Transcat, Inc. (TRNS) Q3 2019 Earnings Report, Transcript and Summary

Greetings and welcome to the Transcat, Inc. third quarter fiscal year 2019 financial results call. At this time, all participants are in a listen-only mode. A brief question-and-answer session will follow the formal presentation. [Operator Instructions]. As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Mr. Craig Mychajluk, Investor Relations. Thank you. You may begin.

Yes. Thank you and good morning everyone. Certainly appreciate your time today and your interest in Transcat. With me on the call today, we have Transcat's President and CEO, Lee Rudow and our Chief Financial Officer, Mike Tschiderer. After formal remarks, we will open up the call for questions. If you don't have the news release that crossed the wire after markets closed yesterday, it can be found on our website at transcat.com. The slides that accompany today's discussion are also our website. If you would, please refer to slide two. As you are aware, we may make forward-looking statements during the formal presentation and Q&A portion of this teleconference. Those statements apply to future events, which are subject to risks and uncertainties as well as other factors that could cause the actual results to differ materially from where we are today. These factors are outlined in the news release as well as with documents filed by the company with the Securities and Exchange Commission. You can find those on our website, where we regularly post information about the company as well as on the SEC's website at sec.gov. We undertake no obligation to publicly update or correct any of the forward-looking statements contained in this call whether as a result of new information, future events or otherwise, except as required by law. Please review our forward-looking statements in conjunction with these precautionary factors. I would like to point out as well that during today's call, we will discuss certain non-GAAP measures, which we believe will be 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 non-GAAP to comparable GAAP measures in the tables accompanying the earnings release. With that, I will turn the call over to Lee to begin.

Okay. Thank you Craig. Good morning everyone. Thank you for joining us on the call today. We will follow the same format as we have in the past. I will provide an overview for the quarter and then Mike will provide a more in-depth review of the financials before I wrap things up with an outlook for Q4 and fiscal 2020 which is right around the corner. The third quarter was interesting in that from a financial perspective, we started off slow and I am referring to October and November, but finished strong in December. In addition, it appears January indicators are right where we want them to be and so we are off to a strong start in the fourth quarter. There were a couple of factors impacting the softer than expected October and November that will include productivity, soft Canadian market which I will address in a moment and it's worth mentioning the timing of the Christmas week. Let's start with our technical labor force. Year-to-date, in fiscal 2019, we hired a record number of new technicians to support growth in our service segment. Many of the new hires were made to support traditional growth, a fair number were hired to support an unusually high level of large in-house labs that were recently outsourced to Transcat. That's really good news. But it does create the short-term timing challenge as a large number of new technicians have to be hired, onboarded, trained and worked through the system. In the early part of the prior year fiscal 2018, we experienced a similar new hire productivity lag that quickly reversed itself in the following quarter or two. We expect the same thing that happened as we progress through the fourth quarter and into the next fiscal year. In fact, even in the latter part of third quarter we experienced notable improvements in productivity as new technicians became more efficient and work at a couple of the new larger client based outsource labs commenced. In addition and as I mentioned a few moments ago, due to how our fiscal year works, this year the holidays occurred in the third quarter as opposed last year when holidays fell in the fourth quarter. The net affect was two less business days in the quarter. This is something we contend with and move on from. But it's helpful to know when comparing year-over-year performance and productivity. Move on to service revenue growth in the third quarter. Our value proposition continues to resonate well and we continue to leverage our value added distribution business to drive service growth. We generated more than 9% growth in our service segment which included incremental business from Angel's Instrumentation, which we acquired in the second quarter of fiscal 2019. The U.S. generated almost 7% organic service growth, which offset soft results in Canada, which was down 3.6% versus prior year. The decline in the Canadian revenue was a result of a combination of factors including macro, tariffs and unsettling noise around trade agreement. The positive news in Canada, for the most part, we maintained we maintained our strong customer base. What we experienced was a decline in the volume from the number of our existing customers and in time we would expect that to recover. Consolidated organic growth between Canada and the U.S. was 5.2%. Moving on to distribution. The segment continues to deliver on our stated goal of generating strong gross profit performance, differentiation in the market and leverage to drive service revenue growth. It's important to point out that prior year third quarter was very strong as we benefited from pent-up demand due to last year's hurricane impact. Still, even with the tough comp, in our present third quarter, we exceeded prior year gross profit, both in dollars and percent. Rental sales increased 17% to $1.2 million in the quarter and contributed to a favorable mix that aided the margin expansion. Another contributor of the margin expansion was our pricing optimization initiative, an early byproduct of our operational excellence program. In the quarter, gross margins expanded 180 basis points to 24.8%. Operating margin expanded 160 basis points to 8.9%. So with that, I will turn things over to Mike to discuss third quarter results in more detail and then I will come back and talk to our outlook.

