10/18/2022

speaker
Operator

Good morning and welcome to the Sonatec Corporation first half fiscal year 2023 earnings conference call. All participants will be in listen only mode. Should you need assistance, please signal a conference specialist by pressing the star key followed by zero. After today's presentation, there will be an opportunity to ask questions. To ask a question, you may press star then one on your telephone keypad. To withdraw your question, please press star, then two. Please note, this event is being recorded. I would now like to turn the conference over to Stephanie Prince from PCG Advisory. Please go ahead.

speaker
Stephanie Prince

Thank you, Gary, and thank you to everyone joining us today. Sonatec released their second quarter and first half fiscal 2023 results after the market closed yesterday. If you don't have a copy of the release, please go to the company's website at sonitech.com and click on the press release news tab in the investor section. The product, market, and geography sales tables on the last page of the release will be part of today's discussion. With me on the call today are Dr. Chris Coccio, Sonitech's chairman and CEO, Steve Harshbarger, president and COO, and Steve Bagley, chief financial officer. Before turning the call over to management, I would like to make the following remarks concerning forward-looking statements. Please note that various remarks that may be made on this conference call about future expectations, plans and prospects for the company constitute forward-looking statements for the purposes of safe harbor provisions under the Private Securities Litigation Reform Act of 1995. Actual results may vary materially from those indicated by these forward-looking statements as a result of various important factors, including those discussed in the company's filings with the SEC. The company assumes no obligation to update the information contained in this conference call. I would now like to turn the call over to Chris Coccio, Chairman and CEO of Sonitech. Chris?

speaker
Gary

Good morning, and thank you, Stephanie, in particular for taking care of the safe harbor statement. Thank you for joining us. Today, we're going to discuss our results that were released yesterday after the market closed for the second quarter and the first half of fiscal year 2023. Bear in mind that ended August 31st, 2022. I will begin with some opening remarks and then Steve Bagley, our Chief Financial Officer, will provide a financial review. Steve Harshberger, President and COO, will then go through the business and operational results. Following his comments, we'll be happy to open the call for your questions. As a reminder, Donald Tech currently holds two earning calls per fiscal year. This is our fiscal mid-year call. Our next earnings call for fiscal year end 2023, which ends on February 28th, will be in May of 2023. Now, briefly for those who are new to us, Sonovec developed a revolutionary method of applying precision thin film coatings several decades ago. The proprietary technology involves the use of patented high-frequency ultrasonic nozzles incorporated into motion control systems that are able to achieve uniform micron thin coatings for our customers. Our solutions offer dramatic savings in raw material, water, and energy usage, and they're all environmentally friendly Among other advantages, the principal advantage is the ability to apply precision thin films, very important in today's world. The strategic shift that we made several years ago to offer more complex complete solutions versus component sales has broadened our addressable market and has resulted in significant growth in our average unit selling prices. Our larger machines now commonly sell for over $300,000. And systems prices more and more often reach $1 million, which can impact quarterly revenue in a more meaningful way than previously. Most recently, we're focusing on opening new markets for our technology. This includes three main areas with very strong global growth. Microelectronics and semiconductors, clean energy, including fuel cells and carbon capture, and medical devices. All three of these sectors are experiencing strong demand from long-term societal needs, and they all benefit from Sonotech's unique thin film coating technology and systems. In August, we were excited to receive the largest order to date from the clean energy sector valued at $1.1 million, validating the resources we've invested in this opening market. This order is also one of the largest in Sonotech's corporate history. As our capabilities continue to advance, more and more of the approximately $8 billion global coating market opens to our advanced solutions. A good example we previously mentioned is the expansion of our coating capabilities in roll-to-roll product handling, which is used in approximately 15% of the global coatings market. In Q2, we were proud to ship our first roll-to-roll order, which went into the food packaging industry. And it's just the beginning of what we expect will become an important product line for us. Revenue for the second quarter ending August 31st was impacted by the slow delivery of components and assemblies that we need to fulfill and ship orders. This resulted in a slight year-over-year increase in the first half sales to $7.8 million and a decline of 8% to $3.8 million in the second quarter. Our backlog of orders remains strong. ending the quarter at $5 million. And Steve Bagley will go into more detail on this subject in a few moments. Operating expenses increased 6% in Q2, in part due to increased employee compensation costs in the current competitive job market. Travel costs for sales and service calls have increased as well now that COVID concerns have faded. Now the increase in employee compensation is expected to have a continuing impact on our earnings going forward. Dollaries have risen substantially to attract and retain the critical technical and managerial personnel that we need in a highly competitive inflationary market. Our people are truly the most important thing. We also expect sales and travel costs to approach pre-pandemic levels over the next nine to 12 months as well. While we have begun raising our prices to reflect these additional labor and material costs, there clearly is a lag effect in realizing those increases as the higher salary and material costs are already in place. However, we continue to see growth opportunities in many of our traditional markets, such as flow class and spray fluxing, and we're especially excited about opportunities in our target sectors of semiconductors, medical devices, and clean energy. We remain confident that our outlook for growth based on the quarter end $5 million backlog and the continuing very high level of customer visits to our development labs where customers test out the feasibility for their new applications. So although we cannot provide any assurance and despite the many economic cross currents today, we continue to expect annual sales to be higher than last year, last fiscal year, with the fourth quarter projected to be the highest of the year. Actual results will, of course, depend on how quickly the supply chain goes back to more normal levels. With that, I'll turn the call over to Steve Bagley, our Chief Financial Officer, for some greater details on our financial results. Steve?

