Mayville Engineering Company, Inc. (NYSE:MEC) Q3 2023 Earnings Call Transcript

Mayville Engineering Company, Inc. (NYSE:MEC) Q3 2023 Earnings Call Transcript November 1, 2023

Operator: Thank you all for joining. I’d like to welcome you all to the Mayville Engineering Company Third Quarter 2023 Earnings Call. My name is Brica, and I will be the moderator for today’s call. [Operator Instructions]. I would now like to pass the conference over to your host, Stefan Neely, to begin. Sir Stefan, please go ahead.

Stefan Neely: Thank you, operator. On behalf of our entire team, I’d like to welcome you to our third quarter 2023 results conference call. Leading the call today is MEC’s President and CEO, Jag Reddy; and Todd Butz, Chief Financial Officer. Today’s discussion contains forward-looking statements about future business and financial expectations. Actual results may differ significantly from those projected in today’s forward-looking statements due to various risks and uncertainties, including the risks described in our periodic reports filed with the Securities and Exchange Commission. Except as required by law, we undertake no obligation to update our forward-looking statements. Further, this call will include the discussion of certain non-GAAP financial measures.

Reconciliation of these measures to the closest GAAP financial measure is included in our quarterly earnings press release, which is available at mecinc.com. Following our prepared remarks, we will open the line for questions. With that, I would like to turn the call over to Jag.

Jagadeesh Reddy: Thank you, Stefan, and welcome to those joining us call and webcast. As anticipated, our third quarter results demonstrated significant year-over-year growth in revenues, adjusted EBITDA and the free cash flow. These strong results were the product of continued steady end market demand and targeted market share gains, particularly in our commercial vehicle, military and power sports markets. Early in the third quarter, we closed on the acquisition of Mid-States Aluminum or MSA, which was also a contributor to our revenue and earnings growth in the third quarter. In addition to the cross-selling opportunities afforded by MSA’s aluminum fabrication and extrusion capabilities, our core business continues to enjoy a robust sales pipeline entering 2024.

Even as we look forward into a potentially more muted environment for end market growth, we are optimistic about our ability to deliver above market growth through the cycle by expanding our share of wallet with our current customers and improving the utilization of our existing assets. Importantly, our operational and commercial self-help initiatives are continuing to deliver improved profitability and cash generation through improved cost absorption, value-based pricing and enhanced working capital efficiency. During the third quarter, we generated a record $16.1 million of free cash flow, representing cash conversion in excess of 80%, a new record for our business. Consistent with our capital allocation priorities, we reduced our outstanding borrowings by more than $17 million in the third quarter, while repurchasing $1 million worth of common equity, leaving $17 million under our existing $25 million authorization as of September 30.

This year alone, we have repurchased $2 million worth of shares under our existing authorization. In September, we hosted our inaugural Investor Day event at our Hazel Park facility outside of Metro Detroit. Of the event, we introduced a 3-year road map for MEC, one that leverages the key pillars of our MBX framework to drive long-term value creation for our shareholders. At the event, we underscore how we intend to drive organic sales growth adjusted EBITDA margin and improve free cash flow generation while continuing to develop a leading manufacturing platform of scale within key growth markets such as energy transition. As a team, we are committed to excellence through accountability and introduced new 3-year financial targets at the event, which our entire team is focused on achieving.

By the year-end 2026, we expect to deliver between $105 million and $135 million of annual adjusted EBITDA, along with annual net sales between $750 million and $850 million, adjusted EBITDA margins between 14% to 16% and annual free cash flow generation of $65 million to $75 million. While these are ambitious targets, they are entirely achievable. Our third quarter results demonstrate early progress towards this plan. We remain focused on delivering ratable, consistent growth into 2024, building upon our track record of execution. While we are very pleased with our third quarter performance, it is important to highlight that these results include continued cost under absorption associated with planned ramp-ups at our Hazel Park and Atkins facilities.