Thanks Lee and good morning everyone. I will start on slide four of the deck. That's where we provide some detail for our revenues for the third quarter and for the trailing 12 month period that ends on December 29, 2018. A reminder that our full fiscal year 2019 ends on March 30, 2019. Consolidated revenue for the quarter was up 1% to $40.9 million, which is a record for third quarter revenue. We acquired Angel's Instrumentation on August 31, which was in our second quarter, so our reported results include a full quarter of that acquisition. Angel's contributed approximately $1 million of revenue in the quarter. The financial results for Angel's were in line with our expectations and we are happy with their performance in the integration process to-date. As Lee mentioned, it's hard to definitively calculate the impact but the Christmas holiday did fall in our third quarter this year as our quarters end on the last Saturday of a given month. Last year, Christmas happened upon the fourth quarter. Also, as a reminder, our fourth quarter this year will have 13 weeks while last year's fourth quarter has 14 weeks and that's why full-year fiscal 2019 has 52 weeks while last fiscal year had 53 weeks. Service segment revenue did grow 9.2% to $20.5 million with, as we mentioned, organic growth of 5.2% when excluding Angel's. This organic growth rate is towards the lower end of our expected range of mid to high single digits and was due to the softness in Canada, macro related and especially in the aerospace and defense sector there. Breaking it down further, in the U.S. we had solid revenue growth of 6.9% while Canada contracted 3.6%. Early read in the fourth quarter gives us confidence that we can achieve our organic revenue growth goals for the full fiscal year In the distribution segment, our prior year comps were tough as last year's third quarter was a very strong quarter for distribution as we benefited from the hurricane recoveries. Distribution sales for fiscal 2018's third quarter were 6.7% higher than fiscal 2017's third quarter. This fiscal year's third quarter distribution revenue declined 6.2% to $20.4 million. But the decrease was largely due to lower levels of non-core lower margin sales and we had more gross profit and higher gross margin than the prior year despite to 6.2% topline decrease. As we have discussed in the past, the focus is on improving gross margin by focusing on the higher margin opportunities such as rentals, which did increase of 17% in the quarter to $1.2 million. Consolidated gross margin contracted 60 basis points and was negatively impacted by Canada soft results, by the service mix changes, by short term productivity issues due to the large number of new techs staff hires and probably to some extent by the timing of the Christmas holiday this year. Total operating expenses were up very slightly to $7.2 million, reflecting our continued investment in infrastructure for the long-term and our operational excellence initiatives. Moving on to slide five. Consolidated operating income declined slightly to $2.4 million and operating margin contracted 70 basis points to 5.9%. Service operating income and margin was $0.6 million and 2.8%, respectively, not strong numbers as the gross profit shortfall and the Canadian business softness previously described fell to the operating income line. Distribution operating income increased 14% to $1.8 million and the segment margin expanded 160 basis points to 8.9%, solid distribution numbers. Slide six shows net income on a trailing 12 month and a quarterly basis. And while we saw a slight dip for the quarter, we believe we are still well on our way to achieving record earnings for fiscal 2019. The effective tax rate this quarter was higher at 25.3% compared to 21.9% in the third quarter of last fiscal year. But the prior year was positively impacted by the reduction of certain deferred tax liabilities previously recorded as provided for in the U.S. Tax Act which was affected in December of 2017 right before the end of our prior year third quarter. Our expected income tax rate for full fiscal year 2019 has been lowered slightly to be in the range of 24% to 25%. That rate includes U.S. federal, various state and Canadian income taxes. On slide seven, we show adjusted EBITDA and adjusted EBITDA margin. Among other measures, we use adjusted EBITDA, which is a non-GAAP measure to gauge the performance of our segments, because we believe it is a good measure of our operating performance and is used by investors and others to evaluate and compare performance of core operations from period to period. I encourage you to look at the supplemental slides that provide the reconciliation of adjusted EBITDA to the closest GAAP measures, which for us are operating income and net income. On a consolidated basis, quarterly adjusted EBITDA was down slightly to $4.4 million while adjusted EBITDA margin contracted 20 basis points to 10.7%. This reflects a solid distribution performance which was offset by the service shortfall. However, we believe our full-year 2019 bottomline profitability levels will be solid, albeit muted in year-over-year comparisons by the 53 weeks in the prior year numbers. Slide eight provides detail on our balance sheet and cash flow. In December, we amended our credit facility agreement and replaced our previous $15 million term loan that had a current balance of $12.5 million, with a new $15 million term loan that has a 4.15% fixed interest rate through the new maturity date of December 25. The previous term loan had a variable interest rate. The excess funds of the new term loan were used to repay amounts outstanding under the revolving credit facility. The revolving line of credit piece of our credit facility still has a variable interest rate, which has ranged from 3.2% to 3.8% during fiscal year 2019. We believe our new debt structure prudently manages interest rate change risk. At the end of the third quarter, we had total debt of $24.6 million outstanding with $20.4 million available under our revolving credit facility. Debt levels are up $1.7 million since the end of fiscal 2018 primarily due to the cash used for the Angel's acquisition. The leverage ratio at the end of our third quarter was 1.30:1. We calculate this leverage ratio as the total debt on the balance sheet at period end divided by the trailing 12 months adjusted EBITDA. The trailing 12 months of pro forma EBITDA of acquired companies is used in the leverage ratio calculation, as provided for in the facility. Other companies may calculate such leverage metric differently. Year-to-date cash from operations increased nearly 25% to $7.2 million, which was used in part for the acquisition of Angel's, to fund our growth focused investments and drive operational excellence initiatives. Year-to-date capital expenditures were $5.5 million and primarily focused on customer driven expansion of service segment capabilities and acquiring assets for our growing rental business. Our anticipated capital expenditure plan for fiscal 2019 has been refined down to the $7.2 million to $7.4 million range. Our pipeline of acquisition candidates remain strong. We have adequate liquidity to act on any opportunities and investments that meet our stated strategic criteria. On slide nine, we provide a breakdown of the various focus areas for CapEx spend expected for our full fiscal year 2019. And lastly, we expect to timely file our Form 10-Q after the market closes today. With that, I will turn it back to you, Lee.

