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Spectrum Control, Inc. (NASDAQ:SPEC)

F3Q08 Earnings Call

September 25, 2008 4:45 pm ET

Executives

Dick Southworth - President, Chief Executive Officer and Director

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

Analysts

Chris McDonald - Kennedy Capital Management

Ted Kundtz - Needham & Company

DeForest Hinman - Walthausen & Co

Operator

Welcome to Spectrum Control Inc.’s third quarter conference call. (Operator Instructions)

Representing the company today we have Dick Southworth, President and Chief Executive Officer and Jack Freeman, Senior Vice President and Chief Financial Officer.

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.

Dick Southworth

I’ll briefly review some key operating and financial highlights after which Jack Freeman will review our financial performance in more detail. We’ll be happy to take any questions after that.

For the third quarter of 2008, the company reported net income of $2.4 million or $0.18 per fully diluted share on sales of $33.1 million. That compared to net income of $3.1 million or $0.22 per fully diluted share on sales of $35.4 million for the same period last year. I think more importantly for the second consecutive quarter, we generated sequential improvements in sales, operating margins, net income and earnings per share.

As a result, we are pleased to report that our third quarter results are consistence with and well within our previous guidance. Despite ongoing challenges in our telecom equipment market, we have successfully managed to increase our revenues each quarter of this year, while implementing numerous operating improvements to increase our profitability.

At this point I would like to introduce Jack Freeman our Chief Financial Officer and ask Jack to review our third quarter results in greater detail. When Jack has completed his presentation, I will conclude with some final comments and then we will open the floor to questions.

Jack Freeman

Sales of our signal and power integrity components were $13.2 million in the current quarter down slightly from the preceding quarter. Although our signal and power integrity components business serves many different end markets, about 20% of these products resulted in communications equipment industry.

Demand for our signal and power products within this industry segment continue to be somewhat soft. Customer orders for our signal and power integrity components totaled about $12 million in the current quarter compared to a little bit over $14 million for the same period of last year.

Sales of our microwave components and systems amounted to $11.5 million in the third quarter of fiscal 2008, up 11% from the preceding quarter. This was down about $1.2 million or about 9% from the comparable period of year ago. Although, this decreased when compared to a year ago, it’s attributable to reduced shipments in support of the RCIED Jammer System programs we’ll commonly refer to as the Crew programs.

Microwave product shipments under these programs were a little under $0.5 million in the current quarter compared to about $1.8 million for the same period of fiscal 2007. These Crew programs remain active however, with orders and shipments for system upgrades, expected to continue throughout the remainder of fiscal 2008 and into fiscal 2009.

Total customer orders for our microwave components and systems were just under $12 million in the third quarter of fiscal 2008. Sales and customer order rates for our other two businesses continue to grow during the current quarter. Sales of our power management systems increased by over $0.5 million or more than 27% with sales of about $2.3 million in the current quarter and about $1.8 million in the comparable period last year.

Shipments for these advanced systems were particularly strong in applications for data storage as well as networking systems in various military applications. Sales of our sensors and controls amounted to $6.1 million in the third quarter of fiscal 2008; that’s up nearly $700,000 or more than 12% from the same period a year ago. Demand for our custom position centers, which are used in various medical equipment, commercial weather instruments, as well as military aircraft and vehicles, all continue to increase.

Customer orders received in the third quarter of fiscal 2008 for our power management systems and our sensors and controls amounted to about $1.6 million and $5.6 million respectively. Overall for all of our businesses, average selling prices remain relatively stable throughout all of our major product lines.

During the current period our overall sales by industry remained relatively unchanged. For the third quarter of fiscal 2008 consolidated sales by major end market were about 47% military and defense, 25% medical and industrial instrumentation, about 18% communications equipment and about 6% commercial aerospace. Throughout the current quarter, as well as throughout the entire year, no single customer was more than 10% of our total consolidated sales.

For the first nine months of the current fiscal year, our total consolidated sales have amounted to just under $97 million, which is down about $5 million from the first nine months of last year. All of this $5 million shortfall can be attributed to reductions in shipments under our various Crew programs.

Crew related shipments were about $2.6 million in the first nine months of this year and that’s down about $7.5 million in the comparable period of 2007. While excluding the Crew related shipments our total consolidated sales were up about $2.5 million year-to-date or about 3% when compared to last year and obviously achieving that and some very difficult economic and market conditions.

