Mayville Engineering Company, Inc.

Hello, and welcome to the Mayville Engineering Company 2Q21 Earnings Conference Call. All participants will be in listen-only mode. Should you need assistance, please signal a conference specialist for 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 touchtone phone. To withdraw your question, please press star, then two. Please note, today's event is being recorded. And now I'd like to turn the conference over to Nathan Atwell on investor relations. Mr. Atwell, please go ahead.

Thank you. Welcome, everyone, and thank you for joining us on today's call. A few quick items before we begin. First, please note that some of the information that you will hear during this call will consist of forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934 as amended. Such statements express our expectations, anticipations, beliefs, estimates, intentions, plans, and forecasts. Because these forward-looking statements involve risks, assumptions, and uncertainties, our actual results could differ materially from those in the forward-looking statements. For more information regarding such risks and uncertainties, please see our filings with the Securities Exchange Commission, including our filing on Form 10-K for the period ended December 31, 2020. We assume no obligation and do not intend to update any such forward-looking statements except as required by federal securities laws. Second, this call will involve a discussion of certain non-GAAP financial measures. Reconciliation of these measures to the closest GAAP financial measure is included in the earnings press release, which is available at mechinc.com. Joining me on the call today is Bob Campos, Chairman, President, and Chief Executive Officer, Todd Butts, Chief Financial Officer, and Ryan Raber, EVP of Strategy, Sales, and Marketing. First, Bob will provide an overview of our performance, then Todd will review our financial results and guidance. With that, I'll hand the call over to Bob. Please go ahead.

