CPI Aerostructures, Inc. (CVU) Q1 2016 Earnings Report, Transcript and Summary

Good morning and welcome to First Quarter 2016 CPI Aerostructure's Earnings Conference Call. 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 Sanjay Hurry of Investor Relations. Please go ahead, sir.

Thank you. Good morning, everyone and welcome to CPI Aerostructure's first quarter 2016 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 CPI Aero website. With us on the call this morning at Doug McCrosson, President and Chief Executive Officer and Vincent Palazzolo, Chief Financial Officer. 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 the customer reduces or modifies its contracts to them 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. Please note further that for the purposes of this call and the [indiscernible] PowerPoint presentation management will be referring to the Company's financial on adjusted basis that excludes the impact of the A-10 program, first quarter of 2016 and the first quarter of 2015. GAAP financials as well as GAAP to adjusted earnings reconciliation tables can be found in the Company's earnings press release issued this morning as well as on the end of the PowerPoint presentation. With that, I'd like to hand over the call to Doug McCrosson, CPI President and Chief Executive Officer. Good morning, Doug.

Good morning and thank you, Sanjay, and thank you all for joining us for our first quarter 2016 results conference call. I will begin today's call by discussing our decision with respect to the A-10 then Vincent Palazzolo, our CFO will review the financials for the quarter after which I will be back to provide a general business update before opening the call to Q&A. Let's begin with some recent history. Starting with Slide 4, as you are aware in 2008 we were awarded a 242 plane A-10 wing replacement program from Boeing to extend the lifespan of this air frame [ph]. We received firm orders under this contract to produce assemblies for 173 wings. In early 2014, the Department of Defense released its 2015 budget request that called for the retirement of the entire A-10 fleet. We ultimately concluded that the A-10 program would end much earlier than originally estimated and we revised our revenue and cost under the assumption that the contract would be concluded in late 2015 and by that time, we would have manufactured wing subassemblies for between 135 to 140 aircraft. At the time, we had firm orders to support the quantity of 173 aircraft but our estimate at that time was not based on running the program through 173. Generally accepted accounting principles required us to estimate the programs financial performance at the completion of the most probably quantity. The revised estimate concluded that the A-10 WRP would be a lost contract and in accordance with percentage of completion accounting when a contract is estimated to be a loss, the entire loss must be recorded in the current period. Therefore in the quarter end June 30, 2014 we recorded a non-cash charge by an adjustment to revenue and cost of sales totaling $47.3 million for the period from the time of the contract award through June, 2014. From June 2014 to the third quarter of 2015, we continue to book revenue for the A-10 WRP as zero margin. As I noted during the 2015 fourth quarter conference call on March 28 of this year, we reported that in accordance with terms of our long-term agreement with the customer, we submitted a Request for Equitable Adjustment or REA to our customers seeking consideration for certain cost that we believe are outside the scope of our contract. Since the REA was not settled, in the fourth quarter of 2015 we booked the cost associated with the claim but did not book any expected increase in revenue, resulting in a negative adjustment to profit for the A-10 program in the fourth quarter of 2015 and for the year as a whole. The REA remains unresolved today. I also reported during the fourth quarter 2015 results conference call, what we viewed as potentially positive development for the long-term future of the A-10 aircraft. Namely that the US Air Force announced this plan to defer the retirement of the A-10 until 2022, giving ongoing operational needs. We believe that the time, that this perceived change in direction could lead to new orders for wings under three scenarios. US Air Force could place orders to Boeing under its current contract with the Air Force or it could order additional wings to the winner of a new procurement program being conducted by the Air Force called A-10 TUSK or finally the Air Force could purchase new wings in some combination of the two previous scenarios. Despite the Air Force's prior declarations however, it now appears that the Air Force intends to begin retirement of the A-10 much earlier than 2022 and is calling for the retirement of a significant quantity of aircraft as early as government fiscal year 2018, that begins October 1, 2017. Based upon this new information and other very recent communications with our customer. We believe that the backed [ph] pattern that exists for the A-10 WRP program today is materially different than it was just a short time ago. The facts we have today lead us to conclude that both the quantity and timing of any future orders remain too uncertain for us to consider such anticipated orders in our current financial results. Therefore, in accordance with generally accepted accounting principles in the first quarter of 2016, we are accounting for all of the remaining cost to complete all open orders under our contract with Boeing under the assumptions that we will neither receive from orders for additional wing subassemblies in 2016 nor we will receive and adjustment to our contract for the claims, we have submitted to our customer. As we did previously, now that the remaining estimated loss in this contract was booked in the current contract. We will book A-10 WRP revenue at zero gross margin each quarter through the completion of the program in early 2017. Likewise, we are revising our guidance under the assumption that the facts will remain essentially as they are today for the balance of 2016. Meaning, we will base our guidance on completing the current open orders with Boeing with no additional new orders and with no increasing contract value related to a settlement of the REA. In this manner, we believe that we have significantly minimized the potential for further charges for this program. It's also very important to note, that our cash receives from Boeing over the remainder of the contract are expected to exceed our cash expenses by approximately $1.5 million and at the A-10 WRP has net inflows of cash each quarter through completion in early 2017. We still anticipate that Congers will continue to seek to postpone the retirement of the A-10 until another platform proves capable of meeting the close air support role of the A-10 and we still believe that the Air Force will need to acquire new wings beyond what is already on order with Boeing. We recognized that the ongoing quarterly charges associated with the A-10 wing replacement program have amassed more meaningful understanding of our ongoing operating performance. I believe, this earnings call and the accompanying Form 10-Q that will be filed with the SEC later today provides clarity and transparency to shareholders that will allow for a more meaningful understanding of the underlying fundamentals of the business. In a few minutes, Vince will provide a detailed review of the financial results but before he does, I want to make a couple of points on our backlog. Moving to Slide 5, you can see both total backlog and funded backlog increased during the quarter. Backlog increased by approximately 5% to $407.4 million at quarter's end and was principally driven by a four-year contract valued at more than $25 million that supplies structural components and kits for the outer wing panels on the E-2D Advanced Hawkeye that will be manufactured for Japan by Northrop Grumman. Funded backlog increased to $104 million from $101.1 million at 2015 year-end. This increase was driven largely by new delivery orders for our commercial programs and in particular the Gulfstream G-650 leading edges and Embraer Phenom 300 engine inlet assemblies. But we also saw an increase in funded backlog for defense as we received orders related to the E-2D for Japan. Moving to Slide 6, since November 2014, we have announced long-term defense contracts worth up to $225 million. Off our $300 million in defense backlog at March 31, 2016, more than $200 million comes from programs on this slide, providing great projected revenue visibility over the next several years. We expect this combination of new long-term defense contracts coupled with steady or improving demand from our commercial customers will drive future success and a return to growth. These factors are also why, excluding the one-time GAAP charge related to the A-10. The as adjusted 2016 profit outlook for the company remains unchanged from our original guidance. I will now turn the call over to Vincent Palazzolo to discuss our financial results, the impact of the A-10 going forward this fiscal year and our current financial expectations for 2016. I will then conclude the call with an update on our plans for the balance of the year before opening the call to Q&A. Vince.

