Hexagon Composites' (HXGCF) CEO Jon Engeset on Q3 2017 Results - Earnings Call Transcript

Hexagon Composites ASA (OTCPK:HXGCF) Q3 2017 Earnings Conference Call November 2, 2017 3:30 PM ET

Executives

David Bandele - CFO

Jon Engeset - CEO

Analysts

Hans-Erik Jacobsen - Nordea

David Bandele

So welcome everybody to Hexagon Composites' Quarter Three 2017 Earnings Broadcast. And I hope everybody had a great Halloween last night, and you should have comfort in the knowledge that our numbers are not quite frightening as that would have been. Saying that's quite the opposite, and today I will take you through the highlights and onto the financials and segment overview, and then Jon Erik will take us through the exciting impacts to Hexagon in the outlook section, and also take us through the Q&A. I will join for that.

So quarter three 2017 quite simply our best third quarter results since 2014. That bodes very well. Low-Pressure grew 74% year-over-year, but also it's the first time we've been able to say that High-Pressure has had a profitable performance overall. So both very good elements. Hydrogen continued its strong growth over quarter three 2016. Last quarter we talked about significant development contracts we have for two new fuel cell electric vehicle models. We have commenced work on that. That will take us through 2019, into the start of 2020, and just to be clear, if those projects are successful that would lead to a significantly material and serial production contracts for Hexagon Composites.

Light-Duty Vehicle was very strong. Mobile Pipeline North America solid volume, especially to oil and gas. Also pleasing after the quarter we received a significant order $11 million and also significant that that was to a industrial sector in North America. However, rest of the world had a dry quarter we have to say, but Mobile Pipeline in general we have some exciting news also to do with the after-sales service market and Jon Erik will touch that. It's to do with regulatory requalification. So we have some exciting news there. Also our investment into Agility Fuels Solution had also a profitable quarter. So very satisfactory Q3.

Let's take the financials. On the far-right hand side in the orange you can see we recorded operating income or turnover of NOK353 million. EBITDA, earnings before interest, tax, depreciation and amortization was NOK51 million and that allowed us to turn in a net profit of 16 million. This will be the last quarter where we have to compare and rebase for the two major transactions we did in quarter four, '16 so what we call the CNG carveout here on this page, and that's the Agility transaction where we took out the Heavy-Duty and Medium-Duty businesses and placed them in another vehicle. And also we acquired xperion. So from quarter four onwards they will be like-for-like numbers in terms of those two transactions.

In terms of EBITDA, aside from the Low-Pressure performance, we also benefited from some extra income from Agility. Speaking of Agility, their normal contribution below the line on the underlying basis very strong. However these were reversed by certain accounting adjustments that I'll cover later. Otherwise very strong cash and liquidity in Hexagon.

Looking at the detailed profit and loss or group income statement. We returned operating income this quarter of 352.8 million versus 266.2 million same period last year. After expenses, EBITDA was 51.2 million versus 4.6 million same period last year. That's a growth of NOK46.6 million. Depreciation NOK 12.2 million, slightly lower than last year. This is mainly to do with the carve out of the CNG business, which is asset heavy. However for amortization and impairment, we're bringing intangible depreciation to do with the xperion acquisition, so NOK 5.2 million versus NOK 1.3 million same period last year.

Washes down to EBIT or operating profit of NOK 33.8 million versus a operating loss same period last year of NOK 12.4 million. So NOK 46 million growth in our operating profit year-over-year, very satisfactory.

Then we go below the line, the share of profit or loss from associates. This is the performance from Agility after some accounting adjustments that was a negative NOK 2.1 million. And then when we bring in the amortization of intangibles connected to that transaction that's an extra NOK 3.3 million in the quarter. When you look at the other financial items, we have NOK 6.6 million in cost, NOK 1.6 million of that is interest and the other NOK 5 million then is currency effects that have impacted negatively. So that leaves us with a profit before tax of NOK 21.8 million against the loss of NOK 18.4 million in quarter three 2016.

So after taxes we record a profit of NOK 16.4 million versus a loss of NOK 10.6 million same period last year. Double-digit EBITDA of 14.5% boosted by other income we received, but very pleasing. Operating profit margin of 9.6% and net profit margin 4.6%. Figures to the far right, the full year 2016 and we will recall that we had a exceptional gain due to the Agility transaction of NOK 348.2 million that was before tax and that's obviously skewed those figures for the year.

