Ducommun Incorporated (DCO) Q2 2012 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen, and welcome to the Second Quarter 2012 Ducommun Earnings Conference Call. My name is Jeff, and I'll be your coordinator for today. [Operator Instructions] As a reminder, this conference is being recorded for replay purposes. I would now like to turn the conference over to your host for today, Mr. Chris Witty, and you have the floor, sir.

Thank you. And welcome to Ducommun's Second Quarter Conference Call. With me today is Tony Reardon, Chairman, President and CEO; and Joe Bellino, Vice President and CFO. I would now like to provide a brief Safe Harbor statement. This conference call may include forward-looking statements that represent the company's expectations and beliefs concerning future events that involve risks and uncertainties and may cause the company's actual performance to be materially different from the performance indicated or implied by such statements. All statements, other than statements of historical facts included in this conference call are forward-looking statements. Although the company believes that the expectations reflected in such forward-looking statements are reasonable, it can give no assurance that such expectations will prove to have been correct. Important factors that could cause actual results to differ materially from the company's expectations are disclosed in this conference call and in the company's annual report on Form 10-K for the fiscal year ended December 31, 2011. All subsequent written and oral forward-looking statements attributable to the company or persons acting on its behalf are expressly qualified in their entirety by the cautionary statement. Unless otherwise required by law, the company undertakes no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise, after the date of this conference call. I'd now like to turn the call over to Tony Reardon, for a review of the operating results. Tony?

Thank you, Chris. And thank you, everyone, for joining us today. I'll begin by providing an update on the quarter and some market color after which I'll turn the call over to Joe Bellino to review the financial results in detail. Ducommun continued to make steady improvement sequentially this quarter. We saw better operational performance in our AeroStructures business, margin expansion within our DLT business unit and benefited from overall strong commercial aerospace demand. We posted revenue of $184.7 million in our earnings, excluding any tax adjustments, rose sequentially to $0.37 per share from $0.23 in the first quarter, while we generated $10.5 million in cash flow from operations. Adjusted EBITDA also rose to 11.6% of sales from 10.3% both the second quarter of last year and the first quarter of 2012. Our operations are clearly benefiting from increased build rates across a number of key commercial platforms, particularly the 747 and the 737, as well as higher shipments for military helicopters like the Blackhawk and Chinook programs. However, within our non-aerospace markets, we, once again, saw a softness in demand, such that our industrial and natural resources areas posted revenue that was down slightly sequentially in aggregate versus the first quarter. We expect these end markets to remain flat for the rest of the year, and with return to a growth likely in 2013. Year-to-date, we generated nearly $6 million in cash compared to an $11 million usage of cash last year, a testimony to our focus on sound working capital management. As Joe will discuss in a moment, we plan to pay down a portion of our debt in the third quarter in line with our goals to delever the balance sheet. At the end of the second quarter, we had a backlog of approximately $640 million, which does not include roughly $18 million of follow-on orders from the Chinook helicopter booked just after June 30, 2012. In addition, we received approximately $15 million in radar rack orders for the F-15, F-16 and F-18 programs year-to-date leading our -- to our best backlog on these important programs in over 1 year. Overall, we were pleased with this quarter and for the sequential increases in both margins and earnings. And we continue to focus on improved shareholder returns. Now let me step back and take a look at the current market fundamentals. As already stated, the commercial aerospace demand is fueling growth in both of our AeroStructures and our DLT operations. We are pleased with the increase in build rates of our customers across the board and the strength of air passenger miles worldwide. In addition, as I'll come back to in a few moments, we're excited about the increased confidence provided to us by our major OEMs, who are coming to value the synergies and the technologies offered by combining our traditional AeroStructures business with our new DLT. We're seeing more opportunities for increased electronic content, higher ended assemblies and more complex tier 2 modules going forward. Within the regional jet and the general aviation market, the picture is still mixed with some platforms showing while others exhibit an uptick, particularly with regard to the larger general aviation aircraft. However, our commercial helicopter business continues to post strong solid growth year-over-year. Moving to the defense side of our business, the story hasn't changed much since last quarter, as I'm sure our listeners are all aware. There remains a great deal of uncertainty with regard to fiscal 2013 funding given the overhang of sequestration. While we're pleased with the potential of the continuing resolution discussions taking place on Capitol Hill, we have seen little planning to date by the government that would allow us and/or our customers to predict what will play out in the coming months. We continue to be conservative in our outlook and in our working capital management, while actively reviewing planning scenarios for the potential implementation of the Budget Control Act. In the absence of sequestration, there will still be a focus on reducing defense expenditures. However, as discussed in the past, Ducommun has a significant presence on a diverse set of key platforms that are unlikely to see material cuts near term. Increased electronic content, upgrades to existing aircraft and robust foreign military sales are anticipated to remain solid, in demand for our programs. And leading platforms such as the Blackhawk, F-15, C-17 and the F-18 continue to be sought after, both here and the overseas marketplace. Within our non-aerospace markets, some softness remains. We expect the revenue within the industrial natural resources area will be relatively flat during the remainder of 2012. But we're actively investing in new business development initiatives while being aggressive on managing costs and working capital. These are important marks to Ducommun that can turn around quickly. But they are overly dependent on a few large customers in the past. We are positioning them for improved performance as we look to secure a more diverse base of clients going forward. The medical markets, however, remain steady, as showing growth in both backlog and revenue, which we expect to continue. We remain positive about the future and confident that Ducommun is taking the right steps to improve shareholder value. We see significant opportunities to both accelerate and expand our margins going forward and expect further sequential gains in our performance during the second quarter -- or second half of 2012. Now I'd like to turn the call over to Joe Bellino for a more detailed financial review. Joe?

