Greetings. Welcome to the Twin Disc, Inc. Fiscal Second Quarter 2022 Earnings Conference. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. [Operator Instructions] Please note, this conference is being recorded. I will now turn the conference over to your host, Stan Berger. You may begin.

Thank you, Shamali [ph]. 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 2022 second quarter and first half financial results and business outlook. Before introducing management, I would like to remind everyone that certain statements made during this conference call, especially those statements that represent 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. 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; Jeff Knutson, the company's Vice President of Finance, Chief Financial Officer, Treasurer and Secretary. At this time, I will now turn the call over to John Batten. John?

Thank you, Stan and good morning, everyone. Welcome to our fiscal 2022 second 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 we go over the results, I'll touch on some of the operational highlights from the quarter. Looking at demand; as we mentioned in the press release, demand improved nicely across most of our markets. The biggest impact we saw was that our North American operations where our orders improved in industrial and transmission product lines. Our global marine demand for our North American-produced models remained flat at the factory as we still work through some of the inventory at our distributors'. But the market activity in our marine product line improved nicely in the quarter and we saw significant new orders at our European operations for those models. We also saw, looking at the market, in particular, continued elevated high demand in the Australian marine market, particularly pleasure craft. Nice unit orders for our marine transmissions and some other product lines that they sell into the market. And as I mentioned, we had a growing number of projects in the Asian, European and North American workboat markets. Continued application growth for our Veth product line, primarily in some new markets for them, the expedition-style mega yachts. That activity increased. The one activity, the one market that still is a little slow as the inland passenger vessel market. But as COVID wanes, we should see that market start to pick up in the calendar year. We did see some initial inquiries for some offshore vessels into Asia. That would be the first time in a long time that we've seen new project activity in any offshore markets. And as you shouldn't be…

Thanks, John. Good morning, everyone. I'll briefly run through the fiscal '22 second quarter and year-to-date numbers. Sales of just under $60 million for the quarter were up $11.3 million or 23.3% from the prior year second quarter and up $12.1 million or 25.4% from the previous quarter. The sales increase reflects continued growth in demand across our markets, as John mentioned, with shipment performance limited somewhat by supply chain challenges across all our locations. As noted last quarter, we've experienced a significant increase in lead times from our suppliers' unpredictable vendor delivery performance and difficulty in getting shipping containers. Despite supply chain challenges, strong demand and improved operational performance have resulted in a 46% increase in industrial product shipments, a 14.5% increase in marine and propulsion shipments and a 13.4% increase in off-highway transmission sales for the second quarter. By region, sales into North America were up 30%; sales into Asia Pacific were up 17%; and sales into Europe, up 5%, while foreign currency exchange was a net negative $1 million impact to sales in the second quarter. Through the first half, we are now 13.6% or $12.9 million ahead of the prior year. The second quarter margin percent was 22.5% compared to 18.3% in the prior year second quarter. The improved margin in the current year is a result of increased revenue and a more profitable mix of product, partially offset by the impact of inflationary pressures on cost as we have seen significant price increases across our supply base. We have taken action, as John detailed, to implement price increases and surcharges to offset these inflationary pressures going forward. And we'll continue to monitor this area very closely to identify any additional required pricing actions. Spending on marketing, engineering and administrative costs for the fiscal '22 second…

Thanks, Jeff. And now I'll just spend a quick moment on the outlook. Obviously, our backlog and project activity has improved significantly, both year-over-year and sequentially versus the first quarter and the end of the prior fiscal year. We are also anticipating improving conditions in North American oil and gas. Our challenge will be to match our internal and supply chain capacity to meet this improving demand. We have the inventory to meet the improving oil and gas trends in North America and we will be building in advance when possible to get ahead of this wave. Hopefully, in one of the next calls, we can highlight more hybrid and electrification applications that we've been working on with our customer base as they are testing it in their prototype process. The R&D and engineering activity has continued in earnest this fiscal year and we are extremely excited about the future developments in all of our markets with respect to hybridization and electrification. That concludes our prepared remarks. And now Jeff and I will be happy to take your questions. Shamali [ph], can you open up the line for questions now?

