Stoneridge, Inc.

Ladies and gentlemen, thank you for standing by and welcome to Stone Ridge third quarter 2020 conference call. At this time, all participant clients are in the listen-only mode. Later, we will conduct a question and answer session and instructions will follow at that time. If anyone should require assistance during the conference, please press star zero. As a reminder, I would like to hand the conference over to your speaker today, Matt Horvath, Executive Director, Investor Relations and Corporate Strategy. You may begin.

Thanks, Boo. Good morning, everyone. Thanks for joining us to discuss our third quarter results. The release and accompanying presentation was filed with the SEC yesterday evening and is posted on our website at sonrich.com in the investor section under webcast and presentations. Joining me on today's call are John DeGainer, our President and Chief Executive Officer, and Bob Krakowiak, our Chief Financial Officer. Before we begin, I need to inform you that certain statements today may be forward-looking statements. Forward-looking statements include statements that are not historical in nature and include information concerning our future results or plans. Although we believe that such statements are based upon reasonable assumptions, you should understand that these statements are subject to risks and uncertainties, and actual results may differ materially. Additional information about such factors and uncertainties that could cause actual results to differ may be found in our 10-Q, which has been filed with the Securities and Exchange Commission under the heading Forward-Looking Statements. During today's call, we will also be referring to certain non-GAAP financial measures and Please see the appendix for a reconciliation of these non-GAAP financial measures to the most directly comparable GAAP measures. After John and Bob have finished their formal remarks, we will then open the call to questions. I would ask that you keep your question to a single follow-up. With that, I will turn the call over to John.

