Helios Technologies, Inc. (HLIO) Q1 2018 Earnings Report, Transcript and Summary

Greetings, and welcome to the Sun Hydraulics Corporation First Quarter 2018 Financial Results Conference Call. [Operator Instructions] As a reminder, this conference is being recorded. I would now like to turn the conference over to your host, Karen Howard, Investor Relations for Sun Hydraulics. Please proceed.

Thank you, Madel, and good morning, everyone. We certainly appreciate your time today for our first quarter 2018 financial results conference call. On the line with me are Wolfgang Dangel, our President and Chief Executive Officer; and Tricia Fulton, our Chief Financial Officer. Wolfgang and Tricia will be reviewing the results that were published in the press release distributed after yesterday's market close. If you do not have that release, it's available on our website at www.sunhydraulics.com. You will also find slides there that will accompany our discussion today. If you look to the slide deck on Slide 2, you'll find our safe harbor statement. As you may be aware, we will make some forward-looking statements during this presentation and also during the Q&A. These statements apply to future events that are subject to risks and uncertainties as well as other factors that could cause actual results to differ materially from where we are today. These risks and uncertainties and other factors are provided in the earnings release as well as other documents filed by the company with the Securities and Exchange Commission. These documents can be found at our website or at www.sec.gov. I also want to point out that during today's call, we will discuss some non-GAAP financial measures, which we believe are useful in evaluating our performance. You should not consider the presentation of this additional information in isolation or as a substitute for results prepared in accordance with GAAP. We have provided reconciliations of comparable GAAP and non-GAAP measures in the tables that accompany today's earnings release as well as in the slides. Wolfgang will get started with some highlights for the quarter. Tricia will go through the details of our financial results, and then we'll turn it back to Wolfgang for his perspective on our outlook before we open up the line for questions and answers. And with that, it's now my pleasure to introduce Wolfgang.

Thank you, Karen. Good morning, everyone. Please turn to Slide 3. We are off to a solid start in 2018. Driven by very strong demand, our first quarter results were generally in line with our internal expectations, although our Hydraulics segment was challenged operationally due to supply chain constraints. Given some actions we've taken, we are already seeing margin improvements thus far in the second quarter. In addition to reporting solid financial results, even more importantly, we continue to make significant progress on our Vision 2025. I'll get more into that in a moment. Let me start with highlighting the financial results for the quarter, and then Tricia will provide some more details. Sales increased by 20% to over $97 million. This is all organic growth. Our Hydraulics segment grew 16% and Electronics grew 28%. If we hadn't experienced supply chain constraints, our Hydraulics growth would have been higher. I'll touch on that further in a moment. For the quarter, we reported net income of $11.9 million. After excluding adjusted items that Tricia will review with you, our non-GAAP net income was $13.6 million, an 18% increase. Our adjusted EBITDA grew to over $23 million, representing a 24% margin. Again, these results were impacted by supply chain constraints due to strong demand for our products and services. As you know, in late January and early February, we accessed the equity capital markets and successfully raised about $240 million net. So you see those proceeds and additional shares flow into our first quarter. In mid-February, we also announced that we signed a definitive agreement to acquire the Faster Group. That acquisition closed in early April. So all of our first quarter results do not yet include Faster. We used the proceeds of the equity offering, existing cash and funds from our amended credit facility to fund that acquisition. As a reminder, Faster Group is a global leader of quick-release hydraulic coupling solutions, complementing our existing hydraulic cartridge valves and manifolds very well. This is a very strategic and transformational acquisition, moving us further along our Vision 2025. Headquartered outside Milan, Italy, Faster brings some very important end markets to us, particularly the global agriculture market, which is entering a growth cycle. Similar to Sun, Faster Group is known for its high-quality, high-performance products and excellent customer service. The Faster brand is number one in Europe and number two globally. These differentiating factors are driving Faster to gain market share, growing ahead of macroeconomic trends. We have already begun our integration activities. Last week, we held our first working session amongst the sales teams from our existing CVT and Electronics businesses, along with the Faster colleagues. There's a lot of excitement around the synergy opportunities. To include the Faster Group and financing costs for the remainder of the year, we have updated our 2018 guidance, which includes increasing our revenue range and maintaining our adjusted operating margin range. I will address this further at the end of the presentation. Please turn to Slide 4, and I will update you on some of our strategic activities in the 2018 first quarter. First, our investments to drive organic sales are ongoing. These include expanding our application specialists in the field to support customer interaction and penetrate white space where we have historically been underrepresented. For example, we are adding engineering and sales talent in India and are in process of adding channel partners and application specialists in Southeast Asia and Latin America. Additionally, our new product development teams are aggressively solving problems in helping customers to create business opportunities, both driving our organic growth. Within our Hydraulics segment, this includes development of the next 2 phases of our FLeX product offering. Recall that we introduced Phase 1 in Q4 2017, and now we are working to launch Phases 2 and 3 of this important product program over the next several quarters. These new products are designed to outperform comparable valves in the market and augment our electrohydraulic product offering, which is the fastest-growing sector within hydraulic cartridge valves market. The Sun FLeX represents our largest new product launch in nearly a decade and is opening up new applications and markets for us. Within our Electronics segment, we drive growth with joint product development with our Vehicle Technologies customers. We then standardize these new products for distribution through our Power Controls business. On the operation side; we have been working very diligently on our LEAN enterprise initiative to improve our processes, which will in turn drive profitability and increase capacity. Accordingly, we have begun the process to consolidate the CVT manufacturing currently housed in our three Sarasota facilities into two. We expect consolidation of the facilities to be complete in early 2019. This will improve the manufacturing flow in alignment with LEAN principles and additionally free up the third facility to become our global CVT engineering and R&D hub. We will be upgrading our testing lab, enhancing flexibility to support our new product development activities. The project to upgrade the lab will be ongoing throughout 2019, with completion currently expected by the end of that year. As I mentioned a moment ago, our Hydraulics segment first quarter results were pressured by supply chain constraints since our customer demand was strong. To alleviate this issue, we negotiated long-term agreements with our largest CVT component suppliers. These agreements address capacity, on-time delivery and quality as well as pricing. We are already seeing improvements in on-time delivery, which leads to more efficient flow on our production floor as well as support our best-in-industry lead times. With respect to our Enovation Controls synergies; recall that our target is $5 million of EBITDA annually beginning in 2020. We have already completed the cost synergies ahead of schedule. And as of 2018, we have begun realizing the annual savings from merging our HCT activities formerly in California into Enovation Controls in Oklahoma. The cost savings are included in our 2018 guidance. The remaining synergies will be realized from sales activities, which are well underway and on track with our original projections. Next, the construction of our new facility in South Korea continues on plan, and we expect commencement of our manufacturing, engineering, sales and warehousing activities at the new location in the third quarter of this year. We look forward to having it up and running to support the significant growth we are realizing in the Asia Pacific region in alignment with our 'in the region, for the region' initiative. Finally, we have completed the road map for post-merger integration of Faster Group, which will remain a stand-alone business. We have identified designated areas of focused joint activities with CVT and Electronics. This is the same approach we took with the successful integration of Enovation Controls. All of these activities are in pursuit of our Vision 2025 goals, which include establishing critical mass at $1 billion in revenue while maintaining superior profitability and financial strength. With that overview, I will now turn the call over to Tricia to review the financial results for the quarter in a bit more detail.