Fixed costs under absorption at Hazel Park alone impacted the third quarter adjusted EBITDA and adjusted EBITDA margin by $1.7 million and 110 basis points, respectively. Excluding the impact of the Hazel Park ramp-up, our normalized adjusted EBITDA was 13.2%. We continue to expect that Hazel Park will ramp up fully by the end of 2024, contributing $100 million in annual revenues with adjusted EBITDA margins of approximately 15% in 2025. As of September 30, we currently had commitment for all but approximately $25 million of the projected $100 million in annual revenue contribution of that facility. Turning now to a view of market conditions across our 5 primary end markets. Let’s begin with commercial vehicle market, which represents approximately 40% of our trailing 12-month revenues.

During the third quarter, commercial vehicle revenue increased 6.6% on a year-over-year basis driven by strong demand and elevated build rates. Customer demand requirements continue to indicate slowing demand going into the end of the year and into 2024, as the industry navigates regulatory changes as well as a general slowing in economic activity. Currently, ACT Research forecasts the Class 8 vehicle production to increase 6.6% year-over-year in 2023 to 336,000 units. The current projection indicates that build rates will slow during the fourth quarter and decline by nearly 4% on a year-over-year basis. For 2024, ACT projections reflect a deeper softening in demand through the middle of the year with current production estimates reflecting an 18.5% decline for the full year 2024.

Furthermore, we are currently experiencing volume disruptions associated with the United Auto Workers strike with one of our customers. This has impacted our volumes for their products so far during the fourth quarter, and will continue to do so until an agreement is reached. Next is the construction And access market, which represented approximately 18% of our trailing 12-month revenues. Construction and Access revenue declined 2.3% on a year-over-year basis in the third quarter, given weaker fundamentals within the residential housing market, which continues to be impacted by the elevated interest rate environment. While residential construction trends appear to have troughed and Infrastructure and Energy market demand remained stable, we still expect to see demand softness year-over-year through the remainder of 2023 and into 2024 with the potential for modest improvement later in 2024.

The power sports market represented approximately 16% of our trailing 12-month revenues and increased by 7.7% on a year-over-year basis in the third quarter. We continue to benefit from market share gains, which include new customer programs, which were partially offset by cooling in consumer discretionary spending. Given current market conditions, we anticipate customers will seek to bolster demand through rebates and incentives going into the holiday season. As we look forward into 2024, indications are that continued slowing in demand would result in growth deceleration as dealer inventory levels have normalized. Our agriculture market represented approximately 10% of trailing 12-month revenues and increased 4.6% on a year-over-year basis during the third quarter.

The increase during the quarter was primarily driven by growth in large ag demand, along with the contribution of MSA’s ag-related sales, which offset continued overall softness in our legacy small ag market. This trend is in line with our expectations as global food stocks remain tight and crop prices remain elevated. Given elevated crop prices, we believe producer demand will increase through the end of the year and into 2024 with some deceleration going into the middle of 2024. The demand tailwinds in large ag going into 2024 should mostly offset softness in small ag demand. Our military market represented approximately 6% of trailing 12-month revenues and increased 70% on a year-over-year basis in the third quarter, driven by new program wins and bill rate increases.

Our customers have solid contractual backlogs with the U.S. government, and we continue to see good volumes based on new vehicle introductions and related programs. However, we foresee volume growth moderating during the fourth quarter and into 2024 due to the expected expiration of some legacy projects. I would also point out that with the completion of MSA acquisition during the quarter, the majority of MSA revenues are represented within our other end market category, which grew by over $12 million year-over-year in the third quarter. The MSA acquisition closed on July 1. And since then, our teams have been hard at work with integration and cross-selling activities. Overall, the MSA integration is going well and we are on track to have them fully integrated by the end of the year, as expected.