Thank you, Tony. And good day, everyone. After the market closed this evening, we reported results for the second quarter of 2012. Net income grew to $5.5 million or $0.52 per fully diluted share, that compares with $4.8 million or $0.45 per fully diluted share last year, excluding acquisition-related expenses that we incurred in 2011. The 2012 second quarter results include a tax benefit of $0.15 per fully diluted share reflecting a lot of hard work and analysis we have done and further integration benefits that we're realizing from the LaBarge acquisition, which in this case, relates to our ability to file consolidated state income tax returns for the combined entities, another win in the integration goals that we've set. Importantly, and as Tony noted, we saw sequential gains in financial performance, including improvements in operating margin, net income and cash flow. While Ducommun's year-over-year returns are available in our earnings report and the 10-Q, we thought it would be more meaningful to you, if given the LaBarge acquisition, to discuss the sequential improvements in our results. During the second quarter of 2012, as compared to the first quarter of 2012, we expanded our gross margins to 19.5% from 18.7%. We reduced our SG&A expenses to 11.9% of sales from 12.3% of sales, and in the process, we expanded our operating margins to 7.6% from 6.4% in Q1 2012. These gains reflect the expansion of margins in both of our business segments, with cost synergies realized at DLT and absorption of new development expenses at DAS. During our previous earnings call in May, we discussed our higher operating margin expectations, and we're pleased to report that we're headed in the right direction. In addition, during the second quarter, we generated $21 million in adjusted EBITDA or 11.4% of revenues, and this compares favorably with $18 million in adjusted EBITDA or 10.3% margin in the first quarter of 2012. Both business segments realized sequential expansion in adjusted EBITDA and in operating margin. Our backlog remains solid at $640 million, which is now 10% higher than we closed the LaBarge transaction in June of 2011. Backlog -- the backlog was down just slightly, approximately $7 million from the March backlogs, and they primarily reflect the timing of new orders which we now have received during the current quarter. In addition, as Tony commented this on, some of our non-aerospace and defense markets reflect slightly lower backlog sequentially from March. In this recent quarter, sales increased 71% to nearly $185 million, including $81 million in sales from the newly acquired DLT assets. On a pro forma basis, sales were about 1% ahead of last year's second quarter with the main driver being increases in commercial Aerospace and the Military and Space revenues. Primarily in the latter sector, it was primarily the military electronics sector, which continues to receive significant market acceptance. And they were somewhat offset by softer sales in the industrial and natural resources markets. We look at results by business segments starting with Ducommun AeroStructures, or DAS, first. DAS' sales for the quarter increased sequentially from the first quarter by slightly less than 4% to $77 million, as the segment benefited from increased sales in large commercial aircraft reflecting rising build rates. Adjusted EBITDA increased to $9.8 million, or 12.8% of revenues, up from $8.7 million or 11.7% of revenues in the first quarter of 2012. The increase in adjusted EBITDA and margin percentages is attributable to reductions in development costs for the new programs as compared to the first quarter of 2012. We expect margin expansion to continue sequentially through the balance of this year. Ducommun LaBarge Technologies, or DLT, posted sales for the quarter of nearly $108 million, it was down slightly from the first quarter due primarily to softer non-aerospace and defense revenues. But adjusted EBITDA grew sequentially to $15.2 million, or 14% of sales, from $13 million, or 11.8% of sales, in the first quarter of 2012. We've benefited from a variety of factors, including a combination of a richer product mix, solid management of the DLT operations and cost savings associated with our continuing integration efforts. Overall corporate, general and administrative expenses, CG&A, which are not identifiable or attributable to the business segments, were 2.1% of revenues for the quarter, compared to 1.7% of revenues in the first quarter. The small difference is attributable to increased accrued compensation expenses. Moving to backlog, as we mentioned earlier, our backlog continues to remain steady and solid with growth primarily in the commercial aerospace and military electronics businesses. We saw a sequential drop in our backlog more as a result of order timing, particularly given the F-15 and F-18 orders that we've recently booked, as Tony mentioned. We continue to see solid underlying demand for our products and services, and believe the softness in some of our non-aerospace and defense markets is more short-term in nature. Another important area is liquidity and capital resources. At the end of the second quarter, we had $391 million in debt outstanding and $354 million in net debt when we consider the amount of cash we have on our balance sheet. Given our trailing 12-month adjusted EBITDA of $83 million, this equates to 4.25x net funded debt to adjusted EBITDA. We continue to focus on debt reduction, along with selected capital investments in our business, as the use of our cash flow from operations. From a cash flow perspective, in the second quarter, as Tony mentioned also, we generated nearly $10.5 million in cash from operations, and our year-to-date generation of cash is nearly $6 million. This compares to an $11 million usage of cash at this time last year, which also excludes a 2011 acquisition costs. We now had about at the quarter end, we had about $37 million of cash on our balance sheet. What we plan to do in the second half of the year coincident with what we've said in our May earnings call was to pay down $25 million in the second half of 2012. We see this most likely being prepayments of around $10 million in the September quarter, and we'll look into the fourth quarter with -- and have prepayment plans up approximately $10 million to $15 million in that quarter to achieve the $25 million that we have been discussing. As we look at it with our cash flows even during the quarter here, in the third quarter, we remain on track to do so. We are driving cash flow generation through a combination of working capital initiatives and other areas to achieve these goals, and we expect that our $60 million revolving credit line will remain unused for the foreseeable future. We anticipate capital expenditures for the entire 2012 to be in the range of $16 million, that's down from our original estimate in our 10-K earlier this year of $21 million. We initiated several growth projects earlier in the year, and now, we see a slight slowdown in the level of CapEx spending through the balance of the year. Further expenditures will continued to be targeted till growth of our manufacturing capabilities, and selected increases in expansion of our facilities to support our strategic initiatives. So in closing, we are very pleased to see sequential gross margin and operating margin improvements during the quarter as we benefit from new program cost performance and synergies realized from our integration efforts. I now would like to turn the program back over to Tony for his closing remarks. Tony?