speaker
Steve Bagley

Very good. Thank you, Chris, and good morning, everyone. For the second quarter of fiscal 2023, total sales decreased 8% to $3.8 million, due to delayed shipments resulting from supply chain challenges. During the quarter, approximately 56% of sales originated outside of the United States and Canada, compared with 62% in the second quarter of fiscal 2022. Gross profit decreased 9% to $1.9 million, compared with the second quarter of fiscal 2022. The gross profit margin was 50.4%, compared with 51% for the prior year period. The decrease is due to a less than favorable product mix compared to the prior year period. Operating expenses increased 6% to $1.7 million compared to the prior year period. Research and product development costs increased 23% to $506,000, primarily due to increased salaries and the higher costs of research and development materials and supplies, which are directed at ongoing focused growth initiatives. Marketing and selling expenses increased 5% to $777,000, primarily due to increased travel and trade show expenses resulting from the global lifting of COVID-19 restrictions. General and administrative expenses decreased 8% to $435,000, primarily due to decreases in professional fees and corporate expenses. Our operating income decreased to $178,000 for the second quarter of fiscal 2023, primarily due to the decreases in revenue and gross profit combined with the increases in operating expenses. Operating margins for the quarter decreased to 5% compared with 11% in the prior year period. Net income was $162,000, or one cent per share, compared with $344,000, or two cents per share, for the second quarter of fiscal 2022. Diluted weighted average shares outstanding increased slightly to approximately 15.8 million shares. For the first half of fiscal 2023, total sales increased by 1% year over year, Approximately 54% of sales originated outside of the United States and Canada compared with 64% in the first half of fiscal 2022. Our gross profit increased 3% to $4 million for the first half compared with the prior year period. The gross profit margin was 51.2% compared with 50.5% for the prior year period. And that's due to a favorable product mix. Operating income decreased 29% to $558,000. Operating margin for the first half of fiscal 2023 decreased to 7% compared with 10% in the first half of fiscal 2022. Net income decreased to 468,000 or 3 cents per share compared with 1.6 million or 10 cents per share for the first half of fiscal 2022. Our net income of $1.6 million, as I just mentioned, does include our pre-tax paycheck protection plan loan forgiveness of $1 million. Cash equivalents and short-term investments at August 31, 2022 were $10.7 million, and there continues to be no debt on our balance sheet. CapEx for the first half of the year was $244,000, and the spending is focused on our ongoing upgrades of our manufacturing facilities. And I'll now turn the call over to Steve Harshberger, President and COO, for an operational review of the second quarter and first half.

