Richardson Electronics, Ltd. (RELL) Q3 2014 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen, and welcome to the FY '14 Third Quarter Financial Results for Richardson Electronics Conference Call. My name is Denise, and I'll be the operator for today. [Operator Instructions] As a reminder, this conference is being recorded for replay purposes. I would now turn the conference over to Mr. Ed Richardson, CEO. Please proceed.

Good morning, and welcome to our third quarter 2014 conference call. Joining me today are Kathy Dvorak, Chief Financial Officer; and Wendy Diddell, Executive Vice President of Corporate Development and General Manager of Canvys. As a reminder, this call is being recorded and will be available for audio playback on our website. Before we get started, I'd like to remind you that we're making forward-looking statements and they're based on current expectations and involve risks and uncertainties. Therefore, our actual results could differ materially. Please refer to our press release and SEC filings for an explanation of our risk factors. [Audio Gap] Third quarter revenues were $32.9 million, a 2.2% decrease compared to net sales of $33.6 million in the prior year. Sales for EDG were $24.2 million, which was flat to the prior year, while sales for Canvys were $8.7 million, down 6.5% compared to the prior year's third quarter. We do not feel that these results are indicative of the opportunity for growth within our business. They do not reflect the investments we're making in vacuum capacitors, microwave generators, high-voltage power supplies and replacement parts for laser and industrial equipment. We then realigned resources to support these initiatives, and will continue to do so until we begin to show real growth and improvement in profitability. Our third quarter started off slowly due to the timing of the holidays. Both December and January ended up being short working months, and our sales reflected this. February, however, came back strong, and backlog has been building in March and April. We're seeing signs that indicate global economic conditions may be improving, particularly in Asia Pacific and Europe. We're also seeing growth in several key markets, including industrial heating for textile, wood, plastics, food processing; the automotive industry, which utilizes CO2 laser cutting equipment; and marine radar. Our sales of consumable laser parts such as lenses, nozzles, dowels and mirrors, have nearly doubled compared to last year with good margin. During the quarter, we continued to evaluate potential acquisitions in the diagnostic imaging and replacement parts market. We remain convinced that the demand for high-quality replacement parts will increase as health care reform makes it more critical than ever for hospitals to focus on reducing costs in the face of declining diagnostic reimbursement. We firmly believe we can play a significant role as an independent parts supplier in the health care market in the future. Now I'll turn the call over to Kathy Dvorak to present the details of our third quarter financial performance.

Thank you, Ed. Unfortunately, the sales environment continues to be challenging. Sales in our third quarter were $32.9 million, down 2.2% from the prior year. Gross margin declined slightly to 29.3% of net sales from 29.5% of net sales in the prior year's third quarter. The margin decline reflects a shift in product mix, as well as a shift in our sales mix between geographic regions. Operating expenses were $10.5 million for the third quarter of fiscal 2014 compared to $9.3 million in the prior year. Operating expenses include nearly $500,000 of expense to fund growth initiatives and expenses related to pursuing acquisitions. We also incurred another $200,000 of incremental IT costs associated with our new system implementation. Operating loss for the third quarter was $886,000, reflecting our lower sales volume, combined with higher expense levels. We continue to balance investment in capabilities and growth initiatives with product cost management. Other income for the quarter included interest income of $277,000, as well as additional proceeds from a class action lawsuit of $432,000. Foreign currency was a small loss for the quarter. Loss from continuing operations before tax was $187,000. Our tax benefit from continuing ops for the quarter was $75,000. For the total year, our cash tax requirements will remain low, while our effective tax rate will be around 30%, excluding any discrete tax events. Loss from continuing operations for the quarter was $112,000. Sales for the first 9 months of fiscal 2014 were $102.6 million, down 3.1% from sales of $105.9 million during the first 9 months of last fiscal year. Gross margin increased slightly to 30.1% from 29.6% during the first 9 months of last year. Operating expenses were $31.1 million for the first 9 months of fiscal 2014 compared to $29.7 million during the prior year. Operating expenses for the 9 months include $1 million of additional expense to fund growth initiatives and expenses related to pursuing acquisitions. We also incurred another $500,000 of incremental IT costs associated with our new system implementation. Other income during the first 9 months included a total of $2.5 million of proceeds from the class action lawsuit and $800,000 of interest on our investments. Income from continuing operations before tax was $3 million. Our tax provision from continuing ops for the 9 months was $530,000, or a 17.5% tax rate, including discrete tax events. Income from continuing operations for the first 9 months was $2.5 million compared to $1.9 million during the first 9 months of the prior year. Cash and investments at quarter end were $132.2 million compared to $146.4 million at the start of the fiscal year. Through the first 9 months of this fiscal year, we've spent $8.7 million on share repurchases and $4.5 million on investments in working capital. We have increased our inventory investment to take advantage of buying in advance of price increases. We believe our working capital requirements will decrease during the fourth quarter and continue to decline as we enter fiscal 2015. We expect sales for the fourth quarter to be around $35 million or flat to our prior year's fourth quarter, with a margin rate that is consistent with the first 9 months of this fiscal year. While business remains challenging, we are positioning the company for growth by investing in high-growth niche areas of our business and continuing our work on building a cost-effective, highly flexible IT platform that will provide a solid foundation for the future. Now I'd like to turn the call over to Wendy to discuss the operating performance of Canvys.