Thanks, Matt, and good morning, everyone. Before we get started, I want to take a minute to recognize the fact that we continue to be in the midst of a global health crisis, and we have and will continue to put the health and safety of our employees and their families at the forefront of every decision we make. I know that this situation has been challenging for many, and I want to thank our employees for their dedication to stoners during this period. Let me begin on page three. During the third quarter, we experienced strong top-line growth as a result of the broad recovery across our global end markets. We continued to focus on improving gross margin through reduced material costs and the efficient ramp-up of direct labor costs as production volume increased across our global facilities. We're able to leverage our fixed cost structure to capture an adjusted contribution margin of over 35% during the quarter on incremental revenue and improved gross and operating margin relative to the first quarter. We expect that revenue will continue to decline slightly in the fourth quarter, primarily due to the impacts of typical fourth quarter seasonality and be partially offset by continued strength in the commercial vehicle production volumes. Additionally, we expect continued strong margin performance in the fourth quarter. Bob will provide additional detail regarding our expectations for the fourth quarter, as well as the primary drivers of our fourth quarter guidance later in the call. Our liquidity remains strong, as we reduced net debt by over $10 million during the third quarter. As a result of our cash generation in the quarter, we were able to reduce our revolving credit facility by $17 million. Based on our current production forecast, a continued focus on inventory reduction, and efficient cash management, we expect stable net debt in the fourth quarter. Our portfolio transformation continues simultaneously with our focus on exciting new products. For example, our exit of the soot business is on track. As we outlined last year, the divestiture of our switches and connectors business to S&P facilitated the exit of our Canton, Massachusetts facility. We recently completed negotiations on a lease with a premium tenant for the building. We are working with third-party brokers to evaluate a divestiture for the building, which we are targeting for the first half of next year. During the quarter, we continue to make progress with mirror eye retrofit and pre-wire applications and prepare for our first OEM launches in 2021. I will discuss our mirror eye progress in the quarter and our expectations for 2021 in additional detail later in the call. Finally, although there was still uncertainty regarding the ongoing impact of COVID-19, This morning we are providing some additional guidance for the remainder of 2020 as well as an outlook for 2021 based on current market conditions and IHS and LMC forecasts. Page four summarizes our key financial metrics for the quarter, quarter to quarter. Due to the ramp up in production volumes in our global markets, revenue increased by 76.6% from the second quarter to the third quarter to just over $175 million. This exceeded the expectations we outlined during the second quarter call by approximately $20 million. The impact was greatest at control devices where sales more than doubled to just over $100 million due to continued ramp-up in North American production to meet the pent-up demand. This was particularly evident in light truck, SUV, and CUV platforms where control devices is more heavily weighted. Electronic sales increased to a lesser extent by approximately 48% to $74.4 million primarily due to continued ramp up in global commercial vehicle markets. Sales at Stone Ridge, Brazil increased by approximately 83% as the impact of the virus in Brazil continued to lessen throughout the quarter. Despite this significant revenue growth in each of our segments, we are still not quite back to normalized production as Q3 revenue was approximately $8 million or 4% less than Q1 revenue. Despite lower sales, our third quarter adjusted gross margin and operating – and adjusted operating margin improved by 80 and 140 basis points, respectively, relative to the first quarter. Our adjusted contribution margin exceeded 35% on incremental revenue in comparison to the second quarter, which is above our historical contribution margin and better than expected in outline during the second quarter call. We continue to focus on continuous improvement and an efficient response to the global crisis, which has resulted in strong financial performance during the quarter. Slide 5 outlines the most recent IHS and LMC information for our OEM end markets. Current market forecasts suggest that fourth quarter production will remain approximately flat for our weighted average end markets relative to the third quarter, as production moderation in North America is offset by growth in Europe. Looking forward to 2021, we expect continued recovery in our end markets as IHS and LMC are forecasting that our weighted average end markets will grow by approximately 13.5% compared to 2020. That growth is led by North American and commercial vehicle markets, where growth is expected to be 17 to 19%. followed by the North American passenger car market, where growth is expected to be approximately 17%. Turning to page 6, we expect that the forecasted recovery across our global end markets will continue to contribute to strong top-line growth in 2021. Adjusted for the discontinued sensor product lines, we expect revenue growth of at least 20% in 2021 to over $715 million in revenue. Additionally, we expect that the annualization of our recently launched Park-by-Wire programs, as well as the launch of a large global driver information systems program, our first two Mirai OEM launches, and the continued ramp-up of our Mirai retrofit and pre-wire programs will drive incremental revenue for the year. Although we are early in our annual budgeting process, we expect that the third quarter of this year will be a good representation of the cost structure we expect in 2021. In other words, based on our current outlook, it would be reasonable to use third quarter performance as a basis for performance expectations in 2021, and as a comparison point to consider contribution margin on expected incremental revenue. We continue to monitor the global business environment, particularly as it relates to COVID-19, and expect to provide detailed 2021 guidance on our fourth quarter call early next year. Turning to page seven. As we discussed on our second quarter call, During the third quarter, we completed installations that expanded the number of Mirai units with three of our fleet partners. These trial expansions are part of a standard rollout approach with many of our fleet partners. Additionally, the option to prewire Daimler truck vehicles in North America launched at the end of the quarter. This allows trucks to be delivered straight from the factory, wired and ready for Mirai retrofit. This prewire option is significant as it reduces install time and complexity in the retrofit process and signals the support of the OEM in this technology transition. Although we do not yet have specific visibility into the fleets and number of trucks being ordered with the pre-wire option, we understand that the initial pre-wire order was made by one of our long-time fleet partners with subsequent orders coming from fleets that we have not undergone evaluation periods with. This suggests that not only do our long-term partners understand the significant benefits of outfitting their trucks with MIRAI, but that the overall market is beginning to understand the significant value proposition that Mirai presents. During the quarter, we train DTNA dealers on the benefits of the Mirai system, and we expect that Mirai pre-wire orders will continue to ramp up as the benefits continue to be understood. Looking at the balance of 2020 and into 2021, we expect the continued ramp up of retrofit orders with DTNA, both inside our existing fleet network as well as from the broader market. Remember, not all fleets order trucks every quarter, so in the beginning of the pre-wire option, orders may come in lumps rather than linearly. We are pleased with the initial interest in pre-wire and look forward to supporting our existing partners and new fleets with retrofit applications as brand new trucks are delivered in the coming months. Additionally, we are working with multiple other OEMs to ensure that pre-wire options are available on more platforms to provide access to Mirai, no matter which truck a fleet prefers. Overall, we expect approximately $10 million in retrofit sales, either through pure retrofit applications or in pre-wire applications in 2021. As we expand our existing retrofit installations and support pre-wire applications, we are simultaneously focused on OEM programs. We are preparing for our initial two OEM launches of the system in both Europe and North America in 2021. We are working with each of our OEM partners to ensure strong penetration of the system through various marketing efforts, including specific fleet activities both in Europe and North America. The previously quoted penetration rates of 10% to 15%, we expect Mirai OEM revenue to be $5 to $10 million in 2021. The development of the Mirai platform has significant synergies between each path to market and each region in which we are working. We remain focused on supporting our fleet partners as they increase the number of systems installed on their trucks ensuring that we are providing the best solutions to solve their safety, fuel efficiency, and driver retention challenges. Simultaneously, we can apply the learnings from the fleets as we work with our OEM partners to develop and launch their systems on their exciting new platforms beginning in 2021 in both North America and Europe. We believe our approach provides the most efficient method of system development and refinement, as well as the fastest path to market. Turning to page eight, in summary, During the third quarter, we demonstrated strong execution as production volumes ramped back up in our global end markets and recognized strong incremental contribution margin. We continue to maintain a strong balance sheet and efficiently manage cash during the third quarter. We remain focused on our Mirai retrofit and prewire opportunities as well as our first two OEM programs. Looking forward to the remainder of the year, we expect revenue to remain relatively stable in the fourth quarter with continued strong margin performance. Looking beyond 2020, improved production forecasts and new program launches are expected to drive revenue in excess of $715 million, resulting in top-line growth of at least 20% adjusted for the discontinued SIP sensor business. We remain committed to executing on our strategic priorities and continuously improving the business to drive strong financial performance and stable, long-term, profitable growth. With that, I'll turn it over to Bob to discuss our financial results in more detail.

