AirBoss of America Corp

TSX:BOS

Earnings Call Transcript 2018-Q3

[Operator]

Good morning, and welcome to the AirBoss of America third quarter results conference call. With us, we have Mr. Gren Schoch, Chief Executive Officer of AirBoss of America; Ms. Lisa Swartzman, President; Mr. Chris Bitsakakis, Chief Operations Officer; and Mr. Daniel Gagnon, Chief Financial Officer. I would now like to turn the conference over to Mr. Gren Schoch. Please go ahead, sir.

[Peter Grenville Schoch, Chairman & CEO]

Good morning, everybody, and thank you for joining this conference call. My name is Gren Schoch, and I'm the Chairman and CEO of AirBoss. We will give you a short summary of results and then the conference lines will be opened up for questions. Before we begin, I'd like to remind you that today's remarks, including management's outlook for the remainder of fiscal 2018, anticipated financial and operating results, our plans and objectives, and our answers to your questions will contain forward-looking information within the meaning of the applicable securities laws. This forward-looking information represents our expectations as of today, and accordingly, is subject to change. Such information is based on current assumptions that may not materialize and is subject to a number of important risks and uncertainties. Actual results may differ materially and listeners are cautioned not to place undue reliance on this forward-looking information. A description of the risks that may affect future results is contained in AirBoss' annual MD&A, which is available on our corporate website, and our filings with the Canadian securities administrature -- administrators on the SEDAR at www.sedar.com. I will now turn this over to Lisa Swartzman, our President for the highlights of the quarter.

[Lisa R. Swartzman, President]

Thanks, Gren, good morning, everyone thank you for joining us. On the face of it, the third quarter of 2018 was very disappointing with consolidated EBITDA declining 16% to $5.4 million and an EPS of $0.06. Approximately, 1/3 of the decline in EPS was the result of the impact to our consolidated tax rate, as a result of US tax changes at the end of 2017 and compared to positive tax adjustments experienced in Q3 last year. The performance of our automotive business within the Engineered Products segment was primarily responsible for these results, as it more than offset the positive quarter generated by our Rubber Solutions segment and the defense business within Engineered Products. On a year-to-date basis, consolidated EBITDA was 4% lower to $19.9 million and EPS of $0.31 was $0.07 lower than 2017. In Rubber Solutions, volume increased approximately 26% for the quarter and 15% year-to-date versus the comparable periods in 2017. For both the quarter and year-to-date, the volume improvements were across several sectors and in particular, conveyor belting, tolling and track. On a year-to-date basis, the mining and off the road OTR sectors also improved, partially offset by softness in the infrastructure, third-party automotive and chemical sectors. As a result, gross profit dollars for the quarter improved 54% to $5.1 million and EBITDA dollars improved approximately 60% to $4.4 million. On a year-to-date basis, gross profit has improved -- gross profit dollars have improved approximately 12% to $16.3 million and EBITDA was $14.1 million, which is $1.5 million dollars higher than last year. We've made meaningful progress with our continuous improvements in supply chain management initiatives. Combined with higher volumes, these initiatives are responsible for Rubber Solutions' strong performance in the quarter and year-to-date and for mitigating the challenges which this business has and continues to face. For both the quarter and year-to-date, these have included continued volatility in raw material prices, higher than anticipated maintenance expenses and higher labor cost, as a result of both changes at the beginning of the year to the Ontario Employment Standards Act and training expenses related to onboarding new employees. Looking forward, the pipeline of business remains strong. In addition, on the operations side, we are on the cusp of installing a dedicated non-black mixing line and significantly improving our lab capabilities in our Kitchener facilities as well as expanding capacity in our North Carolina facility. In Engineered Products, net sales in the third quarter declined marginally to $40.6 million and on a year-to-date basis, increased approximately 7% to $130.4 million versus the same period in 2017, driven by continued improvements in defense and offset by lower automotive sales. For the quarter, gross profit and EBITDA declined to $4.5 million and $1.7 million, respectively versus the comparable periods in 2017. On a year-to-date basis, gross profit was flat at $18.4 million and EBITDA declined approximately 6% to $9.8 million. In each case, improvements in defense were offset by declines in the automotive business. Automotive sales were again negatively impacted by the previously disclosed completion of a spring isolator program as well as lower muffler hanger, dampers and boot sales. These decreases were partially offset by increased demand in bushings and induction bonding applications. The impact of increased raw material prices, particularly with respect to steel and silicone, accelerated in the third quarter and are being by exacerbated by the current tariff environment. Like other automotive suppliers, we are engaged in constructive conversations with our customers to obtain relief from the negative impact of these higher costs. The labor market also remains extremely tight, which is resulting in both higher turnover than previously experienced and difficulty replacing and supplementing with the caliber of talent we're seeking. There is an enormous amount of work being done by our management team in our Automotive business, and although 2018 has and will continue to be challenging, we expect tangible results in 2019. Net sales in defense continued to improve in the third quarter, increasing approximately 26% and by 58% on a year-to-date basis. Driven by increases across the majority of our suite of product, but particularly in filters, masks, shelters, powered air purifiers and overboots. And they were partially offset by a decline in gloves, which will pick back up again starting in the fourth quarter, as we begin deliveries on our previously announced award. Underpinned by the aggregate $122 million in recently announced awards, the outlook for the defense business remains strong for the foreseeable future, although some level of uncertainty as to the timing and size of orders under the existing contracts and new tenders continue to exist. As we look forward to the remainder of the year and into 2019, we're encouraged by the positive changes we've made in certain areas of our businesses, and we recognize there's much work that remains in front of us, particularly in our Automotive business. We remain firmly focused on operational execution and efficiencies to ensure we have the platform in place to pursue the opportunities before us. With these initiatives, combined with management's ongoing efforts to expand and diversify our product line, customer base and target market segment, we believe we're in a strong position to take advantage of growth opportunities and will be able to adapt well to any further market volatility. Thank you, and I'll turn it back to Gren now.

