MTS Systems Corp
Q3 2020 Earnings Call Transcript

Published: 8 Aug 2020

[Operator:]

Good day, and welcome to the MTS Third Quarter 2020 Earnings Conference Call. Today's conference is being recorded. At this time, I would like to turn the conference over to Mr. Brian Ross, MTS Executive Vice President and Chief Financial Officer. Please go ahead, sir.

[Brian Ross:]

Thank you, Shelby. Good morning, and welcome to MTS Systems Fiscal 2020 Third Quarter Investor Teleconference. Joining me on the call today is Randy Martinez, our Interim President and Chief Executive Officer. I want to remind you that we will make forward-looking statements today as defined by the Private Securities Litigation Reform Act of 1995. Future results may differ materially from these statements depending upon risks, some of which are beyond management's control. A list of such risks can be found in our latest SEC Forms 10-Q and 10-K. We disclaim any obligation to revise the forward-looking statements made today based on future events. This presentation will also include reference to non-GAAP financial measures. These measures are used by management to evaluate the operating performance of the company over time. They should not be considered in isolation or as a substitute for GAAP measures. A reconciliation of our non-GAAP measures to the nearest GAAP measures can be found in our earnings release. I will now turn the call over to Randy.

[Randy Martinez:]

Thank you, Brian, and good morning, everyone. It's great to have the opportunity to speak with you on today's call, and we appreciate you taking the time to join us. Before I get started, on behalf of all of my MTS colleagues, we would like to thank the health care professionals, first responders and other front line workers who are dedicated to keeping us safe and healthy. Since I became MTS' Interim President and Chief Executive Officer in late May, my top priorities have been simple and well defined

[Brian Ross:]

