Lydall, Inc.
Q2 2017 Earnings Call Transcript

Published: 5 Aug 2017

[Operator:]

Good morning, and welcome to the Lydall Second Quarter Financial Results Conference Call. [Operator Instructions] Please note this event is being recorded. I would now like to turn the conference over to David Glenn, VP of Corporate Development and IR. Please go ahead.

[David Glenn:]

Thank you, Brandon. Good morning, everyone, and welcome to Lydall’s Second Quarter 2017 Earnings Conference Call. Joining me on today’s call are Dale Barnhart, President and Chief Executive Officer; and Scott Deakin, Executive Vice President and Chief Financial Officer. Dale will start the call with comments about the continued progress we are making in executing our long-term strategy as well as provide an overview of current business conditions. Scott will follow with a review of our financial performance and discuss the key drivers by segment. At the end of our remarks, we’ll open the line for questions. Our quarterly earnings press release and 10-Q report were released yesterday. So you can follow along with today’s call, please reference the Q2 2017 earnings conference call presentation, which can be found at lydall.com in the Investor Relations section. As noted on Slide 2 of this presentation, any comments made on this conference call that may constitute forward-looking statements are made available pursuant to the safe harbor provision as defined in securities laws. Please also refer to the cautionary note concerning forward-looking statements within Lydall’s reports on Form 10-Q for further information. In addition, we’ll be referring to non-GAAP financial measures during this conference call. A reconciliation to GAAP financials can be found in the appendix of the presentation I just referenced. With that, I’ll turn the call over to Dale.

[Dale Barnhart:]

Thank you. Good morning, everyone, and thanks for joining us. On balance, I’m pleased to report a good quarter with solid organic and earnings growth. Improvement -- improving but persistent operational issues in our Thermal/Acoustic Metals segment aside, we performed well this quarter and remain committed to the pursuit of our long-term vision for profitable growth and includes $800 million in revenue and an operating margin target of 15%, which is equivalent to an EBITDA margin of approximately 19%. Slide 3 outlines our recently published financial results. Total net sales for the second quarter increased 27.4% to $174.9 million. This increase was primarily driven by the acquisitions of Texel and Gutsche, which contributed $33 million or 24%. While we had additional pockets of strength, our strong organic growth of 6.4% in the quarter was driven by 2 of our 4 segments. The growth was principally the result of recovering energy-related markets in our Technical Nonwovens segment and improved volumes in the Thermal/Acoustic Fibers. With respect to profitability, adjusted gross margin of 25.1% was down 110 basis points and adjusted operating margin declined 60 basis points to 11.8% over the same period in the prior year. Included in adjusted operating margin is an incremental 50 basis points of intangibles amortization from acquired companies. Despite achieving clear, sustainable improvements in our Thermal/Acoustic Metals segment in North America, operating inefficiencies have persisted in Europe, unfavorably impacting our consolidated margins by 50 basis points. Consolidated adjusted EBITDA in the second quarter was down 80 basis points to 15.1%. This decrease is primarily due to a change in product mix, which Scott will provide more color on, coupled with the inefficiencies in Thermal/Acoustic Metals. Adjusted EPS was $0.80 per share, an increase of 14.3% over prior year. Turning to Slide 4. This is an overview of our long-term growth strategy, which includes 4 drivers

[Scott Deakin:]

