CPI Aerostructures, Inc. (CVU) Q4 2015 Earnings Report, Transcript and Summary

Greetings, and welcome to the CPI Aerostructures Fourth Quarter and Full Year 2015 Results Conference Call. [Operator Instructions] As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Sanjay Hurry, Investor Relations. Thank you, Mr. Hurry. You may begin.

Thank you, Michelle. Good morning, everyone, and welcome to CPI Aerostructures' Fourth Quarter and Full Year 2015 Results Conference Call. With us on the call today are Doug McCrosson, President and Chief Executive Officer; and Vincent Palazzolo, CFO. After management's prepared remarks, there will be 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 their contracts with the company at any time; the government's ability to reduce or modify its contracts if 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 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 their 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 filings with the SEC. With that, I'd like to hand the call over to Douglas McCrosson, CPI Aero's President and Chief Executive Officer. Good morning, Doug.

Good morning, and thank you, Sanjay, and thank you for joining us for our fourth quarter and fiscal full year 2015 results conference call. Our results for the fourth quarter and full year were issued earlier this morning prior to the opening of the market. A copy of our earnings press release and PowerPoint presentation that accompanies this call are available for download at the Investor Relations section of the CPI Aero website. To start, let me provide some context on the past year. Entering 2015, we were coming out of a very challenging 2014 when we were buffeted by the twin headwinds of the Budget Control Act and the Department of Defense's decision to retire the Air Force's fleet of A-10. At the time, the A-10 Wing Replacement Program contract with Boeing was one of our largest revenue-generating defense programs. Based on the facts at that time, we took a substantial noncash charge in 2014 that resulted in a revenue decline of 52% and a loss of $2.98 per share. As we began 2015, we focused management attention on cost cutting, both indirect costs and production costs as we simultaneously sought to diversify our customer base, grow our defense prime contractor business and recast CPI Aero as a value-added manufacturing enterprise capable of managing complex aerospace production and supply chain management programs. We decided to place greater sales emphasis on the defense market while narrowing the aperture of our commercial aviation business to regional and business jet opportunities that we believe are better aligned with our corporate capabilities, capital structure and return on investment goals. Finally, we enhanced our MRO or maintenance repair and overhaul services. Fast-forward to today, and I believe that we have improved our business during 2015 by every measure: strategically, operationally and financially. We enter 2016 with lower manufacturing overhead and G&A rates than they were a year earlier. We increased our defense backlog by 9%, and we see margin improvements on our newest production programs that will begin to contribute meaningful revenue in 2016 and beyond. We won new long-term contracts as a prime contractor to the U.S. Air Force and added 2 new defense platforms to our product offerings, the F-16 and the F-35. Our financial results in 2015 support these changes. As you can see on Slide 4, we are reporting record fourth quarter and record full year revenue. In fact, this is our highest revenue year since 2012 when we reported $89.3 million in revenue. For the year, revenue growth was driven principally by multiyear defense contracts. In the fourth quarter, we also benefited from a change in customer demand that caused certain E-2D/C-2A program activities originally scheduled for 2016 to be accomplished in the fourth quarter of 2015 and drove revenue for the year