Thank you, Nathan. Good morning, everyone. I'm pleased to report that many of the positive trends we outlined last quarter continued into the second quarter. Thanks to the diligent efforts of our team, we produced net sales of $120.2 million this quarter. virtually doubled the amount delivered in the second quarter of 2020. Adjusted EBITDA of $14 million drove operating income of $4.8 million, and both tremendously improved compared to the prior year period. Like many companies, the second quarter of 2020 was the toughest part of the pandemic for MEC, and as things continued to improve in 2021, we have outperformed on almost every metric on a year-over-year basis. Across the board, our end markets continue to strengthen and volumes continue to steadily grow as we transition back towards normal working conditions. Based on the visibility we have today, we remain optimistic about the future. We finished the quarter with an adjusted EBITDA of 11.7%, which was well ahead of the prior year and in line with our expectations. Having said that, Our bottom line performance has been impacted somewhat by the normal lag in contractual raw material price increases and general inflationary pressures. As volumes continue to improve, we expect to make further progress towards our goal of 15% adjusted EBITDA margins. Todd will cover this in more detail in his remarks. Going forward, we remain focused on investing in technology and automation to improve our productivity potential and take on the growing demand we are seeing from our customers, particularly through the launch of business in Hazel Park, Michigan. It is worth noting that while COVID cases are very low in many of our communities that we operate in, we are remaining vigilant regarding the health and safety of our workforce. This is a top priority. As I already mentioned, the end markets we focus on today continue to have a positive outlook. The commercial vehicles market is in a much healthier position today compared to a year ago. The Class 8 truck backlog remains robust and aligns with the order flow that our team saw through the quarter. Given that freight demand continues to be strong, we believe that the market will remain positive. Power sports remain strong as the demand for outdoor recreation-oriented products remains at elevated levels. We anticipate that retail demand will continue to be strong and our customers will continue to rebuild their dealer inventories in the coming quarters to meet that demand. The construction and access end markets continue to show improvement in residential construction particularly for equipment that is tied to housing and equipment rental. While non-residential and oil and gas markets have not seen a significant recovery yet, we think these areas have stabilized and are just starting to show signs of improvement. Between the infrastructure bill combined with the start of the deal of restocking and rising oil prices, we think better days are ahead in these markets. On another note, improving crop prices coupled with relatively low crop inventories lead us to be optimistic and our customers optimistic regarding the ag market. And we anticipate that this area will continue to see stable to improving volumes in the near to mid-term. Concluding with our military segment, which continues to be a stable market for us, with our customers having a solid backlog for U.S. government contracts, Additionally, we are also seeing the potential for increased revenues due to vehicle updates being implemented by our customers. As demand trends continue to be positive, supply side headwinds continue to be a limiting factor to our customers' growth. We are seeing varying degrees of supply chain disruption that is impacting our customers, which in turn temporarily impacts the volumes they need for MECC. and we expect these issues to continue for the foreseeable future. Like the rest of the country, we continue to see inflationary pressure on raw material, labor availability, and component pricing across the board, which is something every company is currently facing. MACD has the right mechanisms in place to minimize these impacts on our bottom line in a timely manner. such as contractual raw material price increases that get passed along to our customers, offset by enhanced continued investment in new technologies and automation. MEC also continues to work diligently to minimize the potential impact to our customers. In addition, one of our top customers experienced union labor issues during the second and into the third quarter, including a short strike. While the issue has now been resolved, that has been additional disruption to production schedules, which in turn has impacted our volumes as well. Although the supply chain issues are expected to continue, they are not getting noticeably worse, and we are proactively managing any challenges we face. While our margins are seeing a temporary impact from the lag in contractual price increases passed through to our customers, We expect to recover these costs in the near term. One other nationwide issue is the ongoing challenging labor market. Our creative recruiting strategies and HR initiatives are working well, but finding skilled employees will continue to be an issue in the second half of the year, which is another reason we are focused on investing in flexible, redeployable technology and automation. I wanted to return to the new strategic relationship with a leading U.S.-based fitness company, which we announced last quarter. Our new client was looking to expand its U.S.-based production capabilities, and as the largest fabricator in the U.S. with an unmatched reputation for capability, quality, and service, they naturally partnered with MECC. With the long-term agreement in place, we will spend the second half of the year starting up our operations, so we are ready to begin production of key components in the first quarter of 22 as planned. As you probably saw in connection with this new relationship, we announced plans in June to open a major new manufacturing facility in Hazel Park, Michigan. Adding this facility will align our production capacity with the demand for the new customer, and we plan to add almost 400 skilled employees in Michigan. in the coming years. After reviewing alternative sites and states, we selected Hazel Park partly because of the availability of a highly skilled manufacturing workforce in this particular area. We signed a 10-year lease for a 450,000 square foot facility. You may remember we were originally looking at a 287,000 square foot facility. but the growing demand potential led us to increase the size of the facility considerably. As part of the agreement, remember we also received a $2.5 million incentive package from the state of Michigan. As we've stated for this new project, 2021 is an investment year with $35 to $45 million of automation and technology projects planned, which are expected to be deployed in the second half of this year. This partnership won't impact our 2021 revenue, but based on current projections, we expect the new customer to be a strong top 10 customer in 2022. This is also a perfect example of the market diversification that is a long-term strategic priority for us. We expect to see more of these types of product localization opportunities in the years ahead. As we've previously stated, We can't provide additional details about this customer or the agreement, but we are pleased to be forging a strong relationship with this new Blue Chip customer. In addition to this major development, we're constantly building relationships and looking for opportunities to expand both our customer base and the sectors we serve. Today, we see opportunities for new projects and takeover business. For instance, in addition to our recent award, Our new customer in the fitness equipment market is discussing further opportunities to support them in other product areas. We also continue to expand our market share for one of our important commercial vehicle customers. As they ramp up their new models, we are continuing to expand our relationship through our quick turnaround with mid-life design changes. We have also been able to expand our market share of next generation tactical wheeled vehicles that we'll be launching over the course of the next couple of years. In addition to future programs, we're seeing strong activity on current programs as well as service orders and expect further market share expansion over the coming quarters. The power sports market continues to be a very active space for us. both on new programs with current customers that will start production next year and on programs with new customers that we have recently added to this market. In the construction market, we have seen our customers expand their product offerings, which has allowed us to gain additional volume across our current products. Overall, the new business pipeline remains robust, with numerous projects being actively pursued. We are very excited about all of these new avenues of growth and will keep you updated on the latest developments over the coming quarters. Turning to capital allocation, this remains a priority and it remains consistent. Our balance sheet is very strong as we've paid down our debt load in recent years and quarters. We have the ability to make important investments to support long-term growth and consider external investment opportunities. Today, we see a stronger M&A pipeline than we have since before the pandemic and remain focused on analyzing potential targets that could open up new end markets, offer complementary product expansion and extensions, develop new relationships with potential blue chip customers, and possibly add new geographies. Above all else, strategic fit, and rational valuation are the top considerations when considering opportunities, and we continue to review and pursue logical potential deals. Our recent performance and current outlook on the business all remain very positive. As we address the supply-related challenges and manage the strong demand trends that we are seeing in virtually all of our end markets, These trends are set to continue in the second half of this year. I'd now like to turn the call to Todd to discuss our financial results in more detail. Todd? Thanks, Bob.

