The Eastern Company (NASDAQ:EML) Q3 2022 Earnings Conference Call November 8, 2022 11:00 AM ET
Company Participants
Nicholas Vlahos – VP of Finance, Treasurer, & Secretary
August Vlak – President and Chief Executive Officer
Peter O’Hara – Chief Financial Officer
Conference Call Participants
Ross Davidson – Benetton Capital
Operator
Good morning, ladies and gentlemen, and welcome to the Eastern Company’s Third Quarter Fiscal Year 2022 Earnings Call. At this time all participants’ have been placed on a listen-only mode. And we will open the floor for your questions and comments after the presentation.
It is now my pleasure to turn the floor over to your host, Nicholas Vlahos. Sir, the floor is yours.
Nicholas Vlahos
Good morning, and thank you, everyone, for joining us. Speaking today will be Eastern’s President and CEO, Gus Vlak; and our CFO, Peter O’Hara. After that, we’ll open the call for questions.
Please note that some of the information you will hear during our discussion today will consist of forward-looking statements about the company’s future financial performance and business prospects including, without limitation, statements regarding revenue, gross margin, operating expenses, other income and expense, taxes and business outlook.
These forward-looking statements are subject to risks and uncertainties that could cause actual results or trends to differ significantly from those projected in these forward-looking statements. We undertake no obligation to revise or update any forward-looking statements to reflect events or circumstances that occur after the call. For more information regarding these risks and uncertainties, please refer to risk factors discussed in our Form 10-K for the fiscal year filed with the SEC on March 17th, 2022, and our other filings with the SEC.
In addition, during today’s call, we will discuss non-GAAP financial measures that we believe useful as supplemental measures of Eastern’s performance. These non-GAAP measures should be considered in addition to and not as a substitute for or in isolation from GAAP results. A reconciliation of each of the non-GAAP measures discussed during today’s call to the most directly comparable GAAP measure can be found in the earnings press release available on our website at www.easterncompany.com under the Investor Information tab.
With that, I’ll turn the call over to Gus for opening remarks.
August Vlak
Thanks, Nick, and good morning to those who have joined us on the phone and those participated via the web. We released Eastern’s third quarter numbers in our Form 10-Q yesterday afternoon. Before Peter reviews the detailed results with you, I’d like to take a few moments to reflect on the quarter.
This was another strong quarter for Eastern with solid revenue growth. Net sales from continuing operations grew to $71.6 million in the third quarter of 2022, that’s an increase of 12% over the third quarter of 2021 and it’s another quarterly sales record this year over Eastern’s 164-year history.
Customer orders were strong. And importantly, our backlog at the end of the third quarter was $85.7 million. That’s up 3% from where it stood at the end of the third quarter of last year, as well as the beginning of 2022. A strong backlog positions us well for the coming quarters.
Sales growth underscores effective execution by each of our businesses to benefit from favorable demand trends across our core markets. For example, our Big 3 Precision team remains well-positioned for the anticipated growth in returnable packaging over the remainder of this year and beyond as the pace of new vehicle launches accelerates. IHS Markit and S&P global research firm predict that there will be 130 electric vehicle models by 2026. And according to Bank of America, GM alone will be releasing 17 new models between 2023 and 2026.
Sales of our returnable transport packaging products grew nearly 24% in the quarter, compared to the prior year. At the same time, sales of our truck mirror programs, that launched early this year, continue to gain momentum as truck builds for these programs ramp up. According to FTR Transportation Intelligence, demand for new Class 8 trucks is expected to remain robust well into 2023.
While raw material cost increases began to moderate for certain key commodities in the third quarter, we continue to operate at a much higher material cost structure than in previous years. We also still experienced labor shortages and supply chain constraints. As such, we’ve implemented price increases, most of which took effect towards the latter half of the second quarter and into the beginning of the third quarter, but if our costs continue to increase, we’re taking further pricing actions.
I’m pleased to announce that subsequent to the end of the third quarter, we divested our interest in Argo EMS, which is the final step in our work to streamline our portfolio of businesses. With this transaction, we’ve now completed the sale of all noncore businesses, and we will be able to focus our efforts exclusively on our three largest businesses characterized within the financial statements as continuing operations.
Moreover, in the 2022 third quarter, we divested our corporate headquarters building located in Naugatuck, Connecticut. And later this month, we will be relocating to office space in Shelton, Connecticut. That will be both substantially reduce our operating carrying costs and also avert the capital repairs that were otherwise needed for the 120-year-old facility in Naugatuck, a true win in my book.
Finally, our balance sheet remains solid, with a very strong current ratio of 2.9 times for the third quarter of 2022. It’s noteworthy to mention that we repaid $3 million of debt within the third quarter. And subsequent to quarter end in the month of October 2022, we repaid another $5 million from the proceeds of the sale of Argo. We are able to deploy capital to repurchase over 10,000 shares of common stock in the quarter, and we believe we are prepared for a rising interest rate environment with nearly 55% of our term debt now locked in at a fixed interest rate of 3.19% through an interest rate swap agreement.
