CIR (2020 - Q2)

Greetings and welcome to CIRCOR International's Second Quarter 2020 Earnings Conference Call. [Operator Instructions] I will now turn the conference over to David Calusdian from Sharon Merrill Associates. Thank you, sir. You may begin. David Ca

Thank you, and good morning, everyone. On the call today is Scott Buckhout, CIRCOR's President and CEO; and Abhi Khandelwal, the company's Chief Financial Officer. The slides we'll be referring to today are available on CIRCOR's website at www.circor.com on the Webcast & Presentation Section of the Investors link. Please turn to slide two. Today's discussion contains forward-looking statements that identify future expectations. These expectations are subject to known and unknown risks, uncertainties, and other factors. For a full discussion of these factors, the company advises you to review CIRCOR's Form 10-K, 10-Qs, and other SEC filings. The company's filings are available on it's website at circor.com. Actual results could differ materially from those anticipated or implied by today's remarks. Any forward-looking statements represent the company's view only as of today, August 7, 2020. While CIRCOR may choose to update these forward-looking statements at a later date, the company specifically disclaims any duty to do so. On today's call, management will refer to adjusted operating income, adjusted operating margins, adjusted net income, adjusted EPS, free cash flow, net debt and organic measures. These non-GAAP metrics exclude certain special charges and recoveries. The reconciliation of CIRCOR's non-GAAP measures to the comparable GAAP measures are available in the financial tables of the earnings press release on CIRCOR's website. I'll now turn the call over to Scott.

Thank you, David, and good morning, everyone. Before getting into our second quarter highlights, I want to acknowledge the CIRCOR team's continuous dedication in productivity during this difficult time. The CIRCOR team has gone above and beyond to deliver essential products to our customers, while keeping each other safe and maintaining business continuity. Please turn to slide three. CIRCOR delivered a strong second quarter, despite unprecedented macro challenges. I'm proud of the portfolio transformation that we've executed over the last couple of years. With the recent divestiture of Distributed Valves, we completed our shift out of Upstream Oil & Gas and other commodity businesses. As a result of this transformation, we've sharpened our focus on our core mission-critical flow control platforms, and we positioned CIRCOR for strong future growth. Our current portfolio of mission-critical businesses is more diversified and less cyclical, mitigating the impact of the broader economic environment. In addition, our portfolio of products has differentiated technology and a strong market position that has enabled us to raise prices through the current downturn. Turning to operations. All of our factories are operating in line with customer demand. As of today, we're absorbing some inefficiencies associated with safety protocols we put in place to ensure our employee safety. We continue to manage some COVID-19-related challenges on the supply chain side. Beyond this, we're experiencing limited direct disruption in operations from COVID-19. Despite these challenges, the CIRCOR operating system is delivering improved operating performance across most metrics. And finally, we're positioning CIRCOR to take advantage of a market recovery. We remain on track to deliver on our commitment of launching 45 new products this year. We continue to invest in front end resources and strategic growth initiatives. We're closely collaborating with suppliers and customers to ensure alignment as markets change. Lastly, we continue to focus on deleveraging the balance sheet. Now, I'd like to provide some highlights from the second quarter. Please turn to page four. We booked orders of $193 million with the book-to-bill ratio slightly over one, and a backlog built of $7 million. Sales came in at $186 million, down 14% organically, largely driven by Industrial. Aerospace & Defense top line remained robust through the quarter. Adjusted operating margin was 8.5%, down 210 basis points from last year. The margin decline was primarily driven by lower volume in Industrial. Despite lower revenue, we managed company-wide detrimental to 22% due to the aggressive cost and price actions we implemented earlier this year. Our cost actions remain in line with the targets we laid out in our first quarter earnings call, and our price actions across the company are coming in as expected. Now, let me turn the call over to Abhi to discuss our second quarter results in more detail before I review the outlook for our end markets.

