Heroux Devtek Inc
TSX:HRX
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Heroux Devtek Inc
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Good morning. My name is Julie, I will be your conference operator today. At this time, I would like to welcome everyone to Heroux-Devtek's Fiscal 2023 Third Quarter Results Conference Call. [Operator Instructions]
Before turning the meeting over to management, please be advised that this conference call will contain statements that are forward-looking and subject to a number of risks and uncertainties that could cause actual results to differ materially from those anticipated. We refer you to Slide 2 of the accompanying presentation available on the company's website for the complete forward-looking statements. I would like to remind everyone that this conference call is being recorded today, Wednesday, February 8, 2023 at 8:30 a.m. Eastern Time.
I will now turn the conference over to Mr. Martin Brassard, President and Chief Executive Officer; and to Mr. Stephane Arsenault, Vice President and Chief Financial Officer of Heroux-Devtek. Mr. Brassard, please go ahead, sir.
Thank you very much, Julie and good morning, everyone. [Foreign Language] On behalf of all of us here in Longueuil, welcome to our third quarter earnings conference call for fiscal 2023. As usual, I invite you to follow along by referring to the financial statements, MD&A, press release and presentation which can be found in the Investors section of our website.
We continue to operate in a very challenging and dynamic environment. Civil aerospace market continues to show signs of recovery with constant growth in passenger traffic and OEMs increasing their production rates. Defense spending also continues to grow, bolstered by the current geopolitical environment. Consequently, our order book has grown significantly due to orders from both the civil and defense sectors reaching, $870 million at the end of December or 28% higher than at the start of the fiscal year.
On the other end, we are facing strong headwinds. The reliability of the supply chain is impacting our production and our ability to deliver products steadily to our customers. Labor availability remains a constraint for us and for our supply chain. And third, inflation continues to negatively impact our costs. This past quarter, we made further progress towards reestablishing our throughput as we delivered $141 million of sales compared to $133 million last quarter and $114 million, the first quarter. This is a good step in the right direction. However, our profitability was not at the level we would have liked. The challenges in the aerospace environment mentioned earlier caused disruption in our manufacturing plants, arming our cost and linearity.
Our focus for the quarters ahead will be to stabilize our production system in order to produce more efficiently and get back to historical margins. Our teams remain focused on execution and are engaged in improving our profitability. First, we need to restore the health of our supply chain by continuing to qualify new sources and by increasing our presence in our suppliers' operations. Second, we will continue the automation of our manufacturing processes wherever possible. And third, we will review our pricing in order to offset the effects of inflation.
Now on to the results, Stephane.
Thank you, Martin and good morning, everyone. As usual, please be aware that we will be referring to certain non-IFRS measures during the call, including adjusted EBITDA, adjusted net income and adjusted EPS. All non-IFRS measures are defined and reconciled in the MD&A issued earlier today.
In Q3, consolidated sales for the quarter rose 7.4% to $140.9 million compared to $131.1 million last year and $132.7 million in Q2, in spite of the ongoing production system disruption described by Martin. Civil sales were up 23.6% to $45.1 million from increased delivery for the Embraer Praetor, Boeing 777 and Falcon 6X program, while defense sales were stable at $95.8 million. Gross profit decreased to 14.1% of sales compared to 16.3% last year. The decrease is attributable to product mix and product system inefficiency and the impact of inflation on workshop supplies and utility, while last year, the impact of COVID-19 was partly compensated for by government relief measures, representing an impact of 1.4% of sales.
Operating income was $5.1 million, down from $10.5 million at this time last year, reflecting lower gross profit and a nonrecurring $1.6 million foreign exchange loss on conversion of monetary items, representing 1.1% of sales. Similarly, adjusted EBITDA decreased to $14.1 million compared to $19.7 million last year. Net income stood at $1.8 million or $0.05 per share compared to $6.5 million or $0.18 per share last year. Cash flow related to operating activity reached $5.2 million in the quarter, a decrease from $17.5 million reported at the same time last year due to lower operating income and $11.5 million more in inventory acquired to mitigate the effect of supply chain delays.
