Tennant Company
Q3 2017 Earnings Call Transcript

Published: 3 Nov 2017

[Operator:]

Good morning. My name is Chris, and I will be your conference operator today. At this time, I would like to welcome everyone to Tennant Company’s Third Quarter 2017 Earnings Conference Call. This call is being recorded. There will be time for Q&A at the end of the call. [Operator Instructions] Thank you for participating in Tennant Company’s Third Quarter 2017 Earnings Conference Call. Beginning today’s meeting is Mr. Tom Paulson, Senior Vice President and Chief Financial Officer for Tennant Company. Mr. Paulson, you may begin.

[Tom Paulson:]

Thanks, Chris. Good morning, everyone, and welcome to Tennant Company’s third quarter 2017 earnings conference call. I’m Tom Paulson, Senior Vice President and Chief Financial Officer of Tennant Company. Joining me today are Chris Killingstad, Tennant’s President and CEO; Jim Stoffel, Vice President of Global Planning and Analysis; and Tom Stueve, Vice President and Treasurer. I also want to take a moment to welcome two very talented additions to our team

[Chris Killingstad:]

Thank you, Tom, and thanks to all of you for joining us this morning. Tennant Company is still in an important period of transition, and I'd like to take the opportunity to expand on how we're continuing to strengthen Tennant as we move into the fourth quarter. Tennant Company has been pursuing a strategic framework for the last several quarters, intended to further strengthen our organization so it can continually deliver value for our customers and shareholders as well as remains stable amidst challenging end markets. This quarter is no different, and I want to walk you through the goals we're pursuing and the progress we've made. Our multiple overlapping initiatives include

[Tom Paulson:]

Thanks, Chris. In my comments today, references to earnings per share are on a fully diluted basis, except for the 2017 year-to-date results, which were calculated with the basic weighted average shares outstanding due to the as-reported net loss. Note that our financial results in 2017 include the financial performance of IPC Group, which was acquired at the beginning of April 2017. For the third quarter ended September 30, 2017, Tennant’s reported net sales of $261.9 million, increased 30.9% compared to sales of $201 million in the 2016 third quarter. Organic sales increased approximately 1.3%, excluding a favorable foreign currency exchange impact about 1.2% and the impact of the August 2016 Florock acquisition and the April 2017 IPC acquisition that increased the net sales by 28.4%. The third quarter 2017 net income was $3.6 million or $0.20 per share. Tennant reported adjusted net earnings of 5.8 million or $0.32 per share. The as-adjusted results in the 2017 third quarter excluded two special items that total the charge of $3.1 million pretax or $0.12 per share. Both the as-reported and as-adjusted earnings reflect $7.3 million or $0.29 per share of amortization expenses related to the IPC in tangible assets. The special items were $0.9 million pretax or $0.03 per share for acquisition costs related to the IPC acquisition and $2.2 million pretax or $0.09 per share for the IPC acquisition-related inventory step-up flow-through. In the year ago quarter, Tennant reported net earnings of $11.5 million or $0.64 per share. Turning now to a more detailed review of the 2017 third quarter. Our sales are categorized into three geographic regions, which are

[Operator:]

[Operator Instructions] Your first question comes from Chris Moore of CJS Securities. Your line is open.

[Chris Moore:]

Obviously lots of moving pieces. Maybe you could do this. If you look at where you are now versus say mid-2018, I know -- trying to understand kind of what issues are likely to be resolved between now and then and which are still kind of be ongoing. You mentioned by the end of Q2 you'd like to get the gross margin back to 43% to 44% range. What else it can happen between now and then? Is the IPC integration done? Can you kind of – just you might help to compare and contrast.