I'll begin with a look at our second quarter financial performance before providing commentary on balance sheets, liquidity, and guidance. As we noted in our press release, we recorded second quarter net sales of $120.2 million as compared to $62.6 million for the same prior year period. The approximate 92% increase was primarily driven by higher sales volumes due to the strengthening market conditions in 2021 versus the prior year. In addition, the lack of operational shutdowns and issues related to the COVID-19 pandemic, which impacted our customers most heavily in the second quarter of 2020. Manufacturing margins were $16.3 million for the second quarter of 2021, as compared to a loss of $1.2 million for the same prior year period. an increase of approximately 1,500%. The increase was driven by the aforementioned sales volume improvements, the utilization of investments in new technology and automation, and the permanent cost reduction in overhead costs and related prior year restructuring costs of $1.8 million following the closure of our Greenwood, South Carolina facility. These improvements were slightly offset by the lag in contractual raw material price increases incurred in the current period. which we expect will be recovered in the near term. Additionally, the company incurred $0.1 million of the expected $3.5 to $5.1 million of launch costs related to the new Hazel Park, Michigan facility for our new customer in the fitness equipment market. Manufacturing margin percentages were 13.5% for the second quarter of 2021 as compared to a negative 1.8% for the three months ended June 30th, 2020. an increase of approximately 1,500%. In line with the higher sales volumes and permanent cost reductions associated with our cost optimization initiatives, incremental quarter-over-quarter manufacturing margins were 30.3%. Profit sharing, bonus, and deferred compensation expenses were $3.2 million for the second quarter of 2021, as compared to $1.2 million for the same prior year period. The increase was primarily driven by the return of discretionary retirement benefits and bonus accruals as business activity and sales volumes continue to move towards pre-pandemic levels. Other selling, general, and administrative expenses were $5.4 million for the second quarter of 2021 as compared to $4.6 million for the same prior year period. The increase is due to higher salary and payroll expenses in addition to higher travel and entertainment expenses, which were artificially low in the prior year period due to the COVID-19 pandemic. Interest expense was $0.5 million for the second quarter of 2021 as compared to $0.6 million for the same prior year period. The modest decrease is due to lower borrowings in the current period and comparable interest rates to the prior year. For the second quarter of 2021, income tax expense was approximately $1 million on pre-tax income of $4.3 million. Our federal net operating loss care report was approximately $12 million at quarter end which was driven by pre-tax losses incurred in prior years. The NOL does not expire and will be used to offset future tax earnings. We continue to anticipate a long-term effective tax rate to be approximately 26% based on current tax regulations. Adjusted EBITDA was $14 million for the second quarter of 2021 as compared to $2.3 million for the same prior year period. Adjusted EBITDA margin percent increased by 810 basis points to 11.7% in the current quarter, as compared to 3.6% for the same prior year period, and represents an incremental margin of 20.4%. Our adjusted EBITDA margin and margin percentages were impacted by the lag in contractual raw material price increases passed along to our customers. Removing this effect of the contractual lag, our incremental quarter-over-quarter adjusted EBITDA margin percentage would have been 30.6%, as compared to our historical average of 22.5%. Now let me address our capital expenditures, balance sheet, and liquidity figures. Capital expenditures were $11.4 million for the second quarter of 2021, as compared to $1.3 million for the same prior year period. The increase, which was in line with our 2021 budget, was driven by our continued investment in new technology and automation and $5.3 million of spending to support the production ramp-up for our new strategic customer, and the fitness equipment market. Continue to expect our four-year capital spend to be in the range of $55 to $65 million, which includes the $35 to $45 million of investment needed to support the Hazel Park addition. As of the end of the second quarter of 2021, total outstanding debt, which includes bank debt and capital lease obligations, was $46.2 million, as compared to $77.5 million at the end of the second quarter of 2020. The nearly $31.3 million debt reduction results in our leverage ratio dropping to one times based upon a trailing adjusted EBITDA of only $46.1 million, which is substantially lower than the 2.4 times in the second quarter of 2020 and significantly lower than our covenant threshold of 3.75 times. Now I'd like to discuss 2021 guidance. Based on our recent performance, the overall economic climate and the broader industry industry and market trends, we are slightly modifying our guidance provided last quarter. Due to the impact of increased material price pass-throughs, the company now expects sales to be between $470 million to $490 million, up from the previous range of $450 to $470 million, while adjusted EBITDA is expected to be between $48 million and $52 million, which has narrowed from the $46 to $52 million and continues to include the $3.5 to $5.1 million one-time launch cost relates to our expansion into the fitness equipment market. The momentum we have built in the recent quarters appears set to continue in the second half of this year. With that said, please remember that our outlook assumes our end markets remain stable, supply chain constraints do not dramatically worsen, and that business activity as a whole continues to trend positively. In addition, please note that our manufacturing and adjusting even margin percentages may be diluted upwards of 150 basis points due to the impact of contractual raw material price increases that contribute to our top-line sales but provide no margin dollars that they are simply passed through to our customers. Despite this short-term impact, we remain confident in our ability to deliver 15% adjusted EBITDA margins when production volumes return to pre-pandemic levels. Finally, we couldn't be more pleased with our current financial health. And I'd like to thank everyone on our team for working diligently to ensure we are in a position to succeed going forward. We are focused on making the right investments and building out the Hazel Park, Michigan facility so we are ready to ramp up production for our new strategic customer as planned in early 2022. With that said, I will turn the call back over to Bob for closing remarks.

