DMC Global Inc. (BOOM) Q2 2018 Earnings Report, Transcript and Summary

Greetings, and welcome to the DMC Global 2018 Second Quarter Earnings Call. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. [Operator Instructions] As a reminder, this conference is being recorded. I would now like to turn the conference over to your host, Geoff High, Vice President of Investor Relations.

Hello, and welcome to DMC second quarter conference call. Presenting today are President and CEO, Kevin Longe; and CFO, Mike Kuta. I'd like to remind everyone that matters discussed during this call may include forward-looking statements that are based on our estimates, projections and assumptions as of today's date and are subject to risks and uncertainties that are disclosed in our filings with the SEC. Our business is subject to certain risks that could cause actual results to differ materially from those anticipated in our forward-looking statements. DMC assumes no obligation to update forward-looking statements that become untrue because of subsequent events. A webcast replay of today's call will be available at dmcglobal.com after the call. In addition, a telephone replay will be available approximately 2 hours after the call. Details for listening to the replay are available in today's news release. And with that, I'll now turn the call over to Kevin Longe. Kevin?

Thank you, Geoff, and hello, everyone. DMC delivered second quarter consolidated sales of $80.9 million, which was an all-time quarterly record. The results were a 71% increase versus the second quarter last year and a 20% sequential improvement versus the first quarter. The growth was primarily driven by continued strong demand for DynaEnergetics' intrinsically safe detonators and perforating systems, which are helping transform the well completion process in North America's unconventional oil and gas industry. DynaEnergetics second quarter sales of $58.9 million were up 120% last year's second quarter and 20% versus this year's first quarter sales at ours. NobelClad explosion and welding business were $22 million, up 8% versus the 2017 second quarter and 21% versus this year's first quarter. NobelClad ended the second quarter with a trailing 12-month book-to-bill ratio of 1.08 and an order backlog of $37 million, up from $35.6 million at the end of the first quarter. Our consolidated gross margin was 33%, up from 30% in last year's second quarter but down from 34% in this year's first quarter. Improved pricing and a favorable product mix at DynaEnergetics drove the year-over-year increase. However, a higher-than-expected increase in DynaEnergetics material costs, as well as operational inefficiencies associated with its capacity expansion program, led to the sequential decline. As I will discuss in a moment, DynaEnergetics is taking a number of steps to address operational inefficiencies to improve its margin performance. At the business level, DynaEnergetics reported gross margin of 37%, which was up from 34% in last year's second quarter but down from 40% in the first quarter. NobelClad reported gross margin of 23%, down from 25% in the year-ago second quarter and up from 18% in the first quarter. The year-over-year decline reflects changes in NobelClad's product -- project mix. Adjusted operating income, which excludes $217,000 in restructuring expense at NobelClad, was $10.4 million versus adjusted operating income of $2.4 million in last year's second quarter. DynaEnergetics reported operating income of $12.2 million, while NobelClad reported adjusted operating income of $1.9 million. Second quarter adjusted net income was $6.6 million or $0.45 per diluted share versus adjusted net income of $647,000 or $0.04 per diluted share in the year-ago second quarter. Second quarter adjusted EBITDA, which includes $1.5 million in litigation expense, was $13.9 million versus $6 million in last year's second quarter and $11.6 million in this year's first quarter. At the business level, DynaEnergetics reported second quarter adjusted EBITDA of $13.8 million, while NobelClad reported $2.7 million. Given the growing demand for DynaEnergetics' intrinsically safe perforating systems, we have increased our 2018 capital expenditure budget to $46 million from the $30 million we announced at the outset of 2018. The additional $16 million will enable the vertical integration of key components used in DynaEnergetics' factory-assembled, performance-assured DynaStage system. We have ordered more than 20 advanced machining centers, which will be installed over the next several months at DynaEnergetics' manufacturing campus in Blum, Texas. We have also ordered additional automated detonator and shaped charge production lines, which will be delivered next year to address anticipated growth and demand for our intrinsically safe perforating systems. DynaEnergetics recently announced it will institute a 5% price increase to address the recent rise in material costs. The increase will take effect August 1. We expect DynaEnergetics' transition to in-house manufacturing of select components, coupled with the price increase, to lead to improved margin performance during the balance of the year. I am very proud of our employees and our many accomplishments during the first half of the year. The continued effectiveness of our R&D and commercial organizations enabled DMC deliver record revenue and strong year-to-date performance. We look forward to continued operational and financial growth during the second half of the year. I'll now turn the call over to Mike Kuta for additional detail on our second quarter financial performance. Mike?

