Good day and welcome to the Twin Disc, Incorporated Fiscal Fourth 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. Stanley Berger of SM Berger. Please go ahead, sir.

Thank you, Ian. 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 fourth quarter and full year 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's 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 fourth quarter and year end 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 quarter results, I will touch on some of the operational highlights and issues from the quarter. We continue to face several challenges in the fourth quarter that reflected in our results, Jeff will provide more color on the details, but supply chain internal capacity continued to affect our ability to keep up with demand in the run up of the 8500s because a lot of strain in our supply base. In order to meet demand on other products we had to move supply to other vendors and not always at the lower cost. Availability and quality were a primary concern because our customers could not wait. We also faced some suppliers who went out of business or shifted focus away from our markets. We have been working hard to resource these parts to a lower cost supply and are on our way to achieving this, but we'll have to work through some existing inventory. Additionally, our newer products like the 4001 RF transmission, the 7600 with the planetary output, and many of our new industrial products are still working through inventory of prototype and pre-production pricing. Q4 had a higher than normal percentage of new products. We should see improving trends throughout fiscal 2020 due to lower cost supply, improved efficiency and pricing actions. As we mentioned on the last call, we did have oil and gas push outs from Q3 and Q4 into the first half of fiscal 2020, which obviously affected the mist. Internal capacity was affected by declining efficiency partially driven by…

Thanks, John and good morning, everyone. I'll brief briefly run through the fourth quarter numbers. Sales of 72.4 million for the quarter were down 1.3 million or 1.8% from the prior year fourth quarter. The quarter decline is the result of a significant reduction in new bill activity in North American fracking market, along with a related reduction in aftermarket activity. This decrease was partially offset by the addition of Veth Propulsion activity and increased activity in our marine and industrial markets. The Quarter was also impacted by continued supply chain challenges resulting in some delayed shipments and excess inventory. We continue to see strength and positive momentum in nearly all of our markets including the global industrial, commercial marine and patrol craft market. For the full year sales finished up 61.9 million or 26%. Adjusting for the Veth acquisition, the organic increase is approximately 3%. This year-over-year growth was driven by oil and gas demand primarily in the first half of the fiscal year, along with improving sales of industrial product which grew over 10% for the prior year. Our gross margin performance for the quarter was severely impacted by an unfavorable product mix with lower fracking demand for new reconstruction and reduced aftermarket demand being the primary drivers. The fourth quarter margin percent was 22.7% compared to 37.4% in the prior fourth quarter. In addition to the mixed impact we were forced to lose the production as John mentioned to higher costs suppliers in order to meet the growing demand of some of our land based transmission system. We are already pursuing alternative vendors or improved pricing to address this issue. The fourth quarter 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…

Thanks, Jeff. Now, I'll spend a quick moment on our outlook. A lot of management time was spent on the integration of Veth in fiscal 2019. Many of the actions that we were looking at to consolidate back office functions, particularly in Europe, were put on hold as we did the acquisition and then the integration. Moving forward, we will continue our efforts to reduce fixed costs in conjunction with their efforts on variable and material costs. That provides us the critical mass and access to talent we need to build a European team. We're already using their experience to develop our marine hybrid line and we look to expand these electrification efforts into our industrial and transmission line. There's been a lot of talk about electric frack rigs. And while the current number is relatively small, we see this as a growing trend in the future. We will be ready with solutions for our customers who wish to pursue this option. Many of you also probably saw our press release in May that Jim Feiertag has rejoined Twin Disc as our President and Chief Operating Officer after spending four years as a Chief Executive Officer of Bemis Manufacturing. Jim's intimate knowledge of our people, products and facilities will be very beneficial in the coming years as we rationalize our global footprint and product portfolios. Finally, we want to convey the message that management continues to focus on diversification and growth. Even as we address the short-term margin challenges in front of us, we will continue to explore further opportunities to grow our industrial business and to enhance our hybrid development. That concludes my prepared remarks. And now Jeff and I will be happy to take your questions. Ian, please open the line for questions.

