AirBoss of America Corp

TSX:BOS

Earnings Call Transcript 2019-Q3

[Operator]

Good morning, and welcome to the AirBoss of America Q3 results. With us, we have Mr. Gren Schoch, Chief Executive Officer of AirBoss of America; Mr. Chris Bitsakakis, Chief Operations Officer and President; and Mr. Daniel Gagnon, Chief Financial Officer.I would now like to turn the meeting over to Mr. Gren Schoch. Please go ahead.

[Peter Grenville Schoch, Chairman & CEO]

Thank you, operator. Good morning, everyone, and thank you for joining us for the AirBoss Q3 results conference call. I'm Gren Schoch, and I'm the Chairman and CEO of AirBoss. Chris Bitsakakis, President and COO; Daniel Gagnon, our CFO; and Chris Figel, EVP of Corporate are also in the room with me.In terms of an agenda, we'll take a few minutes to review some operational highlights for the quarter and then briefly review the financial results before opening the call to questions.Before we begin, I'd like to remind you that today's remarks, including management's outlook for the balance of Fiscal 2019, anticipated financial and operating results, our plans and objectives and answers to your questions will contain forward-looking information within the meaning of 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 or 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 in our filings with the Canadian Securities Administrators on SEDAR, at www.sedar.com.With that, I would like to now turn this call over to Chris to review a few of the operational highlights.

[Chris Bitsakakis, COO & President]

Thank you, Gren, and good morning, everyone. The third quarter was a steady one overall highlighted by further increases in Rubber Solutions volume, measured on a pounds shipped basis, up 5.5% over the prior year quarter and 7.9% on a year-to-date basis. We remain pleased with this trend despite the slight reduction in net sales dollars over the third quarter of 2018 due to the proportion of tolling versus nontolling work completed in this period.The increase in volumes suggests customers continue to view us as a trusted partner for a range of compounding solutions, and we continue to add new customers, building on a trend we saw in the first half of 2019.The reduction in net sales in the quarter was partly offset by a small improvement in the Engineered Products segment, led by the anti-vibration business. Although we still have significant work to do, we believe the anti-vibration business is beginning to stabilize at this level, although it remains sensitive to external factors beyond our control.In 2019 we have invested strategically across the business, with CapEx of $13 million on a year-to-date basis. During the quarter we completed the upgrade of our Kitchener facility, moving into state-of-the-art laboratory facilities and office space that will support enhanced collaboration with customers and better reflect AirBoss' ongoing focus on innovation and proprietary technical solutions that are key to our continued growth.Preliminary feedback from early customer visits has been very positive, and we believe this investment elevates our reputation as a supplier of choice in the industry. This becomes especially important as the industry consolidates and customers look to maintain optionality in the supply of compounded rubber. We are hosting a Grand Opening of the new facilities on November 14.A key focus of our capital expenditure program this year has been diversifying our product offering, with a focus on expanding the number of higher-margin, specialized compounds we can provide. To this end, we installed a white/color mixing line in Kitchener and have already sold 30% of its capacity in the first few months. This initially satisfied pent-up demand, and we are out working aggressively to fill the rest of the open capacity.We've also recently acquired a new tilt mixer which will allow us to produce additional high-value specialty compounds in a smaller batch size and better serve both existing and new customers. The tilt mixer will be operational by mid-November.Another area of focus for our ongoing investment in the business is on reducing costs. In the Engineered Products segment we continue to pilot new presses for the anti-vibration business that are expected to support reduced cycle times and lower labor costs, which should help improve margins. The first 2 presses are in production and