Thanks, Kevin, and good afternoon, everyone. Starting with our second quarter expenses, consolidated SG&A was $15.5 million or 19% of sales versus $10.6 million or 22% of sales in the second quarter last year. The increase resulted from headcount additions, higher litigation expense and increased variable compensation and distribution costs. Second quarter amortization expense was $791,000 or 1% of sales. Looking at our balance sheet. We ended the second quarter with cash and cash equivalents of $6.6 million. Net debt was $28 million versus $18.6 million at the end of the first quarter and $9 million at December 31, 2017. The increase primarily relates to increased working capital requirements associated with growth at DynaEnergetics as well as borrowings to fund DynaEnergetics' capacity expansion program. During the second quarter, we generated $1.4 million in cash from operating activities. Turning to guidance. We anticipate third quarter sales will be in a range of $82 million to $85 million versus the $52.2 million we reported in last year's third quarter. DynaEnergetics sales should be in a range of $62 million to $65 million, while NobelClad sales are expected to be approximately $20 million. We expect consolidated gross margin of approximately 34% versus the 33% in last year's third quarter. SG&A should be in a range of $16 million to $17 million, up from the $11 million in the 2017 third quarter. The increase largely relates to higher expected litigation expense at DynaEnergetics, which is preparing for an October trial related to a patent infringement case. Amortization expense is expected to be approximately $800,000 versus $1 million in the second quarter last year. Interest expense should be approximately $550,000. We expect third quarter adjusted EBITDA, which includes litigation expense, in a range of $14 million to $15 million, up from $8.6 million in last year's third quarter. Looking at the full fiscal year. We are increasing our 2018 sales forecast to a range of $310 million to $325 million versus our prior range of $290 million to $305 million. The increase reflects expanding demand for DynaEnergetics' intrinsically safe perforating systems and growing confidence that DynaEnergetics will achieve certain capacity expansion objectives during the second half of the year. We expect DynaEnergetics sales will be in a range of $235 million to $245 million versus our prior forecast of $215 million to $255 million. We are maintaining NobelClad's full year sales forecast in a range of $75 million to $80 million. Full year gross margin is expected to be approximately 34%, which is in the high end of our previously forecast range of 33% to 34%. We have adjusted our SG&A expectations to a range of $60 million to $65 million, up from our prior forecast of approximately $55 million. The change primarily reflects the higher expected litigation expense at DynaEnergetics. Amortization expense is expected to be approximately $3 million, and full year interest expense is expected in a range of $2 million to $2.25 million. As Kevin noted, capital expenditures for the year is expected to be approximately $46 million, up from our prior guidance of $30 million. Our expected effective tax rate for 2018 remains in a range of 28% to 30%. Our full year forecast for earnings per diluted share, inclusive of $8 million to $10 million and expected litigation expense, is in a range of $1.50 to $1.70. Excluding restructuring and accrued antidumping penalties, but including litigation expense, adjusted earnings per share is expected in a range of $1.80 to $2. We now anticipate adjusted EBITDA in a range of $55 million to $60 million, up from a prior range of $54 million to $57 million. And with that, we are ready to take any questions. Operator?

[Operator Instructions] Our first question comes from the line of Gerry Sweeney from Roth Capital.

So we've spoken little bit about this before, and I've been trying to triangulate from different sources. But as we look at the DynaEnergetics market or maybe even -- well, to say the North American unconventional market, do you have any idea of what the size is? Or maybe some guidepost to relative size of the market versus the last peak and cycle, et cetera? Just trying to get a better gauge on how this market is going to develop over the next several or many quarters.

The international market has been relatively slow or flat year-to-date. Where we're seeing the growth, Gerry, is in the North American onshore unconventional. And we believe that's already approaching and possibly exceeding the previous peak in '14, and that's the result of just more completions, longer laterals, more stages, if you will.