[Operator Instructions] And our first question comes from the line of Josh Chan with Baird. Please proceed with your question.

Good morning, John and Jeff. Thanks for taking my questions.

Thanks, Josh.

I guess first question on oil and gas. Clearly, the backdrop has improved. But I think this CapEx discipline is kind of the phrase for the industry in this cycle. And so I guess I was wondering, John, if you could talk about sort of the conversations that you're having with the customers? And how you think about the trajectory of when you might see orders within this calendar year?

Yes. So the conversations and the quoting activity with the OEMs is going on. And certainly, before we've ever historically looked back at every cycle, before we've had new rig construction, there's been a rebuild. And why we had seen a trickle of spare parts orders last, I would say, the first quarter of this fiscal year and in fiscal '21, the -- that activity has clearly picked up in the last couple of months. So if I go by empirical evidence from prior cycles, that would mean that there would be new unit orders and building in the next three to six months. And I think that we should -- I would expect to see new unit orders this fiscal year for us. Whether or not they come soon enough that we deliver them or the units are going to Asia this fiscal year but certainly, I see -- we will see orders improving within a quarter or two.

Okay, that's encouraging. And I think you mentioned in the press release that you have some completed products, right? So I guess would you be able to serve some demand immediately? Or how does that work?

Yes. We would be able to -- for the first few dozen, Josh, we would be able to react very quickly because we have somewhat of a very balanced inventory. Once we get out, the lead times -- they won't go to 12 months but there'll be a few months lead time once we get past the initial amount. But it's -- that -- as orders are improving in China, that ability to react quickly in North America is -- it won't be a month or weeks. It will be a couple of months on lead times. And that really, Josh, is driven by our internal capacity here on assembly and test and some parts we need from suppliers but we are on top of it.

Yes, absolutely. No, that's encouraging. I guess on the price increase and the surcharge side, historically, we haven't talked too much about it. So could you just talk about how that works? Is it broadly across all your portfolio? Does it hit immediately? And then maybe if you could fold in how much impact do you think that can have on your gross margin improvement in the second half that you kind of alluded to?

So typically, historically, for anyone, I would say, 60 or under, it's an annual price increase. We're no different than anyone. We have one price increase per year. You'd have to go back to the early '80s to find something similar where you are raising prices multiple times per year. Typically, we like to do it and give everyone advance notice that our -- a two month notice that our price is going to go up July 1. So we would announce that by May 1. We did that this year for a price increase in July. I think, like many people, we thought that, that -- what we announced -- two months ahead of time for July would be enough. But it became obvious in August, September that inflationary pressures had increased past that. So we had announced in, I think it was October time frame that we'd have another price increase in January. But really in that November time frame and into early December, the increase is particularly anything related -- a lot of our -- obviously, steel, whether it's forgings, castings, parts that we outsource, steel prices went up dramatically. So in that October-November time frame, we were getting more increases from parts suppliers that are providing us things that are just 100% metal that are high double digits. And that clearly had -- and it was effective on time of shipments. So it was basically -- we're getting it with a surcharge or a price increase. And you saw the impact of the timing of that in our second quarter. So our surcharge was effective on shipments as of January 1. And I know that, that is a bit of a shock because that's coming on top of another price increase. But the inflationary pressures starting…

Right. Right that makes sense. So the 4.5% surcharge, does that mathematically get you back to the sort of the mid- to high, maybe 20% gross margin in the back half? Is that a reasonable guess?

Yes. I mean, that's what we're looking, Josh, right, is that we should be north of 25%, the rest of the year. Obviously, the inflationary pressures will continue. So like John said, we'll need to continue to react to that. But that's what we're looking at is to get back to the -- certainly north of 25%, in the 26%, 28% range for the rest of the year.