In the current quarter our gross margin was $8.6 million or about 26% of sales, compared to $8.1 million or about 25% of sales in the preceding quarter and less than $7 million or about 22% of sales in the first quarter of this year. So, we made continuous improvement in our gross margins throughout this year. This increase in gross margin reflects improved production yield across virtually all of our businesses.

In addition, we have made and continue to make a strategic decision to maintain our production capacity and infrastructure to enable us to quickly and very effectively and efficiently respond to our customers. Accordingly our sales volumes grow; we do not need to add any significant production capacity allowing us to leverage our fixed manufacturing overhead and thereby enhancing our operating margins. This strategy remains a key element of our ongoing business model.

At the end of the current quarter, we had a workforce of a little under 1,500 employees, down about 9% from the end of last fiscal year and as always we expect to continuously review our organization and cost structure to further enhance our operating efficiencies on maintaining sufficient flexibility for additional production requirements.

During the current quarter, our selling expenses amounted to about $2.8 million or 8.4% of sales compared to $2.7 million or about 7.6% of sales for the same period last year. The slight increase in selling expense primarily reflects some additional travel and advertising costs, as well as some slightly higher affective sales commission rates.

Aggregate general and administrative expense was about $2.2 million in the current quarter, that’s down from the $2.4 million in the comparable period of last year and that $200,000 increase in G&A expense, primarily reflects the combination of lower incentive based compensation, as well as reductions in various discretionary expenditures.

Compared to a year ago, our interest expense continues to decrease sensibly reflecting lower average short-term interest rates. In the third quarter of fiscal 2008, our average short-term borrowings were about $6 million and our average interest rate was about 3.6%. In the third quarter of last year, our weighted average return borrowings were just a little bit over $5 million, with an average interest rate of about 6.5%.

For the first nine months of this fiscal year as well as last fiscal year, our effective income tax rate was about 35.1% this year, 37% last year, which compared to an applicable federal and state statutory income tax rate of about 40%. Our ability to have an effective tax rate of slightly below that 40% primarily is the a results of a combination of domestic production activity deductions that are allowable on the U.S. research tax credits as well as state tax divisions and differences in our foreign income tax rates.

Net cash provided by operating activities in the current quarter grew to $4.4 million. This positive cash flow was primarily driven by reductions in our overall working capital requirements, along with our enhanced profitability. This improved operating cash flow and enabled us to reduce our short-term bank borrowings during the quarter by $2 million; as well as we purchased on the open market a little over 313,000 additional shares of our common stock at an average aggregate cost of $2.4 million.

During the first nine months of the current year, we have now repurchased the total of 756,000 shares of our common stock, at an aggregate cost of about $6.5 million. Under our Board of Directors current authorization, we may extend an additional $872,000 under our stock buyback program.

The amount and timing of future share repurchases if any, will continue to be based on our ongoing assessment of the company's capital structure, our liquidity, as well as the market price of our common stock. We believe our ongoing stock buyback program is a positive reflection of our future business outlook as well as our strong financial position.

Our overall financial position does remain very strong. At the end of the third quarter, our current ratio was nearly four to one, and our debt to equity ratio was less than 0.3 to 1, and we currently have $30 million of borrowing capability under our domestic line of credit that support future growth as well as acquisition opportunities and our cash position at the end of the third quarter was about $6.4 million.

With our solid financial position we continue to think we are strategically well positioned to support our future anticipated growth. Now, with that Dick will make some concluding comments.

Dick Southworth

Based on our current assessment of customer demand and our existing customer order backlog that is typical in the fourth quarter, we presently anticipate our fourth quarter’s sales to be between $33.2 million and $34.5 million.

Based on the shipment level, we expect our earnings to be $0.19 to $0.21 per share. If these operating levels are achieved we will have demonstrated sequential growth in revenues and profitability in each quarter throughout 2008. On a longer-term basis, our strategy remained unchanged. We’ll continue to diversify our end markets, we’ll leverage our business infrastructure and provide an increasing array of value-added products and solutions to our customers.

With this strategy we believe our company is very well-positioned for dynamic growth and enhancing shareholder value.

At this point, I’d like to open the discussion up for any questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question is from Ted Kundtz with Needham & Company.