Thank you, Doug. As a reminder, we are referring to our financial on an adjusted basis that excludes the impact of the A-10 program for the first quarter 2016 and the first quarter of 2015. As detailed on Slide 8, revenue for the first quarter of 2016 increased 24% as compared to the first quarter of 2015. Gross profit for the first quarter of 2016 was flat with the first quarter 2015. Gross margin however declined year-over-year by approximately 440 basis points due to excess labor cost in the quarter on three programs. In addition we had excess labor and procurement cost on one program which was the result of some technical issues in the manufacturing process. Additionally, we had an unfavorable adjustment on one small government contract that was terminated early by the government. SG&A increased by approximately $700,000 in the first quarter of 2016 as compared to the first quarter of 2015. Included in SG&A for the first quarter of 2016, our two separate items that are not expected to be in SG&A in future periods. One; accounting and legal fees associated with our year-end 2015 audit and two; our reserve against our accounts receivable for certain old amounts for which realization is uncertain. Pre-tax income for the first quarter of 2016 was $656,000 as compared to pre-tax income of $1.4 million in the first quarter of 2015. Net income for the first quarter of 2016 was $413,000 or $0.05 per diluted share compared to $940,000 or $0.11 per diluted share in the first quarter of 2015. Turning to the balance sheet, as you can see from Slide 9, at the end of the first quarter of 2016, our decision to record adjustments related to A-10 program through the conclusion of the wing order resulted in cost and estimated earnings in excess of billings on uncompleted contracts CEE of $92.9 million, a decrease of approximately $10 million as compared to December 31, 2015. The cost of change in estimate on the A-10 program, we were not in compliance with covenants of our banking agreement. The covenants as of March 31, 2016 had been waived by the bank and certain covenants have been amended. In addition, a new EBITDA covenant has been added to the agreement. Turning to Slide 10, we have updated our 2016 financial guidance to exclude the A-10 program as a component relative to what we provided on the fourth quarter 2015 earnings call on March 28 of this year. As you can see, we now expect adjusted revenue to be in the range of $82.5 million to $88.5 million. The variance to prior revenue guidance of $97.5 million to $103.5 million reflects a reduction in A-10 program revenue from our current fiscal year forecast. Adjusted pre-tax income for 2016 is to be in the range of $9.8 million to $10.5 million. This is unchanged from prior pre-tax guidance provided in March because on an adjusted basis, we are removing the change in estimate on the A-10 program. As a reminder, given the uncertainty surrounding our effective tax rate as detailed on our fourth quarter, 2015 earnings conference call, we have opted to provide guidance on pre-tax income basis going forward. Moving to Slide 11, we remained focused on our four strategic priorities in 2016. For the remainder of 2016, we intend to lower inventory levels and reduced unbilled receivables CEE in order to strengthen our balance sheet. We will continue to invest in automation to improve the efficiency of our manufacturing processes. We will work to lower debt levels by improving operating cash flow and lastly, we will continue our efforts to further reduce overhead and G&A expenses. This concludes my prepared remarks. I will now turn the call back to Doug for his perspective on the balance of fiscal 2016. Doug?