Thank you, Randy. Our third quarter consolidated revenue was $196.2 million, a decline from the prior year of 15.5%. This brings our year-to-date revenue to $613.5 million, a decline from the prior year of 8.2%. The year-over-year decline in our Test & Simulation business of 14.7% year-to-date has been offset by year-over-year growth in our Sensors business of 3% for the same period. Revenue was adversely impacted during the quarter by COVID-19-related issues. With year-to-date revenue growth of 3% compared to last year, our Sensors business saw a decline of 4.8% in revenue in the third quarter, which is the first decline after 11 consecutive quarters of growth. Test & Simulation revenue declined 21.5% in the third quarter, bringing the year-to-date revenue to $362.6 million, a year-over-year decline of 14.7%. The quarterly and year-to-date decline is attributable to the previously mentioned slower orders profile in the last half of fiscal year 2019 and first quarter of fiscal 2020. These declines were offset by the R&D acquisition contribution of $14.1 million in the quarter and $28.8 million year-to-date. Gross margin rate was 33.4% for the quarter, a decline from 36.6% in the prior year, mainly attributable to onetime restructuring charges of $2.2 million. Excluding these onetime charges, our gross margin rate would have been approximately 34.5%. Year-to-date gross margin rate was 34.8%, a decline from the prior year, mainly due to onetime charges in the second and third quarters of fiscal year 2020, in addition to volume declines in the business. Excluding onetime charges in both fiscal years, the year-to-date rate would have approximated 35.9% compared to 37.7% in the prior year same period. The decline was due to a shift in product mix within both businesses and the startup of Endevco production recently transferred into our Sensors production facilities. With cost reduction efforts, we have been able to mitigate the impact that this is having on the gross margins. However, certain fixed costs of the business are currently being under absorbed. Operating expenses of $52.9 million were down 14.9% or $9.3 million from the prior year quarter, inclusive of operating expenses from the acquisitions of Endevco and R&D, which were not in the comparative quarter. Operating expenses included approximately $600,000 of restructuring charges and $2.1 million of acquisition-related charges, mostly due to the earn-out fair value adjustment. We have implemented cost containment programs that effectively reduced operating expenses within the third quarter by over $5 million, inclusive of operating costs for the newly acquired businesses. Net interest expense of $8.8 million increased by $2.2 million compared to the prior year quarter, primarily due to increased debt related to the issuance of our senior unsecured notes in the fourth quarter of fiscal year 2019 and accretion on the earn-out for R&D. We anticipate interest expense to be within the previously announced range of approximately $8.7 million to $9.3 million for the fourth fiscal quarter of 2020. Within the third quarter, we again took advantage of certain tax savings and recorded a net discrete tax benefit of $1.5 million, effectively making our year-to-date tax expense breakeven. We also continue to explore additional tax savings opportunities for our company, including the Cares Act and additional discrete items that will help to lower our corporate tax rate. Excluding these discrete tax items, our effective rate would have been approximately 15.2%, slightly higher than expected. Due to discrete tax items, we expect minimal to no tax expense for the full fiscal year 2020. Third quarter adjusted EBITDA of $28.8 million was down 19% from the prior year quarter, mainly due to the decline in revenue for the quarter. This includes adjustments for $2 million of acquisition-related and acquisition earn-out fair value adjustment expenses, $2.9 million of restructuring expenses and stock-based compensation expense. Stock-based compensation expense in the quarter was negligible due to the large forfeiture of unvested equity awards recognized upon the departure of our former CEO. For the 9 months to date, adjusted EBITDA was $90 million or 14.7% of revenue compared to $103 million or 15.4% of revenue in the prior year comparable period. This includes adjustments of $9.1 million of restructuring expenses, $5.2 million for stock-based compensation expense, $5.2 million of acquisition-related and acquisition earn-out fair value adjustment expenses and $1.1 million of acquisition inventory fair value adjustments. We ended the quarter with $65.1 million in cash, to measure it with the second quarter and up $7 million from the end of fiscal 2019. Notably, we generated positive third quarter free cash flow of $11.1 million or 6% of revenue, a significant increase from the first half of the year. Year-to-date, we have generated $13.4 million of operating cash flow. Capital investments totaled $21.1 million year-to-date to meet the growing demand in our Sensors business and to address the long-term needs of our facilities. We have significantly slowed our capital spending in the second half of the fiscal year as we work to preserve cash and liquidity measures for the company. We ended the quarter with total gross debt of $606 million, making $7 million of debt payments within the third quarter. Our current debt profile includes $170 million of Term Loan B debt due in July of 2023, $86 million on our revolving line of credit with a maturity date of July 2023 and our senior unsecured notes of $350 million due in August of 2027. We ended the third quarter with a gross debt leverage ratio of 4.8x and a net debt leverage ratio of 4.3x in full compliance with our credit agreement. When computing leverage, we also utilized pro forma adjusted EBITDA from our acquisitions to drive a trailing 12-month pro forma. On July 30, 2020, we entered into a fifth amendment to the credit agreement which governs the term facility and revolving credit facility to increase the maximum leverage ratio to 6x through March 31, 2021, with step-downs thereafter. In addition, we amended the interest coverage ratio to maintain 3x through March 31, 2021, with subsequent step-ups thereafter. This amendment was completed to maximize flexibility and available liquidity under our current capital structure in the event we would need to access additional funds. The amendment also -- almost doubles our liquidity position to approximately $180 million, including our cash and undrawn credit available through our revolving credit facility, exclusive of amounts reserved for letters of credit. As announced in the second quarter, we significantly reduced our cost structure in both permanent restructuring measures as well as temporary measures to address shorter-term conditions and position the company for longer-term operational efficiency. We expect to realize in excess of $10 million in savings in the second half of this fiscal year. The permanent restructuring savings in addition to temporary cost reduction actions yielded a savings of over $5 million during the third quarter, exceeding our cost savings expectations with a mix of savings between operating expenses and cost of goods sold. We recognized $2.7 million of restructuring charges in the third quarter of fiscal year 2020 with $2 million for restructuring actions that took effect immediately and an additional $700,000 for the ongoing reorganization of our Test & Simulation European operations. While we expect these actions will be sufficient to provide the needed flexibility to weather the current economic environment, we continue to evaluate the ongoing impact of COVID-19 and may take further cost reduction actions or other actions in future as needed. While we have suspended our guidance, I feel it is important to note a few items as we look to complete our fiscal year. We are expecting an uptick in orders in the fourth quarter on a consecutive basis as we believe the third quarter was a low point for us in orders. We are expecting a very similar financial performance in the fourth quarter as to what we delivered in the third quarter. Our adjusted earnings per share are adjust for restructuring charges, acquisition-related expenses, acquisition inventory fair value adjustments and the impact of the earn-out fair value adjustment related to the R&D acquisition. We expect additional restructuring charges in the fourth quarter due to our previously announced restructurings. We also expect additional adjustments to the fair value of the earn-out as R&D continues to perform expectation and meeting their overall earn out payment. Adjusted earnings per share does not adjust out amortization expense for acquired intangible assets related to our multiple M&A transactions. The amortization of purchased intangible assets decreased our earnings by $0.26 per share for the third quarter and $0.71 per share year-to-date. Amortization expense is expected to impact earnings per share in the range of $0.90 to $1 per share for the full fiscal year. Quarterly amortization expense has increased in the last 6 months as a result of the acquisition of R&D at the beginning of our second fiscal quarter. In addition, adjusted earnings per share does not adjust out stock-based compensation expense, which approximates $0.12 per share on a quarterly basis. In closing, we remain laser-focused on the operational efficiency of the company and mitigating the economic impact of COVID-19. While we have taken aggressive actions to address immediate disruptions, the pandemic's impact has the potential to be longer-term in nature. We will continue to take the appropriate steps to ensure MTS' strategic and financial flexibility for the future. With that, Randy and I are happy to take questions.