speaker
Chris

Steve? Thanks, Steve, and good morning, everybody. Thanks for joining us today. I want to start off by saying that in recent years, a growing proportion of Sonaltech sales are for higher revenue orders and product shipments, which is, of course, a result of our success providing our customers with complete full-coating solutions rather than individual spray-coating machines. As a result of this ongoing shift, product shipments are now more systematically managed for customer timing requirements, for our own internal production flow management, and currently, supply chain issues. As well, orders and revenue can now be more highly variable from quarter to quarter, in particular due to the more frequently seen million-dollar-plus orders, which can result in large fluctuations in our backlog. Now, turning to our results, Sonos Protect breaks down sales in three ways, by market, by product, and by geography. And that's what I'm going to be talking to him about with you today. You can see the reference to the short tables on the last page of our earnings release press release for all these details. For the first half of FY 2023, total sales increased by 1% to $7.8 million compared to last year and decreased by 8% to $3.8 million in the second quarter. The Q2 decline was primarily due to delayed shipments resulting from supply chain challenges. And we're confident that any delayed orders will roll over into these following quarters. By product, we recently launched the Selectiflux X2 product to several large PCB contract manufacturers, resulting in strong Q2 fluxing sales, which grew to 241% over the last year's second quarter to 399,000 and grew 49% to 707,000 for the first half of fiscal 2023. OEM sales dipped by 10% to 762,000 in the second quarter, but remained strong overall for the first half, growing by 12% to 1.3 million. This growth was led by several significant shipments to our OEM partners in Europe. Multi-axis coating systems sales decreased by 21% and 13% to 1.5 million and 3.5 million, respectively, for the second quarter and first half as a result of delayed shipments due to some supply chain challenges, as were already mentioned. By market, Sales to the industrial market grew by 77% to $528,000 in the second quarter, and 118% to $806,000 for the first half of FY2023. This growth included the shipment of the first of seven coating machines that shipped to an industrial manufacturing company. The remaining six machines are scheduled to ship in the second half of our current fiscal year, and these machines are valued at around $216,000 each. Also included in this segment is the first shipment of a Sonotec roll-to-roll system. You know, Sonotec has invested significant capital into integrating our ultrasonic coating systems with roll-to-roll product handling technology. This first system shipped into a food packaging industry application, and looking ahead, we also expect to service several other industries with this integrated roll-to-roll technology, including the medical and the clean energy sectors. Revenue from the medical sector decreased by 27% to $798,000 in the second quarter, while increasing by 36% to $2.5 million for the first half of the fiscal year. The increase in the first half was the result of several large U.S.-based medical companies incorporating Sonotech equipment into their operations. The alternative energy market decreased by 27% and 6% to $697,000, and $1.3 million respectively for the second quarter and for the first half of the year. However, we expect solid growth for the full fiscal year in this segment based on our existing backlog and our forecast. By geography, strong sales growth from the U.S., EMEA, and Latin America in both the second quarter and the first half. was offset by a 49 and 46% decrease respectively in APEX sales. And this is primarily due to decreased shipments to China impacted by COVID-19 related lockdowns. Backlog on August 31st, 2022 increased 19% to 5 million compared to backlog on May 31st, 2022, the end of our Q1. This growth was strongly influenced by new orders from the electronics sector. Backlog decreased 5% compared to backlog of 5.3 million on February 28, 2022, which was the end of our last fiscal year. Customer deposits increased 52% from fiscal year end to 1.8 million, reflecting the new orders received in the first half of fiscal 2023. And in closing, and as Chris mentioned earlier, we currently expect supply chain challenges to continue to impact our deliveries in Q3. resulting in lower revenue when compared to the third quarter of fiscal 2022. We do anticipate following that to see an increase of shipments in the fourth quarter and higher year-over-year sales for the 12 months of fiscal year 2023, which ends on February 28, 2023, bearing any additional significant changes in the economic environment or new unanticipated challenges with our supply chains. And we'll now, I guess, open the call up for questions, and I'll turn it back over to the operator.

speaker
Operator

Thank you. We will now begin the question and answer session. To ask a question, you may press star, then 1 on your telephone keypad. If you're using a speakerphone, please pick up your handset before pressing the keys. To withdraw your question, please press star, then 2. At this time, we will pause momentarily to assemble our roster. Our first question is from Bill Nicklin with Circle N. Please go ahead.

speaker
Bill Nicklin

Good morning, and thanks for taking my call. Good morning, Bill. How are you doing? I have a couple of narrow questions and then one that's quite broad, and the first is on the supply chain. Can you describe what a resolution of the supply chain constraints might look like in Will it result in a lot of machines sitting in inventory and then suddenly moving out very quickly? Or do you think it will be different parts, different components coming in, and then just a gradual drawdown in what's been held back?