Thank you, Vince. I've talked before about our strategy to pursue emerging opportunities within the global defense market. It's a market we know well and a market in which we have historically had achieved great success. I've also described our decision to narrow our commercial market focus on business jet and regional jets. Where we feel we can offer customers outstanding products and value added services at a competitive price that delivers acceptable financial returns for CPI. Slide 13 shows our bid pipeline reflects this strategy, is well balanced between defense and commercial markets and is diversified across our various product segment. Moving to Slide 14, we have submitted or soon be submitting proposal for defense and commercial industry customers in all three of our product segment. More than 50% of the value over bid pipeline is for Aerostructure. Open bids in this segment include structural assemblies for current production military aircraft such the H-92, AH-1Z and F-35. Development aircraft including the CH-53K and the V-280. Military upgrade programs such as for the A-10 TUSK program. Overhaul and repair programs including the F-16 Service Life Extension Program and BLACK HAWK and new regional airliner programs including the Bombardier C-Series and the second generation Embraer E series. We are also seeing continued strong demand within our aerosystem segment and this segment now accounts for more than 30% of the value of the bid pipeline. We have several outstanding proposal submitted to potentially new customers for electronic warfare and EW Pod structures as well as for intelligence, surveillance and reconnaissance pod structures or ISR. Our bid pipeline also includes the follow-on proposal to the multi-year DB-110 ISR pod program, with current customer UTC Aerosystems. As well as for potential new orders to manufacture other pods that we have produced in the past for Northrop Grumman. Finally, customers are seeking out our supply chain management and kitting services as they look to lean out their procurement processes. We have multiple bids for the supply of components and kits to OEMs of business jet and regional airliners including the E-2 regional jet from Embraer as well as a variety of aircraft produced by Bombardier. We are also positioning ourselves to participate on the aircraft and systems that could provide growth for CPI over the longer term. Several of these key future programs are contained on Slide 15. For future platform such as TX and B21, we intend on leveraging current customer relationships and our record of excellent past performance with these customers, to gain a competitive advantage. For the F-16 we intend on using our experience on the F-16 wing component contract we have with Hill Air Force Base to become an approved source of supply for certain components and then market these products internationally. As we move to bid on and secure new long-term defense contracts, our financial expectations for 2016 are grounded in large measure by orders already in hand. As you can see on Slide 16, we have significant revenue visibility stemming from new contracts since the third quarter of 2014. Approximately $200 million off the $225 million won since November 2014 have yet to convert it to revenue and many of these new programs will begin to positively impact profitability during the balance of this year, through 2020 with several past 2020. So in conclusion, the accounting charge related to the A-10 taken this quarter positions us to move forward without the uncertainty surrounding the future impact of the A-10 on our reported financial results. It also allows us to move beyond a single program that for so long has dominated the conversations on CPI Aero and that has diverted attention from the positive improvements we have made to our business over the course of the past several years. Our business is fundamentally unchanged as a result of today's adjustment for A-10. We have more than $400 million backlog the bulk of which is related to newer defense programs announced during the past 18 months. We are operating efficiently with overhead in G&A rates that are historically low and projected to get lower. We are improving gross profit margins on our newer programs as these become to transition from development rates to production rate. We are beginning request to provide proposals on aircraft and systems that will be main stage of future aviation in both commercially and military end markets. We expect to turn many of these proposals into firm orders during the course of 2016. And finally, we have assembled the best team of aerospace professionals that continue to dedicate themselves to making CPI Aero the best company it can be. Before, we open the call to questions, one housekeeping items. Vince will attend and present at 11 AM Pacific Time on May 26 in Hollywood, California at B. Riley 17th Annual Investor conference. If you would like to arrange a one-on-one meeting, please contact B. Riley or Vince. This concludes my prepared remarks. Operator, open the call for questions. Thank you.