[Tom Paulson:]

Yes, what I would say, Chris, is that our anticipation is -- first of all, we hope for being conservative as we're adjusting guidance, but we originally felt that we might get all the way back on track with our gross margin performance before we exited the year, but we thought it could very well go into Q1. Based on the progress we've made we determined -- it's prudent to be more conservative. But we do feel that as we exit Q2, we will be back totally on track from a gross margin point of view and as the initiatives that we've executed will be firmly in place and will be back performing within our guidance range of 42% to 43%, which is adjusted for lower gross margin in the IPC business. We also believe that we hope the demand starts to improve as we're starting to see some signs of that, IPC continues to perform really nicely and is ahead of target, and we will begin to start to see a modest level of our integration benefits beginning to flow through the P&L as we get to the half way point of next year.

[Chris Killingstad:]

And the other thing that I would add is just if you look at our service organization, I think we're making the best early progress there and our hope is that by the end of the year that they're back on stable ground and delivering the results that we expect from the restructured service organization and they deliver enhanced performance. On the -- in our plants, I think what we have now is that we completely stabilized the automation initiatives. Remember there is a warehouse management system in our European facility and robotic welding in our Minneapolis facility, and so they are now fully implemented, stable and we're starting to get the benefits. But it takes a while to ramp up the full benefits of both of those. But they are in place. The problems are behind us. Benefits are ramping up. The other issue we have in our U.S. plants is that -- and it's not just us but most of manufacturers are struggling to find qualified labor, and once again in the third quarter, we struggled mildly. If you look at the third quarter, I would say we had on average probably 10% open positions throughout the quarter and we had over 30% turnover of the people that we did bring in. So what we've done there is that we have changed our compensation policies or training policies in the way we are going to reward people once they come onboard and gain skills. And we're already seeing that we are closing the open position gap and that open -- and that the turnover is way down. Right now it's less than 10%. But there it takes some time for the new employees to ramp up and get to the productivity levels that that we need for the factories to be running really well. And then the final one is on material inflation. There we have a price increase, a significant price increase we are taking at January 1, and we are also aggressively pursuing a cost of goods reduction initiatives. And those are in the early phases and I think will ramp up as we go through Q1 and Q2 of next year. So that's why we believe -- so it's not just we're hoping this al happened. We have very specific initiatives under each of the areas that we are executing against that should deliver those kind of results.

[Chris Moore:]

Price increases, that's normally only done on an annual basis or it’s just timing on…

[Tom Paulson:]

Yes, that's typical, Chris. We would normally execute pricing around January, and at times that will modestly change from that. But we intend to execute early, right on time. And so far we've just begun that process. It's actually going up fine. In reality, in the environment we are in, it's far easier to justify price increases as people are seeing inflation in many instances. And while we are not -- we consider taking pricing early. We made the decision that was better to wait and let things fully develop and we are comfortable we’ll be able to execute global pricing that will be more than adequate to cover the inflation that we’re seeing in our business. So our early days, but we feel good about the ability to take price.

[Chris Moore:]

Can you just -- you guys are in good shape. In terms of the debt covenants covered rate, where you are now? And you don’t anticipate any challenges in those in the future, do you?

[Tom Paulson:]

We don’t, and I mean I'll let Tom add if he wants to add anything, but were actually ahead of target. We paid down all -- we can pay down over $20 million in debt in Q3. We anticipate the opportunity to pay down even further as we are in the quarter that we are in. And as we look out to next year, we don’t see anything out in front of us that’s not going to allow us to continue to be on target or ahead of target. So we are well within any kind of -- we have no issues and any covenants or any issues at all on the debt side. So we are – it’s not to be a core attention, we're still very focused on payment down, we are in the really solid shape.

[Operator:]

Our next question comes from Marco Rodriguez of Stonegate Capital. Your line is open.

[Marco Rodriguez:]

I was wondering if we could talk a little bit more about the, I guess, the gross margin impacts here specifically on the manufacturing inefficiencies, aside from the automation aspects. So can you talk a little bit more about what sort of has changed from the last quarter when we discussed it to today that caused the rather different changes, if you will?