Thank you Mike. While the third quarter presented some challenges around productivity and a soft Canadian market, it did not change our long view on Transcat. We remain confident in our direction and how well positioned we are to capitalize on future growth opportunities. For the fourth quarter of fiscal 2019, we expect favorable quarter-over-quarter comparisons when excluding the extra week from last year's fourth quarter. For the full fiscal 2019, we expect record consolidated revenue and earnings. I also wanted to mention that this past week we launched a new state-of-the-art website to drive Transcat closer to the cutting-edge of digital commerce. The site is faster, mobile and self-service friendly and is expected to drive an increasing conversion rate and overall customer satisfaction. Best of all, the site further connects the dots between our combined business segments. I will conclude with a reiteration of our goal to drive double digit service growth via a combination of organic growth and acquisition. And as I mentioned earlier, we expect to see improved productivity, both in the short-term as new technicians progress along the learning curve and the longer term as we drive process improvement, automation and pricing optimization into our service organization. Improved service productivity and service margin and double digit service growth are at the heart of our strategy. Combined with the continued solid performance in the value-added distribution segment, we are more excited than ever as we look at the road ahead. So with that operator, we can open the line for questions.

[Operator Instructions]. Our first question comes from the line of Matt Koranda with ROTH Capital Partners. Please proceed with your question.

Hi guys. Good morning.

Hi. Good morning Matt.

Hi Matt.

I just wanted to start out with the commentary, I think, that you guys mentioned off the top that you were encouraged by your preliminary look at January. I just wanted to see if you could give a little more detail on where specifically you are seeing signs of strength that warrant the commentary? Is it more in the service or distribution side? And maybe dig in a little bit in terms of end-market demand on service?

