Fathom Digital Manufacturing Corporation (FATH) Q1 2023 Earnings Call Transcript

Fathom Digital Manufacturing Corporation (NYSE:FATH) Q1 2023 Earnings Conference Call May 15, 2023 8:30 AM ET

Company Participants

Michael Cimini - Director of Investor Relations
Ryan Martin - Chief Executive Officer
Mark Frost - Chief Financial Officer

Conference Call Participants

Jim Ricchiuti - Needham & Company
Greg Palm - Craig-Hallum Capital Group
Paul Chung - JP Morgan

Operator

Hello, ladies and gentlemen. My name is Glenn, and I will be the operator this morning. I'd like to welcome everyone to the Fathom Digital Manufacturing Earnings Conference Call. This call is being recorded and a replay will be available later today. After the company's presentation, there will be a Q&A session with instructions to follow at that time.

I would now like to turn the call over to Michael Cimini, Fathom's Director of Investor Relations.

Michael Cimini

Thank you, Glenn, and good morning, everyone. Welcome to Fathom's First Quarter 2023 Earnings Conference Call. Before we begin, I'd like to mention that today's presentation and earnings press release are available on Fathom's Web site at fathommfg.com, where you will also find links to our SEC filings, along with other important information about our company.

Turning to slide two, we note that this presentation contains forward-looking statements within the meaning of the Securities Exchange Act. We encourage you to read the risk factors contained in our filings with the SEC, become aware of the risk and uncertainties in our business, and understand that forward-looking statements are only estimates.

We also note, today's presentation includes non-GAAP financial measures to describe the way in which we manage and operate our business. We reconcile these measures to the most comparable GAAP measure. And you are encouraged to examine those reconciliations.

With us today are Ryan Martin, Fathom's CEO; and Mark Frost, the CFO.

I will now hand it over to Ryan.

Ryan Martin

Thanks, Michael, and welcome, everyone, to Fathom's first quarter 2023 conference call. Our performance for the quarter was above management's expectations as we extended Fathom's track record of profitability and cash generation. During the quarter, we executed well against our expanded optimization plan, while taking active measures to strengthen our go-to-market strategies. As discussed on our previous call, we took advantage of the temporary softness in the macro environment in Q1 to expand our original optimization plan and further right-size our business. Of the current $19.5 million in projected annualized cost savings, we realized approximately $3.5 million in the first quarter, bringing the cumulative amount to $5.3 million.

In Q1, we continued to optimize our national footprint with the integration of our two Texas-based facilities that we acquired prior to going public. This follows the consolidation of our Oakland facility, in Q4 2022. We also reduced our workforce by an additional 14% while prioritizing our investments and operations in line with the near-term revenue generation. We expect to complete our cost reduction initiatives in the current second quarter, and realize the benefits of the remaining $14.2 million in savings throughout the remainder of 2023.

While Mark will discuss our financials in more detail, the ongoing execution of our restructuring efforts contributed to a Q1 gross margin improvement of 810 basis points on a sequential basis. We remain committed to ensuring an efficient cost structure, and we'll take additional steps, as appropriate, so that our production levels match our customer commitments. During the first quarter, we also opened our new Silicon Valley Technology Center, in Freemont, California. This state of the art hub provides a unique opportunity to introduce corporate enterprise customers to some of the latest advancements in additive and traditional manufacturing, while enabling Fathom to maintain a strategic presence in the Bay Area.

Our new evolved additive solution is among the innovative technologies currently featured at the new tech center. We are now producing customer parts of the new STEP technology, while continuing to build the pipeline. The feedback we've received to date from customers reaffirms how Evolve is poised to leave the transition from prototyping to additive production by dramatically reducing lead times for parts across various applications without compromising quality, throughput, scalability or cost.

In maintaining our focus on accelerating customer engagement, we bolstered our commercial leadership in Q1 with the appointment of Kurt Bork as Fathom's Vice President of Sales and Marketing. We believe his considerable experience in enterprise sales and strategic growth management will add considerable value in this newly created position as we renew our efforts to expand our share of wallet with strategic customers and add new corporate accounts. In the brief period since Kurt joined Fathom, we have built positive momentum advancing these critical objectives.

