CPI Aerostructures, Inc.
Q2 2014 Earnings Call Transcript

Published: 7 Aug 2014

[Operator:]

Welcome to CPI Aero's 2014 Second Quarter Results Conference Call. With us today are Douglas McCrosson, President and Chief Executive Officer, and Vincent Palazzolo, Chief Financial Officer. [Operator Instructions] As a reminder, this conference call will contain forward-looking statements, which involve known and unknown risks, uncertainties and other factors that may cause actual results to be materially different from projected results. Included in these risks are the government's ability to terminate their contracts with the company at any time; the government's ability to reduce or modify its contracts if its requirements or budgetary constraints change; the government's right to suspend or bar the company from doing business with them, as well as competition in the bidding process for both government and subcontracting contracts. Subcontracting customers also have the ability to terminate their contracts with the company if it fails to meet the requirements of those contracts or if the customer reduces or modifies its contracts to them due to budgetary constraints. Given these uncertainties, listeners are cautioned not to place undue reliance on any forward-looking statements contained in this conference call. Additional information concerning these and other risks can be found in filings with the SEC. During this conference call, there will be references to adjusted revenue and adjusted earnings, which are non-GAAP financial measures as defined by Regulation G promulgated under the Securities Act of 1933 as amended. A reconciliation of these non-GAAP financial measures to relevant GAAP financial measures can be found in the company's second quarter 2014 earnings press release issued today and posted in the Investor Relations section of the company's website, www.cpiaero.com. Now I will transfer the call to Douglas McCrosson, CPI Aero's President and Chief Executive Officer.

[Douglas J. McCrosson:]

Good morning, and thank you all for joining us for our 2014 second quarter results conference call. If you need a copy of the press release issued this morning, please contact Lena Cati of the Equity Group at [phone] and she will fax or e-mail a copy to you. Also if you would like to listen to this call again, you can hear a replay on our website's Investor Relations section in about an hour at www.cpiaero.com. Before I turn the call over to Vince, who will discuss our second quarter results, I would like to start the call by discussing the A-10 Wing Replacement Program and the effect it had in our 2014 second quarter results. As per the news release we issued earlier today, our results for the second quarter and 6 months 2014 included a one-time noncash charge of approximately $47 million related to revised estimates of a significantly shorter lived and lower production quantity A-10 Wing Replacement Program. The net effect of the charge is a reversal in the quarter of a portion of the revenue recognized in prior periods, dating back to the inception of the program in 2008. The long-term future of the A-10 has been uncertain since March 2014 when the U.S. Department of Defense released its 2015 Budget Request that called for the retirement of the entire A-10 fleet. More recent events have led us to conclude that our A-10 WRP will not continue to the full 242 aircraft as anticipated at the start of the program. For example, the 2015 Department of Defense Appropriations Act passed by the U.S. House of Representatives on June 20, 2014 provides no funding for A-10 operations for the 2015 government fiscal year that commences October 1, 2014. Further, this bill rescinds funding from the 2014 defense budget that was to have been used for the procurement of additional wings for the A-10. CPI has no information to support a different conclusion. As a result, we decided to take this onetime, noncash charge in the second quarter of 2014. Vince will provide further details shortly, but I would like to emphasize that although this is a difficult decision, given the current set of facts, it was the correct one. Our adjusted results for the second quarter and 6 months of 2014 were in line with our expectations and put us on track to achieve our guidance for 2014, excluding the nonrecurring A-10 WRP charge. Our 2015 forecast discounts the contribution of the A-10 WRP to revenue and to net income. As such, our 2015 guidance is unchanged and reaffirmed with the expected growth in revenue and net income for the year to be largely driven by growth in our commercial product lines. So with that prelude, I will now hand the call over to Vince Palazzolo, our CFO, to discuss our recent financial results and our guidance for 2014. Then I will comment on the current business environment, backlog and contract awards, our expectations for 2015 and new growth opportunities going forward. I will then wrap things up and open the call to questions. Vince?