Our financial position remained strong at the end of Q3 with net debt at $152.7 million, stable with March 31, 2022. Back to you, Martin.
Thank you, Stephane. In closing, we are pleased to see continued recovery in demand in the aerospace industry and to report a record-breaking backlog. Our challenge does not lie in obtaining orders but in delivering them in a profitable and timely manner. Future is bright and our strong balance sheet gives us the flexibility required to execute our plans. We have the necessary resources at our disposal to deliver on our strong backlog and our plan to restore health in the supply chain will be key to achieving our profitability objectives.
Thank you for your continued support and I look forward to updating you on our progress in the coming months. Julie, we are now ready to answer questions.
[Operator Instructions] Your first question comes from Konark Gupta from Scotiabank.
So my first one is on the operational challenges that you've been talking about. I'm wondering like what more can you do to mitigate these operational challenges? I mean you have some automation going on, you have kind of tried to kind of get some labor and hiring done but supply chains are still constrained. What exactly can you do here incrementally to get back to the margins? Or are we in sort of a structural margin pressure situation right now for at least the next year or so?
Yes, we have the pressure. But additional is, like I said, is to continue developing new sources and to have our watchtower on the solidity of our supply chain. Obviously, it takes some time when you resource some parts in the aerospace industry and have more effort or more resource on the ground. So we call it the boots on the ground. We have a special team that's covering North America. That initiative has started last year and we are now having the resources to expedite our suppliers in North America and some parts of Europe. So we believe that getting these parts and making sure that our supply chain execute our orders in a timely manner, right, will give us more stability in our production system and will reduce the inefficiencies that we observed in the third quarter for profitability.
And is that something that you would expect in the next couple of quarters? Or is it going to take longer?
It's going to stay there for the next couple of quarters, Konark, to be quite honest. It's not the magic stick but we should see improvement in our margin quarter-over-quarter, gradually.
Okay. That makes sense. And then my second question, before I turn it over, based on the defense business. So defense spending is growing and you've been receiving orders, obviously. Is there a pause in some of these programs or any kind of delays in some of the programs, some like the defense spending -- or defense sales for you guys has been declining on a year-over-year basis, excluding FX variances, so for the last 3 quarters. So I'm like, I'm just wondering if there's any kind of ramp-up going on in some programs which will take effect in the next few quarters and has not happened in the last 2, 3 quarters?
It's all about on the execution, right, of what we're describing. So we have the orders to do more sales. We are set to do $150 million per quarter total sales. And the defense order like on the civil side is slowed down because we're not able to deliver the throughput, right, that we're targeting.
Your next question comes from Cameron Doerksen with National Bank Financial.
So just going back to the margin question. Just looking at comparing versus the prior quarter in your fiscal Q2. I mean you had higher revenues, so higher throughput but margins worsened. So I'm just wondering what incrementally got worse in Q3 versus Q2? And what impact did product mix have on the margins in Q3 versus maybe prior quarters?
So the impact, we see, inflation. If you look at the explanation we have on the MD&A, we see more inflation, for example, on the short supplies of our facility. So it's pretty significant. 20% increase when we compared to previous quarter and that includes the last quarter. Utility cost is higher also essentially from European business but also everyone, right? So we have increased costs. So both together compared to last year, represents 1%. And would compared to previous quarter it's about the same value. So we still have high overtime and labor costs to execute on the delivery that we have.
In the product mix, yes, it had an impact from the previous quarter because we have ramped on the civil sector and we have less aftermarket than what we -- that we had in the previous quarter.
Okay. And just thinking about your fourth quarter, I mean that's normally the strongest quarter of the year for you from a revenue perspective. I mean, should we expect that to be the case this year? And obviously, higher throughput should have a benefit to margins?
Yes. We -- as we reach the targeted throughput, right? And it's first to reach $150 million and then to do it efficiently, right? I think that's -- as Martin described, that's going to be done gradually, right? Let's the $150 million and then we'll improve how we're doing the $150 million. So that's the game plan and that includes management of the supply chain as Martin described.