Recently, we received formal approval as a production supplier for a leading semiconductor capital equipment provider, and a manufacturer of thermal solutions for the EV industry that we believe has the potential to deliver $10 million to $15 million annually in aggregate incremental new business for Fathom. With these two large strategic customers, we expect to strengthen our pipeline with more stable and predictable revenue streams while further enhancing our ability to leverage our extensive low-to-mid volume production capabilities.

Notably, the approval to become an approved production supplier for the semiconductor company took over a year to secure, and creates a significant barrier to entry for competitors and underscores the importance of Fathom as a critical supplier to our customers in the current market. Additionally, we continue to optimize our commercial structure with our new product innovation, or NPI teams, and our production teams, while also implementing other initiatives aimed at taking greater advantage of our expansive manufacturing platform to boost new orders and provide a more streamlined customer experience.

And finally on this slide, we took steps during the quarter to increase our financial flexibility. Specifically, we amended our existing credit facility under favorable terms, providing for extended covenant relief through Q1 2024. These modifications strengthened our ability to withstand the ongoing uncertainty in the global economy as we maintain our focus on preserving Fathom's long-term financial health, while investing in the growth of our business. Additionally, the execution of our $19.5 million optimization plan contributed to notable improvements in our net cash provided by operations, adjusted EBITDA, and adjusted EBITDA margin on a sequential basis.

By actively managing our cost structure and preserving capital, we expect to further improve our profitability and leading margin profile over the remainder of the year, and generate positive free cash flow in 2023. I'm pleased by our company's ability to adapt to persisting macroeconomic headwinds, and believe our resilient workforce, combined with our diverse enterprise-level customer base and comprehensive manufacturing services and deep technical expertise positions our company well, to not only navigate the near-term macro challenges, but benefit from our increased scalability as market conditions continue to improve.

I will now turn the call over to Mark.

Mark Frost

Thank you, Ryan, and good morning everyone. I'll begin our remarks for our Q1 revenue results on slide four.

Our revenue for the fourth quarter totaled $35 million, which exceeded the high end of our forecast of $34 million, but down from $40.5 million in Q1 2022. In Q1, the macroeconomic headwinds persisted as certain production customers, particularly in the capital goods and building industries, have delayed new purchase orders amid the ongoing market uncertainty. We remain optimistic the bulk of these pending orders will eventually close most likely in the second-half of the year.

Now, although near-term demand remained soft, we continue to make steady progress ramping up our new commercial activities and strengthening our go-to-market strategies under new senior leadership as Ryan mentioned earlier. Our revenue by product line was as follows. CNC machining increased approximately 7% to $14.2 million or 40.6% of total revenue as this business continues to perform well among our strategic accounts.

Precision sheet metal was $10.4 million or 29.7% of total revenue, reflecting the ongoing softness in the macro environment. Injection molding was $4.7 million or 13.4% of total revenue. Although our outsource business has shown signs of improvement, we continue to focus on new tooling orders to generate more reorders for production of parts along with new tooling. Additive manufacturing totaled $3.6 million or 10.2% of total revenue. We believe our new technology center combined with the rollout of new additive technologies, including Evolve, will strength our prospects in this segment as we continue to benefit from our consolidation efforts. And finally, ancillary technologies, our smallest product line, increased to $2.1 million, representing 6.1% of total revenue.

Now, despite current market uncertainties, we believe the secular drivers in our business remain sound, including the condensing of product development cycles, consolidation of supplier partnerships and near shoring of U.S. manufacturing to ensure a more agile and local supply chain. We will continue to monitor the market landscape and remain committed to providing global product driven companies with timely value-added solutions that leverage our robust on-demand digital manufacturing pipeline.

Now, turning to slide five, we provide our adjusted EBITDA performance for the first quarter. In quarter one, our adjusted EBITDA totaled $4.1 million, representing a margin of 11.7%. This was above the high end of forecast of $3.5 million with a sequential margin improvement of 380 basis points despite lower sales. In quarter one 2022, we reported adjusted EBITDA of $6.2 million for a margin of 15.2%.