above our guidance set on our last earnings call. In addition, we received revenue from a supply chain management services contract with Northrop Grumman relating to the Japan E-2D program. Vince will go into greater financial detail as part of his prepared remarks, but I wanted to highlight the following. We generated positive pretax income and EPS for the quarter and the full year, which is a substantial turnaround from the losses reported in the year-ago reporting periods. This is indicative of not only the leverage inherent to our business model but also of steps taken to further enhance operational performance. As Vince will detail, pretax income for both reporting periods were impacted by the loss of certain tax credits that increased our effective tax rate above what we had anticipated as well as the delay in concluding negotiations for equitable relief we requested in accordance with our A-10 Wing Replacement Program. What is driving our performance is a greater focus on defense opportunities. Slide 5 shows that since November 2014 or within the past 16 months, we have announced new long-term contracts and contract extensions that added over $225 million to our defense backlog, providing the company a long range of revenue visibility. These include an $86 million contract for Outer Wing Panel kits for the Northrop Grumman E-2D Advanced Hawkeye and C-2A Greyhound; an almost $54 million contract directly with U.S. Air Force as the provider of over 300 structural wing components to the F-16; a $49 million contract again directly with the U.S. Air Force to provide structural components for the fuselage of the T-38C Talon trainer; our first contract on the F-35A Joint Strike Fighter directly with Lockheed, which is a $10.6 million contract to build lock assemblies for the aircraft; and just this past January, we announced another contract with Northrop Grumman for wing components for the E-2D Advanced Hawkeye for Japan at a value of between $25 million and $30 million. These contracts, in turn, as you can see on Slide 6, drove total backlog at year-end to $387.3 million. Defense backlog rose 9% year-over-year to approximately $277 million at the end of 2015, up from the $255 million at the end of 2014. Of this $277 million, approximately $101 million is funded. The commercial segment of our backlog shown on Slide 6 consists of 3 programs. Two are for the best-selling aircraft in their respective categories, the Gulfstream G650 and the Embraer Phenom 300, both of which are at peak production rates. Third is our HondaJet program, which received type certification in December. Honda has begun commercial sales, and we're ramping up production aggressively as HondaJet has announced it expects to deliver 100 planes over the next 2 years. Because of our decision to focus primarily on the regional and business jet markets, we do not have exposure today to the large commercial airliner backlog that are the subject of much debate and concern among aerospace investors. Operationally, we have implemented productivity and lean manufacturing initiatives, including greater use of automation and 3D printing with the goal of driving out waste. These initiatives have resulted in improvements in product margin and cash flow on the programs we targeted in 2015. And we expect to apply these same principles to other programs in 2016. In summary, we made tremendous strides in 2015. This is a testament to the hard work and dedication of our employees, and I'd like to thank them publicly for their efforts. I'd also like to acknowledge the entire management team at CPI Aero who have provided excellent leadership throughout the year and who are all determined to make CPI Aero the best company it can be. I'll now turn the call over to our CFO, Vince Palazzolo, to discuss our financial results and expectations for 2016. I will then conclude the call with commentary on our plans in 2016 before opening the call to Q&A. Vince?

