Earnings Transcript for CVU - Q3 Fiscal Year 2019

Operator: Good day, and welcome to the Q3 2019 CPI Aerostructures' Earnings Conference Call and Webcast. All participants will be in listen-only mode. [Operator Instructions] Please note, this event is being recorded. I would now like to turn the conference over to Jody Burfening. Please go ahead.

Jody Burfening: Thank you, Sarah, and good morning, everyone, and welcome to CPI Aerostructures' Third Quarter 2019 Earnings Conference Call. A copy of the company's earnings press release and PowerPoint presentation accompanying this call are available for download in the Investor Relations section of the company's website. On the call this morning are Doug McCrosson, President and Chief Executive Officer; and Vincent Palazzolo, Chief Financial Officer. At the conclusion of their prepared remarks, management will hold a 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 for budgetary constraints, the government's right to suspend or bar the company from doing business with it as well as competition in the bidding process for both government 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 that may be made during this conference call. Additional information concerning these and other risks can be found in the company's filings with the Securities and Exchange Commission. With that, I would now like to turn the call over to Douglas McCrosson, President and Chief Executive Officer. Good morning, Doug.

Douglas McCrosson: Good morning. Thank you, Jody. I'll start today's call with a recap of our performance for the third quarter. Vince will then provide a detailed review of our financial results and modified financial guidance for 2019, after which I will offer some concluding remarks before opening the line to questions. We are very pleased to report an exceptional quarter of growth, strong operational execution and advancement on our strategic priorities for 2019. Turning to the first highlight on Slide 4. Revenue, pretax income and earnings per share each exhibited robust year-on-year growth with EPS based on higher share count. We are also reporting another strong quarter of new bookings and product sales backlog. The consolidated book-to-bill ratio this quarter was 1.24, and it's greater than 1.4 over the past 12 months. WMI, on a stand-alone basis, had a book-to-bill this quarter of 1.2