Thank you, Wolfgang, and good morning, everyone. Let's begin on Slide 6 with a review of our first quarter consolidated results. First quarter sales were $97 million, up 20% compared to last year's quarter. This is all organic growth. Most of our products do not have any price increases, so pricing had an immaterial impact on the comparability. Foreign currency translation had a favorable $2.4 million impact for the quarter. So the growth, excluding the impact of the currency, is 16.6%. I will now touch on sales by region, which are designated here in the sales bar charts. There is a table in the back of the press release as well as a supplemental slides summarizing this information. As we previously noted, all geographic markets realized considerable year-over-year growth. In the Americas, sales were up 19% over the first quarter of 2017 to $56.5 million, resulting in sales to the Americas market of 58% of the consolidated total. EMEA realized 11% growth to $22.3 million, and APAC region was up 32% to $18.5 million. As you know, we've made investments in sales and marketing, including additional sales application specialists in the field and introduced new products, which we believe are driving market share gains that are in excess of economic market expansion. Regarding profitability, our consolidated adjusted EBITDA was up slightly over last year's first quarter to $23.3 million or 24% of sales. The comparison was impacted by our gross margin results. I'll get into this more as we review the segment results on upcoming slides. But at a high level, our gross margin was pressured by supply chain constraints, higher material costs and certain operational costs, including some of those that began in the fourth quarter of 2017. Turning to the bottom line; adjusted earnings per share were $0.46, up 6% over last year's first quarter. I wanted to point out that our adjusted net income was up 18%, but our average shares outstanding increased during the quarter due to our secondary offering, impacting our earnings on a per-share basis. I also want to remind you that our number of shares outstanding as of April 26, 2018, was about 31.6 million. I'd like to bring to your attention few items that impacted our consolidated results and that we added back for purposes of reporting adjusted EBITDA and adjusted EPS shown here. Please refer to the tables in the back of the press release or slides for reconciliations of GAAP to non-GAAP numbers. During the first quarter of 2018, we incurred the following: first, $1.2 million in costs related to acquiring and financing Faster Group; next, we incurred about $111,000 in restructuring charges associated with the legal reorganization in conjunction with the Faster acquisition; next, we realized a $505,000 charge on the foreign currency forward contracts that we entered into when we signed the agreement to acquire Faster to lock-in the euro exchange rate; finally, we recorded a $402,000 charge associated with interest on the change in fair value of contingent consideration associated with the Enovation Controls acquisition. During the first quarter of 2017, we incurred the following costs, which we added back for non-GAAP purposes. We recorded a $1.8 million charge for the amortization of an inventory valuation adjustment associated with the Enovation Controls acquisition; and we had $200,000 of costs related to acquiring Enovation Controls. Please turn to Slide 7 for a review of our Hydraulics segment operating results. Sales grew 16% to $63 million with particular strength in the APAC region, continuing the trend we saw last year. We saw 35% year-over-year growth for the quarter in the APAC region, 15% growth in EMEA and 7% growth in the Americas region. The growth was driven by our increased market penetration and new products as well as broad economic market expansion. Gross profit increased by 6% to $23 million on the higher sales, but gross margin declined by 340 basis points to 37.5%. We will reconcile that change in detail on the next slide. Operating income declined 2% to $13.4 million or 21.5% operating margin. In addition to the gross margin pressures, our selling, engineering and administrative expenses, or SEA, grew $1.6 million or 19% to $9.9 million compared with $8.3 million in the first quarter of the prior year. This reflects planned increases in sales and marketing and R&D initiatives as well as professional fees for operational improvements and administrative infrastructure to support our growing organization. Please turn to Slide 8, and I will reconcile the change in gross profit from the first quarter of 2017 to the first quarter of 2018 for the Hydraulics segment. Gross profit in the 2017 first quarter was $22.1 million or 40.9% of sales. After adjusting for higher volume, we determined that we incurred a $194,000 or 0.3 percentage points of margin for incremental freight costs due to significant customer demand, similar to that which started in the fourth quarter of 2017. Incremental freight costs improved from Q4 and will further improve in Q2 of 2018. Increases in material costs were about $515,000 or 0.8 percentage points of margin. Recall that we do have a price increase effective July 1 to start covering these cost increases. Interim labor costs were a premium we paid for experienced third-party contract labor that was isolated to the first quarter, again to try to keep up with demand and maintain our best in industry lead times. These amounted to about $461,000 in the first quarter of 2018 or 0.7 percentage points of margin. We have already discontinued the use of this type of labor, so these costs will not repeat in the second quarter. We calculated that supply chain constraints and resulting inefficiencies amounted to about $825,000 or 1.3 percentage points of margin. This includes costs associated with temporary labor and overtime as well as some inventory adjustments. As Wolfgang mentioned, the long-term supply contracts we entered into during the quarter are already starting to reap benefits as we're seeing improved deliveries from our suppliers, which has had a positive impact on our efficiency. Finally, we did realize favorable currency effect of $503,000 or 0.8 percentage points of margin during the quarter, primarily due to the weaker U.S. dollar. The logistics material costs, interim labor, production efficiencies and offsetting foreign currency in total impacted our 2018 first quarter gross margins by 230 basis points. There were other normal fluctuations, such as varying sales incentives and mix that offset the leverage realized on the incremental sales. As we look forward to the second quarter, we are already seeing some improvements, but some of these types of costs will continue. The interim labor costs isolated here will not continue in the future periods. The logistics and material costs as well as production inefficiencies will gradually reduce throughout the year, but will not go to 0 because of inflationary impacts. So all in all, for our organic business, we estimate that about half of the margin impact that we realized in the first quarter will continue in the second and third quarters. We expect the margin impact to be cut in half again in the fourth quarter. The CVT price increase will take effect on July 1. And given the timing of the increase at mid-year, we expect to realize approximately 1.5% to 2% additional net sales in Q3 and Q4 as a result. Please turn to Slide 9 for a review of our Electronics segment operating results. Revenue for the first quarter grew 28% over the first quarter of last year to nearly $35 million. This was driven by ongoing increased demand in Power Controls and recreational end markets. In addition, proactive sales initiatives and increased demand for new products developed in the past year also contributed to growth. Gross margin for the segment increased 14% to $14.2 million, yielding a gross margin of 40.8% compared with 45.7% in the first quarter of '17. I will reconcile that change in detail on the next slide. Operating income in the first quarter grew 14% over the first quarter of 2017 to $7.1 million, with an operating margin of 20.5%. SEA expenses grew $900,000, reflecting planned investments in selling and marketing initiatives as well as R&D to support our growth strategy, partially offset by cost savings from consolidating our HCT business into Enovation Controls. Please turn to Slide 10 and I will reconcile the change in gross profit from the first quarter of 2017 to the first quarter of 2018 for the Electronics segment. Gross profit in the 2017 first quarter was $12.4 million or 45.7% of sales. Similar to the Hydraulics segment, after adjusting for higher volume, we determined that we incurred $170,000 or 0.5 percentage points of margin for incremental freight cost due to significant customer demand. The incremental freight costs are continuing to improve in Q2 of 2018 as supplier delivery performance is improving. Also, after adjusting for higher volume, we incurred over $1.9 million of higher material costs or 5.5 percentage points of margin. The majority of these higher costs, approximately $1.5 million, were due to product mix with higher electronic content versus mechanical content, which are generally higher in cost and sales rebates at the higher volumes. We have been in active negotiations with key suppliers to secure steady supply and competitive pricing going forward. We also incurred about $200,000 of higher-than-normal scrap, about half of what we realized in the fourth quarter of 2017 and in line with our expectation. Finally, we calculated approximately $760,000 of favorable costs due to improved efficiency, as last year we were in the midst of the carve-out process. The net effect of these three items impacted our 2018 first quarter gross margins by 380 basis points. There were other normal fluctuations, such as varying sales royalties and mix that offset the leverage realized on the incremental sales. As we look forward to the second quarter, we are already seeing some improvements, but some of these types of cost will continue. We expect about half of the margin impact that we realized in the first quarter will continue in each of the remaining quarters of 2018. Please turn to Slide 11 for a review of our cash flow and capital structure. This view is as of March 31, 2018, before financing Faster Group acquisition, which occurred on April 5, 2018. In the first quarter, we generated $14.7 million of cash from operating activities compared with $12.4 million in 2017, with the 18% increase driven by higher net income. We are pleased that we achieved our target of 15.1% operating cash as a percent of our consolidated sales for the quarter. We finished the quarter with $199 million of cash. The large cash increase was due to proceeds received from our equity offering, which is done in anticipation of closing on an acquisition target. Total debt was $900,000 at March 31, 2018, down from $116 million at December 31, 2017, upon application of our equity offering proceeds. Following completion of the Faster Group acquisition, net debt is approximately $340 million, and trailing 12-month adjusted EBITDA is about $124 million, representing a 2.7x multiple. Given the strong cash flow of our combined organization, we believe this is a very manageable level and we'll aggressively begin repaying it during 2018. Wolfgang, I'd like to turn it back to you for your perspective on outlook and our updated guidance before we open the lines for Q&A.