speaker
Chris

Yeah, it's a good question, because I guess everybody's encountering the supply chain issues these days. And this past Q2 was really the first quarter we really got noticeably impacted by supply chain challenges. We were, I guess, way out ahead of most companies predicting supply chain problems, but still got hit by some obstacles this past quarter. We are fortunate, however, to have a solid team in place that's been able to plan our way through these supply chain challenges. We have a very systematic method on our approach this way. is in areas where we can predict upcoming parts needed, like for our more standard modules and systems. We're buying inventory now and buying it earlier in much larger quantities than typical. We've come to recognize that we just simply can't trust our vendors' anticipated deliveries like we could in the past. A vendor will commonly tell us, oh, you're going to get it in four weeks, and then all of a sudden that becomes four months, and then all of a sudden it becomes 14 months. You know, so we recognize now we need to put these common parts on our shelves and in enough quantity to eliminate the possibility of running out of parts. And fortunately, our healthy balance sheet, you know, of course, allows us to take on and have the luxury of this extra inventory. The second area that we really put a lot of energy into is that, you know, we have an excellent engineering team that often allows us to engineer our way around supply chain problems. This can unfortunately, you know, use some of our valuable engineering resources in areas that, you know, sometimes we don't really plan for it, but it can sometimes often in an outcome of designing better engineered solutions and provides us with more depth in our parts and components selection for the future. And the last approach that we sometimes take is to address supply chain, which has been a substantial shift for us to recently was to start building in-house several large subsystems that we were presently having Sonotech partners out of house build for us. This approach, you know, will ultimately have a significant impact in two areas for us. First, we anticipate seeing better margins for those items that we're now shifting to build in-house. And secondarily, we'll have better control, of course, of our supply chain because we can manage our own inventory on these systems. So with that being said, I do believe we're going to some level work out our own supply chain problems by shifting the method of how we approach supply chain issues. But we will, for the short term, see some backlog that will end up ultimately building up. And once supply chain is resolved completely, then I would think we would see a big surge as that happens where orders that we would normally ship in three or four months, we will be shipping in three or four months, in addition to the orders that have been sitting out there for nine or ten months at the same time as those parts start to come in.

speaker
Bill Nicklin

Thanks for such a complete answer. My second narrow question is, there's been mention of the high level of customer visits to your development lab. Can you give us some insight into what this entails, these visits, kind of the mix of business it represents, particularly versus a year ago, and the trajectory of the visits and what percent of these visits have traditionally turned into equipment or service revenue? Sure, sure.

speaker
Chris

You know, it's been fortunate that we saw that our laboratories were becoming busier and busier. So we did some pretty significant laboratory expansions over this past year, both an addition of a new lab and an expansion on our existing lab with existing equipment as well. And a huge chunk of that right now we're seeing with customers coming in to us are from the clean energy sector. We always have a large flow business coming through from the medical sector in that area for us, but the clean energy sector seems to really be accelerating, in particular when you get into the hydrogen areas that are coming in. We were fortunate that we did make that expansion for us. We are, although the process is a little bit longer than some sections, like the clean energy sector, it typically might take us six to nine months from the first lab visit to when they ultimately will buy a machine. And then it could be another six to nine months from when they actually get that machine delivered. But the activity is super high, and it's still maintaining right around that 75% mark. It has not dropped for us at all. for any customer that walks into our lab that is ultimately buying a machine, ultimately. So that's very encouraging for us, and that's the model that we're really trying to expand and press in other international labs outside of the U.S. lab as well.

speaker
Bill Nicklin

All right, so that 75% is the percentage of customers or potential customers that visit the lab have some work done there, fool around with the instrumentation, ask questions, and 75% of those end up being purchasers of either equipment or some kind of service that the land provides.

speaker
Chris

Correct, and it usually starts with the initial phase is a service, and we don't really track the percentage of services, or I should say we do, but it's a different percentage than the 75% I'm talking about. The 75% I'm talking about is that they have actually ultimately buy a machine. And a lot of that 75% prior to buying a machine will actually be buying some of our coding services whether it's application, expertise, or contract coding prior to buying in the full system.

speaker
Bill Nicklin

Thanks. All right, now I don't want to monopolize the entire call, but I have a broad question based on some recent observations, and that is that looking back, I've been able to see that Sonitech has been expanding its customer base and application capacity techniques and electrolyzers for the hydrogen industry for well over a decade. There appear to be a lot of interest, but the progress looked plodding for many years. Now with the passage of the Inflation Reduction Act and a similar bill in Europe called Repower EU, there seems to be a dramatic change. Experts I'm reading say that to achieve the goals laid out in those bills, there's going to have to be a significant increase in hydrogen production and a significant decrease in costs. Jefferies recently came out and said that that area, hydrogen production, particularly green hydrogen, will see an eight-fold increase. It looks like, too, that the green hydrogen supply chain starts with the production of electrolyzers, and nothing happens without electrolyzers because it doesn't make any difference how much demand you have. If there's no supply, the markets don't go in any place. And I was reading where the head of HIF said that the numbers, quote, the numbers are very, very big, and we need electrolyzer producers to build a lot more capacity. They are the one critical pinch point in the capacity to actually produce hydrogen. And then the IEA came out and said we need a ramp of several orders of magnitude. And kind of heading toward what you guys do, S&P Global came out and said we need a rejiggering of the electrolysis technology. The Inflation Reduction Act had a billion dollars just for clean hydrogen electrolysis program for reducing costs and increasing efficiency. I did a back-of-the-envelope calculation that showed that your revenues from global electrolyzer activities at some point can be greater than the entirety of all the other markets, even assuming that your other markets are growing at a healthy rate. So I'm going to put you on the spot and ask you if you think that's possible.