So let's walk our revenues for Q3 '17 versus Q3 '16. So last year for quarter 3 on the left hand side we recorded NOK 266 million of revenues. Within that number, NOK 133 million belonged to the business that is now in Agility and reported below the line. So stripping that out, that comparable number would be NOK 133 million in revenue. And then you can see the contributions to the right hand side extra NOK 72 million in growth in High-Pressure and NOK 71 million in Low-Pressure. So combining for 107% organic growth in the company year-over-year, so very significant in Q3.

That takes us to NOK 275 million before xperion and then we place what xperion has contributed in revenues for the period; that's NOK 78 million, takes us to NOK 353 million. So strong growth in both High and Low-Pressures. That is a very healthy position for Hexagon Composites.

Same deal on EBITDA. We recorded NOK 5 million in Q3 '16 to the left hand side. We take out the impacts of CNG business, which is now in Agility. So to rebase that, we carve out NOK 20 million of that and actually comparable position would have been minus NOK 15 million quarter third 2016. And then you see the contributions year-over-year from High-Pressure. So that's been an expansion in EBITDA of NOK 49 million, very significant, and Low-Pressure NOK 18 million. After some eliminations that takes us to NOK 48 million. Total growth then NOK 63 million EBITDA year-over-year. Adding the xperion piece, we get to NOK 51 million for the quarter.

So not to repeat myself, but the pie on the left shows the turnover shares within our business units. The first one 133 million, this is the Agility. That doesn't appear to the pie to the right. So let's start with the grey. That's the 11 million we did last year in Light-Duty Vehicles, and you can see to the right that number is 54 million, so very much a steady-state number in Light-Duty Vehicles this quarter. And what's significant is that it's a far greater share now of our turnover going forward.

Mobile Pipelines admittedly had a very weak performance in Q3 '16 of 20 million and recorded to the right 72 million in the quarter. That's all organic growth. As I said, rest of the world volumes were more or less dry. In hydrogen, exponential growth, both organic and non-organic, mainly non-organic I have to say, from 7 million and it's fourfold this year 29 million. So significant performance continues on hydrogen. And MasterWorks and other recorded about NOK3 million quarter 3 '16. This year is 35 million MasterWorks has increased but most of that increase is to do with extra income from Agility that we place in that area.

Okay. Now the High-Pressure segment, so we've talked about Mobile Pipeline deliveries strong to North America, particularly oil and gas we received large orders start of the year. We're delivering to that steadily throughout the year. In terms of hydrogen, what's very, very exciting to us is these revenues are about over 70% of these revenues are actually commercialized applications, particularly in transport and distribution and storage. Light-Duty Vehicles represents also the other side of the income stream, and that tends to be development contracts today.

On Light-Duty it's had quite a good revenue quarter, actually the highest quarter for 2017, again bodes well. We did have some interruptions to Q1 and Q2. So Q3 is more or less steady state. In terms of MasterWorks, I would say sales volumes are literally beginning to take off and that's because a couple of exciting opportunities are in aerospace and also oil and gas. So overall High-Pressure Q3 we definitely see the profitability improvement. That's great. It's very visible but still at lower levels.

Now we did have some operational inefficiencies that impacted us negatively in Q3. We've also been incurring losses in our Ohio plant, but those were more than offset by extra income from Agility. So still more to go from an absolute level in High-Pressure going forward. Saying that, operating income at the bottom was 189.7 million this quarter versus 173.4 million the previous quarter, and then EBITDA was recorded at 17.7 million versus negative 15 million same period last year. The negative 15 million is headline numbers and that also includes the CNG business.

On operating profit, we did NOK5.1 million against a operating loss same period of 26.2 million. Going below the line then, you'll recall we contributed our CNG Automotive Cylinders and Systems business together with its largest customer Agility Fuel Systems to combine one market leader called Agility Fuel Solutions.