Now, our performance for the quarter was primarily driven by lower sales volumes and the associated overhead absorption impacts. We partially offset the absorption impact by achieving notable progress in lowering our cost structure based on the continued execution of our $19.5 million optimization plan which contributed to a gross margin of 34.1%, up from 26% in quarter four, 2022. We also benefited in the quarter from strategic price increases which should have a positive impact for the remainder of the year and into 2024. In the prior year period, our gross margin was 37.5% when excluding the $3.2 million in onetime non-cash purchase accounting adjustments.

Now, looking ahead, we anticipate further improvement in our gross margin which is expected to be in the high 30s for the full-year 2023 as our restructuring efforts continue to take effect. And following the launch of our plan last year, we remain on track to realize approximately 90% of the anticipated $19.5 million in cost savings throughout 2023 where two-thirds of the total benefiting our gross margin with the remaining one-third resulting in lower SG&A expenses. Now, for quarter one, our SG&A totaled $10.8 million. A year-over-year decline of 27% due to the impact of lower sales combined with reduction in people-related expenses, stock compensation, and public professional fees.

Now, as a percentage of revenue, SG&A decreased to 30.8% from 36.4% in quarter one, 2022. Compared to the previous fourth quarter, SG&A declined 6.6% notwithstanding the higher cost in quarter one related to the publication of our annual report and other SEC filings. Excluding stock compensation, our recurring public company cost declined again on sequential basis to $1.5 million in quarter one compared to $1.8 million in quarter four. In quarter one 2022, our recurring public company expenses totaled $2.3 million reflecting the significant gains we have achieved over the past year in rationalizing our public company infrastructure.

Now, on slide six, we show our liquidity and cash flow. We ended the first quarter with available liquidity of $20.1 million. This includes $12.1 million in cash and cash equivalents, and $8 million of undrawn commitments under our $50 million revolving credit facility. As of March 31, our total gross debt excluding cash was $162.3 million. And net debt totaled $150.2 million with no debt maturities before December 2026. The amortization of our term debt was offset by increase in the usage of our revolver.

Now, cash provided by operations in quarter one totaled $0.5 million, which reflects an improvement in our working capital balance. This compares to cash used in operation of $3.4 million in quarter four, a sequential swing of just under $4 million. In quarter one, our CapEx was reduced to $1.9 million or 5.4% of revenue which was consistent with our expectations and includes payments from some previous commitments made in 2022. Our focus remains on limiting non-essential capital expenditures to generate additional cash savings with only focused CapEx investments critical to near-term growth.

Now, finally as Ryan mentioned earlier, we reached an agreement in quarter one with our senior lenders to amend our existing credit agreement providing for extended covenant relief, specifically, the minimum net leverage ratio and interest covered ratio have been suspended through 2023 and replaced with a minimum adjusted EBITDA and available liquidity requirement. Both covenants will be reinstated in quarter one, 2024 beginning at 5x for net leverage and 2x for interest coverage. We appreciate the support of our lending group in further enhancing our financial flexibility as we continue to reduce cost and optimize our cash position.

Now, turn to slide seven, and we provide our forecast for the second quarter of 2023. For the second quarter, we anticipate further benefits from the execution of our $19.5 million optimization plan, with realized savings, approximately $4.5 million, up from $3.5 million in quarter 1. As we seek to maintain attractive levels of profitability in line with our backlog, the challenging macro environment continues to weigh on our sales outlook. As discussed previously, the near-term economic uncertainty has led to lower customer inventories and extended sales cycles for new orders.

We are cautiously optimistic these trends will begin to improve in the second-half of the year as manufacturing activity recovers and our commercial actions continue to take hold. Currently, we expect quarter two revenue to range between $32 million and $34 million, and adjusted EBITDA range between $4 million and $5 million. This represents an implied adjusted EBITDA margin of 12.5% to 14.7%, up 80 to 380 basis points from quarter 1 '23. Additionally, we remain on track to achieve positive free cash flow for the full-year 2023, and expect to achieve a year-over-year increase in adjusted EBITDA, while enhancing our ability to generate significant operating leverage once the overall market recovers.