Okay. And just final for me. Just, I guess, on the supplier health. I mean I know you've had some issues really over the last 12 months with some of your suppliers maybe being in some financial challenges and you mentioned that you're qualifying new sources of supply here. Did anything, I guess, get kind of worsened in Q3? I mean, did you have some suppliers who just kind of stop shipping? Or maybe you can just talk a little bit about what's going on there?
No, we don't have any suppliers that stopped shipping, so it's mainly delays. So we haven't experienced any suppliers that are bankrupt but we're facing the reality and we're getting ready. That's the point. Okay. Does that answer your question, Cameron?
So I guess, maybe just to follow on that, you mentioned that you have some -- some of your suppliers are -- I don't know how many but facing the financial difficulty. Are these things that have already happened? Or is this something you're expecting and that you're going to have to switch supply in future quarters?
So we're going to have to switch suppliers in the future quarters. It hasn't happened yet, Cameron, in Q3. It hasn't happened but we've made sure that we face what we know and we are taking the measures immediately as we know it.
Your next question comes from Tim James from TD Securities.
I just want to return to Cameron's question there and see if it's possible to provide any insights into those suppliers that are having delays. Are you getting a sense from them what the issues are on the ground for those suppliers? Like what's causing them to not be able to get you what you need on time?
Well, the labor and the absenteeism, right? So we just went through 2 years of disruption and reduction. So people have to let go some people. Now, we need to get it back. So that's the challenge with the labor situation and the capability and we need skilled resource. So we're in aerospace. So that's the challenge that we're all dealing with. It's a labor availability as well as the inflation pressure. And we are not the only company here in the aerospace. Many people are experiencing that. So I have been traveling everywhere in America and Europe and that's the challenge we're all facing. It's not a question of orders. It's a question of getting the resource. A couple of months ago, it was mainly to get the suppliers. Now it's to get the material. Now we're talking more about the resource to produce. And Tier 2, Tier 3 suppliers are important in our link in our industry.
So that's why when I say boots on the ground is to try to help them and to organize and making sure that the priorities -- or the priority are given to them as well. We're working with our biggest customers because sometimes, when they go there, they put their parts in front of ours, right? And we need to work with them. So it's a challenge in all the communication and complexity to make sure that we utilize the resource available to produce what we have to produce as an industry.
Yes, yes. I was just trying to get like specifically not within your operations and your plants, just the suppliers, whether it's still a combination of them not being able to get their raw materials and supplies on time or if it's there having problems with employee absenteeism or it's just poor execution on the shop floor. But it sounds like it is still both for your suppliers. Again, I'm talking employee absenteeism and materials that they're not getting on time.
Labor shortage -- labor shortage, that's why we're focusing. We have 99% of our required resource but we still have turnover affecting the productivity but it's not all the same in the situation everywhere. So people that have to let go 40% of their workforce, now they have to get it back. Also, you see the production rate increase. You see big OEMs with -- struggling with their supply chain because it's getting fast. We need to go up fast, that's the thing. The demand is there. Capacity is not that much -- is that like it used to be. So now we need to rebuild that capacity.
So actually, it sort of leads to another question and very big picture. I don't know if you care to comment on this. But as you look out at what your customers' plans are in terms of deliveries? And I guess, I'm thinking more on the civil and the commercial side of the business but maybe it's a question that you could apply to defense as well. Your customers, when they talk about their sort of delivery plans over the next couple of years, do you think those are realistic? Or sort of given what you're seeing in your business, do you think those growth plans from your customers could end up being challenging?
It's aggressive, let's say, I can tell you. From my perspective, I cannot say that it's unrealistic with our suppliers on them. But it's really aggressive and it's like -- it will be a challenge for all of us to meet that demand. And again, to find a way to produce what we have to produce the most efficient way. But the plans of the rate up are pretty much aggressive. Every platform are going up to --
Okay, that's helpful.