Thank you, Scott, and good morning, everyone. Let's begin by reviewing our segment results. All figures are for continuing operations and exclude divestitures. Starting with Industrial on slide five. In Q2, Industrial segment orders were down 16% organically, due to COVID-19 impact on most industrial end markets. The Industrial segment had sales of $124 million, down 19% organically. The majority of our end markets within Industrial were challenged due to the COVID-19 pandemic. We saw capital project and customer maintenance delays through the quarter. The AOI margin was 10%, representing a decline of 350 basis points versus prior year. This was primarily driven by lower sales volume and inefficiencies associated with the need to maintain social distancing on the factory floor, among other safety policies due to COVID-19. The cost actions that we initiated at the end of 2019, coupled with further actions tied to the pandemic resulted in a drop through of 27%, which is significantly lower than our contribution margin. Turning to slide six. In Q2, in our Aerospace & Defense segment, we delivered orders of $77 million, down 18% organically due do a difficult compare. Last year we received a large Joint Strike Fighter order for $17 million, while this year we have the impact of COVID-19 on commercial aerospace, although, partially offset by the Virginia Class Submarine order for $9 million. Aerospace & Defense had sales of $62 million, down 3% organically due to the COVID-19 impact on commercial aerospace and ongoing 737MAX delays. This was partially offset by strong defense shipments, especially for the Virginia Class Submarine and the Joint Strike Fighter programs. The Aerospace & Defense operating margin was 21.1%, up 500 basis points. With $2 million of lower revenue, the Aerospace & Defense team delivered $3 million of incremental operating income, driven by pricing, productivity and cost actions. Turning to slide seven. For Q2, the adjusted tax rate was 14.8% due to foreign tax rate differential and higher R&D tax credits. Looking at special items and restructuring charges, we recorded total pre-tax charge of $17 million in the quarter. The acquisition-related amortization and depreciation was a charge of $12 million. One-time professional fees were a charge of $4.6 million attributable to last year's unsolicited tender offer, corporate governance actions, and other proxy matters. Interest expense for the quarter was $8 million, down $5 million compared to the prior year. This was a result of lower debt balances and a payable interest rate of 25 basis points. Other income was a $2 million charge in the quarter, primarily due to foreign exchange losses, partially offset by pension income. Corporate costs in the quarter were $9.7 million higher than normal, primarily driven by a write-off of $1.8 million against a retain asset from a previously divested business. For Q3 and Q4, we expect the corporate cost run rate to be approximately $7 million per quarter. Turning to slide eight. Our free cash flow from operations was negative $28 million in the second quarter, which is in line with the guidance provided during our first quarter earnings call. During the quarter, we disposed off our Distributed Valves business for a negative $8.25 million in cash. The company also incurred approximately $10 million of cash disbursements associated with last year's unsolicited tender offer to acquire the company, support for corporate governance changes, restructuring, investment banking fees, and other professional services. At the end of the second quarter, our net debt was at $467 million, which was $205 million lower than Q2, 2019. As we mentioned in our Q1 quarterly call, we expect our Q3 free cash flow to be approximately breakeven to slightly negative, as we complete the final disbursements related to the exit of Distributed Valves and other restructuring expenses. Q4 is expected to be a strong positive cash flow quarter, largely clean of transition and restructuring expenses. Now, I will hand it back over to Scott to provide some color on our end markets and outlook.

