Tennant Company
Q3 2013 Earnings Call Transcript

Published: 23 Oct 2013

[Operator:]

Good morning. My name is Jasmine, and I will be your conference operator today. At this time, I would like to welcome everyone to the Tennant Company's third quarter earnings conference call. (Operator Instructions) Thank you for participating in Tennant Company's third quarter earnings conference call. Beginning today's meeting, is Mr. Paulson, Vice President and Chief Financial Officer for Tennant Company. Mr. Paulson, you may begin.

[Thomas Paulson:]

Thanks, Jasmine. Good morning, everyone, and welcome to Tennant Company's third quarter 2013 earnings conference call. I am Tom Paulson, Vice President and Chief Financial Officer of Tennant Company. With me on the call today are Chris Killingstad, Tennant's President and CEO; Pat O'Neill our Treasurer; and Karen Durant our Vice President and Controller. Our agenda today is to review Tennant's performance during the 2013 third quarter and our outlook for the year. First, Chris will brief you on our operations, and then I'll cover the financials. After that, we'll open up the call for your questions. Before we begin, please be advised that our remarks this morning and our answers to questions may contain forward-looking statements regarding the company's expectations of future performance. Such statements are subject to risk and uncertainties and our actual results may differ materially from those contained in the statements. These risks and uncertainties are described in today's news release and the documents we filed with the Securities and Exchange Commission. We encourage you to review those documents particularly our Safe Harbor statements for a description of the risks and uncertainties that may affect our results. Additionally on this conference call, we will discuss non-GAAP measures that include or exclude special or non-recurring items. For each non-GAAP measure, we'll also provide the most directly comparable GAAP measure. There were special non-GAAP items in the 2012 third quarter and the 2013 first quarter and no such items in the 2013 second and third quarters. Our 2013 third quarter earnings release includes a reconciliation of those non-GAAP measures to our GAAP results as well as a reconciliation of full year 2012 non-GAAP diluted earnings per share for our 2012 GAAP diluted earnings per share. Our earnings release was issued this morning via Business Wire and is also posted on the Investor Section of our website at tennantco.com At this point, I'll turn the call over to Chris.

[Chris Killingstad:]