Thanks, John. Turning to slide 10, sales in the third quarter were $175.8 million, an increase of approximately 77% versus the second quarter. Adjusted operating income was $8.2 million, or 4.7% of sales, resulting in third quarter incremental adjusted operating margin of 35.8%, which exceeded our expectations set during the second quarter earnings call. Control devices sales more than doubled in the third quarter relative to the second quarter to over $100 million, while operating income improved to $13.3 million, resulting in an adjusted contribution margin of 36.1%. Electronic sales increased by almost 50%, resulting in sales of $70.4 million. Electronics adjusted contribution margin of 41.4% during the quarter resulted in adjusted operating income of $1.3 million or 1.9% of sales. Finally, Stone Ridge, Brazil sales increased by 83% in the quarter to $12.8 million, while adjusted operating income improved to $600,000 or 5% of sales. Although there is continued uncertainty regarding the ongoing impact of the pandemic, this morning we are providing guidance for the remainder of 2020 based on current market conditions. In summary, we are expecting relatively stable sales in the fourth quarter and guiding to a midpoint of $170 million in sales, which results in full year revenue of between $624 and $634 million. Based on current production forecasts and market conditions, estimated product mix between the segments, and our view on operating expenses for the fourth quarter, we are expecting adjusted earnings per share of negative 5 to 5 cents, resulting in full-year adjusted earnings per share of negative 22 to negative 12 cents. I will provide additional detail on the specific drivers of our 2020 guidance later in this call. Page 11 summarizes our key financial metrics in more detail and highlights the improvement in all of our key metrics, not only relative to the second quarter, but relative to the first quarter, which was only modestly impacted by the pandemic. More specifically, Direct material costs declined by 20 basis points from Q1 to 52.6% of sales in the third quarter. During the third quarter, due to our focus on the efficient ramp-up of our production facilities, direct labor declined by 40 basis points relative to the first quarter, and overhead declined by 30 basis points over the same period, primarily driven by increased leverage on fixed costs. Adjusted operating expenses, which include SG&A and D&D, declined by $2.6 million and 50 basis points relative to the first quarter of this year. We continue to focus on operational improvement and the efficient ramp up of our production facilities after the global shutdowns during the second quarter. As a result of our efforts, each of the key financial metrics outlined in this slide improved in the third quarter relative to the nearly pre-pandemic levels in Q1, resulting in gross margin improvement of 80 basis points, an operating margin improvement of 140 basis points. Page 12 summarizes our key financial metrics specific to control devices. Control devices third quarter sales were $100.9 million, an increase of approximately 108% versus the second quarter. The increase in sales was primarily driven by production ramp-ups at customer facilities in North America, particularly on light truck, SUV, and CUV platforms. During the third quarter, we saw increased production volumes as our OEM customers ran production back up to meet the pent-up demand after nationwide lockdowns during the second quarter. In addition to significantly increased sales, we saw significant gross margin improvement versus the second quarter through lower direct material and labor costs, as well as lower overhead as a percentage of sales. Our performance resulted in an adjusted contribution margin of 36.1% relative to the second quarter. This resulted in adjusted operating income of $13.3 million for the quarter, or 13.2% of sales. Given that the second quarter is an unusual comparable period, I want to point out that adjusted operating income increased by approximately $3.4 million and 310 basis points versus Q1 on similar sales levels. As we look to the fourth quarter of 2020, we expect a slight decline in sales for control devices due to more normalized due to a more normalized production environment, as well as typical seasonality around holiday production. Page 13 summarizes our key financial metrics specific to electronics. Electronics second quarter sales of $70.4 million, an increase of approximately 48% compared to the second quarter, which was primarily driven by the ramp up in commercial vehicle production volumes in both North America and Europe, offset by traditional seasonality due to European third quarter vacation shutdowns. In addition to the fixed cost leverage benefit of incremental sales on overhead during the quarter, material costs continued to decline as we focused on reducing electronic component costs for the segment. Direct material costs declined by 30 basis points in Q3 relative to Q2 and by 100 basis points relative to the first quarter. This contributed to an incremental adjusted contribution margin of over 40% relative to the second quarter. Looking forward, we expect continued revenue growth during the fourth quarter to offset some of the decline I just referenced in control devices. While we continue to focus on efficient cost management, we expect some additional engineering costs in the fourth quarter as we continue to ramp up support for the large programs that will launch in 2021. Additionally, we expect some incremental SD&A costs relative to the third quarter as a result of the reinstatement of