Thank you, Dale, and good morning. I’ll briefly cover our consolidated results, and then provide an overview of our operating segment results. In the second quarter of 2017, the company achieved net sales of $174.9 million, an increase of 27.4% over the second quarter of 2016. This increase was driven principally by the acquisitions of Texel and Gutsche in the Technical Nonwovens segment. Organic growth for the quarter was strong at 6.4%, driven primarily by two of our sour operating segments. Within our Technical Nonwovens segment, we delivered 26.7% organic growth on improved demand from power generation customers in North America and in China and increased sales of advanced materials for automotive applications. Organic growth in our Thermal/Acoustical Fibers segment of 9.4% was driven by continued platform share gains as well as the benefit from products launched in the third quarter of last year. Organic growth was approximately 1% in our Thermal/Acoustical Metals segment as strong growth in China and moderate growth in Europe was partially offset in North America due to certain platform delays and declines in automotive SAR domestically. Our only area of quarter-on-quarter decline at the segment level was within Performance Materials, where we had a decrease of approximately 1%. This was primarily due to the exceptionally strong quarter last year, where we had over $1 million of nonrecurring termination buys of life sciences products. Adjusting for this, organic growth would have been approximately 2% for this segment. Despite the strong top line growth, gross margin in the second quarter was down 150 basis points to 24.7%. Excluding acquisition-related inventory step-up and restructuring charges, adjusted gross margin of 25.1% was down 110 basis points versus prior year. Unfavorable mix impacted the quarter principally within Technical Nonwovens on lower-margin products for the power generation market and the Performance Materials business, given the higher-margin termination buy last year. Unfortunately, the continuing inefficiencies in the metals segment reduced Lydall’s consolidated gross margin by approximately 50 basis points in the quarter. However, as Dale mentioned earlier, the North American business has demonstrated sustainable improvement in equipment effectiveness and we are confident the operational efficiencies are behind us in this geography. Consolidated operating margin for the second quarter was flat at 11.3%. Included in these results are 50 basis points of incremental acquisition-related intangibles amortization from the recent acquisitions within Technical Nonwovens. Excluding inventory step-up and restructuring-related expenses in the Technical Nonwovens segment, adjusted operating margin was 11.8%, a decrease of 60 basis points over prior year, again with the performance continued to be impacted by the inefficiencies in Thermal/Acoustica Metals segment -- in the -- excuse me, in the Thermal/Acoustical Metals segment. Adjusted EBITDA margin of 15.1% was down 80 basis points year-over-year. The company’s effective tax rate was 28.7% compared to 32% in the second quarter of 2016. The effective tax rate in the second quarter of 2017 was positively impacted by a favorable mix of income in lower tax jurisdictions. For 2017, while we may experience some slight variability on a quarterly basis, we continue to anticipate that our full year effective rate will be in the high 20s. Second quarter 2017 earnings per diluted share were $0.76 compared to $0.63 of earnings in the prior year. Earnings per share in the second quarter of 2017 was negatively impacted by foreign currency of $0.03. When adjusting for the inventory step-up and restructuring expenses, adjusted earnings per share rose by 14.3% to $0.80 compared to the prior year, despite the unfavorable FX impact. As it relates to capital expenditures, we spent $15.1 million through the first six months of the year, essentially flat with the prior year. For the full year 2017, we expect total capital expenditures to be approximately $35 million as we continue to invest at a high rate than usual in support of attractive growth, productivity and restructuring projects. Cash flows from operations in the first 6 months of 2017 were $27.8 million compared with $33.4 million in the same period of 2016. This reduction is driven by increases in working capital, including timing of pension plan and tax payments, but most notably impacted by greater automotive tooling inventory in advance of new product launches in the second half. Finally, our liquidity remains very strong. At the end of the second quarter, cash was $63.5 million after reflecting a further pay-down of $10 million on our debt. Total outstanding debt was $107.3 million for a net leverage ratio of approximately 0.5 times. Turning to Slide 7, I’ll note the progress we’ve made year-to-date. Through the first 6 months, sales of $340.4 million were up organically by 8.7%. Our filtration and engineered materials businesses, which are comprised of the Technical Nonwovens and Performance Materials segments, are up 17.2% and 4.2%, respectively. In automotive, both businesses are up significantly with Thermal/Acoustical Fibers up 11.9% and Thermal/Acoustical Metals up 7%. With respect to profitability, adjusted operating margin declined 70 