So Matt, relative to what we see in January, we are seeing strength in both operating segments. So that's good news. We are seeing a pickup in productivity, which is a problem that we had earlier in the third quarter that I alluded to. We are starting to see some efficiency work its way through with some of our new technicians. But I think, probably the most encouraging part of the uptick is just the volume of quotes and orders in both segments. So I think we would expect, seeing the nearly indicators, that this is going to continue. We are halfway way through the quarter almost at this point and no let up. So we are encouraged by that. And again, it crosses both segments.

Okay. That's great. And then I guess why the bifurcation in the U.S. and Canadian markets this quarter in particular? Trade issues and tariff sabre-rattling has been going on, I guess, for almost it feels like, I guess, better part of year now. Why do think it sort of kicked in and you felt the impact in terms of the organic growth in Canada most acutely this past quarter?

Well, we have experienced some softness in Canada really for the whole year. You go back to even Q1 and Q2, it wasn't to the degree that was saw it in the third quarter but it was still sort of soft or flat. To that point, it really even goes back to Q4 of last year. So Canada has had about the last year or so, it had some softness in revenue. Now, retention rates are very high. And as I mentioned in the earnings call script, it tends to be more volume-based than customer-based, which is a good sign for an ultimate recovery. But I think what we saw in Q3 was just a more drastic trend than we had seen in the previous quarters, but this has been going on for about a year. And I expect at some point, I don't have a clear indication on when that's going to end, we are encouraged in that Canada too has gotten off to a good start in the fourth quarter. So may be, as turning the corner, but it's too early to tell. But I just think that the third quarter was a little bit more intense in terms of what we saw in terms of decline than previous.

Yes. Just a couple of things, Matt. Also in Canada. I think there is a larger shockwave from some of the GM plant closing activity that was announced this quarter and the layoffs there just impacts Canada on a percentage basis probably more than the U.S. as far as headcount. And remember, Canada has a larger aerospace and defense concentration than we do in the U.S. We started to and moved to some life sciences with that company that we bought a few years ago, Dispersion in Canada, but more aerospace and defense. So we were able to fight our way out of it. It was some of the new wins that we have had in the U.S., primarily life science, especially some of these client base labs, these larger wins that we alluded to, that were won. So that mix is a little bit different and I think there is more of that impact in aerospace in Canada that we are feeling in the U.S. because of that mix.

Okay. That makes sense. And then just in terms of the service margin, I wanted to see if we could either quantify things or at least give some directional commentary. How much of a drag was the staffing up of on-site technicians versus sort of the normal expansion of techs that support your traditional growth? I know you called out both of those but sort of buckets that might have caused some of the drag that was on the service margins? I wondered if you could break those out?

Right. So to the degree that I can, we probably had in the range, year-to-date about 65 or 70 new technicians. That's a big number for us which I alluded to earlier. Probably that 15%, 20% of that is for some of the larger outsource type opportunities. What makes that a little bit different is you have to higher these folks in advance of the contract starting. You have to get them onboard. You have got to train them on our systems. Sometimes we get those staff from the customers when they are outsourcing, sometimes we have to go outside of that and recruit. But either way, we have got a month or two of cost in advance of any revenue that's generated. So that's a certain type of drag related to productivity on these large accounts. Of the 65 to 70 new technicians, about half of them or roughly little more than are just traditional technicians. Some of that is to support growth. We have had our normal attrition rate, something that catches your eye in terms of attrition. But the combination of just new techs in general and to support that growth, that's a high number. And so if you look back on what happened last year, you really do see a productivity pickup typically a quarter or two after they are onboard. And then it even ramps up from there. So independent of anything we are working on in terms of automation or process improvement, you are going to just need timing to see that's going to help these folks, both on the large jobs and on the traditional ones. The only difference between them, from a financial impact perspective, is that these large jobs incur cost a month or two before the job commences. Did that add some color for you, Matt?

Yes. That definitely helps a lot. And then just in terms of the pathways to getting back toward maybe those normalized segment EBITDA margin in service and sort of the low double digit, what levers do we have to pull in the near-term? And how quickly do we get back there? Do we have a quarter or two where we sort of track towards that? Or do they snap back pretty quickly towards the more normalized levels next quarter?

