] related programs but that visibility also is I think not only poor for us but poor for just about anybody else that may participate in that program.

Jason Raynovich – Paradigm Capital

So right now the current [PRU] 2.1 program is what is kind of at peak run rates right now and you guys are not a participant in that, is that correct?

John P. Freeman

No, what’s going on now are upgrades to various [PRU] programs and the level of activity for those upgrades overall is just less than what it was in the prior years when that program was in total more active.

Jason Raynovich – Paradigm Capital

And what are the opportunities going forward that you could participate in?

Richard A. Southworth

We categorize in the upgrades and we expect the upgrades to be significant over the next several years and we’ve already got the initial production orders for that and we expect to receive them almost on a quarterly basis going forward. We have the design in with several of the programs for the new [PRU] 3.1 and 3.2 and we’ve also received initial orders for the [Manpap] [PRU] type programs that are for domestic use, for our domestic defense operations.

Jason Raynovich – Paradigm Capital

You’ve already received orders for 3.1 and 3.2 and that’s in your orders you reported and in the backlog?

Richard A. Southworth

But those orders are the initial orders for the 3.1 and 3.2 for development parts for our customers, yes.

Jason Raynovich – Paradigm Capital

Over what period of time will those be?

Richard A. Southworth

We’ve shipped those parts already. Let me just try to clarify it again. I may have confused you. We have initial production orders that we are now just shipping and will be shipping in this quarter and that’s for the upgrade for the [PRU] jammers that are already out in the field. That’s one and we expect that program will be continually running out for several years, everything the information and agreements that we have executed and we expect that just to be continued production for several years.

Jason Raynovich – Paradigm Capital

So your initial shipments last year that totaled $14 million, so now you’re at a dry patch for a few quarters because the upgrades haven’t kicked in but you’re saying the upgrades for the existing are going to start in Q3 and would that be in a greater level than the $1 million to $2 million that you’ve been doing?

Richard A. Southworth

For the second half of the year?

Jason Raynovich – Paradigm Capital

Right.

Richard A. Southworth

Yes.

Jason Raynovich – Paradigm Capital

You’re saying the opportunities are significant on 3.1 and 3.2 but that is, you’re in a development phase but that’s nowhere close to production orders.

Richard A. Southworth

Information that at least is passed on to us is on some of the fronts they are questioning whether 3.1 and 3.2 will ever materialize and another segment believes that that’s the future and we already know that they’re working on the 3.4 version of it which is the higher, higher frequency system than the 3.1 and the 3.2.

Jason Raynovich – Paradigm Capital

Just looking at your costs, your cost of sales and your SG&A has held relatively flat, you mentioned that you’re running at those rates as you expect the business to pick up, are there are any other plans though to sharpen your pencil and optimize your manufacturing footprint or your product costs or your SG&A levels?

John P. Freeman

That’s certainly something that we look at on a continuous basis and what we’ve determined to date is that based on the strong recent order rates and our strong backlog particularly for the latter part of this year that it would not be in the long term best interest of the company to sharpen that pencil and do some significant cost reductions because our concern would be that although we might get a very short term benefit from that, it would impair our ability to respond to the increased production requirements later this year and what we think will continue on into next year. As the facts and circumstances change and evolve, we’ll continue to monitor that but that’s our current thinking, that right now it’s in the company's best interest to bite the bullet a little bit for just another quarter or so and then after that we’ll start to reap some of the benefits of maintaining that production capacity and infrastructure in place.

Jason Raynovich – Paradigm Capital

While you’re saying that short term it’s tough to predict orders the visibility you have under these custom programs that you’re designed into gives you confidence looking out over a 12 or 24 month horizon?

John P. Freeman

It’s not so much the visibility because obviously our visibility is impaired based on the nature of our business, but when we take a look at, we are greatly encouraged by the current order trends and at this point we certainly believe that there is some very significant upside potential and as long as that seems to be a realistic potential we want to make sure that we’re prepared to respond to that when that time arises.

Richard A. Southworth

In addition to that in each of our four businesses our design engineering team, people that we have in these organizations are absolutely swamped with the development of new products and new designs for our customers. I think from that side it doesn’t mean that all those programs will materialize but it’s very exciting that the level of design requirements that has been coming to us and that’s really been for the year. Sometimes these programs take a year to materialize, sometimes less, sometimes more.

Operator

We have a follow up question from Theodor Kundtz - Needham & Company.

Theodor Kundtz – Needham & Company

I wanted to go back to the gross margin question, is there something going on? Because last year you were able to get better margins with relatively lower volumes and I’m wondering if there’s a mix issue going on as well, why you can’t get back those end gross margins.

John P. Freeman

There really is a significant mix issue that during the second half of last year based on our increased business levels at that time and our expectations to further enhance those business levels we made certain investments in technical people support as well as equipment and so what we’re seeing this year is that the depreciation associated with some of that equipment and, for example, this is the first full year in which all of the ceramic related equipment that we invested in state college we’re bearing the full impact of that depreciation for the first time this year where much of that was put in place last year. So we have that additional depreciation on that equipment investment as well as salaries and wages for the people investment that we made throughout 2007 but in particular during the second half of the year. So that’s what you’re seeing currently depressed gross margins but again that we think in the long term it’s going to pay dividends for us.

Theodor Kundtz – Needham & Company

Could you say, Jack, what the depreciation and amortization was for the quarter versus last year?

John P. Freeman

I think on a year-to-date basis because I think our total manufacturing overhead this year year-to-date is about $1.3 million greater than what it was for the first half of last year and of that $1.3 million $900,000 is salaries and wages and depreciation expense. That’s the bulk of it. In total we’re talking about $1.3 million of which $900,000 is in those two items that I talked about.

Operator

We have no further questions in the queue at this time.

Richard A. Southworth

We thank you for joining us today and with no further questions, we’ll conclude the conference call. Thank you very much for joining us.

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