running samples for customer approvals; a further 4 presses are currently on order.Additionally, we have designed and ordered our first robotic workcell that will allow us to significantly improve throughput and reduce labor costs. This is cutting-edge technology and one of only a handful of its kind in the world. Initially, we intend to use it to produce high-volume, less-complex product lines that require minimal manual labor input. This will permit us to operate the equipment at high capacity and allow us to allocate human resources to higher-margin products that require greater manual labor input. We expect the new workcell to be operational towards the end of the first quarter of 2020 and going into production into the second quarter.Within the anti-vibration business, our more proactive approach to dealing with market variables such as commodity price fluctuations and tariffs has begun to pay dividends, as we have successfully been able to negotiate relief with a number of customers, which is expected to support better margins over time. We are also negotiating with customers to discontinue producing products where there is no expectation of improvement.Our longer-term focus for the anti-vibration business remains on actively diversifying into new sectors to reduce the proportion of business that comes from the automotive sector, which remains well in excess of 90%. As indicated previously, near-term areas of focus include solutions for the heavy trucking, bus, construction, agricultural equipment and motorcycle and ATV segments. I would note that many of these solutions involve scaling products previously developed for the automotive industry and that these larger, more heavy-duty, more raw-material-intense offerings can command commensurately higher prices.Turning briefly to the defense business, at quarter-end we secured a new contract from the U.S. Department of Defense for our MALO product. If all units are delivered under the contract it could be worth up to USD 26.7 million. A solid initial order was rapidly followed by a second one, meaning we are well positioned to deliver on nearly 30% of this contract in the next year, with deliveries anticipated to begin in the middle of 2020.With this contract, we have now been awarded nearly USD 150 million in defense contracts over the last 12 months, and we continue to evaluate a global pipeline of tender opportunities. We also feel this latest award helps build greater momentum as we move towards the closing of the ADG transaction.During the quarter we received CFIUS approval to proceed with the merger of the AirBoss defense business with Critical Solutions International, clearing the way to conclude the transaction, currently expected in the fourth quarter. Since announcing the merger we have worked seamlessly with CSI to identify new opportunities for both our existing range of CBRN solutions as well as potential new products, which are already in a variety of phases of development, including preproduction and validation.By leveraging their entrenched military and government relationships, the combined business will have a strong platform with the scale, capabilities and flexibility to act on an array of future growth opportunities, both organic and transactional.In closing, I would like to remind listeners that as a management team we remain clearly focused on 4 core priorities. First priority is growing the Rubber Solutions segment and positioning it as a supplier of choice in the consolidated North American market.Secondly, completing the ADG transaction in the immediate near term and then leveraging the new entity's enhanced scale and capabilities to pursue an array of growth and value-creation opportunities in the broader defense sector.Thirdly, driving improved performance from the anti-vibration business through a combination of efficiency improvements, client relationship expansion, new product development and sector diversification into nonautomotive and higher-margin product lines.And finally, we continue to take a disciplined approach to the targeting of acquisition opportunities across the business, with a focus on strategic fit.We feel each of these initiatives will be important contributors to improved financial performance and growth of the business over both the mid and longer term.With that, I will now pass the call over to Daniel for the financial review. Daniel?

