The Eastern Company (EML) Q2 2021 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen and welcome to the Eastern Company’s Second Quarter Fiscal Year 2021 Earnings Call. [Operator Instructions] At this time, it is my pleasure to turn the floor over to your host, Chris Moulton, Head of Corporate Development. Sir, the floor is yours.

Thank you. Good morning and thank you for joining us today. Speaking today will be Eastern’s President and CEO, Gus Vlak; and CFO, John Sullivan. After that, we will open the call up for questions. Please note that some of the information we will hear during our discussion today will consist of forward-looking statements about the company’s future financial performance and business prospects, including without limitation statements regarding revenue, gross margin, operating expenses, other income and expense, taxes and business outlook. These forward-looking statements are subject to risks and uncertainties that could cause actual results or trends to differ significantly from those projected in these forward-looking statements. For more information regarding these risks and uncertainties, please refer to risk factors discussed in our Form 10-Q filed yesterday – Thursday rather. In addition, during today’s call, we will discuss non-GAAP financial measures that we believe are useful as supplemental measures of Eastern’s performance. These non-GAAP measures should be considered in addition to and not as a substitute for or in isolation from GAAP results. With that, I will turn the call over to Gus for opening remarks.

Thanks, Chris and good morning to those of you who have joined us on the phone and those participating via the web. We released Eastern’s second quarter 2021 results on our earnings press release and our Form 10-Q last Thursday afternoon. The second quarter capped off a historic 12 months. Over this period, we have delivered record sales and record sales growth. I want to emphasize how proud we are of the collective effort of the approximately 2,000 people in each of our businesses. We thank them for their resilience and dedication and their agility to cut through many of the challenges associated with executing during the global pandemic. The way they have stepped up is impressive, taking care of our customers, our people and our communities. They have a lot to be proud of. We can summarize our quarter with three points: strong sales and even stronger demand, margin pressure from raw material and shipping costs, and a commitment to continue to streamline our company and focus on our best core businesses. First, sales from our continuing operations grew by more than 55% compared to the last year, following a solid start in the first quarter. Strong sales were the result of the economic recovery across a broad range of commercial vehicle and industrial markets as well as the impact of our product launches, including a new integrated cable lock that we produced for the incredibly popular, [indiscernible], a new cover locking system for ReTrax tonneau covers as well as the ramp up of several new Class 8 truck mirror programs. According to FTR, North America Class 8 net orders for June were up 13% month-over-month and 71% year-over-year with Class 8 orders now totaling 431,000 units for the previous 12 months. Across all commercial vehicle markets, demand continues to strengthen with strong GDP growth, capacity constraints across multiple shipping modes, at near record truck freight rates and record used equipment valuations. As a result, order rates for red hot in the second quarter and the ending backlog remained near record levels. Our backlog at the end of the quarter reached $89 million, that’s an increase of 61% over the end of the second quarter last year. We are excited about the full potential of these opportunities to support strong revenue growth in the back half and beyond. We believe that the growth in our sales could have been even more robust, if not for delays. OEM production delays related to chronic component shortages, supplier shipping delays to our own facilities, and OEM delays of new passenger car vehicle launches. Yet despite these challenges, we posted strong sales in the second quarter. In the quarter, we also experienced a continuation and in many cases, an acceleration in the cost of key raw materials and freight rates, which pressured our margins. Just to provide you with some perspective of the magnitude of the rising costs. Over the last 12 months, the price of hot-rolled steel increased by 236% and the price for cold-rolled steel grew by 174%. These are examples of key raw materials that we use in many of our products. Similarly, spot shipping rates between several Asian and U.S. ports increased from approximately $5,000 per container in May to more than $18,000 per container in July. Our businesses have been able to pass on some of these price increases to our customers, but we have had to absorb or share some of these costs and there is frequently a lag in the realized price increases relative to the rapid escalation in costs. As a result, we estimate that our margins in the second quarter were compressed by several hundred basis points. That said, although the supply chain remains disrupted and many material prices are still volatile, we are cautiously optimistic that we are beginning to see signs of moderation in the rate of price increases across many of our key raw materials, and we are working with our customers and suppliers to ensure that we return to more stable normalized margins in the coming quarter. Finally, we continue the execution of our long-term strategy to drive growth in our core businesses. And therefore, we are now reporting our diversified product segment as discontinued operations. As these legacy businesses are no longer aligned with our strategy and as such, we are exploring strategic alternatives for each of them. We believe that this change in reporting signals our commitment to focus 100% of our time and resources to ensure that each of our core businesses, the resources that they require and the people and capabilities in place to drive growth and profitability for years to come. With that, I will turn the call over to John to go over the details of our financial results.