Thank you. [Operator Instructions] We'll take our first question, comes from Noah Kaye of Oppenheimer. Please go ahead.

Good morning, gentlemen. Thanks for taking the questions. First, if we can touch on the margins, you pointed to a number of factors here, mix, supply base challenges, can you give us a little bit more granularity on this? How much did mix weigh on margins in the quarter? And then any detail you can give on some of the other factors.

Yeah, I can jump on that one Noah. Mix was – they're kind of related, I guess, in some ways. So the mix – low margin on the on the products that drove the negative mix is really a result of the sourcing issues that that John described. So we've got the lower margin products, the newer transmission products that drove – if we're comparing Q4 to Q4, almost 9 million of unfavorable impact on the margin line. So that that really was the driver and that's where we're focused on, the cost profile of those products that are driving that negative mix as well as pricing on those products.

Right, this is the legacy business really, the Veth margins I think you've previously commented, they're kind of around 20 typical margin and the low to mid 30s. So that was not, if I understand it right, that was not a drag on margin?

That was a little bit of a drag, they finished the year – and I'm excluding the amortization piece, right. So the amortization was about 4 million, 4.1 million for the year. Excluding that they were around 28% for the full year. And they've got a little bit of mix as well in their project. So Q4 in particular, was a challenging margin quarter for Veth.

Okay. And then,

Noah, if I could add a little bit of color. If I look at the transmission products, where we had to shift suppliers, I guess, with a full year looking back those units in general were probably – and I don't have the exact numbers in front of me, but, their margin went down by about 5% based on shifting to – having to shift into different suppliers, if that makes sense. So the gross margin on them probably deteriorated over the year with that supply about 5% which we are working to reverse right now.

Right, and then, you commented to expectations that margin should improve, sequentially over the coming quarters as you take action, just, roughly how should we think about that? Can we kind of get back to the margin levels that we would typically expect with sort of more of a stable number?

Absolutely, mean, we're looking to get back to – at a bare minimum kind of being where we were for a year end gross margins during a down cycle on the high 20s, approaching 30. And it's a combination of – and we've already begun shift finding different suppliers of being able to go back to other suppliers that were lower cost and pricing. So typically, though, first quarter, is usually our lowest margin quarter because of the shutdowns in the US and in Europe. So I expect to see most of our pricing actions start in September and October. So I think the real improvement that you'll see probably be in the second quarter.

Okay, that's very helpful.

So we should be able to –

Sorry, you mean to catch up. Okay, that's very helpful. And then just on the development front, in your prepared remarks, you mentioned, your development of the marine hybrid line of products that you might be looking to take that into some of your other end markets. Can you maybe update us a little bit on what kind of adoption you're seeing or expecting to see for the hybrid product on the marine side and then kind of how we should think about that entering the portfolio for some [indiscernible]

Yeah, we're seeing it's fragmented. Certainly, we're seeing in a lot of urban areas in Europe, demand for hybrid tugs, so being able to operate in low speed mode on from the gen set or batteries. And particularly in marine what we're seeing hybrid in the sense of not diesel electric, for these type of tugs, but running off the gen set are running off of propulsion engines. We're seeing that for passenger ferries and then a lot of the canal boats, river traffic in Europe. And we're seeing that for tugs in the US and in Asia. So I wanted to say it's not a tidal wave. It's happening application by application. And we're seeing it both for the V-drives and for our current marine transmission product line, so it is. We are working as one team to develop the controls logic to be able do this across all of our products.

And then just on how quickly you could introduce a new fracking product?

We are working on current projects right now. I can't say when they're going to be in the field, but they're in development right now with end customers. And I would say this, we probably won't have one single solution it will be different solutions tailored to different customers. But what I'd like to say you'd see something this fiscal year, but I can't bank on that Noah, but it's sooner rather than later.

Okay, thank you very much for the color. I'll jump back.

Okay, thanks.

Thank you. And we'll take our next question, comes from Tim Wojs of Baird. Please go ahead.

Hey, gentlemen. Good morning.

Good morning.

Good morning, Tim.

