AirBoss of America Corp

TSX:BOS

Earnings Call Transcript 2022-Q2

[Operator]

Thank you for standing by. This is the conference operator. Welcome to the AirBoss of America Second Quarter Conference Call. As a reminder, the conference is being recorded. [Operator Instructions] I would now like to turn the conference over to Gren Schoch, Chairman and CEO. Please go ahead.

[Peter Schoch, executive]

Thank you, operator. Good morning, everybody, and thank you for joining us for the AirBoss Second Quarter 2022 Results Conference Call. I'm Gren Schoch, and I'm the Chairman and CEO of AirBoss. With me here today are Chris Bitsakakis, our President and COO; Frank Ientile, our CFO; and Chris Figel, our EVP and General Counsel.

Our agenda today will start with the highlights from our operations for Q2, followed by a brief review of our financial results. We will then open the call to questions.

Before we begin, I would like to remind listeners that our remarks today contain forward-looking statements, including our estimates of future developments. We invite listeners to review risk factors related to our business in our annual information form and our MD&A, both of which are available on SEDAR and on our corporate website.

Also, we will discuss certain non-GAAP measures, including EBITDA. Reconciliations of these matters are available in our MD&A. And finally, please note that our reporting currency is U.S. dollars.

With that, I'll now turn the call over to Chris Bitsakakis for the operational review.

[Chris Bitsakakis, executive]

Thank you, Gren, and good morning, everyone. I'll start today by covering off our Q2 results and will provide an outlook of what we are seeing throughout our various business segments as we advance into the second half of 2022.

In aggregate, our 3 business segments continued to operate in a very challenging environment, fueled by hyperinflation, supply chain disruptions and labor constraints. Our focus on operational effectiveness and driving cost efficiencies remained strong in Q2 as we continue to do this. We've become much more resilient and able to adapt as effectively as possible to the market challenges we continue to face.

Many of our customers and supply chain partners, including the automakers and others, are actively dealing with significant supply chain issues, chip shortages, freight delays and logistics challenges, raw material shortages and cost inflation for both goods and the personnel needed to get the job done. Our consolidated decline in profitability as compared to the corresponding quarter in 2021 was driven mainly by a reduction in revenues within our AirBoss Defense Group due to the delayed timing of new contracts as well as the impact of continued cost pressures that were felt across our Engineered Products business segment.

Underlying the Q2 results, I want to highlight the continued successes within our Rubber Solutions business. Our team within ARS delivered excellent contributions to revenue and gross margins in Q2 on the back of new product offerings and advancements in our compounding capabilities.

Focusing in on AVG's results in Q2, revenues compared to Q2 of 2021 declined as our work to deliver powered air purifying respirators to the U.S. Department of Health and Human Services, or HHS, ended in April of last year. Despite this variability in contract activity driven by sourcing delays with our largest customers, we believe our track record of successfully fulfilling large-scale supply agreements continues to position us to reach into new clients in the healthcare space and to secure new sales agreements that we're actively pursuing in our sales pipeline, which on an aggregate basis within AirBoss currently stands at approximately $1.5 billion.

At AirBoss Defense Group, we are focused on continuing to build up the breadth of our survivability platform, targeting both military and healthcare end markets as the main driver of more consistent revenues. ADG's current proprietary product portfolio is being organically supplemented with new products, including its Blast Gauge system, which is a lightweight wearable blast overpressure sensor designed to detect and protect soldiers from traumatic brain injury. Blast Gauge, along with other new products in development, have the potential to drive significant and new recurring revenue streams as they begin to gain traction.

In addition to the development of new products, we retain our demonstrated ability to execute against large long-term framework agreements. We have proven our ability to supply large government health and safety-related contracts on time, on budget and from domestic production facilities. Given the mission-critical nature of the products we supply, these are valuable skills that enhance our ability to compete for and win new business.

Moving next to AirBoss Rubber Solutions, or ARS. We continue to reap the benefits of our investments in this business, which have been focused on upgrading equipment, increasing our compounding capabilities and extracting maximum value of our acquisitions, which includes our purchase of Ace Elastomers, which we completed in mid-2021.

Within Q2 of 2022, ARS saw strong year-over-year increases in volumes as we capitalized on our expanded scale and global supply chain management expertise to bring on new customers. We see strong potential for the R&D investments we're making within ARS to support new product development collaboration with our customers and create new sales opportunities. Looking longer-term, our strategy for ARS remains intact. We plan to grow this segment of our business by leveraging our large-scale efficiencies in support of our new position as the supplier of choice in higher-margin specialty and color compounding.

