Methode Electronics' (MEI) CEO Donald Duda on Q3 2018 Results - Earnings Call Transcript

Methode Electronics, Inc. (NYSE:MEI) Q3 2018 Earnings Conference Call March 1, 2018 11:00 AM ET

Executives

Donald Duda - President, CEO & Director

John Hrudicka - CFO & VP of Corporate Finance

Analysts

Joseph Vruwink - Robert W. Baird & Co.

Christopher Van Horn - B. Riley FBR, Inc.

Operator

Welcome to the Methode Electronics Fiscal Year 2018 Third Quarter Earnings Conference Call. [Operator Instructions]. As a reminder, this conference is being recorded.

This conference call does contain forward-looking statements, which reflects management's expectations regarding future events and operating performance, and speak only as of the date hereof. These forward-looking statements are subject to a safe harbor protection provided under the securities laws. Methode undertakes no duty to update any forward-looking statements to conform the statements to actual results or changes in Methode's expectations on a quarterly basis or otherwise.

Forward-looking statements in this conference call involve a number of risks and uncertainties. The factors that cause these actual results to differ materially from our expectations are detailed in Methode's filings with the Securities and Exchange Commission, such as our annual and quarterly reports. Such factors may include, without limitation, the following, dependence on a small number of large customers, including two large automotive customers; dependence on the automotive, appliance, computer and communication industries; investment in programs prior to the recognition of revenue; ability to successfully market and sell Dabir Surfaces; significant adjustments to expense based on the probability of meeting certain performance levels and our long-term incentive plan; timing, quality and cost of new program launches; ability to withstand price pressure, including pricing reductions; success of Pacific Insight and Procoplast, and our ability to implement and profit from new applications of the acquired technology; recognition of goodwill impairment charges; customary risks related to conducting global operations; currency fluctuations; the effect of any material modifications to NAFTA and other international trade agreements; ability to withstand business interruptions; dependence on our supply chain; income tax rate fluctuations; breach of our information technology systems; dependence on the availability and price of raw materials; continued economic challenges in Europe, including the exit of the United Kingdom from the European Union; fluctuations in our gross margins; ability to keep pace with rapid technological changes; ability to protect our intellectual property; ability to avoid design or manufacturing defects; ability to compete effectively; successfully benefit from acquisitions and divestitures; costs and expenses due to regulations regarding conflict materials; and the location of a significant amount of cash outside of the U.S.

It is now my pleasure to introduce your host, Don Duda, President and Chief Executive Officer of Methode Electronics.

Donald Duda

Thank you, Michelle, and good morning, everyone. Thank you for joining us today for our fiscal 2018 third quarter financial results conference call. I'm joined today by John Hrudicka, our Chief Financial Officer; and Ron Tsoumas, our Controller and Treasurer. Both John and I have comments. And afterwards, we will take your questions. Year-over-year fiscal 2018 sales increased 16.6% in the third quarter and 10.5% in the first nine months. However, earnings per share decreased to a loss of $0.65 from income of $0.63 in the third quarter of last year.

For the nine months, earnings per share decreased to $0.54 from $1.86. In both periods, the company recognized tax charge of $56.8 million or $1.52 per share due to the enactment of the U.S. tax reform. Third quarter and nine months were also negatively impacted by higher wage expenses, increased intangible asset amortization expense, warranty expense in the Automotive segment, customer price reductions and unfavorable currency impact.

The nine-month period was also negatively affected by acquisition-related expenses and purchase accounting adjustments, increased investment in Dabir, unfavorable commodity pricing in certain raw materials and absence of commodity pricing adjustments and onetime reversal of accruals in the Automotive segment in fiscal 2017. Partially offsetting these factors in both periods were higher sales in the Automotive segment; gain from the sale of a licensing agreement; increased international government grants; and reversal of expense from performance-based stock award amortization due to recent changes regarding fiscal 2020 EBITDA estimates, driven primarily by the slower adoption of Dabir.