So I guess just first question on the gross profit cadence, I just want to make sure I kind of get it in the right ballpark here. Were you thinking kind of high 20s, low 30s gross margin for the year or do you think that's more than run rate that you can exit the kind of back half of next year at?

Tim, I'll answer first. That's what I think. For this year that's where we're going to exit the year.

Okay, got you. That's helpful. Okay. And then you would you would expect it to be, probably down in Q1 relative to what we saw in the fourth quarter and then kind of build – much more of a step up in Q2 and then building into the in the back half the year.

Correct.

Okay, got you. Great, thank you. And then just a housekeeping question, how big was the North American oil and gas business in the quarter if you're able to say that?

I'll let Jeff give you the numbers, but almost all of our activity was aftermarket or rigs – units going into rigs that were taking out – replacing competitive product in existing rigs in the North American market. I think that was almost all that. I think we had maybe a handful of units that went into new rigs in the quarter, very few.

Yeah, that's right, yeah.

Okay, got you. And then when we think about just free cash flow for next year, Jeff, how should we think about – if you kind of look at working capital and kind of the – it sounds like you'll release some working capital maybe in the first half of the year with inventory. How should we think about just kind of a ballpark estimate of what free cash flow could look like in 2020?

It's always a tough one to answer and I know it's an important points. Yeah, we're certainly focused on bringing inventory down. We have inventory, as John pointed out, a big part of our inventory growth is in that oil and gas market. So a lot depends on the market dynamics there and how much we're able to move through, but we're certainly – we expect to be positive free cash flow quarter-by-quarter and certainly for the full year. But I would say something on the order of what we did in Q4.

For a quarterly number you're saying?

Yeah.

Okay, got you. Okay. And then, I guess last question here that I had. When we think through how you're thinking about kind of the oil and gas market in 2020 John, should we expect – do you think this is kind of the bottom quarter, I guess, Q4, did you think you start to see more rebuild activity in the first quarter and then kind of kind of building into the year? How would you kind of frame [indiscernible] in terms of – and when you think new could actually start to ship in a more meaningful way?

I'll start with your last question first. I don't see new rig construction happening in any meaningful way until calendar 2020. And I do think it – will our first quarter be like our fourth quarter. I expected – I personally – and driving for expected us – the first quarter will be a little bit better for our shipments to oil and gas for replacement. So I think that that should be better in the first quarter. But it could easily be the same quarter as the fourth quarter. I mean, it's because the activity requires some rework on the rigs. We're beholden to how they're doing on getting the rigs ready for the transmission. But yeah, it's going to be – my hope is that it's a little bit better, but it could be the same as the fourth quarter, but certainly we have the demand there for that growing replacement market

Okay. Thanks guys. Good luck. Look on next fiscal year.

Thank you. Thanks, Tim.

Thank you. And we'll now take our next question, comes from Ran Giesing of Neuberger [ph]. Please go ahead.

Hi, guys.

Hi, Ran

Hi, Ran

On the E transmission are you guys sort of like the third players in the market there, what's sort of currently available?

I mean, there are whole bunch of – well, there's two ways of looking at. You can do it with variable frequency drives or you can do it with a DC motor and a transmission. Obviously, we are – again, E frack is – when compared to diesel engine for frack, it's very expensive, high maintenance, but it is a growing option. So we are pursuing all avenues. But I would say our primary avenue is DC motor and using a transmission to control the shaft into the pump. So I don't think anything changes with the main players of kind of the three transmissions that are in the market. But again, we're building a team and expertise that we have at Veth on providing the best solution for our customers and we think the most cost effective. We think we hash this out in a few years that we will have a very compelling product portfolio solution for those who are looking to do E Frank?

Okay. As it relates to – it looks like the gross profit was down almost a little over 10 million quarter-on-quarter in Q4. You mentioned 9 million was for the mix issue. Just wanted to sort of confirm that? That's I guess the bulk of the down gross profit.

Yeah. The fourth quarter of last year, I'll let Jeff do the numbers, but was probably the height of new rig construction shipments for us and aftermarket rebuild. It was a – fourth quarter of last year was an incredible quarter.

Okay, perfect.