Thanks, Tricia. Please turn to Slide 13. Leading indicators that are important to Sun continue to signal ongoing growth through 2018. For example, U.S. industrial production is expected to continue accelerating growth into the third quarter of 2018 and then continue growing in the fourth quarter, but at a slower rate. U.S. total manufacturing production and U.S. mining production are currently growing at accelerating rates. All major global economies are in a growth phase, except Mexico. This includes China, Western and Eastern Europe, Canada, India and Brazil. Economies in those regions are also expected to continue growing throughout 2018, but at a slower rate than 2017. Mexico's growth is expected to accelerate as we progress in 2018. As our cartridge valves are important to the construction machinery sector, we look to the status of the U.S. construction market. Currently, expansion is expected in most of the sectors through 2018, especially warehousing building construction. Year-over-year growth is anticipated across most of the manufacturing sector in 2018. Capital goods and North American heavy-duty truck are expected to grow at the fastest rates. Leading indicators point to a mild recession in 2019, with growth expected to resume in 2020. Finally, the U.S. electronics business indicators continue to point to growth in 2018. As you have seen, this economic activity is benefiting us given our current concentrations in material handling and general industrial applications. Important to note, we have stated in accordance with our Vision 2025 plan we expect to outpace macroeconomic growth. This is being driven by the investments we are making to expand our coverage in the field, increase and broaden relationships with OEMs, penetrate regions where we have white space and continue to introduce new and innovative products and solutions. Please turn to Slide 14 for our thoughts regarding our outlook for Sun. Regarding our organic businesses, strong demand and our backlog give us confidence in our growth expectations for the remainder of the year, especially visibility for our second and third quarters. From a profitability standpoint, while certain cost pressures will continue into second quarter, as Tricia mentioned, they are declining as a result of actions we have taken. Further, our CVT price increase, which is the first in three years, will take effect in the beginning of the third quarter, and we expect that it will offset the manufacturing cost inflation we have been burdened with. I want to remind you that our investments in our SEA initiatives are necessary and will continue as they are driving top line growth in accordance with our strategy and providing support for our growing organization. Finally, may I point out that our historic Sun CVT and Enovation Controls businesses are seasonally weakest in the fourth quarter. This may not be the case this year for our Sun CVT business, given the demand we are seeing from the marketplace. Regarding Faster, we have included this business in our updated 2018 guidance beginning April 5 when we closed on the acquisition. Prior to our acquisition, Faster experienced 25% growth in the first quarter of 2018 over the prior year quarter, resulting in about USD 40 million of revenue and generating an EBITDA margin of about 28%. Their historical pattern is that their first half year is modestly stronger than the second half by a ratio of about 53:47. Based on what we see today, we anticipate this will likely be the case in 2018. Please proceed to Slide 15; where we updated our guidance for 2018 compared with the guidance we provided in February, which was prior to closing on the Faster acquisition. We are now expecting revenue between $490 million and $505 million. This includes between $107 million and $112 million for Faster for the remaining three quarters of the year, and it will get reported within our Hydraulics segment. Accordingly, this amounts to consolidated organic revenue growth of 12% to 15%. We expect revenue for our organic Hydraulics business will grow between 13% and 15%, and revenue for our Electronics business will grow between 9% and 13%. We are currently maintaining our consolidated adjusted operating margin at 22.7% to 24%. Following our current reporting methodology, which excludes acquisition-related amortization of intangibles and will exclude an inventory step-up adjustment for Faster Group in the second quarter. We believe this range incorporates the gross margin pressures that we discussed earlier and exhibits our commitment to superior profitability in comparison to other diversified industrial companies. Our interest expense guidance, as shown here, reflects the financing of the Faster acquisition. Our effective tax rate estimate is unchanged. Finally, we have increased our capital expenditures, depreciation and amortization guidance to include Faster and the impact of purchase accounting based on our latest valuation report. With that, let's open up the lines for questions and answers.