basis points to 11% versus the adjusted operating margin for the same period of 2016. Included in these results is an incremental 60 basis points of intangibles amortization from acquired companies versus the same period last year. In addition to this, the decline at the consolidated level was driven primarily by unfavorable mix, increased raw material cost and a $1.7 million or 50 basis points of operating inefficiencies in the Thermal/Acoustical Metals segment. Moving to Slide 8, I’ll discuss our segment results. I’ll just start with our Thermal/Acoustical Metals business. This is our global automotive segment which specializes in providing under-hood and underbody engineered thermal solutions for vehicles. This business delivered organic sales growth of 0.8% during the second quarter. Net parts sales were essentially flat at $41 million, while tooling sales were down $1.6 million, given the timing of product launches. Unfavorable foreign exchange also unfavorably impacted the business by 1.4%. Despite parts sales being up slightly, operating margin declined 170 basis points quarter-on-quarter to 7.3%. Persistent operating inefficiencies in Europe, primarily due to higher labor, overhead and outsourcing, impacted the business. While the business continued to experience moderate commodity cost increases, favorable overhead absorption on increased sales help partially offset the performance in the quarter. While we are disappointed in our execution in Europe, discrete actions continue to be taken and leveraging the successes we’ve seen in North America, we anticipate that the inefficiencies will be behind us by the end of the year. Slide 9 refers to our Thermal/Acoustical Fibers business. This business also serves the automotive industry and provides molded polyester acoustical solutions primarily for underbody applications for vehicles in North America. Sales in the second quarter were $43.5 million, up 9.4% on an organic basis. Quarter-on-quarter growth was driven primarily by the incremental sales of our molded flooring solution that was launched in the third quarter of 2016 as well as sustained demand for all products. Operating margin in the second quarter increased 140 basis points to 27.9% on fixed cost leverage from the increased volume. Moving to Slide 10, I’ll cover our Performance Materials segment. This business provides specialty filtration and insulation solutions to a variety of end markets globally. Sales in the second quarter of $29.3 million declined approximately 1% on an organic growth basis. This decrease is primarily due to the nonrecurring life science termination buys that occurred primarily in the second quarter of 2016. Excluding the impact of this, organic growth in the quarter would have been approximately 2% as we saw modest growth in filtration, primarily driven by fluid power applications as well as increased demand for our specialty insulation products. Second quarter operating margin of 13.2% declined by 240 basis points versus the same period in the prior year. The decline in margin performance again was principally driven by the non-recurrence of the higher-margin life science termination buys. Slide 11 covers our Technical Nonwovens segment. This business produces air and liquid filtration media as well as other engineered products for use in various commercial applications such as geosynthetics, automotive, industrial and medical, among others. For the second quarter of 2017, sales of $67.1 million were up $33 million due to the acquisitions of Texel and Gutsche. Foreign currency translation unfavorably impacted sales by 4.1%. On an organic basis, sales were up 26.7% on the recovery of the U.S. power generation replacement market, coupled with strong demand for our advanced materials products, particularly within automotive. From a profitability perspective, adjusted operating margin for the second quarter decreased by 60 basis points to 11% compared to the same period in 2016. As a reminder, our adjusted results exclude expenses related to ongoing acquisition integration activities, which cost $0.3 million in the quarter but do include 140 basis points or $0.9 million of incremental acquisition-related intangibles and amortization versus the same period last year. In addition to this, the decrease in adjusted operating margin was due to unfavorable product mix, given increased sales of power generation related products, and higher margin of SG&A from the inclusion of the acquisitions. As Dale noted earlier with respect to the acquisitions, the performance and integration of both businesses continues to be on track and we remain confident in the strategic leverage to be gained by the industry-leading market position that we now enjoy. That concludes our review of the second quarter results. Overall, we had a solid quarter with strong top line and EPS growth. Addressing the operational executions in metals and executing flawlessly on our planned integration-related restructuring in Technical Nonwovens continue to be our most significant near-term priorities. Leveraging this improvement and if the strength in our end markets continue, we remain positioned to deliver solid year-over-year improvement in both sales and profits in 2017. With that, I will turn the call back to the operator to begin our question-and-answer session.

