Good day, and welcome to the Twin Disc, Inc. Fiscal Third Quarter 2019 Earnings 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, Sandy. 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 third quarter and nine months 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 third 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 in detail, I'll touch on some of the operational highlights from the quarter. In many ways the fiscal third quarter was frustrating and that represented the amount of work and effort that was put into it. Sales for the quarter easily could have been 6 million to 8 million higher than what we achieved. Some of this was due to order push outs, particularly in oil and gas, continued supply issues and critical components like outsource gears, castings, forgings, and heat treat furnaces all caused certain delays during the quarter. Additionally, we had internal inefficiencies with new employees and training, and much higher turnover than we historically experienced all which led to increased internal capacity issues within the quarter. Things have started to improve, but more of our oil and gas has been pushed into fiscal '20, Q1. One on a positive sign our marine backlog is growing globally. And we're starting to see signs of life and inquiries in the offshore space. RF demand remains at historic highs. And we enter into our fourth quarter in fiscal '20 with an extremely strong backlog in this market. The Veth backlog is growing in North America and we couldn't be happier with the progress that we're making there. And we'll know more after the offshore conference in Houston this week. But our oil and gas projects as far as applications for new rigs are also growing. We also added over 2 million CapEx during the quarter. These will come online in the in the fiscal fourth quarter…

Thanks, John. Good morning, everyone. I'll briefly run through the third quarter numbers, sales of 77.4 million for the quarter were up 12.1 million or 19% from the prior year third quarter. The quarter results include the impact of the acquisition of Veth Propulsion, which closed on July 2. Excluding the impact of Veth sales we're actually down 5% compared to the prior third quarter. The primary driver for the decline in revenue in the quarter is reduction in North American aftermarket demands primarily related to oil and gas product following a historically high level of aftermarket demand in fiscal '18. The quarter was also impacted as John referenced by continued supply chain challenges resulting in some delayed shipments and excess inventory in the quarter. We continue to see strength and positive momentum in nearly all of our markets including the global industrial, commercial, marine and patrol craft markets. Through the first three quarters sales are now up 63.3 million or 38%, adjusting for the Veth acquisition the organic increases over 12%. While much of this growth was driven by oil and gas demand, industrial product sales have increased nearly 16% compared to the prior first nine months and marine transmission sales increased nearly 3%. Our gross margin performance for the quarter was hampered by an unfavorable product mix with lower aftermarket demand being the primary driver. The third quarter margin percent was 29.9%, a decline of 200 basis points from the prior year third quarter. This result includes the impact of the Veth acquisition and related purchase accounting amortization. Excluding the Veth non-cash purchase accounting amortization, gross profit was approximately 31.2% for the third quarter. Spending on marketing, engineering and administrative costs for the fiscal 2019 third quarter increased 2.8 million or roughly 19% compared to the prior year.…

Thanks, Jeff. And now I'll spend a quick moment or two on the outlook. Looking at Q4 and beyond, we feel that we have the backlog and demand to achieve quarters. Like our third fiscal quarter oil and gas for both new units and aftermarket continues to be a bit unpredictable as far as quarterly timing for improving trend. We do not think we are seeing anything like 2015. And as Jeff mentioned, our other markets remain stable. And we enter the fourth quarter and going into fiscal '20 with a very good backlog in all of our other markets. Our main operational focus remains for improving our internal capacity primarily here in Racine and getting our Lufkin facility operational by January 2020. New product development continues to be a priority, as we look beyond marine, hybrid and the electrification of our other product end markets and as we develop and take what we've learned with Veth and our marine markets and apply it to our other product end markets. Those conclude our prepared remarks. And now Jeff and I will be happy to take your questions. Sandy, could you please open the line for question.

Absolutely. [Operator instructions] We'll take our first question now. It is from Noah Kaye at Oppenheimer.

Thanks. Good morning, and appreciate you taking the question. John, you called out a couple of different factors as strikes on the operating efficiency in the quarter. You mentioned the supply chain, labor, just the space constraints, how are we going to parse out which of those are relatively bigger factors? And then can you talk about the actions you're taking to kind of ease each of the bottlenecks?

Sure, I would - Noah, to be fair, I would put them roughly at 50-50. And it's - what we're seeing, we went from a few years of zero oil and gas and then had to ramp up very quickly. So we're taking capacity away from our suppliers and then when the other markets ramped up, we're trying to get all of this hyper demand through people who are supplying us gears, castings, forgings and they have labor issues. So as the bubble in oil and gas slowed a little bit, it's getting better to get stuff for our marine, transmissions and RF market, those supplies through them. What was new in the quarter, I would say is one of our primary heat treat suppliers for gears had some furnace issues continually through the quarter. So that was the new whack a mole issue that came up in the quarter that hindered us. So I attribute roughly half to that, but half also to just trying to hire and find - we've had continued retirement throughout the fiscal year. And we're bringing in new younger employees and people are moving up and stepping up. But they have a long ways to go to get to the capabilities of the guys that were retiring had. But we've also seen, I would say, a much higher turnover rate than then what we're used to seeing. So we're having to hire more and having to train more and the key part there Noah, is not that they can't - training them on, just for instance, one machine tool or another or assembling marine transmissions versus oil and gas. It's just that the guys that are retiring that were here 35, 40, 45 years, they could assemble all of the transmissions or work multiple machines. So it's been a challenge this year with the surging oil and gas demand, the other markets improving to get the headcount up, to get the headcount that says well trained is the headcount that was leaving. Does that answer your question?

Yeah, it does. Thank you. And then just kind of a follow on to that, you commented that you expect the June Q to have kind of comparable results, financial results to the March Q, would that include on the gross margin line as well?

