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Twin Disc, Inc (NASDAQ:TWIN)

F1Q13 Earnings Conference Call

October 23, 2012 11:00 AM ET

Executives

Stan Berger – Investor Relations, SM Berger

Michael Batten – Chairman and Chief Executive Officer

John Batten – President and Chief Operating Officer

Christopher Eperjesy – Vice President-Finance, Chief Financial Officer and Treasurer

Analysts

Peter Resnick – Robert W. Baird

Brian Uhmler – Global Hunter Securities

Kevin Leary – Spitfire Capital

Andrea Sharkey – Gabelli & Co.

Operator

Good morning ladies and gentlemen. Thank you for standing by. Welcome to the Twin Disc, Inc First Quarter Fiscal 2013 Financial Results Conference Call. During today’s presentation all parties will be in a listen-only mode. Following the presentation the conference will be opened for questions. (Operator Instructions). The conference is being recorded today, October 23rd, 2012

I would now like to turn the conference over to our host, Stan Berger with SM Berger. Please go ahead.

Stan Berger

Thank you, Ian. On behalf of the management of Twin Disc, we are extremely pleased that you have taken a time to participate in our call. Thank you for joining us to discuss the company’s Fiscal 2013 First Quarter Financial Result and Business Outlook. Before I introduce management, I would like to remind everyone that certain statements made during the course of this conference call, especially those that states management’s “intentions,” “hopes,” “beliefs,” “expectations” or “predictions” for the future, are forward-looking statements.

It is important to remember that the Company’s actual results could differ materially from those projected in such forward-looking statements. Additional information concerning factors that could cause actual results to differ materially from those in the forward-looking statements is contained in the Company’s annual report on Form 10-K, copies of which may be obtained by contacting either the Company or the SEC.

By now, you should have received a copy of the news release which was issued this morning before the market opened. If you have not received a copy, please call Annette Mianecki at 262-638-4000 and she will send the copy to you. Hosting the call today are Michael Batten, Twin Disc Chairman and Chief Executive Officer; John Batten, President and Chief Operating Officer; and Christopher Eperjesy, the Company’s Vice President of Finance, Chief Financial Officer and Treasurer.

At this time, I will turn the call over to Mike Batten. Mike?

Michael Batten

Thank you, Stan, and good day, everyone. Welcome to our Fiscal 2013 First-Quarter Conference call. As usual I will begin with I will begin with a brief summary statement and then John, Chris and I will be ready to take your questions. Our First-Quarter results were significantly impacted by a challenging North American pressure-pumping market as rig operators continued to adjust to North American natural gas supply overhang and lower prices. We remain conscious about this sector during the balance of Fiscal 2013.

Sales for the First Quarter of Fiscal 2013, easily the weakest quarter of the fiscal year, declined to $68 million from a record performance of $81 million last year. The decrease from sales was primarily the result of lower demand from customers in the pressure-pumping sector of the North American oil and gas market.

The shortfall was partially offset by a higher demand from customers in the North American and Asian commercial marine markets while emands remained steady for equipment use in the industrial, airport, rescue and fire-fighting and military markets. Sales to the global megayacht market remained at historic lows in the quarter. Gross margin for the quarter was 28.2% of sales compared to a record of 37.8% of the same three months a year ago. The anticipated year-over-year decline in margin reflected lower sales volumes in a less profitable mix of business.

ME&A expenses, our marketing, engineering and administrative expenses were 24.2% of sales compared to 19.6% last year. ME&A expenses increased $711,000 versus the same three months last year primarily as a result of increased product development activities, wage inflation and additional headcount.

The effect of cash rate for the first quarter of Fiscal 2013 was 45.6%, significantly higher than the previous year rate of 35.3%. The current year rate was unfavorably impacted by an existing valuation allowance in certain foreign jurisdictions during the quarter. The remaining increase relates to the expiration of a credit for research in development and reduced domestic production activities present and a change the mixture of domestic and foreign earnings.

Net earnings attributable to Twin Disc for the First Quarter of Fiscal 2013 were $1.3 million or $0.11 per diluted share, compared to record earnings of $9.6 million or $0.83 per diluted share for the same period last year.

EBITDA for the First Quarter was $5.3 million compared to $17.8 million for the same quarter a year ago. Total debt net of cash was $18 million at the end of the quarter compared with $16 million last year. With a debt the capitalization ratio of 21.9%, our balance sheet provides us with the flexibility to withstand any near term utility and to continue to invest in forward business opportunity.