[Operator Instructions] The first question comes from the line of Brian Drab with William Blair.

So the first question, just to be clear on the guidance, $120 million raise at the midpoint, is that exclusively due to the Faster acquisition? Or is there any change in the core business outlook?

We did have an increase in the core business outlook on both -- or for Hydraulics. There was a small increase on the Electronics side. But specifically, to the Hydraulics segment, it includes the Faster plus a small organic increase for the traditional business.

And then, Tricia, can you -- I think, you put a lot of great detail in the slides around the gross margin dynamics. Can you just maybe summarize again the pressure quantified in basis points that you saw in the quarter and give us, again, the improvement that you're expecting? Like, if you had a pressure, of -- basis points of x in the first quarter for the segment, then you said it would get reduced by 50% and then 50% again. Can you just give us what that impact was in the first quarter? And then, those ratios again in the periods?

Yes. So for the Hydraulics segment, it was 230 basis points on the additional costs in the bridge. So if you take all of the items in the bridge for Q1, we expect in Q2 and Q3 to have half of that total; and then in Q4, to have half of that again on the Hydraulics side. On the Electronics side, the items in the bridge are about 340 basis points. And if you take all the items in the bridge, we expect to have about half of those flow through into Q2, Q3 and Q4.

And then, just one last one. In EMEA, you had 11% growth on a consolidated basis. What was the FX impact there? And what was the growth excluding FX? It seems to be relatively slower growth among your geographies. Is there anything to discuss in more detail in Europe? And could that reaccelerate?

Almost all of the FX effect that we quoted, the $2.4 million on the quarter, was the result of a weaker dollar to the euro and to the pound. So we're seeing almost all of that effect in Europe, which does reduce that 15% a little further, if you're looking at the base currencies there.

Am I wrong to think that, that growth in Europe was a little bit weaker than some of the other geographies? Or should I just consider that still solid growth, even on an organic basis?

We would consider that, Brian, to still be very solid growth. Obviously, not as exceptional as we see it in Asia Pacific. But based on benchmarks and comparisons, we do -- it's still very solid growth in EMEA.

But nothing competitively or end market-wise to highlight that's unusual or different in Europe at the moment?

Nothing to highlight at this stage.

The next question comes from Charley Brady with SunTrust Robinson Humphrey.

Just I didn't -- I guess, it sounds as though there's no price increase going on in Electronics, and I'm just curious, what's the reason behind there? Is it just a function of the market dynamics don't allow for that? And also, could you just -- I guess, I wanted to understand a little better the mix issue on Electronics that impacted the margin in the quarter.

Yes. So first of all, Charley, on the Electronics side, of course, a higher degree of business is tied to OEMs and to OEM commitments. So obviously, it is much more difficult to pass on any price increases there. That's the main reason. And then to your second question, if we just look at it from an internal commodity perspective, what is mechanical and what is electronic, we are seeing an ongoing shift towards electronic components. But that's nothing new. It's just ongoing and in line with observations we have been making already last year as well.

And then, can you just comment a little bit more on the application specialists that you've added, kind of where you're at today, where you expect to get that to by year-end?

Yes. So we added specialists at the beginning of the year, particularly in India, as we pointed out earlier on. We are in process of adding people in Southeast Asia and in Latin America. So that's the application specialists, but we always try to do that in conjunction, Charley, with appointing also new channel partners. As we have pointed out on numerous occasions, we have these white spots in those designated geographies just mentioned just now, and we wanted to have a better coverage. So with regard to the second question, we will be cautiously adding some more people in some of those white spots. But probably in consideration of SEA expenses and developments, we want to do that in a cautious manner.

And then, just a final one from me. Just -- you talked a little about the Faster growth rate in Q1, and that's helpful to get that color and kind of the seasonality there. I guess, is the -- when you made the announcement to acquire the company, I think the expected annualized growth rate on an all-in basis was 16%, 16.5%. Is that still kind of your expectation for Faster on a full year over full year basis?