Moving on with the financial results. Compared to last year, consolidated gross margins decreased 90 basis points in the third quarter to 26.4% and 30 basis points in the first nine months to 27%. In both periods, margins were negatively impacted by a sales mix related to newly acquired businesses in the Automotive segment, warranty expense, unfavorable currency impact and price reductions. The nine-month period was also impacted by purchase accounting adjustments from acquisitions, higher commodity pricing, increased investment in Dabir and absence of the commodity pricing adjustments and reversal of customer commercial accruals in the Automotive segment in fiscal 2017. Year-over-year fiscal 2018 third quarter selling and administrative expenses decreased due primarily to reversal of a stock award expense and absence of expense-related operating units exited at the end of fiscal 2017. This was partially offset by expenses from new acquisitions and increase of wages and travel.

For the nine months, selling and administrative expenses increased year-over-year due mainly to M&A expense, selling and administrative expenses from acquisitions and higher wages and travel expenses. These increases were partially offset by the reversal of the stock award expense and absence of expense related to operating units exited at the end of fiscal 2017. Year-over-year fiscal 2018 operating income was $35.6 million in the third quarter compared to $29.1 million in the previous year. For the first nine months, operating income was $90.7 million this fiscal year compared to $84.8 million last year.

Third quarter operating margin was 15.6% this year compared to 14.9% in the fiscal 2017 third quarter. For the first nine months, operating margin was 13.6% in fiscal 2018 compared to 14.2% last year, mainly due to acquisition cost in this fiscal year.

Moving on to a review of our segment results. Automotive segment sales increased 22.9% in the third quarter and 14.4% in the first nine months compared to last year due to the sales from Procoplast and Pacific Insight acquisitions, higher customer-funded tooling and design fees and increased hidden switch sensor and user interface product volumes. In both periods, these improved sales were partially mitigated by lower transmission lead frame assembly and steering-angle sensor product lines and price reductions.

Year-over-year Automotive gross margins declined 190 basis points to 27.9% in the third quarter and 110 basis points to 28.4% in the nine months due to sales mix related to newly acquired businesses, price reductions and warranty expense. The first nine months were also negatively impacted by acquisition-related purchasing -- a purchase accounting adjustments, unfavorable currency impact and absence of the commodity pricing adjustments and onetime reversal of accruals related to customer commercial issues, which occurred last year.

Before I move on to the Interface segment, we have been notified that our major U.S. Automotive customer is transitioning to our lower-cost display module beginning with the launch of the new pickup truck and SUV platform. We estimate the revenue reduction in our Automotive segment will be approximately $12 million to $14 million in fiscal 2019.

Moving to Interface. Year-over-year segment sales decreased 6.4% in the third quarter and 9.1% in the first nine months, driven mainly by the exit of Connectivity, which contributed $3.8 million in the third quarter and $13.9 million in the nine months of last year, and lower legacy product sales in Asia, which was $700,000 less than the third quarter and $1 million less for the nine months year-over-year. In both periods, these decreases were partially offset by improved Radio Remote Control sales.

Compared to last year, Interface gross margins declined 90 basis points to 21.9% in the third quarter due to price reductions and unfavorable currency impact, partially offset by improved Radio Remote Controls sales. In the nine months comparison, Interface gross margins improved 30 basis points to 21.9% due primarily to favorable sales mix, partially offset by lower sales and price reductions.

Third quarter Hetronic litigation costs were $1.5 million this fiscal year versus $1.6 million last year. For the first nine months, these costs were $6 million in fiscal 2018 and $8.2 million in fiscal 2017. We anticipate litigation costs to be $8 million to $8.5 million for the year. At this juncture in the proceedings, we anticipate litigation ending in fiscal 2019.

In our Power Products segment, sales decreased year-over-year by 1.3% in the third quarter due to lower PowerRail and bus bar sales in North America and lower bypass switch volumes in Europe, partially offset by newer product launches in Europe. However, segment results improved year-over-year 12.3% in the nine months due mainly to higher bypass switch volume in Europe and increased bus bar volume in Asia.