We’ve clearly sustained our momentum from the last quarter with strong sales, a healthy pipeline and growing end markets, solid execution by our teams and a focus on our core businesses. We believe we are well-positioned to finish 2022 in record territory.
As I outlined last quarter, we are closely monitoring the macroeconomic rewarding sites that are out there. Global inflationary pressure and the reaction of central banks across the world may trigger a natural cyclical contraction, which could depress demand in many of our North American markets, and we will be prepared.
For example, we’re focused on efforts on inventory production opportunities. Inventory, as you know, increased in part due to the protracted supply chains from Asia, our desire to protect our sales during the pandemic with greater safety stocks and general inflationary cost increases that are capitalized while the product remains on hand.
We’re also establishing very specific plans at each of our businesses for operating cost reductions should we see certain factors change in the market. At this time, our order intake and backlog across most of our businesses do not suggest the need to deploy these plans on a company-wide basis, but we will be vigilant and ready for such a scenario.
Peter will now take us through a more detailed commentary on the second quarter results.
Peter O’Hara
Thank you, Gus, and good morning to everyone who’s on the call today. My remarks this morning will focus on Eastern’s results for the third quarter of 2022.
For the quarter, net sales from continuing operations increased 12% to $71.6 million from $63.9 million a year earlier. Sales increased primarily due to increased demand for truck accessories and automotive returnable transport packaging products, as well as from distributors. Our returnable transport packaging sales have continued to benefit from an increase in upcoming new automotive product launches, including several electric vehicle launches.
The effective volume on existing products increased net sales by 5% year-over-year, while price increases and new products contributed an additional 7%. Price increases primarily reflected our efforts to recover increases in raw materials and freight costs.
Gross margin as a percent of sales was 23% in the third quarter of 2022, reflecting an improvement from the 22% weighted average across the first nine months of 2022. In the third quarter of 2022, gross margins were still 1% lower than the prior year, primarily due to unfavorable sales mix. Nevertheless, we remain focused on our effort to seek margin improvement opportunities.
Eastern’s structural costs comprised of product development expense and selling, general and administrative expenses increased $0.7 million or 7% year-over-year, primarily as a result of increased new product development, commissions and other selling costs, payroll-related expenses and travel costs. The increase in selling expenses reflects both the impact from increased sales as well as strategic investments we have made in our sales capabilities.
Net income from continuing operations for the third quarter of 2022 was $4.5 million or $0.72 per diluted share compared to net income of $3.8 million or $0.61 per diluted share in the prior year period. As reflected in the supplemental financial information contained in our earnings press release, adjusted EBITDA from continuing operations for the third quarter was $7.7 million compared to $7.1 million in the third quarter of 2021. Adjusted EBITDA margins remained a healthy 11% in both periods.
In the quarter, we saw only a modest decline in inventory, in part due to a relatively long supply chain originating from Asia that requires time to take a full effect as well as the receipt of a large influx of inventory in Q3, principally from Shanghai, resulting from the shipping delays in Q2 due to the COVID-19 shutdown last spring in China. As we enter year-end, we will continue to balance our focus on inventory reduction with ensuring we maintain sufficient product to meet our substantial sales backlog.
In terms of operating cash flow, the company generated approximately $2.2 million in cash from continuing operations during the third quarter 2022 compared to a use of cash of approximately $7.6 million in the third quarter of the prior year. In the third quarter of 2022, cash flow was primarily impacted by a sequential year — quarter-over-quarter increase in accounts receivable, which is principally timing related. As of October 1, 2022, we held cash and cash equivalents of approximately $5.3 million.
And with that, I’ll now turn the call over to Nick for questions.
Nicholas Vlahos
Thanks, Peter. Operator, I’d like to open the line for the questions. I see that we have some questions from webcast and we’ll address those questions first, then turn to the questions on the line.
Operator
Certainly.
A – Nicholas Vlahos
What are the near-term plans for M&A?
A – Peter O’Hara
I can take that one. I would say that we remain committed to pursuing multiple accretive bolt-on acquisitions, and we have the balance sheet borrowing capacity should those opportunities arise. However, in the current market, and more specifically, with the risk of an economic downturn, we have to carefully evaluate the downside risk of any transaction. And so while we continue to look for these potential near-term acquisitions, right now, we’re very focused on reducing our debt on the balance sheet.
A – Nicholas Vlahos
Thank you, Peter. For the next question, can you comment on the impact of an economic downturn?
A – August Vlak
So as I mentioned, we are monitoring demand closely and not just demand by our customers, but also demand by their customers, primarily customers of commercial transportation, as well as any changes in vehicle launch schedules. Right now, demand remains strong, and industry forecast for many of our markets remain strong and our backlog is very solid.
