Good day, and welcome to the Twin Disc, Inc. Fiscal Second Quarter 2019 Investor Conference Call and Webcast. Today's conference is being recorded. At this time, I would like to turn the conference over to Mr. Stan Berger of SM Berger. Please go ahead, sir.

Thank you, Christian. On behalf of the management of Twin Disc, we're extremely pleased that you have taken the time to participate in our call and thank you for joining us to discuss the company's fiscal 2019 second quarter and first half financial results and business outlook. Before I introduce management, I would like to remind everyone that certain statements made during this conference call, especially those that state management's intentions, hopes, beliefs, expectations or predictions for the future, are forward-looking statements. It is important to remember that the company's actual results could differ materially from those projected in such forward-looking statements. Additional information concerning factors that could cause actual results to differ materially from those in the forward-looking statements are contained in the company's annual report on Form 10-K, copies of which may be obtained by contacting either the company or the SEC. By now, you should have received a copy of the news release, which was issued this morning before the market opened. If you have not received a copy, please call Annette Mianecki at 262-638-4000, and she will send a copy to you. Hosting the call today are John Batten, Twin Disc President and Chief Executive Officer; and Jeff Knutson, the company's Vice President of Finance, Chief Financial Officer, Treasurer and Secretary. At this time, I will turn the call over to John Batten. John?

Thank you, Stan, and good morning, everyone. Welcome to our fiscal 2019 second quarter conference call. As usual, we'll begin with a short summary statement, and then Jeff and I will be happy to take your questions. Before Jeff goes over the quarterly results, I'll touch on some of the operational highlights of the quarter. Obviously, sales you've seen for Twin Disc business were up 13% year-over-year, and as Jeff mentioned, demand was up in all of our markets. The gross margins and operating margins were up year-over-year. Having said that, while our results have improved from a year ago, we continue to face significant supply chain challenges in the quarter, mainly in the area of machine components, gears, castings, forgings and other stuff -- some contracted component. The capacity strengths mainly due to labor shortages that our suppliers and internally is our number one focus operationally. The slowing growth in the domestic onshore oil and gas markets should help alleviate some of these constraints, but we see this slowing growth only as a temporary pause. As we have mentioned in our prior calls, we are investing significant amount of CapEx in our plants to improve throughput that can pass end capacity. Additionally, we are moving our North American aftermarket spare parts business, the facility closer to the I-94 corridor between Milwaukee and Chicago, and we are breaking ground this month on our facility in Lufkin, Texas, where we plan to move all of our North American industrial business and depot activities for the North American market. With his freed up space at our Racine facility, we are adding new gear-cutting equipment, 5-axis machining centers and automated test stand, all with a focus of leveraging the improved efficiency of the newer machines and improving our output in the face of a very tight labor market in southeastern Wisconsin. Additionally, we are looking at bringing in some heat treat processes, so we can improve our lead times and improve our delivery commitment. In the quarter, we also spent a significant amount of time with our new acquisition Veth. Obviously, a lot of time has been spent on SEC reporting with the finance team, but our sales, marketing and engineering teams have all gotten together, and I'll have some comments on my outlook with the Veth hybrid technology and coupled with the Twin Disc marine transmission. After Jeff goes over the financials, I'll go over the outlook for the second half of the year and cover in more detail our outlook on the onshore oil and gas market specifically. With that, I'll turn it over to Jeff for some comments on the financial.

Thanks, John. Good morning, everyone. As john said, I'll briefly run through the second quarter numbers. Sales of just over $78 million for the quarter, up $21.6 million or 38% from the prior year second quarter. The quarter, obviously, includes the impact of the Veth acquisition. Excluding the impact of Veth, sales were up 13%, as John mentioned, compared to the prior year second quarter, which now represent the eighth consecutive quarter of year-over-year growth, demonstrating the sustained growth trend we've been enjoying since the middle of fiscal '17. The primary driver for our improved revenue remains the improved shipments of oil and gas, transmission units into North America, along with the improved North American aftermarket demand, also led by oilfield activity. In addition, we continue to see improving trends in nearly all of our markets, including the global industrial, commercial marine and patrol craft market. Through the first half, sales are now up $51.2 million or 50 -- just over 50% compared to the prior year. Adjusting for the Veth acquisition, the organic increase is over 23%. Again, while much of this was driven by oil and gas demand, industrial products sales have increased over 9%, and marine and propulsion sales over 6% compared to the prior year first half. Gross margin performance for the quarter was strong with a margin percent of 33.4%, an improvement of 120 basis points from the prior year second quarter and 130 basis points from the first quarter. This result includes the impact of the Veth acquisition and the related purchase accounting amortization, which, again, is the one year phenomenon. Excluding that noncash purchase discounting amortization, gross profit would have been approximately 34.7%. The improvement is primarily volume-driven, but also continues to reflect the strong mix related to oil and gas and aftermarket.…