Thank you, Todd. Thanks to the strong work ethic and focus on safety of MEX employee shareholders, We are in a solid position today as our business and the world continues to rebound from the pandemic-related downturn last year. While demand trends are all showing green, we are being limited by the various supply chain, people constraints, and price inflation that will continue to impact MEC and our customers and the overall economy for the rest of 2021. We are navigating through these headwinds and our wealth position over both the near and long term to drive improvements and expand our market leading position. We are pleased with our results for the first half of the year and our outlook holds well for the second half of 2021 and beyond. With this said, I'd like to open the call for questions. Operator?

Yes, thank you. At this time, we will begin the question and answer session. To ask a question, you may press star, then one on your touchtone phone. If you're using a speakerphone, please pick up your handset before pressing the keys. To withdraw your question, please press star, then two. At this time, we will pause momentarily to assemble the roster. And the first question comes from McDobrie with Baird.

Good morning. Good morning. Thank you for taking the question and for all the helpful detail already provided. I guess I want to start with the discussion on supply chain and sort of what you're seeing from your customers. You highlighted disruptions to their production schedules, which obviously we've been hearing about that throughout earnings season. You don't expect things to get worse, but I'm sort of curious as to, first, is there a good way to kind of quantify what the impact on your business might have been in the second quarter from these changes in production schedules. And then, do you expect your customers to be able to make up production either in the third quarter or the fourth quarter?