Yes. And Josh, it's -- some of the increases coming in, it's not -- what we've implemented is, I would say, somewhat broad-based and surcharges on everything. I think we will be looking at specific product lines because the increases, it hasn't been on average. Some product lines have been hit harder than others; so we will be addressing that too in the next couple of months.

All right, great. Thanks for the color and thanks for your time [ph].

Thanks, Josh.

[Operator Instructions] Our next question comes from the line of Noah Kaye with Oppenheimer. Please proceed with your question.

Thanks for taking the questions. So just following up on price/cost commentary. You look at the six months backlog; what is the price cost for that? Is that a headwind to margins? Is it about neutral? And if you assume that sort of pricing initiatives you put in place are generally retained throughout the year, it's -- when does price cost turn positive?

Yes. Well, I think one thing to remember is that -- so what's in the backlog or what's the reported backlog doesn't reflect the price increase. But when those products are shipped, the price increase will be impacting that shipment. So technically, that backlog is going to be shipped at a higher price as of -- the 12/31 backlog will be shipped at a higher price. So I think generally, the backlog that we have is -- would be a positive impact to current margins. It will be trending up once that starts shipping.

Right. And so -- look, I mean, steel prices are elevated year-over-year. It started to back off a little bit. When would you start to see potentially, just based off of what we're watching with commodity indices, when would you start to see, potentially, a little bit of a relief or at least, stability on some of your key input costs? I mean, maybe just given other supply constraints, suppliers may not be cutting prices. But certainly, if the raw input prices are starting to back off a little bit, what would that mean for kind of your price profile?

Yes. No, I think we've -- I'm crossing my fingers and knocking on wood. I'm hopeful that the increases have stabilized and that we're flat. And I agree with you. What I've been reading is that hopefully, that steel prices will start to -- steel and fuel may start to back off a little bit and that we'll see some. But I still -- I haven't seen evidence of any price decreases, or I should say, surcharge easing for us. Haven't seen that yet. But -- and that's why a surcharge for us -- it's the first time in memory that we've done a surcharge. We typically just do pricing. But I think we recognize that some of these inflationary costs may be easing in calendar 2022. So that's why we elected to go with the surcharge. We think that it might turn back. But -- so we have that variable that we can ratchet back as we start to see those inflationary prices ease on us. But we've seen it stabilize, Noah. We haven't seen it improve as far as actual dollar costs coming down.

Great, helpful. And then, I guess, John, maybe a little bit of historical context around taxes spend in the oil and gas market in North America particularly would be -- may be helpful for folks here. You've seen over the cycles, obviously, a varying mix of new build versus repair versus replace in the field. Obviously, we got to some points over this past cycle, where there was almost no new construction-related activity. I guess, just, how do you see kind of the mix of spend trending as you're looking at the improving activity levels? And how does that kind of compare to the past period?

Well, we -- I would say, anecdotally, we have been told by several customers in different regions that they like to rebuild, let's just say, in that 25% to 30% range of their fleet. So if they're buying -- let's say, they're buying -- if there are going to be 100 rigs being built, they want to repair 25 to 30. That's -- I think, in an ideal situation, we've heard that. I don't know if we've ever seen that because we see the rebuild activity start and then a wave of new rig construction because it's faster. It's -- they're spending time and dollars on something that's brand new; so we'll see this time. I mean, if it's -- whatever the percentage is, it's very good to see the rapid increase in aftermarket parts. That means that they are bringing rigs back online that were sitting idle and we'll see. Usually, what happens is that demand of getting sideline rigs back online is not enough capacity for what's needed. And my sense is that, that's going to happen again. What is -- what's the amplifier from our aftermarket parts order to what our new rig orders? I don't want to predict it but it's certainly -- when you're coming off of several quarters of no new units going into North America, you know that this rebuild activity is signaling that they're going to be ordering new units soon for new rig construction.

Great. That's helpful. Thanks so much.

Thanks, Noah.

And our next question comes from the line of Robert Fitch, who is a private investor. Please proceed with your question.

Hi, good morning. If you can just elaborate on that last comment, what is your content per new rig, just in general ballpark?