speaker
Chris

Well, I have to tell you, because we're not a huge company, it's definitely possible. The clean energy and green hydrogen space is, in my opinion, it's our most exciting opportunity in Sonotech, certainly for near-term rapid growth. It's an area that's highly unlikely to be impacted by a potential recession because it's driven by, as you were mentioning, these massive government investments, which are much larger than I've ever seen in any other industry segment. As you mentioned, you have the climate bill, which is $370 billion going into clean energy to reduce greenhouse emissions by 2030. The EU is dropping $300 billion into the green economy. The Asian governments are also joining in with massive investments led by South Korea and the Green Energy New Deal for over $100 billion. Like I said, it's near a trillion dollars combined with all these governments around the world that are focusing on decarbonization and clean energy. Green hydrogen in particular is going to be a huge chunk of the worldwide transition to reduce the carbon footprint. This rapidly growing demand for hydrogen is coming from some massive industries. It's like steel and fertilizer. We're all being pushed to become environmentally friendly conscious. And the reason why green hydrogen is so important is although hydrogen is very environmentally friendly, it emits only water when it burns to create energy. But the creation of hydrogen is commonly done through what they call a gasification process. And that's coming from carbon-based fuels like coal or methane, which is bad for the environment. It emits CO2, which you don't want. But green hydrogen, on the other hand, is created through an electrolysis process. And the energy needed for the electrolysis process can come from environmentally friendly sources like solar or wind. And now, just as you mentioned, where Sonotech is involved with this process, I guess, with our machines is precisely applied as catalyst coating onto the membranes that are used in electrolysis reactions for green hydrogen. The membranes that Sonoteq machines coat, you know, this is really the vital catalyst. It's the heart of where the reaction takes place for the creation of hydrogen. And Sonoteq systems, you know, are really considered a leader in this area for coating these electrolyzer membranes. You know, we've done this for over a decade and we have such a vast experience. because it's very similar to the electrolysis process used in PEM fuel cells where we've been providing our pool coating systems. So our application expertise in this area is really deep. So while we're seeing excellent steady growth in recent years from customers using our systems for electrolysis related to fuel cells, we see a much, much larger addressable market for green hydrogen and carbon capture electrolysis in combination with that. The potential customer base becomes huge, and there's massive incentives by governments to implement these changes, and they're trying to do it with expedience. It's very early for us to accurately predict the impact that these hydrogen expanses will have on us, but I would be shocked if it didn't have a major impact on our activity coming up this next year. It's just such a big area.

speaker
Bill Nicklin

Great. Thanks. And you came up with the same trillion dollars that I was taking a look at. And then I did some simple math and found out that one-tenth of one percent of a trillion dollars is a billion. So I guess there's a lot of opportunity out there. So thank you very much for such a comprehensive answer.

speaker
Chris

You got it, Bill. Good chatting with you.

speaker
Bill Nicklin

That's it for me.

speaker
Operator

Again, if you have a question, please press star then 1. The next question is from Ted Jackson with Northland Securities. Please go ahead.

speaker
Ted Jackson

Thanks for taking my questions. I've got a few of them. First of all, I want to step back into the forecast and the supply chain issues and the numbers that you expect going forward. And pretty simply, can you tell me what makes you confident that you're going to be able to deliver the products that have been delayed by the end of the year, and in particular, you know, how you see it happening just in the fourth quarter?

speaker
Chris

Yeah, you know, we have gone out to our vendors, you know, we've had to shift our expectations for sure, you know, and it did happen this quarter, and we are seeing our vendors that missed, you know, there's kind of a new norm, you know, where a vendor that was saying they would be able to provide it to us In three months, it was hitting it in six months. So we've adjusted all of our expectations from supply chain kind of to the worst case scenario, we believe. Now, can things potentially even get worse? Yeah, it's possible, but we're doing a lot of things here internally at Sonotech to avoid that from happening. There's some cases where we have multiple paths we're going down where we're having a vendor still build something for us, but we're also engineering a solution around it just as a backup. It's taking a lot more time than we would like, but we have a pretty high confidence level at this point that with these already anticipated delayed dates, we're anticipating supply chain will continue to hit us, that we'll be able to hit these machine dates for our revenue and for our customers. Our customers need these machines. They're anxious to receive this equipment as well. They're for some very important applications out there, especially in the clean energy sector that they need to get up and running. So our confidence level is pretty high because of our approach of how we're looking at the backlog and supply chain demand.