Yes, to 2019 level. Even the twin-aisle, trying to push it back up, you know? I don't know what they have disclosed but I know that they're trying to put it back to bring it back up.
My final question and I'm thinking longer term here and I'm thinking about the challenges presented to you, in particular, related to inflation, specifically. Given the fixed pricing nature of many of your contracts, I mean, is that, that margin pressure -- like could that not be kind of a multiyear challenge that you have to deal with where you've got permanently higher costs and you've got pricing that, depending on the contract, obviously, is fixed for a period of time and therefore, you just have to kind of wait this out sort of narrower margins on some pieces of business? Is it -- am I correct in that thinking? Or could you basically kind of recover all of the inflation in some way, shape or form in the short to medium term?
Very difficult for me to answer that question in front of everybody, right, Tim. But we'll do whatever we can to keep our -- and stay healthy and keep our supply chain healthy. So that's the nature of aerospace industry. We always -- as you know, we always fought inflation. There's no inflation in our industry, right? We always have find ways to offset this inflation through productivity and cost structure and best practices and lean practices. So in our DNA, it's like that. But now we're facing all as an industry something that it's been a while that we haven't seen that. It's back in the '90s, right, that we had these type of inflation. So we will have to have many discussions among all the actors of the industry, if I may answer like that, Tim.
Your next question comes from Benoit Poirier from Desjardins Capital Markets.
Just to come back on the labor front. Obviously, you discussed about the labor challenges. But could you talk maybe about the upcoming labor agreement in terms of renewal? And maybe if it could get worse before it getting better. Just wondering about if there's any big agreement up for renewal?
We have 4 agreements in place, right? We have 4 union planned, right Stephane? 4 union planned, 3 of which are the one that is -- 3 of which are for the next 2 years, right, 2, 3, 4 years. The one that is upcoming for negotiation is our Longueuil plan. That union agreement expires in April 2023.
Okay. And just in terms of pricing power -- and could you talk maybe about your ability to or the pricing power discussion you have with the OEMs right now. Whether they are receptive to some costs and/or price increase given the nature of your contract? Maybe the feedback overall from the discussion with your OEM that would be awesome.
I've been 30 year in that business and I've never found a customer that wants to pay higher or more for the product, right? So if you find a customer like that, you let me know. But again, it's going to be a discussion, periods and things like that. It's an industry problem, because we have always been fighting the inflation. And you see some of the results of the people looking at inflation, Tier 1, Tier 2 people, that will have to be discussed. Obviously, if you're in the aftermarket, you don't have these long-term contracts or MRO and things like that. It's easier to pass this inflation. However, when you are on long-term -- like you said, on a long-term contract with the current fixed pricing, those negotiations, we will have to have discussions. So no, they are not welcome you open arms, right?
Okay. And Martin, could you provide some color about the timing to get back to the kind of a 15% EBITDA level? Do you have some visibility on that potential timing?
Benoit, Trust us, we're going to get there. When? I don't have a clear vision.
Great. And now when we look at the order flow in the quarter, there has been several announcements with the Canadian government that is finalizing the F-35 orders. We saw also Dassault and Airbus that have reached an agreement on the FCAS. Also more development around the FLRAA with the Bell Textron. So among those 3 opportunities, could you highlight the potential aftermarket opportunities and maybe the opportunities that you see among those 3.
Well, of course, F-35. F-35, it's something that we need -- we are now working on to get sustainment of F-35, because all the production is made, marking as its supply chain. Unless they we decide to change some of their suppliers, right, because of performance or before because of deliveries, right? There won't be much there but the sustainment, this is something that we're pushing. On FCAS, obviously, Europe has decided to go with the FCAS. This is -- we have a good site in Spain. We will have our discussion with Dassault. Dassault is a good customer of ours. We have a very good reputation with them. And also -- and then there's Airbus, Germany that is in this FCAS. So yes, we do have some discussion. It's going to take time. You won't see the revenue soon but those are programs that we're discussing.