Thank you, Abhi. Now, I'll provide an overview of what we're seeing in our end markets, as well as some of the actions we're taking to manage through the pandemic. Please turn to page nine. Let me start by recapping our end market exposure. First, we've completely exited Upstream Oil & Gas. Looking at today's portfolio, approximately 46% of our revenue is general Industrial, 27% is Aerospace & Defense, with defense approximately twice the size of commercial, and 27% is aftermarket sales and support. I'd like to point out a few aspects of our current portfolio. Our aftermarket business is largely driven by industrial and defense. Aftermarket margins are higher than OEM margins. Orders driven by our large global installed base are mitigating the impact of the broader economic decline. Aftermarket is a strategic growth area for CIRCOR, and aftermarket growth investments will continue through 2020 and beyond. We expect defense to remain robust. Our defense team is winning new programs, and next year's U.S. defense budget appears to be coming in at 2020 levels or slightly better. In addition, we're seeing strong support from many of our larger defense platforms. Our commercial business represents 8% of revenue and less than half of it is driven by Boeing and Airbus commercial aircraft platforms. The majority of the remaining commercial sales come from a long list of OEM platforms across business and regional aviation, civil helicopters and space programs. Our industrial business is very diversified by end market. Outside of Downstream Oil & Gas, which represents 10% of revenue, no end market represents more than 6% of revenue. This offer significant diversification, reducing cyclicality and our dependence on anyone end market. Please turn to slide 10 to discuss the current market outlook. Let's start with industrial. Orders overall in Q2 were down 16% organically. During the second quarter in the industrial business, we saw the impact of COVID-19 across most major end markets. Core market orders were down 23% impacted by an overall slowdown in global manufacturing, as well as large project delays linked to the global reduction in CapEx. We saw capital project delays in commercial marine, machinery manufacturing, chemical processing, and building and construction end markets. The impact on water and wastewater was relatively modest compared to other end markets. Alternatively, we saw slight order growth in our U.S. consumer goods manufacturing sector. The COVID-19 environment, coupled with some customer shifting consumer goods manufacturing from China to the U.S., created a moderate increase in orders in this sector. Aftermarket orders were down 8% organically in Q2. Our global installed base, combined with our dedicated aftermarket commercial team, is mitigating the impact of steeper declines in four-market capital projects. The aftermarket weakness was most significant in commercial marine due to lower utilization of cruise ships and offshore service vessels. We're seeing pockets of growth in some areas, like nuclear power in Asia and midstream oil and gas in Latin America. Downstream order intake in the quarter was relatively low due to delayed capital projects and maintenance turnarounds. Refiners are minimizing short term spending and reducing the scope of activities planned for the fall turnaround season. Aftermarket backlog is expected to grow as we exit the year in preparation for the delayed maintenance activities from 2020 and layering on top of the already planned repair and maintenance work slated for 2021. Quoting activity remains strong for long cycle capital projects in growth markets. For industrial overall in Q3, the end market outlook is similar to market levels in Q2. We expect the impact of COVID-19 to drive a year-over-year decline in revenue of 18% to 28%. We expect most OEM end markets in Q3 to remain at Q2 levels, due to ongoing capital expenditure reductions and capital project delays. On the aftermarket side, we're starting to see some improvements sequentially in Europe and Asia, as those markets recover from the COVID-related downturn. In North America, we expect Q3 revenue to be inline with Q2 regionally. Regionally, the general industrial market is expected to decrease in Q3 versus the prior year in North America, Europe, and India. However, we expect to see growth in China. Please turn to slides 11 and 12. Our Aerospace & Defense segment delivered orders of $77 million in the quarter, driven by ongoing strengthen in defense programs like the Joint Strike Fighter, the U.S. Navy Virginia Class Submarine, the CVN-80 aircraft carrier and various missile programs. Strengthen in defense orders offset weakness in commercial aerospace orders, which were down from the previous quarter due to the impact of COVID-19 on production rates at Boeing and Airbus and the ongoing delays with the 737MAX. Overall, we expect Q3 orders to decrease sequentially, driven by the timing of defense program orders and COVID-related headwinds in the commercial business. For Aerospace & Defense in aggregate, we expect revenue to be up sequentially in Q3, but down 3% to 5% versus last year. Commercial revenue is expected to be down approximately 30% to 40% versus last year, while defense should be up 12% to 17%. It's important to note that we're increasing prices on both sides of the business, defense and commercial aerospace. With carryover pricing from 2019 and new increases this year, we expect to net a 4% price increase in Q3. The price increases are heavily weighted in the aftermarket. Before I wrap up, I want to reiterate that despite COVID-19, we're still driving the transformation we laid out last summer, and have continued to make strong progress. While the pandemic has had a significant impact on our end markets, we've responded accordingly by accelerating and expanding many aspects of the plan, particularly with respect to reducing structural costs and leaning out the company. It's also important to know that we're preserving the growth capacity of the company, despite the expanded reduction of structural costs. Notably, we've increased our commitment of new products launched in 2020 to 45, up from 40 in the original plan. And finally, price remains an important part of our playbook. Due to the mission-critical nature of our products, we've been able to raise prices this year, in line with the original plan we committed to last year, despite the recent market disruption. To summarize, we're taking the appropriate steps to navigate the current environment, while continuing to execute on our strategic plan. As the market continues to change, we will continue to adapt to ensure we're positioned to succeed. I'd like to close by once again thanking the entire CIRCOR team for their service and unwavering dedication to our customers. They've been doing a remarkable job. We remain committed to positioning CIRCOR for long-term growth, expanding margins, generating strong free cash flow and deleveraging the company. Now, Abhi and I will be happy to take your questions.

