Park-Ohio Holdings Corp. (NASDAQ:PKOH) Q2 2022 Results Conference Call August 3, 2022 10:00 AM ET
Company Participants
Matthew Crawford – Chairman, President and CEO
Patrick Fogarty – VP and CFO
Conference Call Participants
Steve Barger – KeyBanc Capital Markets
Yilma Abebe – JPMorgan
Operator
Good morning. Welcome to the Park-Ohio Second Quarter 2022 Results Conference Call. [Operator Instructions] After the presentation, the Company will conduct a question-and-answer session. Today’s conference is also being recorded. If you have any objections, you may disconnect at this time.
Before we get started, I want to remind everyone that certain statements made on today’s call may be forward-looking statements as defined in the Private Securities Litigation Reform Act of 1995. These forward-looking statements are subject to risks and uncertainties that may cause actual results to differ materially from those projected. A list of relevant risks and uncertainties may be found in the earnings press release as well as in the company’s 2021 10-K, which was filed on March 16, 2022, with the SEC. Additionally, the company may discuss adjusted EPS and EBITDA as defined. Adjusted EPS and EBITDA as defined are not measures of performance under generally accepted accounting principles. For a reconciliation of EPS to adjusted EPS and for a reconciliation of net income attributable to Park-Ohio common shareholders to EBITDA as defined, please refer to the company’s recent earnings release.
I will now turn the conference over to Mr. Matthew Crawford, Chairman, President and CEO. Please proceed, Mr. Crawford.
Matthew Crawford
Good morning, and thank you for joining our second quarter 2022 call today. As I mentioned in our press release last night, we’re pleased with the revenue acceleration across the business. The broad nature of this growth and the contribution of new business as well as the resurgence in markets that have been struggling until recently, most notably rail, aerospace, oil and gas, which all showed improved results bodes well for the balance of the year. Zooming out a bit, we see 2 additional positive signs on the horizon.
First, we believe that most of our end markets will benefit from an improving supply chain environment over the next year or so as our customers seek to restock their inventories. We do not believe a deep recession is a base case for our end markets at this time. But regardless, any reduction in demand caused by the Fed tightening cycle should be offset by the restocking demand at some level.
Secondly, we are watching with the close eye of the federal government’s legislation which targets businesses and infrastructure investments. While it’s too early to foretell all the specifics, we may benefit in a variety of ways. A few include: first, increased investment in semiconductor production will benefit directly a number of our supply technology customers.
Second, green energy and particularly electric cars, wind turbine energy and the de-carbonization of the industrial sector will also benefit most significantly our ACG and our Engineered Components segment.
And three, broad investments in infrastructure related to rail, roads, bridges and grid will touch a wide portion of our business. Despite this revenue momentum, earnings fell short of our consolidated expectations. Inflation, logistics and labor challenges continue to be every day to be in every day and continuing challenge for the business. Supply Technologies, whose active part numbers reach well over 100,000 SKUs, has continued to leverage strong supplier relationships and a significant incremental inventory investment to battle these challenges and fulfill record customer demand.
Our Engineered Products group has worked similarly hard to manage record backlogs and secure important materials to complete jobs. Assembly Components has been the most affected due to unique challenges and volatility of the auto supply chain. We’re addressing these challenges with significant restructuring, which will reflect a lower cost structure and increased pricing from our customers where inflation has impacted us most. Since many of these actions take 3 or 4 months to impact our profitability, we anticipate market improvement in the second half.
Lastly, we’re happy to have closed on 2 acquisitions recently. As most of you know, we have grown significantly over the years through deals and believe not only do these transactions fit the mold of our most successful but also pay vigorous attention to where we see the most long-term opportunity for Park-Ohio and will be accretive to our gross margin and our bottom line immediately. Thank you as well to all of our teammates. These last couple of years have been filled with challenges, and I appreciate the hard and smart work fruits of this effort. With that, I’ll turn it over to Patrick to cover the results.
Patrick Fogarty
Thank you, Matt. Before I review our second quarter results, I want to discuss the 2 strategic acquisitions for our Supply Technologies segment, which were completed subsequent to June 30. The first acquisition of Southern Fasteners based in North Carolina which supplies commercial fasteners and industrial supplies throughout the United States. Southern specializes in the design of customized inventory management programs for its customers in several end markets. Southern is a great complement to our Supply Technologies business and will accelerate our industrial supply growth initiative, which is centered around delivering MRO products to our OEM customer base.