So if a rig is $1 million to $1.2 million and there's probably -- I'm going from a year ago, so we're going to have inflationary pressure in there. A pressure-pumping transmission is going to be $175,000 to $200,000 of that. So not quite 20% but it's -- the big components are the engine, the pump -- the engine, the cooling system, the pump and then the transmission.

Okay. Can you talk also generally about the transition in your product lines, serving various end markets of the transition from diesel to electric and what the opportunity is there? Or is it cannibalizing some of the diesel products to a greater extent?

So we're exclusively off-highway. So it's -- the challenge for us in the hybrid and electrification is just the number of projects that you have to do to satisfy that. So we're not like an automotive manufacturer where you can design one electric powertrain or hybrid powertrain for a number of different vehicles. So what we do for one OEM on a crane, the solution may be different for what we do for a different OEM on a crane and those will be 10 to 12 per year. And then what we do for one boat manufacturer is going to be different for A, B and C. So there's a lot more engineering and effort required to get it. So -- but the opportunity is -- Robert, the opportunity is huge because our markets have been doing the same thing, relatively the same way for decades. A diesel engine, a gearbox -- the gearbox could be a manual gearbox with the clutch. It could be an automatic transmission with a torque converter. But by and large, it has been a diesel engine, a transmission, clutch, torque converter and then the driveline. And the engine has been the primary focus of whatever application it is. What's different now is -- and we'll see where the market takes us. But now it's -- the diesel engine for hybrid is still a significant part of it being able to generate the power and the electricity. But the other components are equally as important. So the gearbox has to take multiple inputs, whether it's from an electric motor or a battery pack or an engine. The control system is more complicated to manage all of that. So it's exciting; it's redesigning the commercial off-highway markets and marine markets. But it's challenging, because there's only…

Understood. With your broad customer base, though, do they pay you for the engineering for products that may be customed to their needs?

Yes. Robert, it's different in each market. A lot of it right now and that's a model that you're trying to perfect is how you get paid for that. Some of the first -- I would say we've been all over the map but we've been paid for engineering. A lot of these initial applications, they're joint development projects. So we're learning as the OEM is learning. And so whether -- it depends on the application. If there's significant volume on the backside, you just amortize those engineering costs over what you ship. But one of the things that's also important is picking the right customer. You got to pick the winners. So you got to pick -- know our customers, know our markets and know -- and being able to analyze what they're trying to do and work with the customers and the OEMs and their products that you know are going to be a market success. So, that's also one of the challenges that everyone's facing right now is the timing of when certain markets will accept the increased cost of these hybrid and electric systems.

Did you mention what level of cash flow you expect this year and next?

We've been trying to stay free cash flow positive. The quarter -- the second quarter was a little short of that. Year-to-date, we're a little short of that. So we expect to be cash flow positive -- free cash flow positive in the second half despite what should be a ramp-up of capital spending as some of the things that are on order start to arrive, so in the single-digit millions free cash flow positive in the next few quarters.

I was going to say is working capital the greatest pressure on how much is for you or not in the next 12, 18 months?

Yes. I mean a lot has to do with -- that number could get significantly better depending on the level of North American or 8500 demand for fracking rigs and transmissions. We can liquidate and turn a lot of inventory into cash if that demand ramps up, right? We have demand. The demand we have would support, what I -- I just projected. But yes, inventory is really the one lever that can make that number better.

And should you begin to approach a couple of turns of inventory annually again?

Yes. Yes. Certainly, as we exit this year, I think we should be there.

And do you have a variable outlook related to your U.S. versus non-U.S. business?

They're such different businesses. It's hard to give a quick answer to that. I mean they're all -- they're very different markets. Obviously, that Asian oil and gas market has been stable and consistent through the last two years, probably our most stable market. Australia is -- the Australian pleasure craft market has been growing. I think it's up 40% over the prior year. So it's a little bit all over the map, I think but everything is going in the right direction, just at varying degrees. I think the North American marine is probably the one that isn't hitting where we think it should be yet, I think, because of the buildup of inventory at our distribution locations. But I think we expect that to start catching up as well. I don't know if that answers your question.

