NN, Inc.
Q1 2019 Earnings Call Transcript

Published: 10 May 2019

[Operator:]

Good day and welcome to the NN Incorporated First Quarter 2019 Earnings Conference Call. Today's conference is being recorded. At this time, I would like to turn the conference over to Mr. Robbie Atkinson. You may begin, sir.

[Robbie Atkinson:]

Thank you, operator. Good morning everyone, and thanks for joining us. I'm Robbie Atkinson, Executive Vice President and I’d like to welcome you to NN's first quarter 2019 earnings conference call. Our presenter this morning is President and Chief Executive Officer, Rich Holder. If anyone needs a copy of the press release or the supplemental presentation, please contact Abernathy MacGregor at 212-371-5999, and they'll be happy to send you a copy. Before we begin, I'd ask that you to take note of the cautionary language regarding forward-looking statements contained in today's press release, supplemental presentation and in the Risk Factors section in this Company's 10-K for the year ended December 31, 2018. The same language applies to comments made on today's conference call, including the Q&A session as well as the live webcast. Our presentation today will contain forward-looking statements regarding sales, margins, foreign exchange rates, cash flow, tax rate, acquisitions, synergies, future operating results, performance of our worldwide markets and other topics. These statements should be used with caution, and are subject to various risks and uncertainties, many of which are outside of the Company's control. The presentation also includes certain non-GAAP measures, as defined by SEC rules. A reconciliation of such non-GAAP measures is contained in the tables in the final section of the press release and the supplemental presentation. First, we'll give an update and overview of the first quarter and Rich will provide commentary on the business. Then we will walk you through the numbers and discuss Q2 outlook. Then afterwards, we'll open up the line for questions. With that said, Rich, I'll turn the call over to you.

[Rich Holder:]