[Vincent Palazzolo:]

Thank you, Doug. As announced earlier this morning, our results for the second quarter and 6 months of 2014 include a one-time noncash charge of approximately $47 million related to revised estimates of a significantly shorter lived and lower production quantity A-10 Wing Replacement Program. Doug has addressed the recent events that have triggered the change in estimate for the A-10 WRP. Let me highlight some of the factors that led to the change in estimate. Since 2008, we have received firm orders for assemblies to produce 173 wings for the A-10 program. This was expected to be a 242 aircraft program, as originally planned. It is our belief that we will end production on the A-10 WRP at between 55% and 60% of the original planned quantity. The noncash charge taken this quarter assumes that the contract will conclude no later than September 2015, the end of the 2015 government fiscal year, at less than the current 173 order quantity. As a result, we are no longer able to realize the expected return on the investments we made in the past to improve efficiency and lower supply chain costs. Our negotiating leverage with our suppliers has been impacted by the constant media reports predicting the aircraft's retirement. Additionally, future cost-saving initiatives that are no longer worth pursuing on a program with limited life and instead will now be deployed in support of our longer lived commercial programs. For example, we had planned to invest in automation equipment for assembling parts with significantly reduced manual labor, and we're deploying alternative supply chain strategies to drive down procurement costs. Finally, this program has incurred significant tooling and nonrecurring engineering and other labor costs associated with achieving the required technical specifications and production rate at the targeted labor cost. These tooling and other nonrecurring costs will now be amortized over a significantly shorter program life. When adjustments are required for the estimated total revenue on a contract, these changes are recognized within an exception to date effect in the current period. When estimates of total cost to be incurred exceed estimates of total revenue to be earned, our provision for the entire loss on the contract is recorded in the period in which the loss is determined. The cumulative adjustment to revenue from the inception of the program in 2008 through June 30, 2014 for this change in estimate is $44.7 million, all of which is adjusted in the 3-month period ended June 30, 2014. In addition to the $44.7 million adjustment to revenue, we have recorded a $2.6 million adjustment to cost of sales, as a result of the change in estimate on the A-10 WRP. That said, adjusted results for the second quarter and first 6 months of 2014 were in line with our expectations. Specifically, adjusted revenue for the 3-month period and 6-month period ended June 30, 2014 was approximately $21 million and $42.9 million, respectively, compared to $21.1 million and $41 million respectively for the same periods in 2013. Adjusted earnings per share for the 3-month and 6-month periods ending June 30, 2014 were $0.20 per share and $0.41 per share, respectively, compared to $0.21 per share and $0.41 per share for the same periods in 2013. Due to the loss incurred in the quarter ended June 30, 2014, we were not in compliance with the net income financial covenants contained in our credit agreement with Santander Bank and Valley National Bank. On August 6, 2014, we entered into an amendment and waiver to the credit agreement, which among other things, provided for a waiver of the covenant. Going forward, we have an opportunity to lower our estimated cost on the A-10 WRP, either by equitable adjustments to our contract with Boeing or by a government termination for convenience, and we will be exploring all avenues to reduce our loss. The GAAP loss recorded in the second quarter of 2014 will allow us to claim a 2015 tax refund of over $9 million from prior year tax payments and is expected to yield a more than $5 million tax credit that will offset our anticipated tax liability thereafter. In total, this adjustment we are making to the A-10 WRP will improve 2015 cash flow by approximately $14 million. As Doug mentioned, excluding this charge, our guidance for 2014 on an adjusted basis remains unchanged. Specifically, we expect adjusted revenue to be between $83.5 million and $85 million. Of note, our adjusted revenue for the first half of 2014 increased to $42.9 million compared to $41.0 million for the first half of 2013. For full year 2014, our commercial programs including the G-650, Honda Jet, the Cessna Citation 10+ and the Embraer Phenom 300 business jet are expected to generate a higher percentage of total adjusted revenue, as compared to 2013. During the first half of 2014, compared to the same period in 2013, commercial programs generated 14% higher revenue or approximately $15 million which accounted for approximately 35% of the total adjusted revenue. This compares to approximately $13.1 million or 32% of revenue for the first 6 months of 2013. Product deliveries for 2014 are expected to surpass our 2013 record year by approximately 10%, due to increased demand for our commercial products. Of note, in the first 6 months of 2014, we shipped product valued at approximately $38.2 million compared to $34.4 million of shipments in the first half of 2013, an increase of 11%. Adjusted gross margin is expected to be in the range of 20.0% to 21.0%, as several of our long-term programs currently are in their initial production stage. As these newer programs mature into 2015 and beyond, we expect margins to improve. We will continue our efforts to further lower our overhead costs. Due to our recent efforts, our overhead rates are the lowest they've been since we moved to this new facility in 2011. Adjusted net income is expected to be in the range of $6.6 million to $7.0 million. We expect cash flow from operations to be in the range of $1 million to $1.25 million. Now I will hand the call over to Doug who will comment on the backlog and contract awards, current business environment, expectations for 2015 and new growth opportunities going forward. He will then open the call to questions. Doug?

