Kaman Corporation
Q4 2015 Earnings Call Transcript

Published: 1 Mar 2016

[Operator:]

Welcome to the Kaman Corp Fourth Quarter 2015 Earnings Conference Call. [Operator Instructions]. I would now like to turn the conference over to Eric Remington, Vice President Investor Relations. Sir, you may begin.

[Eric Remington:]

Good morning. Welcome to the Kaman Corporation fourth quarter and full-year 2015 earnings call. Conducting the call today are Neal Keating, Chairman, President, Chief Executive Officer and Rob Starr, Executive Vice President and Chief Financial Officer. Before we begin this morning, please note that some of information discussed during today's call will consist of forward-looking statements setting forth our current expectations with regard to the future of our business, the economy and other future events. These include projections of revenue, earnings and other financial items; statements on the plans and objectives of the Company or its management; statements of future economic performance and assumptions underlying these statements regarding the Company and its business. The Company's actual results could differ materially from those indicated in any forward-looking statements due to many factors the most important of which are described in the Company's latest filings with the Securities and Exchange Commission including the Company's 2015 annual report on Form 10-K and the current report on Form 8-K filed yesterday evening together with our earnings release. In addition, we expect to discuss certain financial measures and information that are non-GAAP measures as defined in applicable SEC rules and regulations. Reconciliations to the Company's GAAP measures are included in the earnings release filed with yesterday's 8-K. Specifically in today's remarks, we expect to make reference to the non-GAAP reconciliation in Tables 10 and 11. With that, I will turn the call over to Neal Keating. Neal?

[Neal Keating:]