Thanks, Robbie. Good morning, everyone and welcome to our Q1 2019 conference call. As usual over the next few minutes, I'll take you through our Q1 results and then we will open the line for questions. With that, let's dive into the highlights. Net sales for the quarter was $213.3 million. Sales growth of 44.1 million, the majority of which was driven by our life sciences business. Acquisitions contributed a total of 55.2 million within the quarter to the top line. Adjusted EBITDA of 34.5 million with operating performance as expected and I will say that our integrations are all on track and performing as expected. Adjusted operating margins expanded by 30 basis points over the prior year to 10.8%, led by the improvements by Life Sciences -- by the growth as well as the synergy capture, but also in large part by the appropriate flexing of our mobile solutions business in the face of significant market headwinds. Adjusted diluted EPS of $0.20, free cash flow for Q1 was a usage of cash of 16.8 million, which actually is slightly better than plan. Let me remind you, as we talk about cash, I think we introduced this on the last call. We told you we would move to a standard definition of free cash flow and so our definition is now operating cash flow minus CapEx. So it's right off the face of our financial documents. As we move over to page 4, again in the net sales column, net sales up 44 million versus prior year. Total acquired sales, inclusive of organic growth within the acquisitions, was 55 million, offsetting the contraction primarily in our mobile solutions business of about $10 million in actual sales. On an adjusted diluted earnings per share at $0.20, let me remind you that in third quarter of 2018, we issued 14.4 million shares and so you can use that for the appropriate comp. From a gross margin perspective, we were 24.4%. Our margin was offset by continued investment and integration activities. Those activities in total equate to about 150 basis points. SG&A, acquisitions added $5 million. I think the comp on SG&A begins to be a little bit more realistic, as we get further into the year. But SG&A is performing as expected within the business. As we move over to page 5, adjusted operating margin of 10.8%, again, an expansion of 30 basis points. And I have to point out that that the mobile solutions business flexed in an expected manner, and held -- and in fact, increased their margins over and above what we would have expected. Adjusted EBITDA margin of 16.2%, and as we move towards the bottom of the page, if you recall, last quarter, we introduced you to this slide. We wanted to give you a view into our debt and leverage position, as it relates to our credit agreement. We had lots of questions around that. So we wanted to be as transparent around that as possible. So as you look at this chart, and you compare quarters on a year over year basis, you can see the effects on our leverage. Q1 2019 leverage came in a bit better than plan and currently sits at 5.1. As I'm sure you’re aware, our normal seasonality around cash is we use cash in the first half of the year, we begin to generate cash in the third quarter and we generate a significant amount of our cash in the fourth quarter. It's a little bit smoother than it was in years gone by, but our seasonality remains the same. So there's no reason to expect our cash generation profile to change. As we go into the businesses, on page 6, Life Sciences group. Let me just take a moment to orient this chart. The red bar represents the performance of the business, had we owned all the acquisitions on January 1, 2018. It's intended to allow you to get a very clear view of the organic growth that's occurring inside of the businesses as we put these businesses together. So, as you look at the comparison -- from a comparison basis, this business is up $12 million or roughly 17% inorganic and 55 million from the Q1 actual plus inclusive of acquisition. Our integration and synergy plans are on track. And you see the effects of this continuing synergy capture when you look at the comparison in the adjusted operating margin section from 17.4, going up to 20.0. Maybe a couple of key points on the life sciences business that you want to be aware of. Our backlog continues to grow and currently sits in excess of $200 million. Our new business pipeline is in the neighborhood of something north of $100 million. So in total, one could argue we have about $300 million sitting in internal backlog and we continue to expand our engineered solutions business, utilizing all our facilities to make product to go into total solution sets that we’re selling into the marketplace, which was a significant strategic move for us, as we put these businesses together. So we feel pretty good about the performance of our life sciences business. As we move on to page 7, power solutions group, this business again underperformed within the quarter. The underperformance was again the result of the same customer supply chain disruption that was not abated. I will tell you it does appear now that the issue has been resolved, as we're seeing normal shipping volumes as of the month of May. So fundamentally, we may still see some overhang in the second quarter, because the volume didn't get back to normal until May. But we think this issue is largely in our rearview mirror. Sales were fundamentally flat and you see the operating margin at 16.9, largely on the backs of the new program launches, which are all on track and all now shipping at low rate of production volumes. The ramp ups are expected to occur, the majority in the second half of the year. And in concert with those ramp ups, you should expect to see the margin of the business begin to return to its normal state. As we move over to mobile solutions, this is sort of the mother of all headwinds. We're all aware of what's going on with the global automotive markets. This is a very tough comp, I will tell you, because Q1 of 2018 was a record sales quarter for our business. And so we're down some $12 million year-over-year. When you think about the makeup of that, 2.5 million of that 12 million is all in FX, working against us. Geographically, North America is down about 11%. So we expected that as the markets began to turn. Europe down about 2% and the rest of the world’s flat. So China has leveled off. Certainly, Brazil is up a little bit. So, the world of so -- it's sort of fell into about a $93 million -- 93 million unit saw rate, which is about what we expected at trough. Our business is flexing appropriately, as we begin to and we continue to finish many of our product launches, which occur in the second half of the year. We have a significant amount of spending abatement in this business and we have a sales uptick in this business. And so we expect margins to normalize in this business, as we go through the second half of the year. Nonetheless, noteworthy performances in terms of flex from this business. As we go to page 9, the summary. Again, sales of $21.3 million, organic growth across the entire corporation of 1%, driven by 17% organic growth in the life sciences business and of course offset by the contraction in the mobile solutions business. Adjusted EBITDA of 34.5, adjusted operating margin improvement of 10.8 and adjust EPS of $0.20. As we go over the guidance, our guidance for the year has not changed. So I won't really spend any time on this chart. We'll just go to guidance for the second quarter. As we look up to the second quarter, we think our top line will be between 215 and 222. And we expect EBITDA to come in between 35 million and 40 million. I think with that, we can open the lines for questions.

[Operator:]

[Operator Instructions] Our first question will come from Rob Brown, Lake Street Capital Markets.

[Rob Brown:]

Nice job on the quarter and good execution in a mixed environment there. Just wanted to touch on life sciences, you're seeing good strength there. What’s sort of the operating margin thinking that that can become and maybe some further clarity on the integration, where you're at and the synergies you're starting to see there?