The second acquisition is Charter Automotive, which is strategic to our fastener manufacturing business and its location in China. Charter is a manufacturer of auto components and will help accelerate the global growth of our proprietary [indiscernible] technology to our U.S. OEM customer base in China and the growth of electric vehicle production throughout the region. The combined revenues of these acquisitions are approximately $40 million annually, and both will be immediately accretive to our operating margins and earnings per share. The combined purchase price is approximately $30 million and includes deferred payments that will be paid over 2 years.
Now to our results for the quarter. Our second quarter results were highlighted by solid performance in both our Supply Technologies and Engineered Products segments driven by strengthening end market demand, strong capital equipment and aftermarket backlogs, increased product pricing and implemented operational improvements.
For the second quarter in a row, we achieved record revenue levels in Supply Technologies and revenues in Engineered Products were at their highest level since the first quarter of 2020. Despite the positive results in Supply Technologies and Engineered Products, our results in our Assembly Components segment were negatively affected by restructuring charges during the quarter and ongoing increases in raw material costs.
The onetime restructuring charges relate primarily to the downsizing of one of our aluminum plants and the completion of our plant consolidation of one of our fuel products facilities. Also, we have finalized price negotiations with several customers and are negotiating several other price increases in our fuel and rubber products businesses which we expect to positively impact our segment results in the second half of the year.
In the second quarter, our consolidated net sales were $429 million, up 22% compared to the second quarter of last year. Higher sales levels were driven by increasing customer demand across all 3 segments and in most key end markets, improved product pricing and increased production in our industrial equipment business. Our gross margins in the quarter were 11.6% compared to 11.4% in the second quarter of last year. On an adjusted basis, our gross margins were 12.6% in the quarter, an improvement of 100 basis points compared to the second quarter of 2021. SG&A expenses were $45 million compared to $43 million a year ago, with the increase due to higher selling expenses from the higher sales levels and general inflation, which has impacted costs in each of our segments.
As a percentage of net sales, SG&A expenses were down from 12.4% a year ago to 10.5%. During the second quarter, in connection with the consolidation of our pipe threading equipment operation in our Engineered Products segment, we sold the related real estate for net proceeds of $4 million and recorded a gain on the sale of approximately $3 million which is excluded from adjusted earnings per share. Interest expense totaled $8.3 million compared to $7.4 million a year ago with the increase driven by higher average borrowings driven by increases in working capital to support the higher sales levels.
Our effective tax rate in the quarter was 32%, which included a discrete expense item which caused the rate to be higher than the full year expected rate of approximately 25%. GAAP EPS for the quarter was $0.08 per diluted share.
Adjusted EPS, which excludes $5 million of onetime charges and the gain on the sale of the real estate was $0.21 per share in the quarter. In addition, our results in the quarter were negatively impacted by currency fluctuations compared to a year ago, which, in the aggregate, reduced EPS by $0.05 per diluted share.
During the quarter, we used operating cash flow of $28 million to fund higher working capital levels driven by the sales growth in each segment. We expect free cash flow to be positive in the second half of the year as net working capital days begin to decrease from current levels. EBITDA is defined more than doubled year-over-year and improved to $52 million year-to-date compared to $40 million a year ago. We continue to focus on increasing free cash flows in each of our business units and expect net debt balances to approximate current levels after considering the 2 completed acquisitions. CapEx in the first half of the year totaled $8 million and $15.5 million respectively. We continue to expect full year CapEx to be approximately $30 million.
Our liquidity at the end of the second quarter was $200 million, which consisted of $61 million of cash on hand and $139 million of unused borrowing capacity under our various banking arrangements, which included $29 million of suppressed availability. During the second quarter, we increased our revolving credit facility to $405 million from $375 million based on the strength of our current collateral base. Our outstanding borrowings under this agreement totaled $288 million as of June 30.
Turning now to our segment results. In Supply Technologies, net sales were a record $176 million, up 4% over the previous record set last quarter and up 13% compared to last year’s second quarter sales of $155 million. Sales were strong across most of our end markets throughout the United States and Europe in spite of currency headwinds, which impacted sales by approximately $10 million in the second quarter. Average daily sales in our supply chain business increased 18% year-over-year driving the overall segment sales record. During the quarter, we saw significant year-over-year sales growth with significant increases in heavy-duty truck, semiconductor, industrial and agricultural equipment and civilian aerospace. In addition, our fastener manufacturing business continues to perform well and is seeing increasing sales and strong operating margins as customer acceptance of our proprietary self-piercing and clinch products continue to gain traction with the OEMs around the world.
