EnerSys (NYSE:ENS) Q3 2024 Earnings Call Transcript

EnerSys (NYSE:ENS) Q3 2024 Earnings Call Transcript February 8, 2024

EnerSys isn’t one of the 30 most popular stocks among hedge funds at the end of the third quarter (see the details here).

Operator: Good day, and thank you for standing by. Welcome to the Third Quarter 2024 EnerSys Earnings Conference Call. At this time, all participants are in a listen-only mode. After the speakers’ presentation, there will be a question-and-answer session. [Operator Instructions] Please be advised that today’s conference is being recorded. I would now like to hand the call over to Lisa Hartman, Vice President of Investor Relations.

Lisa Hartman: Good morning, everyone. Thank you for joining us today to discuss EnerSys’ third quarter fiscal 2024 results. On the call with me today are David Shaffer, EnerSys’ President and Chief Executive Officer; and Andrea Funk, EnerSys Executive Vice President and Chief Financial Officer. Last evening, we published our third quarter results and filed our 10-Q with the SEC, which are available on our website. We also posted slides that we’ll be referencing during the call. Slides are available on the Presentations page within the Investor Relations section of our website. As a reminder, we will be presenting certain forward-looking statements on this call that are subject to uncertainties and changes in circumstances. Our actual results may differ materially from these forward-looking statements for a number of reasons.

These statements are made only as of today. For a list of forward-looking statements and factors which could affect our future results, please refer to our recent 10-Q filed with the SEC. In addition, we will be presenting certain non-GAAP financial measures, particularly concerning our adjusted consolidated operating earnings performance, free cash flow, adjusted diluted earnings per share and adjusted EBITDA, which excludes certain items. For an explanation of the difference between the GAAP and non-GAAP financial metrics, please see our company’s Form 8-K, which includes our press release dated February 7, 2024. Now I’ll turn the call over to EnerSys’ President and CEO, Dave Shaffer.

David Shaffer: Thank you, Lisa, and good morning. We delivered solid third quarter earnings, including adjusted EPS, which was above the midpoint of our guidance range. We achieved impressive gross margins, as we continue to sustain our pricing position and benefited from increased IRA benefits. Sales were lower versus our strong prior year, as we continue to see demand pauses in our telecom and broadband end markets. We delivered exceptional free cash flow generation, which allows us to maintain our robust balance sheet, reduce our net leverage, providing ample dry powder for future growth investments, and uphold our consistent capital allocation discipline. Andy will give details on our third quarter fiscal ’24 performance and outlook, but I will first provide a few highlights.

Please turn to Slide 4. Revenue of $862 million, was broadly in line with our expectations, including our ability to maintain pricing. We saw some encouraging signals in order rates and our book-to-bill was approximately one. Order rates in the Americas were flat to down overall with slower demand in telecom and broadband, as well as some rebalancing in motive power on normalization of supply, partially offset by strength in specialty with robust demand in transportation and A&D. We saw favorable trends from our international markets with stronger order rates for specialty in EMEA and Energy Systems in Asia. Adjusted gross margin in the quarter improved by 760 basis points over prior year, to 30.7% due to IRA benefits, as well as solid price retention and mix improvements.

Excluding the IRA benefits, adjusted gross margin was 23.9%, up 80 basis points year-over-year. Adjusted operating earnings of $130 million and adjusted EPS of $2.56, both represent significant increases over prior year. In Energy Systems, we saw continued strength in industrials and data center, particularly in the Americas, as the need for critical uninterrupted power solutions is fueling infrastructure upgrades, where we would normally see an increase in spending at the end of the year from telecom and broadband customers. Those expected spending months did not materialize, marking a deeper spending pause than we had expected when we started the quarter. This was in line with our revised guidance. We are working closely with network carriers on multiple projects and beginning to see some green shoots.