Thank you, Doug. As Doug previously noted, we are reporting record revenue for both the fourth quarter and full year 2015. As detailed on Slide 8, revenue for the fourth quarter of 2015 was $31.6 million compared to $21.5 million in the fourth quarter of 2014. Gross profit for the fourth quarter of 2015 was $3.6 million on gross margins of 11.3% compared to $4.5 million on gross margin of 21.4% in the fourth quarter of 2014. Income from operations for the fourth quarter of 2015 was $1.9 million compared to $2.7 million in the fourth quarter of 2014. Net income for the fourth quarter of 2015 was $0.7 million or $0.08 per diluted share compared to $1 million or $0.20 per diluted share in the fourth quarter of 2014. For the full year, revenue for 2015 was $100.2 million compared to $39.7 million in 2014. Gross profit for fiscal 2015 was $16.6 million on gross margin of 16.6% compared to a loss of $29.7 million on negative gross margin of 74.8% in fiscal 2014. Income from operations for fiscal 2015 was $9 million compared to a loss of $37 million for fiscal 2014. Income -- net income for fiscal 2015 was $5 million or $0.58 per diluted share compared to a net loss of $25.2 million or $2.98 per diluted share in fiscal 2014. Our fourth quarter and fiscal 2015 financial results reflect both a higher-than-anticipated effective tax rate and was adversely impacted by a delay in concluding negotiations for equitable relief related to our A-10 program. To provide you some color on the higher-than-anticipated effective tax rate, as those of you who have followed CPI for some time, our historic effective tax rate has been in the range between 30% and 32% of taxable income. Our rate has been below the statutory federal income tax rate of 34% because of our ability to utilize the domestic production activity deduction available to companies that do manufacturing within the United States. Starting in 2015, we began providing for state income taxes in states in which we now have nexus [ph]. As such, our effective tax rate for 2015 is approximately 37%. As you can see from Slide 9, gross margin for the fourth quarter and full year of 2015, excluding the effect of the A-10 program, were 21.1% and 22.6%, respectively, as compared to 24.5% and 22.3%, respectively, in the same periods in 2014. As a reminder, we continue to record revenue on this program with 0 gross margin. Moving to Slide 10. In the fourth quarter of 2015, 64% of total revenue, or $20.3 million, was generated from defense programs, of which $20 million was from Tier 1 military subcontracts with OEMs and $0.3 million was from government prime contracts. 36% of total revenue, or $11.3 million, was generated from commercial programs mainly from our Triumph, Embraer and Honda programs. For fiscal 2015, 58% of total revenue, or $57.9 million, was generated from defense programs, of which $57 million was from Tier 1 military subcontracts with OEMs and $0.9 million was from government prime contracts. 42% of total revenue, or $42.3 million, was generated from commercial programs mainly from our Triumph, Embraer and Honda programs. Turning to the balance sheet, as you can see on Slide 11. At the end of the fiscal year, we have a capital structure to support our business strategy. And as we announced earlier this morning, we have secured additional liquidity and flexibility via a new credit facility that expands availability by $5 million to $40 million. Slide 12 summarizes our financial guidance for fiscal 2016. We anticipate revenue to be in the range of $97.5 million to $103.5 million. Breaking with past disclosures, given the uncertainty surrounding our effective tax rate, we have opted to provide instead guidance at the pretax income level for 2016, which will be in the range of $9.8 million to $10.5 million. To provide guidance on our effective tax rate, we expect that future tax rates will approximate the 2015 effective tax rate and be in the range between 35% and 37%. Our guidance for fiscal 2016 assumes no margin contribution from the A-10 Wing Replacement Program and that a favorable resolution of the A-10 contract could be upside to guidance. The following slides, Slides 13, 14 and 15, provide 2016 guidance breakdown by market, subcontractor role and business segments. Starting with Slide 13, revenue guidance breakdown by market. Given the defense contracts recently secured, as Doug noted, we anticipate our defense business to account for 64% of revenue in fiscal 2016. This compares to 58% of 2015 total revenue from defense. The expected mix shift reflects our greater sales emphasis on the defense market. Revenue from commercial business as a percentage of total revenue is expected to decline year-over-year given the mix shift. Moving to 2016 revenue guidance breakdown by subcontractor role. You will see on Slide 14 that in line with our strategy to grow our defense prime contract business, we expect growth in revenue as a prime in 2016, which will be driven principally by recent wins on the F-16 and T-38C. Turning to Slide 15, 2016 revenue guidance breakdown by business segment. We anticipate that non-aerostructures business will generate 45% of revenue in 2016. Growth will be led principally by kitting and supply chain management contracts for recent wins on the Northrop E-2D, the F-14 (sic) [ F-16 ] and the T-38. On Slide 16, we have 4 strategic financial priorities in 2016. First is to strengthen our balance sheet, particularly through tighter inventory management and a reduction in unbilled receivables to improve cash flow from operations. Second, we're going to continue investing in automation and other processes and technologies to improve productivity. As such, we do anticipate our CapEx budget for the year will be slightly higher than the approximately $457,000 of last year. In 2016, we expect that the investments made in 2015 will favorably impact program margins. Third, we will focus on improving our debt coverage ratios, which are already lower than industry peers. Finally, we'll remain focused on cost reduction. And to that end, we expect to further lower overhead and G&A rates that are already at historic lows. This concludes my prepared remarks. I will now turn the call back to Doug for a perspective on fiscal 2016.

