Good day, ladies and gentlemen, and welcome to the Twin Disc, Inc. Fiscal First Quarter 2020 Earnings Conference Call and Webcast. Please note, today's conference is being recorded. At this time, I will turn the conference over to Mr. Stanley Berger. Please go ahead, sir.

Thank you, Holly. On behalf of the management of Twin Disc, we are 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 2020 first quarter 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 2020 first quarter conference call. As usual, we will 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'll touch on some of the operational highlights from the quarter. As we previously mentioned in the prior call, we faced several supply challenges in the run-up of the 8500s in fiscal 2018 and 2019. 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. This coupled with some key suppliers who went out of business resulted in quick decisions just to maintain supply and resulted in higher prices on some key components for our marine transmission, RF transmissions and newer oil and gas models. I'm happy to report that between a combination of pricing and component cost reduction, we are just beginning to see the effects of our cost reduction efforts. While many of the wins have come from finding new suppliers, other wins have come from the improved efficiency of our new CapEx equipment recently installed in our plant here in Wisconsin. Assuming a static mix and volume going forward, as an example, we would expect to see improved margins going forward over the next 4 to 8 quarters as we bring the new supply sources online. We will also address other cost drivers, such as overhead and make the necessary adjustments. Now I'll turn to a couple of our key strategic objectives for a moment. We continue to drive actions and strategies that will limit our exposure to deep oil and gas cycles and prepare us…

Thanks, John, and good morning, everyone. I'll briefly run through the fiscal '20 first quarter numbers. Sales of $59.3 million for the quarter were down $15.4 million or 20.6% from the prior year first quarter. The quarter decline is the result of a significant reduction in new build activity in the North American fracking market, along with the related reduction in aftermarket activity. This accounted for $14.8 million of the first quarter reduction in sales and is the continuation of the slowdown we saw in the fourth quarter of fiscal '19. While this important market is in a temporary pause, we continue to see solid growth in our industrial markets. Global industrial volume was up 5.9% over the prior year first quarter, following 10% growth in fiscal '19. Global sales of marine and propulsion products were down 3.5% from the prior year first quarter, primarily on project timing. We continue to see strong project and quoting activity in the global commercial marine market and anticipate increasing volumes as we work through fiscal '20. The first quarter margin percent was 16.3% compared to 32.1% in the prior year first quarter. Our gross margin performance for the quarter was severely impacted by a continuation of the unfavorable product mix experienced in the fiscal '19 fourth quarter with lower fracking demand for new rig construction and reduced aftermarket demand being the primary drivers. In addition, we recorded a $3.9 million charge to address a product performance issue on our high horsepower fracking transmission associated with the unique set of application characteristics. This charge is intended to cover the entire population of impacted units, and we estimate that $2.6 million of the cost will be addressed with existing inventory, resulting in a net cash impact of approximately $1.3 million. Excluding this charge, gross profit…

Thanks, Jeff. Now I'll spend a quick moment on our outlook. We know the main question on everyone's mind is the timing or return of new rig construction in North America and what, if any, effects political promises to ban fracking will have. Both are good questions. I do believe that the effective horsepower is much lower than most people believe and it could go lower. If prices and demand improve, I think you could see a rebound in mid-2020. Some of that growth, 10% to 15% potentially, may be E-frac solutions, and we are ready for those type of applications. With respect to political promises to ban fracking, I don't see how that can be universally implemented beyond federal lands. If somehow it were, the net cost of energy for everyone would soar. And I don't think people realize how widespread pressure pumping is for oil and gas production and completion. 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 ahead of us, and these should begin to improve going forward in the next few quarters. We continue to explore further opportunities to grow our industrial business and enhance our hybrid development. That concludes my prepared remarks. And now Jeff and I will be happy to take your questions. Holly, please open the line for questions.

[Operator Instructions] Our first question today will come from Noah Kaye with Oppenheimer.

I guess maybe just to start with the discrete product issue that drove the charge you mentioned that was a function of maybe a customer-specific application. Can you give us just a bit more color on the application and really what drives your confidence that the issue is kind of confined here and buttoned up?