Year-over-year, segment gross margins in the third quarter decreased 290 basis points to 23.7%, but only 40 basis points in the first nine months to 25.9%, primarily due to increased copper prices. Improved sales in the nine-month period helped to mitigate the higher raw material prices. As we indicated in the release this morning, Methode updated fiscal 2018 guidance to sales in the range of $900 million to $910 million from $880 million to $900 million, pretax income from operations in the range of $125 million to $130 million from $114 million to $127 million and earnings per share in the range of $1.23 to $1.33 from $2.43 to $2.63. The U.S. tax reform charge will negatively impact fiscal 2018 earnings per share by $1.52.

The guidance ranges for fiscal 2018 are based upon management's expectations regarding a variety of factors and involve a number of risks and uncertainties, which have been detailed in this morning's release and Form 10-K. Methode's fiscal 2018 has, thus far, been a good booking for us. As far as new business in the third quarter, we had some moderate wins across all of our business units averaging $7 million in new annual revenue beginning our fiscal 2021. Of particular note, with the acquisition of Pacific Insight, Methode will have product in the next generation of Ford's F-150 truck platform. Pacific Insight will provide the ambient LED lighting for the platform. This will consist of customizable illumination in several interior areas, including floor lighting, cup upholders, door panels, map pocket and door handles. The light output level will be in ambient hue in the vehicle to enhance the overall driving experience. The program launches in our fiscal 2020 with annual revenues of approximately $10 million.

Now let's move on with an update on Dabir. In the quarter, we added 2 new hospitals and health systems, which now uses Dabir product plus one existing hospital, which expanded the use of product to another surgical area. These new customers include Cancer Treatment Centers of America in Pennsylvania, Henry Ford Macomb in Michigan, and the expansion being at the Cleveland Clinic in Ohio. In addition, we are anticipating purchase orders for 2 other hospitals in the coming months. We continue to expand our clinical evidence with a neurological study that has been submitted for publication in the American Journal of Critical Care. We are also working with a number of industry experts on a peer-reviewed publication titled Pressure Injury Prevention Across The Entire Acute Care Continuum to be published mid-year in American Nurse Today.

Additionally, one of the most recent adopters of a Dabir -- of Dabir performed over 1000 surgeries in 90 days with 0 reported pressure injuries. Admittedly, we are disappointed on the slow pace of the products' adoption. However, I am pleased that in the last six months, we have added five more hospitals, which are utilizing Dabir, which is, by far, the greatest progress we have had to date.

Now I will turn the call over to John, who will give further details regarding our financial results.

John Hrudicka

Thank you, John. Good morning, everyone. I have just a few brief comments on the quarter and nine-month period. Before I begin my commentary, I want to clarify that my comments include 4 months and six months of results for our acquisitions of Pacific Insight and Procoplast, respectively. As a result of the enactment of the Tax Cuts and Jobs Act of December 2017, the company recognized a tax reform charge of approximately $57 million or $1.52 per share in the third quarter of fiscal 2018. The tax charge was primarily related to the cash held in accumulated overseas profits and the remeasurement of deferred taxes. In addition, the company has a fiscal year-end of April 30, 2018, which resulted in a blended U.S. federal tax rate of 30% for fiscal 2018, reduced from 35%.

For the quarter, including this tax charge, the company reported an effective tax rate of 162% and 78% for the third quarter and nine-month period, respectively. The company's tax rate, excluding the impact of the tax reform charge, would have been 16.9% for the third quarter and 17% for the nine-month period. The provisional estimates of the tax reform are based on the company's initial analysis. The changes included in the tax reform are broad and complex. The final impacts of the tax reform may differ from the amounts estimated above due to, among other things, changes in the interpretation of the tax reform and legislative guidance. The company currently anticipates finalizing recording any resulting adjustments within the 1 year allotted remeasurement period.