Thank you, Vince. 2015 was a year of strong execution and a return to growth for CPI Aero. In 2016, we intend [ph] to continue on the same path. And as our financial guidance suggests, we have the opportunity to drive growth to the top and bottom lines over the year. Our expectations for 2016 are grounded in large measure in our strong backlog. As you can see from Slide 18, the vast majority of our backlog, which as of December 31, 2015, stood at $387.3 million, consists currently of 12 programs. What you'll also see from the time line at the top is that we have excellent visibility into the business as far out as 2022. I would highlight that very few of these programs end before 2017, so that gives us a measure of revenue certainty in 2016 and 2017. As we deliver against backlog, headwinds are turning into tailwinds, and we see opportunity for additional multiyear defense opportunities on the horizon. Domestically, the passing of the 2016 Omnibus Appropriations bill and the recent fiscal 2017 President's budget request signals a return to growth in defense spending while also giving the marketplace greater spending clarity in the near term. Greater spending certainty, in turn, should create opportunities in several defense programs that are key to CPI Aero. An example, and as you can see on Slide 19, the proposed 2017 budget pushes out the retirement of the A-10 through 2022 in order to preserve the aircraft's capabilities during the Air Force's transition to the F-35. We expect that this major change of strategy is behind the Air Force's recent announcement that it is considering to procure up to an additional 120 wings on top of their current order with Boeing, which would result in more than 290 A-10 aircraft receiving new enhanced wings. The Air Force's precise procurement strategy is still evolving, but it likely will be one of three scenarios: one, exercise the last remaining option on the current Boeing contract; two, place orders on a new contract that the Air Force has publicly announced it intends to award this year; or three, a combination of both. In Option 1, since the ordering period under our Boeing A-10 Wing Replacement Program contract has elapsed, CPI Aero would have to negotiate a new order with Boeing. In Option 2, since this will be a fully open competition among qualified manufacturers, including Boeing, CPI Aero would have to bid our products to the eventual winner of this new contract. We are very confident that our nearly 8 years of experience on the WRP program will enable us to retain at least our current scope of work no matter what company or companies the Air Force selects. I expect a clearer picture will emerge during the next 6 months. So in summation, the fact that the U.S. Air Force plans to defer retirement of the A-10 is a net positive to CPI, and there are many ways in which we can remain a major supplier of wing structure for the A-10 aircraft for years to come. Greater spending certainty should also be a positive for new Air Force modernization programs, such as, for example, the B-21 long-range strategic bomber. With regard to the B-21, we believe our long track record as a Tier 1 supplier to the bombers' prime contractor, Northrop Grumman, positions us to receive opportunities either direct from Northrop or from one of its partners. Another new program for which we are already working with prospective bidders is the Air Force T-X Trainer. An RFQ for the new trainer from the Air Force is expected at the end of 2016. Geopolitical tensions are also driving defense spending, and we are seeing evidence of increased spending internationally. The recent decision by Japan to procure the E-2D Advanced Hawkeye from Northrop Grumman is but one example. We also believe that regional instabilities will increase demand for intelligence, surveillance and reconnaissance, or ISR solutions, such as the DB-110 surveillance pod we manufacture for our customer, United Technologies Aerospace Systems. The standing are [ph] increasing the operating tempos by both U.S. and allied air forces will increase the demand for spares and maintenance actions. This trend bodes well for our MRO-related programs, especially our F-16 wing components MRO support contract with the United States Air Force and our BLACK HAWK stabilator repair and overhaul contract with Sikorsky, now a part of Lockheed Martin. Concurrently, we have also begun to ramp up marketing and business development efforts to better position ourselves for new MRO- and ISR-related programs. For example, we're negotiating a multiyear contract modification with United Technologies for the DB-110 ISR pod. We are responding to RFQs for several new ISR and electronic warfare pods. And we are preparing ourselves to participate as a prime contractor or teammate on the upcoming F-16 Service Life Extension Program, or F-16 SLEP. Our sales and business development efforts are pivoting towards defense. And we are already starting to see the impact on our bid pipeline. As you can see from Slide 20, currently 76% of our bid pipeline comprises defense opportunities. And these opportunities spanned our entire suite of products. The drivers of growing defense spending, together with our efforts to bid and secure multiyear defense opportunities, we believe will continue to drive backlog additions in fiscal 2016 and beyond. As we did in 2015, we also see opportunities for further margin expansion as productivity and lean manufacturing initiatives take hold. Cost reduction continues again in 2016 to be a strategic priority as we look to further lower overhead and G&A costs. As I reported in a prior call, we performed a kaizen event on one of our largest production programs that has the potential to reduce annual direct costs on this program by approximately $0.5 million. The newly configured manufacturing cell has recently been completed, and we are less than 2 months away from beginning to see the benefits, both in terms of reduced cost as well as an increase in output. We're also pleased to announce that we have received multiple customer approvals, including most recently from Embraer, on our automation equipment that will significantly accelerate the transition from manual to automatic operations across a wide spectrum of products. To conclude, we are well positioned to win our fair share of bid opportunities in 2016. Our large, diverse and growing backlog affords us substantial revenue visibility, and we see opportunities in both existing and new programs. With investments made in 2015 expected to favorably impact operating margin, we are also expecting greater profitability ahead. Finally, the conditions are favorable this year to get some positive resolution on our A-10 program that could enable the A-10 to again be a top line and bottom line contributor. We believe we have the components in place for a very successful 2016, and we are excited and energized to deliver superior results. This concludes my prepared remarks. Michelle, please open the call to questions.