And we took a 50% stake in that investment. What that meant is that the numbers are deconsolidated as of quarter 4 2016 and bearing in mind in 2015, CNG posted revenues of round about NOK 700 million and way over NOK 100 million in EBITDA. So those numbers are coming out. However, it should not be lost on us, if you look at the left-hand side of that pie, Agility Fuel Solutions represents almost 40% of our balance sheet.

So how did Agility Fuel Solutions perform in Q3 '17? The chart to the top right hand side shows a turnover of $41 million for the quarter. So fairly solid quarter both on revenues and the number below is $4.8 million adjusted EBITDA, which is the most cash-like EBITDA performance and that is 12% EBITDA margin. If we go to the chart below, we can see how that $4.8 million translates to profit before tax. We then take off the on cash impacts of share-based compensation and other expenses, and that takes us down to $3.6 million and then after depreciation and amortization of $2.1 million and interest expenses of $0.3 million, we come to a profit before tax of $1.2 million. Also Agility remains similar to Hexagon, good cash position, good working capital position. In terms of an investment, it's fully funded. Going into some of the Agility-reported segments, we can see that Heavy-Duty truck remained very solid for Q3, so year-over-year growth was significant, admittedly against a weak 2016. Bus volume is a little bit the other way. It's been relatively soft in the quarter, and it showed year-over-year decline just in this quarter just because we had a very strong Q3 2016. Otherwise it's tracking very well year-to-date. And positive news on refuse truck sales, which picked up in the quarter and for the first time we've shown year-over-year growth in that segment. The final segment, Powertrain Systems, which near-term is a medium duty propane play, good to see that that is very much tracking to the business plan.

Technical I know, but how do these results translate to Agility. There is three main things we'd like to cover: one is the underlying results much stronger than the headline results show. One of those factors this is a elimination of some of that income from Agility, 50% of it to be precise, and that is almost NOK 11 million effect that is non-cash. The second element is this share-based compensation. The accounting cost is far higher than the cash cost. So we're taking those charges as well. And the third element is the intangible assets that are depreciated over their lifetime. So if we look at the top right hand side, we start with the $1.2 million profit before tax. We take our 50% share translated into NOK and it's NOK 4.8 million. We then add NOK 3.8 million of accounting driven adjustments. This is more going from U.S. GAAP to IFRS, but unfortunately that will take us to NOK 8.6 million and unfortunately we have that elimination there of the income from Agility to Hexagon of negative NOK 10.7 million, and there we see a NOK 2.1 million profit before intangible amortization. With the amortization, that takes us to a negative NOK 5.4 million headline result. Why it's much stronger underlying is if you start with that negative 5.4 million, you add back the accounting adjustment, the 10.7 million, add back the intangible amortization and also the delta between the cash and accounting impacts on the share-based compensation, we actually get the underlying cash value of 11.4 million. So that's a NOK16 million spread between the headline and the underlying.

So last but not least, the Low-Pressure segment 74% year-over-year sales growth. This is indeed a record third quarter sales, so all time record, again volume driven. We were beneficiaries of a lot of deliveries into very good customer in the Middle East, and pleased to say that we are on track with the CapEx programs that we have been publicizing and year-to-date spend on a financial calendar year is NOK31 million. In terms of operating income for Low-Pressure, quarter three returned 165.8 million, so a very full quarter for Low-Pressure then against the seasonally low, more typical quarter three for Low-Pressure of 95.1 million. For EBITDA it recorded 36.2 million versus 18.2 million in the same quarter last year, and operating profit or EBIT was 31.6 million versus 12.5 million same quarter last year.

Not a lot of change in the balance sheet. One thing I'll point out to is the line investments in joint ventures and associates. That's the holding value of the Agility investment. Due to the significant reduction in the U.S. dollar to NOK between Q2 and Q3 this has led to a reduction in that value in terms of Norwegian knone and most of that effect then has gone into straight into equity and not through the P&L. Otherwise no significant changes to the balance sheet. We are to the right-hand side reporting net interest debt of NOK217 million, which is under 10% of our total assets and our equity ratio remains 55%. So very solid balance sheet with very good capacity.

For cash, I'll close on that, quarter three 2017 was a very positive quarter. Not only did we have significant positives from the great results that's the 48 million from underlying operations, but we had a quarter of very positive working capital movements as well, and those have been very volatile as you know. But that has taken us to 234 million in cash by the end of the quarter.

