Twin Disc, Incorporated

Greetings and welcome to Twin Discs Fiscal Third Quarter 2023 Earnings Conference Call. At this time, all participants are in a listen-only mode. A question and answer session will follow the formal presentation. If anyone should require operator assistance during the conference, please press star zero on your telephone keypad. As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Jeff Knutson, Vice President of Finance, Chief Financial Officer, Treasurer, and Secretary. Thank you. You may begin.

Thank you, Doug. Good morning, and thank you for joining us today to discuss our fiscal third quarter 2023 results. On the call with me today is John Batten, TwinDisk CEO. I would like to remind everyone that certain statements made during this conference call, especially statements expressing hopes, beliefs, expectations, or predictions for the future, are forward-looking statements. It is important to remember that the company's actual results could differ materially from those projected in such forward-looking statements. Information concerning factors that could cause actual results to differ materially from those in the forward-looking statements are contained in the company's annual report on Form 10 , copies of which may be obtained by contacting either the company or the SEC. Any forward-looking statements that are made during this call are based on assumptions as of today and the company undertakes no obligation to publicly update or revise these statements to reflect subsequent events or new information. During today's call, management will also discuss certain non-GAAP financial measures. For a definition of non-GAAP financial measures and a reconciliation of GAAP to non-GAAP financial results, please see the earnings release issued earlier today. By now, you should have received the news release, which was issued this morning before the market opened. If you have not received a copy, please call our office at 262-638-4000, and we will send a release to you. Now I'll turn the call over to John.

Good morning, everyone, and thank you for joining us today. I'd like to start today's call with a few highlights from the quarter. Strong demand across our end markets, coupled with an easing supply chain constraints, and in turn higher shipments translated into a 24% increase in sales year over year and double-digit sales growth in our North American markets, and Asia Pacific regions. Margins were adversely impacted by multiple factors, including a non-cash LIFO charge related to a reevaluation of inventory and higher costs that more than offset the pricing actions we implemented mid-quarter. Normalizing for the non-cash impact of margins, the operational accomplishments of our team would have resulted in sequential margin improvement, which has been and will continue to be a top priority. Further, we also generated nearly $7 million of cash from operations and ended the quarter with our highest backlog in more than four years and VETS largest backlog ever. We have already taken a number of actions to respond to headwinds stemming from supply chain constraints and higher costs. And we've been working with other strategic vendors to source components that are in short supply or that are currently sourced from a single supplier. The operational accomplishments of our team lend to a significant improvement in shipments, which will allow us to continue to decrease inventory and further improve lead times. I'm also encouraged by the results we are seeing from our collaboration between VET and ROLA. The VET team has been working with our propeller manufacturer to include more twin disc content in their designs and provide a better overall product to customers. There has been a noticeable increase in the number of applications of our hybrid and electric offerings, and we are seeing a correlated increase in new orders as a result. Our marine and propulsion systems product group continues to experience strong demand across end markets. We are seeing more activity within offshore oil and gas, which is translated into offshore oil supply vessel inquiries, something we haven't seen in several years. As the geopolitical environment in the South Pacific continues to evolve, we've concurrently observed a significant increase in the number of inquiries from U.S. and European governments for small military marine transmissions used in shallow water boats. VET has had a number of wins recently. and has experienced its geographical reach beyond its core northern European markets, booking orders across North America, Asia Pacific, and the rest of Europe, including Italy, which is a key luxury yacht market. We are excited about what those opportunities represent. On the land-based transmission side of our business, the lack of oil and gas investment over the past few years has increased utilization and the need to rebuild or replace fleets. That said, as we continue to see elevated demand with the oil and gas end market, customers continue to face constraints on new engine availability from third parties, which has led to delayed orders for new transmissions. Instead, we've experienced increased orders for rebuilding existing transmissions, work we are uniquely positioned to complete. Our EFRAC testing continues to progress, and the feedback on the results to date remain extremely positive, and we anticipate orders to begin shortly after this fiscal year. Within the industrial product group, we continue to experience stable demand across end markets and have been able to maintain volumes in line with the spike observed last year. While still early days, there has been a noticeable increase in opportunities to work and to partner with key domestic OEMs on a variety of exciting projects. Additionally, we have seen the number of hybrid and electrification system applications continue to grow. The greater twin-disk content in these systems presents an opportunity to accelerate sales growth and expand the margin profile for the industrial product group. Focusing on inventory and backlog for a moment, strong end market demand persisted throughout the quarter, resulting in our highest backlog level in over four years. And easing supply chain headwinds and operational execution enabled Twindes to significantly improve shipments and reduce inventory on a dollar and percentage of backlog basis. We are still experiencing shortage of certain components or materials and are working to find alternatives to mitigate these headwinds. as we experience or are able to find and able to anticipate them. For example, one of our major suppliers hasn't been able to source enough material for a graphite ring that seals the inside of a piston. We've explored alternate suppliers as well as a change in material. Either path requires significant lab testing for extended time periods, which presents its own challenges. That being said, The bulk of the supply chain headwinds faced in prior quarters like heat treatment and capacity constraints started to subside in the third quarter, and we expect those trends to continue. As we navigate and respond to each challenge that our business faces, we evaluate our options based on how they align with our commitments and long-term strategy. We strive to be the leading hybrid and electric solution provider for our marine and off-highway land-based applications. As we look to the future, it is clear that controls and systems integration provides greater sales and margin opportunities than a continued focus on individual components would. We've also noted that the vet business has had a lot of success recently, and we expect that trend to continue as we extend and expand that business across geographies and markets. As with the acquisition of vet, our M&A priorities continue to be focused on industrial and marine technology, especially for the hybrid and electrification solutions where we strive to be the leading provider. Further, we need to modernize and optimize the global footprint of our business to be more efficient and improve customer response and lead times. As we think about capital allocation, and more specifically, returning capital to shareholders, I think it's important to clarify our approach. First, we will continue prioritizing the reduction of net debt, which We've been able to accelerate in recent quarters as we've closed on the sale of various facilities around the world. Second, TwinDisk has historically paid a dividend to shareholders, and we have a strong desire to resume paying a dividend. However, we won't use debt to fund it. We will only resume the dividend after we've established a track record of free cash flow generation and have a positive outlook on the cash generation potential for the business. We continue to make investments within our business to fuel growth, through research and development, geographic diversification and expansion, and our marketing efforts. We will also continue to evaluate and pursue bolt-on and or transformational acquisitions that align with our strategic and financial fit characteristics, as well as other considerations, which we've consolidated on slide nine. As we look forward, I think it is important to provide clarity around our near-term expectations of external factors and the actions we are taking in response. We expect broader manufacturing and supply chain headwinds to continue to moderate while acute components shortages, especially those sourced from European suppliers, are likely to persist or resolve and then reemerge elsewhere in the portfolio over the next several quarters. We are doing what we can to anticipate and to address these headwinds as early as possible. We have not experienced a reduction in raw material costs despite the lowering prices of key commodities. Our pricing actions to restore and protect margins are already in effect And at the moment, we do not expect lower raw material costs to be the material driver of margin improvement in the near term. Our team continues to progress on our plan to modernize our legacy facilities, equipment, processes, and geographic footprint. This work has and is expected to continue to deliver improved shipments, lower inventory, reduced lead times, and lower costs, all of which will contribute to better margins and cash flow for TwinDisk. With that, I will now turn it over to Jeff to discuss the financials.