Vincent Palazzolo: Thank you, Doug. Starting on Slide 8. I'll begin my review of the third quarter results. Revenue increased approximately 35% year-over-year to $25.7 million from $19.0 million for the third quarter of 2018, driven principally by the contribution of our WMI subsidiary and from our Northrop Grumman E-2D Advanced Hawkeye and Raytheon Next Generation Jammer Mid-Band programs. Gross profit increased to $5.0 million from $3.9 million in the prior year period, an improvement of approximately 28%. SG&A was flat for the third quarter compared to the same period last year at $2.6 million. SG&A for the third quarter of 2019 included $400,000 in additional operating expenses from WMI that we did not have in the prior period. Pretax income for the third quarter increased approximately 186% to $2.0 million from $700,000 in the same period last year. We recorded income tax in the quarter of $323,000. As you may recall from our last quarterly earnings call, we received additional information from the IRS in the second quarter related to the possible disallowance of our net operating loss carryback. Based on this information, we reduced the liability related to this uncertain tax position by approximately $1.4 million in the second quarter of 2019, which results in an income tax credit for the year-to-date period. Net income for the third quarter of 2019 was $1.7 million or $0.14 per share on a higher number of shares outstanding following our October 2018 public offering. This compares to net income of $586,000 or $0.07 per diluted share in the year ago period. Turning to our balance sheet highlights on Slide 9. Cash and restricted cash at September 30 was $2.5 million. $2 million of this cash on hand at quarter-end is held in escrow pursuant to the acquisition of WMI. Contract assets were $121.5 million, an increase of $8.2 million compared to December 31, 2018, and an increase of $1.2 million compared to June 30, 2019. The increase in contract assets since year-end was the result of increased production on the Next Generation Jammer pod program with Raytheon as well as increases in inventory on 2 commercial programs that had some delays in shipping. Total long-term debt stood at $2.4 million compared to $3.9 million at December 31, 2018. Our outstanding balance on our revolving line of credit at quarter-end was $26.7 million compared to $24 million at December 31, 2018. Shareholders' equity at quarter-end stood at $100.2 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 lease assets 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 842 does not have a material impact on our income statement. On Slide 10, we are modifying our 2019 guidance, as Doug noted. Several factors, some positive, some negative converged this quarter that has caused us to revise our full year forecast. On the positive side, the recent surge in new business awards improved our top-line outlook, but we'll consume more cash this year as we start executing on our record backlog earlier than originally planned. On the other hand, WMI has required greater operational, financial and legal resources to execute on its business plan than previously forecast. We have taken decisive steps in response to the shortcomings we have observed at WMI since we began operating from a single facility in March. For instance, we accelerated the planned transition of the WMI enterprise software system to the CPI system by more than 5 months. This effort is complete and should be extremely helpful in improving operational and financial performance, particularly in the area of on-time delivery and inventory management. We have also reorganized WMI's personnel to more closely resemble our proven program centric structure, which we believe will improve customer support and strengthen the relationships with our customers. We are already seeing signs that these steps are making progress. We believe that the organizational and manufacturing changes we've made at WMI should get it back on track heading into 2020. WMI's operating cash flow performance has also been adversely affected by the working capital deficiency that is the subject of a current litigation between us and the CELP, as I'll discuss in a moment. Specifically, the value of the inventory received in the acquisition was lower than represented, which required us to make large cash outlays for inventory to get WMI's production line moving. For fiscal 2019, we now anticipate revenue of approximately $103 million compared - this compares to revenue of $83.9 million for fiscal 2018. Pretax income of approximately $9.0 million as compared to $6.8 million in fiscal 2018. An aggregate operating cash flow to be a use of cash of $1.5 million as compared to a use of cash of $2.5 million in fiscal 2018. Nearly all of the adjustment to pretax income guidance results from lower than targeted margins on lower-than-expected sales at WMI and higher legal and accounting expenses resulting from litigation to recover the working capital adjustment. About half of the adjustment to cash flow guidance is due to lower profit at WMI. The other half is related to an increase in working capital related to the new program starts at CPI. Finally, we entered into new litigation against the seller of WMI to affect the settlement of a dispute related to net working capital adjustments totaling $4.2 million. Of this amount, $2.0 million sat in escrow at September 30, 2019. Subsequent to the end of the quarter, $619,000 was released to us from the escrow. If the balance of the dispute is settled in our favor, the balance of the adjustments totaling approximately $3.6 million would be a positive for our cash position. This concludes my prepared remarks. I will now turn the call back to Doug for additional commentary on the quarter and closing remarks. Doug?