I'll now turn the call back over to Ryan. Ryan?

Ryan Martin

Thank you, Mark. I will provide some closing comments on slide eight. Our results for the first quarter demonstrate management's commitment to take aggressive actions aimed at driving future performance in a challenging macro environment. The ongoing execution of our $19.5 million optimization plan will help ensure we maintain attractive levels of profitability as well as cash generation, while our commercial enhancements continue to gain more traction. By strengthening our go-to-market efforts, we intend to focus more on our strategic relations within the Fortune 500-tier companies, and return to market outgrowth for our additive and traditional manufacturing technologies.

We believe the positive long-term fundamentals in our industry remain intact, and that our flexible hybridized approach integrating speed, quality, technical ingenuity, and problem solving positions Fathom well to continue to meet the high mix, low-to-mid volume production needs of companies in a manner that supports customization. Our focus remains on leveraging our profitable business model, including an extensive and entrenched blue chip customer base across diverse end markets and a breadth of leading offerings, driving long-term scalable growth.

This concludes our prepared remarks. And we'll now open the call for questions.

Question-and-Answer Session

Operator

Thank you. [Operator Instructions] Our first question comes from Jim Ricchiuti from Needham & Company. Jim, your line is now open.

Jim Ricchiuti

Hi, thank you. Good morning. Mark, first off, just wanted to make sure I am clear on this. So, as you think about adjusted EBITDA in '23, you still think you could be up for the year as a whole, did I hear that correctly?

Mark Frost

That is correct. Based on our cautious optimism for the second-half, with that assumption in mind that would lead, coupled with the optimization plan, that we can overachieve last year's adjusted EBITDA number of $24.9 million.

Jim Ricchiuti

With the optimization plan now underway, and it sounds like things moving a little faster. What kind of revenue range would be required to realize that level of adjusted EBITDA? I know mix plays a big role in this, but if there's a range that we should be thinking of that gets you there?

Mark Frost

Yes, what I would say, Jim, is we will need to improve upon our current guidance and be at a higher level in the second-half. I don't think it's a massive improvement, but we will need improvement for our quarter 3, quarter 4 second-half revenues, and I think I indicated last call, Jim, that we see improvement towards hopefully -- yes, I'll leave it at that.

Jim Ricchiuti

Okay. I have one other question. You came in modestly above your revenue guide for Q1. And so I'm curious what drove that, and as it relates that, and normally Q1 is seasonally your weakest quarter. If we take the low end of your guidance for June, I'm just wondering what maybe factors into that? Obviously macro, but I'm also curious if there were any unusual contributions possibly in Q1 that, from a business line standpoint, that may not repeat in Q2?

Ryan Martin

Yes, Jim, Ryan Martin, good morning to you. I would say as it relates to Q1, typically, you're right on that, it continues to build through that. I think we've continued to be cautiously optimistic in the macro environment as we look into Q1, and beyond. We saw some continued macro challenges in April. However, I will say, in May, we've seen a really strong start to the month. I think we're seeing a lot of the actions that we've seen from the commercial efforts that we're taking, and bringing on Kurt with some key customers there, as well as we've seen some of our production customers that we talked about, in Q1, that were delaying some orders, some of the stuff that Mark talked about.

We're starting to see those reorders start to play out towards the end of April, and beginning to May. And so, I think we continue to be optimistic that the momentum that can keep up with the actions that we're taking will build into the second-half of Q2, and into the second-half of the year, Jim, but there was no outliers related to Q1, nothing unusual.

Jim Ricchiuti

Got it, thank you. I'll jump back in the queue. Thanks a lot.

Ryan Martin

Thanks, Jim.

Mark Frost

Thanks, Jim.

Operator

Thank you, Jim. We have our next question coming from Greg Palm from Craig-Hallum Capital Group. Greg, your line is now open.