speaker
Ted Jackson

Going into kind of the waiting, I know you're expecting to see year over year growth in terms of full year, and you're looking for your third quarter to be down year over year. Can you give some kind of guidance in terms of where you think your third quarter revenues might be? I'd ask more just in terms of as I reflow my forecast to kind of make sure I align with what you're expecting.

speaker
Chris

Yeah, yeah. We haven't given too much guidance there and very upfront. The reason being is we have a lot of orders that could potentially shift into Q3 and we hope they're in Q3, but they could go out one month later. They're right on the edge. When we look at our supply chain issues of where they will drop, they're very much close to that edge of which side they're going to fall. You know, I suspect, you know, we're probably going to be something in the area like we were this past year, but we'll have to kind of this past quarter, but we'll have to kind of see how that plays out. There's just a lot of variables that could come into play here for that to happen. But, you know, a good chunk of our quarter, I mean, you're not going to see some sort of drastic drop or anything like that.

speaker
Ted Jackson

Okay. Shifting over to operating expenses, I mean, I know when I had done all my due diligence and rolled out coverage that this was something you'd flag, so it's not that I wasn't expecting it to be up, but they were a little, I mean, they were actually, I mean, substantially higher than I expected them to be. Can you provide a little color on how you see your OpEx on a go-forward basis? I mean, is it kind of, you know, at this point we've got this jump up and kind of, trend sideways, or are we going to continue to see it at this percentage of revenue and grow with revenue going forward?

speaker
Chris

Yeah, I think expensive... Go ahead, Chris. You want to take that one?

speaker
Gary

Yeah. Thank you. This is a key point for a high technology company like ours. Some companies just let the staff disappear because of competitive offers elsewhere or unwilling to... to meet what is driven by inflation and we made the decision that we're going to meet that because it would be a much more difficult situation if we were to allow some key technology and management people to disappear and then we have to refill all that. So I think we're going to be in a stronger position. That said, I think we've accomplished that in the past six months or so. We've adjusted throughout the company salaries so that we we will be much less subject to, let's call it poaching or whatever you want to call it, inflation-driven losses. So I think that has come to sort of an end, not 100%, but I would say pretty much we've addressed it throughout our staff, and we're not anticipating another major change in compensation. And we started pricing increases at least three to six months ago, but they take a while to roll through the system. So I think we're going to see an improvement over time in that relationship between inflation-driven compensation and our product pricing.

speaker
Ted Jackson

Okay, thanks. Then I want to, just a quick question, is the drop in tax rate. I think you just give a little color to what brought the tax rate down so much.

speaker
Chris

Steve Agley, do you want to answer that one?

speaker
Steve Bagley

Absolutely. And kind of what you see it going forward to. Well, let's see. The drop in the tax rate, what you see happening right now this year is in the prior year, we did not pick up the R&D tax credits that were flowing through. And that was primarily because you had to earn enough of those credits before you could apply them. And now what our accountants have told us is that, yes, you can pick them up during the year. as you earn them versus having to have to wait to have quite a bit of tax, the credits themselves. You combine that with the drop in the taxes, sorry, the drop in the income before taxes, and that is primarily why you see that drop.

speaker
Ted Jackson

So it's fair to say with the tax rate, the reason the rate was down was a catch-up for the R&D tax credit. And going forward, you're just going to be accounting for the R&D tax credit on a quarter-by-quarter basis?

speaker
Steve Bagley

Yes. Prior year, if you took our earnings, hang on, I'm running through the numbers here. All right, we had about $1,100. prior, and I think it was about 21% if you exclude the PPP forgiveness. And you should still be, I'm going to have to say that you're going to be at, what is it, 85% and 553%. I would run with about 15% to 20% right now going forward. Yes, yes. The biggest, like I said, the biggest thing is the application of those R&D tax credits is And basically just right now it was the decrease in earnings before income taxes. So it all comes together. Okay.