Yes. We're still in that range on a full year basis, at least at the top end of the range that we gave for those three remaining quarters, $107 million to $112 million. If you factor in the $112 million with the first quarter, we're at about that range of 16% to 16.5%.

The next question comes from Jeff Hammond with KeyBanc.

So I appreciate all the color, Tricia, on the bridge in each of the segments and kind of the improvements. Can you just talk about, from your perspective, what are the big risks that these costs linger on or they don't improve to the extent or they push into '19?

Yes, I think the biggest pressures come from improving the efficiencies and being able to ramp up production to cover the levels of demand that we're seeing. We're certainly working on that very diligently, but it's probably a little bit slower process than any of us would like. You can't really complain about the demand levels that we're seeing, but there are some inherent issues that come along with those. Bringing the suppliers online with the agreements that we have and also helping them do their planning to make sure that we're getting efficient flow of the material is critical in both segments.

I think, Jeff, there might be one additional risk factor to answer your question very specifically. If demand were to increase -- were to further increase, that would put, of course, additional pressure onto the system. So that could be a risk as well. Right now as we pointed out, we don't see that, but that could be a risk factor there. It is a potential risk.

The next question comes from Mig Dobre with Robert Baird.

I want to go back to this discussion surrounding gross margin. I'm trying to do the math here to try to incorporate your guidance and see how the year would flow through, and this is -- I guess, I'm not quick enough, so I'm asking for some help. When -- Trish, when you're looking at the gross margin for the full year '18, in both Electronics and Hydraulics, how are you thinking for the full year? What's embedded in your guidance for each segment?

For gross margins?

Yes. Yes, because you've given us the...

Yes. Yes, we don't guide specifically to gross margin percentages. That's why we've guided to the operating margins and tried to give some color around the gross profit changes that we're seeing from these costs coming in.

Right. Well, so here's the challenge that I've got. When I'm looking at your commentary that basically has some of these inefficiencies and acting drags beyond Q2 in both segments. It looks to me like gross margins could be flat to maybe potentially down for the full year. And if that's correct, given what's going on with your SG&A-type expenses, I'm having a bit of a hard time understanding exactly how we get to higher incremental margins -- operating incremental margins, as the year progresses to be able to get to your operating margin guidance, right? Because these inefficiencies, my initial assumption was that they were going to go away in the back half of the year. Apparently they're not. So I'm really kind of trying to understand how you got to your numbers for the full year on an operating margin guidance?

So, yes, I can say that based on where we ended Q1 from a gross margin perspective, we are forecasting to be up a bit from that for the full year. But, again, we aren't going to guide to a number on that, specifically.

But in the back half, you're going to be up gross margin-wise year-over-year versus the prior year in both segments. Is that fair to say?

So I would say Q2 and Q3 probably are where you're going to see maybe a bit higher margins because of the revenue expectations from both segments in Q2 and Q3. As you might recall, Q4 is seasonally a lower quarter for the Electronics business, so we do see margin pressures in Q4 as well as what most people see around holidays. So I would say in -- from a flow perspective, Q2 and Q3, given the increased revenue, would probably see the increases over Q1.

In Electronics though -- and I'm sorry to keep beating this dead horse, but I remember that in 4Q '17 in Electronics, we had an unusually low gross margin. It's fair to say that with the incremental volume, even though seasonally things are the way they are, we should be looking at a pretty substantial increase in gross margin on a year-over-year basis in the Electronics in the fourth quarter?

Yes, that's a fair statement.

Quarter-over-quarter, that's correct, Mig. If you compare Q4 '18 with Q4 '17 for Electronics, that's correct.

Correct. So what you're saying is, sequentially, gross margin is going to be down in the fourth quarter, but it will be up substantially year-over-year. Okay.

Correct.

Right.

I want to also maybe talk a little bit about pricing. You talked about a price increase, and it seems like you've taken a bit of a different approach, especially in Hydraulics with how you deal with pricing versus what I knew from years prior. How are you -- what is your approach on this price increase? Is this basically going to be offsetting material costs and all these other headwinds that you described here as we look into '19? Is that the idea? Or is this supposed to be a source of potential margin upside into '19 the way pricing used to be done traditionally?

So we were -- just looking at '18 here and basically with the introduction of the price increase, Mig, on July 1, that will compensate as we outlined earlier on for inflationary pressures we see. So that will compensate for 2018, for Q3 and Q4. I think we also have to be careful here, and we don't want to make any assumptions for 2019 at this stage because we don't know how commodity pricing will develop anyhow at this stage. I mean, we are seeing different trends here. If you look at the latest situation in oil and gas, that would heavily influence it again. So the price increase, to answer your question, will cover the inflationary pressure we see in operations for Q3 and Q4.