We estimate that our effective tax rate will normalize for Q4 activity. But with the overall impact of the tax reform included in these amounts, we expect our full year effective tax rate to be in a range of 63% to 65%. Excluding the impact of this quarter's tax reform charge of $57 million, we expect our full year effective tax rate to be in the 17% to 18% range.

Turning our attention to SG&A. You will note that in the third quarter, SG&A, including intangible amortization as a percent of sales, was 10.7% compared to 12.4% the prior year or a slight increase of $0.2 million. During the quarter, we had increases of $3.7 million of selling and administrative costs and $1.4 million of intangible amortization from our new auto acquisitions. We also experienced increases in wages and travel of $1.6 million and $0.4 million, respectively. These increases were mostly offset by the $6 million reversal of the performance-based stock awards mentioned previously and the absence of $0.9 million of expense related to our Connectivity and AES reporting units exited in Q4 fiscal 2017.

For the first nine months this fiscal year, SG&A, including intangible amortization as a percent of sales, was 13.2% compared to 13.1% 1 year ago or $8.8 million higher. This was driven primarily by $6.8 million of acquisition-related expenses, $5.5 million of additional selling and administrative costs from acquisitions and $2 million of associated intangible amortization. We also incurred increases in wages and travel of $2.1 million and $1 million, respectively. The increase was offset, in part, by the $6 million reversal of the performance-based stock awards mentioned previously and the absence of $3.3 million of expense related to our Connectivity and AES reporting units exited in Q4 fiscal 2017.

Moving to capital expenditures. In the first nine months, we invested $34.7 million. We are revising our capital investment slightly downward to be in the $44 million to $48 million range from our previous estimate of $48 million to $52 million. Expense for depreciation and amortization for the first nine months was $20 million. For fiscal year 2018, we expect depreciation and amortization to be between $28 million and $30 million.

Shifting to EBITDA. This was $46.4 million for the quarter or 20.4% of sales. For the nine-month period, EBITDA was $113.2 million or 17.2% of sales. For fiscal 2018, we expect EBITDA to be between $150 million and $160 million or in the 17% to 18% range. This represents an increase from our previous estimate of $135 million and $150 million or 15% to 17% range.

Free cash flow for the nine-month period was $5.7 million. Adjusting for the $57 million tax reform charge, free cash flow would have been $62.5 million. The transition tax is payable over 8 years, while the change in deferred taxes is a noncash event. Excluding the impact of this quarter's tax reform charge based on our revised estimate and lower capital investment I discussed previously, we expect fiscal 2018 free cash flow to be between $85 million and $92 million. This is an increase over our previous estimate of $65 million to $75 million.

Lastly, as we announced in the release this morning, we revised fiscal 2018 guidance for sales in the range of $900 million to $910 million, up slightly from our previous guidance range of $880 million to $900 million, primarily due to an increase in both our European and Asian Automotive sales. We have also revised guidance for pretax profit in the range of $125 million to $130 million, up from our previous guidance range of $114 million to $127 million. This increase is driven by the benefit of the reversal of performance-based stock awards, a government grant and margin flow through on the increased Automotive sales. We continue to be negatively impacted by FX, particularly the stronger peso on both our North American auto and appliance products, higher copper prices, electronic component pricing and lead times and customer pricing reductions.

Due to the tax reform that I discussed previously, we have lowered our guidance for earnings per share to $1.23 to $1.33 range from our previous range of $2.43 to $2.63. This is driven by the tax reform charge of $57 million or $1.52 of earnings per share comprising the onetime repatriation charge and remeasurement of U.S. deferred tax assets.

Don, that concludes my comments.

Donald Duda

Thanks, John. Michelle, we are ready to take questions.

Question-and-Answer Session

Operator

[Operator Instructions]. Our first question comes from the line of David Leiker with Robert W. Baird.

Joseph Vruwink

This is Joe Vruwink for David. With the resetting of the long-term -- or 2020 stock-based comp plan, what does that assume now for that 5-year CAGR maybe? What does it assume for the next couple of years remaining on that plan in terms of EBITDA growth?