Operating income in this segment totaled approximately $12.7 million in the current quarter, an increase of $2.5 million year-over-year. Operating margins were 60 basis points higher than a year ago, driven by the profit flow-through from the higher sales levels and successful customer pricing strategies as we continue to recover a high percentage of our increased inventory costs with customers in this segment. We expect continued strong sales in most key end markets throughout the second half of the year in spite of the ongoing supply chain challenges, which may impact customer demand and production schedules. In our Assembly Components segment, sales for the quarter were $154 million compared to $110 million a year ago, an increase of 41% year-over-year.
Sales in the current quarter were higher primarily due to increased volumes from new fuel-related business launched in 2021 and increased customer pricing, which included the pass-through of higher raw material and operating costs. The segment operating loss was $7.5 million in the second quarter compared to a loss of $6.1 million last year. On an adjusted basis, excluding the onetime charges related to the restructuring of certain plant operations in our aluminum and fuel products businesses, our adjusted operating loss in this current quarter was $3 million, an improvement from an adjusted loss of $5 million a year ago. Operating losses in this segment were a result of the ongoing negative impact of increasing raw material costs primarily rubber compounds used in several products as well as general inflation on most operating costs.
For the remainder of the year, we expect to generate positive operating income in this segment, driven by agreed upon customer price increases, which take effect in the third quarter and reduced operating costs resulting from our restructuring activities. In our Engineered Products segment, second quarter sales were $99 million, up 15% compared to $86 million a year ago and at their highest level since the first quarter of 2020. In our capital equipment business, sales were up 11% compared to a year ago as customer demand for our equipment continues to be robust. New equipment bookings in the first 6 months of this year totaled $122 million compared to $85 million in the first half 2021, an increase of 44%. The Equipment backlogs totaled $162 million at the end of June compared to $121 million at the end of 2021.
In our Forged and Machine products business, sales in the quarter were also at their highest level since the first quarter of 2020 as several key end markets continue their recovery, including oil and gas, rail and commercial and military aerospace. Sales were up 27% year-over-year, and we expect orders to continue to trend higher in the second half of the year. During the quarter, operating income in this segment was $7 million compared to an operating loss of $1 million a year ago. The profitability improvement year-over-year was driven by the higher sales levels, implemented operational improvements and product pricing initiatives. We are clearly seeing the benefits from cost reduction actions taken in prior quarters which includes the consolidation of our crop forge facility into our Canton Drop Forge operation and the significant operational improvements in our forging plant in Arkansas.
For the remainder of 2022, we expect continued year-over-year improvement in sales and operating income in this segment as we convert our strong capital equipment backlog into sales and from the recovery in certain key end markets in our forged and machine products business.
And finally, corporate expenses totaled $7.5 million during the quarter compared to $6.8 million a year ago, the higher expenses in the current year were driven by higher personnel costs and incremental professional fees in the current period. And finally, with respect to our 2022 guidance, we continue to expect revenues to be at record levels for the full year with year-over-year revenue growth of approximately 15%. In addition, we expect significant improvement in profitability for the full year 2022 compared to last year. And we also expect our third and fourth quarter adjusted net income to improve sequentially compared to the second quarter.
Now I’ll turn the call back over to Matt.
Matthew Crawford
Great. Thank you, Pat. As you can see, we’re excited about the short-term and long-term trends around revenue. Our earnings have been playing a little catch up to that, but we like the trajectory and expect enhanced performance in the second half and some of the actions we’ve already taken start to yield some benefit. With that, we’ll ask for questions.
Question-and-Answer Session
Operator
[Operator Instructions] Our first question is from the line of Steve Barger with KeyBanc Capital Markets.
Steve Barger
Matt, you brought up restocking in your prepared remarks. How real or maybe better said, how broad do you think the restocking trend is based on what your customers are saying about what they need for parts over the next 6 to 12 months?