So I will summarize by saying this is a very, very pleasing set of quarter three results and bodes very well for the direction and momentum of our profitability going forward. And if I can invite Jon Erik.

Jon Engeset

Thank you, David. Good morning, everybody. So back in August we announced that we would supply cylinders to Toyota for heavy-duty truck in North America. I thought I would start the morning by showing a video to cheer us all up because the tanks have been installed and there is a pretty cool video available on YouTube, so please. Watch the acceleration.

[Audio/Video Presentation]

So I'll talk more about hydrogen later. But first I will touch on some of the other business areas, starting with Mobile Pipeline. So as you will remember, we have had challenges in the Mobile Pipeline segment for the last 2 years. I have to say, things are looking considerably much better at this stage. We had a decent Q3. We will have a better Q4. And looking into 2018, we see a lot of opportunities. What is different now from when this segment boomed back in 2014 is that the

drivers behind the market opportunities are not entirely shale gas play, although, of course, an oil price North Sea oil above $60, WTI at $54 yesterday. That will certainly help. But primarily the market is driven by environmental reasons. Outside North America, the order intake is still slow. The prospect list is very long, so we are by no means pessimistic, but at this stage, we have low visibility outside North America.

Numerous new applications are considered in these projects. Flare gas capture is coming back on the agenda. Several gas utilities have to manage their venting of methane and the growing number of biogas plants also release a transportation requirements. We have projects in Brazil, gas islands, towns and villages that have a local network but lack the supply system into their network, and also new opportunities of gas transportation by sea. Also we are now launching a rental service offering in North America, so our customers can choose to rent our modules if they so prefer. We sent out a release a couple weeks ago about a new approach to mandatory regulatory requalification testing. So it varies from country-to-country, but normally tanks have to be re-qualified within certain intervals.

And our Modal Acoustic Emission approach, which we can see here, which is the system is installed in the containers, avoiding disassembly of the modules, saving a lot of time. The tests can also be performed close to the location of our customers and that, of course, saves valuable time and secures better uptime. We have received now the DOT approval and we see a number of units coming up for this regulatory retesting in 2018 and forward. The first project will be now in this quarter with our valued customer NG Advantage.

Moving on to the LDV sector. So I'll again spend a few minutes on discussing the natural gas, biogas alternative vis-a-vis battery electric. Because there is a lot of press about battery electric. So let me assure you, we are not against electric vehicles. On the contrary, our fuel cell technology -- sorry, not our fuel cell technology, but or hydrogen technology for fuel cell is indeed to electric vehicles. A fuel cell vehicle is an electric vehicle. So long-term, we think it's a very interesting trend with electrification. It will solve short-term local emissions, but it is a fact that in most countries, also in Europe, battery electric vehicles will do very little, if nothing, for the climate.

And if you believe that the climate challenge is among the greatest challenges, then we have to look at other alternatives to address that short and medium term, at least for the next 10 years. This graph shows the real footprint if you take into account the production of the cars, batteries, fuel cells -- sorry, not fuel cells, battery, cars, and also the real emissions from the generation of the electricity. So in several countries, including, for example Poland in Europe, a large share of the power production is from coal, emitting substantial CO2. So what this chart shows is the real per kilometer equivalent CO2 for electric vehicles -- battery electric vehicles in different countries, and then you have the comparison with petrol and with diesel. Pure CNG, meaning natural gas only, is in comparison at 131. If you mix in biogas from bio waste you get down to 78. And only few countries in Europe are actually below that using battery electric cars. So this is an extremely important point, if you want to understand why gas is a part of the mix for vehicle transportation in the coming years.

We will increasingly use the term g-Mobility. You know the e-Mobility term. I think in the coming months and years not only we but a number of other players also will talk a lot more about g-Mobility as the fastest way to CO2 emissions reduction in the transportation sector. This is data from Volkswagen, our illustration, but their Golf TGI they are at 95. This is not including the footprint of car itself, so that's why it's different from the 133 on the previous page. Natural gas is in its pure natural gas form is slightly above, but you see if you only use biogas, you are well below the EU target of 95 in 2021 and synthetic natural gas even below that. So again these is why Volkswagen and also other OEMs are so much focusing now on CNG as an alternative to electric, not an alternative but a supplement rather. So despite a very strong E-Mobility push, which we have seen at the various automotive shows, several new CNG models are also launched and we are expecting to see more in the years to come. We have seen a strong development for LV CNG business, as David showed. We see a continuation of that now in Q4 and also in 2018 and forward we expect strong if not a very strong growth in this segment. Back to hydrogen, I'll show you another video. This is the Mercedes GLC hybrid fuel cell and battery electric that has hexagon tank in it. So please watch.