Okay. Just -- since you mentioned the international side. At some point -- I mean, obviously, most of your business is levered to the North American unconventional, just because of the intensity of it. But if international were to (inaudible), and I think there is some expectations at some point in the future for that to happen, could that have -- what kind of impact would that have on your overall market or revenue?

It's factored into our guidance and for the balance of the year. And obviously, we forecasted that being flat compared to the prior year, but we would start to see that add to the guidance that we would put forth for '19 and '20. So it would improve, but we're not in a position yet to give guidance for 2019.

Okay. Have you hit your targeted -- I mean, your, I guess, targeted market share goals? Or curious as to where we stand with that. And is there an opportunity to expand even at that target?

Yes. I think probably, most importantly, we're not hitting the demand yet that we have for our products. Our sales organization and our customers, year-to-date, we could have sold more than what we've delivered. And so -- I would put it in the context of we're interested in meeting our customer requirements at acceptable margins and that's been capacity-constrained year-to-date rather than demand-constrained. And so we see an opportunity for us to keep improving our market share in the near future.

Got it. And then there's been a lot of talk about the Permian, some takeaway bottlenecks and some CapEx flowing there, et cetera. One, have you seen any of that with any of your sales? And if that issue is removed, I would expect, I guess, completion activity to expand there. Is that a fair way of looking at it? Not trying to look for guidance for 2019 or anything like that but just wanted to get a little bit clarity.

Our constrained year-to-date and going into this third quarter -- in this third quarter have been, again, on the capacity side of it. We have not experienced a slowdown in demand. We have a smaller share in the Permian. And our products are such that with our customers, the demand can move to other basins. And so we focus more on the customers than the basins, and they -- our customers are staying quite busy, actually.

Got it. And then litigation, obviously, taking a step-up. How much more is left? I mean, I know it's an open-ended question or a loaded question. But as we look at the October trial and then I think we've even talked -- there's always going to be some type of litigation expense in your G&A, just because you got to protect your patents and things like that, but...

Yes. And we try to give clarity in this call, in this earnings release around the litigation expense, and that's the litigation expense only. It does not include the recurring legal expense that we have as a company. And so the litigation expense will go away when these cases in which we're a defendant go away. We've had 3 -- probably 4 major areas that we have had litigation expense in recent times and going forward into the fourth quarter. As you will recall, there was a one case that the jury found in favor of DynaEnergetics and then also on a trademark infringement they found in favor of DynaEnergetics. And then there was another patent case in which -- and the second case, the jury also found in favor of DynaEnergetics, and so we've had a pretty good record going forward. October of this year is a busy month for us with remaining litigation and some actions that we've filed in the EU from a -- both from a defendant standpoint and also from an IP strategy standpoint. And we would hope that this would be behind us in the majority by the end of the year.

Our next question comes from the line of Edward Marshall from Sidoti & Company.

So you called out inflation and inefficiencies within DynaEnergetics that pressured the margin. I'm curious if -- in those 2 buckets, I'm curious if you could quantify that -- it was almost $2 million delta there on the gross margin line, kind of talk about maybe I could kind of give you a weighted average to...

Yes. The majority of it probably -- not probably, but 80-plus percent of it had to do with higher material costs and it had to do with purchased components. Our domestic pricing and some of those purchased components have increased. And in order to meet some of the demand that we had, we have airfreighted components from various countries to the U.S. where we would normally not have such a high freight cost. But demand was stronger than we anticipated in the quarter.

I'm assuming you're referring to -- based on kind of what we know about the components, I'm assuming its perforation pipe. I thought that was a small piece of your overall cost of goods in this particular product. Was it because of the airfreight, I guess?

We've had tandem sub adapters that we have in our DynaStage gun, which are consumable, which we both have supplied domestically but also internationally. And there was airfreight cost associated with the import of those components. And then also, we're -- some of the shaped charges and things that we're getting from Europe, shaped charge and detonators, until our capacity is onstream on the shaped charge production in the U.S., we've had higher freight costs than anticipated.

Got it. So maybe we can talk maybe a little bit about the timing of that capacity, not just for the shaped charges but some of the other adjustments that you're trying to do that kind of offset and mitigate. So for the third quarter, it looks like the margin is already starting to recover. So maybe walk us through that.