Matthew Crawford
Great. Steve, yes. No, I think that we’re beginning to see some broader news cycle on that issue. So broadly, I think that certainly, we’ve seen a pretty well documented discussion in the auto industry regarding what they expect in terms of restocking. So I think that, that one is fairly well documented and understood. I think around the rest of the business, I think we continue to see very strong expectations from our customers in terms of their build rates going out through the rest of the year and even into early next year. Some of that, of course, is based on continuing expectations around demand, but some of that is also related. Some of our key customers, you don’t have to do much besides drive by a dealer a lot to notice that their lots are empty. So whether it be specific information from customer build rates, looking out through the rest of the year, anecdotal evidence we see relative to inventories they’re holding in auto and other industries. I think we feel pretty confident that they’re anxious to get some more product on their shelves, so to speak.
Steve Barger
That’s great. And it’s really good to see a step up in Engineered Products margin. I know a lot of heavy industries you serve have big backlogs like railcar and aerospace. For the casting side specifically, since you consolidated that, how much operating leverage is in that business or what does incremental margin look like as production picks up there?
Matthew Crawford
Yes. I’d comment first, we do appreciate some of the traction in the equipment business in the Engineered Products group I know that’s not where your question went, but that has traditionally been our highest margin segment. Those who are may be new to the company haven’t seen that level of performance.
We have put a tremendous amount of effort into restructuring there. It is not complete, but we’re beginning to see the benefits of it. So I think that we’re quite excited, I think, between the restructuring and the backlogs, we anticipate that to return to a margin leadership position. It’s also an area where we have tremendous brand loyalty around our aftermarket services.
That’s one of the highest margin profile businesses the throughout Park-Ohio. So no, I’m not surprised to see that take a leadership position. Clearly, that’s been the business most affected by rail and aerospace and oil and gas seeing some stabilization there will benefit it as well. So that is not a surprise to us, albeit we’ve been anxious to see it. We expect that to continue to show traction, not just this year but going into next year as well. So yes, in terms of that. In terms of general aluminum, Pat, do you want to take on the incremental operating leverage question.
Patrick Fogarty
Sure. Steve, I’d expect our flow-through from all the restructuring that we’ve done to impact the business and put our operating income margins back to historic levels. Now we don’t expect to see that throughout the course of this year as the restructuring is being finalized. But as we move into next year, we would expect margins to get back to where they’ve been in the past. The pricing on raw material affected this business more than any other segment of our business. We expected that. We’re starting to see aluminum prices begin to come down and hopefully stabilize as we enter into 2023, which will be positive for this business. We’ve been able to negotiate price increases. That effort is never done. We continue to work with our customers to improve pricing, not only on the aluminum casting side, but also on the fuel and the rubber products side. This process takes a lot longer than any of us would like, but we’re working through with each customer, improved pricing so we can get to the returns that we expect in this business, which is north of 8%. — and that would get us back to historic levels.
Steve Barger
Yes. Matt, I know my question probably threw you off your game because I asked about Engineered Products and then I said casting. I actually met forgings as you’ve consolidated crop into Canada Drop Forge.
Matthew Crawford
Yes. Sorry. You had me going to different direct. That’s why I asked Pat to answer it. Forgings, we’ve made a significant investment in that consolidation. And listen, there’s a learning curve. I think that the can and Drop Forge people are a center of excellence in these large forgings. That doesn’t mean there’s not going to be some learning relative to some of the parts we’ve transferred from Chicago down to Canton.
So I think that investment is beginning to pay off, but we won’t be in the meat, I think, of that return until probably mid next year. The good news is their order book is exploding on their traditional business. So I think we’re going to see — begin to see some real leadership from our forging business, particularly there, but also Arkansas steel. I think which will be affected meaningfully by the increased railcar builds. So no, I think we’ll see some nice momentum there over the next 6 to 9 months. And then I think we’ll begin to see significant operating leverage at Canton as they’re able to on-board more people, execute against their backlog and really start to make the parts we’ve transferred from Chicago at a meaningfully profitable level.
Patrick Fogarty
One last point there is, in addition to the investment that we’re making in the consolidation of crop and [indiscernible] we made a significant investment in a new hydraulic press line in Arkansas. The completion of that and the gearing up for production occurred right at the time the pandemic hit. And so we have suffered for 2 years without real volume to be on that line. And we’re starting to see with rail orders and railcar build rates escalate. We’re starting to see the benefit of that. And the big turnaround in that segment from a loss a year ago to $7 million in operating income this year is a huge turnaround that takes into effect the work that’s been done operationally as well as these new investments.
Steve Barger
Yes. And you must feel like you have a couple of years of visibility on that line now, right?