You are talking about the revenue growth in the mid to high single digits, Matt? Or are you talking --

The service EBITDA margins. They were relatively depressed this quarter. But how quickly do we kind of snap back to the more normalized low teens sort of EBITDA margins in service?

Some of it, remember, fourth quarter is our most impactful quarter, right. So typically, you are going to see a volume increase which is ultimately going to fork its way through. Some of it is volume based, right. So you will see that in the fourth quarter, no doubt about it. You will also see a pickup in productivity in the fourth quarter versus the third and even the second quarter. So we have got two things going for us entering this quarter. Over the longer term, you will get to a point where we should be at our normalized productivity which is not what you saw in the third quarter, but you should see that in the fourth quarter. And beyond that, the improvement you are going to see is going to be based upon some impetus, some change that we make in the organization and that's all the things that we are working on relative to optimizing our process, automation, functionality in our software. And all these things are, over a longer period of time, what's going to drive it above our normalized level. So I think I would look for the normalized levels in Q4 based upon all the things we have stated.

Yes. And I think a big piece of that is these larger client base opportunities that we happen to have a large win rate recently. And what's great about these is, once you incur the cost and the projects start, it's a very sticky business. So it will impact the fourth quarter as well as next year or two. But we kind of felt the pain with the hiring and the startups into the third quarter. And I think you have got all those other ones that I was just going to mention too. The productivity of the staff have been here for another three months, that will impact. Some of the tools are very closed. Some of them we are actually seeing in beta now, some metrics and some productivity metrics that we are able to use and help us run the business on a daily basis. These are things we have talked about in the past, but actually some of them now are in that beta test and that will impact the short term and certainly impact fiscal 2020 too.

Great. I assume then the quarter results don't really show the full impact of those new onsite contracts that you won. And I think, Mike, you are alluding to those ramp over the next couple of quarters. Any way to think about how those impacts core growth in the service segment? Should we be bumping up our expectations in terms of the organic growth rate in the next couple of quarters as those come online? Or those are just sort of part of the normal mid to high single digits that you guys typically talk about?

I think it's a little higher than what normally we build into that the lower or the higher range of that single digit, Matt. So I think it would be the high. And I have to just caution everybody again, when you are looking at last year, you have got to remember it's 53 versus 52. So you are going to have to kind of then model in somehow normalized one way or the other because we have to make up for that extra week when you are comparing year-over-year. So my long answer is, I think some of the growth and some of the wins that we have had would be built into that normal rate that we should be able to get to the higher part of our range. That would be nice if Canada has a little bit of a recovery too and the productivity needs to recover as we are anticipating that it will.

Okay. Last one and then I will leave it to someone else here. But I think I noticed you guys said you were starting to deploy some of the pricing, analytics and optimization that's been helping your distribution margins to drive better margins in service. So is there a way to provide maybe an example or two of how that actually works in the service segment at the ground level?

So at a high level, I will say it is a similar platform that we are going to be employing and it really helps control margins, particularly on the transactional side of our business. So we have got three buckets, right. You have got the transactional business, which, let's say, is everything around, let's say, $10,000 a year or under. These are people who eventually, it will be more automated through our website in terms of price quoting, all that will be automated and taken out of our sales people's hands. We get to $20,000 to $120,000 on an annual basis. The pricing optimization will also help that group. So it's a set of guidelines. It's a set of features that really help interpret what's going on in the market and what our ultimate price should be. And it's all sort of a schematic that is ultimately going to expand margins. Once you get above the $120,000 a year, you get to some of our larger accounts, it probably has less effect there, because we go through modeling with each one of those account, different threshold for review. So I would say anything under $120,000 a year, which represents 70% of our business or in that range, don't hold me to that number, but it's around there, that's the group of customers that are going to be potentially impacted in a positive way from some of these new tools that we are putting in place.

Okay. Very helpful. Guys, I will jump back in queue here. Thank you.

Thanks Matt.

All right Matt. Thanks.

[Operator Instructions]. Our next question comes from the line of Dick Ryan with Dougherty & Company. Please proceed with your question.

Thank you. So Lee, can you give us some perspective on Canada? I think you have got three centers up there, but what percent of service revenue to those Canadian centers represent?

Yes. In total, you are in the 8% to 10% range for Canadian sales as a percentage of our overall service sales.

Okay. And did you say that's mostly A&D related, aerospace and defense?