Thanks, Kathy, and good morning, everyone. Canvys finished the third quarter with sales of $8.7 million, which was 6.5% below prior year. Gross margin improved during the quarter to 28.9%, driven by strong margins in Europe and lower freight costs, as the division consumed inventory delivered in prior quarters. Gross margin was up from 26.9% during the third quarter last year. The quarter was highlighted by 2 significant wins in our custom OEM segment. It is anticipated that each program will generate revenues in the range of $1 million to $2 million per year. While billings on these programs will not begin until later in the calendar year, it reconfirms our ability in both North America and Europe to develop and provide customized display solutions to blue chip companies. These wins represent 2 distinct industries: medical and retail point-of-sale. We won these programs by carefully considering how the products will be used, what existing challenges the users faced and then solving these issues through a combination of engineering designs and new technology. As we look across all 3 business segments, North America OEM, Healthcare and Europe, our strongest performer in the quarter compared to prior year was Healthcare. Healthcare finished the quarter with sales that were appreciably higher than Q3 of FY '13. Although we enjoyed a stronger sales quarter, the market for PACS displays continues to be soft as hospitals struggle with health care reform, reimbursement rates and other financial challenges. During the quarter, we made our first shipments of 6-megapixel displays, which previously were only produced by one of our key competitors. We are also exploring product line expansion and new relationships with companies such as CompView Medical and FSN Medical, both are leading companies in the surgical imaging market. CompView Medical manufacturers NuBOOM, an all-in-one visualization equipment management and ergonomic boom appliance for surgical suites. FSN Medical is the leader in video signal management, distribution and displays for the medical device industry. We are actively pursuing products and partnerships outside of radiology, which take advantage of our North America technical sales and support team, as well as relationships we have with decision-makers in thousands of hospitals throughout the U.S. Revenues in both our custom OEM display segments were below prior year, but productivity remained strong and backlog has been building in recent months. Business generated from new customers in the fiscal year represents nearly 10% of the revenues from the custom OEM segment. Gross margin in both areas, particularly Europe, was much stronger than prior year due to a combination of improved scoring procedures, purchasing power maximization and inventory management. As we move into a new fiscal year, we will redouble our efforts to capitalize on customer wins. We will focus on niches where we are strong and have recent references and lead more with what we call platform products. Platform products enable the sales team to initiate the sale with a base product and then offer customization based on customer requirements, technology differences and price point. The customer can see immediately how technology and price interact and use this to further define and refine requirements. This will speed up our ability to quote and provide additional purchasing power. We will continue to offer highly customized solutions in parallel, ensuring our ability to offer a range of solutions to meet our customers' requirements. As a result of restructuring actions taken during the last fiscal year, operating efficiency continues to improve. There is sufficient room for sales growth without incremental headcount. The team remains focused on working capital efficiency. We've seen a substantial improvement in inventory turns and cash flow generated from the business. Ed will now provide an update on EDG.