Ted Kundtz - Needham & Company

A couple of questions for you; one, could you talk a little bit more about the outlook for order trends that are going forward? I know they tend to be kind of lumpy, you had a great bookings trend and a great booking numbers in the third quarter and this one dropped off a bit to the book-to-bill ratio as 5.94, so do you have any sense of what you expect to see going forward? How lumpy this is? And what kind of projects you have any visibility on?

Dick Southworth

It’s not in the projects specifically Ted. Year-to-date we are at a one point, almost ’09 book-to-bill, and I would expect this year to end up at about that level. We have a lot of major programs that were a sole source on the majority on them and we just wait to come to provision here in the fourth quarter and unless there some impact from the current base of the economy we expect them to be realized.

Ted Kundtz - Needham & Company

Okay. Are you seeing any impact of the economy or you mentioned obviously the telecommunication sector was probably being the most affected by it, any other areas that you’re seeing at the moment?

Dick Southworth

I would say publicly for us Ted, the greatest thing is the uncertainty of the timing and the funding of the different programs for our military markets, but other than that the medical and industrial instrumentation sides, all seem to be going really without any ups and downs, they are very steady.

Ted Kundtz - Needham & Company

Okay and the telecomm side, is that the only area of real sort of weakness you’re seeing?

Dick Southworth

Yes and most of that has gone international now and I should say it’s over in Asia and its in fact the only area that we see any type of graph made on. In ’06 and ’07 we went through the search for the crew business, to get all the products out there for our troops and this year we will definitely be down, but it will be a good part of our business still, and we expect that that crew for Spectrum Control will be a strong ongoing market. It’s not in the step bed or anything like that; we just had to ramp up our operations tremendously in ’06 and ’07 to get all of that stuff out in to the fields for our troops.

Ted Kundtz - Needham & Company

Okay, so you’re still seeing some follow-on business for the crew; too basically is what that is? Is that some upgrade business you’re seeing?

Dick Southworth

Yes, we’re seeing always the requirements now to extend the capabilities of the equipment that’s out there in both power and frequency.

Ted Kundtz - Needham & Company

Okay, do you have any visibility for the next lag of the crew? I guess it’ll be called as maybe the crew three I guess; is there any added visibility on when that could kick in or if that’s going to kick in at some point?

Dick Southworth

I really don’t that timing. All I can tell you is we’ve got a lot of qualifications already in place, but we are in the second tier down, so we really don’t know when it’s going to break.

Ted Kundtz - Needham & Company

Okay and then Jack Freeman a question for you would be, the trending gross margins, you still see them kind of inching up? I guess you’ve kind of indicated it was contingent of volume increases and what would be the given sort of targets for next year?

Jack Freeman

The answer to the first part is we have the experienced a consistent improvement in gross margins throughout the first two quarters of this year. We would expect that improvement to continue for two primary reasons; one is our production yields throughout virtually all of our businesses are improving and so that certainly is improving what we call our prime margins of the sales revenue less material on labor.

Also since we have consciously kept much of our significant amount of capacity in place, so we could respond very quickly to increases in volume as we experienced some increase in sales volume, we’re able to leverage our manufacturing overhead very effectively. So, on an incremental basis we have some very strong margin.

The gross margin before the third quarter was about 26%; we would expect to continue to see ongoing improvement with that and the extent of that improvement as you indicated has a significant relationship to our sales volume, but our goal has always been in the low 30% and just with a target of say 33% or 34%, we don’t expect to hit that target in the next quarter or the next two quarters, but we hope to make consistent progress towards that as production yields continue to improve and our volume increase.

I guess the simple answer to your question is that we would expect to see the same sort of incremental margin improvement that we have seen for the last three quarters; we would expect that to continue in the near-term.

Ted Kundtz - Needham & Company

Let me get this straight, you said your goals was 30%, but then you mentioned a 33%, 34%; is that a longer-term?

Jack Freeman

That’s a longer-term goal, which is obviously a number of things have happen to achieve that an a sales significant increase in sales volumes is part of it, but we continue to have aggressive sales revenue targets going forward, both through organic growth or a combination of organic growth and acquisition growth. So, if we’re able to make that happen we would expect to continue to move towards those targets.

Ted Kundtz - Needham & Company

And the intermediate one of the 30%, could you reach that with say a 10% sales increase, is that a durable kind of relationship?