Yes, that's good. Outside of oil and gas, kind of what kind of end markets do you feel best and/or most visible about as you kind of look out in the intermediate term?

I would say the most positive, just our global marine markets. Our orders on our European operations improved significantly both in the first quarter and the second quarter. Industrial with the operation in Lufkin has seen a tremendous increase in new unit orders. We have a team down there focused on that market. So feeling -- Robert, feeling good about all our markets, the one that -- and I mentioned at the beginning, is just offshore oil and gas has been very, very slow. But I'm hoping to see some activity. And then there's been an announcement of some wind farm activity down in the Gulf. So it's -- I'm hopeful that there will be activity there for vessels going out. So, I just -- everything -- Jeff said it, everything is pointing in the right direction. It's just that some are moving faster than others. But I would say most confident, the recovery of our Global Marine market just beyond the transmissions that are produced here in North America. Our industrial business is seeing strong demand growth. And I do think we're going to -- there'll be another wave of North American oil and gas sometime this calendar year. So feeling good about that.

Okay. Just last two questions. Should we expect any growth in the next year to be principally or solely organic?

Certainly, in the next -- I would say, in this fiscal year, in the next few quarters, the growth will be almost exclusively organic. And by organic, I could also -- things that we're buying from partners to include in our hybrid and electrification systems. So beyond just an organic -- we don't manufacture it inside but it's part of the system that we're buying and reselling. I think you might have to go out beyond that window a little bit to see something more in the M&A activity.

Okay. And lastly, just on the labor front. Are there constraints to your growth, either at the manufacturing or at the, say, admin and engineering level?

Say, definitely a concern is being able to grow the workforce here in Racine. It's been in Southeastern Wisconsin, finding -- sometimes we feel like a duck swimming upstream. There's a lot of activity on the feet going underneath the water, just replacing retirements here. But we also have Lufkin. Yes, it's the challenge. And then the ones that are just one step removed is -- I can't -- just -- it's hard to express the supply chain issues with quarantines and people being out sick, everything -- finding out last minute. I think that's getting better, Robert. But if there's one -- yes, the one that we have to work on the hardest is making sure that we have the people in the shop to make it all happen and get product out the door. And that will be -- and it's really being sure that we have everyone available 100% of the time. I think we've crested there and that's getting better. It's being able to add workforce, both here and in Lufkin. Doesn't seem to be as much of an issue at our -- the global operations. It's been, honestly, more of an impact here in North America than it has been in other parts of the world.

Okay. And I guess I wasn't honest. I got one more question. Obviously, you guys have been quite cyclical over the years. But can your assets and staff -- can you largely support sales and revenue levels that you've had any time in the last 10, 15 years without meaningful capital spend?

It will take -- I would say not -- if we can get the machine tools that we've planned for this year and next year, I think our capital spend can do it. We're spending more time on developing supply chain strategies on partners outside of our four walls to supply key components. But to support growth back to our prior level and that -- it is a very good question, we will need more internal capacity on assembly and test and primarily in North America. So we'll need to find those resources either in Racine or in Lufkin to get back. So yes, we need to increase both capital and we need to increase headcount within our four walls are two things that we have to do.

I appreciate your frank responses. Thank you very much.

Thanks, Robert.

And we have reached the end of the question-and-answer session. And I'll now turn the call back over to CEO, John Batten, for closing remarks.

Thank you, Shamali [ph] and thank you, everyone, for joining our conference call today. We truly appreciate your continuing interest in Twin Disc and hope that we have answered all of your questions. If not, please feel free to call either Jeff or myself and we'll get you your question answered as quickly as possible. And we look forward to speaking with you again following the close of our fiscal 2022 third quarter. Shamali, I'll turn the call back to you.

Thank you, John. And this concludes today's conference and you may disconnect your lines at this time. Thank you for your participation.