Thanks, Wendy. EDG sales in the third quarter were $24.2 million, flat with the prior year. Gross margin was 29.5% compared to 30.4% last year due to product and geographic mix of sales. Revenues in both the Asia-Pacific and European regions exceeded sales compared to last year. Business in some of our product lines and market segments increased. Demand for industrial products in the textile, wood and plastic industries continue to improve, and as a result, sales in our industrial heating business increased over the third quarter last year. The CO2 laser tube business and the associated consumable parts performed well. Sales of consumable parts nearly doubled again over the prior year. We were also pleased to see our sales in the marine business increase over the prior year, as major shipbuilders ramped up production after a period of slowdown. We're also happy to see a nice increase in high-power capacitors during the quarter, as our efforts to further penetrate this business begin to take hold. We're seeing many inquiries for new applications for both RF and microwave generators across various markets and applications, including mining, industrial heating, cooking, drying and plasma. Our new product development team of microwave engineers is heavily involved with the sales and marketing groups to ensure we are engineering solutions that can be marketed and sold to many more markets. We've recently booked some substantial orders for microwave generators in China, with additional significant projects in the pipeline. The initial prototype order for one project exceeded $1 million. Now a second order for $1 million is in process. We signed an exclusive agreement with this customer in March, which provides for a minimum purchase of 27 generators, with the potential for more than 100 new systems that use 9 generators in each system, which will be installed over an extended period of time. We're also quite pleased with the progress of the engineering firm that we acquired last July in Germany to expand our activity in the power capacitor market. We estimate the power capacitor market to be about $200 million annually. The additional resources have helped expand a number of products that we now offer. We're also strengthening our ability to offer solutions to the original equipment manufacturers. Historically, our focus has been on the replacement market. With our standard engineering resources, we are developing unique products and widening our product range with new partnerships. As a result of our investment and effort, our revenue and backlog for power capacitors is increasing. Overall, we're disappointed that we weren't seeing more growth in EDG, but we believe the building blocks are in place to capitalize on the economic recovery, and we remain convinced that our investments are focused on areas with high-growth potential. All of this bodes well for our future and our ability to capitalize on our existing global infrastructure. As we look to the future of Richardson Electronics, we continue to build the line of replacement parts for the diagnostic imaging market. Our initial focus is on glassware, which includes flat panel detectors, as well as CT and X-ray tubes. We've signed an agreement with Thales to distribute a complete line of flat panel detectors for replacement and diagnostic imaging equipment. The resale price of these detectors ranges from $75,000 to $100,000 each, which will be below the price offered by the original equipment manufacturers. We have plans to expand our portfolio of flat panel detector replacement solutions later in the calendar year. We're confident that our sales in the diagnostic imaging replacement market will grow through the balance of FY '14 and more significantly, in FY '15 and beyond. We continue to feel there's a major opportunity to become an independent supplier to the healthcare industry of a wide range of high-quality replacement parts at price levels well below the OEMs'. The trend for hospitals to use third-party service organizations and to buy replacement parts outside of the OEM is rapidly spreading throughout the U.S. and the rest of the world. With our global infrastructure, technical sales team and experience serving the health care market, we're uniquely positioned to take advantage of this trend. This will gradually expand Richardson Electronics' position from being the leader in Power Grid Tubes to a key player in the high-growth, high-profile health care industry. We repeat our commitment to our shareholders that we'll use the funds received from the sale of RFPD in March 2011 to make strategic acquisitions, invest in growth strategies and repurchase stock. Today, we've spent $6 million on acquisitions, which provided additional resources, customers and knowledge base support to the Electron Device Group. We're investing in resources to develop our own intellectual property and [indiscernible] more sophisticated sales in the future. We've spent $56 million on our stock buyback program, which has reduced the number of shares outstanding to 14 million. We're confident that our acquisition program will accelerate in the near future, which will ultimately result in substantial revenue and earnings growth. While economic conditions have made sales growth challenging, we do see the global economy slowly improving. At the same time, we've worked hard to improve the efficiency throughout the company and reduce costs within the business wherever possible. At this point, Kathy, Wendy and I will be happy to answer your questions.

[Operator Instructions] Our first question comes from Mark Zinski with 21st Century Equity.

Ed, just wanted to dive a little bit into the -- what was going on with revenue in the quarter in terms of -- do you think that the severe winter had any impact on your business? Or was it more the timing of the holidays versus any kind of -- it seems like -- the suggestion is that market demand really -- softness in market demand wasn't that much of a factor, or if you could elaborate, that'd be great.