In Montreal, the bulk of our business, based on the acquisition we made years ago, is aerospace, primarily aerospace and defense. As you go into Toronto, you are going to see more general purpose, general manufacturing, but you are also going to see some aerospace and defense. And to the point that Mike made earlier, if you just take the last 12 months, there's no question that 80% or some high percentage of our growth has been within the life sciences segment, because that's where we are concentrating. So our overall plan in Canada in the last couple of years has been to sort of shift to our specialty, which is life science. It doesn't mean we ignore aerospace and we are certainly capable of servicing that market, but we want to do some sort of a pivot in Canada to life science, so it reflects and mirrors what we do in the U.S., because we have had the success have had here.

Yes. The life science company, Dispersion, was Montreal based. So geographically, there would be more of the impact in Montreal versus Toronto, which is more general purpose.

Correct.

Okay. Great. So on the large customer labs, are you seeing wins expanding applications within existing labs that you already control? Or are these new wins altogether?

On the large side of the outsourcing opportunities that we have won, these are all new and they are predominantly in life science, but not exclusively, I would say. The bulk of them have been life science. And we have definitely seen and we have asked ourselves the question, our sales staff is certainly attuned to selling to this particular in-house labs. But the success we have had in this past year and you will see some of it play out in future quarters, could be a byproduct of the economy, hard-to-find technicians and some of the struggles and challenges that these in-house labs have and it's not their specialty, it's not their core competency. So yes, these are new opportunities. It's good for our company. And I have mentioned in the past, how well positioned we are as a company to capitalize on these sorts of shift in the market. And I think that's to be noted, because we were really well positioned once these opportunities presented themselves. So that's a good thing for Transcat.

Can you give us a rough count of how many in-house labs you are now running?

I would say probably in the 15 to 20 range.

Yes. That's the exact number. Yes. Normally, we pick up maybe one a year. We never lose them, because we are very sticky, because once they transfer and move to us, it's very hard for them to go back. They use our software. We have the technicians now that are on our payroll. But if there has been a move, maybe it's labor market related, maybe it is just other circumstances, but we picked up more than one in this past 90-day period, for sure.

And how is the margin on that business?

It depends. So overall, the margins on an incremental basis tend to be, because the volume is a little bit lower, but these can run anywhere from 25% to 35% depending on the account and like Mike said, you are locked in for the future and you can get very embedded very quickly, versus more of an incremental type margin on a product that reaches one of her depo labs could be 50% or higher. So it all gets blended together. But it's on the lower end, but I would add also that in this past year, there have been several leads that have been won. They have been a little bit higher margins than we typically see in these types of large accounts and that's been strategic for us. We have tried to drive that through a variety of tactics when dealing with these larger customers.

Okay. So you mentioned the tight labor market and that you haven't really seen attrition, but have you had to pay more to keep what you have or attract new? Or how is that dynamic?

Yes. So we have seen attrition, but the attrition is within the sort of normal percentage, what we typically see on any given year. I don't want you to come away with that we don't any attrition, but we have some. We are seeing, in the past quarter or two and it is a contributing factor not material enough to necessarily bring up, but since you asked the question, yes, we are seeing some escalation in price in the cost of our labor to maintain our quality workforce and if all things work out the way we intend, you get that into your pricing over time. Now some of these deals are under contract for a period of a year or two years and you have got to wait sometimes to get the escalation in price, but we do have our annual price increases that in the end should cover, at least theoretically should cover, the majority of the increases we have in our labor force. But yes, short answer, we are seeing an escalation in wages.

Okay. Great. Thank you.

Thanks Dick.

Thank you. We have reached the end of our question-and-answer session. I would like to turn the call back over to management for any closing remarks.

Okay. Well, thank you all for joining us on the call today. We appreciate your interest, your continued interest in Transcat. I did want to announce that for those of you on the West Coast, we will be participating at the ROTH conference in Dana Point, California on March 18 and 19. So if you are attending the conference, feel free to check in with us. Otherwise, feel free to call us at anytime. Mike or me. We look forward to talking to you all again after the closing our fourth quarter. So take care. Thanks for joining.

Thank you. This concludes today's teleconference. You may disconnect your lines at this time. Thank you for your participation and have a wonderful day.