Patrick Fogarty
I think that we have visibility to return to where we have been. I think we’re still working through how and with which customers and products we’re going to envision for the long-term excess capacity. We’d like to diversify the business from rail a little bit. We’re looking at some other great partners. So in terms of what I view, if you recall, Steve, some of that investment was made to backstop some of the demand in the rail industry. I still think we have tremendous opportunity as we work down the backlog to find great long-term partnerships in the construction or ag industry that will really take us to levels we’ve never been.
Operator
Our next question comes from the line of Yilma Abebe with JPMorgan.
Yilma Abebe
My first question is on free cash flow. I believe you mentioned in the back half of this year expect working capital to come down. Can you give us a little bit more color in terms of the key new drivers there? And I’m trying to think about sort of your sales growth and then putting that in context of working capital investment needed to support that the growth in the balance of this year?
Patrick Fogarty
This is Pat. Two things are going to drive free cash flow in the second half of the year. Obviously, the improvement in earnings and EBITDA will benefit free cash flow our days in working capital, as I described in my script, are at higher levels than we have seen historically, primarily because of the elongated supplier lead times, we’re carrying more inventory as a result of inventory that’s on the boat coming over from Asia. Some of that we expect to scale back. We’ve carried more inventory in support of our customers’ demand than we historically have. We’re starting to bring those levels down and we saw that happening in the month of June. Our working capital levels generally to our every sales dollar is about 24%. Some business is a little higher, some a little less. But our drive for each of the business units is to get back to historical levels, which will obviously benefit our free cash flow. We expect that to start taking hold in the second half of the year a little longer than what, quite frankly, I had hoped for, but we’re starting to see that happen.
Matthew Crawford
I’d only add that we are expecting, I think, significant cash flows at the back of the year, which is fairly typical for the company, but recognize some of the business dynamics that are going on right now that may take a little longer to harvest. One is in Supply Technologies lead times on product from Asia can be 60, even 9 months.
So some of the inventory we’re taking on now to protect our customers and make sure that we’re fulfilling at a rate that’s acceptable to them over 100,000 SKUs could be considerably difficult to manage 6 to 9 months out. So I think we’ll have some play in those numbers that it will take a little longer to play out. Also, I think that supply chain challenges in the equipment business have been challenging as well.
The backlog has grown to very high levels, principally because of business activity in the order book, but there’s also a piece in there, which is some of the challenges to get equipment out because we’re waiting on components, et cetera. So we’re holding a little more inventory that we have purchase order for that we may not like, but we’re going to have to do that to manage our supply chain. So that may take a little longer than year-end. So we expect a really good year-end, but that’s not really the whole store opportunity we have on the balance sheet.
Yilma Abebe
I guess maybe a quick follow-up on that. As we look forward to next year and then more specifically on working capital, in the context of what you discussed in terms of supply chains and issues and holding more inventory. How should we think about working capital trends as we go into next year, assuming the demand picture holds relatively constant to current levels?
Matthew Crawford
I think that will depend on the business unit and where demand shakes out for next year. But just to put it in context for you, for every 5 days of working capital, that equates to about $20 million. So if we have $5 million to $10 million of increased days of working capital, we’re saying that we have $30 million of excess working capital where volumes are today. So we believe that embedded working capital could come out of the system if sales remain constant as we head into 2023.
Yilma Abebe
And then one final one. In terms of capital allocation and M&A and looking at leverage and debt, how should we think about your M&A in the pipeline and incremental debt for acquisitions?
Matthew Crawford
As you know, we have been traditionally very interested in growing by acquisition. I think that we are still interested in that. I’d say that we have been increasingly focused on organizing the business in a way that; number one focuses on our best products and services in terms of both what success looks like over 5 to 10 years and also 2, what provides sort of incrementally strong either operating leverage or gross margins to the business. So I do think we’re a little more selective and that’s why we haven’t done as much over the last couple of years. I think you will continue to see our appetite for those kinds of acquisitions that support initiatives inside each of the businesses. So we’ll continue to be selective. I think that you can expect we will continue to be adhere to the principles that got us here, which is being thoughtful buyers. So I wouldn’t suggest to you that we are not going to be active, we are, but I think we’re going to continue to be more selective over the near horizon.
Operator
Thank you. At this time, I’ll turn the floor back to the management team for closing remarks.
Matthew Crawford
Great. Well, thank you very much for your time today. We appreciate your support and look forward to an exciting second half. Have a great day.
Operator
This concludes today’s conference. You may disconnect your lines at this time. Thank you for your participation.
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