Douglas McCrosson: Thank you, Vince. As Vince just detailed, due to factors both outside and inside of our control, we did not realize the financial benefits of the WMI acquisition that we hoped for back at the start of 2019. However, the thesis behind the acquisition remains intact and the strategic value to opportunities for growth over the coming years remain strong. For example, the assemblies we will produce for Boeing on the A-10 contain not just structure, but also electrical wiring and welled details that can now be produced internally by WMI. Likewise, just this week, we submitted a proposal for an integrated electronic Pod assembly that contains bended tube assemblies and electrical wiring bundles that we now can internally manufacture and keep more of the contract dollars within CPI. These are but two examples of how leveraging newly acquired manufacturing capabilities is expected to make us to be even more valuable to our customers. And as Vince said a moment ago, we are very confident that WMI is entering 2020 with the right team and processes in place to deliver the returns we envisioned when we acquired them. As we look ahead to the balance of the year and into fiscal 2020, we believe we are approaching an inflection point in our business based on our growing backlog and business development efforts that are aligned with defense spending priorities, supported by an improved cost structure and better competitiveness. As most of you probably know, the 2020 fiscal year started on October 1 without an approved defense budget and the DoD is being funded by what is known as a continuing resolution or CR. CR cap spending on continuing programs at fiscal 2019 levels and allocates no funding to new programs without first obtaining a waiver. While this has unfortunately become standard operating procedure down in Washington, our shareholders still see the headlines and want to know how this affects CPI in our future plans. In short, the fact that we are under a CR has not impacted our 2019 results at all. And unless we have a CR that extends well into calendar year 2020, we do not expect a substantive change to our current 2020 business plan. Funding from 2019 or prior years was used to start to several new programs we announced, such as the T-38 TRIM and Pacer Classic, the BLACK HAWK Gunner Doors for Turkey, the A-10 Re-Winging, the SDTA phase and Next Generation Jammer Mid Band, et cetera. We do not anticipate any impact to these programs from the delay in the signing of the fiscal year 2020 Defense Bill. The main impact on CPI Aero, should there be an extended CR that goes beyond March or April of 2020, is the potential to see a slowdown in how fast the proposals in our bid pipeline convert into new wins. That being said and as I noted on our call last quarter, we're excited about what we believe will be in the 2020 defense request when essentially gets signed into law. 2020 budget calls for growth for key programs in our current portfolio as well as new funding for 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, surveillance, advanced missiles, including hypersonics and autonomous systems. We remain very well positioned in light of defense priorities, even if the timing may be for now a bit uncertain. Turning to Slide 12. The bid pipeline is heavily weighted by defense bids at the Tier 1 level. Within the Kitting and Aerosystems segment, this comprises 70% of the value of our pipeline. Our products and services in these 2 business segments can potentially achieve better margins than our Aerostructure segment, and our business development efforts are aligned with this. Over time, with the continued success in capturing work in these segments, the shift in mix should be a catalyst for margin expansion in future periods. As I mentioned before, it is our goal to have our bid pipeline more reflective of our strategy to have a roughly 70-30 mix between defense and commercial revenue, which is roughly the mix through the first 9 months of 2019. Over time, we would expect that this chart will change as commercial opportunities in our business development funnel become converted to firm proposals. Within our bid pipeline, there are several opportunities I want to highlight this quarter. Slide 13 contains those new program opportunities that we expect will be decided over the next 60 to 90 days. Projects listed in bold type represent proposals we have submitted for follow on work, meaning for a program for which CPI Aero is currently the incumbent. I want to note that 2 of these programs, the wet outer wing panel for the Japanese configuration E-2D and the E-2D welded structure effort were both awarded during the third quarter and are included in our reported backlog as of September 30. Details of the awards will be released pending the required customer and government approvals, at which time they will be removed from this chart. Given our record backlog, we have very good revenue visibility through 2021, and I want to spend a few minutes to present our 3-year outlook for top-line growth, which we introduced for the first time publicly in September at the GE Research 25th Annual Aerospace and Defense Conference in New York. Using 2018 as a baseline, we have projected a 3-year growth rate across each of our business areas. Kitting and Aerosystems offer comparably higher growth rates than Aerostructures, which is consistent with our business development initiatives, as I noted a moment ago. Using fiscal 2018 as our starting point, the second column shows 2018 revenue contribution from each area. The third column shows what percentage of our backlog is represented by those business areas as of September 30. And the last column shows an estimated compound annual growth rate for each business area of its corresponding fiscal 2018 revenue. The key platforms column shows which platforms are driving our expectations across each business area. To briefly walk you through. In Aerostructures, we started at $45.5 million in revenue in 2018. On the strength of projected growth for platforms, such as A-10, F-16V, BLACK HAWK and HondaJet, we believe this segment of our business will grow in the range of 12% to 18% year-over-year through 2021. Aerosystems is our fastest-growing area and is predominantly driven by our electronic warfare pods, some of the electronic systems programs we acquired through our acquisition of WMI and a variety of nonstructural assemblies we produced for F-35, CH-53K and BLACK HAWK. Roughly 44% of our backlog is in this segment. We believe growth across all of the programs indicated will drive a 3-year compound annual growth rate in the range of 16% to 20%. Within our kitting and supply chain management area, at the bottom, we started at a revenue base of $18.3 million in fiscal 2018. We believe that the growth in our E-2D program, our new T-38 program and the Embraer E2-175 Regional Airliner will drive a 3-year compound annual growth rate in the range of 16% to 18%. Turning to Slide 15. Our defense and commercial programs have the potential to cumulatively generate approximately $534 million over the remainder of their periods of performance. As a reminder, this figure is as of September 30, and as such, does not include the newest Raytheon pod contract. Before I open the call to questions, I would like to take a moment to recognize the tireless work and effort of our more than 300 CPI team members. I'm very proud of the achievements we've made so far this year. We have earned a best-in-class reputation for quality and performance, which provide a firm foundation for future success. This reputation brought CPI Aero national attention recently as our peers and customers presented us with an Aviation Week Program Excellence Award. This award recognizes the best of the best in program execution and testifies to the successes we have achieved in the past and those we seek to attain in the future. With that, I will now open the call to your questions. Sarah?