In our Engineered Products segment, or AEP, we have continued to focus on our operational improvement plan while making every effort to secure price concessions on existing automotive contracts. These contracts have been adversely affected by the extreme hyperinflation environment, coupled with significant labor issues and turnover in addition to the sales challenges related to customer slowdowns due to the chip shortage and other supply chain constraints. Management is addressing these challenges head on through margin improvement strategies, which target cost management; enhancing our product pricing with new raw material indexing and investing in our manufacturing to lower our long run production costs.

The segment also continued its focus on diversifying its product lines to support expansion to sectors adjacent to the automotive space. As an additional element, we're working closely with a top-tier advisory services firm to optimize pricing strategies with our key customers with the goal to regain our ability to profitably run this business. Across each of our 3 segments, as we pursue strategies to deliver organic growth, we continue to assess possible M&A opportunities, which can offer new ways to strengthen our supply chain positioning, bring additional diversity to our product portfolio and customer base and expand our businesses into new sectors.

Looking ahead, we believe we're well-positioned to continue leveraging our investments as we work to convert our pipeline even as conditions in our main markets remain challenged. For ADG, we believe market conditions favor our expanded product portfolio and manufacturing capabilities. Our priorities are to secure new contracts to deliver PPE consumables and protective military equipment to our customer base and to continue innovating to develop new survivability solutions for defense and first responder applications. We will continue to seek out strategic acquisitions that strengthen the value of our ADG platform.

For ARS, we're focused on building on our current sales momentum, deepening our product lineup and improving our margins. Our expanded compounding capabilities have supported strong performance for ARS to date in 2022 and position us well to keep growing this business. As well, we'll continue to opportunistically assess acquisitions as a possible source of new incremental revenue streams.

For AEP, we are focused on regaining profitability through new product innovations, prioritization of higher-margin products, capturing operating efficiencies and, most importantly, working with our customers to reestablish mutually beneficial relationships. As well, we know that exposure to new industries has the potential to bring us important diversification benefits and will offset the supply chain risks being faced by many users of our products.

In summary, throughout our business, our opportunity pipeline remains at record levels, and we're looking forward to successfully securing and executing on new sales agreements in 2022 and beyond.

With that, I'll now pass the call over to Frank for the financial review. Frank?

[Frank Ientile, executive]

Thank you, Chris, and good morning, everyone. As a reminder, dollar amounts discussed today are U.S. dollars. Percentage growth figures are for Q2 '22 versus Q2 '21 unless otherwise noted.

Focusing first on our top line, external net sales decreased by 6.7% to $110.5 million on a consolidated basis, largely due to delivery of PAPRs and nitrile gloves to the U.S. HHS in the corresponding quarter in '21. Underlying these results, we continued to see strong contributions from growing sales volumes within our Rubber Solutions business segment in Q2. Consolidated gross profit decreased to $14.8 million, which represented gross margins of approximately 13.4%, driven primarily by a shift in product mix in ADG and also the market conditions Chris referenced earlier, which include cost increases for labor, freight and raw materials and the elimination of government wage subsidies. Improved contributions from Rubber Solutions were a positive offset to the trajectory of our gross profit.

Adjusted EBITDA decreased to $10.5 million, with the decline in gross profit, partially offset by lower operating expenses from lower stock-based compensation and selling costs. As a percentage of sales, operating expenses for Q2 '22 declined to 8.9%, which was down from 11.2% in Q2 '21 and from 12% in Q1 of this year. Adjusted profit was just under $2.5 million, or $0.09 per diluted share compared to $18.5 million, or $0.65 per diluted share in Q2 of '21. Again, this decline as compared to Q2 last year was mainly due to the delivery of respirators and nitrile gloves to HHS that were recorded in Q2 of '21 and also from higher effective tax rate for Q2 this year, partially offset by lower operating expenses.

Turning to our individual segments. ADG's net sales decreased to $25.8 million, a decline of 54.5% due to the execution of the HHS contract in Q2 of '21. Gross profit at AirBoss Defense Group decreased to $9.8 million, with the decrease driven by the decline in sales due to HHS contract in '21, cost increases for labor, freight and raw materials, a shift in business mix and the elimination of government wage subsidies.

Net sales at AirBoss Rubber Solutions increased to $63.2 million, a 51% improvement over Q2 of '21. The sales increase in ARS extended the strength we saw in this segment in Q1 this year and was driven by strong business momentum in the majority of sectors in which our customers operate despite continuing supply chain challenges related to raw material supply and elevated freight and labor costs. Gross profit at ARS increased by 78% to $9.8 million. Gross margins in ARS improved to 15.5%, and this was driven by our focus on high-margin product offerings and increased tolling and non-tolling volumes as well as overhead cost containment initiatives.