We are optimistic that demand will strengthen in the back half of the calendar year, and remain very bullish on our small cell revenue and margin expansion opportunities. In motive power, we saw continued healthy demand but experienced a modest decline in the top line, compared to a very strong prior year. Maintenance-free sales were once again a highlight, reaching a record 23% of the total sales in the quarter. We are encouraged by the progress we are making in customer conversions, including our lithium solutions, and are tracking well to our long-term plan, for maintenance-free product sales. We remain bullish on this business as our customers are expanding their production capacity, to meet their increasing customer demand, driven by automation and electrification initiatives.

We are seeing fuel cell conversions to batteries, and our own innovative product road map is driving growth opportunities for EnerSys. In specialty, we had near-record orders paced by our capacity limits. We are seeing strong market acceptance in fleets with higher vehicle electronic loads continuing to drive demand for higher-performing batteries. We are progressing well toward the aftermarket share targets, we laid out during our Investor Day. We are continuing our work to balance our production lines, for optimal output across our segments. We are advancing our leadership in aerospace with several space exploration projects in the pipeline. In our New Ventures line of business, we are progressing towards delivering our initial fast charge and storage systems, with enhanced energy storage, and dual charging capabilities.

Our sales pipeline is growing, and we are very excited to see this new line of business beginning to materialize. Please turn to Slide 5. The team is executing to deliver on our strategic priorities. Let me share some highlights from the third quarter. Starting with Innovate. We continue to make significant strides on our innovation road map. We have many exciting technologies in our pipeline, but I will just name a few. Last week, we announced the commercial launch of our NexSys AIR wireless chargers for AGVs, enabling our customers to truly automate their operations by eliminating physical charger connections and increasing safety for their workforce. I am particularly excited about the diverse capabilities of this technology, which is compatible with our traditional flooded, TPPL and lithium batteries.

This innovation is being enthusiastically received by our customers. In addition, our industry-leading lithium product offerings, are gaining traction with key customers. We were awarded a grant from the Defense Innovation Unit, DIU to prototype a high energy lithium 6T battery, leveraging our proven lithium technologies in space and our economies of scale to provide the Department of Defense with a high-quality domestic source of lithium cells. And last but not least, we are scheduled to begin trials of our 48-volt lithium batteries this quarter, to help telecom customers mitigate risk from grid instability. We continue to focus on optimizing the business. We are taking decisive actions to reduce costs. In Energy Systems, the exit of our residential renewables business, and closure of our Spokane production facility, are both substantially complete, and the scope of our restructuring actions has increased.

We are proud that our team was able to complete these initiatives in a very short time frame. We now have an optimized organization and footprint in energy systems and are positioned well to capitalize on the growth opportunities ahead when our communication networks customers resume normal spending patterns. In our Missouri factory, we are maturing our operations processes. The additional lost volume from the deeper telecom and broadband spending pause, along with longer lead time than originally expected for equipment and tooling to execute flexibility in these factories, has created additional pressure, which we are diligently working on. These efforts will have long-term benefits for the company, enabling us to more swiftly rebalance production lines, to optimize both growth and cost reduction opportunities, when demand fluctuates between lines of business and accelerating.

I am extremely pleased to say that we have received the first POs for our recently launched DPX, fault managed and Hyperboost power systems for 5G small cell and macro sites, respectively. We are encouraged with how quickly customer demos, have converted to orders for these innovative new products. In fast charge and storage, our team was able to integrate two energy storage systems into a single 1.2 megawatt hour system in as little as two months, demonstrating the modularity of this revolutionary system and our ability to deliver quickly on customer requests. We also continue to advance the planning efforts for our new lithium battery giga-factory in the U.S. We finalized our site selection, and we plan to announce more details about the location, state and local funding to support this investment next week.

We are pursuing additional investment at the federal level with DOE funding decisions, expected in late summer. Board approval to move forward will be dependent on an accretive internal rate of return. We continue to believe that the long-term market dynamics for lithium products strongly support the strategic importance of owning our own domestic supply of lithium cells, and we expect to produce our own lithium batteries, at a lower cost than we can source externally solely for EnerSys consumption. Please turn to Slide 6. Along with our strategic framework, we remain highly focused on our sustainability goals. In January, we published our second task force on climate-related financial disclosure report, with additional climate modeling and related analysis, which prepares us, for expected future climate legislation.