Thank you, Tom, and thanks to all of you for joining us this morning. We are very pleased to report record third quarter sales and increased earnings. We continue to see positive trends in our business. As a reminder, last quarter we achieved the second strongest sales quarter in Tennant's history. We are delighted to follow that up with another outstanding quarter. Tennant's 2013 third quarter sales were led by record third quarter sales in our largest geography, the Americas. Like last quarter, sales rose due to continued high demand for new products and strong sales of industrial equipment. Notably, in the 2013 third quarter, the company's organic sales growth of nearly 7%, mark the highest level that we have achieved in two years. Additionally, our ongoing focus on operational excellence initiatives generated further leverage of our cost structure. Gross margins were within our target range of 43% to 44% and sales and administrative expense as a percent of revenue declined 110 basis points year-over-year through companywide cost controls and process improvement initiatives. Taking a look at our sales by geography. Sales in the Americas benefited from a record third quarter in North America and continued strong results in Latin America. We experienced continued high demand for our new products. To build on our momentum, we are duplicating our successful North American strategic accounts strategy in Brazil, which is an attractive market for Tennant that is performing well. In the region of Europe, Middle East and Africa or EMEA, sales declined, with city cleaning equipment sales continuing to be constrained by tight municipal spending in Europe. Our new strategic account structure continues to gain traction, with sales up 10% year-to-date in EMEA. In addition, we are pleased with the performance of our master distributor in our Central Eastern Europe, Middle East and Africa markets. As we anticipated, this new go-to-market approach has enabled us to grow more aggressively in these important markets. Along with the steady stream of new products that we are introducing, we believe we are well-positioned to take advantage of growth opportunities, once the macroenvironment improves in EMEA. In the Asia-Pacific region, organic sales increased due to strong performance in China, which had about 30% organic sales growth. During the quarter, we made progress on our initiatives in this key geography. These include expanding into the western part of the country, where we expect to open a sales office within next nine months. And extending our manufacturing capabilities, in order to locally manufacture our first industrial product in China in the 2013 fourth quarter, which will be the T12 rider scrubber. Further, we plan to roll out our successful North American strategic account structure and strategy in China next year. We are confident about our continued growth prospects and expect double-digit sales growth in China for the 2013 full year and for 2014. Turning to our new products. We continue to execute against one of the most robust new product and technology pipelines in the company's history. As you know, innovative products and technologies are a significant driver of Tennant sales. Among the new products that were strong contributors to our third quarter sales, were the T12 rider scrubber, which is the first new product in our redesigned modular large equipment portfolio. The B10, Tennant's first rider burnisher, which enables rapid cleaning and polishing of large areas. And the T3 Orbital Scrubber, which provides a chemical-free way to clean and strip floors. Sales of the 17 new products introduced in late 2012 and 10 in early 2013, rose from 2% of total equipment sales in the 2013 first quarter to 6% in the second quarter, to 7% of total equipment sales in the third quarter. This illustrates the growing momentum of new product sales, as we complete our launches and demand accelerates. In the 2013 fourth quarter, we plan to introduce 16 new products, including a line of walk-behind burnishers as well as canister carpet extractors and grout cleaners with high heat functionality. Additionally, we expect to unveil a steady stream of industrial and commercial products each year through 2016, with the majority manufactured on modular equipment platforms. Modularity allows us to offer a wide range of possible machine features more efficiently and cost effectively. These new core equipment offerings are engineered to improve cleaning performance and operator safety, lower operating costs and reduced environmental impact. Regarding our sustainable water-based cleaning technologies. Led by gains in North America, sales of scrubbers equipped with Tennant's ec-H2O electrically activated technology, grew approximately 3% in the 2013 third quarter to $38.2 million. We anticipate further growth of ec-H2O equipped scrubbers in the fourth quarter. Our ec-H2O technology converts water into an innovative cleaning solution that cleans effectively, saves money, improves safety and reduces environmental impact compared to daily cleaning floor chemicals. This technology is based on the established science of electrolysis. In September, we announced our decision to channel our resources into new product innovations. And we withdrew our appeal of the German court decision, regarding advertising language for ec-H2O. We continue to fully stand behind ec-H2O and strongly disagree with the German court's decision. Our focus remains on innovation rather than litigation, to grow the business and our portfolio of water-based cleaning solutions. At the end of 2012, Tennant had a strong installed base of more than 4,000 ec-H2O customers worldwide, 40,000 ec-H2O scrubbers in the marketplace and $444 million in cumulative ec-H2O sales. In addition, our Orbio Technologies Group continues to execute on their product and technology roadmap. Orbio is developing an exciting new product with split screen technology that will deliver an anti-microbial solution as well as an effective multi-surface cleaner, for use in a wide variety of customer segments. We plan to introduce this new Orbio product in the first half of 2014. While Orbio is not yet material to Tennant's results, it is a very important piece of our future. I'd also like to touch on another strategic growth area where we've had success. One of our priorities is to increase our share in new or underserved market segments. Our recent focus on healthcare has led to some encouraging wins. During the 2013 third quarter, we worked with one of our building service contractors to secure new business with a senior facilities healthcare company that operates more than 300 locations in North America. Moreover, we partnered with a national distributor, who will now supply Tennant's cleaning equipment to a leading chain of about 135 U.S. hospitals. Additionally, we are pursuing opportunities to increase our penetration with hospital cleaning management companies and group purchasing organization. Now, let's take a look at our progress and gaining operating leverage. Since late 2010, we have worked to standardize and simplify our global business processes. We call this initiative, campaign to cash. It is a platform to enhance Tennant's sales growth and profitability. As I have previously discussed, one of the areas we tackled first was pricing. The goal is to bring consistency to our global pricing and discounting policies, resulting in greater efficiency and profitability. Our completed pricing project goes live in November, and further initiatives centered on invoicing. Here again, we will achieve a critical milestone in November, when we released improvements that will provide customers with a more consistent experience worldwide. This is a win-win for Tennant and our customers, as we will be able to provide consolidated invoicing for different products. This will improve invoicing accuracy, minimize disputes, accelerate payments to Tennant and enhance our profitability. To wrap up. Our strategies are working. We are focused on growing Tennant's revenue by introducing a strong pipeline of new core products; increasing market penetration of our sustainable cleaning technologies, including Orbio-developed cleaning solutions and scrubbers equipped with ec-H2O; expanding our strategic accounts business with particular emphasis on large regional and global customers; ongoing penetration of emerging markets; and building our share in new or underserved market segments through channel partners. We are encouraged that our organic sales growth returned to the mid-single digits in the 2013 third quarter. We expect good fourth quarter performance, as new product sales accelerate and growth continues in both our global strategic accounts and overall Americas business. We also anticipates further improvement in our operating profit margin, as we strive to attain our goal of 12%. Now, I'll ask Tom to take you through Tennant's third quarter financial results. Tom?

