Earnings Transcript for CVU - Q2 Fiscal Year 2019

Operator: Good morning, and welcome to the CPI Aerostructures Second Quarter 2019 Earnings Conference Call. All participants will be in listen-only mode. [Operator Instructions] After today’s presentation, there will be an opportunity to ask questions. [Operator Instructions] Please note, this event is being recorded. I would now like to turn the conference over to Mr. Sanjay Hurry. Please go ahead.

Sanjay Hurry: Thank you, Ben. Good morning, everyone, and welcome to CPI Aerostructures second quarter 2019 results conference call. A copy of the company’s earnings press release and accompanying PowerPoint presentation to this call are available for download at the Investor Relations section of the company’s website. On the call this morning are Doug Crosson, President and Chief Executive Officer; and Vincent Palazzolo, Chief Financial Officer. At the conclusion of their prepared remarks, management will hold the Q&A session. As a reminder, this conference call will contain forward-looking statements, which involve known and unknown risks, uncertainties and other factors that may cause actual results to be materially different from projected results. Included in these risks are the government’s ability to terminate its contracts with the company at any time; the government’s ability to reduce or modify its contracts, its requirements or budgetary constraints change; the government’s right to suspend or bar the company from doing business with them as well as competition in the bidding process for both governments and subcontracting contracts. Subcontracting customers also have the ability to terminate their contracts with the company if it fails to meet the requirements of those contracts or if the customer reduces or modifies its contracts due to budgetary constraints. Given these uncertainties, listeners are cautioned not to place undue reliance on any forward-looking statements contained in this conference call. Additional information concerning these and other risks can be found in the company’s filings with the SEC. Before I turn the call over to management, be advised that management will be in attendance and presenting at the 39th Annual Canaccord Growth Conference in Boston tomorrow. With that said, I’d like to hand over the call to Douglas McCrosson, President and Chief Executive Officer. Good morning, Doug.

Douglas McCrosson: Good morning. Thank you, Sanjay, and good morning to everyone. Thank you for joining our call. As all of you who are undoubtedly aware, last week, CPI Aero was awarded a contract from the U.S Air Force valued at up to $66 million for work on the T-38 Talon trainer aircraft. Given the significance of the award, I’ll start today’s call with this before I recap our performance for the second quarter. Vince will then provide a detailed review of our financial results for the quarter, after which I will offer some concluding remarks before opening the line to questions. As you can see on Slide 4, at almost $66 million, the T-38 contract we announced last week represents the second largest prime contract with the DoD in the company’s history and our largest prime contract since 2004. We also announced the receipt of a first delivery order under the contract valued at $3.4 million. Under the terms of this contract, CPI Aero will provide structural modification kits, program management, logistics and other sustainment services in support of Phase 3 of the T-38C Pacer Classic III fuselage structural modification kit integration program, we call Pacer Classic III; and the Talon Repair Inspection and Maintenance program, known by the acronym TRIM. We have a long history of supporting sustainment of the T-38 airframe, dating back to 2001. And we are currently performing Phase 2 of Pacer Classic III for the U.S. Air Force under a contract we won back in 2015. We’re honored to continue to work on this platform, which is essential for training future generations in military aviator. Next month, we plan to host the Air Force at a kickoff meeting, where we may get better clarity on future demand in order to assess how this contract will impact our financial performance. But based on what we know today, we estimate that this program will contribute some revenue and profit during the fourth quarter of this year. However, as we progress into 2020 and beyond, we believe this new program will have meaningful positive contributions to revenue and profit. Based on what we know today, we believe it is possible that more than half of the Air Force’s requirements could be ordered during the first 36 months. This contract illustrates the success of our strategy to focus on defense market opportunities, bringing to bear our world-class engineering capabilities and exceptional supply chain and program management expertise to build our multi-year backlog. It’s also a testament to the excellent program execution we have become known for, especially on our prior work on the T-38. Wins of this magnitude require a lot of hard work by a diverse group of employees who work tirelessly to ensure CPI Aero is always in the best possible position to succeed. They deserve our thanks. Government bids are very difficult to prepare and they require extraordinary attention to detail. So I would like to, especially thank our Bid and Proposal team for their efforts and bringing home a milestone win for CPI Aero. Turning to the second highlight. We are pleased to again deliver a solid year-on-year growth in revenue and net income during the second quarter. That reflects continued operational execution and progression on our strategic priorities for the year. Net income for the quarter benefited from the lowering of a reserve we took in the fourth quarter of 2018. Vince will have more details on this in his prepared remarks. But even excluding this pickup, net income was up in the second quarter of 2019 by approximately 30% compared to the year-ago period. Diluted earnings per share was unchanged compared to the year-ago period on a higher number of shares outstanding. We’re reporting another strong quarter of new bookings and product sales backlog in the second quarter. Consolidated book-to-bill for the second quarter was 1.7