[Audio/Video Presentation]

So still very active marketplace within hydrogen. Again, we shall not discuss it in the next few years battery electrical have significantly higher market share than fuel cell electric vehicles will have. So fuel cell is 10 years behind the battery electric on the growth curve. We think that there will be segment or portion of that market which will be fuel cell electric. We don't think battery electric necessarily is the solution for all geographical markets and certainly not for all types of cars. And we see that a lot of the majors or several of the majors have programs for new models, and we expect more or we know for a fact that there will be more to come in the next few years.

This is by the way the truck that we saw in the opening video. This is our close colleague from Mitsui, David Sum, who was out in California test driving. We have still high number of requests and enquiry from all segments. California at this stage is leading the way, already 3,000 fuel cell electrical vehicles on the road and 30 retail hydrogen refueling stations built and another 13 are under development. And what has emerged in the last few months is market related to power to gas, so storage of surplus solar power energy or other clean energy as hydrogen. So light went out. Will you try to correct that? Thank you.

So of course, if there is solar energy available that the grid is not able to absorb, then storage as hydrogen is very efficient alternative. And then that requires tanks. So we see growing potential for Hexagon in that field. Our joint venture with NEL and Swedish PowerCell is now operational. The management has been recruited and are in full operation. So far primarily focusing on maritime opportunities and there are a number of them in number of segments, but we also see opportunities in other sectors where more comprehensive integrated solution is required. So that is indeed the purpose of Hyon, cooperating closely with its three owners.

Back in January at the Davos Summit the Hydrogen Council was established. It has now 24 members, of which Mitsui & Co is one. It is the CEO of Toyota who is one of the two Chairmen. You see their vision of hydrogen's place in the society in the blue box there. And the original 13 founding members, they have together investment plans of $10.7 billion over the next five years. So lot of majors, including Statoil by the way, are participating in this for driving the hydrogen industry forward.

Moving on to Agility, a very good year in 2017. We are, as I have expressed previously, very pleased with the management of Agility and how they have handled the integration with Hexagon's previous facility linking and also how they have managed the opportunities throughout 2017. We see a relatively soft Q4 unfortunately, also relatively low visibility going into 2018, but certainly the high oil price is a very positive factor. So we hope that will stimulate demand so that we get another good year in 2018.

Strong focus still on optimization and harvesting our synergies. The Powertrain Systems business units, the propane business addressing the medium-duty truck market in the U.S., among which the school bus market is an important part, is progressing, and we expect to see strong growth from that business in 2018. And as we have reported previously, we successfully entered the UK in 2017. We expect to establish Agility business in more international markets reducing the dependency in the U.S. going forward.

LPG it's just a lot of joy. We have a full order book for Q4. So 2017 will be a record year. We have had very strong years previously as well. However, we have not had any maintenance break in 2017, so we need to take long one, planned one, in December. So that will impact the results of the quarter. Also we have a relatively complex product mix. So some configuration are produced at lower efficiency than the average, and we have planned to do a relatively large share of that now in Q4. So don't expect as good results in Q4 as we reported now for Q3, but still relatively speaking strong Q4 2017.

Solid order backlog for first half 2018, more or less full. So our focus now is on filling the order book for the second half of 2018. Good traction in the Middle East, and we have opened yet another market, this time Lebanon and where you see from the commercial here that it is the corrosion properties of our offering, which is promoted as a main feature of the Ragasco cylinder.