Okay, understood. And then, before I get in the queue -- back in the queue, on your outlook, Wolfgang, you spoke about weaker U.S. manufacturing potentially into 2019. And I get it that this is an outlook comment, but I'm wondering what you're thinking is behind that. And depending on what -- the way you define manufacturing, I'm wondering what the related impact on Sun Hydraulics to potentially be into 2019?

Yes. So basically what I'm looking at is, first of all, industrial production, and then I'm looking at some of the more specific end markets that we obviously serve, U.S. construction machinery, industrial machinery, as such. And if I look at the latest economic trend analysis there, we see a softening in 2019. So that's where the statement derives. How this will impact us? I think in the meantime, we are much more diversified than we were three or four years ago. So I feel more comfortable because we are serving much more end markets and industrial sectors. But nevertheless, if this became true, it would have an impact obviously on revenue in 2019, resulting out of the construction machinery market and anything else that is tied to industrial production. With regard to industrial production, Mig, we don't see that only in the U.S. I think the industrial production numbers are also down for Canada, Brazil, Western Europe and Eastern Europe for next year, at least based on the trend analysis and the information we have on hand.

Okay, I understand. I'll squeeze one more here. If -- with that in mind, now that the business is maybe a lot different than it was in prior cycles, how do you think about some of the things that you can do and are within your control in order to manage costs in an environment where, I don't know, say your forecast plays out into '19 and demand is maybe a little bit weaker?

I think we have still tremendous flexibility here in the system. Also, compared to the past, as you know, we have now a portion of the workforce is a temporary workforce, so that creates some certain flexibility. As I pointed out earlier on to the one question with adding additional application specialists in the field, we'll probably be a little bit more cautious, already now keeping an eye on developments towards 2019, probably a little bit more cautious in terms of hiring. Having said all that, I think we still have to pay attention to certain geographies that are still booming and where we are still creating tons of opportunities, last but not least, in the Asia Pacific region. So we want to be very selective in the approach we are taking. But to answer your question, I think we have flexibility in the system to kind of hunker down and prepare for a softening early enough, without threating obviously our competence because, I mean, we want to hold on to the core competence that we have in the company that we have been building up successfully over the last years.

The next question comes from Nathan Jones with Stifel.

I think ITR have been predicting a recession next year for about the last five years, so I suppose they'll be right eventually. I'm going to get back to the Hydraulics gross margin and come at this a little bit of a different way here. You have -- outside of currency, you have headwinds here that were 310 basis points in the quarter. Now I would imagine that currency impact is going to lessen as we go on, assuming flat rates. That one's a little bit up for grabs. If you say you're going to have half the headwind in 2Q with no price increases, then you'll have half the headwind in 2Q. If you have half the headwind in 3Q, with 150 to 200 basis points of price increase, wouldn't that then get you to a positive comparison just on those headwinds and tailwinds in the third quarter before you have volume mix, sales and incentives, and then that would be even more positive in the fourth quarter year-over-year, if you halve those headwinds again?

That could be -- we're -- in looking specifically at the costs that we have in the bridge, those are the things that we're trying to estimate and control and give the guidance on. But the price increase in Q3, there is always in the first quarter of a price increase a little bit of a roll-through period because any orders that are placed ahead of that are still at the old pricing. So we're trying to make sure that we understand that effect in the third quarter as well. And probably we'll see a little bit more of that pricing effect in the fourth quarter than in the third quarter. But yes, you're right. You're also right that the FX will lessen because the comps change as we work through the quarters.

So maybe a little more uncertain on whether it's positive or negative in the third quarter, but should be positive by the fourth quarter then?

When you say positive, what do you mean?

Quarter-to-quarter comparison.

Positive on price versus those drags on margins, with price compensating for what you're looking at there?

Yes. Yes, that's a fair statement.

And maybe you could give us a little more color on supply chain inefficiencies in both segments. It sounds like you've largely taken care of a lot of that in Hydraulics, but maybe not so much in Electronics at this point. Can you talk about what the supply chain constraints are? How you've negotiated with suppliers to, I guess, get to the front of the line to make sure that you've got a reliable source of supply there? Just any color you can give us on the supply chain constraints?

Yes, sure, Nathan. I mean, first of all, if you look at the electronics industry as such, so we analyze it as follows. So we see very strong growth for PCBs, for printed circuit board, and we still see continuous growth for the electronic manufacturing services and then in the semiconductor industry. And obviously, those trends are heavily influencing us. So we see commodity price increases there with some of the key suppliers for ceramic capacitors, resistors, silicon chips and so forth. So that is creeping into the system. As I mentioned earlier on, as a reply to a previous questions, as we do the majority of the business with OEMs, we are obviously embedded into firm pricing arrangements over certain period of time, so we have no opportunity to pass on these commodity price increases to the customer base. Having said all that, we are negotiating on an ongoing basis with our suppliers in order to secure, first of all, supply -- steady supply, because in this type of booming environment, it's not always guaranteed that supply is adequate. So we are negotiating steady supply as well as competitive pricing so that we have more planning security as far as that is concerned.