I don't know, probably more of the timing of the holidays. Certainly, the severe weather in the U.S. had an impact. But December was one of the poorest months we've seen in years. It was like a 2-week month for sure, and that sort of followed in January. But fortunately, it picked up in February, and we're seeing a pickup since then as well. So I think it was sort of a temporary blip. We're hoping, anyway.

Okay. In terms of the -- your sort of renewed focus on product development, do you see that spending on product development, then continuing over the next several quarters?

Yes. Yes, we're convinced that we need to develop our own intellectual property, and we're fortunate to employee 3 or 4 engineers. We've mentioned in the past that Microwave Cavity Labs, a company here in Bowing Brook, was acquired by CPI, and they chose to close that facility. And it was fortunate for us, we were able to hire their manager of engineering and 3 or 4 of his engineers. Microwave engineers are very difficult to come by. So we're really pleased to have them on board and we have them working, developing our own intellectual property, probably first addressing microwave generators for industrial heating applications. But you'll see that expense continue for a while.

Okay. So given kind of the renewed focus on product development, have you kind of -- previously, you've kind of always had an operating margin goal. Has that kind of gone to the wayside a little bit because of this newer spending?

Not really. I mean, we still have an operating margin goal of 5% in the near term, and we think we can get there. The difficulty that we have, and we know it, is we have an infrastructure that's -- a global infrastructure that's large enough for a $200 million, $300 million company and we're running it $140 million or $150 million. So we just have to add new products, go into new markets and utilize that infrastructure on a global basis.

Okay. And geographically speaking, it sounds like the consensus out there is that Europe seems to be in a real kind of, not a vibrant recovery mode, but definitely in somewhat of a recovery mode. Is that what you're seeing as well?

Well, we're seeing, yes, some recovery, but certainly at single digits. We've seen more recovery in Egypt...

Okay. And then last question, I just wanted to clarify something on the CO2 laser market. Has there been any competition from the fiber lasers? And how do you see that -- I guess, if you -- yes, if you could add some specificity to the CO2 versus the fiber market?

Right. Well, certainly, the fiber labors -- lasers are taking market share in new applications for new equipment. Up until recently, they weren't able to cut thick metal as efficiently as the CO2 laser. But the technology is improving every day and so there is a market shift. Our market is the aftermarket for existing equipment for CO2 laser equipment that's been produced over the last 20 years. And the largest manufacturer in that space is a company called TRUMPF, the German company. And we estimate that there's about somewhere in the area of 14,000 sockets globally, replacement sockets, and that's our target market, at least for that one manufacturer, there are others as well. So we're looking at our target market being 3 to 5 years after the original equipment's been sold. So the new fiber labor equipment is just being -- laser equipment is just being sold now and won't affect our aftermarket for some years to come.

Okay. And you're still -- I mean, the applications for CO2, like within the cutting for the auto industry, is still pretty standard practice and fairly well-insulated in your opinion.

Yes. I mean, that technology will be here for as long as the...

Okay, great. And do you guys have a -- in terms of stock repurchases, do you have a heavy stock repurchase number outstanding that's still possible under the plan?

Yes. Kathy, what's the total amount that's still outstanding? It's about 15 million, isn't it?

Right, yes.

It's about 15 million that's still outstanding.

Our next question comes from Al Tobia with Sidus.

So the -- if I just take the stock here today, we've got a -- if I just take your cash inventories and receivables, minus all your liabilities, that's about $15 million more than the equity value of the company. With what you've got left on the buyback, do you think it makes sense to get more aggressive on the buyback down at these levels?

I guess, we'll continue to be opportunistic and see what happens. Obviously, what we want to do is to do some acquisitions and take advantage of the global infrastructure we have in place. And that's our mission, and we've been working hard in that area. And hopefully, in the not-too-distant future, we'll be able to give you some positive news in new acquisitions.

But I guess, using a 3-year time horizon here, the stock is down 30% or so in 3 years, and the operating business is not getting any value assigned to it. And you've bought some stock back, you've issued a dividend and you've talked about acquisitions. I guess my question is, what do you think you need to do to get the stock moving in the right direction that you can control? I know that we're in -- we went through an economic period where you're carrying a little bit more scale on the operating cost side than you've got. And revenue, in theory, should pick up if your R&D is productive and if the acquisition opportunity presents itself, it's there. But is the thought of possibly doing an acquisition holding back efforts on either making the dividend or the buyback significant enough?