[Operator Instructions] and our first question will come from Mike Crawford of B. Riley.

Thank you and just to clarify, if there's no further A-10 work issued to CPI Aero, you expect to take in $1.5 million of cash and then to have certain claims and could you just go over, what those certain claims are again?

Well, Mike yes, if no more new contracts come in, then and we don't get the claim, the results are as indicated today. The claims that we have are for cost associated with the program that we believe were not in the original contract and the general nature of them are specification related detailed technical points that we feel are outside the scope of what we originally proposed back in 2007, 2008 and those are being negotiated currently with our customer. The financials we reported today it anticipates or does not account for any claim settlement or any future orders for A-10 under the variety of scenarios I laid out.

And just the cost, associated with the program that you believe were not in the original contract, so that has nothing to do with the fact at a different subsequent point, you had to assume that you wouldn't be able to ship 173 units. So then, you did not order all the parts you needed but then later when production continued then you needed to go back and pay higher prices for certain parts and there is no claim to recoup that part that's just too bad.

The claims are based on the contract and the allowable claims and that would not have been an allowable claim. Allowable claims are things like, they've changed designs, they added features that were not anticipated in the original contract. The charge we took today or the forward-looking, the cost that completion factoring all of those inefficiencies that had resulted in the program because of all of the uncertainty surrounding it for several years now, that is all now fully accounted for in our cost to complete.

And then, you mentioned a couple other items, one; a reserve against AR, so what was that for and what was the amount about?

We had some odd amounts that were some discounts, that some customers had taken overtime, some disputed amounts that customers where they said that had made a return and we had, it was just some small and ended up accumulating to a larger number but some small amounts here and there that always happen when you're dealing with bigger customers, larger organizations that had really kind of we've been going back and forth with the customer over a longer period of time and we just at this point didn't feel that it was likely that we're going to realize, a lot of that, so we just reserved against it now.

Okay and then the accounting in legal that's something that Doug mentioned that was for year-end, but I imagined there had to be some additional expense related to all this A-10 stuff and then so two-fold question of, is that accounting and legal always going to be higher in Q1 than in the other quarters and then how much additional might have been related to A-10 issue.

There wasn't really a whole lot of additional amounts related to the A-10 program, at year end. That we - our year-end financials we didn't file on the normal - at the timeline, we went on extension with the SEC, it took us longer than anticipated to close out the books related to the year-end and that by extension made it a little bit more difficult and for our auditors to finish their work, it also required some extra-legal time related to the filing of the extension forms, the extra filings related to the 12b-25, those were all really kind of odd kind of things, those wouldn't happen in a normal first quarter, it just happened this, just this year.