Thank you, Eric. Good morning and thank you for joining us on today's call. 2015 was a challenging year marked by persistent macroeconomic headwinds that impacted many of our customers in industrial and commodity linked businesses. This resulted in weaker trends in our distribution segment partially offset by strong margin performance in our aerospace business. Against this backdrop, we're controlling what we can and taking action to best position Kaman to navigate the current market cycle including optimizing our cost structure to drive margin enhancement. We believe we have the right assets and strategies in place and are focused on executing our key priorities. I'm pleased with the ability of our business leaders to react to the macro events that impacted our operations and I'm confident we're taking the right steps to work through this challenging market environment. Now let me turn to an overview of our results. Our fourth quarter results include a higher level of one-time costs resulting from the acquisitions of GRW and EXTEX as well as a number of other items that Rob will cover during his remarks. The fourth quarter was adversely impacted by an accelerated downturn in some of our end markets led by mining and energy which negatively impacted our distribution segment resulting in an 8% decline in organic sales per day. This was compounded by an already difficult comparison with four fewer operating days versus 2014. At the consolidated level, fourth quarter sales were $452.3 million compared to $477.9 million in the prior year. Adjusted earnings in the quarter were $0.69 per diluted share compared to $0.76 per diluted share in 2014. Moving on to the full year, in our aerospace segment, adjusted operating profit dollars increased 6% despite lower revenues. Higher profitability was driven by product mix and strong execution across our JPF and bearing product lines. This performance led to a 200 basis point improvement in year-over-year operating margin on an adjusted basis to 19%, a record level of profitability for the aerospace segment. In our distribution segment, total sales increased by 1.3% to $1.18 billion which included $53 million in acquired revenue. Organic volume presented increased challenges as the year progressed which resulted in a full-year organic sales per day decline of 3.2%. Much of the sales decline related to energy and mining end markets which were down more than 27% versus the prior year and continued to decelerate throughout the fourth quarter. The decline was even more pronounced in our fluid power platform which is more dependent on energy and mining end markets. The diversity of our end markets and platforms provided benefits however as sales within our automation control and energy platforms were up and bearing and power transmission platform sales were down slightly for the year. As a result of the negative organic growth, adjusted 2015 segment operating profit was $51.8 million or 4.4% of sales compared to $57.3 million or 4.9% of sales in the prior year. While we're not expecting an improvement in some of our weaker end markets in 2016, we do expect volume to stabilize in the first half and show modest improvement in the second half as comps become easier. While our OEM end markets will continue to face pressure, we do see favorable conditions in other markets we serve including food and beverage, construction, water treatment and healthcare to name a few. At the consolidated level, revenues were stable at $1.78 billion in 2015. Adjusted earnings per diluted share for the full year were largely in line with prior year with 2015 earnings per diluted share of $2.42 compared to $2.43 in 2014. Next, I would like to briefly discuss the key drivers by segment in the fourth quarter and provide some insights into our plans for 2016. Beginning with aerospace, total segment level sales were $186.6 million, a 6.5% increase over 2014. Sales were driven by higher volume in our bearing business, the contribution of acquisitions and substantially higher JPF shipments as we delivered a total of almost 10,000 fuses in the quarter. This was partially offset by lower sales from the scheduled completion of our New Zealand SH-2 program. Adjusted segment operating profit in the quarter was $36.3 million or 19.4% of sales compared with $33.2 million or 18.9% of sales in the prior year. The higher level of profitability was driven by JPF mix and the operating performance of our specialty bearing product lines. As we look forward to the year ahead, we're anticipating record volume and EBITDA in aerospace. Our guidance range for 2016, which Rob will detail in a few minutes calls for a revenue increase of between 17% and 20% driven by continued strength at bearings, record JPF deliveries, higher missile fuse shipments and the contributions from our 2015 acquisitions. Before moving on to distribution, I would like to provide you some additional color on aerospace. During the fourth quarter, we reported a charge of $4 million related to the AH-1Z program. This settlement relates to the resolution of program contractual issues and while we're disappointed to record this charge, we think it will be a net positive development for the program. We now have a stable longer term program with much lower risk and can build toward the future. On the K-MAX, the restart of this program remains on track and we expect deliveries to begin in early 2017. At the end of the year, we had five aircraft in firm backlog and deposits on three additional aircraft. We're seeing strong interest and in fact I'm headed to HAI's HELI EXPO later today and will be meeting with a number of existing and potential customers. In addition, we continue to pursue unmanned opportunities with the Marine Corps and the fire-fighting mission with the Department of the Interior. On November 30, we completed the acquisition of GRW Bearings, our largest ever acquisition. GRW is a German-based designer and manufacturer of super precision miniature ball bearings focused on the demanding application segment of the miniature ball bearings market for low noise requirements, extreme temperatures and ultrahigh speeds require both exceptional engineering design and continuous operating performance capabilities. We believe GRW is a great addition to our specialty bearing and engineered products line. While our current bearing manufacturing business is aligned with GRW through a focus on solving the critical problems of OEM customers and achieving the highest standards of performance in the most demanding applications, GRW offers us entry into several new markets beyond aerospace including the fast-growing healthcare market. The acquisition expands our most profitable business line and is expected to generate approximately $50 million in annual sales with initial EBITDA margins of approximately 20%. GRW is a terrific company with a very strong management team and I know they will be a great addition to the Kaman team. Finally, we're progressing with our integration of EXTEX including a facility move and remain focused on the synergy opportunities with our existing engineered products business. Turning to distribution, sales in the quarter were $265.7 million reflecting an organic decline in sales per day of 8.1%. Adjusted operating profit was $8.1 million or 3.1% of sales compared to $14.3 million or 4.7% of sales in the prior year. The lower margin primarily resulted from the negative leverage of lighter sales volume. We've taken a number of steps to bring our cost structure in line with the reduced level of sales. However, many of these actions occurred later in the quarter providing only a partial offset for the period. Looking at the Q4 margin a little bit more closely on a comparative basis, we had a relatively strong performance in Q3 delivering 4.9% operating margin. However, the sales decline accelerated considerably in the fourth quarter and over ran the leverage of operating expense reductions we executed during the quarter. We believe we have appropriately adjusted our cost structure given the expected sales levels going forward but we may not see the full benefit until the second quarter. As you might expect, lower vendor incentives had a significant impact on our fourth quarter results. We always look at this area carefully and with the sales volume trending lower, we opted to manage inventory levels versus gain incremental near term margin. Looking forward to 2016, we're not anticipating any recovery in energy and mining end markets. However, we do expect them to stabilize. Energy represents a relatively small portion of our overall sales mix but the magnitude of the decline has created a more pronounced effect. Our fluid power platform which is more dependent on OEM end markets is also under topline pressure in the current macro environment. As a result, our sales outlook for 2016 is for organic sales to be down between 1% and 5% for the year. We expect the rate of organic sales to improve as the year progresses and comps get a bit easier. To best position Kaman to compete and drive profitable growth through the current market cycle, we have recently accelerated some of our actions to reduce costs and improve margin performance. First, we implemented a workforce reduction program in the fourth quarter to right-size our headcount for lower volumes. Second, during 2015, we closed several facilities and consolidated debt volume into adjacent locations and in 2016 we plan to close an additional four facilities while consolidating four others into existing facilities in their local markets. Finally, we're investing to improve customer service and data analytics in an effort to drive both higher volume and profitability. These actions position us to recognize modest sequential margin expansion in the first quarter of 2016 at distribution and we expect to see improved margin for results as the year progresses as these initiatives take hold and we see modest topline growth relative to the first quarter. Now I would like to turn it over to Rob to provide you with some additional details. Rob?