Greg Palm

Thanks, good morning, everybody. I wanted to maybe just follow-up on the last bit of thinking here, maybe just in terms of visibility, whether it's gotten better, worse, or maybe unchanged relative to six, seven weeks ago? And can you maybe just quantify the amount of some of these production orders that you alluded may be coming back in the second-half?

Ryan Martin

Good morning to you, Greg. This is Ryan. Yes, I would say we're spending a tremendous amount of time. And I talked a little bit about this in the first quarter earnings call. Out in front of these particular repeat production customers, we've talked about before, one of the real strengths of the Fathom manufacturing platform is the long-term relationships we have with many of these Fortune 500-tier companies. And what we've consistently seen, as I've talked to them, and Kurt, and others in our sales team, is that we are not losing that business. They've just had a reduction in their inventories as they have been more cautious.

What we're seeing here play out over the last couple weeks as we've continued to meet with these customers, we're starting to see their inventory levels came down, that demand hasn't slowed up as much as maybe they thought it would. And so now, they're starting to have to reorder. We had a couple of large medical customers that placed pretty significant purchase orders that, historically, we would have gotten at the end of the year. We saw those orders placed in the April-May time period. And so, we're seeing those come back. We talked about some of the semiconductor work that we've done. I was meeting with one of our largest semiconductor capital equipment providers last week, out on the East Coast.

And we've seen slowness there, but they're anticipating a pretty big ramp into the second-half of this year, and really into 2024, which is, I think, pretty consistent across the industry. So, we are seeing more visibility into the orders and into the pipeline, which is going to continue. As that starts to materialize and ultimately converts into orders and backlog, I think that'll give us a lot more visibility and confidence as well look into the second-half of this year, Greg.

Greg Palm

Why wouldn't some of the more recent orders or activity translate into a higher revenue guide for the current quarter? Maybe you can just tell us what your assumptions are based on these last six weeks. But sounds like maybe it's just more of a timing thing where that's going to hit and contribute more in the second-half of this year versus the specific quarter we're in.

Mark Frost

Yes, Greg, let me comment on that. And this goes to our better understanding of NPI versus production, where an order comes in for NPI, you can turn it around within weeks, as you're familiar with. With these production orders, as Ryan indicated, we saw a continued soft April, both on shipments and orders, that then colors our view of what's going to happen in May and June, because you have to bring the orders in and then we will likely in most of these cases deliver 30 to 60 days out for a production order once you get the order in-house.

Now, as Ryan said, we're starting to see in May and our expectation is we'll see more, I would say multimillion types of orders in June, that we won't have the capability to deliver that until the second-half, Greg, is basically the situation and that's why we're being cautious optimistic. Now, if we do have more NPI type orders that could lead to an outperformance on what we're talking to you about today. But if it is purely production, likely receiving the orders in mid-May, early June means it's not being delivered till July or August in the second-half. Does that help, Greg?

Greg Palm

Yes, understood. That makes a lot of sense. And I guess just lastly, I wanted to touch on a couple of these customer wins, and I guess it wasn't clear whether these and I'm alluding to the 10 million or 15 million of new business. Are these new customers -- are these wallet share expansion opportunities? And just to be clear, do you have orders in hand or maybe a little bit more color around the timing of this incremental new business because it was pretty significant, at least in size?

Ryan Martin

Yes, related to the semiconductor, it's really an expansion. We've been, the large customer for us, we've been a conditionally approved supplier for a period of time. So, becoming a full production supplier for them allows us to be able to access their entire buyer network across that. And so, we have a combination of new orders in hand as well as it opens up a significant funnel for new opportunities. And based on the conversation conversations we've had, we feel pretty confident around those numbers and what we've discussed with the company and the different programs that we're going to be working on for them.

As it relates to the other EV related thermal supplier, that is really a new customer for us from a production standpoint. So, that's new incremental where we do have orders in hand as well, and then we're ramping from that. And so, we're working on the first orders that we've gotten for them on sheet metal fabrication parts.