Yes, they are. And the -- we added another automated detonator assembly line. I think we may have mentioned it previously in April that started. That was a line that we had an order for over a year. That addressed one of our bottlenecks. The capacity -- the manufacturing capacity for assembling DynaStage guns that's coming onstream, that facility will be complete August 31. And so we'll begin to see some relief in September. And the additional shaped charge capacity, which we're bringing on in North America with the addition of 2 shaped charged lines, one will be coming onstream end of September, beginning October. And the other in the first-- most likely the second quarter of 2019.

Got it. And the 30% increase in CapEx, is -- what does that encapsulate?

The increase is primarily in sourcing manufacture of some of the higher-cost components that go into our products. And we're bringing that in-house as the supply chain has become more difficult and more expensive, and we see a significant opportunity to expand our margins by bringing that in-house.

And that was some of what you mentioned earlier, the tandem sub adapters, et cetera?

Yes. And we placed an order for a number of machining centers which will allow us to be self-sufficient on the supply and tandem sub adapters and see the margin improvement that comes with that.

I'm curious, though, when's the timing of that install?

For that product or component, there's 15 machining centers, 5 have been installed in the last 2 weeks. And our -- the balance will be coming between now and the end of the year. And the first article of the first machine, I was given a picture of last night. So...

So all systems go, right?

All systems go.

Let's cross our fingers, right? So at the segment level, not to get to the nitty-gritty. But the G&A increase was -- within Dyna was stronger than the revenue increase by a considerable amount. Is that where the -- is that the litigation expense that's running through those? Is that what I'm seeing?

Yes.

Okay, Okay. And then, I guess Gerry hit on this a little bit earlier. I'm looking at the data through June. You talked about the duct data that when you look at completion data, it looks like it's telling you, if not outright, slowing in the month of June. So I'm curious. You said you didn't see any slowdown in demand, and that's good. I'm curious if you can maybe talk about shared gains versus market growth. And where are you seeing the bulk of the improvement right now?

Yes. We're still seeing a pretty robust level of demand, and there's been talk. I'd listened to some of the other conference calls that some of these larger companies are experiencing maybe of a softening in the third quarter in the Permian, in particular. That's not really a factor for us, and we kind of look at it on a longer-term basis. I think that we have the demand to meet our guidance for the balance of the year, and I think that some of the things that are causing a little bit of lull in performance that others have mentioned will be resolving themselves at the same time that our capacity is coming onstream.

Yes. I mean, that's the concern, right? The concern is you're adding capacity in front of some concerns that some of the larger wireline guys or service providers and how that might play in. But my sense is you're probably taking market share in the market right now, and that probably will offset, or at least slow, any kind of gap down, if there is, in completion work as we kind of wait for pipeline activity to kind of pickup.

Well, in the market, the market has been strong. I mean, that's been a big impact on the industry in terms of the growth year-to-date. We're also stepping up in terms of the manufacturing capacity that's needed for the products that we've been designing for the last couple of years, and we're also onshoring supply of components that have either come from Europe or from other markets. And so we've had a number of things that are impacting our capacity. We're -- needs, and we're very comfortable. We are not a capital-intensive business. We just happen to be capital-intensive right now because of a step change in terms of our demand and also our business strategy.

Got you. You mentioned a lot of capacity upgrades. I'm just curious, removing bottlenecks, everything that's inclusive. If I looked at your business 1 year from now after that final capacity increase that you talked about goes into place, what percent increase are you looking at from today as far as your ability to meet customer demand?

Well, we're not giving guidance yet for 2019.

No. I understand that. I'm not assuming...

Yes. Go ahead.

I'm not assuming it'd be fully utilized, but just I'm curious what your total potential capacity would be.

By the fourth quarter of this year, we will be demand-constrained rather than capacity-constrained. And so I want to be careful because I don't want the revenue forecast to be based on the capacity. There's a number of factors that go into filling that capacity, and we're -- we're just removing current bottlenecks. But we're comfortable. We're certainly up significantly compared to the prior year in DynaEnergetics. I believe it's 120%. That's a pretty fast rate to continue, but we still expect it to grow at a faster than GDP rate. And we'll be coming out with guidance in the first quarter of '19 for '19.

Got it. And finally, do you have a target for free cash flow for the year, for '18?

Mike?