[Rob Starr:]

Thank you, Neal and good morning, everyone. I would like to begin this morning by reviewing our financial performance for the fourth quarter and full year. We delivered adjusted earnings per share from continuing operations of $0.69 for the quarter and $2.42 for the full year, effectively flat with our 2014 full-year adjusted earnings per share of $2.43. 2016 adjusted operating income which excludes unusual items was up approximately 2% year-over-year to $116 million as we delivered strong margin performance at aerospace and tightly managed discretionary expenses across the entire Company. Looking at some of the details within aerospace, sales were lower year-over-year as we wound down the C-17 and New Zealand SH-2 defense programs and had a number of program push outs most notably legacy missile fuses and our SH-2 Peru program. We were also impacted by currency translation during the year which represented an $8.1 million and $1.4 million headwind for the year and quarter respectively. Both of our aerospace acquisitions closed in the fourth quarter and combined, they contributed $7 million in sales. Aerospace's operating margin results remained strong at an adjusted 19.4% in the quarter moderating a bit as expected from the levels earlier in the year. This was a result of the sales mix in the quarter and the normal cyclicality of fewer production days in the fourth quarter. Touching on distribution for a moment, I would like to provide additional color on our cost control efforts at distribution. As Neal mentioned, we took a number of actions during the year to reduce operating expenses and our fourth quarter SG&A level excluding the $1.5 million restructuring charge is down approximately 6% year-over-year. These actions position us to enter 2016 on solid footing. For the full year, distribution's organic sales declined approximately 3%. However, our three product platforms were impacted to different degrees based upon the end markets they serve. Our bearing and power transmission business was down low single digits for the year, fluid power was down nearly 10% given their higher OEM and oil and gas exposures. And lastly, our automation, control and energy platform was slightly up in 2015. Distribution's relative strong topline performance speaks to the benefit of our three-product platform strategy. Our balance sheet position remained strong as we exit 2015 with our year-end debt to capitalization ratio at 44.8% and a debt to EBITDA ratio of 2.7 times, both well within our long term target ranges. We have significant financial liquidity that will enable us to continue our long term growth strategies. I would like to turn to our 2016 outlook. At aerospace, we expect a significant topline of growth between 17% and 20% which corresponds to a sales range of $700 million to $720 million. This growth is driven by a number of factors including anticipated incremental sales of between $60 million and $65 million from the two acquisitions completed in 2015. We're also protecting growth in excess of 40% in our fuse and product lines. This includes estimated Joint Programmable Fuze deliveries between 30,000 and 34,000 fuses and significantly higher missile fuse deliveries including the units which were pushed out from 2015. Adjusted operating margin in aerospace is expected to moderate a bit from 19.2% to a range between 18.3% and 18.6%. This moderation is driven by a number of factors including a higher mix of U.S. government Joint Programmable Fuze sales, a year-over-year increase of approximately $8 million in depreciation and amortization expense primarily in tangible amortization expense from the GRW and EXTEX acquisitions and increased aero system sales which carry lower than segment average margins. Our outlook for aerospace operating margin is adjusted to exclude one-time acquisition costs of approximately $5.5 million such as inventory step up and integration expenses. We have also provided an outlook for EBITDA margins for 2016. At aerospace, we expect the adjusted EBITDA margin to be in a range of 21.8% to 22%. Aerospace is projected to record approximately $25 million in depreciation and amortization expense this year, an increase of more than 50% that is largely due to the impact of our acquisitions. Distribution sales are expected to be down slightly for the year given current market conditions. The sales range outlook is $1.125 billion to $1.165 billion, which translates into an organic sales decline between 1% and 5%. Our expectation is that our comparative organic sales growth rates will improve most notably in the second half as the comps get easier. Operating margin and distribution is expected to improve slightly year-over-year to a range of 4.4% to 4.6% as we benefit from the cost reduction actions we have taken and see stabilization in the market. Similar to prior years, we expect distribution in first quarter margins to be lower relative to subsequent quarters in part due to the timing of certain employee-related expense accruals that largely reverse later in the year. Distribution EBITDA margins are expected to be in a range of 5.8% to 6%. Depreciation and amortization expense at distribution should be relatively flat year-over-year in 2016. Our 2016 interest expense will be higher at approximately $16 million given our higher debt levels related to the acquisitions completed in the fourth quarter. Overall, the midpoint of our 2016 outlook calls for an approximate 9% increase in adjusted net earnings for the full year. We expect first half adjusted net earnings to be largely in line with the first half of 2015. However, first quarter adjusted net earnings are projected to be considerably lower than Q1 of last year. Contributing to the earnings cadence, our expectations for the timing of acquisition-related expenses, the ramp up of our K-MAX and Peru programs as well as improved bearings and distribution performance as we move through the year. Free cash flow for the year is forecasted to be in a range of $50 million to $60 million. Our lower free cash flow generation is due to two primary factors. The first is a ramp up of working capital to support K-MAX production. This should stabilize as we begin to deliver aircraft in early 2017. In addition, we have essentially completed the New Zealand SH-2 program ending the conversion of that inventory to cash. We have indicated our long-range target for free cash flow conversion is between 80% and 100% of net income and our outlook for 2016 would produce a three-year average free cash flow conversion in excess of 100%. On a final note, we're expecting to continue our share repurchase program that is primarily focused on offsetting dilution associated with management share programs. With that, I will turn it back over to Neal for his closing comments.