Greg Palm

Understood. Okay. I appreciate all the color.

Operator

Thank you, Greg. [Operator Instructions] We have our next question comes from Paul Chung from JP Morgan. Paul, your line is now open.

Paul Chung

Hi, thanks for taking the question. So, gross margins saw a nice rebound here sequentially, despite some lower revenues. So, as we think about the rest of the year, can you expand on some of the cost action impact on gross margins and where we should kind of shake out as we exit 4Q?

Ryan Martin

Sure, Paul. So, there's a number of elements in the cost plan. One was the downsizing by about 14% of our labor force. So, that's one of the first elements. The second element was the consolidation of our Oakland facility into Heartland, which was completed at the end of the year. So, that triggered benefits starting one. The third element was the consolidation of our two Texas sites, which was finished by the end of March. So, we'll start seeing those benefits in quarter two. And then, the fourth element was the management of overtime. And then a last element is the management of cost savings projects, both from a material savings, better contracts, as well as other cost initiatives.

So, all of those elements together, you can see it's multidimensional. All of that will be in place by the end of quarter two. A lot of it's already been executed. And then it's just a question of realizing those savings through gross margins as we go through the year. So, that gives us confidence Paul, we will be towards the high 30s as we exit the year, at the end of the year, so, another further 400 basis point improvement in our gross margins.

Paul Chung

Okay, great. That's a very good improvement. So, we have kind of seasonal slower in 1Q. You mentioned kind of positive free cash flow for the year. So, how do we think about how that cash builds through the year? Thank you.

Mark Frost

Yes, so we had a nice sequential improvement. We're still negative free cash flow. We're a positive operating cash flow. So, we expect to see improvement every quarter as further cost savings kick in. And as we talked about our optimism to see an improvement in revenue in the second-half, both of those factors will contribute. And the third element, Paul, is we've been more aggressive, particularly on our AR and collection efforts. So, we're seeing a drop in our DSO and we saw that in the first quarter and expect to see further improvements. And we're looking at our inventory and DPO management as well. So, all those elements contribute that our belief will get to positive free cash flow, likely by fourth quarter on a run rate basis.

Paul Chung

Great, thank you so much.

Mark Frost

Yes, no problem.

Operator

Thank you, Paul. We have a follow-up question from Jim Ricchiuti from Needham & Company. Jim, your line is now open.

Jim Ricchiuti

Yes, just on the end markets. Ryan, you talked a little bit about what you're seeing, hearing in semi-cap and it looks like you saw a little bit of a pickup in demand in medical. I wonder if you could give us some color on some of the other end markets particularly the ones that have been lagging. You mentioned I think Mark alluded to capital goods and the building industry. Are you guys anticipating that a change in demand that gives you the confidence as you look out into the second-half?

Ryan Martin

Great question, Jim. So, I think as it relates to the capital goods, semiconductor obviously I think everybody is very familiar big ramp, and now, we've got a little bit of a slowdown and then long-term the trends remain very, very optimistic related to the growth of that industry. So, I feel really good about how we're positioned with some of our key customers to support their growth on that side of things, areas that we're continuing to see growth in that we're really well positioned Jim, transportation, EV, Automation, aerospace and defense, we're continuing to see growth in those areas.

I'd say the capital goods and building, supply industry continues to be a little bit soft. I haven't -- starting to see some signs of comeback there but I think we're going to continue to see some softness there and so it is my view and so from a commercial perspective where we're focusing a lot more of our attention is the areas that we are seeing growth which is medical, transportation, EV, automation, aerospace and defense. We're continuing to see great traction there and then we think towards the second-half of this year from the semiconductor side of things which is an important industry for us as well. We'll see start to come back in the second-half of this year. And from all the conversations I'm having with executives, some of our key customers in the semi industry, they're anticipating a really, really robust 2024 and beyond as a lot of the fab facilities really start to gain traction related to the Chips Act and all the investments that's happening in the U.S.

Operator

Thank you. We have no further questions on the line. Ladies and gentlemen, this concludes today's call. Thank you for joining. You may now disconnect your lines.