[Operator:]

[Operator Instructions] The first question comes from Matt Koranda with Roth Capital.

[Matt Koranda:]

Just wanted to start off with the Thermal/Acoustical Metals segment. Could you just provide a little bit more color on how volume and mix in Europe deferred from your prior expectations? Was it something with the customer changing releasing or the release schedule with you guys in somewhere was a change in the content on a particular platform?

[Dale Barnhart:]

Principally, the change in mix, as what we anticipated, is we have some older products that we thought were going to be out of production by now, end of life, that are continuing. And they tend to be our single-wall, lower-margin products. That’s the primary mix change that we’re seeing in Europe.

[Matt Koranda:]

Okay, got it. And then on operating margins, if I add back the $900,000 in inefficiencies in Europe, I guess I get to normalized margins of around 10%, which would actually be about 100 basis points better year-on-year despite the revenue decline here. How did mix sort of impact the margins in this segment if we kind of normalize those margins?

[Scott Deakin:]

I think there’s two points to it, Matt. One is the stronger Europe overall is lower margins. And as Dale indicated, that lower margin product there versus our expectations. The other piece is, Europe was higher relative to North America. So I’d say on total, it’s probably worth in the ballpark of another 50 basis points or so.

[Matt Koranda:]

Okay. Great. And then you guys said Europe challenges run off by the end of the year. Could you just help us what sort of operating margin trend through the remainder of this year? And then secondly on that, I know you guys mentioned you’re still ramping up in China. Are there any dual wall programs in that region where you can draw on some of the lessons learned from North America and Europe? And do you see any impact to margins there?

[Dale Barnhart:]

Actually, in China, I’ll start with China first, Matt. China, we’re very pleased with. Their revenue is up. I mean, as you know, we’re starting slow. But year-over-year, our revenue is up substantially in China. We were profitable at the end of last year. We continue to be positive at the operating income line. And in the past 60 days, we’ve won some significant new applications in the high-margin category that we’ll be launching as we enter 2018. So our strategy of focus -- of controlled growth, measured growth and focusing on high-margin products in China is well on track and we’re very pleased with that.

[Scott Deakin:]

And I’d say, Matt, just to give further color, Q3, as we indicated in the release, is going to face some pressure and you’ll expect to see the metals margins down in the third quarter. But as we indicate, our expectation is that we’ll start to see that turnaround coming into the fourth and fourth quarter expectations are to have -- to be much higher than, obviously, the very difficult Q4 we had in ‘16.

[Dale Barnhart:]

And also, the mix in the third quarter, which is a positive side for the metals business is that significantly higher tooling revenue in the third quarter and that mixes down our margins. But we’re launching over -- well over 100 new parts this year between North America and Europe, which leads to new products for us going forward.

[Matt Koranda:]

Okay, got it. And you guys have indicated in the past, sort of given some good numbers around program launches for the year in both T/A Metals and Fibers, can you give us the directional sense in terms of program launches that you’d expect heading into 2018?

[Dale Barnhart:]

Well, specific programs, not platforms, no. But again, specific dual wall launches in North America. As you know, we’ve invested in a second high-speed line, a replica of the one that we launched last year, which will be, as we move into 2018, we will be filling that line up with platforms we’ve won. And most significantly for our European operations, today, that business is predominantly our lower-margin single wall product. As we exit 2017, we’re putting an investment in there, a high-speed line, to support applications that we’ve won, which are dual wall high margins. So as we move into 2018, you’re going to see two impacts on -- positive impacts on the European operation. First, the resolution of these inefficiencies we’ve been fighting this year. But most importantly, a transformation of our product mix to the higher-value products that we are now producing in North America.

[Scott Deakin:]

Just one more point of color to that, Matt. So if you think about tooling as a proxy, as a leading indicator for future sales growth, our tooling sales in the metals segment will be more than double what they were in 2016. Obviously, that has a near-term impact on margins in the fourth quarter. As I indicated, we’ll have a particularly strong quarter, even with that impact, but that really sets up a very favorable 2018, or as we’ve talked about, we expect our organic growth to be in the mid-single digits based on the launch of those programs on a relatively flat SAR expectation.

[Matt Koranda:]

On the fiber segment, I know you guys have kind of commented on it in your prepared remarks. But could you put a little bit more color to the magnitude of the potential drop that we see sequentially in Q3? And how does visibility look for you guys in that segment, just given some of the shutdowns and changeovers that are happening this quarter?

[Scott Deakin:]

I’d say it’s pretty consistent with what we’ve seen in prior years, may have a little bit of slings based on some tooling differences and things like that. But I would say it’s largely consistent with our 2016 sequential change from Q2 to Q3.

[Matt Koranda:]

Maybe just last one from me. In the Performance Materials segment, I know down year-over-year but that seems mostly due to the discontinuation of the termination buys that happened last year in the life sciences product line, but pretty strong sequential EBIT margin rebound here. Could you just talk about the drivers there? And can you sustain the current run rate from Q2 into the back half of the year? What are the puts and takes that sort of move margins in Performance Materials?

[Dale Barnhart:]

The margin improvement has lots to do with product mix. What we saw in the second quarter was a very significant increase in our fluid power sales. And I’ve mentioned some of the new product development we’re doing in that area that’s having a significant impact on our margin expansion in that business as we go forward.