[Douglas J. McCrosson:]

Thank you, Vince. Looking past today's noncash charge related to the A-10 WRP, we see a business that is as strong as it ever has been. We have a large backlog and its funded portion is on track to reach an all-time high. At June 30, 2014, our total backlog was $391 million, as compared to $431.4 million at December 1, 2013, with 43% of total backlog for commercial aerospace contracts. Funded backlog was $96.4 million, compared to $110.4 million at December 31, 2013. Unfunded backlog, which is the value of our long-term contracts that has not been converted to funded orders, was $294.3 million, with 49% related to our long-term commercial aerospace programs. This figure does not include the recently announced $9 million amendment to our contract with Embraer for the Phenom 300 engine inlets that occurred in July 2014. From June 30, 2014, we have received approximately $19.2 million of new contract awards, $18.7 million of which were commercial. This is 45% greater than the total of $13.2 million of new contract awards of all types in the same period of 2013. We expect to announce several contract wins during the coming months, and we are confident we will have a very good second half of the year for new contract awards. Our goal is to close the year with a funded backlog of greater than $110.4 million, which was the value of our funded backlog at the end of 2013. As a result, we have good visibility for 2015 and the guidance we've provided to 2015 in our first quarter '14 earnings release remains unchanged. Approximately 80% of our 2015 revenue guidance comes from our funded backlog and expected orders coming from our existing long-term contracts as they convert from unfunded to funded backlog. The remainder will be generated from our big pipeline for awards we expect to win within the next 12 months. Approximately 40% of that bid pipeline includes high-value proposals in the commercial aerospace markets, including the business jet and large commercial airliner markets. Again, we are confident we'll have a very good second half of the year for new contract awards. Finally, in our 2015 forecast, we discounted the contribution of the A-10 WRP to revenue and net income and therefore, we are reaffirming the 2015 guidance we provided during the 2014 first quarter conference call. Specifically, for 2015, we expect revenue to be between $90.5 million and $94 million, the highest in our history. Production for existing programs and initial production for several new programs including the recent $9 million Embraer order to manufacture engine inlets for the Phenom 300 business jets are expected to ramp up in the coming months. We project single-digit growth in military revenue and double-digit growth in commercial revenue in 2015, as compared to 2014. Our commercial programs are anticipated to continue to generate a higher percentage of total revenue, approximately 42%. Gross profit margin is expected to be higher than 2014 at a range of 22.0% to 23.5%, mainly driven by higher production rates and lower unit costs, as several of our newer commercial programs are expected to mature into 2015. Now I'd like to discuss our new business opportunities, starting with the defense program opportunities. Defense has been and will continue to be an important part of our business. Regardless of the recent budget issues, defense market is an incredibly large market with great potential for CPI in certain segments. In 2015, we see a return to top-line growth in 3 of our 4 military segments

[Operator:]

[Operator Instructions] The first question comes from Mike Crawford with B. Riley & Co.

[Michael Crawford:]

Can you, Doug, please just walk through a couple of scenarios on how this equitable adjustment with the contract with Boeing could happen and the same with a possible termination for convenience with the government? And regarding that latter part, that -- the termination for convenience would be from the government to Boeing, not from the government to you, correct?

[Douglas J. McCrosson:]

Yes, that's correct. It would be to Boeing and then them to us. Let me start with the -- what we did with this write-off, Mike, was we assumed that the contract would run out as is with no equitable relief or termination for convenience. And that's how we based our write-down and how we based our new revenue recognition as a result. The equitable relief would be, we feel that we have certain investments that we made as a result, primarily during the settlement negotiations with our customer. I would rather not go into too many of the details, but we feel we have some valid room to seek equitable relief from Boeing in this particular case, and we will continue to do so. But the write-off assumes that we will not be successful in that. Likewise, for a termination for convenience by the government, we would be entitled to some of our expenses that we spent already that were to go for a full-length program that no longer will be applied to that full-length program. So there's a couple of scenarios that we would be able to, I guess, have a positive onetime nonrecurring benefit from. But those are not included in today's results.