I think we continue on all fronts. Again, we're opportunistic. We've raised the dividend once. We've actually done 3 small acquisitions. Unfortunately, it takes just as much time to do a small acquisition as it does a large one. What we'd really like to do is to reposition the company as a aftermarket health care parts supplier, and we're working in that direction. As we mentioned earlier, certainly, the acquisitions that we're working on are in that space. And we think if we're successful there, we can change the future of the company dramatically and get some value to the shareholders.

What was the average price paid? I think you mentioned, what was it, $8.7 million, in stock bought back? Kathy, was that what you said? Or Ed, I forgot who said that.

Yes.

This year.

This year, so...

We've spent $56 million on stocks so far.

No, no, I know. But what was bought this year, $8.7 million bought to date?

I think, that's right, yes.

And so what was the price paid roughly per share?

One second...

Kathy is going to try to give you a number. It's 11 something, I know that.

Yes, 10 something. Somewhere around 10.50.

I think that's too low.

10.50 would be low. That would be very opportunistic.

Yes, it's 11 and change.

11?

Ed, do you think that the B shares are hurting the company now? And have you given consideration to simplifying the capital structure of the company by eliminating the B shares?

I guess that's a question we've been asked a lot. If I really thought it was impacting the value of the stock in some major way, we'd think about changing it. But so far -- I've heard the question asked a lot, but I really haven't been able to verify the impact.

So the statements that you've made when I listened to the tone of business sounded more positive than the results in the quarter sounded. So my assumption is that despite you guys knowing vacations and what the calendar was and where the holidays fell, it was even weaker than you expected in December and January. The exit rate, I guess, in February, was, from a percentage standpoint, better, but still leading to year-over-year flatness. My assumption is that, so far, since it is a May quarter and we're in the middle of it now, are orders good enough for you to believe that you're going to see growth in August, sequentially?

I can't tell you we focus much on August at the moment. We're really -- we're working hard on the fourth quarter and trying to put the plan, finalize the plan for next year. And August, normally, the summer quarter is our slowest quarter. And what happens in August, is Southern Europe, in particular, takes a 2- or 3-week vacation, and so that happens to give us a real impact. But I haven't thought much about it this year if that's going to change.

Good. I don't want to monopolize too much time here. I just wanted to ask. So if you could just tell us maybe a little bit more about the M&A environment that you're seeing out there. It seems to me that the company is way, way overcapitalized, unless you really have some good M&A targets, given where the stock is trading now. You've been looking for a while, and I guess my question is, it sounds like you feel better that you're closer to some M&A. Can you talk about what kind of valuations, is it -- are there lots of targets? Have the prices moved your direction? Like what's going on that you could share with us from an M&A standpoint?

Well, I guess in the medical space, in the aftermarket parts space for diagnostic imaging equipment, we've spent a lot of time looking at various companies in that space. And there are some roll-ups going on, smaller ones and the multiples that are being paid are just multiples that we're not willing to pay. So we've sort of have looked at a few and backed off on that basis. We have one major transaction we've been working on for a long time that we're very impressed with, that's also a very complicated transaction. And we're hopeful in the not-too-distant future that we'll get a little closer to being successful where we can go public with what we're doing.

[Operator Instructions] Our next question comes from John Kratky with Valor Capital Management.

Ed, John Kratky at Valor Capital Management. Listen, we own shares in the company. And what precludes us from owning more or a significant thing that precludes us is the B shares. And I'm just wondering what it would -- what you would need to see to understand that the B shares are a significant obstacle for a lot of people to buy these stocks. I mean, you talk about you hear it from a lot of people, but you don't see anything that shows it to you. What is it that you would like to see to show you that the B shares are a bad thing for shareholders?

Well, I haven't spent a lot of time trying to research the subject, but you got lots of questions and you -- and statements similar to yours, but I've actually not seen some kind of a survey that shows companies that have B stock at a certain percentage that their stock is depressed compared to other companies, I guess. That isn't something I would spend a lot of time looking at, but I'd have to see something like that, that actually, has statistics that made a case for it.