[Rich Holder:]

Yes. So recognize, as we put this business together, we told you we have kind of a three year integration plan from the point in time that we got Paragon, recognize there was Bridgemedica before that, DRT before that. On the other side of all the integration and after all the synergy captures, we think this is sort of a 23% to 25% business. We had this year, overall, we think we should see this business sort of rise to about 21%, as we get the synergy capture within this year, and then there's some spillover into next year. And then of course, there's a full year effect of the entire synergy. So when you think about this business, in a normal run rate environment, call it 24 to 26, bottom of the cycle to top of the cycle.

[Rob Brown:]

Okay, great, that's a good business. And then shifting to mobile. You're seeing headwinds and you flex down, but are you sort of -- how do you kind of handle this environment? Are you continuing to introduce new products or is it a case of you've kind of got the product set, now ramping and you're just following the market demand and managing your cost structure against that?

[Rich Holder:]

Yeah, so candidly, it's a little bit of both, right? The biggest movement in mobile, as you look towards the balance of the year is recognize that we have been investing in a significant amount of new programs. We talked about it a lot last year. And we said that, you would see those new programs manifest themselves, basically mid to second half of ‘19 of this year. And so, that is the expectation we are seeing those programs move out of SLP and things like that and move into full production. Now, it's clear that the full production volumes that we had originally anticipated is somewhat muted, but nonetheless, it's full production volume. And so it's offsetting some of the market headwinds as we go forward. In terms of brand new programs, I mean, we are always looking at brand new programs. We are, I think, making wise investment decisions as we look forward to some of the newer programs, because, you know, in this businesses, you know, you've got to put capital in place 12 to 18 months ahead of production volume. And so, we are mindful of what that may or may not do to the business. And so that's certainly a filter, we still believe in this business. And we still think this is a great business to grow. I think we just have to grow in an intelligent fashion. And that's kind of the way we're going at it.

[Operator:]

Our next question will come from Mig Dobre, Baird.

[Mig Dobre:]

Couple of questions for me. I want to start with guidance. When I'm looking at your Q2 guidance, it seems to be below on both revenue and EBITDA from the ranges that you've hinted at or you provided rather with your 2019 preview, talking about last quarter slide deck, slide 17, specifically. So, I guess what I'm kind of scratching my head on is, if Q1 was pretty much in line with what you were thinking, so performance here was in line, you're reiterating the year, Q2 is not as robust as you were thinking initially. What changed? And can you maybe provide that commentary at a segment level? And how do we make up for a slightly softer than expected Q2?

[Rich Holder:]

Yeah, so I don't think anything has changed. I think we continue to take a prudent look at the year. I think what we said to you was the way to think about our business was, in Q1, we'd see sort of 23% to 25% of our sales. Q2, we'd see kind of 25% to 27% of our sales. I think we're still holding to that model, as we suggested in the 2019 preview. Candidly, nothing has changed. We performed a little bit better in Q1 than expected. And so I think we should take a prudent view of all quarters. And that's what we continue to do.

[Mig Dobre:]

And Rich, math is math. If we apply those ranges to the midpoint of your guidance, we end up with a different Q2 than what you're currently guiding to. So, I mean, the numbers are what they are. My question is, why is the quarter looking different now than what you originally guided, and I get the fact that nobody's got sort of perfect visibility, but I'm trying to understand exactly what the delta is versus your initial plan.

[Rich Holder:]

Yeah, I will tell you, and we can certainly discuss this in some detail offline. I will tell you that at best, the quarter has moved around maybe a point. So we don't view it as we came off of any numbers change in a substantive way. We've not come off the year, we've not come off the time phasing that we thought. And so maybe what we need to do is, sit together and work through what you're looking at versus what I'm looking at, but we're not seeing the substantive change that you seem to be in the game.