Looking at our outlook, our six-month backlog at the end of the First-Quarter was $82 million compared to $98 million at June 30, 2012 and $165 million at this time a year ago. The backlog reflects continued weakness in demand from the North American oil and gas market that we anticipate we’ll continue for the majority of Fiscal 2013. While the decline in demand from this sector will have an obvious near-term impact on our business, we are well positioned to grow when the market rebounds.

Further, interest in our oil and gas transmission is improving in other areas, mainly Asia as producers are beginning to develop shale formations within their own country. And finally, while demand from oil and gas has an influence on the company, our business today is far more diversified in terms of products in market and geography than at any other time in our history. As the year progresses we anticipate a slow recovery in oil and gas with more robust demand coming from our traditional sectors such as commercial marine, legacy military and our ARFFmarket.

That concludes my prepared remarks and now John, Chris and I will be happy take your questions. Ian, please open the lines for questions if you will.

Question-and-Answer Session

Operator

(Operator Instructions). Our first question is from the line of Peter Resnick from Robert W. Baird. Please go ahead.

Michael Batten

Pete, are you there?

Peter Resnick – Robert W. Baird

Can you hear me?

Michael Batten

Yes. Now we can.

Peter Resnick – Robert W. Baird

Yeah, good morning. Sorry about that. I guess first question if we can talk a little bit about the oil and gas market and your market assumptions there. It sounds like 1Q very difficult obviously but maybe some visibility as things get better in the-- call it the back half of the year, maybe Fourth Quarter. Can you give us a sense of a couple of things? One, just how you are thinking about the North American piece. Does that effectively get better here on the later part of the year and then international as well? And then just kind of if you can maybe give us an aura of magnitude of what we might be seeing near term and in our immediate term that would be very helpful as well.

John Batten

Okay, Pete, it’s John. North America has slowed dramatically. Most of what we’ve seen year-to-date is driven by Asia and will probably be the same in Q2. I would say it be the same in Q2. I would say that we are hopeful and expect North American demand to pick up in the second half. But it’s going to be probably a lot closer to Q4 and maybe even the later stages of Q4. There’s quite a bit of inventory of rigs, finished rigs and then also of inventory at some of the OEMs to build the rigs, transmissions and engine. So I know your next follow-up question is how many months of inventory? I would say it’s probably four to six months, but that’s at current rate. But if you go back to the peak, there’s a month-and-a-half of inventory sitting out there. So if it ramps up quickly, the inventory will get used up pretty quickly. But we could see a very slow second half of the year in North American Oil and Gas. Having said that, going back to Asia, Asia was still and still is very good for us, but I see the Chinese market maybe developing a little bit slower than we’d anticipated. They have trouble doing the horizontal drilling. Their soil has a lot more clay in it than in North America. So while that’s going to be the main market for us in the next few quarters, it’s not going to be the rocket that we had anticipated.

Peter Resnick – Robert W. Baird

Okay. And then maybe Chris willing be willing to answer this one. If we look at the backlog and 50% decline I guess year-over-year and down 16% or 17% sequentially, can you give us a flavor for how much of that deterioration was oil and gas and maybe color commentary on what the other markets were doing in terms of that backlog?

Christopher Eperjesy

Yes, Pete, it is Chris. The majority of it, more than half of it is going to be driven by-- the decline year-over-year is going to be driven by oil and gas in terms of reduction in the backlog, more than half. The other piece of it is going to relate to, we had talked about the past two backlogs last year at this time at our European operation particularly for marine transmission, That has worked its way through, so that’s going to be another portion of the decline year-to-year. And then as you know versus sequentially it’s not untypical during the first quarter for the backlog to come down. But clearly the biggest piece of it is going to be the oil and gas.

Peter Resnick – Robert W. Baird

Okay, all right. And then as we see this volume decline, Chris, how should we think about the ME&A rate? The first quarter looked like it was a little bit higher, at least than what we had modeled, but I’m just wondering how that piece of the cost structure should delever as we see the volume come down.

Christopher Eperjesy

Right. Pete, one part of it, if you remember last year, the first quarter, there was a significant adjustment to stop these confrontation because of the stock price movement in Q1 of ‘12.

Peter Resnick – Robert W. Baird

Right.

Christopher Eperjesy

So actually, essentially there was stock-based, I’ll call it income, but there was a negative number in the first quarter of last year. This year was more normalized. So you did have negative effect there that would have played out in the first quarter, somewhat offsetting that, obviously given that this would be a down year, the incentive compensation was lower in the first quarter, significantly lower. I guess the answer to your question is, obviously there is a base level of ME&As that will be there as we continue to invest in research and development and growing some of our activities around the world, geographically in particular. So there will be a base level that as volume goes down, obviously that percentage will go up. But it is something that we monitor closely and certainly as the results would indicate, that we would look at cost-cutting opportunities everywhere that we can.