[Tom Paulson:]

Actually there is really no change. And I mean, in that we haven't seen any new issues come onboard during Q3 that we didn’t experienced in Q2. We just didn’t make as much progress really in all three areas. In the issue of servicing efficiencies we made progress, but not as much that we'd like to have. To your specific question, in two factor we've done major automation initiatives. And while we're stabilizing and we're beginning to see improvement, we didn't make anywhere near the levels of improvement that we anticipated in Q3. We do expect we will be fully back on track as we get into Q2 next year. And then the only thing that was really -- other than we were a bit slower making progress, we did see more inflation than we anticipated in the quarter and we clearly -- we considered it. We determined not to take pricing early, but we did see more inflation. But other than that no new issues came onboard and we still feel we're doing the right things and we will get back into our normalized gross margin range.

[Marco Rodriguez:]

And so then in terms of just not making enough progress or not making the progress you guys had expected, I mean what were the challenges there that caused that issue?

[Chris Killingstad:]

Mark, I mentioned the labor situation in our U.S. plants, and they are the two biggest plants by far have material impact on our results. As I said, we're running 10% open positions over the whole of Q3. We did not anticipate that would happen. And we had over 30% turnover. So it wasn't until the end of Q3 that we initiated these new compensation policies, training policies and ability to reward people who come onboard and gain skills, and we're seeing a dramatic improvement in our ability to attract and retain. And our hope is, in Q4 we stabilize the workforce, we reduce the turnover and then it takes a while to really ramp them up and get them to the productivity levels that we anticipate. So that's one example. The other one is the robotic welders in Plant 1. We have two robotic welders. I think it took us -- taken us longer to get all the parts kind of qualified on those robots and so we're hoping that we will be fully staffed and up and running in the second -- on the second shift in the third quarter. And we didn't -- we kind of stabilized our first shift operational robots. I think as we go into the Q4, second shift has now stabilized, but we also have to have them running 24/7, so a third shift is absolutely required. And until we do that what happens is we need to outsource some of our fabrication, like as we don't have the capacity internally to handle it, and that cost us a lot more money. So that's also driving some of the negative variants that’s impacting our gross margins. As Tom said and as I said before, we're making good progress in all these. We hope we're being conservative in how long it's going to take to ramp up and get back to the full benefits we expect. And that's why we're saying end of Q2 is when we feel very comfortable, but we're going to do everything in our priority to get there earlier.

[Marco Rodriguez:]

And just a clarification on the comments about the 30% turnover, is that the new employees that you're bringing or is that 30% turnover you saw when you started to do the new efficiency project?

[Chris Killingstad:]

It's the new. And then we decided -- they would come in and you spend a week trying to train them and then if you are gone because they went at some place that offered them another buck and a half. So you have a lot of disruption to the factories when that happens.

[Marco Rodriguez:]

And then I was wondering if you can maybe talk about the accelerated amortization, not to get too far deep into the weeds but just kind of what drove what process, what made the change and then obviously that had a pretty big impact on your EPS guidance?

[Tom Paulson:]

We made a simplifying assumption. As you know, do have 12 months to finalize your balance sheet and finalize your amortization methodologies. We took a simplifying approach in the second quarter and just to assume that we amortize on a straight line basis, so an equal amount every quarter across the period of time. And we knew there was a chance, we might have to change from an accelerated methodology, and when we went deep into the analysis of that which is pretty complicated, it really lined up that we needed to accelerate and amortize faster. And it's important to note that it has absolutely no impact on the economics of the transactions. It's completely non-cash. It has no impact on taxes. It's just -- it just looks – it makes GAAP earnings look unusual and that's why we are going to – yes, that's why we are going to talk a lot more about EBITDA. So it's completely timing related and that has no impacts on the cash flow of the business, what so ever. But it is -- we would have never anticipated that it would be that big of a difference from straight line; but in reality, as we did the analysis, it was and we needed to move forward on that basis.

[Marco Rodriguez:]

And maybe if you could talk a little bit more just kind of coming back here to the price increases that you guys are going to be taking a look at implementing in fiscal '18, maybe if you could talk a little bit about the decision making process there as the why not to go ahead of little bit -- ahead of time like in this quarter?