We recently approved our EcoVadis score, moving us into the top 14% of all companies retaining our Silver top 15% rating. This is a rigorous process respected and relied on, by our customers, to ensure their supply chains meet their sustainability requirements. I will now turn it over to Andy, to take you through our results and outlook in greater detail. Andy?

Andrea Funk: Thanks, Dave. Please turn to Slide 8. Third quarter net sales of $862 million were down from prior year, driven by a 7% decrease in volume, due primarily to temporary pauses and network investments, by our telecom and broadband customers and partially offset, by a 1% increase in price mix. During the quarter, we booked an IRA benefit of $59 million, as a reduction of cost of goods sold, including $29 million of retroactive credits attributable to our production in the first three calendar quarters of 2023 on expanded qualification of our domestic batteries. We achieved adjusted gross profit of $265 million, up $52 million. Excluding the IRA benefit, adjusted gross profit was $206 million, down $7 million on the lower sales volume, but up 80 basis points, as a percentage of revenue, compared to the prior year.

Our adjusted operating earnings were $130 million in the quarter, a $45 million improvement over prior year, resulting in adjusted operating margin of 15.1%. Excluding the IRA benefits, we achieved adjusted operating earnings of $71 million, down $14 million versus prior year, due entirely to the telecom broadband temporary spending pauses with – an adjusted operating margin of 8.3%, 90 basis points lower year-on-year. Adjusted EBITDA was $144 million and adjusted EBITDA margin was 16.7%, an increase of $46 million and up 600 basis points, respectively, versus prior year. Please turn to Slide 9. In line with our updated guidance, adjusted EPS was $2.56 per share, an increase of 102% over prior year, including IRA benefits of $1.44 per share in the quarter.

Adjusted EPS, excluding the IRA benefit, was $1.12, a 12% decrease over prior year’s $1.27 adjusted EPS. In the third quarter, our effective tax rate was 3.2% on an as reported basis and 20% on an as adjusted basis, before the benefit of the IRA. Let me now provide details by segment. Please turn to Slide 10. In the third quarter, Energy Systems revenue declined 14% from prior year to $374 million, primarily driven by the lower volumes previously mentioned, partly offset by improvements in price mix. Services within Energy Systems continued to grow nicely with double-digit revenue growth in the Americas in the third quarter. Adjusted operating earnings of $14 million, were $12 million lower than prior year, and adjusted operating margin of 3.8%, decreased 230 basis points over the prior year.

As Dave mentioned, we are working closely with many of our customers and projects, for the coming quarters, and we are prepared for strong demand to return, in this very important end market. We are continuing our disciplined cost reduction efforts in Energy Systems, and we anticipate generating a combined annual savings of approximately $27 million per year, on an ongoing basis, from our Energy Systems cost and infrastructure optimization initiatives, which we will fully realize next year, with one-time costs of approximately $30 million, of which the bulk has already been recorded. Please turn to Slide 11. Motive power revenues decreased 2% to $355 million on lower volumes, partially offset by the positive impact of acquisitions. We continue to see a return, to normal ordering patterns, with variation quarter-to-quarter this year and last, as labor and supply challenges are overcome and we continue to benefit from our customers’ growing enthusiasm, over our proprietary maintenance-free offering.

Motive power again reported strong adjusted operating earnings this quarter, contributing $53 million, up 12% over prior year. Adjusted operating margins were 14.8%, up 180 basis points over prior year. We remain bullish on our growth opportunities in this segment, due to the strong market appetite for automation and electrification, which our proprietary maintenance free and wireless charging solutions satisfy. Please turn to Slide 12. Specialty revenue increased 7% from prior year to $133 million, driven by a 6% increase in volume and a 1% positive impact from FX. Adjusted operating earnings of $7.5 million, while improving $2 million sequentially, were down $4 million from prior year, and adjusted operating margin of 5.7%, was down approximately 340 basis points.