Do you anticipate having any disruptions in the supply chain that could cause problems? I guess, it's particularly in the Electronics segment at the moment into Q2? Did it impact your revenue at all in 1Q not having reliable supply the whole time?

No. I mean, it's just pressurized. I mean -- but it's -- and that's been more internal issues of absorbing the growth. As we pointed out, I mean, the Electronics business grew 22% again in Q1 over Q1 last year. So we are seeing tremendous growth here again, after 33% growth all of last year. But to answer your question, no, that's not the issue, but there is just pressure in the system obviously.

The next question comes from Joe Mondillo with Sidoti & Company.

I just wanted to follow up also on sort of the pricing situation. A lot of companies are starting to see more sort of headwinds in the second quarter as raw material prices increase. But have you -- I'm just wondering how or why that does not become a little bit more of a headwind in the second quarter, considering where the price increases in July compared to the first quarter?

We don't see additional headwind in the second quarter. I think we have seen the brunt of headwind already in Q1, Joe.

So all these raw materials have been continuing to sort of rise. Why do you say that?

Well because, I mean, a portion of these prices were already passed on. And then we are -- we have negotiated, as we pointed out, long-term agreements with -- on the Hydraulics side, at least, with our suppliers that pretty much locked in pricing. So we have a guarantee there in place. So that's why we don't see additional headwind in Q2 or Q3.

The SG&A growth investments, just wondering in terms of the 1Q run rate, I mean, you sounded a little more cautious on application specialists. Just wondering if that's sort of going to be stable throughout the year and, looking into 2019, does any of that sort of SG&A investments, does any of that sort of fall off? I'm guessing no. But just wondering relative to the 1Q run rate, where we're at in terms of that?

Well, we're -- because of the investments that we're making, even though we're being cautious, we are still making investments where we know it makes sense. We will see some run rate increase on the SEA line.

And so that increases in the second quarter and maybe plateaus in the back half of the year? Or is that going to continue to increase through the -- into 2019?

I think it will steadily increase because of the approach that we're taking. It's not going to be big lump sum applied, but certainly we could see some creep up there just because we are trying to make sure that we're prepared for the growth that we need in all of the regions as we work toward Vision 2025.

And then, the low end of the Faster revenue guide essentially seems a bit conservative relative to the growth that you saw in the first quarter. And it seems like the first quarter was maybe pretty strong relative to expectations. Just wondering about that low end of the Faster guidance. Is that sort of a conservative guide and maybe there's upside? Just wondering your thoughts on that.

Yes. Given the rates that we saw in the first quarter for Faster, it definitely is projecting that their growth rates over last year would slow a little bit as we're going through the quarters. But there's also, from what we're seeing, maybe a little bit of FX pressure coming as the euro has been declining to the dollar. So we're trying to -- we aren't trying to outguess the Fx market, but certainly recognizing that there could be some translation impacts in future quarters that we didn't -- wouldn't have seen in Q1.

And then, just last one from me. I'm just wondering if you could comment on sort of the timing of some of these Faster synergies. I know Enovation saw a good amount of cost synergies trend ahead of schedule, and you saw those sort of more -- much more upfront relative to that long-term synergy guidance. Just wondering how Faster synergies are sort of coming along here in the very early stages?

Yes. So as we said, Joe, so we met already for the first time to look at the revenue synergies. We haven't taken a look at any cost or expense synergies so far. As you know from earlier announcement, we want to generate $7.5 million in EBITDA by 2022. But I think it's a fair assessment that we are comparing it to the process with Enovation Controls. We are already further ahead. I mean, let's take into consideration we just closed on the acquisition four weeks ago, and we are already talking about the concrete project on the customer level to generate sales revenue. So we are definitely further ahead. I think to the ramp-up curve, you will see again out of the $7.5 million, we estimate 70% will be revenue synergies and the ramp-up curve will be pretty linear in between 2019 and 2022. 2018, we want to just use to basically do the groundwork and then, starting to see first revenue synergies as early as 2019, and then you can probably ramp it up on a linear basis till 2022. On the Enovation side, with regard to the synergies, as we pointed out, so we have realized the cost synergies already earlier than originally anticipated. Again, that was 25% cost synergy, 75% revenue synergies. The 25% are already realized and are already embedded in the guidance here for 2018. And with regard to the revenue synergies, I think, we are well underway to meet or maybe even slightly exceed the expected synergies by 2020.

Just the one last question; I just wanted to confirm the share count that you're looking at for the go-forward as 31.6 million. Is that what you said in the prepared commentary?

Yes.

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

Thank you for your interest in Sun and for your participation this morning. Also, thank you to all of the hard working Sun employees who are driving these results. We look forward to updating all of you on our second quarter results in August. Thank you very much, and have a great day.

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