certain wage and benefit programs as well as the normalization of certain operating expenses. Looking beyond 2020, we expect electronics to drive substantial growth in 2021, driven by the launch of a large global instrument cluster platform, the continued rollout of our Mirai retrofit and pre-wire applications, and the launch of our first two OEM Mirai systems. Page 14 summarizes our key financial metrics specific to Stone Ridge, Brazil. Stomer's Brazil second quarter sales of $12.8 million increased by approximately 83% relative to the second quarter. Gross margin declined as product sales ramped up during the quarter driving an increase in material costs. This was partially offset by fixed cost leverage leading to declines in overhead and operating expenses as a percentage of sales. Operating income increased by approximately 12% or $1.1 million relative to the second quarter which resulted in incremental operating margin of approximately 19%. Compared to Q1, operating margin almost doubled despite revenue declining by approximately 12%. Despite continued macroeconomic challenges in Brazil, we expect stable revenue in the fourth quarter and moderate revenue growth in 2021 based on current market conditions. Turning to slide 15, I would like to provide some additional color on our fourth quarter guidance and the major drivers of our expected performance relative to the third quarter. Starting with revenue, as has been the case in prior years, we expect that control devices revenue will be lower during the fourth quarter due in part to holiday shutdowns. In addition, this year we are expecting reduced revenue in the fourth quarter relative to the third as a result of the stabilization of North American passenger car production volumes. More specifically, in the third quarter, we saw increased production volumes as we supported our OEM customers as they ramped production back up to meet the pent-up demand after nationwide lockdowns in the second quarter. We are expecting a more normalized environment in Q4. In contrast, we expect that electronics revenue growth will outpace control devices due to the continued global ramp-up of commercial vehicle production. Additionally, we expect relative growth versus the third quarter as a result of the traditional European holiday in the third quarter. Overall, we expect that the reduction in control devices revenue during the quarter may not fully offset the growth in electronics in Brazil. As a result, we expect that the shift in mix from control devices to electronics during the quarter will have an unfavorable impact on operating performance. As we discussed previously, our third quarter adjusted contribution margin exceeded 35%, which is above our historical contribution margin range. During the third quarter, As a result of strong performance, as well as an improved outlook in our end markets, we reinstated some of our annual wage and benefit programs. Additionally, we expect the relative impact of the European summer holiday in the third quarter and the normalization of production expenses in Q4 to drive incremental costs next quarter. Finally, we expect additional engineering expenses as we continue to support some of the large program launches in 2021. As a result, we expect an additional $2 million of SG&A expenses and $1 million of D&D expenses in the fourth quarter relative to Q3. Despite these additional expenses expected in the fourth quarter, we expect contribution margin to be at the high end of our historical range of 25% to 30% relative to the trough during the second quarter. Finally, based on our expected revenue and earnings for the quarter, we are expecting additional tax expense during the fourth quarter. Considering these factors, we are guiding the fourth quarter adjusted earnings per share to negative 5 to 5 cents on midpoint revenue guidance of $170 million. Turning to page 16. During the quarter, net debt decreased by approximately $10.3 million in Q3, resulting in net debt of approximately $83.3 million, or 2.4 times trailing 12-month adjusted EBITDA. As of the end of the quarter, we had a cash balance of approximately $68.3 million and approximately $254 million of undrawn commitments, resulting in over $320 million of liquidity. Our ability to manage the significant ramp-up in production volume during the third quarter drove strong operating performance, resulting in cash generation of over $10 million in the quarter, which approximately offset the cash burn during the second quarter. As a result of strong cash performance, we were able to reduce the balance on our credit facility by $17 million during the quarter. Our 2020 cash flow outlook remains strong, as we expect stable net debt during the fourth quarter. We will continue to take any necessary actions to right-size our cost structure, effectively manage our cash position, and ensure a strong balance sheet. Stone Ridge remains well positioned with relatively low leverage and significant available capital. Moving to slide 17. In closing, I want to reiterate that we are pleased with the improvements we drove during the third quarter that drove an adjusted contribution margin that outperformed our historical range and exceeded our previously outlined expectations. We expect continued stable performance for the remainder of the year as we focus on the items under our control and work to offset or take advantage of externalities to drive strong financial performance. StoneAge is committed to driving shareholder value, and that focus remains at the forefront of all of our strategic initiatives. With that, I will open up the call for questions.