Donald Duda

So we've moved from $220 million of target down to $200 million of EBITDA at the end of 2020. So that's a $20 million reduction, mainly almost all because of the slower adoption of Dabir. I should explain a little bit. We are required to rep that we are 70% certain of our future earnings in a particular area. And for Automotive, you generally can look at releases and bookings and be confident. But because Dabir is a new product and its adoption has been slower than we thought, and that's a test we do every quarter, we weren't able to do that. Now do I think Dabir will meet its numbers? We're fairly confident that once we get the traction we need, we'll get there. But we're not 70% confident. Hence, the change. And I didn't calculate the CAGR.

Joseph Vruwink

Just, I guess, simple way. Midpoint of guidance this year is $155 million in EBITDA, so the CAGR for '19 and '20 would be 13%, 14%, pretty strong growth. Can you just maybe walk through some of the biggest drivers of why you're still expecting, outside Dabir, double-digit growth in your core auto, Interface, Power divisions?

Donald Duda

We've done two acquisitions. We've continued to see Hetronic perform. That will -- that's anticipated to perform better into '19 and '20. Appliance, we didn't have that in there originally. And we've had some good bookings there. We are anticipating some additional bookings that will launch before 2020. So there's a number of factors that play into that. And again, the most notable that we're paying close attention to is Dabir because that has not reached the numbers that we had originally anticipated. Again, as I said in my remarks, we will get there, and I am confident that -- or I take confidence in that we have in the last six months, we've got 5 more hospitals and I don't know how much more I can gain into, unless we'll end up talking about next year's guidance, which we're not prepared to do. But there's a number of factors. And then John is pointing out our magnetoelastic sales, $30 million, so far, in 2020 at extremely good margins. So again, a number of factors.

Joseph Vruwink

That's all great detail. Looking at the Automotive business this quarter, 2 things kind of stood out to me. One is if I do my math right, the North America Automotive business declined, call it, 4% organically. Actually, a bit better than what industry volumes did in the quarter, and I'd imagine end-of-life pricing on K2XX explains most of that decline. So on one hand, I think your North America business seems to be doing pretty well. And then in Europe, I think Europe grew almost 30% organically, which is substantially above the market. So in thinking about those two drivers, is there anything, obviously, into next year, will get GM's truck transition, but when you look at your new business backlog, it seems like you have the ability to continue outgrowing what the end markets would do? Am I missing anything in that assessment?

Donald Duda

The only thing I would point out, as I said in my prepared remarks, is we'll see a further reduction on the display modules on T1 as that launches. So that will be a headwind that we will face going into next year. We do have other launches. It's hard to say what -- if we can continue to do that. It really depends on the customer take rates. Europe did better than we originally planned in the year. So that it -- I won't say no, but I'm not necessarily going to say that we can continue at that. We do have a -- not necessarily connected to sales, but we are seeing component -- electronic components go up in price. We're seeing lead times go up. We've already seen increases in copper. So there are some headwinds from a total business that we're facing as we go into '19. So those would affect the flow-through from any increased sales. We saw that this quarter, and part of that was also because we added Procoplast and Pacific Insight at lower margins, which reduced our overall margin. Now we will work in the next 12 to 18 months to get them to our standard margins.

Joseph Vruwink

Okay. And then my last question. I didn't quite follow what you said on your new business award. So you won a handful of programs that, in aggregate, were $7 million beginning 2021 and then separate from that was the Pacific Insight for $10 million with Ford?

Donald Duda

That's correct. Yes, the $7 million was $1 million here, $2 million there. Not enough to really go into great detail. But I thought the F-150 on Pacific Insight was worth mentioning.

Operator

[Operator Instructions]. Our next question comes from the line of Christopher Van Horn with B. Riley FBR.

Christopher Van Horn

I wanted to just follow up on the F-150 award win. Just -- could you give us some clarity on the -- was Pacific Insight or you all the incumbent on that? And how competitive a process was that? It's obviously a significant win for you.