[Neal Keating:]

Thanks, Rob. As we have said, 2015 was a year that presented us with a number of challenges and I'm pleased with the ability of our team to adapt to current conditions while continuing to drive our long term strategy. At distribution, we have adjusted our cost structure to position us to be able to navigate the market we're faced with and our aerospace operations are well-positioned to gain advantage from favorable conditions for a number of our programs while benefiting from the strategic investments we have made to drive improved shareholder value. With that, I will turn it back over to Eric for questions. Eric?

[Eric Remington:]

Thanks, Neal. Shannon, may we have the first question please?

[Operator:]

[Operator Instructions]. Our first question is from Edward Marshall with Sidoti & Company. You may begin.

[Edward Marshall:]

So I wanted to talk about mining and energy comments that surround industrial distribution and typically I don't see your business as an energy-related content within distribution and I know mining is about 12%. What happened there that energy ticked up? Was it something in an acquisition that you weren't sure of? Was it more content kind of from customer specifics or did you increase the content of energy within your mix of business?

[Neal Keating:]

If you were to look at it, energy overall is a relatively small part of our business at about 8% but it was cut in half for the year. So, that was a very dramatic impact in that segment which rippled through to 4% for the business overall. So I think that while we don't have as direct an energy exposure as some other companies, it just underscored how bad both energy as well as mining got during the year.

[Edward Marshall:]

And we're just hearing about this now in the fourth quarter which I mean the rest of the companies in the universe have seen. Was it your positioning in the supply chain that led it to be a fourth quarter shift or did you see it earlier in the year and it just wasn't as dramatic?

[Rob Starr:]

No, we had highlighted certainly indirect exposure to oil and gas and certainly the mining impacts that we were seeing as a contributor to the decline in organic sales. Really what we saw was certainly like many others, an acceleration of that in the fourth quarter in particular which drove our negative 8% organic growth year-over-year. So we feel that we have an appropriate level of exposure to that sector. But as Neal touched on just the rate of decline this year has an outsized effect but I think that is also the reason why we performed relative to some of our competitors better on the topline is because we have a slightly lower exposure to that sector. We're not happy with the results but certainly we think we managed it about as well as you could.