Thank you, Gus. My remarks this morning will focus on Eastern’s results for the second quarter of 2021. As Gus had just noted, we recognized that the companies within the Diversified Products segment no longer align with our strategy. And as such, we are exploring strategic alternatives for each of them. And in light of this, the Diversified Products segment meets the criteria to be held-for-sale and furthermore, we determined that the assets held-for-sale qualify as discontinued operations. Therefore, the financial results of the Diversified Product segment are reflected in our consolidated financial statements as discontinued operations for all periods presented. Additionally, current and non-current assets and liabilities of the discontinued operations are reflected in the unaudited balance sheets for the periods presented. The loss recognized in the write-down of the Diversified Products segment to par value in the second quarter was $8.1 million net of tax with anticipated cash flow over the next 12 months for approximately $25 million should we successfully divest each business. The majority of the cash would be allocated to debt reduction. I’m now focused on the second quarter of 2021 as compared to the second quarter of 2020 from continuing operations. For the second quarter of 2021, net sales increased 55% to $61.2 million compared to $39.5 million for the second quarter of 2020. Sales increased largely due to increased demand for truck accessories, automotive, returnable packaging, global tooling and distribution products. Net sales of existing products increased 44% in the second quarter compared to the same period in 2020. The price increases in new products increased net sales by 11% in the second quarter of 2021 compared to the same period in 2020. New products included various truck mirror assemblies or compression launches, cable locks and mirror cams. Gross margin as a percent of sales was 23% in the second quarter compared to 26% in the second quarter of 2020. The decline in gross margin was due in large part to unprecedented increases in prices of many of the raw materials as well as freight rates. For example, price of hot-rolled steel increased 236% year-over-year from the second quarter of 2020 to the second quarter of 2021. Cold-rolled steel increased 174%, nickel increased 42%, scrap iron increased 178%, copper and zinc increased 81% and 49%, respectively, to the same period, while freight costs increased $1.4 million or 148% and $2.1 million or 97% for the 3 and 6 months ended July 31, 2021 as compared to the corresponding period in 2020. Price increases to customers were only able to offset a portion of these increases. Product development expenses increased $0.2 million or 19% in the second quarter compared to the same period in 2020. As a percentage of sales, product development expenses was approximately 1.8%. Selling and administrative expenses increased $2.8 million and 43% in the second quarter compared to the same period in 2020, primarily due to increased commissions, other selling expenses, amortization expenses, payroll-related expenses and incentive costs, which were suspended in the second quarter of 2020. Net income for the second quarter was $2.8 million or $0.44 per diluted share compared to net income of $2.1 million or $0.33 per diluted share for the same period in 2020. Now for a quick summary of our cash flow and balance sheet highlights. Cash flow from operations was $2.2 million for the second quarter, lower when compared to the same period last year due to an increase in inventory and accounts receivable. This was primarily the result of significant increases in sales, partially offset by an increase in ounces payable. Inventories of $48.8 million as of July 30, 2021, represents an increase of 13% as compared to $43.1 million at the end of fiscal year 2020 and an increase of 12% as compared to $43.7 million at the end of the second quarter of 2020. In certain of our businesses in anticipation of increased prices and material shortages, we selectively purchased – pre purchased key raw materials. Accounts receivables were $35.1 million as of July 3, 2021, as compared to $31.8 million at 2020 fiscal year-end and $28.4 million at the end of the second quarter of 2020. As of July 3, we had cash and cash equivalents of $18.5 million and untapped $20 million revolving line of credit. Our net leverage ratio was 2.3x, and our fixed charge ratio is 2.7x, both of which are well within our bank covenant of 4.25 and 1.25, respectively. With that, I’ll now turn the call over to the operator for questions.

Thank you. [Operator Instructions]

Thank you, operator. We do have some questions that have come in via the webcast. So let’s start with those. So let’s go to the first question. One, can you explain the $10 million restructuring charge that we took this quarter?

Yes. Every quarter, we continuously evaluate all our reporting unions for impairment, and we do this by comparing the estimated fair value of each reporting unit with its carrying amount and if the carrying amount of the assets exceed the fair value, then we have an impairment, and we have a write-down. In this last quarter, we determined that the discontinued operations do not fit our long-term strategy. So – and we wanted to focus on our core business. And as a result, we reevaluated the fair value of these legacy businesses, and we recorded an impairment. As part of this, we recognized a goodwill write-off of approximately $5.9 million into the discontinued operations when we classified the disposal group as held for sale.

Okay. And second question, when will you have completed the sale of the discontinued operations?