[Michael Crawford:]

And if you were to have some success in those endeavors that maybe that's something that wouldn't happen this year or do you think that's a possibility that could happen this year, more likely next year and then if -- and then further to that, I guess, that would then reduce expected refund because you'd have less than expected loss from prior periods?

[Douglas J. McCrosson:]

I'll let Vince answer that one.

[Vincent Palazzolo:]

Mike, what actually would happen is if the program is terminated, let's say, our estimate right now is that the program is going to be terminated in September 2015. We would not expect to recoup any termination liability or equitable adjustment until after that point. So legitimately, you'd probably be talking about 2016. And those would be cash inflows at the time that it were to actually happen in 2016. So we would get income then. We -- there's nothing -- and we could not book those items because there they would fall into the broad category of contingent gains until we actually get the cash or have it definitive agreement to get the cash. So it's not going to affect the tax carryback that we're going to file for the tax refund, which will come to us in 2015. So whatever equitable adjustment or termination liability will not affect the 2015 tax refund or the carryback. It would be -- it's more likely that it would be a 2016 event, if that happened.

[Michael Crawford:]

Okay. I think I'll move away from that one. Just real quick on the business. I know you were at Farmborough and we did see this TacSAR announcement from UTC. So how different is that system they're developing with Selex and the DB-100 pods that you're -- reconnaissance pods you're making now?

[Douglas J. McCrosson:]

Well, the -- structurally, they're very similar. They're very similar in size and overall complexity. They share some common elements, actual exact same parts that are in the DB-110. From a radar standpoint, it's -- one can see in all weather, which is the TacSAR and one needs some good weather. So it aims -- they're complementary systems for their targeted customers. But it essentially is, I mean, it will look very much like the DB-110 pod we currently make for them.

[Michael Crawford:]

Okay, and then final question is how much floor space would you say right now is comprised by the A-10 rewinging program? And what program or programs do you think would be most likely to fill that space once you switch it out?

[Douglas J. McCrosson:]

I'm going to estimate. I don't know about but 7,000 to 8,000 square feet of floor space right now that over the next 14 months, between our Embraer product line floor space is -- needs to grow, as does our Honda Jet. So we will be utilizing some of that floor space for growth in those 2 particular lines. But obviously, we would need a new program to utilize that balance. Maybe another, we'd probably have, I'm going to say, around $4,000 to $5,000 of available space that would need to be filled. Inside of 130,000 square-foot total manufacturing footprint. That's not all that much.

[Operator:]

Our next question comes from Les Sulewski with Sidoti & Company.

[Les Sulewski:]

I just wanted to get a few technical issues out of the way. Just so I understand clearly, the past quarters will not be restated. So this is -- is that correct?

[Vincent Palazzolo:]

Correct. We would only restate prior quarters if there was an error. And this is not an error. This is a change in estimate based upon new facts and circumstances.

[Les Sulewski:]

Okay, and then what was the percentage of the government sales in this quarter? I understand government sales about $13.2 million by my calculations, and what was it relative to A-10 program?

[Vincent Palazzolo:]

On adjusted basis, the A-10 had nominal revenue in the quarter for us.

[Les Sulewski:]

Nominal. Okay, and what was it last year?

[Vincent Palazzolo:]

Under $2 million. Under -- closer under $1 million.

[Les Sulewski:]

Okay, and do you have amount, Vince, for cash flow from operations for this quarter?

[Vincent Palazzolo:]

We were positive, about $1 million.

[Les Sulewski:]

All right. And then just one more. On the E-2D program. What's -- what are your expectations on the size of scope that can -- that you can perhaps win on that program?

[Douglas J. McCrosson:]

Well, on the E-2D alone, it would be for an additional, up to say 20 aircraft for us. And on the C-2A, a similar number, maybe a few more. So taken in totality, you're looking at 40 to 45 aircraft. And we have quite a bit of content on that. I think if you look back and do the math, you can kind of come to a number. It's probably north of $60 million of potential new backlog.