[Thomas Paulson:]

Thanks, Chris. In my comments today, all references to earnings per share are on a fully diluted basis. For the third quarter ended September 30, 2013, Tennant reported net sales of $188.5 million compared to $178.3 million in the prior year quarter. Organic sales grew approximately 6.8%, excluding an unfavorable foreign currency exchange impact of approximately 1%. As you may recall, Tennant's organic sales grew approximately 0.9% in the 2013 second quarter, excluding an unfavorable foreign currency exchange impact of approximately 0.5%. We are encouraged by the higher level of organic sales growth we achieved in the 2013 third quarter. Third quarter 2013 net earnings were $10.6 million or $0.56 per share. In the year ago quarter, Tennant reported adjusted net earnings of $8.9 million or $0.47 per share. Turning now to a more detailed review of the 2013 third quarter. Our sales are categorized into three geographic regions, which are

[Operator:]

(Operator Instructions) Your first question comes from the line of Joe Maxa from Dougherty & Company.

[Joe Maxa:]

Couple of questions. I wanted to talk a little bit about the new products, 10 new products this fourth quarter. I'm wondering if you see these as being incremental to your business as much as the T12 and the B10 have been.

[Chris Killingstad:]

What I will say as they are incremental to our business, because we have had a limited offering in this range historically. So most of the sales drive from these new products will be incremental, but remember they are smaller commercial products at much lower price points than a T12 for example, and so the overall impact on our revenues will not be of the same magnitude of the T12.

[Joe Maxa:]

And then, regarding Orbio, how we should we think in about the rollout next year? Is this going to be more of maybe like the original Orbio kind of a slow deliberate region-by-region or given learnings, would you expect to roll it out more broadly sooner?

[Chris Killingstad:]

No, I think that we are still doing the planning on that. We've obviously learned a lot from the initial rollout. I think one of the things that we have determined is that we're better off if we focus on by fewer, early adopter, bigger customers with whom we can go deep, because then we can develop this more intimate relationship. But I think it's necessary to ensure that the technology takes hold and that we address all their issues in the early going and get them comfortable with the technology going forward. So I think that I'm willing to say that at this point other plans have not yet been developed. But since you talked about Orbio, I think one of things also you need to know is that the rollout of the 5000 continues. What we know is this, it has been slower than what we anticipated, but we also know that customers, who have adopted the technology, love it and it works. As a matter of fact, they are excited to change their entire cleaning protocol over to Orbio technologies and they're going to be able to do that when we have the new product we'll launch in 2014 that provides the antimicrobial output, right. Because right now, they can only use Orbio for cleaning processes, they can't use it for sanitizing and disinfecting. They'd like to standardize their entire protocol. What we've also learned is that a lot of customers who are very interested in the technology are saying we're going to take a wait-and-see position, because the 5000 in some cases is too big for our needs. But more importantly it only solves a part of our cleaning process. So we change half of our cleaning protocol and we'll have to maintain the other half with the old process, using chemicals to sanitizing disinfects. So they're very interested in the launch of the new product with the antimicrobial capability in the first half of 2014 as well. So we are excited about this new product and we think that it will have a fairly dramatic impact on the Orbio business going forward. And what I'll tell you is that by the end of 2014, we should have a pretty clear indication of where we are with this technology and it's future potential.

[Joe Maxa:]

But again one for me on the gross margin side, we haven't seen that 44% number in a few quarters now? Is that something you expect you can get back to in 2014 or perhaps even the fourth quarter?

[Thomas Paulson:]

It's certainly a possibility next year, Joe, but it's just one of the areas that we continue to be conservative on and I wouldn't expect the fourth quarter to be much different. Maybe we'll see some modest improvement. And there is possibility we could see ourselves getting back to 44% next year. It's going to be very dependent upon our pricing capabilities and what happens with inflation and our ability to price quickly. We certainly would anticipate, given what we're beginning to see what typical kind of a pricing scheme within the first quarter of the year, but there is still more data that needs to come in on that one. But we're satisfied with our gross margin performance. We're within the range and we do think we have the ability to have some upward moment.