Vincent Palazzolo: Thank you, Doug. Starting on Slide 8, I’ll begin my review of the second quarter results. Revenue increased approximately 14% year-over-year to $23.2 million from $20.3 million for the second quarter of 2018 due to contributions from our WMI subsidiary and much greater production activity on the next-generation Jammer Pod program we have with Raytheon. Gross profit increased to $5 million in the second quarter of 2019 from $4.6 million for the second quarter of 2018. Gross margin declined to 21.4%, compared to 22.6% in the prior period, due to low gross margin on the WMI jobs, approximately 18%. As a result of business combination purchase accounting and an unfavorable contract mix on CPI Aero jobs. Selling, general and administrative expenses increased by $152,000 for the second quarter compared to the same period last year. The increase reflects the addition of WMI and approximately 200,000 in new salaries, offset by lower professional fees, which were associated to WMI’s acquisition and contract work. Pre-tax income for the second quarter increased approximately $61,000 to $1.7 million from $1.6 million in the same period last year. We recorded a benefit from income tax in the quarter of approximately $1 million. As you may recall from our fourth quarter earnings call, we received information from the IRS last February that the net operating loss carry back that was utilized in 2014 and carried back to 2012 and 2013 was under examination and could possibly be disallowed. Although we had not received any formal documentation or notice of such disallowance, in accordance with ASC 740-10 accounting for uncertain tax positions, we opted to be conservative and record a liability of approximately $3.1 million for the quarter ended December 31, 2018, representing the maximum net tax adjustment for the disallowance of the net operating loss carry back. In the second quarter, we received further information from the IRS related to the possible disallowance of our net operating loss carry back. Based on this information, we reduced the liability related to this uncertain tax position by approximately $1.4 million for the second quarter. This resulted in a benefit to income taxes of $1,039,000 for the second quarter of 2019, compared to a provision for income taxes of $353,000 in the year-ago period. Net income for the second quarter of 2019 was $2.7 million, or $0.23 per share on a higher number of shares outstanding, following our October 2018 public offering. This compares to a net income of $1.3 million, or $0.14 per diluted share in a year-ago period. Net income for the second quarter of 2019 includes approximately $0.09 per diluted share, arising from the reversal of the tax liability. Turning to our balance sheet highlights on Slide 9. Cash and restricted stock – cash at June 30 was $2.8 million, $2 million of the cash on hand at quarter-end is held in escrow pursuant to the acquisition of WMI. Contract assets were at $120.3 million, an increases of $6.9 million compared to December 31, 2018, but a decrease of approximately 400,000 compared to March 31, 2019. The increase in contract assets since year-end was the result of work performed on the next-generation Jammer mid-range Pod program. The decrease in contract assets since March 31, 2019 was the result of increased shipping in the second quarter of 2019, as compared to the first quarter. Total long-term debt stoat $3.0 million, compared to $3.9 million at December 31, 2018. Our outstanding balance on our revolving line of credit at quarter-end increased marginally to $25.7 million from $24 million at December 31, 2018. Shareholders’ equity quarter-end stood at $98.2 million, compared to $93.4 million at December 31, 2018. Effective January 1, 2019, we adopted ASC 842, which sets out the accounting treatment of leases. As a result, on January 1, 2019, we recognized operating leases of $5.3 million and operating lease liabilities totaling $5.8 million. In accordance with the accounting standard, we elected not to recast prior comparative balance sheet periods. The adoption of ASC 840 does not have a material impact on our income statement. On Slide 10, we are reaffirming our 2019 financial guidance. We expect revenue in the range of $98 million to $102 million. Pre-tax income is anticipated to be in the range of $11 million to $11.3 million. Cash flow from operations is expected to be in excess of $3.5 million. We expect cash flow from operations to increase in the second-half of the year, driven by a significant increase in next-generation mid-band Jammer Pod shipments, as well as catching up of WMI shipments, as Doug noted. Given the lack of visibility on our NOL carry back, we are withdrawing our effective tax guidance for the year. This concludes my prepared remarks. I will now turn the call back to Doug for additional commentary on the quarter and closing remarks. Dou?