There's also the Tempest in the U.K. that U.K. government wants to launch. So when you're number 3 in the landing gear and you have footprints in the U.K., in Europe and North America, so we participate in those discussions. Is it -- are we going to get the contract at the end? That's always -- there's other 2, 3 other companies there that are competing, depending what market, right. Sometimes it's 2, sometimes it's 3. So yes, we entertain that. But obviously, for revenue in the midterm, again, I want to remind you that we have the CH-53K, we have the MQ-25 and we have the MRO of F-18. What else?
Those are -- we have the business jet -- the 2 business jets that are coming. So we should see revenue profile going up. And we need to get it back to stabilize our production system, get healthier with our supply chain or to get healthy and then produce as we used to, right. Produce as we used to in a more predictable fashion.
And just lastly on the FLRAA competition, what about your exposure on the Bell Textron product?
We had exposure to -- we're Tier 2 on that platform. We believe that we can -- we will have some work on Tier 2.
Okay.
Not landing gear, Benoit. Mainly in landing with our competitors.
Your next question comes from Jonathan Lamers from Laurentian Bank Securities.
Could you give us an update on how you're thinking about tuck-in acquisitions and your plans going forward given the ongoing supply issues that are pressuring the EBITDA side of the leverage ratio?
Acquisition, so we still -- if the right opportunities happens, at the right price, it's accretive to our shareholder, we'll do it. We have the balance sheet to do it. We'll do it. Right now, our mind is more to focus on the level of operation. But of course, we're going to look at all opportunities on all sides to be able to complement our offer to our customer. And should this acquisition be accretive, we'll do it. We have strong partners. We have good partners. We can do a vast or a large area of business acquisition. Stephane, do you have anything to add?
No.
No.
Okay. And just on your contracts in general, could you remind us how the standard cost escalators work that are included in the line purchase orders and your ability to improve the pricing longer term under the longer-term programs?
So we do have escalation clause in our life of the program contract when we have the IP. So this is typical in the industry. This is standard in the industry where you have a long-term contract, you have the IP. So we have the escalation clause that follows the WPU index and the CPI which is the labor. So those are contractually in the contract. So obviously, we have a lots of fluctuation these days and I haven't found a customer that wants to pay more for its product. I'm sure if you find one, let me know. But again, this is contractually and there's no reason why we cannot exercise our right there. Then we have a long-term contract. So we have the PO to PO basic contract which are lasting, like I said, 1, 2, 3 years. So when you place a PO for a landing gear, you're going to get the product in 2 years.
So those, as soon as we're renewing and repeating, we take the opportunity to revise our pricing and it's going there and we're asking. It's a bid, obviously, it's a bid we're going with our supply chain and then we pass it on the actual cost. So -- and the aftermarket, well, it's a list price and then this is -- it's much more faster to put it in a price.
Does that answer your question, Jonathan?
Yes. So maybe just one follow-up, if I can. So the margin issues that resulted from pricing this quarter that you highlighted. Did those result from like cost inflation exceeding what you're able to capture through the escalators that are included in the orders?
Yes. Again, those orders that we're delivering in Q3 were orders that we received 2 years ago.
Right. So the pricing would have been fixed at that time 2 years ago.
That's right. We got the deal -- we win the deal years ago and then we're delivering on that deal. And then the deal we received today, we're going to be delivering in 2 years.
Okay. And I have a question on the backlog and the impressive growth we saw this quarter. How much of that relates to order terms and lead times getting longer? And I guess, how much of a higher level of annual revenue would you expect that to support once you're able to get the production capacity to meet that demand?
I think it's not a question of order for us to ramp up the volume, right? We have the order. It's a question of execution. So as Martin described, both sectors are very strong on the defense side. And on the civil side, everything is ramping up. So it's really the strength of the order book is coming from those 2 groups, right? So.
Okay. So truly a stronger demand. And just one other question on the margin outlook which I know you've spoken about quite a bit. But if you're paying to add staff and your suppliers to increase production throughput, would you expect that to be a net positive or a net margin net -- sorry, a net positive or a net negative for your margin percentage in the short term?