[Daniel Gagnon, Chief Financial Officer]

Thank you, Chris, and good morning, everyone. As a reminder, please note all dollar amounts presented are in U.S. currency, except for dividends per share, which are Canadian dollars.For the third quarter ended September 30, 2019, volume in Rubber Solutions segments continued to grow, with a 5.5% increase in pounds shipped, although consolidated net sales dropped by 0.8%, to $77.2 million, compared to 2018.As I will further explain shortly, the slight decrease in Rubber Solutions net sales of 3.5% was due to an increase in tolling versus nontolling sales, and that was partly offset by a 1.7% increase in the Engineered Products segment. The opposite was true for the year-to-date period, as consolidated net sales increased by 0.9%, to $242.4 million, compared to 2018, and that was due to increases in Rubber Solutions segments that were partly offset by decreases in the anti-vibration business within Engineered Products.Consolidated EBITDA improved by 12.1%, to $6 million, in the third quarter and 16.6%, to $23.2 million, in the year-to-date period as a result of solid performance at Rubber Solutions, some realized operational efficiencies and, additionally, for the year-to-date period, growth in the defense business.Fully diluted EPS grew to $0.07 and $0.33 per share for the quarter and year-to-date periods, compared to $0.06 and $0.31, respectively, in 2018.For the year-to-date period, a portion of the EBITDA increase was also due to the settlement of an insurance claim of $1.2 million, recovering costs incurred as a result of a fire in our Scotland Neck, North Carolina, facility that occurred in Q1 2019 and a gain relating to the adoption of IFRS 16 related to lease accounting of $1.4 million. These favorable impacts were offset by $0.7 million in increased professional fees related to the announced merger in the AirBoss Defense Group.After normalizing for these onetime items, year-to-date EBITDA would have been $21.3 million, which is still ahead of last year's $19.9 million. And on an EPS level, we would have remained as reported, at $0.33, versus $0.31 last year. This includes the adjustment for $0.4 million of an impairment charge in 2019 related to the same fire that occurred in the Scotland Neck facility.Turning briefly to the segmented data, as I noted earlier, while overall volume in Rubber Solutions segment increased by 5.5% for the third quarter in 2019, net sales decreased by 3.5% from the comparable period in 2018. The decrease in net sales was in the track, conveyor belt and off-the-road sectors. These decreases were partly offset by increased demand in the mining and defense sectors.Despite this decrease in net sales, volume, as Chris mentioned, was higher, driven by a 33% increase in tolling volumes. As a reminder, in tolling applications we only realize net sales on the provision of compounding services for customer-supplied material, versus in nontolling where AirBoss also supplies the raw material inputs that are reflected in net sales. As such, net sales in isolation may not provide a complete picture of what's really happening in the business.Net sales in the Rubber Solutions segments for the year-to-date period increased by 3.6% from the comparable period in 2018. The increase in net sales was principally the result of a 7.9% increase in volume, with broad support from many of the sectors the company serves. The increases were partly offset by softness in track and chemical sectors.Gross profit in Rubber Solutions for the quarter increased by 11.5% and were 15.9% of net sales, versus 13.7% of net sales in 2018. Gross profit for the 9-month period increased by 20.4% and was 17.3% of net sales, up from 14.9% a year ago. For both 3- and 9-month periods, these increases were principally due to higher volume and labor efficiencies.Turning now to Engineered Products. For the 3- and 9-month periods, net sales in anti-vibration business increased by 2.4% and decreased by 3%, respectively, over prior periods, whereas net sales in defense business decreased by 0.5% and increased by 3.9%, respectively, over the prior year periods. The decrease in the quarter in the defense business was a result of an expected shift in scheduled deliveries into the fourth quarter of this year.Gross profit in Engineered Products for the third quarter increased by 9.8% and were 11.8% of net sales, versus 11% in 2018. Despite the decrease in net sales in the defense business for the quarter, gross profit was broadly similar to the comparable period in 2018 due to a favorable product mix.Looking at the 9-month period for gross profit, it decreased by 13.6% and it was 12.4% of net sales, which was down from the 14.1% realized a year ago. The decrease in gross profit and gross profit as a percentage of net sales was principally due to lower net sales in the anti-vibration business, and this was partially offset by the higher gross profit in defense, which was due to increased net sales and a favorable product mix.Our balance sheet remains strong at the end of the third quarter of 2019. I'd like to remind everyone that the term loan and other debt presented in the MD&A and financial statements includes $8.3 million related to the adoption of the new accounting standard IFRS 16, which relates to lease accounting. In accordance with the new standard, leases were capitalized effective January 1, 2019, with no restatements to prior years.Excluding the impact of new lease accounting standards, our net debt to TTM EBITDA was healthy, at 1.8%, compared with 2x in Q3 of 2018, and our credit facilities of $60 million remain undrawn. This positions us well to make the necessary investments required to support growth, innovation and operational efficiencies.Operator, that concludes our prepared remarks for this morning. We'd now like to turn the call for questions.

[Operator]

[Operator Instructions] The first question comes from Scott Fromson with CIBC.

[Scott Douglas Fromson]

Can you give a little bit more detail on the deferral or delays at defense, please?

[Chris Bitsakakis, COO & President]

I can do that, Scott. We had a major shipment that was scheduled for Q3. In the process of production, our customer had designed a new test that was not part of the original protocol that they felt very strongly was important for our product to pass. The test that they had designed was not repeatable or reliable. In other words, you could put the same product on the test fixture and sometimes get a failure, sometimes get a pass.So we stopped production for a few weeks while we worked hand-in-hand with our customer to make sure that we were able to accommodate their needs for this test. And in the process, we designed with them a new testing protocol that was both reliable and repeatable. And at that point, we just received approval to ship, but we received approval to ship the first week of the fourth quarter.So with that, we are planning to make that shipment in Q4. The test protocol is now in place. We have received approval. And we are back able to make that shipment. So that's where that deferral came from in Q3.