[Operator Instructions] Our first question comes from the line of Mark Jordan with Noble Financial.

Doug, in your guidance or revenue range for 2016, what is reflected in there in terms of revenues on the A-10 program?

We're not going to individually say what the revenue is for each program, but on a macro level, it is the same as it was in -- roughly the same as it was in 2015. So we are expecting a not insignificant amount of revenue for A-10.

Okay. In terms of...

There's no margin contribution to that revenue, however.

All right. In terms of positioning the company with regards to guidance and with the A-10 program, is it fair to say that you are taking a fairly conservative position here, assuming no positive contribution when you still have the potential for equitable relief from the prior relationship and that if you were to sign on for something that you wouldn't do at a loss. So again, so we should say that it's -- and kind of this is not necessarily worst case, but pretty doggone close to it?

Yes. I mean, the whole A-10 issue, as you know, has been very fluid, especially now in this time of the year when the President's zero [ph] budget request just came out, and now they're going to be debating it in Congress. So I think it's very fair to say that we've taken a conservative approach here. As we mentioned in the prepared remarks, should either the equitable relief happen, should a new long-term contract be negotiated or -- either with Boeing or with a winner of the new competition, those, all over the long run, are very favorable to CPI. We're probably way too early. Maybe over the next 6 months, we'll know whether or not some of the good things that we anticipate happening this year will, in fact, lead to higher guidance for the year. But I would say that we're being pretty conservative in our estimate.

The revenue guidance for 2016 kind of virtually straddles the revenues reported for this year. On your Slide 13, you have percent of revenues commercial going from 42% in 2015 to 36% in 2016 with HondaJet increasing in volume. Given the mix shift towards defense, what is declining on your commercial side?

Right now, it's the S-92 from Sikorsky, which has seen a rather large decrease in historical annual revenue as a result of the softness in that market for our customer as well as some softness currently in the Cessna Citation X program. Both of those programs are year-over-year decliners in 2016.

Okay. Final question from me. Relative to expected cash flow from operations and including CapEx, do you see yourself as a consumer of cash? Do you expect bank lines to be up this year or neutral with regards to cash generation?

Mark, we are kind of projecting that we're going to be a consumer of cash this year, but that's predominantly the result of us building up inventory on the new F-16 program. That's the biggest generator of -- or burner of cash because of the inventory that we have to build up on that program. We just don't think that we can burn down the inventory of the other programs fast enough to offset that.

Can you quantify what the incremental cash needs would be for the year?

We've decided not to give cash flow guidance. So I don't think it would be appropriate if I were to say that.

Okay. But in terms of the facilities you have in place, you're very comfortable with availability of cash and needs?

Yes.

Our next question comes from the line of Ken Herbert with Canaccord Genuity.