Sure. I guess on the first question, Mig, there was, I won't say it was minimal, but it wasn't that big of an impact on us. It would have helped certainly our results for the second quarter had we not faced some of those issues and I think people would have been more pleased with our results than they already are. But on the supply side and I guess what we see happening, we do think that it's stabilizing. We think there are better days ahead, especially on the employment side. as some of the federal assistance goes away on the unemployment benefits and school begins and healthcare or daycare for children and schools are open again. So we're looking forward to better days there. I think the worst part is behind us. So that's the people part. On the supply side, certainly that helps our other domestic suppliers become more capable of fulfilling their obligations to our customers. On the import side, I think our ports are getting better for bringing product in, but they're not where they should be yet. So they'll be, and I'm not certain on how that one's going to shake out. From our customer standpoint, I think they are looking forward and they will want to be able to make up that volume it will depend on these headwinds as to whether they'll be able to do so.

Okay. Then, you know, in your updated outlook, I'm trying to figure out here if we should be thinking that revenue here is up sequentially and do you expect normal seasonality into the fourth quarter or sort of how do you have things kind of planned out for the rest of the year from a revenue standpoint?

Yeah, I would say we're looking at a solid second half. I think the resources and output that we've shown we're capable of doing in the first half will continue and maybe modestly up a bit in real output, not price-adjusted output. So we see our output improving, and there being largely the material cost adjustments going into those revenue increases. And with that, very modest accretion to earnings because of that.

But, you know, are you able to maybe parse out the third versus the fourth quarter? I'm just trying to think as to how we should be thinking of revenue sequentially here. If it builds in the third quarter and then slows down into the fourth, with holiday shutdowns, or is there a different way that you might be thinking about this?

When you look at third and fourth quarters, really it builds a little bit because of the price pass-throughs that happen in the third quarter. It really stabilizes. When you look at third and fourth quarters, they're very much very similar from a top-line sales perspective, other than when you take out the impact in the fourth quarter. for the holiday shutdowns. So really that production is very much stabilized in the back half and very consistent.

Understood. Then last question for me. If I'm looking at your top line guidance, I just want to make sure that I understand the $20 million raise. How much of that was this pricing pass through that you're talking about relative versus maybe some of the end markets themselves? performing a little bit different than what you previously expected. Thank you.

Yeah, so on that $20 million lift, we would say about approximately two-thirds of that was related to price pass-through. Some of it is just strengthening market conditions.

Okay, thank you. And the next question comes from Andrew at Capital Woods with Citi.

Good morning, Andy. Hi, this is Aton Buchbinder on for Andy. Good morning.

Good morning, Aton. Good morning.

Similar to your new fitness customer, have you seen further demand from both old and new customers to localize their supply chain during Q2? And how much runway would you say that a potential reshoring trend has to go?

Yeah, I think we continue to see opportunities there, obviously. supply chain constraints both domestically and globally cause the customers to reevaluate their situation. So I can't really put a number on what that means, but I can say we continue to pursue additional opportunities both on an outsourced basis domestically, but then also as you think about reshoring, onshoring for folks that are using an international supply chain.

That's helpful. And you've previously mentioned potential opportunities regarding warehousing and packaging. So what are you seeing in terms of that business potentially contributing to revenue over the coming quarters?

Yeah, I mean, it was, I guess, a couple years now or at least a year and a half that we brought on some new customers in that space, which continue to grow. We haven't necessarily highlighted those in our past few calls, but definitely continue to build strength in the market and Overall, when we think about the impact of just the change in consumer spend and the goods, it's good for our commercial truck market. When you think about freight movement, those all have to sit in cross-docs, warehouses, et cetera, and the two end up kind of being tied together. So we feel good about the customers we have. We also see additional opportunities in multiple ways. It could be in the automation within the consumer. the conveyors and warehouses themselves to carts and many other things. So we're optimistic in the future that that will continue to grow for us.

Thanks. And one last one, if I can. Given the impact of lagged price realization and ramping launch costs, how are you thinking about the cadence of margin in Q3 and Q4?