[Operator:]

[Operator Instructions]. We'll take our first question from Deepa Raghavan with Wells Fargo.

[Deepa Raghavan:]

Randy, Brian, a few questions from me. First, I will start with Randy. Randy, Can you talk about how the quarter played out? Did you exit June better than April, May? And was July sequentially better than June? Any comments there? And if you can rewind your thoughts, if some verticals actually improved better than you have expected, and perhaps there are also some verticals that have been decelerating sequentially?

[Randy Martinez:]

Deepa, thank you very much for your question. And yes, the quarter did end up improving as we went through it, June being better than May. And as we look at July, we are seeing some upsides in July, especially on the orders front. So there's a little bit of optimism there. And so we're excited about that. In terms of some of the verticals, we've seen strength in infrastructure spending, and we expect that to continue. Obviously, the renewable energy infrastructure spend has been good as we've talked about in our R&D strong performance. Industrial automation is picking up. So the trends are at least positive there. And we hope that continues. On the defense side, the Department of Defense has been a great benefit for us and especially for the products that we offer. So we're encouraged by their spending and see that continuing. If we had to identify a couple of the lagging industries, obviously, aviation has been impacted around the globe, and we have a couple of businesses that have a bit of exposure there, but not a lot. And then, of course, service is down a little bit. So that's kind of an overall view.

[Deepa Raghavan:]

That's very helpful color. So automotive, too, I'm assuming is kind of a little suppressed? Or did you see any sequential uptick there?

[Randy Martinez:]

It's a little bit suppressed, but I -- we'll see if it starts to come back a little bit as we go forward.

[Brian Ross:]

Yes, Deepa. Automotive, obviously, has been a point of discussion for the last couple of years for us, and we continue to see pressure in the automotive world. And we've talked about many reasons why that's happening. We don't see a lot of return in the automotive space here in the short term. However, we just continue to monitor the market going forward.

[Operator:]

[Operator instructions] We'll take our next question from John Franzreb with Sidoti & Company.

[John Franzreb:]

Just a little bit on the service side of the market. I realized it was tough to get into facilities during the peak of COVID. But could you talk a little bit about what's easing and what's not easing as far as service businesses, both in Test and Sensors?

[Brian Ross:]

Yes, John, and thanks for the question. What I would say is that service certainly has been difficult for us for the last couple of quarters. What we did see is a little bit of uptick here in the latter part of the third quarter. We are starting to see access to customers, although it's a little bit muted. Still at this point, we're seeing some progress in that area. I would say largely in the China region, we've seen that starting to emerge a little bit faster than what we've seen in the Americas and Europe. And with the majority of our service revenue sitting in Test & Simulation, I would say that there's not much the state around the Sensor side of it. So, we have been depressed in the service world, almost solely due to access to our customers, as that's been a pretty heavy focus for us over the last few years to grow our service business. So we're starting to see some progress there. I would say, cautiously optimistic that we'll continue to progress here into the fourth quarter.

[John Franzreb:]

Okay. And when you look at, historically, the opportunity pipeline, can you talk a little bit about what markets tend to come back fasters in terms of you try to redesign or refresh their products versus others?

[Brian Ross:]

Yes. Overall, for the entire company and looking at -- I would state that Sensors is probably the market that we see rebound a little bit faster. Test has shown us in the past where it's taken a little bit longer to rebound. Automotive being at the point where it's been for the last couple of years and that where they're focused spending in automotive is at the current time frame, we see a slower recovery for automotive. Of course, our infrastructure-focused products that we're providing continue to be a really good point for us. And the renewable energy wind space has continued to be resilient through this, especially with our R&D asset. As far as the industry automation, heavily into our Sensors business, it was in a really good spot for us leading into COVID. And we anticipate a return to growth in that area as the world becomes more automated, as factories become more automated, as machines and other things become more automated. Preventative maintenance is a huge item for that, positional sensing to automated factories, we think that even in a time frame like this where human-focused items become restricted because of access or abilities to come into work, that there could potentially be the need for even faster automation, which plays nicely for us in the industrial side of the world.