Douglas McCrosson: Thank you, Vince. Looking ahead, the recent passage of the new two-year federal budget agreement authorizes increases in defense spending in 2020 and 2021. Once passed into law, defense spending is expected to increase from $718 billion in 2019 to $738 billion in 2020 and $741 billion in 2021. We are optimistic that Congress will pass defense appropriations bills that will fund the DoD at these levels and do so prior to September 30, the end of 2019 government fiscal year. Getting the 2020 defense spending bill enacted on time should be a very positive event for CPI Aero. Significantly, the 2020 budget appears to call for growth and proposed funding levels to key programs in our bid pipeline. It also includes funding for technologies and capabilities we have been making strategic business development priorities, including electronic warfare, intelligence, reconnaissance and surveillance, advanced missiles and autonomous systems. As you can see on Slide 12, the bid pipeline is at the moment, heavily weighted by defense bids at the Tier 1 level. We removed some commercial aerospace bids from the pipeline during the quarter, either because the customers decided not to proceed with the subcontract or it awarded the contract to a competitor. Ideally, we want a more balanced opportunity set, and to that end, we are preparing commercial aerostructure proposals that we expect to submit in August that should bring the percentage of the commercial portion of our bid pipeline back to historical norms. CPI Aero recently attended the Paris Air Show, the first major trade show since we closed WMI acquisition, and we spent a lot of time with current and prospective customers that were interested in WMI’s capabilities and how these increased CPI Aero’s value proposition. For example, we saw significant interest in WMI’s two pending and welding capability that is already converting into quote activity. And interest in CPI Aero’s core product and service offerings has never been higher. We’ve held productive meetings, in particular, with large defense companies who express strong interest in our aero systems capabilities, such as our experience in manufacturing fully integrated pod structure. We also drew attention from a European aerospace OEM, seeking to establish a U.S. supply chain for an existing platform they want to sell into the Department of Defense. Business development team expects to convert many of these meetings into actionable bid opportunities during 2019. Let me spend just a few minutes on specific opportunities within our bid pipeline, as shown on Slide 13. The A-10 program is a significant program opportunity for us, and we are expecting that the Air Force will make an award decision before the end of September. We recently held very good meetings with the two prime contractors we understand are the only ones competing for the award. We believe we are in a very good competitive position with both of them. As a reminder, the 2018 and 2019 budgets secured approximately $247 million in funding for the re-winging program that is yet to be obligated. The 2020 budget is seeking an additional $169 million to support the re-winging effort. In our Kitting and Supply Chain Management segment, we received the authorization from Northrop Grumman to begin work on long lead items required for the Japanese variant of the E-2D Advanced Hawkeye. As I mentioned in our first quarter call, we are currently in discussions with Northrop Grumman to finalize the potential $47.5 million multi-year two order on the E-2D we announced last October. Multi-year two orders are for the U.S. Navy version of the E-2D only. The Japanese aircraft would be additive to the aircraft covered by multi-year two, and we expect to receive the Japanese orders for up to an additional nine aircraft later this year. Staying with the E-2D, I noted last quarter that WMI is separately pursuing an order for the multi-year two program totaling approximately $10 million across three different RFPs. WMI expects to hear if it has been selected for multi-year two work during the current quarter. Also noteworthy, in our Aerosystems segment, we earned a competition to provide a new pod structure for current customer and we expect an award decision within the next few months. Bidding activity across all of our segments remains quite strong, and we hope that the next couple of months heading into the end of the current government fiscal year will bring new contracts to build upon our first-half bookings success. Turning to Slide 14, multi-year defense awards gives us excellent long-term revenue visibility. Our defense and commercial programs have the potential to cumulatively generate approximately $448 million over the remainder of their periods of performance. As a reminder, this figure is as of June 30, and, as such, does not include last week’s T-38 announcement. In conclusion, we’re on track to achieve our revenue and net income goals and to deliver on our key strategic priorities we established at the start of the year. As we head into the second-half of the year, we have business momentum with a firm backlog and a proposal pipeline that supports opportunities for new program starts, as well as follow-on orders. And our established reputation as a valued supply chain partner puts us in the mix on future platform and systems that should drive our growth into 2020 and beyond. This concludes my prepared remarks. I want to thank you all for your attendance and continuing support with CPI Aero. Ben, you can open the call to questions. Thank you.

Operator: We will now begin the question-and-answer session. [Operator Instructions] Our first question comes from Ken Herbert with Canaccord Genuity. Please go ahead.

Ken Herbert: Hi. Good morning, Doug and Vince.

Douglas McCrosson: Good morning, Ken.

Ken Herbert: Doug, I just wondered if you could provide a little more detail on the cadence we should expect on the T-38. It sounds like maybe in the fourth quarter of this year, maybe three to four, $3.5 million or so is possible at revenues. But if I understood correctly, it sounds like potentially an incremental or $30 million or so in the 2020 to 2022 period, if things move according to plan, is that relatively linear? Do we see a step-up in 2020 to 2021, or how should we think about the revenue ramp in the next few years on the T-38?

Douglas McCrosson: Okay. So after we host the meeting next month, we should have better information. But going by the proposal documents and the estimated quantities during the various ordering periods of contracts, we believe that up to about $38 million or so could be ordered within the first three years of the contract. The reason for that is the Pacer Classic III portion of that contract is only over a three-year ordering period, and there were a lot of requirements needed for that program. So on an order of magnitude, we’ve been averaging on our current Pacer Classic III contract, somewhere between $4 million and maybe $6 million a year in annualized revenue, and we would be looking to see that probably double, if not, go more than double for the first three years, they’ll figure 2020, 2021 and 2022. Hope that helps.