So margins in Q3 and Q4 will have that same drag effect on. We think the dilution, like I stated, about 150 basis points compared to our normal sort of run rate. So that is going to have a little bit of a dilutive effect in the third and fourth quarters. So I do expect it to be slightly beneath where we were in second quarter. But again, with timing, I think we could improve upon that.

That's helpful. Thank you very much. I'll pass it along.

Thank you. Thank you. Thank you. And the next question comes from Larry DiMaria with William Blair.

Hey, thanks. Good morning, everybody. Good morning, Larry. So, obviously, reiterated your 15%, you know, you've been adjusted to that margin target on the sales return to pre-pandemic levels, which presumably happens next year. Just Wanted to understand how we go from, you know, 11% or so this year to 15%. Your confidence in getting to those numbers or, you know, just further confidence in hitting those numbers because that's obviously where, you know, expectations are. Yeah.

I guess a couple of things and I'll ask Todd to provide some further color perhaps. But our margins will be better, our direct margins and our overhead absorption. will be better with that higher volume. So there should be two factors contributing to that improvement. It also depends on where raw material prices sit. If raw material prices remain high, we pass that along, but we don't pick up additional margin on that. So that has its own impact on that. It's had its impact in the second quarter plus the lag, and we'll have the same ramifications in the second half.

Yeah, so as Bob mentioned, you know, when you think about pre-pandemic levels in 2019, we were at $520 million, and we've all talked about that 15% occurring once we reach that sort of level of volume. And when you think of today's material pricing, if you were to push that back into 2019, that would have created about $40 million of additional sales, right, with no further bottom line improvement. So really it's that production volume. So when you look at our estimates this year at $470 to $490, we're still well beneath our pre-pandemic run rate from a production standpoint when you think of that overhead absorption and that favorable impact. So this quarter, because of that lag, we had a very large step up in material prices from Q1 to Q2. There'll be a modest increase in Q3, and the expectation is the stabilizer will come down in Q4. We took the bulk of that kind of margin, I'd say, impact in the second quarter, and when you compare that back to 2019, we stabilized that. Again, it's a short-term impact. We're very confident, a couple of material pricing stabilizing with the overhead absorption and the cost reductions we've already done, that we have that pathway to 15-plus percent.

Right, and I can appreciate that. That's kind of my point, is that we're targeting 15%, but if material prices don't cooperate, 50% is not going to happen. So should we be thinking about an absolute number next year of $90 million or more is a better bogey to think about, considering material costs could be so volatile?

Well, the material costs, if material costs stabilize and you don't see that volatility from quarter to quarter, so we won't have that quarter to quarter impact, we still can reach 15% adjusted EBITDA. Now, we need to have that kind of higher level volume, sales volume, you think of it, because, again, the material is just a pass-through. But if we were to achieve, let's say, $5.50 in sales next year, even with a higher material price, we still can achieve 15% EBITDA. We just can't have that volatility from quarter to quarter because that drags on our quarter to quarter margins, right? There's a short-term impact.

Okay. I understand that. Thank you. And then, So you're on track with the new customer supplier. Any concerns or comments with regards to are they on track? Is there a supply chain outside of you on track? Have you looked into that at all? I just want to understand how confident you are.

I guess first we're focusing internally on our commitments to the schedule, to the cost, to the preparedness. And we are right on path and on track with our expectations internally. The other things, you know, when we look into those or try to look into those, we'll stay focused on what we're responsible for taking care of and certainly keep our eye on those things. But there's nothing really to report there either. It all appears to be going as expected.

Okay. Thank you and good luck.

Thanks.

Thank you. And once more, if you would like to ask a question, please press star, then 1 on your touchstone phone. All right. As there is nothing else at the present time, this concludes the question and answer session. I would like to return the call to Bob Comhouse, Chairman, President, and CEO, for any closing comments.

Thank you. Thank you all for your time today and your continued interest in MECC. We look forward to talking with some of you later today at Jeffrey's conference. So with that, we'll say goodbye, but thanks again for your attention today. Appreciate it.

Thank you. The conference has now concluded. Thank you for attending today's presentation. May now disconnect your lines.