Just first off, can you quantify what the fourth quarter pull forward was associated with the E-2D and the supply chain work you did for Northrop -- the revenue impact?

The supply chain work wasn't necessarily a pull-in. The E-2D/C-2A Outer Wing Panel kits were. These were new kit deliveries that were scheduled in '16 that were moved by our customer into '15. I don't have the exact number. If I was to guess, I'm going to say around $2 million of additional revenue that otherwise would have been in 2016.

Okay. Okay. That's helpful. And then second, the -- just big picture, how much of the 2016 guide is currently in the backlog? And how much is still yet to win?

It's probably -- well, it's 2 -- there's 2 phases to that have to win. One is anticipated follow-ons to current contracts, and then there's brand-new wins. I would say the brand-new wins are under -- maybe between 3% and 6% of the guidance.

Okay. And the follow-ons...

I don't have the precise number of follow-on, but there is still -- we're constantly getting orders for our commercial accounts and also from our military customers. For example, F-16 and T-38 are on recurring delivery orders. So there is a certain amount of that factored in as well. But in terms of brand-new, not yet won or announced programs. It's a very small number.

Okay. And the -- the follow-on programs, whether it be T-38, F-16 or others on the commercial side, are there any of those you'd classify as higher risk? Or do you -- are you pretty confident about those follow-on orders coming in this year?

Very confident.

Okay. And then just finally, again, back on the A-10, my understanding was at some point in the first half of this year, you would have shipped through the units that you wrote off when you took the charge back in 2014. Assuming the revenue contribution is relatively flat from '15 into '16 and what's implied in the guidance, is there a risk that there's another charge or earnings impact coming perhaps from this program as you shipped past what was originally accounted for in the initial charge? Or is the risk now of a charge on the A-10 essentially off the table? How should we think about that heading into midpoint of this year?

Yes. As I mentioned to Mark, it's really kind of hard to say right now. And the -- what happened in the fourth quarter was we were accounting for some top line growth that didn't materialize in the time that we wanted it. So that's a major driver towards what might happen in 2016. So there's 3 or 4 different types of scenarios, as I mentioned, all of which would or could impact how we estimate that job with each coming quarter. So I know it's kind of an evasive answer, but it's -- with so many facts changing, including the negotiation with Boeing, there's some external conversations between Boeing and its customer, and then they have the brand-new start, which may or may not involve Boeing. So there's a lot going into it. I will tell you that we treat the A-10 program like we treat every program. And every 3 months when we do the quarter, we will assess all of the facts and information that are available to us at the time, and we make a decision on how to make that estimate. And we'll continue to do that on the A-10. From a big-picture standpoint though, I don't think there's a question in my mind that the deferment or the delay in the eventual retirement of the A-10 is a net positive for us and will keep us making these structures probably through the next 5 or 6 years. So while there might be some short-term noise based on certain facts and how we interpret those facts to make our estimates, I think over the longer term, it's a positive for us.

Okay. All right. It sounds like there's obviously still a lot of uncertainty around this program. I guess, just one final question. As you look here into 2016, there's clearly -- I know you're confident in what's on the books now. There's been certainly some increase in just some concern around some business jet programs and that market and sort of the growth or lack of growth into 2016. Aside from the Citation program, are you seeing any changes? Are you concerned about any potential changes in any of your other business jet programs just based upon some of the macro weakness?

No. I have been reading like you have probably with regard to the Gulfstream product in particular. It's getting a lot of talk these days. But we are not seeing any of that in our delivery forecast and in our customer orders. So if there is any weakness, it's not in '16. And we have actually firm delivery backlog for some of those programs into '17. So we're not seeing that, no.

[Operator Instructions] There are no further questions at this time. I would like to turn the floor back over to management for closing comments.

Thank you all for participating on this call. We look forward to speaking to you again in May when we announce our 2016 first quarter results. Thank you, and talk to you soon.

This concludes today's teleconference. You may disconnect your lines at this time, and thank you for your participation.