Thanks, Joe. And before opening the call to questions, I'd like to expand on a point I made earlier about Ducommun's evolving relationship with our customers. A few weeks ago, we exhibited at the Farnborough Airshow, where we had the opportunity to meet with many of our A&D customers. And we heard on a number of occasions just how interested they were in our expanded offerings and capabilities since the LaBarge transaction. It's one thing for us to say that we're a much better and more capable company, but it means a great deal more coming from our customers. The OEM market is increasingly using more integrated electronic content on their platforms, and they now understand that our business model, with our combined DLT and AeroStructures operations, can provide more advanced assemblies, sub-assemblies and modules going forward. With this in mind, we're working to deliver more value-added solutions and deepen our customer relationships. This won't happen overnight. And it's already taking place in terms of technical discussions, collaboration, high-content opportunities and the broader breadth RFPs that we're receiving. In a very -- it was very exciting to hear about the future of our customers, and we're working very hard to secure our position in that future. Overall, we're pleased with the progress to date and with our sequential improvements in the operating results. And we remain positive about the focus that we have in terms of ensuring our margin expansion and our earnings increases going forward. Given our backlog and strong mix of programs, we believe the second half of 2012 will bring a converging of positive factors across our business, positioning Ducommun for solid results in the quarter to come. Lastly, before closing, I'd like to welcome Joel Benkie, who joined Ducommun on June 18 as the Executive Vice President and Chief Operating Officer. Joel comes from a distinguished career with Parker Aerospace, a unit of Parker Hannifin, and has a strong strategic and operational background. He's already proven to be a great addition to the team, and will make a positive impact on our future results. As always, we appreciate our investors' patience and interest, and we remain confident that we're on the right path to increasing shareholder returns. With that, Jeff, I'd like to turn the call open for questions, please?