We kind of valued the entire SG&A variance including these, what I would refer to as non-recurring SG&A cost, at roughly $0.06 per share just to give you an impact of what those G&A hits were, this quarter. So hopefully that add some scope to the or context to the adjustments that involved G&A this quarter.

Okay, thank you and then just a last question or set of questions related to the new debt agreements, so you have the $10 million term loan you had, a $30 million revolver, you've got this new EBITDA covenant where there is a maximum three to one leverage ratio, is that what you expect to be the greatest limiting factor on availability under that line of credit or is there a different covenant that might better watching more closely.

I think the three to one ratio.

Well, it's three and half to got to be amended amount, that's the one that's the most limiting the EBITDA one, is just a monitoring covenant that they kind put in to make sure that we're staying relatively close to the projected amounts that we give the bank. The one that would be the most limiting I would say will be the leverage ratio to three half to one one.

Okay, so that's just fair to June and September balance sheet dates and then after that a reverse three to one.

That's correct.

Okay, all right. Thank you.

Your next question will come from Mark Jordan of Noble Financial.

Thank you, gentlemen. Doug, remembering back I think to 2014 with the initial charge on the A-10 was taken. I believe at that time you said that production was going to extend through 2015 and that you had accounted for breakeven gross margin basis. With the charge you're doing today, you're talking about production extending into early 2017. What has occurred that is in essence extending the production period from late 2015 until early 2016 and is the reason why it's fully reserved for is that, you don't have an active contract with Boeing, although you're obligated under the original contract to deliver through this period and if you got a contract, could you in theory recoup much of this revenues.

I'll try to address all of that. You're absolutely correct that in the 2014 second quarter, we anticipated that we would not produce that the program would not run to even the 173 that we had on firm order at that time, I believe the number was somewhere between 135 and 140 aircraft was our estimate at that time. The reasons why we've extended it now is largely based on the fact that the Air Force has been now had changed its mind or so, the full extent of what they changed their mind to may not have been known but it seemed late at the end of the last year and going into this year, that there was a reversal of thought, by the Air Force on the retirement and when they came out and they said that we're not going to retire the plan until 2022. I think many of us concluded that they finally gave up the fight that they've been waging everywhere with Congress and they were kicking it downstream to the next administration and the fact that A-10 was doing great service in the field, all indicated that the program itself was saved for quite a bit of time [indiscernible] was that they would need to keep the wing program going. So it's no longer a case where, a termination at the convenience of the government seemed, the case because they were out on the public saying that they not only were they saying, that they needed the aircraft, but they had already publicly announced that they were going out to procure more wings that would take it beyond the current volume contract. So all of that information kind of concluded A; that we weren't going to get a termination from the government or from Boeing and B; it made financial sense to continue our program with Boeing, so that we can maintain our incumbency and bridge the period of time between the original estimate and future orders. What has happened recently that the reason why we took the charge now to complete those 173, is recent developments very recent developments in fact have indicated that maybe the Air Force, I said one thing back in February early march and meant the different thing and what it looks like now is that the Congress and Air Force are going to be fighting again over the timing of the retirement, if they retire it at all and so, it shed some uncertainty as to the timing and ultimate quantity of any future order that could have been used to offset the charge. So while we still feel at some point in time and I still feel near the end of 2016, the government will place orders with some company for new wings, how much and when it's too uncertain for us to calculate that in our estimates for the current period and that's why we took the charge.

Okay.

I think you asked also, if we were to win a new contract before the end of the year or get a claim from Boeing before of the end, would it reverse some or all of what we took in the first quarter and the quick answer is yes, but of course it's going to depend on how large in order, the timing of the order and other factors which we will evaluate if and when we get such an award.

Okay, thank you very much.

[Operator Instructions] I'm showing no further questions. This will conclude our question-and-answer session and I would like to turn the conference back over to Doug McCrosson for any closing remarks.

Thank you all for participating in today's conference call and if you have any questions or want to schedule a post call follow-up contact Sanjay Hurry at LHA Associates. Thank you very much, good bye.

The conference is now concluded. Thank you for attending today's presentation, you may now disconnect.