Yeah, we knew that was going to be a different comp when we printed it. So yeah, that's it. The mix is the big story.

Okay and what – it was if I just think of sort of like year fall loss where we're having inefficiencies, can you just sort of – is it how meaningful is that. I guess I'm trying to understand it. Obviously, you're getting in boarded from suppliers.

So Ran, the internal efficiency is it's twofold. Obviously, there are external factors and internal factors. Supply base not knowing what parts you're going to get in and we're trying to build what we can in each month because we're hand to mouth with a few suppliers is one issue. So it drives inefficiency if you're building one product and then you realize you're not going to get all the parts, and you have to pivot. Secondly and a big factor, we in that in the prior 18 months, I don't – you'd have to go back to the early 70s or kind of post World War II or when Twin Disc started, the amount of new people that we added in scene is the most I've seen in my career. And I know when I started, we hadn't had a hiring ramp up like that since probably the late 60s, early 70s. It just took a while to get people, trained and up to speed, particularly on some of our new products that are a lot more technical and more complicated to build. So I see that improving, all the employees have had six months to 12 months under their belt have been trained. So I see that efficiency, employee efficiency improving. But as we find alternate suppliers and get a more steady stream and we can bank on it, you'll see our efficiency, improve output and inventory start to come down. So I do believe we've turned the corner and you will see some improvement throughout the next four quarters.

Okay. The last question I had was if we think about your slice, I think you called it out and press release sort of 48% is marine, how do you feel like that – I'm hoping it's a grower as we head into '20. So sort of thinking like that, apples-to-apples for the acquisition. Is that a sort of a mid single digit grower you think as we look to '20?

I think our traditional product lines in the marine transmission product line and propellers and surface drives, I think that is a mid single digit grower. I think we have the opportunity to beat that with the Veth product line, provided that the markets in Europe remain stable. I see good growth opportunities in North America and Asia in the coming year. So I think we can beat that with the Veth product line.

Okay. And I guess I do have another question just popped up. Do you guys see in the next 18 months do it and other sort of non oil and gas, add on pipeline, such that you could do that or rather – obviously, you got some manufacturing things going on too so maybe?

That is the goal, I mean, we do want to bring – we do not want to take the eye off the ball on our Lufkin facility. I personally believe and management does believe that this facility can have as much of an impact to Twin Disc as the Veth acquisition. Getting the industrial products out of our 21st Street operation into a dedicated facility with a dedicated team, I think it'd be – when we look back a few years from now, it'll be as impactful to Twin Disc as the Veth acquisition was.

Okay, alright. Great, thanks for the update, guys. Good luck.

Thanks Ran.

Thank you. We'll now take our next question from Mario Gazelle of Gamco Investors. Please go ahead.

Hi, Mr. Bailey actually had to step into a meeting. It's Christina Bronec from Gamco Investors to take Mr. Gabelli's question. What is different this cycle from previous cycles? I know a couple dynamics have been touched on, but if you could just sort of summarize that would be great?

I really Christina are you talking about the oil and gas cycle?

Yes.

Okay. Well, I think the difference this time – the easy one is the price of oil is a lot higher. The last cycle we saw volume disappear because of pricing in Asia and North America, there wasn't a lot of rebuild activity. We weren't replacing competitive products with our 7600. But that is that has changed this cycle. We still see the price of oil remaining strong; we see a lot of activity; the equipment is being used and used hard. So we see continued rebuild activity on the horizon. And our order board for units to replace competitive product has never been higher. So I mean that gives us a little bit of optimism that this cycle will be better than that 2015, 2016 cycle.

Great, thanks so much.

Okay. Thank you, Christina.

Thank you. [Operator Instructions] At this time we have no further questions. Looks like we have no further question, so Mr. Batten, I'd like to hand the call back to you.

Alright, thank you, Ian. Thank you for joining our conference call today. We appreciate your continuing interest in Twin Disc and hope that we have answered all of your questions. If not, please feel free to call Jeff or myself and we look forward to speaking with you again following the closer fiscal 2020 first quarter. Ian, now I'll turn the call back to you.

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