[Operator Instructions] It looks like our first question comes from the line of James Lebenthal with Lebenthal Asset Management.

I apologize because I'm going to ask you a question that I think you've answered before. I know you've answered before, but looking at the debt pay down, could you just remind me and others which particular debt instruments you're looking to pay down in the second half?

We're looking to pay down on our Term Loan B.

And what is the interest rate on that? I'm sorry to ask you to remind me.

It's $190 million of aggregate. We were paying at 1% down quarterly, principal and interest. But the all-in rate right now is 5.5%. The other piece that we have is a $200 million unsecured senior debt. That is a non-call for that is pretty onerous for us to prepay before we get to the 2015.

And would I assume that in 2015 that all things being equal, obviously, none of us can predict what the world will look like, but if you have the cash in 2015, you would try to pay that down instead, right?

That's a correct statement, yes.

Absolutely.

Yes. Yes. Yes. I mean because our all-in cost of interest is about 7.75%. So we're trying to drive that down, both from a reduction of the amount of outstanding debt, as well as change in the mix.

Our next question comes from the line of J.B. Groh with D.A. Davidson.

The backlog was down a little bit sequentially, which I'm assuming is maybe timing related. Could you talk about orders subsequent to the quarter and how those have progressed?

Yes. Sure. Just -- J.B., we had a large order from Philly on the Chinook program for about $19 [ph] million, which we've subsequently booked. We have a couple other orders that are in the -- that are finalized, we're just waiting to get through the DCAA audit process. But suffice to say there's $25 million to $30 million or $40 million of those orders that are on the military side waiting. And then every quarter, we pick up an order on the Boeing 737, so that increases on a quarterly basis in that program. So I think that we're pretty well positioned. We -- of the major programs that we have, in particular on the military side, we're just starting to see the bookings on the Blackhawk program coming through now. So we should see we should see a relatively good pick up in the second half of the year.

And then on the 737, what -- the order flow that you're getting now, sort of, what build rate does that reflect?

It's about 34 to 35 ships sets a month.

Okay. So there's still a little room to go there?

Yes. Yes. We don't expect to see anything in a larger area increasing until late in the year from a -- to get to the 38, if they do that.

Okay. And then just from your comments, it seems like you guys have a relatively high degree of confidence that your military portfolio is pretty stable, even in the face of sequestration. How do -- how are you doing that? I mean...

I don't -- hopefully, I didn't give the impression that it was stable in the face of sequestration. It's stable, and I think that there are opportunities out there. So I think that what we're seeing, I don't think anybody is stable in the face of a sequestration. So if I gave that impression, that was not correct because everybody's going to take a hit on that, the way that's set up right now. Unless there are some things that are worked out between now and the end of the year. But I do think that there are a number of programs that we have that are not impacted by a sequestration. So the C-17, for example, is a perfect program. Most of those sales, I can say 95% of those sales are foreign military sales that we have. So that backlog is loaded with foreign military sales, and the current U.S. government sales I don't see them cutting any of those from sequestration. F-15 and F-18 programs, they're both loaded with foreign military sales. F-15 is all foreign military. So we've got a good size of our backlog on the defense side that is posted for foreign military sales. And so we do not expect those to be impacted by the -- by a sequestration. So it would reduce the impact on us by some margin, because of that.

How do we -- any way to -- can you give us a, sort of, indication as to what percentage of your military business should be foreign? Is there a way to do that?