Net sales in AEP declined by 2.8% to $26.8 million in Q2 of '22 due to lower volumes in our SUV, light truck and minivan platforms as compared to Q2 of '21. Our sales relationships with the Tier 1 OEMs continued to feel the strain, with global electronic chip shortages serving to suppress industry production volumes. Gross profit at AEP declined to negative $4.7 million in Q2 of '22. This was primarily driven by the elimination of government wage subsidies along with supply chain challenges facing our major customers, continued labor challenges and partially offset by operational cost containment initiatives.

In Q2, free cash flow was approximately $7.7 million, and cash generated from working capital was $5.6 million. The working capital inflows was due to a reduction in trade and other receivables and offset by a decrease in payables. CapEx, including intangibles, was approximately $2.2 million in Q2, primarily focused on growth and sustainability initiatives. CapEx has been approximately $14 million over the trailing 12 months.

Our balance sheet and liquidity continues to support internal growth investments as well as opportunistic M&A. As at June 30, '22, a total of $148 million of our $250 million credit facility remains available. Our net leverage at the end of Q2 '22 was 1.29, which is within the debt covenants in place with our lenders.

Operator, that concludes our prepared remarks this morning. We would now like to open the call to questions.

[Operator]

[Operator Instructions] Our first question comes from Yuri Lynk of Canaccord Genuity.

[Yuri Lynk, analyst]

Maybe this is for Frank. Just on ADG, this was obviously the first quarter in a while that didn't have any large orders in it. And wondering if that 24% EBITDA margin is a good run rate for quarters such as this? Or was the mix advantageous in the quarter?

[Frank Ientile, executive]

Yes, Yuri. Definitely mix was advantageous in the quarter, including some improvements on our industrial business, which is similar to what we've seen on the ARS side. So I'd suggest that it was very strong, but mix played a big part of it.

[Yuri Lynk, analyst]

And can you quantify that, or in terms of benefit you might have seen?

[Frank Ientile, executive]

Yes, I think it's difficult to articulate; although I would say that, if you look at sort of pre-COVID levels, that's more the run rate that we would see in the ADG segment.

[Yuri Lynk, analyst]

Second one for me. I just want to follow up on engineered products. Negative gross margin in the quarter. I understand you've got a number of initiatives to try to turn this around, but the numbers are going in the wrong direction. Just how long are you willing to carry these losses before you take more dramatic action?

[Frank Ientile, executive]

Not very much longer, Yuri, to be honest with you. We've taken an additional step now this summer because, up until now, we've been negotiating very aggressively with our customers. As you know, the automotive contracts are very restrictive, and they don't allow for this kind of passing on of cost increases because it's not just material cost increases. We've seen massive increases in the material, massive increases in freight, massive increases in labor and massive turnover as it relates to retraining new people in this new climate. So being able to pass those on has been extremely challenging. And as we've been working with the purchasing teams, we've had some limited success. We've been able to get from most of our customers some concessions as it relates to some portion of the raw material because they are protected by their contracts. They basically have a very strong negotiating position.

So in many cases, we have to take what we can get, but it's never enough. And it's normally just on raw material. When it comes to freight and labor, we've been unsuccessful in getting those through our purchasing channels. And so we've hired a top-tier advisory services firm that specializes in these types of aggressive negotiations with customers to make sure that we are getting what we need to stem the losses here.

So we're quite concerned about it, but we are taking much more aggressive action as we speak to try and get our customers on board to making sure that they're paying for what they're getting. Our steel costs have gone up 300%. Our rubber costs have gone up. Freight has gone through the roof, as you know. Before because the pandemic, a container of anything from Asia to North America is $5,000. Now it's $25,000. We've had incredible turnover rates in our people, which require new training. And so our customers are going to have to come to the table and work with us in order to find a way to make this a more viable business.

[Yuri Lynk, analyst]

I guess if they don't, is there anything in your contracts that would stop you from just not selling to them? Or are you obliged to provide a certain amount of volumes?

[Frank Ientile, executive]

Contractually, we're obliged to provide those volumes. How aggressive we take and how much we threaten the interruption of those volumes has also long-term implications as well as short-term implications. But at this point, given what we see, every single option is on the table.

[Yuri Lynk, analyst]

Yes. I don't have to tell you, your EBITDA would have been about 60% higher, right? You guys know where you stand on that.

[Operator]

Our next question comes from David Ocampo of Cormark Securities.

[David Ocampo, analyst]

My first few questions are for Frank. You mentioned it in your prepared remarks, but I didn't necessarily see it in the filings. I was just curious what the reversal of the stock-based compensation was that's embedded in that $10.5 million of EBITDA.

[Frank Ientile, executive]

Yes, Yuri (sic) [ David ], it was $4 million of stock comp that was in that number.

[David Ocampo, analyst]

And Frank, when I take a look at where the inventory is today, it does look elevated versus historic norms. I think that's because you guys probably have a little bit of nitrile gloves that you're carrying on your balance sheet just because the HHS contract was ended a bit early. Can you confirm that?