Peter Resnick – Robert W. Baird

Okay. The first quarter sort of a fair-based run rate for that ME&As level on an absolute dollar basis?

Christopher Eperjesy

It’s not far off of what I would have expected to be typical, but then with the caveat of movement and stock based compensation it’s difficult to predict.

Peter Resnick – Robert W. Baird

Okay, yeah. I understand that. All right. And then last question. John, balance sheet in good shape. Sounds like you’re relatively comfortable that things maybe get a little bit better here in the later part of the year and into fiscal ’14, I guess. What’s the thought process behind potential buyback activity with the stock obviously coming off a bit here and how do you think about capital allocation, given that backdrop, I should say?

Michael E. Batten

Pete, it’s Mike. I’ll jump in here if I may. And with respect to buyback, you see that we increased our ability to buy-back shares at the July board meeting up to $500,000. So we had that dry powder and quite frankly we see the stock prices where it is today as a buying opportunity. So we’re bullish on the company long term and we will be prepared, without being specific to buy into the market at these levels.

Peter Resnick – Robert W. Baird

Okay. And then I guess the natural follow up, is there anything in the acquisition pipeline that would maybe pre-empt that from the buyback activity from happening?

Michael E. Batten

Nothing that is immediate such as the buyback opportunity. Our acquisition work or conclusion of any acquisitions would be a little bit further down the line.

Peter Resnick – Robert W. Baird

Okay. All right, that is very helpful. Thank you all for your help.

Operator

Thank you. Our next question is from the line of Andrea Sharkey with Gabelli & Co. Please go ahead.

Andrea Sharkey – Gabelli & Co.

Hi, Good morning. I guess maybe talking about the margin a little bit. Can you give me a sense of how much of the degradation either sequentially or year-over-year was due to the makeshift away from the oil and gas transmission because they have the higher margins?

Michael E. Batten

The majority of this is going to be mixed and volume related to oil and gas, Andrea. So the majority of it will be driven by that.

John Batten

Yeah. The rest, Angie, we have – it’s John. Usually in the first quarters, we have shut down all of our manufacturing facilities in which case the first quarter is typically the lowest gross margin quarter of the year. Last year was a complete anomaly because we had a record shipment of 8500 in that quarter that we could not get out in the fourth quarter and customers were still clamoring. So we did everything we could to pull them in from the second quarter. But typically, having the operations on shut-down both here in North America and Europe drives the gross margin down for the quarter.

Andrea Sharkey – Gabelli & Co.

And actually I guess quarter I know you guys actually talked about that, that the Q1 shut-downs would have an impact, but that overall you thought a good target for the year, maybe coming at Q1 with the 30% gross margin. Do you think that that’s still feasible or has that changed a bit given the maybe greater decline in the oil and gas transmission demand?

John Batten

If the oil and gas does not improve, we’re probably looking at high 20. But if the oil and gas comes back obviously we would change our target.

Andrea Sharkey – Gabelli & Co.

Okay, sounds good. And then maybe just to give us some sense of you mentioned, the other end market is going to be bigger drivers now this year. Can you refresh our memory on the military end market, what you’re selling into there and is there anything that we should be concerned about with potential sequestration that may happen January 1st?

John Batten

Sure. Kind of two areas. In the U.S our primary military business is the legacy military, the transmissions that we sell to BAE and TACOM for the M88 and the Hercules M88. That is very steady business. We have not heard anything affecting that from sequestration. But I’m going to have to look into that, how that would be. But we have orders out to 2016, nothing that couldn’t change in January, given what happens in Congress. The other part on more a global basis is the patrol boat and military, mostly marine type activities and that business is going very well. The only caveat there is timing from quarter to quarter because building boats can sometimes be unpredictable on when they finish and when they need a product. But both of those markets there as of right now are going very well for us.

Andrea Sharkey – Gabelli & Co.

Okay, great. And then last question from me on CapEx. Do you think your budget, I think last quarter you said $15million to $20 million for this year. Q1 seemed very light, so I was just curious if that was just a timing issue or if maybe you’re retrenching a bit on your CapEx plans?

Christopher Eperjesy

Actually the answer is both. It was timing issue. It’s not a typical debt. The first quarter tends to be low from a CapEx standpoint for some of the reasons John talked about, plant shut-downs, but other logistics of getting it approved and getting it ordered and received. But also given the earlier comments, we’re probably looking more to $10 million to $15 million range as opposed to the $15 million to $20 million.

Andrea Sharkey – Gabelli & Co.

Okay, great. Thanks a lot. That was really helpful.