Donald Duda

I don't believe we were the incumbent, and we can get back to you on that, but I don't believe so. And the significance of it, it's like being on K2 and T1. That's a major accomplishment for the Pacific team. I congratulate them on that. It's not a center console, but it is, it gives them, I think, very good credentials to garner other automakers. So I think it's very important to them, albeit a $10 million, I'm not going to diminish that.

Christopher Van Horn

Yes, yes. Okay. And then on that note, I think some of the reasons that Pacific Insight looked attractive to you all is kind of giving that more of a bigger opportunity for a product presentation or a product pitch. And I just was curious how the pipeline is looking for you, either for traditional center consoles or kind of this all-encompassing opportunity that you mentioned before in previous calls.

Donald Duda

It gives us another, I guess, product that we can incorporate into our total offering. And as I've said before, we look at the center console, starting to merge with the instrument panel, merging with the overhead console, and lighting is an integral part of that. So we can now go to our customers and the PI's customers and -- with a complete package. So it's very much a tool that we'll use for increased sales and probably, very importantly, increased styling. Price is always very important in automotive. But styling, as we know, is becoming -- in the cockpit is becoming extremely important. And both Methode and PI are both working and now working together on how all that -- those 3 areas come together. So I have no major awards to announce, but there are a number of things that we're working on. And they're not going to affect, '19, '20, but will affect '21, '22 and beyond. But it does position Methode essentially, to use one of our words, state-of-the-art enhancement of the build for cockpit. And I think that, although we're -- I think we're a few years out, I think that also bodes well for us as autonomous vehicles come into being. I will also add, one of the things that we have to do, we see it in the margin effect this quarter, is we do need to take cost out of those products, which Methode does very well, but that is also -- are going to be key to our success.

Christopher Van Horn

Yes. And I think you mentioned at the end of your prepared remarks, you feel like you can get back to more traditional Automotive margins as you integrate these acquisitions. Any update to the timing of that? I mean, I'm sure it depends on volume as well, but are you thinking a year out, a couple of years out?

Donald Duda

I would say 12 to 18 months. I don't think [indiscernible] in six months. And we do face some headwinds. As I said, I think, to Joe's questions, electronic components are going up in price, and lead times are going out. So we've got some headwinds to deal with. Now the added volume helps, so...

Christopher Van Horn

Yes. And just another on the T1, the move to the different display. Did I hear you correctly? It's kind of a lower grade display. And is that across the whole program? And I'm just curious what...

Donald Duda

No, no. No, no. And I've got to be careful there because I'm not going to -- I can't speak for the -- for our customer. No, I believe it's the same manufacturer. They're just integrating the touchscreen, the display and then there's a control module. And displays have, historically, over the last 5, 6, 7 years, have come down in price, and our customer is taking advantage of that. No, it is as good a display, probably better than others. So no, I want to correct that right now. It's not a less-features, less-quality display. It's better.

Christopher Van Horn

Got it. Yes, I apologize. I misunderstood. My apologies. Final question for me is with the tax reform. You obviously have a lot of cash overseas. Do you see opportunities to use that cash in the kind of 6 to 12 months' time frame? And if so, is it reinvesting in operations? Is it returning cash to shareholders in some form? Just curious what you're thinking about there.

John Hrudicka

So this is John. So I think, in terms of priorities, and we are evaluating that, but there's a number of things we could do. We could bring back that cash. We could pay down debt. We could invest a portion of that into operations, as you indicated. Also the past several quarters, we've been very vocal about continuing to pursue acquisition targets, evaluate acquisition targets, so that would will be another use for the cash. Those would be the priorities, again, ahead of a buyback program or increasing the dividend at this point.

Operator

There are no further questions at this time. I would like to turn the call back over to Mr. Duda for any closing remarks.

Donald Duda

Michelle, thank you very much, and we'll thank everybody for listening and their questions, and have a good day. Thank you.

Operator

This concludes today's teleconference. You may disconnect your lines at this time. Thank you for your participation and have a wonderful day.