[Scott Douglas Fromson]

Will that impact any of the shipments in Q4 that were planned?

[Chris Bitsakakis, COO & President]

No, it will not because we had built up much of that inventory to ship already in Q3. And so we still have a portion of that shipment to complete in Q4. So we're fairly confident that there won't be any further slip on that particular shipment into Q1 of next year.

[Scott Douglas Fromson]

Okay. For the purpose of modeling, can you give a bit of guidance on what the impact in Q3 may have been?

[Daniel Gagnon, Chief Financial Officer]

On a net sales basis only, we can tell you that based on the total [ 4, ] there was about $3.5 million expected to ship in Q3, which will now go into Q4.

[Operator]

The next question comes from Nav Malik with Industrial Alliance.

[Navdeep Malik, Research Analyst]

I just was wondering on the Engineered Products division, the gross profit increase, could you split out maybe what was from anti-vibration versus defense, just to give us some more clarity on how that played out directionally?

[Daniel Gagnon, Chief Financial Officer]

Well, we can't give you precise numbers, but we can say that in that case for Q3 it was mostly on the anti-vibration side, given their increase in net sales.

[Navdeep Malik, Research Analyst]

Okay. So I guess you're seeing progress then on some of the initiatives in terms of new products? Or maybe you could kind of give us an update on how that, in terms of strengthening the sales and marketing team, new products, how that has been progressing.

[Chris Bitsakakis, COO & President]

We're certainly seeing progress in operational efficiencies. It's slow, but it's coming along. We're seeing that light at the end of the tunnel.In terms of the sales and marketing group, we've been driving very hard on the nonautomotive side. It's still in the early phases. We're meeting with customers. We're getting approvals to be on their supplier list. We're dealing with the engineering teams at many of these nonautomotive companies, and we're getting some very favorable feedback from all of them. But we're still not in a position to start realizing any of those sales. But I do believe that the investment we made in a dedicated sales and marketing team driving into the nonautomotive space will pay dividends off in the near future.

[Navdeep Malik, Research Analyst]

Okay. And I just wanted to ask, moving to the Rubber Solutions side, so in terms of volumes, tolling versus nontolling, I'm just kind of looking back at the previous quarters, as well. And there's a lot of kind of variability there. I guess is there any visibility with respect to the type of business that comes in? Or is there any way to give some color on how does that shape up on a quarterly basis? Or is it just more or less a function of what the market demand is?

[Chris Bitsakakis, COO & President]

It really depends on the market demand. But in this particular case the growth in tolling is not a short-term kind of growth. We are seeing sustained demand in that tolling. And so we don't expect significant variability, although tolling can be a little bit fickle. If the economy does falter in some way, many of the customers that we're tolling for have their own in-house compounding capabilities.But what we're doing is we're working with those particular tolling customers to take on some of their more difficult products, some of the products that create inefficiencies for them because they're set up for a different kind of process than we are, so that we can kind of take a little bit of that fluctuation out of the long-term view. But certainly, tolling is such that it depends on their open capacity in-house, but we're trying to minimize that through helping them make products that they don't currently feel they are set up for.

[Navdeep Malik, Research Analyst]

Okay. And then just following on that, really lastly here, is so on the Rubber Solutions side the gross profit was up nicely year-over-year, but it was down I guess sequentially. Is there some seasonality in that segment that would explain that? Or is that just again the function of the mix?

[Daniel Gagnon, Chief Financial Officer]

It's really a mix functionality.

[Operator]

[Operator Instructions] The next question comes from Tim James with TD Securities.

[Tim James, Research Analyst]

Just wondering if you could talk about the decline in defense revenue from the shelters, filters and PAPRs in the third quarter, why that was and if the third quarter is kind of a revenue run rate in those products that we should think about, going forward.

[Chris Bitsakakis, COO & President]

I think in those product lines, particularly shelters and PAPRs, the input is quite lumpy. The orders come in hot and heavy, there's system fill, and then the orders disappear for a while. And so I think we're seeing more just of that seasonal type swing. But there's certainly no concern that those product lines are not viable, going forward.