Thank you. We will now be conducting a question-and-answer. [Operator Instructions] Our first question comes from the line of Andy Kaplowitz with Citigroup. Please proceed with your question.

Hey, good morning, guys.

Good morning, Andy. How are you doing?

Good. How are you? Scott, so, obviously, strong performance on the A&D margin. Can you talk about whether the transition to the Morocco site is complete? You mentioned pricing quite a bit in your prepared remarks. How much is that contributing? Is mix helping? I think it is. And then the sustainability of this type of margin, even when commercial aerospace continues to be so weak.

Sure. Okay. So, a lot in that question. So, let me start with your Morocco question. So, Morocco is not done. We expect -- we have a five-year plan from Morocco. So, Morocco will continue to grow every year, as we leveraged that as our low cost platform for Aerospace & Defense. So, it has contributed this year to the margin expansion and will continue to contribute to ongoing. And we're finding in Morocco, by the way, is that our customers are actually very interested in Morocco. In many cases, they are asking us to move programs to Morocco. And, of course, we share the savings with them. So, you should expect the Morocco story to continue for years to come here With respect to the margin expansion, there were lots of contributors here. Pricing you mentioned is a big one. And probably the biggest factor in the quarter would be pricing. Mix is helping. If you step back and look at Aerospace & Defense, the margins are better in aftermarket. You can see from the growth in aftermarket in defense is much higher than what we're seeing elsewhere and more than offsetting the decline in -- on the commercial side. So, we're seeing a mixed benefit by having more aftermarket and less OEM, if you will. So, that certainly helping. As far as the sustainability of the margins in Aerospace & Defense, we're very comfortable with where we are. We believe longer term, this is a mid-20s operating margin business and the levels that we're at right now are certainly sustainable through the remainder of the year, based on what we're seeing now.

Thanks for that, Scott. And then, if we step back and think about the momentum of the overall business, right? Industrial revenue guidance for Q3, as you said, the declines are relatively similar to Q2. You could argue maybe slightly worse, maybe you'd just be conservative there. And A&D guidance is only slightly better if you include a little bit weaker commercial and stronger defense. So, maybe you could talk about the shape of the recovery you're seeing. How concerned are you that the shape of the recovery is more L-shaped versus U or V-shaped?

So, you're right, the way you just recapped how we're seeing Q3. So, I would say we are seeing similar types of revenue in Q3 versus Q2 in Industrial. We'll see moderate growth sequentially on the Aerospace & Defense side as we go from Q2 to Q3. If you drill down into that to see some of the dynamics, in Industrial -- let's start with that. Aftermarket, we are starting to see an improvement in aftermarket orders in Asia and Europe. The U.S. we are not. We're seeing flat, maybe slightly down a little bit in aftermarket in the U.S. On the OEM side, we're not seeing much change at all. The order rate that we saw in Q2 has continued through July, and we're not expecting to see much change through the remainder of the quarter. We think that's going to recover slower. So, I think the way we've guided Q3 with revenue more or less in line with Q2 is what we're seeing in July, and probably what will happen barring some kind of change with infection rates around the world, or some change in one of our factories, something like that. Based on what we're seeing today, it looks to be more or less in line with Q2. On the Aerospace & Defense side, we have a good solid growth in the aftermarket on defense. This is largely driven by orders in the first half of the year. So, we've got a backlog coming into the back half on the aftermarket side. Longer term, you won't see this level of growth in aftermarket. This is probably a high single digit growth component of our business, but for the remainder of the year, you'll see very good growth in aftermarket on the defense side. And then, on the commercial side, it's really just driven by the platforms. We've got a number of new programs in defense that are launching this year. For Aerospace & Defense overall, we're launching 25 new products this year, which are all linked to new program wins. So, we're seeing pretty good momentum here on defense. Commercial, I mean, we're seeing what everybody else is seeing, pretty significant drop in revenue. But as you can see, we're offsetting that with the defense side of the business.