Yes. We didn't provide guidance on that. We're pretty close to neutral through the first half. We're probably going to -- in the second half to fund the CapEx and the growth. We're probably going to be $10 million to $15 million negative free cash flow in the second half because of the CapEx and the working capital.

[Operator Instructions] Our next question comes from the line of Jim McIlree from Chardan Capital.

I just -- I want to make sure I understand the capital expansions that are taking place. So the shaped charge lines and the gun assembly, those are the things that we've talked about in the past, and those are mostly for increases and let's call it unit demand. That's your ability to satisfy the increased unit demand that's out there.

Correct.

The incremental capital of spending that you referred to this afternoon, that's more of a margin investment. Is that, right? I mean, it's not really -- we're not really increasing the number of units that's being sold. Is that a fair way to think about it?

That's the proper way of thinking of it, Jim. There's also in the addition, there's down payments on some long lead time items, detonator lines primarily, that we see a need for in 2019. And there are 40- to 50-week lead time items that we've gone ahead and placed an additional order but the majority of these expenditures is for margin improvement.

Okay. And so for gross margins for DynaEnergetics in the second half, the factors that are going to impact that on the negative side would be startup costs, inefficiencies when you this first start up production, trying to get those kinks out. On the positive side, well -- and the continued robust (inaudible) to have some expedited costs that you referred to earlier. And then on the positive side, as you get these capital plan -- capital things in place, you should have some improved margins. But it kind of sounds like the margin pressure continues through the second half. Is that right? And it's really -- you would really see more of a margin benefit in 2019. Is that right?

We will see a margin benefit in the third and in the fourth quarter. For material cost increases that are impacting not us specifically but more of the general industry, there's -- we have a price increase to recoup some of that in the beginning of August. We are already seeing improvements in our supply chain that will lessen the additional freight that we've paid in the third quarter. And as we bring on more of this TSA manufacturing, we're going to see a pickup in our margins. And so we're forecasting a return to a healthy margin or design margins in the third and fourth quarter, and we feel that we can actually grow from there as more of the TSAs become layered in as the year unfolds. So we will benefit in the second half. And then obviously, we'll have a full year benefit into 2019. A lot of the operational inefficiencies we're working through, and they'll be behind us by the end of August. And it just has to do with doing construction around facilities that are also operating, and that is 75%, 80% behind us.

Okay. So it's not like you have -- I mean, there's always work to do, but it's not like you have -- you're well underway on that. So my assumption that you're still going to have margin pressure is probably too pessimistic, as you just said. All right.

I would think so. We're expecting our margin for the year to be above our year-to-date average, and that's with improvement in the second half.

Got it. None of the higher costs that you mentioned seem to be related to any sort of tariff action. Is that just a non-event preview so far?

Maybe indirectly. We're seeing a general increase in the cost of steel components and other things. I can't put my finger directly on tariffs, but we're starting to seeing some increases in metals that you wouldn't think would apply to tariffs.

[Technical Difficulty] Margin is better because of mix. Can you detail what the mix was that resulted in better margins?

Jim, we lost the first part of your question. You broke up. Can you repeat that?

Yes, sure. You talked about better margins at NobelClad because of mix, and I'm just wondering what was that mix shift?

Yes. We had a large order in the first quarter that we took at a lower margin, and we shipped that over the -- in the first quarter and partially in the beginning of the second. And that brought down our margin, primarily in the first quarter. And as we went to more normal mix -- target mix on our contribution margins on projects, we start to see it come up. It's really more the size of the project that is driving it than it is anything else.

Okay. And again on NobelClad, in the past -- in the recent past, you've talked about seeing some improvements in the market overall. Is there -- is that how you would still characterize it? Is this still, let's say, improving at least marginally or generally?

Modestly. From a very low base, our book-to-bill is up year-to-date. And so I'd say it's a modest improvement. We haven't changed our guidance on NobelClad. Our guidance has stepped up on DynaEnergetics as the years progress.

Ladies and gentlemen, we have reached the end of the question-and-answer session. And I would like to turn the call back to Kevin Longe for closing remarks.

Thank you, everybody, on the call. We appreciate your interest in our company and look forward to speaking with you again at the end of Q3. Thank you.

This concludes today's conference. You may disconnect your lines at this time. Thank you for your participation.