So for example, the three primary industry forecasts for 2023 Class 8 vehicle production, of the three, two projected increase in vehicle production from 2022 to 2023, while the third forecast or projects just a very modest contraction. At the same time, all our Class 8 customers project an increase in the number of trucks that they plan to build between 2022 and 2023. And similarly, IHS still predicts very strong new vehicle launches in 2023 from end as well as 2024.
Now despite these very encouraging signs, we know that conditions can change on us very quickly. So we have begun to prepare plans so that we can respond and are ready to respond very quickly if we see any softening in demand from our markets.
A – Nicholas Vlahos
Thank you, Gus. To what extent did the Eberhard labor issues and rise in wages impact gross margins in the quarter?
A – Peter O’Hara
I can start that off. So what I would say there is we had a mild increase in our overall labor costs. However, we’ve remained focused on taking price increases. And so there’s really been a minimal impact overall on our gross margins at Eberhard.
A – August Vlak
Yes. And I would add to that that we are continuing to find ways to improve labor productivity at Eberhard and that’s really paying great dividends for us.
A – Nicholas Vlahos
Thank you, Gus and Peter. We — I’m not seeing any questions via the webcast. Operator, are there any questions on the phone?
Question-and-Answer Session
Operator
Certainly. [Operator Instructions] Your first question is coming from Ross Davidson from Benetton Capital. Your line is live. Ross Davidson, your line is live.
Ross Davidson
Apologies, I was on mute. Good morning, guys. Thanks for taking the question. I was hoping you could just elaborate a little bit on gross margin as you said here, and I know you said in the past, you’ve been working to recover through price increases any offset to the quite a bit higher raw materials?
Looking at the gross margin, you’re up just a little bit from Q2, about 10 basis points on a percent of sales basis. But as you said, the price increases went in effect again in Q2, beginning Q3. So I was hoping you could just elaborate a little bit on where are you in your view of sort of a journey back to the potential gross margin for the business and sort of what’s your outlook from here in terms of your ability to continue to see that go up?
Peter O’Hara
I’ll start that off, Ross, and then I’ll hand it over to Gus to help out as well. So what I can tell you is we had — if you do the actual computation, you’ll see the gross margins for Q3 ’22 were slightly above 23%. And Q3, 2021, they were slightly below 23%. We’ve rounded our numbers, and we described it as a 1% diminution year-over-year, although it’s more around 0.7 or so.
We’ve done some calculations of our own sales mix here. And what I would say is out of that 0.7, around 0.5 of it relates to unfavorable sales mix in the company overall. And so while we’ve been able to recover on — with price increases, we’re also finding — basically, we need to also focus on selling the higher-margin products and moving more higher-margin products in relation to how we performed in the prior year.
Ross Davidson
That makes a lot of sense. If you go back further in history and, yes, I see the 70 basis points is not a full percentage totally. You used to run — or the business showed capability of running 27%, 28% gross margin. Obviously, product mix changes, lots of stuff has changed since then. But is that a long-term goal to get back there still? Or do you think that just given where the business is today and given how raw materials have increased so much and just things have changed, is the actual sort of terminal gross margin you think a little bit lower in your view?
August Vlak
So we’ve been working on our long-term plans, and we do not see any structural reason why we should not be able to make our way back to those historical gross margins. Now I can’t say that’s part of our fourth quarter plan. But certainly, over time, we see no reason why we shouldn’t be able to commence that kind of a gross margin.
Ross Davidson
Fair enough. That’s helpful to hear. And then just a quick question, Peter, if you could just elaborate on the AR and the DSOs increasing. You said it was a timing-related. Is that just slipping something, something from one quarter to the other or something else? Can you just tell a little bit more about that?
Peter O’Hara
Yes. It’s ultimately a slippage from one quarter to another and within one of our operations and they had some rebuilding they had to perform and they now need to collect on those — that rebuilding.
Ross Davidson
Got it. Great. Well, thank you, guys. I appreciate all the color.
Peter O’Hara
Thank you.
Operator
Thank you. [Operator Instructions] There are no further questions in the queue.
Nicholas Vlahos
So with that, I’ll turn the call over to Gus for closing remarks.
August Vlak
Thank you, and thanks, everyone, for joining us this morning. We are pleased to see the continued acceleration in demand for our products and services across all of our businesses. And the strength of our backlog provides us with a great deal of comfort and confidence that we can sustain growth across our businesses in the future.
Supply chain and inflation-related pressure aside, we’re optimistic about the remainder of the year and our long-term future. Over the last year, our team has been increasingly effective at managing supply pressure and volatile raw material costs and has driven better throughput. Our team is committed, resilient and prepared for the challenges ahead, and we are well-positioned to capture the opportunities in front of us with a great sense of optimism and urgency, which we all share so that we can show you what we’re truly capable of delivering.
Nicholas Vlahos
Thanks, Gus. With that, I’ll hand the call back to the operator.
Operator
Certainly. Thank you, ladies and gentlemen. This concludes today’s event. You may disconnect at this time, and have a wonderful day. Thank you for your participation.
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