[Edward Marshall:]

I wanted to touch on the Black Hawk program for a second in looking at the fiscal 2017 budget and the shift down in production. I know it is just a proposal at this point but when would you start to see kind of a decline in the order rates or the shipment rates, production rates, manufacturing rates the Black Hawk as it pertains to the fiscal 2017 budget? Kind of talk about maybe your timing.

[Neal Keating:]

Our current expectation, we're currently operating under a multi-year eight and our expectation is that we would see stable production certainly this year and we would expect to see that actually through 2018. The amount that is shown in the 2017 budget is most likely relating to multi-year nine and that procurement for that fiscal budget year. And we think there will likely be some level of carryover budget for multi-year eight so we're not expecting to see a near term decline in Black Hawk. We expect that to be fairly stable.

[Edward Marshall:]

And the additional working capital expenses for K-MAX and the facility expansion and the [indiscernible] wind down that is going to affect cash flow this year, can you kind of talk about the different components there and maybe quantify maybe specifically the working capital?

[Neal Keating:]

Look, our cash flow difference year-over-year is about $30 million or so kind of midrange, that is really predominantly a working capital build up on K-MAX. That really is the largest contributor to that. And it is really a combination Ed, of both inventory as well as -- I mean we're doing a number of these units on a cost of cost basis. So as we made progress through the year, we're going to attract additional working capital in particular inventory and then at the end of the year accounts receivable relating to those contracts.

[Operator:]

Our next question is from Steve Levenson with Stifel. You may begin.

[Steve Levenson:]

I know you had some foreign currency headwinds and now with GRW, you've got more exposure to the euro. Is there a different plan going into 2016 for hedging?

[Neal Keating:]

No, we continually look at our exposures particularly on a functional currency basis and you are correct that with the inclusion of GRW, we have additional U.S. dollar euro exposure. It is not as much as you might think because we do sell a number of the products that are outside the aerospace business in Europe. So, it is not as significant as it would be if it was a direct aerospace business because everything there is priced in dollars but we're expecting a modest headwind in 2016 relative to 2015 based on what we expect for our FX rates. It is probably, let's call it in a $3 million to $5 million range of headwind year-over-year but it is all going to come down to what rate we actually see.

[Steve Levenson:]

And I guess it is a little early to try to--?

[Neal Keating:]

Yes, certainly if we were to look at the pound where we have other exposures, that has come off with their concerns around exiting the EU. So we have seen the pound come down relative to our expectations so far in the year but we will have to see.

[Steve Levenson:]

And on the industrial distribution, I know you have been very active in controlling costs but it seems that there is a level of unpredictability on some of these markets. I know in addressing a broad number of markets, it reduces that risk but is there anything you think you can do to mitigate things further or is it just the inventory controls of customers that really impacted or that swing sales during the fourth quarter?

[Rob Starr:]

Steve, it was really a dramatic decline in sales through the last month probably of the third quarter through the fourth quarter. We actually at 5.1 and 4.9 had relatively strong performance from an operating income perspective in the second and third quarter of last year and it really tailed off so quickly. I think you raised a very good point though. We did take some actions that we outlined in our prepared remarks related to both some reductions in our workforce as well as some consolidations and closures. We have to look at our facilities all the time because we do have customers that move, markets that move and that just inevitably means that we don't any longer need a local market presence. And also as you know, we have done a number of acquisitions and some of those even though they are in different product platforms are in the same local geographic area. Chicago is a great example where we have consolidated fluid power, our bearings and power transmission as well as our automation control and energy platforms all into a single office, so smaller real estate footprint, lower cost etcetera. What we don't want to do is cut into the muscle of the business. So we're going to really try and drive smart topline growth in 2016 and keep all of the customer facing resources that we can possibly get within that business.

[Operator:]

Our next question is from Matt Duncan with Stephens. You may begin.

[Will Steinwart:]

This is Will Steinwart on the call for Matt. Going back to KIT trends, you hit on the 3Q, saw a drop off into the 4Q. Can we get some more detail on that fourth quarter from a monthly basis? And as a follow-on to that, some of your peers have started to see a slight sequential uptick in January and February. Are using the same thing there at KIT?