Well, reporting these discontinued operations now means that we are confident that we will be able to complete these within the next 12 months. We expect that the net cash proceeds of these sales is somewhere in the area of $25 million, and we intend to use these proceeds primarily to reduce our outstanding debt, which will help us continue to strengthen our balance sheet and set us up to support the growth of our core businesses.

Okay. And we have a third question. How much EBITDA did the discontinued operations contribute in the first half and second quarter of 2021?

Well, actually, we haven’t reported those numbers. And we did report the net income from the discontinued operations in Note B of our latest 10-Q. Also, if you reviewed our 10-Q for 2020, first six months, we reported adjusted EBITDA. And in our 10-K for 2020, Note 12, we reported our segment reports, which identified the Diversified Products segment. With those, you can kind of compute what the EBITDA would have been contributed from the discontinued operations, but it would not have been material relative to the total EBITDA from the company.

Okay. We have a fourth question. What is the impact of raw material prices on your earnings?

Well, I think as we have mentioned, raw material prices and shipping costs have increased at unprecedented rates. And although we pass on these costs to our customers, there is often a lag. And in the past, I would say the impact of the lag was fairly noticeable because we were able to raise prices more in line with higher costs. But because of the rapid sustained, actually should say the sheer scale of the cost increases, we have not yet been able to fully recover these in the past quarter. As a result, we estimate that our gross margins fell by several hundred basis points. Our ability to recover will improve as we work with our customers as the rate of price increases slows down in the coming quarters.

Okay. Question number five, how is the integration of Big 3 Precision going?

So, we acquired Big 3 Precision in August of 2019, and we are very pleased with the acquisition. It’s one of our core businesses. We have taken a number of steps to help drive growth. In January, we brought on a new leader for the business, and we have hired and promoted several other senior leaders inside the business. On the transfer packaging side of the business, we believe that with his team, we are well positioned to capitalize on the increase in the number of new vehicle launches that are scheduled for the next 4 years to 5 years, including the launch of many electric vehicles. So, BofA estimates that in 2021, there will be roughly 34 new vehicle launches. They also estimate that the average for 2022 to 2025 is 60 new vehicles per year. The other thing this team will be able to do for us is help us diversify our customer base going after some new markets and also integrate new bolt-on acquisitions that will help us expand our product offering and geographic market coverage. On the tooling side of Big 3 Precision, we had an exceptional 2020, driven in part by the demand for hygiene packaging and 2021 is just as strong through the first six months. You may so recall that we added hailing based in Ontario, Canada to this business. It was last July. Hailing expanded our offering Big 3 Precision to include two-step formal tooling. And it’s been a very strong addition to – overall to the organization. On the commercial side, hailing is fully integrated, and really, we couldn’t be more pleased with this addition. Now while I am on the topic of integration, I will note that we are also working on the combination of our Eberhard and Illinois Lock businesses, and this is progressing extremely well. Through this combination, Eberhard not only benefits from the consolidation of synergies, and they are currently working on streamlining their manufacturing footprint. But more importantly, it can drive the adoption of electromechanical and digital products into many of our markets. In the past few years, Illinois Lock has invested in many of these capabilities, including the acquisition of Load N lock, which we completed in 2018. And with the combination now of Eberhard and Illinois Lock, we can bring these products to these capabilities to many of our best body building, service body and truck accessories customers. We believe that by 2025, more than a third of total Eberhard sales will come from electromechanical and digital products.

Alright. It looks like we have one more question. How does the sale of discontinued operations impact your goal of becoming a $100 million EBITDA company?

Well, far and away, I think as John mentioned, most of our EBITDA comes from our continuing options or the core businesses. So, from purely mathematical perspective, I would say the impact is minimal. But more importantly, but – what this will allow us to do is allocate all of our capital to our highest return businesses. And as a result, we should see faster top line and bottom line growth from these businesses. And we are going to have more capital for accretive bolt-on acquisitions.

Okay. I am not seeing any further questions via the webcast. So operator, can we open the line for questions.

[Operator Instructions] There appear to be no questions over the phone.

Okay. Thank you. With that, I will turn the call over to Gus for closing remarks.

Thank you. There are many signs for continued optimism as we enter into the back half of the year despite some of the supply chain difficulties and the raw material price volatility. Our backlog is strong, and we are making progress on pricing, and we are confident that our focus on our core businesses, Big 3 Precision, Eberhard and Velvac will translate into material sales, earnings and cash flow growth throughout the remainder of 2021 and beyond. Thank you.

Thanks, Gus. I will now hand the call back to the operator.

Thank you. Ladies and gentlemen, this does conclude today’s teleconference. We thank you again for your participation. You may disconnect your lines at this time and have a great day.