While we’re beginning to recognize cost benefits from the closing of our Sylmar plant, they are not yet visible, as we continue to experience plant loading issues, from transitioning energy storage capacity, from telecom and broadband to transportation, which pressured our fixed cost absorption. We are laser-focused on optimizing the flexibility and performance of our operations and returning to full productivity levels. Given the strength in transportation and aerospace and defense end markets, combined with the enhanced capacity flexibility, and expansion we anticipate in the coming quarters, we are very optimistic about our growth opportunities in specialty. Please turn to Slide 13. Our balance sheet remains strong and positions us to invest in growth, and navigate the current economic environment.

As of December 1, 2023, we had $333 million of cash and cash equivalents, and our net debt of $587 million represents a reduction of approximately $300 million from the prior year. Subsequent to the end of the quarter, we capitalized on favorable market conditions, to issue $300 million of senior notes at 6.625% due in 2032, using the majority of the proceeds to paydown term debt, resulting in overall net neutral interest expense. Our credit agreement leverage was 1.1 times EBITDA adding back our off-balance sheet asset securitization program, our leverage ratio was 1.3 times EBITDA, the lower target range of two to three times and an improvement of 0.4 times from the end of the second quarter of fiscal 2024. In the quarter, we achieved an adjusted free cash flow conversion rate of approximately 106%.

We reduced inventory by $21 million versus Q2, achieving our lowest inventory balance in seven quarters, driven by a targeted reduction in specific raw material, and product categories while maintaining inventory reserves in energy systems, to be prepared when a speedy telecom broadband recovery occurs. CapEx was $23 million in the third quarter and $59 million on a year-to-date basis. Please turn to Slide 14. Our capital allocation strategy remains focused and disciplined around investing in organic growth, complemented by strategic M&A, maintaining a net leverage ratio, at the lower end of our two to three times adjusted EBITDA target range, in the current interest rate environment and returning capital to shareholders, through dividends and share buybacks.

As part of our growth strategy, we are evaluating potential bolt-on acquisitions, which will be a strong strategic fit and, which will add value to our portfolio, as well as the investment in a domestic lithium plant. During the third quarter, we paid $9 million in dividends and repurchased $35 million in shares. We currently have $112 million remaining on our buyback authorization. Please turn to Slide 15. Based on proposed regulations issued by the U.S. Department of Treasury in December, we concluded that more of our battery sales than previously anticipated, qualified for the IRA tax credits. Now approximately 90% of our batteries produced in the United States. As a result, we expect our annual IRA benefit to be in the range of $120 million to $160 million through December 2032, when the program is scheduled to conclude.

The phase out in the last three years of the program. As mentioned previously, we booked an IRA benefit of $59 million as a reduction of cost of goods sold during the quarter, including $29 million of retroactive credits. For further breakdown, please refer to our posted slides. Our eligibility for these benefits underscores EnerSys’ critical role in supporting the energy transition in the United States. In keeping with the intent of the IRA legislation, we intend to use the proceeds to invest in the development and production of our energy dense battery solutions in the U.S. Please turn to Slide 16. We remain optimistic about the trajectory of our business, and are particularly pleased with our continued ability to maintain pricing. While we are seeing healthy demand trends in the majority of our end markets, we are managing our business prudently, to navigate the temporary spending process by our telecom and broadband customers.

Based on this, we expect fiscal Q4, 2024 revenues to improve sequentially, but be down year-on-year versus a record fiscal Q4, 2023. Our fiscal fourth quarter 2024 guidance range is $1.98 to $2.08 adjusted diluted earnings per share, including the significant benefit of $0.80 to $0.90 per share from IRA benefits, but pressured by continued abnormal telco broadband spending pauses and incremental investments in fast charge and storage as we prepare for our sales launch in fiscal year ’25. We anticipate realizing gross margins of 26% to 28%, including 350 to 410 basis points from the IRA benefit. Our CapEx expectation for the full year of fiscal 2024, is in the range of $80 million to $100 million, reduced from our prior range on equipment supplier delays.