speaker
Ted Jackson

And then my last question just kind of around financials. You know, I mean, if you look at the quarter, you know, your operating cash flow was negative. You had a big pickup in receivables. Sounds like you've got a fair amount of sales, I'd say, sitting in your inventory. I assume that the tick up in receivables is tied to your supply chain issues and, you know, the kind of, you know, pig in the python that's going to come through in, you know, third and fourth quarters of this year. What can we expect to see with regards to kind of your receivables as we roll into the back part of the year? Same thing with inventories, and then what does that mean in terms of operating cash flows?

speaker
Steve Bagley

Well, I'm looking at – you mentioned there was a negative cash flow on operations. I don't know if you were looking at just for the three months. Just for the three months. Okay. All I have right in front of me is that six months, and our operating cash flow was positive at $223,000. Now, if you look at the AR, my AR increased $885,000. And the primary reason for that was there are – Well, so number one, customer agreements that we have. But there were a few customers who were, it was set up, okay, they did not have to pay us until there was final installation and approved installation took place. So do I anticipate that to happen? I would hope not, but to be quite honest, it's all gonna depend upon the agreements that we have. And our inventories, of course, did increase. Part of that increase was due to some whipped and finished goods that we had sitting here that we couldn't ship due to customer requirements. I mean, the supply chain goes both ways. It's getting stuff in and getting stuff out. A lot of our customers ask us to use their own freight forwarders. And logistics is certainly affected by these supply chain issues as we have seen going forward. I would have to say, I mean, one of the biggest things we do work on here is for the next quarter and year end, of course, is to have the least amount of open AR. I mean, you're always going to have it. It's going to depend upon timing of the sales. But all I can speak to right now is that large increase in AR, which I tell you, it did drop subsequent to the quarter end.

speaker
Chris

And I should note that it's funny that our AR here, we take very little risks at Sonaltech. We're fortunate that way. We write off almost nothing with our customers. They give us pretty hefty deposits. And the only people that get good terms with us are companies that are super, super stable. And we feel like there's no risk of not collecting. So like international sales as an example. we collect a lot more up front on an international sale than we would, for example, on a U.S.-based sale, which we know the company, and we have a very ability to collect with much easier.

speaker
Ted Jackson

But I guess where I'm driving at this, I'm just kind of trying to get a sense into the second half of 23, you know, cash flow generation. You know, you have this, you know, large piece of, you know, this large receivable number, and so I'm kind of curious where that receivable number is going to go as we kind of march through this year. And then, you know, there's kind of a cross-current in terms of inventory messaging in that one is that, you know, you probably have a fair amount of inventory that will go out the door because of your supply chain issues, but then on the other hand is your have a higher inventory level than you might have had, say, 12 or 18 months ago because of supply chain issues. I'm kind of curious where you see your inventories going for the back half of the year. And really where I'm driving at is just I'm kind of curious in terms of what happens with operating cash flow in the back part of 23.

speaker
Steve Bagley

I understand that. Let's see. I'll just look at the inventory. at year end was 2.4, and as of the quarter end, we were at 2.8. As Steve mentioned, and we've mentioned it before, we do purchase additional inventory items to protect us from the supply chain. And also the flip side is I know that I have a few units sitting in there at quarter end that should have shipped. Can I tell you specifically what the number's gonna be at year end? Of course not. It's all going to depend upon a certain number of factors going forward. The AR, I know that that did drop subsequent to quarter end, and that was due to a number of agreements that we had with our customers. And as Steve just mentioned, we try to minimize that, the amount of risk we have out there. We do not ship outside of the U.S. without having a considerable cash deposit, or a letter of credit in process. Those two items are going to be in flux. And I think the key thing is that we're going to have to see where we are at the end of the third quarter and go from there. I mean, that's the best I can do for you right now, Ted.

speaker
Chris

And we do predict inventory to grow up, Ted, for the second half of the year. That is something that will be happening. It will be a conscious decision. Some of that will be because we have machines that are sitting here that are big expensive machines that are waiting for a part to come in in order to ship them. And some of that is just conscious building up inventory for the future so we can stop having these supply chain demand issues.

speaker
Gary

Yeah, I would like to say too, Ted, that one of the benefits of where we have positioned the company over time is to have so much cash and market securities and no debt is that we can make more intelligent decisions. They're not driven short range. So we can say we think our team is the key thing and so we can make decisions about compensation and we think that by having more inventory we can protect ourselves for future problems and get back on track in terms of delivery schedules. We can do that and it's a very small impact on our total balance sheet. that gives us the freedom to act in a way that's best for the long-term interest.