[Operator:]

[Operator Instructions] Our next question comes from Mark Jordan with Noble Financial.

[Mark C. Jordan:]

My question relative to the A-10. On an adjusted basis, what would you believe would be sort of the range revenue for the -- for 2014, and what have you assumed for 2015?

[Vincent Palazzolo:]

The total revenue prior, not counting the adjustment for 2014, is around $5 million and would be under $3 million for 2015.

[Mark C. Jordan:]

Okay, and in your modeling here, that is all funded currently?

[Vincent Palazzolo:]

That is all funded. Correct.

[Mark C. Jordan:]

Okay. What is your CapEx expectation now for 2014?

[Vincent Palazzolo:]

Our CapEx expectation is around $0.5 million for the whole year.

[Mark C. Jordan:]

Okay, cash flow from 2015, with given the $9 million tax refund that would be received in '15, do you have a rough estimate of what your free cash flow might be in that year?

[Vincent Palazzolo:]

We haven't worked up a full estimate on that yet. but closer to the $9 million tax refund. Our range is still kind of big. But we were targeting being -- last year, we were $3 million cash flow, all positive from operations. We were targeting $15 million, at higher than that, not counting the tax refund. So, right? Is that'll ballpark you at a bottom number of $12 million. But I haven't done a hard enough estimate that I'm going to give you the top of that range yet.

[Mark C. Jordan:]

Okay, last question for me, Doug. We've had conversations over the years of going back about, having bids in on large commercial pieces of business. What is it that is going to get you over the hump and actually receive something? What has been missing in the past that you have, you feel you have today to start to get content on Boeing or Airbus platforms?

[Douglas J. McCrosson:]

One of the things that we have to keep in mind is that we are often bidding at almost a, I'll say, a Tier 1 level and the types of products that we're hoping to build. And in many cases, that involves our customer taking work out of their own shop. And I think what we really need to do is quite honestly, we just haven't come with a compelling argument for them to take that job out of their own factory and move it to ours. I think that I'm probably being overly honest with that assessment. But we -- while we do show a cost advantage, it is not -- their risk of moving a program, particularly one that's in flow, is proving to kind of offset that, the -- the financial savings that they would effect. So the types of things that we're doing is we're really working hard to make ourselves as cost efficient as we can, use of automation because our customers use automation, use of international and global supply chain, because likewise our customers are using that lower cost supply chain. And these things are very -- they're maturing, but not fully mature in our company. And I would say over the next several months, we hope to start seeing some traction and giving our customers a sense that we're on the right path to making sure our costs are as low as possible going forward. It's never a question of our capability. It's never a question that, of our quality or on-time performance, as much as these are not insignificant pieces of structure we are attempting to build. And I think we just have to develop an overwhelming reason for them to move the work from their own shop. If I can just kind of elaborate a little bit, just because I know where you're going. I think with regard to our reaffirmed guidance in 2015. I don't normally provide this kind of granularity. But the large commercial airline, a win that would generate revenue in 2015, we only have about 2% to 3% of our total guidance, top line guidance in that space. So our '15, clearly I would like the win. I think we're going to get the win. It's more a matter of 2016 in that market. But our guidance really kind of assumes that it's going to take some time to get this large commercial win and then allow some time to ramp up the revenue.

[Mark C. Jordan:]

And then that ramp would be -- the potential offset for the final loss of the A-10, that would be the [indiscernible]

[Douglas J. McCrosson:]

I would -- no, I think that will happen before then, Mark.

[Mark C. Jordan:]

Yes. I know that, but I'm just saying you have some revenue in '15 relative to the A-10. But the growth in that commercial program in '16, that growth component would offset the fact that there isn't any A-10 in '16 than '15.

[Douglas J. McCrosson:]

That's correct. Correct.

[Operator:]

[Operator Instructions] I'd like to turn the floor back over to management for closing comments at this time.

[Douglas J. McCrosson:]

I'd like to thank all of you for participating in this call and look forward to speaking to you again in early November when we announce our third quarter results. Thank you.

[Operator:]

Thank you. Ladies and gentlemen, this concludes today's teleconference. You may disconnect your lines at this time. Thank you all for your participation.