[Peter Grenville Schoch, Chairman & CEO]

Thank you, Lisa. I think we'll just go to questions and do the summary at the end.

[Operator]

[Operator Instructions] Our first question is from Nav Malik with Industrial Alliance.

[Navdeep Malik, Research Analyst]

I just want to maybe focus a bit on the auto side, particularly the margins there. I guess, you kind of alluded to it in your remarks, but what's the likelihood or the process now, in terms of maybe raising prices to customers or passing along some of those cost increases?

[Peter Grenville Schoch, Chairman & CEO]

I let Chris take that question.

[Chris Bitsakakis, COO & President of Rubber Solutions Division]

So we have engaged immediately with our customers as this whole tariff environment started to hit. In fact, you know it was brought forward, it was originally going to be, at least the second hit was going to be on January 1, it was brought forward to a few weeks ago. So we immediately sent letters to all of our customers, engaging with them immediately on the exact impact by park number for their product lines. We have set up meetings with each of these individual customers. I'd personally met with our largest customer that is being impacted by this. And up until now, we are getting, at least in the beginning, we were getting quite a few delay tactics, which I think we are through now. They've requested a whole bunch of information. We've provided the information, we are engaged constructively in negotiations with them. And up until now, they have shown willingness to work with us on getting some relief in this area, but we're not finalized on those negotiations yet. But so far, we are, although moving a little bit slower than we had hoped, and we -- but we would expect that, given the magnitude of the issue, but of course, they are getting this from their entire supply base, and we are in there negotiating to get relief. And so far, it looks like they are willing to do it but we don't have any concluded negotiations yet.

[Navdeep Malik, Research Analyst]

Okay, fair enough. So it's safe to say, probably your fourth quarter will continue to be impacted, like it wouldn't be until more like next year, before you start to see some ability to actually raise prices? Or to implement the price increase?

[Chris Bitsakakis, COO & President of Rubber Solutions Division]

We expect to conclude the negotiations in the fourth quarter, at least that's our drive. We also are driving to get some retroactive relief. However, because it's a negotiation, I'm not sure if we're going to be successful in that area. So I guess, at this point, I would suspect that we'll see the relief beginning in Q1 of next year.