[Daniel Gagnon, Chief Financial Officer]

And last year, Tim, you'll recall we talked about there was a large filter contract that was fulfilled throughout the year and it kind of trickled into Q3 and it was fulfilled by that time, which didn't replicate this year.

[Tim James, Research Analyst]

Okay. So that was down. If we sort of exclude that filter contract and just think about shelters and PAPRs, and again I know we don't know exactly what the revenue is coming from those, but as we think about 2020 do you expect any sort of material change in that source of revenue next year? Or is the full year 2019 kind of a good indication?

[Daniel Gagnon, Chief Financial Officer]

I don't think we expect any material change going into 2020. It's still product lines that are critical to us, going forward, and we expect to deliver on those next year, as well.

[Tim James, Research Analyst]

Okay. Great. And then just turning to Rubber Compounding, I'm just wondering, Chris, if you have a sense at this point. I know it's hard to nail down thinking about 2020, but in general, does your kind of line of sight suggest growth in overall volumes next year?And secondly, as part of that, do you see any notable shifts in sort of the mix of volume next year, any new customers coming in or exiting that would kind of impact the revenue or the sort of price per pound that you're going to be generating next year? Just any color you can provide would be great.

[Chris Bitsakakis, COO & President]

We've seen some good momentum. We're bringing on new customers all the time. There's been some consolidation amongst our competitors that has driven even more opportunities our way. So we expect growth next year. We're still in the process of preparing our budgets for next year and understanding what our targets will be and that kind of thing, but I'm relatively optimistic that we'll be continuing to grow the business.And if you keep in mind, too, that we've added new capabilities that we've never had before. We've added this color and white mixer that we've never had before. We've added a tilt mixer that we haven't had before. Both of which allow us to grow in the specialty compounding side, which although is lower volume, it's higher margin. And we're seeing opportunities now across a much broader range of capabilities. So we're going to continue to drive that growth into next year and that will be our plan.

[Tim James, Research Analyst]

Okay. That's great. Thank you very much. And then just to confirm, the 20 million to 50 million incremental pounds of capacity that those investments have brought on, how much of that has been available to you in 2019? Or really should we think of all of that as just incremental beginning in 2020? I'm just trying to get straight the timing of when those came online.

[Chris Bitsakakis, COO & President]

Well really the second mixing line in Scotland Neck really did not become fully operational until the middle of the summer, and the color line came into operation about a month ago, and the tile mixer will be later this month. So of course as you put in new capacity, the first little while you're testing, you're trialing, you're doing all sorts of things, but you're not necessarily producing salable product.So I think I would personally look at it more going into next year, having that capacity available to us. Although it's available now, it takes time to get customers approved, customers identified and all the kind of the kinks taken out of the system.

[Tim James, Research Analyst]

Okay. And then just a final question, just to clarify. If I'm understanding the MD&A correctly, the 20 million to 50 million in incremental capacity, is that just from the Scotland Neck mixer and the new color mixer? Is this tilt mixer sort of part of that reference to 20 million to 50 million pounds of capacity? Or is that incremental to the 20 million to 50 million?

[Chris Bitsakakis, COO & President]

Well, most of that capacity is the second mixing line in Scotland Neck. The color/white mixer is a smaller mixer. And the tilt mixer is a very small mixer. Because on very specialty type compounds, normally people don't buy thousands of pounds. It's a much higher price. It's a much more engineered product. But normally they're making products that don't require millions of pounds. So most of that capacity is Scotland Neck, some of it is the color line and the tilt mixer has not been factored into that yet.

[Operator]

The next question comes from Ben Jekic with GMP Securities.

[Ace Mirali, Research Analyst]

I have a couple of questions, and the first one is, Chris, is there any impact, and if there is, how much impact, from tariffs with China, in terms of buying certain products from Asia? And if you could, if not quantify but at least give some directional sense of how much that impacts the results?

[Chris Bitsakakis, COO & President]

What I can tell you, Ben, is that we have been negotiating very aggressively with our customers to be able to pass on the impacts of these tariffs to them. We have been successful getting either some or all of it mitigated, depending on the customer and depending on the negotiation. We have one major customer that is still not working with us on it. However, we've made some significant progress in that area.So it's taken most of the year to get there. But as we look forward, we believe that the impact of the tariffs will start to dissipate as we're able to pass some of those impacts on.