[Tom Paulson:]

Yes, what we made a determination that -- we have taken pricing at the beginning of the year already, and we felt that it was just try to implement a midyear price increase when it wasn’t been in the normal timing. And also we wanted to let things play out and be able to have a better sense of what was driving the inflation, which I think was a good decision in reality now. We saw more inflation in Q3. We have better clarity. We've been able to do a far better job as we are in front of a customer now to justify the level of price that we’ll take in January and then lastly you armor sales organization to show that the pricing is just viable. And so we think it was really a matter of having everybody be more educated and be smarter and execute on our normal timing. And so that was really the thinking and we stand by our decision in that regard, to be honest with you.

[Chris Killingstad:]

And there’s really no historical precedents for this – for players in this industry taking more than one annual price increase, not only monitor the competition facing the same issues than we are pretty much did not take a price increase. What we do periodically is take -- add a surcharge on for a specific item, for example batteries this year because of the lead being expensive. So we took surcharges on batteries to help cover those cost. So even we think something has gone up high enough on a specific component, we do sometimes do that, but we have never taken a price increase outside of our normal schedule.

[Marco Rodriguez:]

And last quick question and I'll jump back in queue. You guys have called out some of the strategic accounts as far as having some, I guess, timing issues in the quarter. Can you maybe talk a little bit about that as far as how you obtain that sort of, I guess, data? And then also your kind of like your level of confidence that those are going to actually start to return?

[Chris Killingstad:]

I'd say that if you look back at the last five years, one of our key growth drivers has been strategic accounts. We reorganized against strategic accounts in North America and it's been extremely successful. We haven't really -- not lost a major strategic account deal for a long time now. Now, what we know is is that strategic accounts tend to order on two to three to four year intervals. They have that cycles, and we're getting -- and we're at this point now where there's a lot of the contracts that are coming due. So we have great visibility to what they are, who they are and what the amount of business can be generated from them. But what we've also learned is that with the big ones, and the ones we're looking at now are some of our biggest. The bid or the confirmation of the bid can be pushed out a month or two. And it's been pushed out of the third quarter into the fourth quarter. We do still anticipate that we will learn of winning these bids in this quarter. But the fact is is that we have built volume to the third quarter into the fourth quarter that we no longer will see, so we're going to start ramping these ones -- these deals up in the first quarter of next year most likely. But they're significant, which is why we are confident that we'll get back on track with strategic accounts. And the pipeline beyond just those also looks pretty good.

[Tom Paulson:]

It's also important to note that the strategic accounts at times will exhibit more patience than we'd like because it might be a two- or three-year timeframe that they're ordering against. The way we want to get it right, they're willing to negotiate a bit longer. We're a bit more impatient, but we also want to make sure we get to the right price. But winning these bids is, it does matter to the business over as long as a two- to three-year timeframe. So it's important to get it at the right price and we’re will to sacrifice a little lower revenue in a quarter to get to the right place with our most important customers.

[Operator:]

[Operator Instructions] Your next question comes from Jon Fisher of Dougherty. Your line is open.

[Jon Fisher:]

A couple of questions on some topics that have already been touched on, we'll start with price. Just given the negative organic growth in Asia and the negative trends in the Americas and just kind of soft trends last fiscal year, is the demand environment such that you can actually get -- I think as you described it significant price increase through, especially if -- and you can correct me if I am wrong, but I think you also said that your competition did not take price this year, so….

[Tom Paulson:]

No, they – yes, the whole industry did take pricing this year, John, so we were similarly pricing. And we've actually gotten some level of pricing benefit in a relatively low inflationary environment in the three years prior to 2016 and we did get, I would say, adequate levels of pricing this year for the first part of the year and we -- in the back half I wish we were bit higher. But when I say meaningful price increase, I don't want to overstate it. I mean we would hope that -- we would get price stick in the 1.5% to 2% range, and in a lower inflationary environment, you might only get a price stick of 0.5% to slightly over 1%. So it's not -- we would say it's very justifiable, but getting 1.5% to 2% in our industry to stick is -- that's higher than normal. But I do think -- you really do need to price in an environment where there is inflation, you combine that with running your factories well at it presents opportunities ideally to not only keep margins flat but actually to expand margins over a period of time.