We continue to methodically execute on our strategic growth plans. We remain highly confident in EnerSys’ positioned, as a global leader in electrification and energy storage applications with demand driven, by critical global megatrends. With our industry-leading system solutions and strong customer relationships, we are well positioned for growth in our diverse end markets. With this, let’s open it up for questions. Operator?

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Q&A Session

Operator: Thank you [Operator Instructions]. Our first question is coming from Gregory Lewis with BTIG. Please proceed.

Gregory Lewis: Yes, thank you. Good morning, everybody. And thanks for taking my questions. A little hoarse here this morning. I guess my first question is, it was good to hear on the specialty. You kind of called out some maybe favorable trends in Asia and Europe. Could you talk a little bit more about that? I mean, obviously, everybody is watching the new seen mix messages out of parts of Asia. Kind of curious maybe what you’re seeing and what’s driving some of that?

David Shaffer: Well, let’s just specialty and there’s two pieces. It’s the transportation side and it’s the aerospace and defense side. So the – in the, specifically in the rest of world, I would say most of the opportunities are in the transportation area. And it just seems like there’s been a level setting of some of the economic pressures we’ve been facing quarters prior, and things are improving there. In the Specialty segment, in the aerospace and defense side, both in European market and in the – especially in the U.S. market, we’ve seen a tremendous increase in activity, quoting activity and opportunities. As you can imagine, is related to a lot of the geopolitics and the issues going on around the world in the Ukraine and in the Middle East and so forth.

So yes, there’s a lot of positive momentum building. We’ve had some big wins, and in the space area of late. So yes, specialty has got some great trends. The challenge, Greg, as you know, has been in our ability in the Missouri factories to achieve the transportation revenue targets we’re looking at. This is – and I alluded to this in my prepared remarks, I want to make sure it’s clear that let’s say, our five-year models and our long-term planning have always assumed a certain mix of products between our different business segments. And even though they’re all TPPL, there the tooling and the equipment necessary to build our different SKUs can be very different. And that mix has changed dramatically as our telco broadband business has slowed down.

So we’re – the point we’re trying to get to, I’d say, point B, is the expression we use, the endpoint is align assembly lines that are sort of ambivalent as to what products we’re making, whether it’s transportation. And our journey to get to Point B, has been a little challenging. As we came out of COVID, a lot of the tooling and equipment lead times we were seeing were in the 18-month, 24-month category. And we really expected going into this budgeting cycle that those lead times were coming down, and they really haven’t. And it’s been – we’ve been pulling our hair out a little bit with some of our suppliers, especially on the equipment and tooling side. So I don’t know that we’re going to be fully at point B until probably calendar year ’25.

Maybe as March, April time frame is where things are winding up right now. So in the meantime, that’s just – that puts a lot of pressure on the specialty P&L. And – but we certainly are moving in that direction. So Greg, hopefully, that’s enough color on the specialty side.

Gregory Lewis: Yes, no that was great. Thanks for that. And then I did want to talk a little more about the IRA benefit. I mean it’s not finding money in your pocket, what it kind of is. And as we look out really for – through – I mean pretty much almost for the next decade, we’re really going to be benefiting from that. How has – and I guess it might even be still too early to tell just we started realizing that last year. Has that done anything to change, how you’re thinking about capital allocation? I mean, you mentioned the potential, or not the potential, the most likely path of investing in maybe some projects in the U.S. If you could kind of, just talk about maybe how that changes how you’re thinking about capital allocation and maybe a little bit more color around, what those investments might look like?

David Shaffer: Sure. The explicit purpose of this benefit is to stimulate additional manufacturing of volume – high-volume density batteries in the United States. That’s the whole purpose. And with EnerSys, indeed, that’s what we intend to do with the proceeds. So whether that’s a combination of investment in our TPPL factories. As you noted, we are still working very hard on the business plan, to manufacture our own lithium ion cells domestically. These are all factors, which are accelerated, or enabled by the additional funding. It de-pressure the balance sheet in terms of our leverage ratios. So there’s a lot of positive impact. As you noted, it’s got a terminal value. I mean it has a terminus state. So, we’re on the shot clock in a sense.