[Frank Ientile, executive]

Yes. Absolutely. There's definitely carryover gloves there, which is what's driving a little bit lower of the free cash flow conversion, but we're very focused on converting that in the coming quarters as well and working down our cash conversion cycle.

[David Ocampo, analyst]

Do you guys have a sense that there's demand from customers, or could you potentially use this in another RFP with HHS, going forward?

[Peter Schoch, executive]

There is demand with customers, and we're working with some potentially large ones at the moment.

[David Ocampo, analyst]

And then my last one is just on Rubber Solutions. You guys had a pretty good lift in volumes. And I know you guys significantly expanded your capacity in 2019. So have you backfilled most of that capacity now? Or is there still more runway to go? I guess I'm just trying to get a sense on how much growth is left in the tank before you guys need to put more capital to work.

[Chris Bitsakakis, executive]

Yes, we haven't backfilled all of it. We still have some open capacity on the color mixing line that we installed in Kitchener. And we have pockets of capacity still available for growth. The second mixing line we put into Scotland Neck still has about 1/3 of that capacity available. So we're not kicking off any new capacity expansion yet until we get closer to that to that 80% or 90% point. So there's still some room to grow, but the team has done a good job getting the right kind of business for those capacity investments.

[Operator]

[Operator Instructions] Our next question comes from Jessica Zhang of CIBC World Markets.

[N. Zhang, analyst]

Just I guess a couple of my questions have been asked. I guess I had one on ADG, and I know contract timing has been very ambiguous. But could you guys maybe give us an update? What are you hearing from the administration? And any update that you could provide us in terms of timing? What are you seeing?

[Peter Schoch, executive]

We continue to hear optimistic sounds about timing for a lot of things, but we've been hearing those for a while now. I guess on a good news basis, we have about a little over half of what we call our opportunity pipeline is currently in firm bids awaiting the results of the competition. So we are expecting some awards this quarter, and they could be significant. On the bad news side, the Level 4 ground, which was the huge contract potential the government published last November, has been delayed from this fiscal year to next fiscal year for the government. Now, I'll remind you that their fiscal year is September 30. So for various reasons, they didn't get the money in this fiscal year spent on that because other things popped up that had priority. However, they have told us that it's definitely going to be in next fiscal year and that is a very, very large opportunity.

So I guess the bad news is that we haven't got it yet, and it's not happening before the end of September. The good news is that it hasn't gone away, and it's still going to be there for next year, hopefully.

There was another $900 million program that we are bidding on for another product, which also slipped from this year to next year fiscally. So probably well over $1.5 billion slipped from fiscal '22 to fiscal '23. Having said that, we still have another $800 million or so currently in firm bids.

[Operator]

Our next question comes from Michael Robertson of National Bank Financial.

[Michael Storry-Robertson, analyst]

I just had one follow-up on the inventory front. Frank, you spoke to some of those dramatic raw material input costs. And I was just wondering if you could maybe ballpark or quantify how much of that sort of elevated inventory you're carrying right now would be to carryover versus just the impact of those rising costs?

[Frank Ientile, executive]

Yes, it's a good question. It's a difficult one to understand because obviously, as Chris mentioned in his part of the call, the raw material price increases have been more than double-digit in many of our core commodities, which is significant. And that's obviously been driving it, but we're obviously keeping a close eye on that. And in the case of ARS, we are doing the indexing for flow-through. As it relates to the nitrile gloves, again, we did have some carryover from the original contract that we're very comfortable right now that we're working towards moving that down. And I'd say it probably represents 20% to 30% of a historical run rate on our inventory, that would be moving.

[Michael Storry-Robertson, analyst]

So could you maybe provide some commentary around how you sort of see that trending over the coming quarters? I know it's tough with how much prices have been fluctuating, but you have a sort of ballpark run rate figure where you would expect those inventory levels to sort of plateau, I guess?

[Frank Ientile, executive]

So I'd say we're at the height, and it's going to only go down from here going into the end of the year, subject to any inventory build on new awards, which obviously will then tie up working capital as we continue to convert on new contracts.

[Peter Schoch, executive]

Just one other comment is that, because of the supply chain issues and shortages, particularly in the ARS side, we have been running higher inventory levels than normal just to make sure that we've got the material on hand. I mean just-in-time doesn't really work in this kind of an environment.

[Operator]

This concludes the question-and-answer session. I would like to turn the conference over to Mr. Bitsakakis for any closing remarks.

[Chris Bitsakakis, executive]

Thank you, operator, and thanks again to everyone for attending today's call. Please reach out to us directly or through our IR team if you have any questions on our results or in general. Thank you very much. Goodbye, and have a great day.

[Operator]

This concludes today's conference call. You may disconnect your lines. Thank you for participating, and have a pleasant day.