[Mig Dobre:]

If I may ask this question, it looks to me like your implied EBITDA margin guidance for the second quarter is essentially baking in fairly sizable margin compression, about 130 basis points. We've seen some margin compression in Q1 as well. The back half guidance is implying pretty significant margin expansion. Can you give us a sense for how you're looking to deliver that? I'm presuming a good chunk of it comes from life sciences. But some of the other segments, your perspective there would be helpful as well.

[Rich Holder:]

Yeah, so I think -- so I think you hit on certainly on one of those things, right. So life sciences, certainly is a more robust business. And in the latter part of the year, just simply seasonality has a lot to do with folks meeting their deductibles and so on and more procedures taking place in the later part of the year. So the life sciences business is certainly up H2 over H1. We're also deeper into synergy capture during that time, and so both significantly affect margins. The other thing that happens is, there's a significant amount of spending abatement in the -- in both the power solutions and the mobile solutions business, because as mobile solutions moves more these programs into full production, there is a fair amount of spending abatement there. And the same thing happens in power. So that really is the predominance of what drives better margin performance in the second half, as well as volume.

[Robbie Atkinson:]

I would just add one thing, Mig. I'm not exactly sure I followed the comment on and maybe we can again talk about this offline. But in Q2, the guidance for EBITDA would imply, at the bottom end of the range, effectively the same margin, to a margin that gets about 180 basis points better quarter-over-quarter. So, we could talk about that more offline. I think we're talking on a couple of hours. But, I don't see margin compression.

[Mig Dobre:]

Robbie, is your comment year-over-year or sequential?

[Robbie Atkinson:]

Sequential. Yeah. I mean, again, we talked about it. We can talk about it again offline, but I think.

[Mig Dobre:]

We can. My point was that on a year-over-year basis, you're expecting margin contraction in the second quarter, on a year-over-year basis, in the back half of the year, you're expecting pretty significant margin expansion. That's how you get there. So sequential comment has to do with seasonality and other items, which you’re right, but year-over-year, that's really how probably everybody is modeling your business.

[Rich Holder:]

Yeah, so on a year-over-year basis, the performance of the mobile solutions business in the second quarter of ‘18 versus the second quarter of ‘19 is substantially different. And so, there is definitely contraction in that business on a year-over-year basis. And so that's probably what we are seeing. The other thing is that the business that we had in the second quarter of ’18 is not the business we have in the second quarter of ‘19. Right? We didn't have Paragon in there. There's a number of things that we didn't have in that we weren't as pre-integrated as we are now. So, I take your point. But I think we're -- we may be comparing apples and oranges.

[Mig Dobre:]

Very well. Then I'll ask one last question on leverage. Can you give us a sense for how you think about this number through the year? Where do you see the leverage peak? And it looks to me like on the last call, you expect the leverage to peak at about 4.9 times, that was in the Q&A discussion. We're already above that. So how do you think about that? And more importantly, if -- depending on macro customers, whatever, the volume outlook changes as the year progresses? How do you think about managing your leverage, as you look into the second half of the year and into 2020 from a risk perspective? Thank you.

[Rich Holder:]

Yeah. So in terms of the year, I think we continue to follow our normal path. As I said, Q1 came in a little bit better than our expectation. I think what you'll see is a slight tick up in Q2, as is normal for our business. And then you start to see substantial drop in Q3 and Q4. That is just due to our normal seasonality. That's where we generate the cash, that's just our normal seasonality. We continue to be laser focused on de-levering this business. We understand the concerns around it. We certainly expect to make a substantive move on this, as we get into the end of ‘19 and into 2020. That is what the organization is certainly focused on. Beyond that, I'm not sure what else I can tell.

[Mig Dobre:]

Are you willing to provide a view as to where you think your leverage would top off in ‘19?

[Rich Holder:]

Yeah, so I think, I don't have a number in front of me, but I will tell you, it's probably will top off slightly up to where it is today in Q2 and then begin to come down. And if you look at the chart and you go back to Q2 of last year, sort of the same, the same run rate and a lot of that has to do with building working capital and other things that then gets relieved in the second half of the year and generate cash. So, the profile of the business hasn't changed substantially. It's a little smoother, but it hasn't changed substantially.