[Operator:]

And we'll take our next question from Deepa Raghavan with Wells Fargo.

[Deepa Raghavan:]

Sorry, guys. I think I got cut off before I could ask my follow-up. I apologize. Brian, this is for you. How much of a leeway do you think you have in taking additional cost actions without actually structurally impacting when recovery emerges? I mean, it doesn't look like you announced additional actions today, at least not something that impacts Q4 at this time. Is that correct, first? And curious, how do we think about decrementals going forward versus the temporary nature of some of the cost cuts, like traveling, et cetera, it's probably going to come back. Maybe some salary cuts are going to come back in the next few quarters. But also offset with some potentially additional permanent actions that you could take, I'm assuming without structurally impairing a recovery when it emerges. Can you talk to that, please?

[Brian Ross:]

Yes, certainly. And yes, to confirm, we haven't announced additional actions here in the quarter. It's kind of ongoing restructuring charges that we saw in Q3 as well as we'll see in Q4 for our European reorganization. And overall, that's the important piece for us is it's not to structurally impair the business in the long term. And so we continue to focus on areas within the business where we can get more efficient. Sometimes that's just getting more efficient. Sometimes, it does include the cost reduction side of the world. But it's a continuing piece for us that we will continue to search through the organization, make sure that we're making not only investments, but also slowing areas that are not good for the business long-term or as we see a reemergence for this. So with Randy coming on board, we'll continue to look into the business to make sure that we are actually working as optimally as possible with the cost structure, as optimal as possible. Decrementals, overall, what I would state is this -- and very similar to Q3 is we still have the ability if things were to go in the wrong direction from a market standpoint to reduce our cost structure. But we feel the actions we took at the end of Q2, leading into Q3, set the stage for us as an operating structure that we have. Certainly, we haven't incurred a lot of traveling expenses, and that really depends on the ability to access our customers, one. And our ability and willingness to travel to see our customers and our employees globally. But for the time being, that's pretty much shut off. And that would start to come back on when time allows as well as safety of our employees is there.

[Randy Martinez:]

And Deepa, I would just add to Brian's comments that I have come in with a bit of a different lens to look through at where MTS has been. And I believe that we have reduced the cost structure to the relevant point needed to ensure our liquidity needs are met in the short term. But if conditions were to worsen or if we determined changes need to be made in specific areas of our business, we will continue to do what we need to do to ensure business performance. And I focus a lot on the cost structure, the team would tell you that.

[Deepa Raghavan:]

No, that's helpful. Randy, just again, through your lens, you brought that out. Can you give us your thoughts on capital deployment. I think my question is twofold. One, how do you think of M&A continuity, given these backdrops? You've announced a few this year are pretty accretive, good deals. But how do you think about continuity in the next -- in the near-term versus the need to conserve capital? And two, your thoughts on dividend reinstatement time line, if at all.

[Randy Martinez:]

Well, I guess I would start by first saying that I think our M&A activity that we've had over the past few years has been very productive to the foundation we now have here, as I talked about in my remarks. So we're very pleased with the ability to have diversified our product offerings, our markets and our customers through these acquisitions. Frankly, my focus now from a capital standpoint is our leverage and trying to get our leverage reduced as quickly as we can. I think that's really crucial for our shareholders and just for the stability of our balance sheet. So that's a big focus for me. So that's kind of how I'm looking at this.

[Brian Ross:]

Yes. And we did suspend our dividend, and that's for the time being, and that's the way that we look at it. We feel that deleveraging is certainly a powerful point for us and something that we have our concerted and focused effort on. I would state that the renegotiation of our debt agreement on the revolver, the important thing there is it provides some flexibility and maximum allowance to liquidity as need be. But at the current time, we're generating positive free cash flow in the third quarter. That is really just around our ability to access if needed. So for right now, our capital deployment is really debt focused as well as maintaining some internal investments in the business that we've been working on that will help improve margins.

[Operator:]

We have no more questions in the queue at this time.

[Randy Martinez:]

Okay. Well, thank you so much for participating in our call today and for your interest in our company, and we look forward to updating you on our progress again next quarter. So thanks so much for being with us, and have a nice day.

[Operator:]

This concludes today's teleconference. Thank you for your participation. You may now disconnect.