Jeff? Thanks, John. Good morning, everyone. We delivered sales of $73.8 million for the quarter, up $14.5 million, or 24.4%, from the prior year, driven by strong demand across our end markets, especially within our marine propulsion systems and land-based transmission product groups. As John mentioned, shipments improved significantly in the quarter, and we are seeing light at the end of the tunnel for our supply chain. Net income attributable to TwinDisc for the quarter was 2.7 million or 20 cents per diluted share compared to 2.2 million or 17 cents per diluted share in Q3 of fiscal 22. The approximately 20% year-over-year improvement in net income was primarily the result of our sales performance and lower income tax, which was driven by the geographic mix of earnings. Marine and propulsion systems and land-based transmissions both delivered double-digit growth sequentially and year-over-year, while our industrial product group delivered another quarter of sales in line with expectations. Looking at sales by geography, we saw our year-over-year and sequential increased sales within North America and Asia-Pacific regions were primarily driven by efforts to diversify the VET business outside its core northern European markets. VET has had a number of wins recently and currently boasts a record high 12-month order backlog. We see a clear path to further growth in this business. As John mentioned, within the luxury yacht market, VET is now partnering with ROLA, our high-end propeller design and manufacturing firm, to design and develop components that are more fluid dynamic and leverage additional content from twin-disc. Gross margins of 26.1%, a decrease of 370 basis points from the prior year period, were negatively impacted by a non-cash write-down of domestic inventory as a result of LIFO accounting in the quarter. We expect this to similarly impact Q4 as we continue to reduce inventory to pre-COVID levels. As John noted, we have seen commodity pricing continue to trend down, but that has not yet translated into decreased prices for our raw materials. TwinDisc doesn't buy raw steel. Instead, we buy forgings or castings, which have held firm on pricing to date. We expect our raw material pricing to remain elevated throughout 2023 and implemented additional pricing early in the third quarter as a result. I want to take a moment to highlight the progress we've made with our balance sheet and leverage ratio since the end of fiscal 22. In three short quarters, we've been able to reduce net debt by approximately $7 million. Our cash position is now $14 million, which is approximately 12% higher than at the start of fiscal 23. EBITDA is up 14.8% compared to the year-ago period, primarily driven by higher depreciation and amortization, with net debt of $17.3 million at the end of Q3, and EBITDA over the last 12 months of $23.4 million at Our leverage ratio has gone from 1.1x to 0.7x in just three quarters. The balance sheet progress we've achieved is foundational to our pursuit of bolt-on or transformational M&A opportunities, as well as a key factor in our ability to optimize the global footprint and operational efficiency of TwinDisk. Building on the near-term expectations that John laid out, I'd like to take this opportunity to reaffirm our medium-term targets Over the next three to five years, we believe the execution of our strategy will deliver revenues of approximately $400 million, with gross margins of 30%. To get there, we will need to take advantage of and extend our leadership position across hybrid electrification opportunities, continue expanding the geographic reach of the vet business, and evolve our business practices to adapt to the ever-changing operational environment. We also see a path to delivering consistent free cash flow conversion of 60% through streamlined supply chain operations, optimizing our manufacturing footprint, and remaining disciplined with our capital spending. And before we open the line for questions, I'd like to leave you with a few key takeaways. The robust demand and sales momentum experienced in Q3 is expected to continue through Q4. We've seen the bulk of our supply chain headwinds moderate and are working to resolve component shortages faced in the quarter. Our teams have been working tirelessly to improve our operational efficiencies, and that has allowed us to ramp up shipments in Q3 and position Q4 for success. I think it is also important to highlight our current capital allocation priorities, framework for M&A opportunities, and reaffirm our confidence in our strategy and ability to achieve our medium-term targets. That concludes our prepared remarks. John and I will be happy to answer your questions.