speaker
Ted Jackson

Well, I mean, I'm not being judgmental on it. I mean, I think the more important is, you know, the growth opportunities in front and the top line. It's, you know, it's just more just from a getting an understanding of modeling and, you know, I mean, longer term and at the end of the day, you know, eventually you do want to see this stuff fall down to the bottom line. Can I ask, I mean, I actually thought I was done with financials. I do have one kind of more fun question, but Just kind of going into your delays and listening to the commentary and reading what you put in the press release, it sounds like a big chunk of what is waiting to go out the door is in your multi-axis coding systems. Is that a fair statement?

speaker
Chris

That is a fair statement. A big chunk of where we had supply chain demand hiccups waiting to ship things was in that area of the multi-axis coding systems. There's a lot of complex parts in there and a lot of parts that require semiconductor chips. One of the biggest areas for supply chain demand that we're seeing right now, and everybody's seeing this, comes from the chips area. Those chips are needed on some of our circuit boards, and trying to get those can be a real battle these days.

speaker
Ted Jackson

Would it be, because of that, then would it also be fair, I mean, you know, that when we look at the back half of this year and those systems ship out, if my memory is correct, it's generally a relative, say, your fluxing and your integrated coding solutions, a better margin that sail for you, that we would see your gross margins, maybe a percent or two better than we've seen, say, in the first half because of that?

speaker
Chris

Our multi-axis coding systems have okay margins. They're not like one of the ones that's like, oh, that's the best margins. Our systems like our medical systems or our OEM platforms have the best margins that we have in there. Now, if we sell some of these larger platforms, like the six-axis robotic platforms, they actually have really excellent margins. But there's not one of those in the existing backlog mix right now at this point.

speaker
Gary

Okay.

speaker
Ted Jackson

Okay. And then my last question, which is just more for helping me learn and educate, I know you're excited about the roll-to-roll products and shipments and stuff. I wondered if you could just take a couple of minutes and just describe what that is in terms of a, you know, a technology, a solution, and the different industries that use it. Sure. You know what I'm saying? I mean, it's not, you know what I mean? Like I'm still learning Sonotech, to be honest.

speaker
Chris

Yeah, yeah, no problem, no problem. So if you picture, take it in the simplest format, you know, you have sheets of things to cover or like boards to cover or you have a continuous roll. So it's a difference between napkins and a paper towel roll. You know, if I'm covering napkins, that would be individual pieces coming through. And we don't really cover napkins, of course. But if I'm covering something the size of a napkin, I coat it, it goes and enters the machine, then it leaves the machine. So it's a process where you go in, you stop, you coat, and then you leave. Well, a lot of manufacturers are switching to a roll-to-roll process where they can just continuously roll product through machines. Non-stop like almost like a paper towel roll or a picture a big roll of paper And and especially in things like the clean energy sector They're making a lot of flexible films these days in the membranes that we're quoting in the hydrogen space are flexible films and right now they're mostly most manufacturers are quoting them piece by piece today and But as you start to increase your production volumes for high volume throughput, there's all of a sudden desire to say, hey, can we make this go roll to roll so we can put through a higher quantity in a set period of time? And we've been seeing this coming with our existing customer base as they start to have interest of transitioning from R&D to pilot to high volume production. the interest level starts to increase to say, hey, we are thinking about going to roll to roll. And Sonotech wants to be able to be there with them when they're ready to make that transition. And it's in several marketplaces. You know, the clean energy space is one that's very significant and targeted for us. But things like anything where you see a film, whether that's food packaging going on top of a container or whether it's medical devices, a lot of bandages are and gauze type applications are wound up in rolls before they're cut. So they're coated in a roll format. And again, they're all really to increase the efficiency of your throughput. And it's just a matter of the product handling of how you manipulate that roll through the coating system and how you do things like curing it and drying it and everything else comes into play too. And roll-to-roll handling, it sounds super simple, but it's actually not, believe it or not. Every product, when it's moving through, has different technical aspects of how you need to move that through successfully so as not to rip it or break it or damage the product that you're coding.

speaker
Ted Jackson

That was very educational. Thanks, and thanks for the patience with all my questions.

speaker
Chris

Oh, it was great. Nice talking to you, Ted. Talk to you later.

speaker
Operator

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

speaker
Ted Jackson

Well, thank you.

speaker
Gary

And thank everyone for joining us today. Final Tech continues to have a strong outlook, and we're excited about our opportunities for growth. Please contact us directly if you have any additional questions. We'll hold a fiscal year-end conference in mid-May when we report results for the 12 months of fiscal 2023, ending February 2023. So have a great day. Be well. Goodbye.

speaker
Operator

The conference is now concluded. Thank you for attending today's presentation. You may now disconnect.

Disclaimer

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