Operator

Thank you. (Operator instructions) The next question is from Brian Uhmler with Global Hunter. Please go ahead.

Brian Uhmler – Global Hunter Securities

Hey, good morning. How are you? I have a question for you on the product development you spoke about, you spent some money last year on that. I was curious if you had anything on the pipeline that was somewhat new, smaller, maybe working with gas turbines for pressure pumping or anything such as that that will help us out on the order front as we move through what is going to be a relatively tough year for North America in the oil and gas side.

John Batten

Brian, it’s John. We have looked at the gas turbines as far as how it relates to the frac market. I don’t have any updates there other than it is an option that we’ve considered because we’ve had from several different sources that this is a consideration. As far as other product development, we’re investing all the time and looking at a lot of different products and technologies, but it’s too soon to announce anything at this point.

Brian Uhmler – Global Hunter Securities

Okay. Now staying in that market, calendar Q2 basically the quarters dropped that at the end of that calendar quarter. So our fiscal Q1 we just finished, would you see that as a drop in orders or do you think that there were still some excess inventory that was being bought? Or can we go down from here? Was that pretty much the bottom in your view this quarter?

John Batten

It’s John again. If I had to guess it would be, potentially it’s going to be the first quarter-- looking at our fiscal year, Q1, Q2, Q3 is going to be the bottom. It’s hard to say. It will happen sometime in those months but I expect that it will start to come up in the next quarter or two. The backlog – here is the problem, the backlog, the components of the backlog are changing with a lot of oil and gas transmissions out which are 12-month lead time-type items. They obviously are very good for the backlog. But once you get into our aftermarket and clutch business PTO, those are three-week lead time items and so they’re in and out of the backlog before they can be reported so that is why there is a caveat. Certainly, our aftermarket business, industrial business and marine business look very good going forward. It’s just hard to predict when the backlog is going to bottom out and start to come back up.

Brian Uhmler – Global Hunter Securities

Okay. That makes perfect sense. And one final question, were there any-- did you experience at any point in time any cancellations in the quarter?

John Batten

Very small, but most of it was push out. The customers do not want to lose line for the transmissions that they had on order when the market comes back. Everyone is very sensitive that when the ramp up occurs again, they want to be able to deliver.

Christopher Eperjesy

It’s Chris. So those wouldn’t be the six-month backlog.

John Batten

Yeah, they’d be beyond that.

Brian Uhmler – Global Hunter Securities

Okay. Perfect. Thanks for your help. Appreciate it.

Operator

Thank you. Our next question is from the line of Kevin Leary with Spitfire Capital. Please go ahead.

Kevin Leary – Spitfire Capital

Good morning guys.

John Batten

Good morning Kevin.

Kevin Leary – Spitfire Capital

First question on ME&A just thinking about maybe scenarios for the rest of the year. Under what scenario might you dial back your dollar spend on ME&A? Let’s say that demand sort of stays down 15% range, would you look at that dialing back or would things have to get incrementally worse from here?

John Batten

We’re already looking at our ME&A spending, kind of operational spending, both cost of goods sold and ME&A. And obviously, given what’s happened in the first quarter and the outlook of North American Oil and Gas, we’re being very prudent on how we spend. I neglected to chime in, some of the ME&A adds that we’ve had, obviously we’re investing in people. In Asia the business is expanding there and we have a larger company-owned distribution territory now. We have some additional people in the mid-Atlantic region. So that kind of the year-over-year increase in people. Certainly if things were to change, we would be very aggressive as we’ve shown in the past at controlling and reducing cost. If it comes to that, that’s certainly not out of the realm of possibility.

Kevin Leary – Spitfire Capital

Thanks, that’s helpful. And then just one cleanup. On the statement of cash flows there is a $1.7 million of other cash outflow. What is that?

Christopher Eperjesy

That’s a good question and I believe it was the stock buyback.

Kevin Leary – Spitfire Capital

Do you guys have a number in front of you in terms of buybacks in the quarter?

Christopher Eperjesy

You know Kevin and I apologize, I don’t.

Kevin Leary – Spitfire Capital

Okay. We can follow up. Great, that’s all I had.

Operator

Thank you. And we have no further questions at this time.

Michael Batten

Okay, thank you, Ian. Thank you all again for joining the conference call today. We appreciate your continued interested in Twin Disc and hope that we’ve answered all of your questions. If not, please free to call Chris, John or me. We look forward to speaking with you again in January following the close of our third quarter. Ian, I’ll turn it back to you now for the close.

Operator

Ladies and gentlemen, this does conclude the Twin Disc, Inc first quarter Fiscal 2013 financial results conference call. Thank you for your participation. You may now disconnect.

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