Thanks, Jeff. Just looking at the outlook here and the backlog. Obviously, it dropped about 6% from Q1 to Q2. And late in the second quarter, just before the Christmas shutdown, we had some cancellations in oil and gas, cancellations at new orders for frac transmission, and this trend continued into Q3. And I've got to want to emphasize that we are driving this activity to make sure that all the transmissions in our backlog have a specific project at the end, and we're not just driving a forecast, which has been driving the inventory. Just as a side, we did receive the second or third largest aftermarket order in oil and gas in January, so the activity continues. But a lot of this restructuring of our backlog is to make sure that our demand is driving an appropriate inventory level. We are well positioned for the next few quarters on inventory for oil and gas. We do see this demand in the frac market flattening for the next few quarters, but we do not see it disappearing. Again, we have several projects for retro fit of existing fleet, and the aftermarket demand continues for all of our product in the field. I would like to finish just covering specifically the Veth acquisition. I would say for the first six months, it has exceeded our expectations in almost every way. Obviously, day-to-day activity has been spent on bringing up the SEC reporting. But we've had meetings and developments between our sales team, our marketing team and our engineering team. And I can't overstate how excited we are to having this part of the Twin Disc team, and specifically, their knowledge in the hybrid area and diesel-electric area of the marine market and what that means for our marine transmission and bringing a single technology-type solution in the marine hybrid space. I do firmly believe that the Veth and Twin Disc combination pushes us to the front in this space in our market area. Additionally, in a tight labor market access to high-quality marine engineering talent in the Rotterdam area is also a huge benefit for us. So I'd look to hear more about the Veth acquisition in the coming quarters and seeing the development of the products that go into the marine hybrid area. Christian, with that, that concludes our comments, and we'll turn it over to questions at this point.

[Operator Instructions]. We will now take our first question from Noah Kaye from Oppenheimer.

So in the release and in your comments, you commented on our expectations to decrease inventory throughout the year and a down debt. Is it possible to, sort of, give us an order of magnitude on how much you're expecting that retainment to be? And how far you think you can work through those inventory levels?

That's a challenging one, Noah. We think we're really trying to balance what we need to bring in to satisfy customers and be prepared for the demand we're expecting. I think we would like to recover what we -- as a minimum, what we tossed that what we experienced through the first half. So I think, in our minds, we would like to get to, as a minimum, to breakeven free cash for the year.

Okay. That is very helpful. And you talked about the Lufkin breaking ground and relocating the aftermarket. Can you comment on once you have this additional capacity? What kind of revenue levels do you think that could support? And then also, how do we think about kind of the efficiency gains and the impact on margins from this reconfiguration?

Well, no, I would say, freeing up the square footage in our plant here in Racine and moving industrial to Lufkin aftermarket out, I would say that we have the square footage and the freed up space to put the capital in, that would get us leaving all other pieces equal. This would get us to a 500 -- the potential to get to a $500 million run rate given that we add the necessary capital and we have the right employees. But as far as the walls and the building, I think, we are set to get to that $500 million mark. Looking at gross margin, it's probably going to be, as we -- or bring facilities online, I would -- my goal, I'll be honest now, is to maintain gross margin as we -- we're putting a little bit of cost before the payback. But I would -- the goal is that as our gross margin cycles through different cycles, there were at least, 200 to 300 basis points higher in a cycle. Does that make sense?

Yes.

That we're able to maintain a higher level of efficiency throughout the cycle that's about 200-plus basis points higher.

As a result of the reconfiguration or as a result of the kind of recent cost action type?

Yes, yes.

Okay. All right. That's very helpful. And maybe one last one for me. You commented on kind of the work you're doing with Veth, and I'm just wondering, what are the conversations you're having like with customers around the hybrid drive offering, the synergy with urine transmission? What's the response then? And do you think that this may start to take up kind of more of the market?

I think so. I haven't been in every meeting, but I've been at several shows. It's -- in my 23 years at Twin Disc, nothing -- and this is true, nothing has been more electric at any trade show, and when I'm out with customers, than this acquisition. It's -- we have -- I put our global distribution network and service -- I mean, they are the cream of the crop. So this opens doors outside of Europe for the Veth product. We've set -- we've already set up some of our dealers to be their distributors -- sorry, our distributors to be their dealer. We set up new ones -- independently new ones. We're working with traditional Twin Disc product through some of their agents. And the z-pillar was -- as a product was more conducive to diesel-electric dual inputs or an electric motor input. And so, we've already begun a path to hybrid technology with our traditional marine transmission. And it was nice to see that we, independent of what that was doing, we were using some of the same software, same hardware, same processor. So they were much farther along, but getting our two teams together has been fantastic as far as the quality of the hybrid product that we're going to continue to develop for their product line, but also what it's going to mean to a hybrid application with a traditional marine transmission. So -- no, go ahead.