So we’re trying to do as much of these business planning activities in parallel that, we can do. So in terms of site selection, in terms of lining up our technology partner in [Burcor], we’ve been doing as much as we can in parallel, working towards a point at, which we can make a final investment decision with our Board, as to whether to proceed, with the various capital investment plans, we’re laying out, including the new lithium factory. So Andy?

Andrea Funk: Yes, I was just going to say. Greg, good morning, hope you’re feeling okay. Just to add on to Dave’s comments on general capital allocation that you brought up. We remain committed to the capital allocation approach that, we laid out at Investor Day, including staying within our targeted leverage range of two to three times EBITDA, and in this current interest rate environment, on the low end of that. Our primary focus, as we’ve said before, is on businesses that have a strategic fit, with our growth and transformation, such as areas like power electronics, data centers, lithium charging and lithium plant, looking at more, not as an acquisition, but as an internal investment. We’re not looking at large transformational acquisitions that, would take us out of this target EBITDA range.

Ideally, for us, an ideal acquisition, and of course, we’ve got a balance sheet to be flexible here, but would be something in the $100 million to $300 million range, with growth higher than GDP, accretive margins. We’re not looking for a turnaround, a solid internal rate of return and most importantly, clearly answers the question why EnerSys. I hope that helps.

Gregory Lewis: Super helpful to everybody. Yes, this is great. Thank you. Have a great day.

David Shaffer: Thank you, Greg.

Operator: Thank you. One moment for our next question please. And it comes from the line of Noah Kaye with Oppenheimer and Company. Please proceed.

Noah Kaye: Good morning. Thanks for taking the questions. You characterized the telecom and broadband customer spending is abnormally low. And I was hoping, can you help us put a finer point on, how the revenue you’re seeing now in telecom and broadband, compares to prior trough. And the level of revenue growth you’re expecting, as we get into the September and December quarters, Dave, given your comments around expectations for that to return in the second half of calendar ’24?

David Shaffer: Right. So Noah, it’s good to hear your voice. Just as a level set, just – remember, we’re about – our exposure to telco broadband globally is around 33% of revenue. Roughly, I don’t think that’s an exact number. But it just gives you a sense for how important this segment is to us. And we have two on the board. We have two telecom veterans. I grew up in the telecom piece of the business. Sean and Drew, obviously, have that. I don’t think any of us remember seeing a situation where spending declined so rapidly and so abruptly across the segment. So it’s been a very unique period of time, at least – in recent years, and we’ve been adjusting. And a lot of our initial focus, has been on revenue recovery in different areas.

So we push or in data centers. We’re outperforming in aerospace and defense. And the biggest piece, as I noted earlier, when we were talking to Greg is to try to rotate more of our TPPL production capacity in the transportation segment. So that’s what we’re trying to do on the revenue side. And then we’ve been taking – we noted in my prepared remarks and Andy’s on the cost side. We closed Spokane. We’ve exited resi business. We’ve done a restructuring in that business. And so Andy, what would you say the annualized savings, are for those actions we’ve taken so far?

Andrea Funk: Yes, for those three actions, $25 million, we’ll have about a $27 million savings…

David Shaffer: So, they’re definitely material actions. And then in terms Noah about when we expect things to recover. So as I again said in the prepared remarks, and this is the first time for a lot of us, almost always in the DC power and battery world in December, we get a bunch of use it, or lose it kind of spending from our customers. We just didn’t see it this year. It was very unique, very different. And then January got off to, I would say, a slow start in terms of when budgets are released. Now the good news is, we’ve seen budget releases at two of our three biggest telco customers, and we expect the budget release on the third big telco customer here in the coming weeks. So it’s slow for sure in terms of recovery, but we are seeing opportunities.