Just one more quick one for me. Can you sustain the kind of detrimentals that you had in Q2 going forward, given you laid out pretty explicitly sort of temporary versus structural cost out last quarter? How does that balance out as you go for the balance of the year?

Yeah. Andy, this is Abhi. If you think about company detrimentals moving forward, I'd say it's fair to assume that overall for CIRCOR, you'll detrimentals in the 20% to 25% range. So, very similar to what you saw in Q2.

Thanks, guys. Appreciate it.

No problem.

Thanks, Andy.

Thank you. [Operator Instructions] Our next question comes from the line of Jeff Hammond with KeyBanc Capital Markets. Please proceed with your question.

Hey, good morning, guys.

Morning, Jeff. How are you?

Good. Doing real well. A lot of good color on industrial, but I guess what I'm hearing from a lot of other industrial companies, there's kind of bottoming April, May, and then starting to get less bad, I guess, in June, July. And you guys seem to be a little more stable. I'm just wondering, what markets are getting definitively less bad? And how much is like -- it seems like downstream is maybe going the other way. And so, how much of a drag is that kind of in the -- as you kind of assess the whole group of businesses within industrial?

Sure. I think it's easier for us -- end markets -- the end markets aren't moving around that much. I mentioned water -- wastewater is doing a little better than some of the other end markets. But I think where we're seeing the most differences is by region and then aftermarket versus OEM. So, if you step back and look at our order intake and what's happened the last couple months versus earlier in Q2, you'll see aftermarket improving regionally in Asia and aftermarket improving in Europe, but we don't see that yet in the U.S. If you look at the regions -- I'm sorry -- if you look at the OEM side of the business, we're just not seeing an inflection point really in any part of the business. We're seeing things move around here and there, and some pockets of growth. I mentioned nuclear power in Asia. We saw strong orders in the second quarter for nuclear power. I mentioned midstream in Latin America. I mean, these are relatively small pieces of our business, but we saw strong orders in the quarter. So, there's pockets of activity. But broadly speaking, it's really only aftermarket that we're seeing things improve in a material way. And it's only in Asia and in Europe at this point.

Okay. And then last quarter you gave kind of a 2Q, 3Q view and clearly have a little more visibility in A&D side. So maybe you can speak -- is this trend of kind of defense being better and commercial being worse. Does that carry into 4Q as well?

Yes, we have -- you're right. We do have more visibility in Aerospace & Defense. I think what you're -- you should expect to see into Q4 is going to be very similar to what you're seeing in Q3 in Aerospace & Defense. So, from a sequential standpoint, you should expect to see similar kinds of revenue. Margin expansion will continue year-over-year as well in Aerospace & Defense. So, we've got a decent visibility through the remainder of the year that you -- you're not going to see a huge change to what you're seeing in Q3.

Okay. And then, free cash flow, Abhi, I think you made some comments. But it looks like you're paying everybody on time and maybe your receivables aren't coming in as fast. So, just talk about like working capital for the year, given the revenue decline? And how much free cash flow -- how much of this negative free cash flow we can offset into the second half?

So, we are -- so just -- let me just start with what we're expecting to happen in cash flow. So, for cash flow in Q3, we're expecting to be about breakeven. We're still absorbing disbursements associated with the exit of Distributed Valves. We've still got some restructuring expenses that we're going to absorb here in the third quarter. So, roughly breakeven, maybe a little bit negative in Q3. Going into Q4 should be largely clean. You should see good, solid operating cash flow relatively clean cash flow in Q4. As far as working capital, we -- that was a headwind for us in the first half of the year. In Q2, you see we increased working capital. You're going to see that reverse here in Q3 and Q4. So, working capital will be a tailwind and will help us generate cash through the remainder of the year. As far as how we're thinking about capital allocation, it's all about debt repayment and debt reduction for us right now. So, we are -- we have cut capital expenditures this year. So, you'll see a significant cut year-over-year on CapEx and then the cash that we generate the remainder of this year will all go towards paying down the debt.