Jack Freeman

I guess getting that specific is difficult because it does (Multiple Speakers) functions regarding sales mix in the above, so I guess I’m not in a position to give you a good answer on that one.

Operator

(Operator Instructions) Your next question comes from DeForest Hinman with Walthausen & Co; please go ahead with your question.

DeForest Hinman - Walthausen & Co

Just a few questions; can you talk about the buybacks over the next few quarters and then also acquisitions in terms of multiples that we’re seeing and also how you’re prioritizing share repurchases and acquisitions in this environment, we’ll start off with those one?

Jack Freeman

Sure, let me try to answer this part of that. As I indicated there is a little bit under $900,000 of the current board’s authorization that has yet to be extended for stock buyback. We will continue as we have throughout the stock buyback period to monitor and really balance many of the things that you may reference to.

It’ll balance what the opportunities are for acquisitions and the demand for cash both internally through growth and CapEx and externally through acquisition and we’ll also measure that against the opportunities we see with the stock buyback and the value of the stock and so, I guess all I can say is that we expect to continue to monitor that and make those types of judgment based on kind of the facts and circumstances as they evolve.

DeForest Hinman - Walthausen & Co

Can you hope one headed the other; I mean in terms of if you can’t find the track to the acquisitions, are we liable or more apt to repurchase shares and then increase as the board will increase the authorization?

Jack Freeman

Perhaps although I guess the initial premise of your question is one that we wouldn’t subscribe to and that is we continue to view acquisitions as a very significant part of our ongoing growth strategy and we’ll be very, very disappointed if we don’t identifying and consolidated acquisition going forward.

So, currently we don’t expect that we’re going to be forced to make that type of decisions where we would expect for any prolonged period of time; the acquisition opportunities not to prevent themselves. We continue to think there is a lot of opportunities out there and it’s up to us find them and structure them in a way that make sense for us.

DeForest Hinman - Walthausen & Co

Can you talk about the multiples that you’re seeing in market?

Jack Freeman

I guess overall, I would say the trends have been increasing in terms of multiples and we’ve shared this in the past that we have some pretty strict payback expectations for an acquisition and as a result we’ve really looked to find those acquisitions where we bring a lot to the table, post acquisitions in terms of consolidation opportunities, whole entry of products, utilizing our sales channels and low cost manufacturing centers.

Historically, the valuations that we paid have been anywhere from on average, four times to 6.5 times, trialing adjusted EBITDA going forward and as we continue to look at acquisition opportunities, these stores that we’re seeing is probably the trendiest, some upward pressure actually on those evaluations.

DeForest Hinman - Walthausen & Co

Alright, and kind of a different line of questioning, I don’t know if you addressed this, but can you talk about the material cost as a percent of revenue or labor cost as a percent of revenue. You disclosed those on previous calls, I believe in your manufacturing overhead costs?

Jack Freeman

I don’t have that specific information in front of me; I can tell you that it’s approximately during the quarter our material costs were about 23%; our sales and our labor costs were about 12.5% of sales and on a combined basis, that’s an area where we continued to experience improvement, for a variety of reasons and a variety of programs that we have in place. In general raw material and labor costs as a percentage of sales, we are able to continually drive down.

DeForest Hinman - Walthausen & Co

And I know we’ve talked in the past on consolidating some facilities at State College; is that completed or is that something that’s still ongoing and has there been any expense in the past two quarters related to that, the moving expenses?

Jack Freeman

It’s not completed. We certainly have made a lot of progress and actually what we’re trying to do on State College is ramp up with new programs and train the workforce there in those new programs. It’s quite a large facility; right now we occupy and use for manufacturing about two thirds of it; so we still have that more area to continue to consolidate and grow, but a good portion of that that we’re looking forward to fill up as we continue to expand and grow and make acquisitions.

DeForest Hinman - Walthausen & Co

And kind of the last question I guess; is there any update on I’m not going to say it right, but the product that we’re trying to get built into the electronic motors for the auto industry; I don’t think we’ve talked about that in a while. Is there any update on where that stands?

Dick Southworth

We have a have few wins, but they’re on the lower demand side as far as volume. The big ones we have still have not landed yet. We continue to upgrade those products.

Operator

Your next question comes from the line of Chris McDonald with Kennedy Capital Management.