[Navdeep Malik, Research Analyst]

Okay. And then, I guess, in terms of -- staying on the auto side, in terms of the revenue decline, what -- how are -- in terms of initiatives to introduce new products or to grow the top line, what -- where are you at on those initiatives?

[Chris Bitsakakis, COO & President of Rubber Solutions Division]

Yes, so I think the revenue decline in Q3 was a little bit unique in that we have a traditional shutdown in July and because there was a changeover in one of our product lines, that shutdown, which was quite a driver for us, was a little bit extended. So it dropped our sales in Q3 more than what we had anticipated as it was sort of a last-minute decision from this particular customer. So -- but going forward, we are launching several new products that are already in queue. And so we don't see that decline going into 2019. Of course, Q4 is a little bit slower normally because of the break between Christmas and New Year's. But we don't see any continued drop. We should get to back to our normal level, and we have several new products in the pipeline, including some new innovations that we've already started sharing with our customers that appear to be getting some interesting airplay. So I'm not concerned that our sales will continue to drop. I think we're going to start growing, but of course, in the Automotive cycle, it's a longer cycle than in other industries.

[Navdeep Malik, Research Analyst]

Right. So I guess, if I'm hearing correctly, so the 7% drop this quarter, probably shouldn't be -- we shouldn't sort of expect that type of drop in future quarters?

[Chris Bitsakakis, COO & President of Rubber Solutions Division]

That's right. I guess, Q4 is always a little bit lower because of the Christmas shutdown but going into next year, no, we don't expect that particular drop to continue.

[Operator]

Our next question is from Tim James with TD Securities.

[Tim James, Research Analyst]

I'm just wondering if you could comment on where things stand with the large multiyear opportunity that you had been outlining in previous quarters? Is that coming through and a significant contributor to the 26% volume growth that we saw in this quarter?

[Chris Bitsakakis, COO & President of Rubber Solutions Division]

Yes, I mean, we've been speaking about this for quite a few quarters. The interesting thing is that a lot of that volume has already started to flow in. Hence why you see the Rubber solutions growth that you're seeing. We are trying to formalize that in contracts with our customers, but there was, particularly in one of our segments, some uncertainty in how much those minimum volumes should be and what the structure of the agreement should be. But we're seeing, we are realizing a lot of that revenue already, and as we go forward, we're going to try and formalize that, so that we don't, sort of, get the swings in revenue going forward. But we are making really good progress on getting that revenue in, and we're also making progress on formalizing it going forward.

[Tim James, Research Analyst]

Is it fair to say that there's still some ramp up in that contract in terms of volume, sequentially, as we look forward over the next several quarters or more?

[Chris Bitsakakis, COO & President of Rubber Solutions Division]

Yes.

[Tim James, Research Analyst]

Or is it a steady run rate at this point, I guess is what I'm wondering?

[Chris Bitsakakis, COO & President of Rubber Solutions Division]

No, there will be some continued ramp up.

[Tim James, Research Analyst]

Okay, could you talk about the operating leverage in the defense business specifically? I know there's not a lot of disclosure around it in revenue. So maybe just in general terms. Just wondering, how much overhead is there in the business that would potentially remain relatively flat as revenue ramps up over the next several years? And then -- does the nature of the manufacturing processes in that business, does that allow for much gross margin expansion as volume picks up?

[Lisa R. Swartzman, President]

I'll let Chris speak more specifically, if you want, Tim, on the operational side, but we're working on a number of -- as part of our continuous improvement program, we're working on a number of initiatives that especially if we ramp up volume, given the breadth of the new awards that we've recently announced, that should make for a tremendous amount of efficiencies in our manufacturing process and should expand our gross margins fairly significantly. Especially in a couple of our product lines, particularly our new mask line. In terms of their operating leverage, and you're right, we don't give you that much information but you can sort of back into it, the majority of it will be levered. And so the part that really increases is that where we had sales internationally, we tend to have reps and agents that do that. And so commissions on the sales base will go up. They're not a hugely material amount, in terms of the percent that we pay. So I think what you'll continue to see is EBITDA expansion. So some gross margin expansion from operational improvements and then EBITDA expansion from leveraging the internal structure.