Thank you. Ladies and gentlemen, at this time, we will begin doctoring a question and answer session. If you'd like to ask your question, you may press star one on your telephone keypad. A confirmation tone will indicate your line is in the question queue. You may press star two if you would like to remove your question from the queue. For participants using speaker equipment, it may be necessary to pick up your handset before pressing the star key. One moment while we poll for questions. Once again, that is star one to ask a question. We do have a question from the line of Simon Wong with Gabelli Funds. Please proceed with your question.

Hey, John and Jeff, how are you? Hey, Simon, how are you? Just starting with the oil and gas business, how much revenue was that in the quarter?

So it's a little bit hard to break that out real cleanly, but it was obviously a big part of the quarter aftermarket and forward market. I would say 25% to 30% of the quarter, top line.

Okay. How much is that new equipment versus consumables or aftermarket?

I would say it's probably more than half aftermarket. maybe 60, 40 aftermarket versus new equipment, with most of the new equipment headed to Asia.

Oh, okay. I'm sorry, just to clarify, the 25% or 30%, is that total of total revenue or just land-based transmission?

Of total.

Okay. And then staying on the oil and gas, what are you seeing from your customers? I mean, given the recent... in oil prices and lower natural gas prices. Are they continuing activity, or are you starting to see them park equipment?

What are you seeing there? Simon, we haven't seen any slowdown in the rebuild activity. They may have idled some equipment, but I think it's mostly equipment that needs to be rebuilt or replaced. Every conversation that I've had, whether it's for Asia or North America, the rebuild activity is going to continue and they're actively looking at new spreads. Because some of the, particularly in North America, traditional frack rigs are going on their fourth, fifth, maybe sixth rebuild. And there's still, we're seeing that that is going to continue through the rest of the calendar year. And availability of engines is still out a couple quarters, so we probably won't see a significant of the traditional frack fleet, some build, but I expect to see that at the end of this calendar year.

Okay, great. And then one more oil and gas question. In your last upcycle, how big was the offshore part of the business for you guys?

Oh, Simon, offshore was – historically a very big component. But I would say, you know, just that that was probably high single digits, 10% of our business when it was at, you know, when it was near its peak.

Yeah. Okay, 10% of its peak. It can be a meaningful contributor going into the next few years if offshore really comes back as the industry saying it is. Okay. Just one last question, and I'll jump back into the queue. Outside of oil and gas, anything in your new product pipeline that you're excited about that you can talk about?

Well, just I would say a lot of the industrial products, some of our PTOs, whether it's electrically shifted or hydraulically shifted, those are starting to gain traction. And really what's exciting, are the amount of hybrid and electrification applications, projects, quoting that we're doing, and the systems. You know, the Hinkley is the one that we've been able to talk about, but we should have some exciting industrial ones to talk about. And I'm guessing we'll have, you know, through this calendar year, certainly next fiscal year, a lot more coming out where, you know, the full system is provided by TwinDisc. So a lot of controls developed. And that's been a bit – I mean, our controls group has done an amazing job resourcing a lot of just the base components that were in such short supply over the last 12 to 18 months.

Okay. All right. Great. Thank you, guys. Yep.

Thanks, Simon.

If there are no other questions in the queue, I'd like to hand the call back to management for closing remarks.

Thank you, Doug. I just wanted to take a moment to thank our teammates around the world for their perseverance and hard work. Please reach out if you have any further questions for Jeff or me. Have a great rest of the day, and we look forward to speaking with you at our fiscal 23 year-end conference call later this summer. Thank you.

Ladies and gentlemen, this does conclude today's teleconference. Thank you for your participation. You may disconnect your lines at this time, and have a wonderful day.