Ken Herbert: Yes, that’s helpful. Thanks. So the incremental or the part from the new contract in 2019 is minimal, or is there something we should expect or you’re expecting in the fourth quarter?

Douglas McCrosson: It should be minimal. We’re still running the – what is Phase 2 of Pacer Classic III. And so we definitely have T-38 revenue throughout the year, including the third and fourth quarter. There will be just labor work that is done in the fourth quarter. The real revenue recognition comes as the bigger costs come in, which is the material needed for the kits, which won’t happen until – till 2020.

Ken Herbert: Okay, great. And if I could on WMI, is the $2.5 million you called out in terms of the – some of the timing of some of the revenues that were pushed to the right, was that all the result of the delays in the welding certifications, or was there anything else that contributed to those delays?

Douglas McCrosson: No, that’s a good question. It isn’t only because of the welding specifications. There was, I would say, obvious disruption to workflows. And as best as we tried to manage those physical movement of the shop, it caused some of the delays as well. And then there were some – a large amount of customer-generated delays, meaning, customer schedule is going to get in here to buy off product in June, as anticipated, and that kind of bled into July. July was a very strong month for WMI, and the back-half of the year is real strong. And none of the sales that were missed in the first-half of the year are gone, meaning, the customer – they weren’t customer cancellations, it’s just a matter of timing now.

Ken Herbert: Okay, that’s great. And I’m guessing that explains some of the lower gross margin for WMI in the second quarter. And then as part of that, what’s a reasonable expectation for gross margins on the WMI business in the second-half of this year or coming out of 2019?

Douglas McCrosson: The – our expectation for second-half margins for WMI are, I would say, are higher than the core CPI’s margin. I think I’d probably just leave it at that. But they should be between the increase of – a dramatic increase in product shipments in the second-half of WMI, combined with a much increased gross profit, they should be a big contributor to our overall margin in the second-half.

Ken Herbert: Great. All right. Well, thank you very much. I’ll pass it back there.

Operator: Our next question comes from Arthur Winston with Pilot Advisors. Please go ahead.

Arthur Winston: Thank you. Good morning, Doug and Vince.

Douglas McCrosson: Good morning.

Arthur Winston: Two questions. If the A-10 were to go forward, when – and you, in effect, supply your components, as expected. When would it begin to hit the income statement in terms of sales and profits?

Douglas McCrosson: We would – if the timing holds and a prime contractor is awarded in September, we would expect to fairly quickly be on contract with the winner. But from a – you have to look at real – the real contribution will probably be, say, six to nine months post award to to us. We’re planning. So just figure a slight contribution first-half of next year and starting to be a meaningful contribution with the third quarter of 2020.

Arthur Winston: Okay, good. And in terms of everything you said on WMI, it sounds like nothing has come out of the closet other than these natural delays and, in effect, this business is more or less what you thought it would be when you bought it, correct?

Douglas McCrosson: Yes. It’s definitely what we thought when we bought it and the synergies have been there. We’re already kind of moving towards operating as a single company under the single operating system. The cooperation from the more than 50 employees that came over has been exceptional. I thank them again for that. And it’s just a matter of kind of working out some of the kinks on startup. And and I’ve been really impressed with the customer reaction and responsiveness and the – as evidenced by the new bookings that we were able to get with a backlog of over $20 million.

Arthur Winston: And just real quickly, in terms of some of the businesses going to – hopefully going to come on as expected, do you have enough skilled labor, in effect, to get around bottlenecks? I mean, can you produce what may come on in the next 18 months?

Douglas McCrosson: Yes. We’ve – we’re out of – we’ve been out ahead of the curve in terms of hiring, where it is a pretty tight labor market. I’m not going to sugarcoat that too much. But we’ve not had a problem to date in getting the manpower here. It’s a matter of trying to get ahead of this demand, but not having so many bodies where your overhead rate goes up when they’re not waiting for the contract to come. So we’ll kind of strike the right balance. And – but I think we – we’ve planned it. We have some visibility in terms of the timing of some of these awards and our HR department is that is actively out there looking for people. We have about 10 open reps right now for people and we’ve started another apprentice training program. So we’re doing the things that we need to do to make sure that we get in front of that.

Arthur Winston: Thank you, Doug.

Operator: [Operator Instructions] That concludes our question-and-answer session. I’d like to turn the call back over to Doug McCrosson for any closing remarks.

Douglas McCrosson: All right. Thank you, Ben, and thanks again to everybody for listening to today’s call. And Vince and I look forward to speaking with you again when we announce our third quarter results. Thank you very much. Have a great day.

Operator: The conference has now concluded. Thank you for attending today’s presentation. You may now disconnect.