[Tim James, Research Analyst]

Okay, great. That's helpful. Then my last question, returning to the Automotive segment. When and at what level do you think, and again, I know this is sort of a business that you don't specifically break out the margins for at this point, but I'm just trying to get a sense for whether it's a drag or benefit longer term. So I'm just trying to think about at what point and at what level do you think ultimately, Automotive EBITDA margins can return to? What's a normalized rate, and obviously, I'm thinking with a perspective back to when you were disclosing those margins previously?

[Lisa R. Swartzman, President]

I think in the current environment it's a little bit -- there's so many things at play that it's little bit tricky to say where we go back to and whether we'd be back at the levels that we were before. I think we probably -- we probably have a couple of years of work in front of us, before we can get back to those levels. Mostly because we've got interplay in both sides, right? We've got it both in terms of what's going on in the input price -- input cost side of things, if the current environment continues and if we continue to see the volatility in the raw material cost. What we need to really see, though, I think to drive that forward more materially is as we move into the new programs that will get launched over the next couple of years, and you get the -- we've talked about this before, about the program life cycle management. And being able to have new programs that are coming up to offset the ones that are in a declining volume or in a declining cost structure. With the way -- the typical Automotive to get that.

[Tim James, Research Analyst]

And then maybe just a follow-up to that. Do you, I mean, as you look at the competitive environment and knowing who you compete with out there, do you feel the Automotive business has a cost structure that is as low as the competition or in line with the primary competitors?

[Chris Bitsakakis, COO & President of Rubber Solutions Division]

Yes, actually I do think we're well positioned in that area. We probably can do better, and we are doing better, in fact. A lot of the efficiencies are starting to turn the corner, and we're seeing some good results. We do have this Malaysian joint venture that in a situation where we need to resort to offshoring some products in order to compete with international costing, we can do that. And in terms of domestic pricing, we're in line. So from a competitive standpoint, I think we're in a good position in our Automotive division.

[Operator]

Our next question is from Ace Mirali with CIBC.

[Ace Mirali, Research Analyst]

Just have a -- if the information is not available, we can take it off-line. We previously did some work on potential NVH revenue opportunities from North American light truck and SUV vehicle platform redesigns. And launch pipelines, and we saw that 2020 is expected to be a big year. I was just wondering, how flexible products sales efforts are tracking, so far in relation to these -- to this or these.

[Lisa R. Swartzman, President]

I got to say, Ace, I haven't gone back to the initiating report and sort of taken a look at that. So let's take that off-line, and I'll talk with Chris about it.

[Ace Mirali, Research Analyst]

Sure, sounds good. Just have a 2 more questions really quick here. Given 2018's weak auto segment that we just went through, the tariff impacts and higher input cost aside, is there any progress being made regarding new contract wins, and if not, may I ask how these improvements will be achieved moving forward?

[Chris Bitsakakis, COO & President of Rubber Solutions Division]

Yes, we are making good progress in a couple of different areas. We -- for example, we talk about the negative impact of the tariffs but also there's a lot of products that are currently being made in China, for example, from our Tier 2 customers that they are scrambling to get produced domestically and because we're in a good position to do that, we've seen quite an influx of new quotes in order to do that sort of a thing. So we see a very healthy pipeline going forward. In addition to that, a big portion of our revenue is in the small truck area, in the light truck area, versus passenger cars, which we know on the passenger car side, the Automotive industry is a little bit soft. So I think we're in a good position for new awards going forward. We have quite a few in the pipeline, quite a few sort of in late stages in that pipeline. So I think I'm pretty optimistic that we should be in a good position in that area.

[Ace Mirali, Research Analyst]

And just a final question here. In your opinion, are there any industry implications from the Continental acquisition of Cooper Standards NVH business?