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

Kenneth Herbert: Hi. Good morning Doug and Vince.

Douglas McCrosson: Hi Ken.

Vincent Palazzolo: Good morning, Tim.

Kenneth Herbert: I just wanted to first ask on the third quarter on the gross margins, was there anything else besides the $400,000 you called out in unusual expenses associated with WMI that could have been a headwind in the quarter? I'm just trying to get a sense if there was anything else flowing through from legacy CPI or anything else from an execution standpoint we should be thinking about.

Vincent Palazzolo: WMI's gross margin is still considerably below where we forecasted, not just the SG&A operating expenses of $400,000, but their gross margin is probably in the 400 basis points below where it should be. So that's really dragging the overall gross margin for the company below where it would be, and that flows all the way through the financial statements.

Kenneth Herbert: Okay. And obviously, the guidance reflects the sort of the outlook there, but what's the visibility of improvements here on the legacy on WMI business into 2020? And at what point does it maybe get closer to CPI gross margins?

Douglas McCrosson: Well, I can address that, Ken. So this is Doug. The steps we've taken recently, in particular, the new system that we finally - we finally have their operating system and ours merged as one. They - as we executed on their contracts and particularly easier to do once they're under one roof with us, it was pretty clear that they had a lot of manual processes, a lot of excel spreadsheets, not a lot of forecasting, not a very good MRP system. And so the first step towards realizing the efficiencies that we've come to expect at the core CPI business, we feel we've taken the first step with the integration of those two systems. We are already seeing a little progress in that area. There's much more automation, there's much better working capital management and there's getting - the parts are getting out to the floor when they need to be there. So that's going to take probably this quarter and maybe into the first quarter of next year to start attaining the margins that we expect. And keep in mind, our expectation of WMI is not simply the CPI margins, we actually feel that we could achieve higher than our margins at WMI, and - but we need to get the manufacturing processes under control, and we think we've made the right step to do that.

Kenneth Herbert: Okay. That's helpful, thanks Doug. And can you remind us what percent of the growth, the top-line growth in the quarter was WMI versus the other contract wins in organic growth?

Vincent Palazzolo: In the quarter, WMI was about $5 million in revenue. So CPI's revenue increased about more than 10%. Our revenue went up almost from 20 to - from - sorry, from $19 million to $20.5 million.

Kenneth Herbert: Okay. All right. That's great. And if I could, just two more quick clarifications. Did you comment, Doug, on when you expect to get word on the potential relief of the $3.6 million still outstanding under the working capital adjustments?

Douglas McCrosson: Yes. We - the papers are all in with the court I think last week or so. I would expect that within the next, say, 30 to 45 days, the court will do something either ask for a hearing or potentially could rule on just the paperwork. But we don't think it's a year away. We think it's months away.

Kenneth Herbert: Okay. That's hopefully some good news coming there. And then just my final question is, you're obviously continuing to do a great job on providing better visibility on the top-line. I really appreciate the three-year outlook. You've announced a lot of contract awards and the pipeline seems very healthy. But Doug, I guess, just the fundamental question is, how can you help frame the opportunity on the margins from the new programs? And to what extent, as you're layering in additional business on to the facility, do we maybe see better incremental margins? Or to what extent can the incremental margins in the next couple of years move up based upon, obviously, the higher volume you've outlined?

Douglas McCrosson: So all of this work, keep in mind, we won, it hasn't started. Some of them have started on the floor, but things like A-10, F-16V, some others that we intend to win, they haven't started producing the hours that the - the manufacturing hours out of the shop floor, which they will in 2020. There's a significant benefit to our fixed cost absorption when these starts being out on the floor, and we're actually applying a lot of direct labor hours to them. So you'll start seeing that naturally occur within the next, say, 6 to 9 months. Don't forget though, a lot of our growth is with some of these newer programs, and we do carry these lower programs at, say, lower than production rate volume margins. So the expectation is that the top-line continues to grow. Will there - will we be able to achieve full run rate gross margins in 2020? I think that's kind of sporty. Certainly, by 2021, not only is the top-line approaching kind of not peaking, but higher again still than 2020. And then you'll see a full year's worth of benefit of all of that absorption and better manufacturing efficiencies. And once we get WMI on track and executing on their more than $20 million in backlog at higher margins, I think the combination is a good story for mid-2020 and on.