Well, it's, Noah, I'll give you some details. I can't give you all the details because there are other components involved. But it really is, I would say, an extreme application, highest horsepower, highest pressure and the highest usage rate per day. So generating the most hours in the shortest amount of time. And just the application in general, where there's other things like torsional vibration, alignment, things that there are multiple people, multiple suppliers involved in. And it really is sitting down and addressing how could this overall rig last longer, and then it has. It is, in many cases, well exceeding our warranty period, but it is not living up to the expected life of our transmission and some other components. So it really, to Jeff's comments, it covers almost every potential unit out there. So we're being conservative in our estimate. And we're addressing it by, it is something that we can address on a rig without having to pull our transmission.

Okay. And then just on the sort of the strategic actions to improve margin. You kind of listed a number of different items here. I guess if we just sort of add this all up, what, any way to think about kind of order of magnitude in the static demand environment? And maybe what really are kind of the biggest drivers here of margin improvement?

Sure. So just to answer, how to answer it first. I would, the goal, Noah, is to exit the year in the high 20% gross margin. I don't know if we'll get to 30%. But there's a very good chance we'll get to 28%. And a lot of that has to do is, so we've had, and I mentioned in the call, the ramp-up of oil and gas in the 8500s, we did not, very honest, make the best sourcing decisions with respect to costs. We were looking for quality and availability. And a lot of time, we've obviously clearly brought in too much 8500 inventory for the moment. That, so moving other products for our marine transmission and RF to other suppliers to free up capacity for 8500 resulted in net cost increase. We had a couple of key suppliers, primarily for castings, that went out of business. And there, we were scrambling just to find some shops that had availability, oftentimes, with significant cost increases. I'm happy to report that that's where we found the first impact because we never, we moved the castings, but we didn't stop. We immediately were looking for new sources because we knew the costs have gone up significantly. We're just now seeing production volume of these castings at a much lower price coming through the door. So you're going to see steady improvement over the next few quarters with cost decreases based on components that we found newer sources for or that we've brought back inside, and we can do it less expensive. That's one driver. Second driver, our cost increase, price increases on some of our RF transmission models and lower horsepower oil and gas models. Those are going into effect, I would say, starting this quarter, late this quarter and early next quarter. So we'll have pricing improvement, cost improvement. Those would be the, I would say, no, those are the 2 main drivers. You'll see some, we have, aftermarket is operating more efficiently. Once we get the industrial product out, this will greatly improve efficiency at our plant here in Racine, and we'll be able to adjust overhead accordingly. The ratio, particularly, the ratio of direct to indirect, we have, I would say, we still have a lot of indirect temps. I would say the plant here is still very full, and we spend too much time moving inventory around. So it's going to be a combination of all 3 of those. But the immediate effect that you'll see will be roughly 50-50 on margin improvement due to lower cost of components and higher prices.

Great. I appreciate that. I guess on the demand environment, you obviously are seeing stability now in the backlog. And I think with respect to marine, you commented on kind of continued positive direction for quoting and demand. Just kind of wondering because as we continue to hear about macro uncertainty impacting CapEx broadly, right, this is a global theme for industrial. Just how would you characterize marine spending trajectory. And can you give any color on how the portion of your backlog, specifically relating to the marine end markets, has been trending?

Sure. I would, the new dimension for us is Veth because they typically are, to put it in perspective, a small order is several hundred thousand dollars, a big one is over $1 million a project for a vessel. So when you have a $60 million business, each order is a big chunk. And that activity has remained constant, it's actually because, in Europe, but we're getting more and more interest and more and more project development in Asia and North America. So that's what I think gives us confidence that even in a stagnant market, we have the chance, or a declining market, if it were to decline, we have a chance to remain flat or increase our sales. It's a little bit tougher to say on just our traditional business, particularly here out of Racine, which is definitely more, particularly in North America and in Asia, actually, is more tied to the overall economy. So as long as the economy is doing well, and people are confident, I expect the marine, our domestic marine transmission market, where it is right now, to remain, to reflect the trends. If it were to, if things were to decline in the macroeconomic environment, I think you'd see a slight decline in our marine transmission backlog.

Okay. Great. And if I could just squeeze one more in before turning it over. IMO 2020 implementation beginning on January 1, are you seeing any impact on demand or mix, really? Any shift to battery, electric or any other alternative marine fuels? Or is there any color you can give on how maybe this is having an impact on what would normally be business as usual?