Just as a last point that presumably, those sort of synergies and development improved your time to market. So how should we think about kind of a product?

I would say, we're at handful of initial hybrid activity projects, orders for our traditional marine transmission. I don't know if I can give you number. Would this double our growth? But it's certainly grows -- it improves the growth rate of our applications in hybrid for all of our product line. If that makes sense? It's going to fast-forward it significantly thanks to software and hardware to help us. Yes.

[Operator Instructions]. We will now move on to our next question from Josh Chan from Baird.

I was just -- was wondering if you could talk a little bit about the oil and gas market. You talked about -- I think you're proactively trying to form up some -- your order book, I guess. And then I guess, you talked about also the belief that the activities is stabilizing in sort of in January. Can you talk a little bit about what's going on there, I guess?

Sure. I guess late in December kind of, just before the Christmas shutdown, the end of everyone's quarter, we did receive some cancellations for units that were from our customers, but didn't necessarily have a home yet. As I mentioned, we also had new orders in the quarter. It's just that the cancellations outpaced the new orders. In January, we've continued that to shake down what everyone has on order with us to make sure that people aren't chasing the same business and that we aren't driving more inventory than is necessary for the next 2 to 3 quarters. So we led that activity. We kind of forced the issue. If -- what's your chance -- what do you believe your chance of getting this business and then, here trying to talk about are we all chasing, do we have multiple customers chasing the same business? So our goal is to make sure that our backlog, the number of units that we have on order at the factory matches as closely as possible with the number of units that are actually needed in the field, if that makes sense, Josh? So we do see a flattening demand. I mean, the growth rate that we saw for the prior four quarters was not sustainable. So we knew that there would be a flattening. But we have a very good order book for oil and gas transmission going out in next few quarters. But we do see -- we all read the same articles. We see all the same information about the Permian. There's definitely been a little bit of -- a lot of slowdown in the growth rate for sure, but we still see building activity. As I mentioned, we had one of our largest spare parts orders for oil and gas transmissions ever in January. So it's not that the activity is grinding to a halt, but it's definitely flattened out.

Okay. And would you say that spares or overhaul, would that comprise the majority of your activity going forward as opposed to new units being added to the field? Or how do you think about that composition?

It's not -- spare parts and overhaul is not the majority, but it's definitely a bigger percentage of the ongoing business, especially if you include new units just to swap out a unit that's at a rig. So I would foresee the spare parts business, and we'll call it a retrofit, is going to be -- for the next 3 to 4 quarters, it will be a much bigger part of our business than new rig reconstruction.

Okay. And then -- just so that, maybe, we're not surprise or no one is surprised, because you're trying to formulate your order book in January, would you be surprised if the backlog at the end of March was a little bit lower than the December one? Or how should we think about that?

I would not be surprised at all if we saw a drop of that 6% -- of 6% to 10%, again, in the third quarter. I wouldn't be surprised. It's still a healthy backlog and it doesn't change the fact that what we have to deliver. Our order book for the next 2 to 3 quarters is pretty firm.

Okay. That's good to hear. And then on gross margin, usually, it builds over the course of the year as you get more seasonal volume. Do you expect that to be the case this year as well, given the strong start in the year?

Yes, Josh, you're right. Typically, that is the case. I think, what different this year is, we're sort of at the level of the high-margin product that we're going to ship. So what's going to be incremental is more of our lower margin business that's in backlog today. So I don't anticipate that we'll see improving margins through the second half. Still very good margins, but I don't think we should anticipate a jump on improving margin percent through the second half.

Okay. And then my last question, just housekeeping. Should we expect any kind of onetime-type cost or disruption with respect to sort of the facility moves this coming quarter? Or do you expect that to kind of go pretty smoothly?

No, I would say, I don't anticipate any really of the -- any onetime big thing for Lufkin, and our lease on aftermarket facility begins in April. So we'll kind of have half of a quarter. So no, nothing significant.

There are no further questions in the phone queue at this time.

Okay. Well, thank you, Christian. And thank you for joining our conference call today. We appreciate your continued interest in Twin Disc, and hope that we've answered all of your questions. If not, please feel free to call Jeff or myself. And we look forward to speaking with you again in May, following the close of our 2019 third quarter. Christian, I'll turn the call back to you now.

Thank you. This will conclude today's conference call. Thank you all for your participation. You may now disconnect.