The expansion program at Raufoss is on track. About NOK75 million in the period 2017 to 2019, part of it into extension of the footprint. The main purpose is to further strengthen the differentiation properties of the LPG cylinder, but as more or less by-effect you also get an increased output. So higher speed, lower scrap rates, that is all good stuff, and we expect by the middle 2019 to reach a true capacity of 2 million cylinders. The nameplate capacity is higher, but because of product mix variations, the real capacity is expected to be at least 2 million cylinders per year. Also there is a very close correlation between volume and unit cost. So this will also help us to reduce the unit cost further.

So, in summary, Mobile Pipeline set to grow, continued positive if not strong development expected for Light-Duty, continued very high hydrogen activity, softer through Q4 for Agility. We hope that the oil price will stimulate a pickup in demand in 2018, but at this stage we have low visibility. Strong LPG order book. We expect 2018 to be yet another strong year. So all-in-all, looking pretty good I would say.

So with that closing remark, David, please come back to the floor, and we welcome questions.

Question-and-Answer Session

Q - Hans-Erik Jacobsen

Hans-Erik Jacobsen, Nordea. Is it possible to give some guidance on how much you're spending on FOU on the hydrogen side and when do you expect to go cash flow breakeven from that business? Also, could you tell us a little bit about the competitive landscape, who are your biggest competitors and are you seeing new competitors coming up given the solid outlook for hydrogen?

Jon Engeset

I don't think we are prepared to break down the research and development quite yet. You can consider that and give more insight into that at a later presentation. However, you might say that all of hydrogen, at this stage, is in the development phase. So, I would say all activities are really supporting the ramp-up of that business area. What is for sure is that we are under-spending at this stage. We are so busy fulfilling the obligations that we have that we have not yet had time to ramp it up. We are going to do something drastically about that. So the overheads will be considerably higher next year than this year. I think actually this year this is a profitable business unit. It was not planned. We planned it to be dilutive, and we are planning it to be dilutive, strongly dilutive over the next three years. So our expectation is that maybe from '21 onwards, this will reach a critical mass and then start to pay back. Our competition is widespread so depending on segments. I would say at this stage at Toyota they have an internal program. So in a way they are our -- one of our more notable competitors, although we see that as a very serious, of course, contender and player which is supporting the attention and build-up of the industry. Apart from that, I think I would prefer to revert at a later stage to discuss the competitive landscape. It is still unclear. We have heard a number of rumors of various companies planning to enter, but we have focused on our development over 15 years. It has been a very demanding learning experience. And we expect that the competition will need to go up similar learning curve. And so it will take them some time to be able to commercialize the products. But, of course, the serious competition like Worthington, Luxfer primarily type three, but they will be part of the competitive landscape for sure.

Unidentified Analyst

Congratulation with a strong performance in LPG, and you're saying this is due to higher market activity. Could you elaborate a little bit? Is this due to increased market shares or is it simply that you are successful with the entrance of new markets? And if you also could share with us a bit more in detail the plans in that context next year.

Jon Engeset

So it's very satisfactory on several levels because we made a strategy three years ago, and we have more or less stuck to it very tightly and it is working. So I think it has three core elements: one is to be active in a number of markets. So at the time we considered whether we should focus on a few large markets or whether we should spread out and participate in many markets. And today we are -- we have sold to more than 70 markets around the world. And that is working, and we see every year that we get recurring orders in more and more geographies, and that is adding up to the high volume.

We've had some large contracts also this year, but not of the size that we had, for example, back in 2014 or back in 2009, which were also very good year's volume wise. So it is now a much more complex and in our opinion sounder customer base. The other factor is to work on the product, improve the product. So branding has been a very important part. More flexibility in placing, more customer's specific tailor-made visual impression of the products, and that is appreciated by the customers. And we have more in mind, but we will wait with announcing that until we are ready to release.

And the third is to continue what Ragasco has been, very innovative and leading since the beginning. Highly automated production, getting down the downtime. We're now down to one cylinder per 11 seconds if I remember well. When they started out back in around 2,000 it was at 78 seconds. And that not only increases the volume, but it also improves quality, consistency throughout. And all these good things they work together to produce good profitability. And going forward, we're going to stick to this recipe. So those three strategies are they're simple, but they're working and that is the plan also for the next few years.

Unidentified Company Representative

Thank you. There are no questions from the web audience today.

Jon Engeset

All right. Then I thank you all for participating this morning and wish you a good rest of the day. Thank you.