Yeah, we think I mean, the gross margin, I'd say the - for what's been happening as far as supply issues. I'd say that the gross margin is, I would say for the next couple of quarters, that's a fair estimation going forward for the next two. Although that once we get to fiscal '20, the purchase account drops off, so we lose that anchor. But I would say right now like what we have an available backlog to ship looks fairly constant for the next six months.

Okay, very helpful and turning to the backlog. You just want understand in last quarter, you were pretty explicit that a lot of what happened with the backlog was - you guys are really shaking out and making sure you didn't have any kind of duplicative or soft orders in there. How much of kind of the step down this quarter was, you know, the same versus kind of any actual softness in the market?

Yeah. No, this time, I think this was just this was oil and gas shipping and not being replaced. So we're waiting for - we have some new orders for oil and gas, but we shipped more than we took in orders.

I think the cancellations were around the 6 million - in the 6 million range I remember right Noah.

Okay. Perfect. And maybe if I could just sort of squeeze one more in here, you commented on the under strength and the continuing strong interest on the marine propulsion side, sort of specific to Veth, can you give us a sense of what kind of the development synergies you're actually seeing here on the hybrid products? You mentioned benefit not just for the thrusters but for the transmissions. Can you elaborate on that a little bit, please?

Yeah. So Veth, the engineers in Rotterdam have a lot more experience in dual inputs into the gearbox of the propulsion system, so electric motor in diesel direct, so which is where we're going with our marine transmissions. We're developing master clutches for our standard marine transmissions to have that dual input. So the engineers there have been doing this for a few years on the software, but they also have the hardware developed. So the screens and the controller handles that let it all happen from the helm. So it is jump started our hybrid activity for standard marine transmissions. So we've seen - we're so much farther ahead just after a year of integration of where we were before the acquisition. Our engineers in Racine have designed the master clutch module to go on our marine transmission. And we're able to utilize the expertise for that from Veth on the control system, so could not be happier about where we are there. And it's just taking the same philosophy of controlling the gearbox, whether it controls the propeller, steers a thruster or controls the output of a vehicle transmission like RF. For oil and gas we are well on the way to understanding the software of how to do it, but also the hardware to make it happen.

Perfect, thank you so much.

Thanks, Noah.

[Operator Instructions] We'll take our next question from Tim Wojs at Baird.

Hey, gentlemen, good morning.

Hey, good morning.

So, I guess maybe you just - maybe I'll start on free cash flow, just how much of the working capital drag that that you saw in the third quarter maybe reverses in the fourth quarter? Is it enough to get free cash flow to slight positive for the year? Do you think that's going to be a little bit of a stretch?

I think positive for the year at this point is a stretch to be honest. I think we have a good chance of having very positive cash flow in the quarter, but I don't think we reverse the three quarters that we've had so far. I think we will continue to have - there's a good chunk of CapEx spending that that will be flowing through - at least we anticipate flowing through in Q4 as well.

Okay. And as we look at kind of 2020 you should see some further progress on the inventory drawdown and then I would imagine that CapEx would step down into 2020 from '19 levels.

I think we still have a fair amount of investment that we'll be doing with the new Lufkin facility. So I think it might come down some, but I think it'll still be at - historically at a slightly higher than average level.

Just given that too.

And Veth rate, but adding to that up next. I think working capital wise we have a good opportunity, again through the fourth quarter and also in fiscal '20.

Okay. And then on the marine business, John, I mean you sound a little more positive there. And I know, probably over the last six years maybe that business has kind of bumped along the bottom a little bit. I mean, are you seeing a kind of a notable improvement in kind of the discussions you're having with your marine customers now. I mean, you mentioned offshore which I don't think you've mentioned offshore a couple years.

No, we're just starting to see some - well, very interested to see what happens to go - OTC they arrived today. So I'm interested to see what comes out of that, but I've seen a little bit more signs of life in discussion of projects and it helps because Veth doesn't have any market share there. So this is a growth opportunity on a certain size class for Veth, but continued activity here in Racine. No, I just again, it's being driven by the North American market, honestly, Gulf Coast up through the inland river. But we've also seen some new orders from Asia, which has been a long time coming. So that's kind of what's changed a little bit even since the last quarter , so slightly stronger orders and improving trends from Asia.

Okay. And then on oil and gas, how did orders kind of progress through the quarter because I know we've had some kind of bottlenecks in the Permian. Has that kind of extended into the summer or how do you - how are your customers kind of talking about what's going on down there?

Trying to remember, I mean, we didn't get a lot of cancellations early in the third quarter at all, I would say was more in that late February, March timeframe with some push outs into late this fourth quarter, but they're going international, so it will still fall into next year. But everyone that I talked to, they want to go on record but kind of thinks that it would be late summer fall when we - but we have a lot of projects going both domestic and in China. We should see some improving trends the second half of the year as far as orders and results. And Tim we had inventory to ship.

Yeah. Okay, got you. Okay. And then the Veth business in the quarter, was there a way to give us what the revenue dollars were for Veth in Q3, and then just curious what the reversal was or was that just a an accounting thing?

In other operating income, is that what you're referring to?

Yeah.

Yeah. So what that was - we had an accrual - as part of the acquisition, there was an earn-out provision and that earn-out was to be paid either in cash or to end the stock at our discretion. So we made the determination within the quarter that we would be paying that in stock. And therefore there was a sort of a mark to market adjustment because of the change in the stock price from the timing of the agreement to the end of Q3.

Got you, okay. And then was the revenue 14 million or so in the quarter?

A little over 15 million.

Yeah. Got you, great. Thanks for the time, guys. Good luck on the rest of the fiscal year.

Sure, thanks, Tim.

Thanks, Tim.

[Operator Instructions] It appears that no further questions at this time, I would like to turn the conference back to your host.

We can close Sandy

This concludes today's call. Thank you for your participation. You may now disconnect.