[Operator:]

Our next question comes from Edward Marshall with Sidoti & Company. Please go ahead.

[Edward Marshall:]

So I wanted to piggyback on the last question as we look at the Performance Materials. And I’m curious about what you’re saying because this does seem like a seasonally strong quarter over the last couple of years in that business and I understand last year was a bit of an anomaly. But as we look forward, are you guiding to kind of that low to mid-teens margin through that business through the remainder of the year?

[Scott Deakin:]

I think you’ll find Q3 to be relatively consistent to last year, so not as strong sequentially as we saw in Q2. We have a number of things that could pop for us to make Q4 very, very strong for us. But we are still working through a few things there, so we’re not fully counting on it yet. But we -- regardless, I think we expect Q4 to be stronger than prior year.

[Edward Marshall:]

And when I think -- when you talk about the Q4, is it timing of a particular order? Or is it some operational changes? Or what is it that might be lingering?

[Dale Barnhart:]

With some of the new product launches we referred to in fluid power and our specialty insulation area where we have some really promising development. But again, timing of commercialization can move around a little bit. We’re anticipating to see some positive impact of that in the fourth quarter.

[Edward Marshall:]

If we don’t see it in the fourth quarter, can I assume that you’ll see it in 2018?

[Dale Barnhart:]

Yes.

[Edward Marshall:]

Got it. As we look at the metals division, I guess, last quarter, we talked about an $800,000 impact in North America, $700,000 in Europe. It looks like Europe got a little bit tougher. I’m curious to get your comments to what are the inefficiencies going on in Europe? And are you seeing any kind of persistence from the competitors there? I know there’s more competitors around the double wall than domestically.

[Dale Barnhart:]

No, again, our business mix in North America now is predominantly the higher value shields that we produce. In China, we’re focusing on winning those type of applications. Europe, on the other hand, is still predominantly single wall and we’re going through that transition to the higher value. The big swing in that area will occur as we move into 2018 as we’ve won several really nice applications there. So really, the fundamental issues in Germany right now is that we’ve had products -- lower-margin single wall product that we thought would be out of production by now, but the OEMs have continued to consume. It’s actually increased our demand higher than what we thought. So we’re seeing mix and it’s creating situations where we have to run overtime and do other things that are required to support that demand of low-margin product. In addition to that, we just haven’t operated as well as we have. So that’s why we’ve made a management change there. That’s why we have principals who really drove the efficiency gains we’re seeing now in North America, which are quite significant in Europe right now, addressing those issues.

[Edward Marshall:]

To be fair, it sounds more like market issues than operational inefficiencies.

[Dale Barnhart:]

No, no, no. Ed, I don’t want to -- the single wall does have a negative impact but we’re not doing it as efficiently as we should. So we’ll get those inefficiencies behind us. And then when we really see the nice enrichment in margins in Europe is when we finally make the transition to these higher-value products. We have some of them now, but we’re seeing some very -- we’ll see some very significant mix change as we enter in 2018. At the end of this year, we’re putting in place a high-speed line that will produce these large dual wall parts to support business that we have been awarded.

[Scott Deakin:]

Just to give a little more color to that point. Most of the inefficiencies we saw in Hamptonville in the second quarter were really related to labor inefficiencies. And it’s really about just trying to handle that volume and that mix that Dale talked about, which was different from what we expected as we’re going through some transition and as we phase out some of these other products, we’ve got some overtime and some labor inefficiencies that are causing us problems. But based on our lean activities and other programs we should be able to work through those.

[Edward Marshall:]

Is it -- I mean, is it that they’re producing more cars in Europe or they anticipate the supply to dwindle as we kind of move -- as the market moves to the dual? I’m just trying to understand that a little clearer?

[Dale Barnhart:]

No, they are -- production is up in Europe versus last year. And it’s just the transit -- sometimes model changes and platform changes get delayed. And that’s what’s caused the continuous of some of these lower margin, single wall products that we have in Europe, which we anticipated to be out of production by now.

[Edward Marshall:]

Got it. And a lot of these -- these are contract-based businesses, so you kind of know what’s coming down on the pipeline, I guess.

[Dale Barnhart:]

Yes. The variable, as you know, Ed, is how successful that vehicle is going to be. A great example on our fibers business, we’re on the F-Series pickup. First half of this year, production sales were relatively flat, slightly down on North America. Ford F-Series was up 8% to 10% and we benefited from that.