[Rob Starr:]

During the fourth quarter, I would say October on a year-over-year basis was our weakest very high single digit year-over-year organic decline. That came off a little bit kind of roughly flat in November to October performance and December year-over-year was flatly up but as you know, December not the greatest month for comparisons just given some of the unproductive sales days toward the end of the year. We're seeing in the first quarter, in the first couple of months certainly some relative rate improvement from January to February. We're tracking fairly in line with our daily sale that we saw in the fourth quarter. So we're certainly seeing stabilization at this point. We're down probably in the range of about 5% organic through February year-over-year. So it is certainly down as we anticipated. We will see what March brings but we're seeing a relative stabilization. We're not seeing a further deceleration.

[Will Steinwart:]

Moving over to aerospace, can you give some more details on the sales from the earnings perspective, the flow through the year. You mentioned the ramp at K-MAX and the Peru programs early on and into 2017, but any color on the significance of that ramp into the back half that would be helpful to try to tune things in a little bit more.

[Neal Keating:]

No, I think that is a very good question. In terms of the general cadence, we do expect our first quarter in aerospace to really be our lightest quarter from a topline perspective and also from a profitability perspective. And then as we tick through the year, we expect to see sequential increases, I mean we're not going to see as much volatility as we saw perhaps this year, Will, in terms of the quarter-to quarter revenue stream in aerospace. So in terms of the pickup, a lot of the earnings or the back half weighted contribution really does come from K-MAX and Peru as we ramp those programs up but also on the bearings side. I want to be clear that we do expect our baseline order rates and expected time of shipments within bearings to see significant improvement in the back half of the year and bearings as we all know historically has been our most profitable product line. So that has a disproportionate impact as we go through the year within aerospace.

[Will Steinwart:]

Last thing for me on M&A at KIT, any good opportunities there, are you looking, what kind of multiples? Are the targets currently expecting versus what you are willing to pay currently?

[Neal Keating:]

Will, it is an interesting time because as not unexpected, companies are valuing their businesses based on revenue and profitability from a couple of years ago rather than today's environment. So quite frankly, we're cautious right now because we're in a downturn in the distribution business. We would certainly be opportunistic if there was something that was particularly attractive to us but again not surprisingly people are valuing their business on a different time and we just think the risk-adjusted profile of that doesn't make sense for some of those valuations today.

[Operator:]

[Operator Instructions]. Our next question is from Shannon Burke with Gabelli & Company. You may begin.

[Shannon Burke:]

So just on the GRW acquisition, have you seen any synergies that you weren't expecting or as the integration has progressed, what are you seeing?

[Neal Keating:]

Shannon, I think that the integration -- it is very early as you know. The integration is progressing pretty much on track. I think that some of the key synergies that we see coming out over the longer term or the midterm in that business are first of all certainly from a sales perspective, we will have a much broader sales organization in particular in the aerospace market that can take their products to the end customers far more effectively so we see that. And also we see some manufacturing and operational synergies as well as we integrate the facility in the Czech Republic, our traditional RWG business etcetera. But I would say that most of 2016 will be focused on integrating the Company and we would expect most of those synergies to be maybe beginning in late 2016 but probably more so in 2017.

[Shannon Burke:]

And then turning to distribution, you were able to hold margins up in second and third quarter like you touched on and then a significant drop off in Q4. Do you expect the margin to be more stable over the course of 2016 or are you going to -- how bad will it get necessarily -- I don't want to say bad but you have done a great job but how big of a swing do you expect as you go from Q1 to Q4?

[Neal Keating:]

Shannon, we expect that we should have a sequential improvement from the fourth quarter to the first quarter but it will be relatively modest because a number of the actions that we took during late 2015, those costs will flow into 2016 as well. So we do expect to start at likely the lowest and then ramp up during the course of the year to get to that, the outlook that Rob provided of low end 4.4 so we would be flat up to 4.6. So we do see some sequential improvement throughout the course of the year. I think that is predominantly going to be in the second and third quarters, Shannon. The fourth quarter is always a little bit of an outlier simply because we don't know what customers will do at that point in the year with earlier extended holiday shutdowns, kind of like what we experienced in 2015.

[Operator:]

I'm showing no further questions at this time. I would like to turn the call back over to Eric Remington for closing remarks.

[Eric Remington:]

Thank you for joining us for today's call. We look forward to speaking with you again when we report first quarter results next month.

[Operator:]

Thank you. Ladies and gentlemen, this concludes today's conference. Thank you for your participation and have a wonderful day.