[Operator:]

Our next question will come from Steve Barger, KeyBanc Capital Markets.

[Steve Barger:]

Rich, on mobile, if I heard you right, you said North America was down 11%, which is quite a bit deeper than what we heard for overall auto production in the quarter. Are you on a specific program that declined or any more detail around what's going on there?

[Rich Holder:]

Yeah, I think for us, it had as much to do with program timing as anything else. If you recall, there were a couple of quarters that we weren't down as bad as the market was. And now essentially what this is sort of our catch up, right? We hadn't seen this level of degradation in North America prior to this, in part because we won late cycle programs. But now those programs are coming to an end, the new programs are coming in. So there's about a month or two delta to offset. So that's why we're at 11%.

[Steve Barger:]

Well, and from a modeling perspective, maybe you said this and I missed it, we should expect negative growth in 2Q as well. And just to confirm, do you still expect positive growth for the year?

[Rich Holder:]

Yeah, we still think positive for the year, roughly somewhere between 1% and 2%? We're not talking massive growth. But yeah, we're still holding that for the year at this point.

[Steve Barger:]

But down in 2Q?

[Rich Holder:]

Yeah, we think a little bit down in Q2.

[Steve Barger:]

One of the focus points has been growing the industrial business to offset some of this global auto exposure. Can you talk about progress there and maybe talk about how you view the size of the -- the realistic size of the market opportunity in your circle of competence?

[Rich Holder:]

Yeah, I will tell you that we've been working pretty diligently in trying to grow that piece of the business. We have had some success, we have recently won a significant new program that will be going into one of our Mexico facilities. It's not going as quickly as I think as we'd like it, and I think we're in the process of looking at this and seeing if we can sort of redouble our efforts around that space. I think trying to put a sort of a ball around the market size in this space is a little tough, I’d tell you the market that we're looking at and we can plan is easily, sort of a $50 billion to $70 billion dollar market across the entire globe. Part of what we're trying to make sure that we do is maintain our focus on growing the wallet share of the customers that we already have. And not running out and having to establish brand new relationships. So, most of our program focus is on customers, some of the diversified industrial customers that we have today that have general industrial segments that we can have one large customer relationship is probably the best way to think about it.

[Steve Barger:]

Yeah. How are you balancing prospecting in that process between medical and industrial? Is there a limitation in terms of sales and engineering? Or do you -- are you capacitized enough to go in multiple directions right now.

[Rich Holder:]

So with respect to the general industrial segment, we're capacitized to go in multiple places. We know, we sort of don't allow that across over into the life sciences side of it. There is, for lack of a better phrase, a Chinese wall between the two. So there are no limitations in terms of prospects for Life Sciences at this stage of the game at all.

[Steve Barger:]

Okay, last one for me. When do you think about the free cash flow characteristics of the segments, as Life Sciences becomes a bigger part of the portfolio, shouldn't it help balance cash generation through the year? Or does it have the same use in the first half stores in the back half kind of pattern?

[Rich Holder:]

Yeah. So it should smooth the generation a bit, but recognize they still have very much a second half, sort of mid-year to second half bend, right. And that has directly to do again with, what I said earlier, there are more procedures taking place in the second half of the year than the first half of the year. So generally, there are inventory bills, there's inventory positioning, there's a lot of dollars, if you will, spent in the first half of the year, that kind of all find their way through the cycle in the second half of the year. And it's directly related to when people meet their deductibles from the medical plans.

[Operator:]

[Operator Instructions] Our next question will come from Daniel Moore, CJS Securities.

[Daniel Moore:]

Maybe in power solutions, Rich, it sounds like you're confident that the customer supply chain issues are in the rearview mirror, can we possibly quantify the impact on Q1 revenue and operating income in the segment, and any detail in terms of progress and what gives you confidence that we're behind that?