[Edward Marshall:]

Right, right. And on that comment, I guess, I’ll ask, collectively, auto sales have showed some trouble, I guess, through July and year-over-year, still relatively high. You’re SUV and truck weighted and that’s fared better to date. What have you heard from your customers as it relates to kind of the demand there, especially in North America as it might relate to your business on a go forward?

[Dale Barnhart:]

I think what we’re hearing from the industry is that the SUV and pickup will be the healthiest of all. The vehicles that are being hurt the most, as far as decline in demand, is the small pass vehicles. So right now, the fact that we have favorable mix, particularly in fibers in SUV and pickups, is benefiting us. And as we continually say -- state, whatever the threshold is in the marketplace, we should be 4% to 5% better than that because of the share gains we’ve had. The business that has the most volatility as far as model mix is the metals business because we’re on engine platforms that are used on various vehicles, from pass vehicles to SUVs. And so we have a broader diversity of model mix in the metals business.

[Edward Marshall:]

It does seem that you are outpacing the industry on top line. Looks like collectively, you were up almost 2% in sales for your 2 auto businesses versus last year. So that’s good to see. As we switch gears to Technical Nonwovens, some good organic growth there, I’m curious, you broke down kind of the collective revenue per -- for the acquisitions. I’m curious if you can do it for Texel and Gutsche and also from the profit side as well. And if not, if you could add the profit from -- collectively in the segment for the quarter, that would be helpful.

[Scott Deakin:]

Yes, we don’t break it down by the individual businesses.

[Edward Marshall:]

Can you talk about the -- what acquisitions added from a profit perspective in the quarter or maybe from an EPS perspective?

[Scott Deakin:]

Well, I’d say it’s consistent with what we talked about initially. As we indicated, our acquisitions are performing per the acquisition integration plans. Largely, the purchase accounting impact is consistent with what we initially talked about when we did the deals. If anything that was pulled forward a little on some of the inventory step-up. And acquisitions, integration spending was about $300,000 against an overall objective for the year that’s in the couple of million range and you’ll see that roughly equally split between Q3 and Q4 going forward. So I just -- without getting into the details by business now, I’d say everything is very consistent with what we talked about when we did the acquisitions.

[Operator:]

[Operator Instructions] Our next question comes from Robert Majek with CJS Securities.

[Robert Majek:]

Just following up on a previous question. Can you disclose the platform launches that should set us up for a favorable 2018?

[Dale Barnhart:]

No, we really don’t like to tip our hands on where our new products are growing. But as far as which vehicles because for competitive nature, but again good high-value product launching in Europe as we enter 2018 and continuation of what we’ve been doing in North America. As we stated, we have -- second line is up and running now in Hamptonville, a duplicate of our high-speed line that we launched last year. And again, that line will be full of large dual wall product for various OEMs.

[Robert Majek:]

And then I just wanted to talk about pricing in the Thermal/Acoustical business. I know you usually have price step-downs built into your contract, but I was wondering if the OEMs are becoming any more aggressive at the negotiating table.

[Dale Barnhart:]

No, they have always been aggressive, Rob, so that’s just the nature of that business. It varies anywhere from 1% to 2% a year that we give in our productivity programs.

[Robert Majek:]

And then just taking a step back, just to talk about the big picture. Where do we stand on the international expansion opportunity in the Thermal/Acoustical Fibers business?

[Dale Barnhart:]

Again, we are on with a major European OEM who has a global footprint. We’ve won business with them in North America. We’re now listed as a qualified supplier, and we are receiving our FQs from that OEM to support some of their global platforms. So we’re actively pursuing opportunities in the bid process.

[Operator:]

This concludes our question-and-answer session. I would like to turn the conference back over to Dale Barnhart for any closing remarks.

[Dale Barnhart:]

Thank you, everybody, for participating on the call. Very pleased with our second quarter performance, given the inefficiencies we’ve had in our Thermal/Acoustic Metals business. And most importantly, as we look forward to the second half of this year, I’m very confident that we’ll be delivering both top line and EPS growth over 2016. Thank you very much.

[Operator:]

The conference has now concluded. Thank you for attending today’s presentation. You may now disconnect.