If you're paying more your supplier mean, is that going to be --
I believe you said in your opening remark that you were looking to add staff at your suppliers --?
Okay, yes.
So that we could increase the supply flow and improve your throughput?
Yes.
So I'm just wondering if that's net negative for you or net positive, just as we think about the margin percentage going forward.
Should be positive, because we're doing that to make sure that our shop will be linear and we don't create hole in our production system.
Yes, that's for sure. It's going to ramp up the volume. In addition, as Martin said, month-to-month, I mean, or week-to-week will stabilize the incoming material so that we have a more regular flow within our shelf.
Okay. And one more, if I can. Earlier in the year, you had identified 3 production facilities that we're experiencing challenges. Can you just provide us with an update on those? It sounded like they were trending low into September and October. And are we right to understand that the issues in Q3 was kind of just across the board, not at those facilities?
Well, those 3 facilities, they performed as well as in Q2. So there's no deterioration from those 3 facilities. Although, we have not improved them, right? Or the improvement was not following our plan, right? So there's still room for improvement on 2 of the 3 facilities, right? The U.K. one, I think, it's pretty on its prime now, right. And the other 2 are the ones that we are targeting improvement and it's achievable, so for those 2. We have another one in the U.S. which is impacting our result this quarter. So throughput was lower than what we anticipated from that facility. And that's the go-get this quarter in order to stabilize that throughput that is coming from that facility and it's basically how the translation from Q2, Q3 is. So basically, the 3 facilities, one is at the level that we are expected and the other 2 are gradually improving.
Very good. Thanks for your color.
Not to the level that we're satisfied yet. Okay.
Your next question comes from Konark Gupta from Scotiabank.
And just as a follow-up here. Martin and Stephane, you guys have been talking about the labor issues for some time now. I'm just wondering, is there room for more automation in your factories to offset some of that labor availability?
Yes. All the time, Konark and our strategy is still to absorb production rate increase of the 777 without adding resources. But we're still on with this, right? We're still on with the automation in our facility in Ontario and in Springfield, Ohio. And those are the ones that are -- will benefit more from the automation and will continue to do that. We're doing the same thing in the Spain and in Laval. That the -- but the greatest impact should come from Ontario and Springfield would you agree?
Right, Stephane?
Yes.
So because we're going to see these rates from 2 to 3 and maybe to 4 months right now, 777 and 777X.
Right, that make sense. And then one more for me quickly on inventory. So there's been a $47 million kind of inventory built in the first 3 quarters. Do you expect any major reversal in Q4?
No.
And is that because stabilizing productions maybe or...
Well, as Stephane said it's -- our goal is to get to $140 million to $160 million a quarter. So we're going to have some ups and downs, Konark but that's our goal.
[Operator Instructions] Your next question comes from Tim James from TD Securities.
Just want to return, Martin, you were talking about 3 different types of contracts in response to kind of an inflation question. Am I correct that the life of program contracts that you talk about. Number one, the escalation that comes in, there's -- is there typically a delay on that, like the costs will inflate but it will be the next year before you really get to benefit from the pricing? Or is it matched better than that?
Yes. There's always a delay. But for those contracts that I have in mind and not 2 years, the delay is shorter. So it's 1 year.
Okay. And then I guess just to follow on that, those 3 categories, if you will, of revenues. Could you give us a sense for -- in the current fiscal year, let's say, by the year is done, approximately how much revenue will come from each of those or what percentage of revenue will come from each of those 3 different types of contract, life of program, the POs and aftermarket, just approximate values if possible?
Thank you for asking the questions, Tim. But you can understand that we cannot disclose that and you guys are pretty good in figuring it out.
There are no further questions at this time. I will turn the call back over to the presenters for closing remarks.
Thank you. Thank you for your continued support once again and for your interest towards our company. So rest assured that we'll do what we have to do to bring it back, to navigate through the environment or the turbulent environment and to improve our performance. So thank you very much and have a good day.
Ladies and gentlemen, this concludes today's conference call you may now disconnect. Thank you.