[Rich Holder:]

Yeah, so round numbers in the quarter. And I say round numbers about $2 million. The confidence that we have, number one, the customer is telling us that they think this problem has been abated. But maybe more importantly, the way we build this product is we receive dunnage [ph] from the customer. And so we build to the dunnage, it’s a just in time line. So we built to the dunnage and ship to the customer. So if the customer has any level of disruption, they need to balance inventory or anything in any way shape or form, what they do is they restrict the amount of dunnage that they send to us. So there's only so much we can build. Right. So in this particular case, we couldn't even build inventory if we wanted to. Because where the product sits has to sit in the dunnage. And so what gives us the confidence factor that this has abated is the fact that we are getting dunnage that is at or beyond our normal shipping levels in the month of May, we did not get that in April. But we are getting -- we have been getting that in the month of May. And there appears to be a small, I’d say, a modicum move of catch up, if you will, if you look at the dunnage, but we'll see. We'll see how that plays for the rest of the month.

[Daniel Moore:]

And switching over to mobile solutions, maybe just drill down a little in terms of free cash flow within the segments. In the past, you've kind of described it as typical downturns, you would work down working capital that would reverse and you see a free cash flow benefit, wondering if you're seeing that in the first half of the year this year, recognizing you’ve got some offsets as you expand platforms, but are you seeing that? What you would normally expect as far as that goes?

[Rich Holder:]

Yeah, so I think we've seen a bit of improvement certainly in the quarter. And I think it speaks to their detrimental performance, certainly. But recognize we have programs that we're launching in the middle of the year. So we are not in sort of Sky is falling mode in that business. Right, we're still talking about a business that is largely flat to a 1% to 2% growth in the business. So we are not, for lack of a better word, in harvest mode, like we would have been in in sort of 2007, 2008. Right, we're still investing in the business, we're still running the business, we're still looking to grow the business and it is still a sort of top quartile business in its space.

[Daniel Moore:]

And then one last one, may be drilling down on synergies that are expected. Maybe just update us on where we are in terms of the overall synergies expected to be captured in life sciences, what's embedded in the 2019 guide and how much is left for 2020 and beyond?

[Robbie Atkinson:]

Yeah, so Dan, good question. If you look at where we are in relation to our synergy plan, I think you have to step back a little bit from Paragon and look at the entire business. And, as you pull it together, you have -- remember the life sciences segment is 15 months old. And so you have the integration there, you have integration of Paragon pulling that together, and then you have DRT, Bridgemedica as well, all in there. And so, when you look at it, the good news is, is we're on track, right. So we're able to look at the synergy plan that we had and where we are in terms of what we expected to be delivering from an operating profit dollars perspective. And we're right where we expected to be. I think, we still have room to go in terms of operating efficiency. We're not saying bingo yet in terms of that we got all the way there. But, we are at a place where we're really starting to see those synergies come through, and I think you saw that in the first quarter performance in the step up from Q4 in margin. So we're excited about that. And we think as you look out throughout the year, you'll continue to see margin expansion in the business, driven really in large part by synergies and continuous improvement within the entire segment, as we pulled that entire business together. And then certainly, we would expect margins to continue to expand as we move toward that strategic target of 24% to 26%.

[Daniel Moore:]

Okay. And in terms of dollars, on a run rate basis, not possible to quantify sort of what remains beyond ‘19, or just continued improvement?

[Robbie Atkinson:]

I think we laid out a three year $30 million synergy plan. And it's not -- the second year is the largest year in that, so it's not a sequential 10, 10, 10. We didn't give granular guidance, or we've not given granular guidance on how the synergy specifically lay in over that period. But you should think of it probably like a bell curve, synergies tend to take a moment to ramp up because you don't want to make too many changes at first. And then they, you tend to get sort of peak synergy activity in year two, and then they start to wind down in year three.

[Operator:]

Thank you very much. At this time, we have no further questions in the queue. So I'd like to turn this conference back over to management for closing remarks.

[Rich Holder:]

Thank you, operator. Thank you all for joining us on this call and we will chat with you next quarter. Thank you.

[Operator:]

Thank you very much. Ladies and gentlemen, at this time, this conference has now concluded. You may disconnect your phone lines and have a great rest of the week. Thank you.