It's very tough to do that. But it's -- if you just took a look at the percentage of the defense business that we had, and said that somewhere between 25% and 30% of that was devoted to foreign military [indiscernible].

J.B., I might add, though. When you look at the Q that we've filed that's been posted, a breakdown of those backlogs, I think, are really telling. Because in the DLT military electronics sector, since the beginning of the year, those backlogs have grown from $212 million to $251 million. There is a good underlying growth of that. That includes some of the bookings of F-15 and F-18 that's mostly to wiring and interconnectivity solutions, which are smaller applications per order. Where we see flatness and some shrinkage in our Ducommun AeroStructure military portfolio, where the beginning of the year was $141 million, we booked some orders on the C-17 for 2 years, and there it's shrunk to $115 million. But when we add in the $18 million of the Chinook, it's $134 million, $135 million. We do expect 3% to 4% shrink coincident with the decline in the Defense budget on just the structure side but our underlying military electronics business looks very, very solid, positive and growing.

And the DLT stuff is mostly retrofit, correct?

No. It's actually new build and some retrofit market.

And defense, missile defense.

Missile defense. Heavy on the missile defense side. So it's-- I think that's an area that even if you look at [indiscernible] budget, we'll look at what governments do, both the House and the Senate are doing. Both those budgets look pretty stable on -- and consistent with what [indiscernible] is doing on the Department of Defense side.

Some of the drivers of those again are -- the macro drivers are more electronic content in cockpits and other parts of the aircraft that requires more complex solutions, we benefit from. Thank you.

Our next question comes from the line of Alex Hamilton with EarlyBirdCapital.

Joe, you had mentioned -- you highlighted how margins sequentially improved this quarter. And I believe you had said that you expect sequential improvement to continue. Can you talk about the low hanging fruit and what gives you the confidence to get there? And then can we talk about sort of a longer-term profile that we should expect?

I'll go back and, say, from the fourth quarter, when we had an unacceptable 17.2% gross margin, and we expected that range to be between 17.8% and 18.4% and we hit 18.7%, we were pleased to show that we exceeded that. And we said that we continue to make improvements and that the improvements will come on the DAS side as we continue to drive down the cost of delivering some of these new programs that we have been dealing with over the last 16, 18 months. That's the primary driver of seeing the margins improve. On the -- when you look at the numbers on the DLT side, you'll see, sequentially, our sales were down because we had softness in the non-A&D portfolio over there. But we've managed that business well to maintain the margins and take some costs out. So in terms of -- we look to keep working on a continuous improvement to nominally improve those margins, and hopefully, we'll get a pickup in sales at some point in time that will improve our operating margins a bit.

Our next question comes from the line of Carter Leake with BB&T Capital Markets.

So I'll be taking it for Jeremy. So bear with me as I get up to speed like he was. Let's start with the weakness in the RJ market. Can you give some color on that? What were you seeing there?

Weakness in which market?

Regionals.

The regionals, yes. I think that we're heavy on the Bombardier 700, 900 series. So they've cut back on their build rates from last year. So that's -- so they've gone from, roughly, 4 through most last year and cut back to about 2 ships sets a month. But we see some of that picking up, actually, now. And then -- that was the biggest part of the softness on the RJ side.

But do you see that picking back up? How does that pick back up?

Well, I think we're seeing some spares pick up on their side of the business. But it's not -- I don't think the build rate itself is going to...

Okay. Just -- you mentioned some platforms, can you give any A350 impact this quarter? Or is it too early for you?

We have some A350 sales but it's not -- it's still on the development side.

And then you mentioned 737s and 747s, any color on 777s and 7-8s [ph] in the quarter?

Well, they were up, both of them. Quarter-over-quarter and actually year-to-date both programs were up. 747-8 is starting to come into its own. So we've got pretty good content on that aircraft. So it's -- we saw an increase in revenue on that.

And I'm not sure if you guys do this, but I have a June presentation that it looks -- your annual expected growth rates, do you update that on the quarter? Is that something that you do?

Yes. Yes, we do. We -- those growth rates that we post on our website, we review those quarterly and even sometimes monthly. We just posted ours today that reflect our updated financial information and that. We haven't changed those growth rates because we think they're really more applicable to 2 to 3 years out rather than just quarter-to-quarter.