[Chris Killingstad:]

Yes, but what we were saying is that the competitions didn’t take another price increase out of sequence, they will also be…

[Tom Paulson:]

We believe and you never known until it happens that the industry will likely take pricing together. But until that happens, you don’t for sure.

[Jon Fisher:]

But you are comfortable that the demand environment overall just based on the quarterly organic growth rates that I'm seeing from the company supports getting 1.5% to 2% instead of 0.5% to 1% or maybe 0 to 0.5%?

[Tom Paulson:]

We believe so and we will be very conscious of where we take pricing. It does vary by component of our business by geography, by the type of equipment, by the strength of our market position. So it's not unified across the board. I mean it can change in various areas.

[Jon Fisher:]

And then just kind of ducktails. Just looking at organic growth and just everything going on here domestically in the industrial world would just would indicate that the demand environment is good, strong and you've put up two quarters of negative organic growth. Asia, you’ve put a multiple quarters of negative organic growth. And I can’t help but look at the big organic growth numbers that you that the company generated in fiscal '14 and recently Americas in fiscal '15, and I'm just wondering how do you counter the argument that maybe in fiscal '14 and '15 you fold demand forward to get those big organic sales growth years. And if you've got product that lasts five to six years, I mean it could be fiscal '19 or fiscal '20 before that product technically needed to be replaced in these organic growth issues could persist for another year or year and a half?

[Chris Killingstad:]

There are definitely cycles, but the two things. One, if you look at our direct business and our distribution business, which in many ways is more tied to GDP, they are performing really well. So the piece that is underperforming right now is strategic accounts. But what we are saying is it's a delay in the orders from some very big potential deals. And once those play out, then we should see, as Tom said, two to three years of consistent sales coming from those contracts to get us back on track. So the underlying direct and distribution is often times the key indicator if they have a problem, the demand in the marketplace because that's where it shows up first. Strategic accounts is more timing-related. But we're actually coming into a pretty robust strategic account period here over the next year or so. So we’re feeling good in the Americas. You mentioned Asia Pacific, there it's a totally different issue. I think the demand is there in most of their key countries, accept maybe Koreas right now, but we have, and we've talked about this, reorganized our management team almost across the board all of the key countries over the last two years. That has now stabilized. We have new leaders and new leadership teams in place in places like China and Australia and we feel much stronger whether you now have the ability to start driving organic growth and get to a more sustained trend in that regard. So two very different issues. There is not a market demand problem in Asia Pacific, it's just the way I think we were lead and the way we were structured. But those things have been resolved and should deal benefits going forward.

[Jon Fisher:]

And then one last question. Can you tell me the split in the Americas between -- from a revenue standpoint between strategic accounts and direct distribution?

[Tom Paulson:]

We have not historically provided that, Jon, and for competitive reasons we prefer not to go there. What we can say is it. It has meaningfully shifted and has been our largest source of growth over the last five years, but it's also -- and I one of the reasons I'm hesitant is the definition of a strategic account is -- it's not purely defined, it's just large customers and somewhere we can move easily from been a normalized customer to a strategic account based on the way we penetrate. So it's a -- we're hesitant to do that for a few reasons.

[Operator:]

Since there are no further questions at this time, I would like to turn the call over to management for closing remarks.

[Chris Killingstad:]

All right. Thanks, Chris. Today we believe Tennant is well positioned strategically and operationally, despite our quarterly challenges. As we close the quarter, we are looking ahead the continued revenue growth from both our core Tennant business and IPC. We are also focused on initiatives that will get gross margins back to a stated range of 42% to 43% by the end of the second quarter in 2018. Lastly, we are creating an outstanding relevant product portfolio for our customers and continuing to drive strong cash flow and debt management that will deliver improved value to our shareholders. We look forward to further updating you on our strategic progress and our 2017 year-end results in February. So thank you for your time today and for your questions. Take care, everybody.

[Operator:]

This concludes today's conference. You may now disconnect.