Chris McDonald - Kennedy Capital Management

Just a follow-up on the Crew program; the company issued a press release about a month ago that highlighted in order it in that you received and on an upgrade a program that appears to be ongoing. I’m wondering if you could just elaborate on the timing and potential magnitude of that opportunity in particular?

Dick Southworth

Right now, we would expect the next release to be in the early part of next year and the potential we think next year for that to be at least twice what was released this year.

Chris McDonald - Kennedy Capital Management

Okay and that’s to you having a longstanding customer on this program?

Dick Southworth

Yes, as one, but we have others; as far as Crew goes, we have all the end programs for the [inaudible] and it’s not just that. I guess I want to just make sure that I qualify it to you.

Chris McDonald - Kennedy Capital Management

Okay, I mean it sounds like that over the course of the next 12, 18 months or so you’d expect an up tick or a rebound if you will from this somewhat, the pricing level as you experienced here over the first nine months, on crew in particular.

Dick Southworth

Yes, next year we believe we’ll be much stronger than this year. I don’t think it will be the ’06 and ’07 levels, but there’s certainly an outside chance of that. So, as one program, the major program out there for the advanced equipment, if it does get funded embrace it with certainly change and add to…

Chris McDonald - Kennedy Capital Management

Okay very good and typically from a mixed standpoint, does more Crew revenue put upward pressure on your gross margin levels?

Dick Southworth

I would say that there is not a significant difference between the margins for those programs and in the average margins that generate our overall gross and so there’s not a big mix impact as a result of that.

Chris McDonald - Kennedy Capital Management

Okay, so the key largely is volume driven? Okay thank you.

Operator

Your next question comes from Ted Kundtz with Needham & Company; please go ahead with your question.

Ted Kundtz - Needham & Company

Dick, could you go just little back and maybe try and review for us the bidding activity that you guys are seeing and maybe I don’t know how you could characterize it; is it increasing or steady or decreasing compared to last year early on even year?

Dick Southworth

I would say, first let me the say for overall this year, it’s stronger than last year and it has continued to increase each quarter. Our engineers are designed people, our technologists are just, I don’t know swamped is the right word for it, but they are very, very challenged and the order rates just continue to increase modestly from quarter-to-quarter and as we need to address that, we take various steps as far as we’re making time available for two more, adding people to get that done, but there is a lot of programs out there that are being aggressive this time, which should reflect in the good 2009 for us.

Ted Kundtz - Needham & Company

Assuming your wind rate stays healthy, you’d expect to see them go up and had a program that’s different or I’m trying to see if you can characterize it a little better for me. Are they in new areas for you, just why is it increasing? What’s causing the increase in the recording activity?

Dick Southworth

It’s new, especially let say from the military side, it’s a new programs and we’re doing some design work right now that we don’t expect significant dollars for it until 2010 and 2011, but we did the same thing back in 2007 and 2008 and we’re waiting for those programs just to release. We’re designed in, we’re the source for those programs, they’re funded, but I would say what we’re doing right now, we don’t redesign typically for existing programs, so almost everything we do is constant for new programs.

Ted Kundtz - Needham & Company

What would you say the next would be between the military and the commercial side in terms of the bidding; is it pretty much as similar as your revenue mix is?.

Dick Southworth

Yes, there maybe some military programs that are a little stronger but our commercial side of our business hasn’t weakened other than telecom and if you may remember in our history in telecom, last year was soft, the first quarter was soft; we seen an up tick in the second quarter, third quarter went soft. We really don’t know where telecom is going, but our business is so diverse right now, telecom is 120% of our overall revenue; so it doesn’t have a destructive impact on us because the other segments are growing at a very good rate.

Ted Kundtz with Needham & Company

Okay, so going forward you’d expect the mix to stay basically the same, maybe a little weaker, maybe a little less in telecom, but maybe if that continues to weaken, but for the most, commercial mix will stay roughly the same, is that basically what you’re saying?.

Dick Southworth

Well, I would say if telecom remains flat, it’s going to shrink as an overall percentage because the other segments are all growing.

Operator

There are no further questions in the queue.

Dick Southworth

Well we’d like to thank you for joining us today and with no further questions, we’ll conclude this conference call.

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Source: Spectrum Control, Inc. F3Q08 (Qtr End 08/31/08) Earnings Call Transcript
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