I would have to get back, I will dig into more details. But every month, Noah, every quarter, there are more and more hybrid applications coming up. What is both good and bad in marine, for us at least, is it's not a Toyota or a Honda or a GM, where they can design one solution and throw it across 3 or 4 platforms and sell millions of vehicles. You're dealing with a design for each boat builder, each owner. So it's a lot more work for each application. But absolutely, any customer of any size in any market is exploring, particularly in marine, a hybrid solution, not, or diesel-electric solution. And it's absolutely being driven by environmental concerns, emissions. In many cases, there are tax incentives to do it. So part of it is economic. But it's hard to design one solution that fits all. So it's, we're doing, I think we're doing a very good job with Veth on designing a control system that can go across multiple models, and we're designing each one of our marine transmissions to be able to simplify with plug-and-play. We want to be able to react to a multitude of hybrid diesel-electric solutions in the marine market or any of our markets. So that's a lot of where our product development and thinking is. We know, particularly, it's going to go hybrid. And we want to be ready. We also want to be ready if it goes purely electric. But in a lot of our marine markets, purely electric is difficult to achieve.

Yes. Yes, understood. I'm sorry, just one quick housekeeping one, I apologize. Any chance, Jeff, you could provide the revenue breakdown for manufacturing and distribution and eliminations in the quarter?

I don't, yes, one second. I do have that information currently. So it was, for the quarter, round numbers, $55 million manufacturing, $22 million distribution and about $18 million in eliminations.

[Operator Instructions] Our next question will come from Josh Chan with Baird.

I guess my first question is on the backlog. Would it be fair to think of your kind of backlog right now as predominantly marine and industrial? And if you were to get any improvement in oil and gas that would be kind of on top of what the number is right now?

Yes. Yes, absolutely.

Okay. And so then, I guess, on the oil and gas potential improvement. I mean you guys mentioned that you're continuing to quote projects. So what are you hearing from your customers in terms of how they're thinking about timing and what that is dictated by, I suppose, over the next couple of quarters?

Josh, it's John. We still have a small, we call it, of what the overall peak was in Asia. So we have continued projects going on in Asia. I would say in North America, it's, the capacity, I think the pipeline issue out of the Permian is being addressed. I think, honestly, it's, again, different for each person I talk to, each company. But it's price stability and cost and cash flow. I think, I do think you're going to see the effective horsepower continue to decline in the North American fleet. So if there's any improved demand in pricing, I think, sustained, I think you'll see the faucets turn back on, on new rig construction. But it's not something I see in the next quarter. Maybe 2 quarters out, middle of 2020. But again, the problem is, is that if we get there, we get closer to a general election. So we'll see, Josh, but I don't see it getting much worse than it is right now on new rig construction in North America. But the rigs, again, everything that can, everything that, all of our equipment is being used almost every single day.

Right. Okay. Yes. And on the charge, I just wanted to make sure that, is it the expectation that there wouldn't be a similar charge in the next quarter? And then also, just the mechanics of it. If you kind of took it against the inventory, would that mean that when you sell that inventory, you would have lower gross margin? Just kind of how would that kind of flow through.

Yes. So no, we wouldn't be selling the inventory. We would be taking inventory out to replace the components that need to be replaced in the rigs. So it would be a reduction in inventory and an offsetting reduction to the accrual that we made. That accrual was intended to cover the population of impacted units. So yes, based on what we know today, we don't anticipate an additional charge.

Anything else, Josh, I think would be covered under our normal warranty spending, warranty accrual. If something else, that we don't know about today. But that would, yes, that would be it.

Okay. That's great. And then last question is, is this still the expectation that you might be able to generate positive free cash flow this year based on how the first quarter has gone? What are your thoughts there, Jeff?

Yes. It's going to be tight, right? I mean, we had a little bit of, I would say, accelerated timing in CapEx just in terms of timing of deliveries of machines. So that should ease somewhat on average over the rest of the year. I'm confident we're going to see some inventory reduction, but a lot of that depends on what the market does. So I think we have a good chance of being positive free cash flow. I would say, for the rest of the year and for the full year, breakeven, I think, is a reasonable target.

Yes. I would say if we weren't bringing Lufkin online, we would be. But that is a strategic imperative for us to get that up and running.

And at this time, we have no further questions in our queue. I'll turn the conference back over to our speakers for any additional or closing remarks.

Okay. Thank you, Holly, and 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 close of our fiscal 2020 second quarter. Holly, I'll now turn it back to you.

Thank you. And ladies and gentlemen, that does conclude our conference for today. We thank you for your participation.