[Operator:]

Your next question comes from the line of Jason Ursaner with CJS Securities.

[Jason Ursaner:]

Sort of a follow-up to the last question, have a couple on then the new T12, the modularization strategy, want to make try understand the long-term margin potential, so now that you've ramped the T12, are you already seeing the margin benefit relative to the 7100?

[Thomas Paulson:]

Yes. We're very affirm in the way we approach new product introductions, that on a worst case scenario we will in some instances accept flat margins, but our general approach is we have better margins as we introduce new products. The T12 is particularly interesting because of the modularity side of it. But what I would say is that it's just one product, and so for modularity to have a big movement in our gross margins at a global level, we need to get the far more new introductions into the market. But it's going very successfully. It's more than meeting expectations and modularity in and of itself is alive and well within our supply chain.

[Chris Killingstad:]

And as we've said, we are launching both new commercial and industrial modular rebuild products every year up to 2016 at least.

[Jason Ursaner:]

And have you guys ever previously tried to quantify what the margin expense would be have incremental new large equipment products that's part of redesign?

[Thomas Paulson:]

We obviously do some things internally from a modeling point of view. And we have very robust financial plans running in new product introduction. But we will take instances where to be more competitive in given parts of the world we might actually take pricing down. So we're not prepared to quantify anything externally around that. But it's important from a revenue growth point of view and it will be important over the long haul from a margin improvement point of view, but we're not prepared to quantify that.

[Jason Ursaner:]

And can you just update real quick on the share repurchase program? I didn't hear you mention if the company was active during the quarter?

[Thomas Paulson:]

Sure. We were purchasing shares in the quarter. We did bring our total share repurchases up to 343,000 shares on year-to-date basis. The purchasing profile was similar in Q3 to Q2. Our total repurchases now are at $16.6 million, which is again is a $2 million below where we were at through nine months last year. But I can't comment on that further today, but through the end of the quarter we're at 343,000 and just under $17 million of share repurchases.

[Jason Ursaner:]

And last question, at a higher level investors can make the argument that company is over capitalized with no significant CapEx investment really needed to support the growth strategies. So just wondering, if you can comment the longer-term capital allocation strategy? And in terms of the target capital structure, if the plan is sort of to just continue doing share repurchases versus other alternatives like greater investment or maybe acquisitions?

[Thomas Paulson:]

Our plan over the period of time is we will return money to our shareholders through share repurchases and also through dividends. We will, as we always do, evaluate whether a dividend increase is appropriate, at given points of time. It's something we look at every quarter and we'll make those decisions as they're appropriate. We would like to find ways to spend more capital. And we are below our D&A level. We'd be pleased to take that number up as long as we can keep the appropriate mix of profit, adding projects and profit sustaining projects. Our target is that we want 70% of our capital spending to drive value and 30% of that to be of a maintenance nature. And we will continue to look at transactions. And we're unlikely to do a large M&A deal, but we'll look at partnerships and outright acquisitions, and they will be centered around technology and driving our innovation platform and also expanding sales and service coverage in market that are important to us. So we would like nothing better than to find a few more deals of similar type of transaction we did in Brazil with our Alfa acquisition. But that's our view. We will continue to generate cash, we believe that. And we will continue to look for ways to use that cash to drive to great value.

[Operator:]

Your next question comes from the line of Scott Graham from Jefferies.

[Scott Graham:]

So really, just two questions. Just kind of wondering, how the sales trends were as the quarter progressed, particularly in North America and Europe?

[Chris Killingstad:]

In Q3?

[Scott Graham:]

Yes.

[Chris Killingstad:]

I'll first comment on Europe on some level of improvement. But we're still seeing organic decline, so we're far from pleased. But we're seen improvement and we have pockets of areas that are performing well, like France. We do believe we will continue to see improvement in Europe at the current time in the fourth quarter. And we might even have an opportunity to drive some modest organic growth as we go into next year. But as I comment around the kind of the profile of the quarter, in total it was pretty steady and we had descent order patterns in July and August. They're always slower periods, but they were as expected. And September it was right in the realm where it needed to be, as we saw, and that's always the important part of the quarter, because you're coming off the summer months and that negatively effects Europe and North America. And I would remind you that we did enter Q3 with a really healthy open order position and that did help the quarter, but we did see order patterns that what we expected. We have a more normalized open order position as we enter Q4, but we do continue based on our guidance to see healthy organic growth expectations within the quarter.