Thank you. Ladies and gentlemen, if you have a question at this time, please press the star and then the number one on your touch-tone telephone. If your question has been answered or you wish to remove yourself from the queue, please press the PAN T. Your first question comes from the line of Justin Long from Stevens Inc. Your line is now open.

Hey, good morning. This is George Sellers on for Justin Long. Thanks for taking the question and congrats on the quarter.

Thanks, George. Good morning, George. Thank you.

So looking at your revenue guidance, it looks like it assumes you're going to outgrow your end markets by about 6.5% in 2021. If for some reason the end markets aren't up as much as the current third-party forecasts, is that outgrowth of 6.5% still achievable? And said a different way, how dependent is that outgrowth on your end market performance?

So, George, let me answer the first piece, and I'll let Bob give some additional detail. As we talked about in the script and we've talked about many times, But 2020 was always a year of significant preparation for launches that would happen in the end of this year and in the next year. So the annualization of our Park by Wire programs, the launch of the Grabber Information System program, the launch of the two OEM near-eye programs, as well as a series of other small launches, those will all drive growth outsized to the market. But we still are... our base revenue is tied directly to our end markets. It's why we give you the IHS and LMC data. But we're really excited about the number, the organic growth that we have just with the launches that we've been driving in the last two years. Yes, George.

Thanks so much for the question. So at this time of the year, we're going through our planning process. And at this point in time, we're getting our arms around our revenue number for next year. So right now, just given the current IHS and LMC projections, you know, we feel comfortable that that 6.5% growth is a really good number for next year, you know, at a minimum. Obviously, to the extent that, you know, that things change with respect to product mix in the market or in the regions, you know, obviously then you can basically run some sensitivity, George, by looking at our sales by region and and making your own judgments around sensitivities, around volume. With the information that we give you, you can basically run your own analysis and figure out what you feel like the potential puts and takes are. But the way you're looking at it is correct, 6.5% over the market right now based on the current projections. Gotcha.

Okay, thanks. That's helpful. And then when you think about the free cash flow profile of the business headed into next year, Is there any reason why the conversion should not approximate 100% of net income?