[Chris Bitsakakis, COO & President of Rubber Solutions Division]

I don't think much is going to change for us. Our product line intersects a little bit with Cooper Standard's product line but not very much. Although it's sort of in the same neighborhood, we don't necessarily compete on the exact same product lines. So the overlap is not that great and the acquirer is also a customer of ours. So we have an interesting relationship there with them, in terms of perhaps being on their bid list for certain products that they don't want to compete in. So I think in aggregate, we shouldn't see much difference from that acquisition.

[Operator]

Our next question is from Ben Jekic with GMP Securities.

[Ben Jekic]

I might ask a question that's been asked but maybe from a different angle. You guys have been experiencing the auto sales pattern in the last few quarters where we saw the end of a certain number of product and mandates that have not been replaced with new products and you can correct me if I'm wrong. Can you maybe quantify, like in order for you to be in a situation where new product -- where old products will be replaced by new products, and you'll sort of have that cascading effect, there's probably some innovation going on in the background. Can you maybe quantify some of the trends that are going on internally that should put you in the position 2019 and '20 to, kind of, make those transitions in the Automotive business a lot smoother?

[Lisa R. Swartzman, President]

Ben, I just want to make sure that understand the question a little bit. You're asking about, sort of, more specific things that we're doing internally to make sure that we're on bid lists and expand the bid lists as we go forward and try and replace platforms?

[Ben Jekic]

Yes.

[Chris Bitsakakis, COO & President of Rubber Solutions Division]

Okay. We undertook a very specific strategy early this year to start developing products that are a little bit on the higher end scale with a little bit less competition so that we can drive higher margins. And we've made some significant progress in that area. We have a couple of new products that are in our design phase that are very attractive for us and for our customers. And so we are pushing pretty hard on that. We have at least 2 customers that are willing to work with us on a prototype basis and see if we can get some of these products tested. So I'd say long-term, our strategy of getting -- moving our products up the technology scale is coming along, although it's a fairly long cycle that way. And in terms of replacement business, the business that we are -- the incumbents on, we are already in the process of designing the replacement parts. So we're in a good position to get those products replaced for us. And in addition, like I mentioned earlier, there's a lot of products being brought to the domestic production scale, that we're also in a good position. And so I think that from that perspective, we should see growth in Flexible going forward, however, as we all know in the Automotive cycle, it's not as quick as it is in some of our other industries.

[Ben Jekic]

Okay, and in terms of improvements across the company, I mean, here in -- you do say that in the Rubber Solutions segment there have been operating initiatives that have resulted in meaningful gains, maybe you can again quantify or at least describe what some of those gains are? But -- and then generally if you can say, between now and end of 2019, like is the impact from these operating improvements in Rubber Solutions going to be greater than in Automotive or, sort of, equal or the other -- like where is more work required?

[Chris Bitsakakis, COO & President of Rubber Solutions Division]

So we are applying the same standards, processes and improvements across all of our business units. And if you look at it from a percentage basis, I think, you'll see equal improvements across the board. I guess, the larger parts of our company will see more dollars go to the bottom line from those improvements just from the math, but we are driving hard every single one of our divisions as we implement all the efficiency improvement programs that we put in place, and we are seeing very good significant progress this year, and I believe, we're going to see that next year even better. So I think we are not focusing on 1 division or another, of course, given the results at Flexible and some of the unique challenges there, we have to pay a little bit closer attention there to be more creative, but we'll see the improvements across all of our business units. And we have already.

[Operator]

Our next question is from Maggie MacDougall with Cormark.

[Maggie Anne MacDougall, Director of of Institutional Equity Research]

I apologize, I missed the first part of the call, but I was wondering, if you may be able to discuss what you're doing with regards to pricing pass-throughs for raw material cost inflation in various parts of your business? And in particular, in the Automotive side?