[Ace Mirali, Research Analyst]

Okay. Thank you. And then the second question is fairly qualitative in nature. Like when you say, "We're adding customers, we added x number of customers over the last quarter or 2 quarters," what does that mean in terms of the time from sort of, okay, we'll do testing, I don't know how that procedure works, until actual orders, actual revenues? Are we talking a 6-month period or a 9-month period? Or does it vary, simply?

[Chris Bitsakakis, COO & President]

It depends, Ben. As you know, we have thousands of proprietary compounds that we have developed and own the IP for. And on occasion we get a customer that wants something specific that we already have off the shelf, and we'll send it to them. And from our perspective there's no development needed because that's the product that they need and that they want. But then they have to qualify their products with their end customers. And sometimes that takes weeks, sometimes it takes months. It depends.And if we put ourselves in a position where the product that we're developing for them doesn't exist in our repertoire yet or there's an existing product we have that needs an adjustment, that adds to the time.So unfortunately, I can't give you an exact number, but it can go anywhere from, let's say, 1 month to 6 months.

[Ace Mirali, Research Analyst]

Okay. Okay. Thank you. And the last question is just on the tilt mixer, and I apologize if it was already mentioned. Where is it going to be located, is the first question. And the second one is you are saying so this would be lower volume, higher margin. Can you give some examples of industries or types of customers that would be interested in this?

[Chris Bitsakakis, COO & President]

Certainly. The tilt mixer at this point in time has been installed in Kitchener. However, because of the size and the configuration and the fact that it doesn't need an engineered mezzanine to sit on, we could theoretically move that to Scotland Neck if we needed to at some point. But we are starting it up in Kitchener.And in terms of the kinds of products, the types of products you can think about is, like, FKM polymers, which are a multiple of a price per pound versus other type polymers. And those kinds of things can be used in a variety of industries. It can be used in oil and gas. It can be used in transportation. It can be used in very specific seals in engines. There's a lot of different applications that it can be used. You see it in heavy truck. You see it in windmills. You see these specialty compounds in a variety of industries. But like I said, normally they come in smaller batch sizes, much higher cost per pound and much more engineered.

[Ace Mirali, Research Analyst]

And will there be sort of a learning curve as you start to operate that mixer? Or it should be a smooth transition to sort of optimal margin levels?

[Chris Bitsakakis, COO & President]

I think there will be a learning curve, but from our -- in our development lab we have experience with these formulations and these polymers. So we're able to make them, we've designed them, we've built them and we're able to meet the specifications that are required. The problem has been in the past is that because we didn't have that specific type of mixer, having to mix these on assets that were not designed for these kinds of compounds would increase the cycle time, increase our cost and it would make us less competitive.So now with the right asset, we have the technology in-house through our chemical engineering department and now we have the right asset to make it in a competitive way. So we'll be more competitive, going forward. There will be some learning curve, but we're fairly well versed on what it takes to make this happen.

[Operator]

The next question comes from Scott Fromson with CIBC.

[Scott Douglas Fromson]

Just a question on the new mixing capacity, particularly the noncolor white and the tilt mixer. Who do you think you will be taking market share away from on those products?

[Chris Bitsakakis, COO & President]

Much of the market being consolidated between Hexpol and Preferred, those have been the 2 companies that we're mostly competing with, and that's where we're taking most of our new products from in this particular area because both companies had capability in color and other specialty compounds.

[Operator]

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

[Chris Bitsakakis, COO & President]

Thank you, operator. And thank you to everyone for attending this morning's call.Looking ahead, we expect that the core Rubber Solutions segment will continue to grow, and we have made a number of investments this year to support that growth. While the anti-vibration business does continue to experience some challenges, we have a clear plan in place to diversify and grow that business. Finally, we are gratified by the momentum we are seeing in the defense business and expect there to be meaningful opportunities for it in the time ahead, especially as we complete the AirBoss Defense Group, or ADG, transaction and establish a platform that is best positioned to capture growth.We look forward to updating you all on our progress on our year-end call in 2020. Thank you again for attending today. Have a great day.

[Operator]

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