Okay. And what's the other expense item? There's like $2 million headwind, I think.

Yeah. The other income, so it really what it is, is the FX impact that we saw in the quarter for the intercompany loans that we have. So that was a bad guy for us in the quarter. We have taken some actions in place for Q3. So, moving forward, it will not be that big an impact for us.

We're hedging -- we're hedging that away going forward.

Okay. Thanks guys.

Yeah.

Thank you. Our next question comes from the line of Nathan Jones with Stifel. Please proceed with your question.

Good morning, everyone.

Good morning, Nathan.

I'm just going to go off for a little more detail on the industrial order trends. If you're willing to, could you talk about how they progressed through the quarter? Did they -- did the comparisons on orders at least improved as you went through the quarter? And any comments you'd make on July?

Sure. So, we -- when we had the earnings call, the Q1 earnings call, we were seeing order rates and expecting revenue at the better end of the range that we had guided. We came in a little better than that. So, I'd say very modest improvement through the quarter last year -- or I'm sorry -- last quarter in terms of orders and revenue. As we look at Q3, we are coming in -- as July would indicate that we're at the better end of the range, the revenue range that we're indicating here in the in the presentation. So, we're at the -- we're right at the better end. So, it could get worse. We'll see what happens with infections here in the U.S., that's our biggest concern is what's going on in North America. But right now, we're coming in at the better end of the range.

And just to follow-up on the comment that you're cutting capital expenditures pretty significantly this year. Can you talk about where the CapEx is getting cut and where you're maintaining that CapEx to invest in growth and those kinds of things? Just so we know what's getting cut and what's still getting funded?

Right. So, you'll see roughly a 20% to 25% reduction in CapEx for the full year. We have preserved all of the growth capital expenditures that we were expecting to spend coming into the year. So, that -- so -- and that's OpEx as well. So, the resources that we were expecting to invest in coming into the year, largely in emerging markets we're still investing in that. We're still investing in engineering and product management. So, those things are still happening. On the capital side, it's hard to -- there's not broad categories that we're cutting, Nathan. It's basically parading out the projects and cutting off the tail, things that are least important to driving results at CIRCOR. So, of course, we're preserving all of the safety capital. We're maintaining all of the equipment that we need to maintain. We're doing all the things that we need to do to ensure business continuity. But the things that were on the margin that were close to the line, we would push them below the line for this year and we'll pick that back up next year.

What I really wanted to hear there was that you were cutting the growth investments, so that's good. On pricing, obviously, a lot of pricing going through this year. It's usually a pretty difficult environment when revenues are down this much to be able to push price. Can you talk about -- a little bit more about the areas that you're pushing price through? What gives you the ability to get that pricing through any normal circumstances four -- three, four points in price would be a lot. And the customer acceptance of these pricing increases?

So, we're -- we've got a pretty detailed playbook for how to raise prices. We raise prices where we know we have the value that we're delivering to the customer to justify it. And in many cases, we are in situations where we're a sole source. So, if we talk about Aerospace & Defense first, we're sole sourced in -- on the vast majority of this business. The aftermarket part of the business is -- we're not on long-term contracts. And so, we're able to raise prices more freely in that part of the business. If something is urgent and the customer needs something very quickly, we will typically charge for that, as well. And so, it's a -- there's a pretty detailed decision tree on how we work our way through what the price increase should be, and is typically based on the value that we're providing to the customer. So, on the Aerospace & Defense side, obviously, we're getting a lot more price than we are on Industrial. We're getting about 4% on A&D. On the Industrial side, we're getting about 1%, that's largely happening in the aftermarket piece of the business. So, selling -- and the majority of our aftermarket is selling replacement parts, screws -- for screw pumps, et cetera, but also replacement product. And it's the same kind of logic. We have an installed base. Many of our customers will order parts, and we're able to get a premium to display those parts, especially if they need them emergently, we will typically charge for that. So, that's essentially how we're doing it.

Great. Thanks for taking my questions.

Thank you, Nathan.

Thank you. We have reached the end of our question-and-answer session and the conclusion of today's call. You may now disconnect your line. Thank you all for your participation, and have a wonderful day.

Thank you.