[Scott Graham:]

I guess the only other question was around the operating margin goal of 12%. So I think when we spoke last that that goal was kind of still in place, but the hope for fourth quarter of '14 rather than '13. Your opening comments Tom, you didn't quiet say that again. Maybe it was just that you just didn't come across or is the company still thinking fourth quarter of '14 for this?

[Thomas Paulson:]

We were assuming that we have growth in our targeted range in the mid-to-high-single digits. We would certainly expect that we would have the capability to deliver 12% operating margin as we exit the year and have that to be sustainable into the following year. But it will be dependent on achieving that revenue growth. So it would be by the fourth quarter of next year, we would certainly expect that that would then be sustainable as we go into 2015. Hitting it in a quarter doesn't matter, it's got to be at sustainable level. But we are marching towards that number. We feel very good about the progress we've made particularly in an environment that's been for many quarters dramatically below the kind of growth expectations we normally have. We think we're extremely well-positioned to deliver that 12% now.

[Operator:]

Your next question comes from the line of Rosemarie Morbelli from Gabelli & Company.

[Rosemarie Morbelli:]

I am new to this story, so I may ask you question that you and everyone else knows. But when you introduce new products you are looking for higher margin, how long of a lead way do you have on that higher margin? I mean when those new products become one or two years old, isn't competition coming in and then you actually have to lower your price and margin or am I might not looking at this the right way?

[Thomas Paulson:]

Our business is a little unusual and that we really get to our targeted margins quite quickly and we come right out at normalized pricing and we get to our margin targets fast. And that there isn't a long start-up curve that you have in a lot of businesses and we get there quickly. And then, we will typically see a revenue ramp that won't reach its peak until the second or the third year of the time that our products in the market. Obviously, every product is a little bit different, but the rollout, it happens in a stage and it will reach its peak in year two or year three. A big reason for that is people. We don't change the cycle of when people buy. They buy new equipment when their old equipment is ready to be replaced generally, there is always exception. There is place where people are buying brand new equipment for the first time, but generally we're in a replacement cycle, where they are replacing an existing piece with a new piece.

[Rosemarie Morbelli:]

What is the life, I mean, if you sell your T12 for example, how long before it needs replacement?

[Thomas Paulson:]

Very dependant upon the level of hours that it runs and the harshness of the environment it's operating in, but our typical piece of equipment is going to be on average five to six years or so. And a T12 operating in the harsh environment might actually last less than five years, but there will be places where it can last for over 10 years. So there's a wide range of timing on virtually all of our products.

[Rosemarie Morbelli:]

And then, if I may, Diversey is still there and bringing their cleaning equipments from Europe into the U.S. for the first time. Have you seen them in the marketplace already and how is it affecting your own business?

[Chris Killingstad:]

We are aware that they are bringing the products into the U.S. for the first time. I mean the products have been here, but on a limited basis. I think it's the first time they have a conservative strategy to push the cleaning equipment. We are monitoring their progress, but as of right now it is not impacting our business. And that we are not seeing them come up against us on all the most important deals that we're in on.

[Thomas Paulson:]

I'll comment further on that and say that the Taski tends to be a bit stronger in some vertical markets that we don't have as big of a presence in, like the hotel area. They are particularly strong in that area. That's not a vertical market, that's an area of strength, but we're paying close attention.

[Chris Killingstad:]

And because we know that in Europe, for example, they are strong. They have a well-established equipment business in Europe. We do see them in most of the countries that we play. And then we respect their position. So we are not being complacent.

[Operator:]

There are no more further questions. I will now turn the call back over to management.

[Chris Killingstad:]

As I mentioned earlier, we are encouraged that our organic sales growth returned to mid-single digits in the 2013 third quarter. We anticipate further improvement in our operating margin. It will enable us to attain our goal of 12%. We are also pleased with our accelerating new product sales and the continued growth in both our global strategic accounts and our overall Americas business. So thank you for your time today and for your questions and we look forward to updating you on our 2013 fourth quarter and full year results in February. Take care, everyone.

[Operator:]

Thank you. That concludes today's conference call. You may now disconnect.