Our next question comes from Ronan [ph] with SGF Capital.

This is Jeff Gates from Gates Capital. Ed, how long -- what could the current level of SG&A be to support -- to sustainably support the level of current sales? I mean, if you didn't find a deal, for example.

Well, where we've been in the past, Jeff, is that -- and basically, when the infrastructure is fully loaded, we run the company at sub-20% SG&A. And that's what we're used to doing, but it will take $200 million, $250 million of the revenue to get there. And we're hopeful to accelerate that process through some of these acquisitions. But if not, we do it from internal growth. That's sort of our target, always has been.

So you're basically saying if you didn't find a deal or something, you could survive on less than $30 million, it's about $10 million or something like that?

Yes. Yes, somewhere in that area.

Okay. And then I guess the other question, how many years before you give up on a deal and do something else with solving your overcapitalization issue?

I don't give up easy, but...

No, but is it 20 years, is it 10 years, is it 2 years? Is it -- I'm just -- it's already been 2 years, right? It's already been 3 years, actually.

Right. I guess I really haven't come to the realization that there's a time when I'll give up. We think we're very close to doing a major deal, which we'll be really pleased to discuss with you and we're working a lot of hours, 7-day weeks trying to make that happen.

Right. And so there were no buybacks during the quarter, so we should -- should we assume that you're restricted during some periods through this quarter?

We think so, yes.

Okay. Are there any legal settlement proceeds remaining?

A small amount, yes.

And how much would that be?

$200,000.

Okay. And then, can you talk about how you're thinking about -- actually, 2 final questions. One is, can you give us a cash breakdown geographically? And secondly, can you talk about price volume for each segment for the quarter and how you're kind of looking at that on an ongoing basis?

Let's see. Kathy is looking up where the cash is. I know we have about $65 million in the U.S., so we give you that one first. And there's $14 million, $15 million in China.

But in total, there's about $40 million in Asia, overall, and then the balance is sitting in Europe.

Did you get that, Jeff?

Yes.

Okay.

$41 million in Asia, overall.

$41 million in Asia, about $15 million of that is in China.

And the price volume?

The nice part about the acquisitions that we're looking at, if we're successful, a portion of our international cash can be used on those acquisitions. And as I'm sure you realize, those are $0.80 dollars. You're second question, I -- would you repeat it for me?

Yes. Can you tell me what price and volume change was during -- for I guess price mix and then volume for each segment for the quarter and how you're kind of looking at that on an ongoing basis longer term?

Well, I can tell you, in general, with EDG, the revenue, as we've mentioned, was flat in the quarter and just about flat for the year. It's down a little bit. So what you'd see there is you'd see a decline in units, but you would see an increase in the unit prices. My guess is, you have somewhere around a 6% unit decline, that's pretty much normal for the tube business. And you have something similar to that as a price increase, which keeps the market about flat. Wendy, in Canvys, could you address that? Your unit prices are dropping all the time on LCDs.

Not so much, no. We've done some work in studying the unit prices, and it's really more -- the variable is more customer demand for specific models. So -- but if you look at the average selling price per customer or per model that we sell to customers, because again, everything is customized, you won't see a tremendous decline in pricing.

Okay. The areas, Jeff, where we really see some opportunity is sort of vertical integration from the tube business to equipment like the microwave generators. The microwave generator project, I mentioned, uses a 915-megahertz magnetron at 75 kilowatts. And the magnetron itself, we sell for about $7,000. But when we sell the generator, we sell the generator for $100,000. So it gives you an idea what happens to the served available market where you go from just selling the tube to selling the entire piece of equipment. And that total piece of business, the project where we have 2 prototype systems, $1 million apiece, that opportunity could be a $100 million.

And what's a reasonable distribution margin on the capital equipment versus the consumable?

In that particular project, it's about 35%.

We have no further questions. I would now turn the call back over to management for closing remarks. Please proceed.

Thanks, Denise. Well, thank you, again, for joining us and for your ongoing support of Richardson Electronics, and your patience. We look forward to discussing our fiscal 2014 fourth quarter results with you in July. Thanks a lot.

This concludes today's conference. You may now disconnect. Have a great day.