[Chris Bitsakakis, COO & President of Rubber Solutions Division]

So on the Rubber Solutions side, we have mechanisms in place with our customer base. So we have a mechanism that immediately passes on those raw material increases on a quarterly basis. On the Automotive side, we have -- most of our customers -- it's a negotiation. We have one of our customers, where we are on specific indices that allow for this kind of a mechanism, but we're not on those direct indices with our other customers. So when an occurrence, like the tariff situation that we're dealing with right now occurs, we have to enter a specific negotiation in order to get that relief. And so it makes it a little bit harder, little bit longer, but we are committed to getting the relief in that area, particularly on the steel side that we're seeing right now in the Automotive and up until now, we are getting at least indications from our customers that they're willing to work with us on it.

[Operator]

We have a follow-up question from Nav Malik with Industrial Alliance.

[Navdeep Malik, Research Analyst]

I just wanted to actually ask on the defense side, if you wouldn't mind just sort of clarifying that comment, in terms of the uncertainty with respect to timing and size of orders. What exactly are you referring to there? Do you have certain contracts that are rolling off that you're unsure whether they get replaced? Or what...

[Lisa R. Swartzman, President]

No, to be honest, I put it out there always as a bit of a caveat. Because the geopolitical situation and government budgets on our multiyear contracts, we'd still require that a budget to be in place. We have no real expectation, or we don't anticipate anything being different than anything that we've either announced recently or that our maximum awards are. Specifically, the way those contracts come, they come -- they're called an IDIQ. And so they come with a base year and then they come with multiyear options off of that, depending on the contract and it's really just in relation to that, but we don't anticipate anything.

[Navdeep Malik, Research Analyst]

Okay, and, I guess, so then with the new contracts that you announced in October, like in terms of when do you -- when you, would you know -- I think the size of the -- the way the contracts were announced or the way that I understood it was that they were "up to" contracts, meaning that the size of the contract is up to whatever the amount for each respective contract. But when would you know the -- when would you actually get those orders? Like how much in advance would you know the exact details?

[Lisa R. Swartzman, President]

So it depends a little bit per contract but for the most part it's like I just said, they give you a base year level and then when you, sort of, get through that year and they know a bit more what their purse strings are and what the situation is and if nothing has changed then they give you the orders for the next one. So for your next delivery order. So typically they come with a number of delivery orders attached to them and the time frame that the government needs to get back to you on. We do have one where we're getting much more frequent ones and that's really just because there are -- the -- it's with our bunny boot. And that's really just because the military is working on what their inventory is and filling size requests as urgently required. And so they're sort of downloading that on a pretty frequent basis to us.

[Navdeep Malik, Research Analyst]

And then, I guess, sort of maybe a political comment but what are your views now in terms of the change in Congress in the U.S.? Whether that impacts defense budgets and spending in the U.S.?

[Lisa R. Swartzman, President]

So I don't want to show my ignorance in politics. I personally don't think it's going to have any impact, and I'm not sure that the House can change it. But I don't think it will have any impact, and I think that both sides -- really all sides of the political spectrum in the U.S. recognizes that the last few years, they've massively underspent on their military and there is a need to sort of replenish the inventory that's there. And then as we've said before, the changing nature of wars over the last decades, so moving from 2 desert wars into sort of more of a cold and more arctic warfare. That doesn't change, and so what's happened is because of their lack of spending over the last few years, the environments that they're currently in, they really don't have inventory for.

[Operator]

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

[Peter Grenville Schoch, Chairman & CEO]

Just in summary, we had a disappointing quarter but things are looking much better for the future. 2 of our 3 business units, the defense and Rubber Solutions have got more business on the books for the future than at any time, in recent history anyway. And Flexible has been a drag -- a significant drag on us and it has taken us a lot longer to get that fixed than we had hoped but under the direction of Chris, it is coming, and although you can't see it in the results in the third quarter, you can feel it on the plant floor and those initiatives will start to show up on the bottom line going forward. We don't give guidance, but I'm not -- I'm hoping you'll never -- you won't see another -- quarter anytime soon. And with that, I would like to thank everybody for participating, and we will talk to you after the next quarter.

[Operator]

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