Kenneth Herbert: That's helpful. And just, again, you're not - in terms of footprint and capital, you're largely set to support the higher volume. I mean, I can imagine there's some headcount and other things you need to add. But you're not looking at any major investments in terms of the capital, the footprint to support the volume, correct?

Douglas McCrosson: We are not.

Kenneth Herbert: Okay. Excellent. All right. Well, thank you very much.

Douglas McCrosson: Thank you, Ken.

Operator: The next question comes from Jeff Feinberg with Feinberg Investments. Please go ahead.

Jeffrey Feinberg: Thank you. Good morning.

Vincent Palazzolo: Hi Jeff.

Jeffrey Feinberg: Good morning. Can you guys please give some clarity in terms of the previous calls, I thought it was an excellent question in terms of where you think the pretax margin you have a lot of awards and strong contracts here. Can you help us understand at steady state, please, where the potential is in pretax margins?

Douglas McCrosson: I'd really like to answer it this way, Jeff. The - when a year or two ago, we were probably in the, what would you say, 11%, 12% pretax margins. I would think that, that is reasonable for us to attain again. We were on track, and that was really kind of - on track to achieve that this year with the assumption that WMI's pretax income contribution would be up to a plan. So I think it's - if - that is something that we could reasonably attain in short order. Beyond that, the improvements to the gross margin that I mentioned before, a combination of not necessarily expanding our SG&A expenses, there's leverage there as we grow. So maybe a percentage or two higher than that in 2021.

Operator: Our next question comes from Walter Morris with Baraboo Growth. Please go ahead.

Walter Morris: Thank you.

Vincent Palazzolo: Good morning, Walter.

Walter Morris: Hi gentlemen. My follow-up question is along the lines of one of the questions Ken asked. Can you - you said on the call that you should be on track with WMI heading into 2020. What does that mean as far as carryover impact of these issues you've dealt with in the second half of the year here with WMI? Will there be minimal negative impact in 2020 from these WMI issues? And if so, could you quantify that?

Douglas McCrosson: Well, I can tell you that there won't be any negative issues. I mean, I guess, for clarity, the WMI is still - it was a profitable business, not as profitable as we would have planned, particularly on the gross margin line and then there was some kind of headwinds in the SG&A for the first year, largely related to the litigation. But - we envision 2020 being a very good year. Optimistically, we should be shooting in the, say, 20% gross margin range next year because - and probably because with the back end of 2020 being higher than that. But no, I think it's hard to say on a call the number of improvements that we've already made and will continue to make to make sure that the operations of WMI are run with the efficiency that we've - that we're known for. I mean, keep in mind, we are known in the industry as being good operators of manufacturing and good manufacturers. And we're employing all of our best practices on them. We have to - I think the - we overshot what we thought we would get and how quickly we would be able to come in and make the improvements that needed to be made. So that - I guess that was an error in optimism, but long term - and by long term, I mean, next 6 months, I think, we're going to see that operation turnaround.

Walter Morris: So again, to emphasize, what I thought I heard you say is there would be minimal impact on 2020 from these WMI issues and by early next year, you'll be operating at the efficiency and profitable levels you anticipated?

Douglas McCrosson: Absolutely, Walter.

Walter Morris: Thank you, gentlemen.

Operator: [Operator Instructions] It appears there are no further questions. This concludes the question-and-answer session. I would like to turn the conference back over to Doug McCrosson, CEO, for any closing remarks.

Douglas McCrosson: Thank you, Sarah, and thank you, again, for joining us on the call today. We look forward to speaking with you when we report our fourth quarter 2019 and full year 2019 results in March of 2020. Bye for now.

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