Okay. But these are the new -- the ones I'm seeing in the June presentation are the current annual expected growth rates?

Yes. And we have an August presentation out now on the web -- our website.

You do? Okay. Great.

Yes.

Our next question comes from the line of Bhakti Pavani from C.K. Cooper & Co.

You guys touched on the sequential margin expansion for the gross margins on the operating income. Could you share some color on the top line on what sort of sequential growth are you expecting for the second half?

Well, on the -- if you trend it, we have been ranging, in the last 4 or 5 months -- quarters, excuse me, between $182 million and $188 million a quarter. We've been averaging $185 million. As we look to the second half of the year, we see continued growth in our military electronics business, and we see increased shipments in our commercial aerospace business. Offsetting those, we're going to just be seeing softer sales, either flat or sequentially down a little bit in the industrial sectors and in the natural resources sectors. So we're looking for measured improvement in growth, sequentially.

Okay. Talking about the tax benefit that you guys received for Q2, is that something that is one time? Or do you expect that continuing going forward?

No. That's a permanent change. We expect that, we're -- we -- we're -- we spend a lot of time in terms of tax planning and tax strategy. And because we're able to file consolidated returns with all the entities involved, it translates to a lower effective state tax rate, really a permanent change in the future.

But it's -- but it won't be that size [indiscernible] So we were able to pick up first quarter and second quarter in that reduction. And so going forward, it will be -- it will have an impact of somewhere between 1% and 3% on an overall tax rate.

Okay. Last -- I mean, last -- I'm sorry, last week you received a contract from Bell Helicopter for the AH-1Z Cobra program. Could you share some light on what does that mean for Ducommun? And what growth -- I mean, what kind of a growth opportunity do you have there? If you could share some color.

Well, the actual program that we received is a significant in a couple of ways. I think that it's a development program that -- with the -- this is a brand new helicopter development program. So as we go forward, it's a combination of 2 of our business units. So it's driven through both our engineering division, as well as our structures division. And it has some significant growth opportunities. We have a couple of nice applications on the ducting system for this helicopter. So we don't -- I mean, we -- I think we gave some dollars output in the release. But we're actually limited about what we can say about the program from our customer.

[Operator Instructions] Up next, we have Mike Crawford with B. Riley & Co.

First, regarding next year, your -- you have some trepidation regarding if there's actual sequestration. But if there's a 6-month continuing resolution that reverts that kind of worse-case scenario, what kind of impact do you -- would you see that having on your business?

Mike, this is Tony Reardon. I don't believe that the continuing resolution has any impact on sequestration. So sequestration is part of the Budget Control Act. And so what the continuing resolution does is allow the budget to go forward for 6 months. So it gives the government the ability to go spend on the things that they need. But the impact of sequestration would impact the funds available for the continuous -- the continuing resolutions. So you would be impacted by sequestration no matter what.

Okay. And then just on the expected margin expansion, I think it's a little bit -- several factors: one, just gaining more experience on some of the new programs; two, maybe working on more value-added complex subsystems. And then, I guess, reduction of R&D expenses. But if you tried to weigh the importance of each of these factors, what's giving you the most bang for the buck?

Well, I think the -- clearly, the biggest bang for the buck is the reduction of the development costs. So we've got a very aggressive operational excellence program running in the facilities there in brand-new development, and we've been successful quarter-over-quarter in hitting the targets that we placed before the operations. And so we're going to continue to do that. I think that there are also opportunities to expand margins on some of these higher level assemblies that we're looking at. So we have a number of opportunities out there, many we -- we haven't captured those, and I'm sure that there'll be some start-up development costs related to those. But I think that as we go along, I think the biggest bang for the buck is going to come from moving the AeroStructures margins north and reducing the overall exposure on the development costs.

Ladies and gentlemen, since there are no further questions in queue, I'd now like to turn the call over to Mr. Reardon for closing remarks.

Okay. I would, again, like to thank everybody for joining us today. And again, thank you for your continued interest and support. And we look forward to speaking with you for the next quarter. Thank you very much.

Ladies and gentlemen, that concludes today's conference. Thank you for your participation. You may now disconnect. Have a wonderful day.