No, there's nothing that's – so John talked about it a little bit. So we're still going through the finer points of next year, but John made the comment about we feel really comfortable that this third quarter performance is a really good proxy for next year's performance. We still have some work to do on the plan, obviously, for next year. We're early in our planning process, but initial look, there's nothing fundamentally different about the mix and about the performance and the cash flow generation of the business. Gotcha.

Okay, and then combined with your outlook, how are you thinking about share buyback activity going forward?

You know, George, we constantly evaluate the options and the uses of our capital between M&A, share repurchase, and just investing in the business and It's really not, it hasn't changed at all as a result of the pandemic. We've talked about the things that, you know, that we were going to do as a company. So we, you know, we took some aggressive actions and cut our SG&A costs, but also we have a lot of, we've got three years of record new business wins, and we're also investing, you know, we did not just kind of go pro rata across the business. We were very, you know, we were very, you know, meticulous about how we went down the path of cutting our costs to make sure that we didn't do anything to sacrifice the investments that we need to make to continue to grow this company.

Okay, great. And then lastly, if I could sneak one more in, are you anticipating any new OEM contracts related to MirrorEye in the near term?

George, I mean, we continue to talk to our OEM partners on a – regular basis. Nothing that we anticipate in this forthcoming quarter, in the fourth quarter, but we're very excited about the opportunities that we have and the way in which our customers, our OEM customers, are responding to the product and to the quality of the system that we have. We're very optimistic.

Okay, great. Thank you all for the time.

Thank you, George.

Thanks, George.

Thanks for your questions.

Your next question comes from the line of Gary Prestopino from Barrington Research. Your line is now open.

Hey, good morning, everyone. Yeah, you know, my question kind of revolves around, well, revolves around a number of things here. Number one, you know, with some of these changes in Europe in particular with the pandemic and lockdowns going down in some countries and all that, and then even what's going on in the United States at this point, Does that in any way change what you're looking for in Q4? Was it dependent on things being where they were three weeks ago?

First, Gary, thanks for your question. What we're seeing right now with the changes in lockdowns and the stuff that's in the press is, one, it's very location-specific. Typically, it's also very service-focused, if you will, bars, restaurants, and those sort of things. So at this point, we have seen no change in production. Even where it's the hottest in our regions where the COVID is changing the most, it hasn't changed our ability to run our plants. It hasn't changed our customers' abilities to run their plants. So what we're seeing is that, yes, there are increasing cases. It's been focused on congregation areas, bars, restaurants, those sort of things. And it's not been focused on really a manufacturing or production of goods. And as long as that is the case, we believe that what we're putting out there is the right way to go.

Okay. And then in terms of what your Salesforce is doing now, you know, obviously, nobody's seeing each other, nobody's traveling. I would assume they're aggressively marketing via zoom or telephonically. But beyond the programs that you've got signed up, and you're talking about how is the pipeline looking at this point, and just trying to get an idea if things have really stalled dramatically, or are, you know, better than you would have expected given the situation.

So we're not doing everything via Zoom. We are where customers will meet with us. We are going. It's gone so far as me being out at some customers where they'll meet with us. We also know that certain customers, you know, they close their doors for multiple weeks. So there are certain programs and certain sourcing decisions that were delayed, but We continue to talk to our customers. We continue to meet with our customers. We continue to do technology reviews and technology shows. And most importantly, we continue to execute on the launches and the things that we told them we would do. And we have a tremendous number of interfaces and opportunities to delight our customers. And regardless of pandemic, we're continuing to do that. And so we feel pretty good about where the pipeline of opportunities is.

Okay. Thank you. If anyone wants to ask a question, please press Tower 1. I'm showing no further questions at this time. I would now like to turn the conference back to John DeGainer.

Let me thank you all for your participation in today's call. In closing, I can assure you that our company is committed to continuing to drive shareholder value through strong operational results, profitable new business, and focused deployment of our available resources. This management team will respond efficiently and effectively to manage and control the variables that we can impact and continue to drive strong financial performance. We are confident that our actions will result in continued success for 2020 and beyond. Thank you all and have a good day. Ladies and gentlemen, this concludes today's conference call.

Thank you for participating and have a wonderful day. You may all disconnect.