Importantly, as we highlighted at our Investor Day, we see MSA generating over $100 million of sales by 2026 with at least $25 million coming from revenue synergies with legacy MEC customers. As of end of September, we are progressing as expected towards the target, as well as the expected cost synergies that we are targeting through the implementation of our MBX lean manufacturing framework an MSA. Shifting now to an update on our MBX initiative. During the third quarter, we continued to progress in the implementation of our MBX value creation framework. I am pleased to report that we are on track to achieve the objectives we laid out last fall when we first announced the MBX framework. As we highlighted at our Investor Day, MBX is rooted in organic commercial growth, improved cost absorption through lean manufacturing practices, value-based pricing and working capital efficiency.

These key areas of self-help initiatives will allow us to create sustainable value and deliver above-market growth through the cycle. Commercially, we are targeting growth in higher value, high-growth adjacent markets, including clean technologies and energy transition in addition to expanding our share of wallet among our current customer base. Achieving this goal is dependent on good utilization of our equipment through better labor productivity as well as utilizing existing capacity at MSA and Hazel Park. Allow me to share some of the commercial milestones we achieved during the third quarter. Starting out, we are pleased to report that we have been awarded purchase orders for our first cross-selling win after the acquisition of MSA. Our first award was in the commercial vehicle space, which was the largest market opportunity within our cross-selling targets.

A modern commercial vehicle on the road, its engine powered by the company’s drive system.

We have continued to build momentum in our core activity, and we expect to continue to win awards for the coming quarters. During the third quarter, we continued the expansion of our customer relationship to supply battery thermal management products to multiple end customers as the EV transition continues to progress. This relationship will continue to expand as our customer grows their electric vehicle battery systems while we also are starting to work on significant outsourcing programs with this customer. In the quarter, we further expanded a new customer relationship in the power sports market with new program wins on new products. We expect to see continued significant growth with this new customer relationship as we look ahead into 2024.

We also made progress on securing additional market share within our large ag and construction customer. These new parts were related to next-generation products and continue to build momentum on winning new business with the capacity we have installed in Hazel Park. We have continued to gain additional market share as our commercial vehicle customers plan for their vehicle updates, both on next-generation products and battery electric vehicle platforms. We expect to continue to grow share over the next 2 years with the amount of change that will occur in this industry. As we highlighted during our Investor Day, our 2026 net sales targets are dependent on capturing incremental customer commitments of $65 million to $125 million, including MSA cross-selling synergies.

Based on our current level of sales activity and recent wins, we remain confident that this is achievable. The other pillar of MBX is commercial excellence, where our focus is to implement strategic and value-based pricing models across our customer programs. Year-to-date, the teams have been working tirelessly to implement a programmatic pricing model. On the operational excellence front, we have continued our rigorous implementation approach centered around our quarterly President Kaizen, supplemented by monthly operational and commercial excellence guidance. During the third quarter, we completed 25 Kaizens with a focus on sustainability of cost savings measures identified. Overall, our team has performed over 100 MBX lean events through the end of the third quarter.

These savings put us on track to achieve the 40 to 70 basis points of margin improvement reflected in our 2023 guidance, as well as the 100 to 150 basis points of margin improvement we expect to achieve by 2026. Given the current demand environment, the execution we have achieved with our MBX initiatives and the ongoing ramp-up of new program launches, we continue to expect consistent margin performance and free cash flow conversion to close off the year. Looking ahead to 2024, we anticipate some modest softening across our end markets given broader expectations for a general slowing in the U.S. economic growth next year. However, we anticipate ongoing operational and commercial growth initiatives will position us to deliver above-market growth.

Our ability to deliver above-market growth into 2024 depends in part on driving improved asset optimization across our system, continued price discipline and sustained cost management, all of which were on pace to deliver. 2024 will be a year of ratable progress for us, one where we expect to begin to fully realize the benefits of MBX initiatives, which are expected to support sustained organic growth, margin expansion and improved working capital efficiency. As before, we intend to price cash generation towards the aggressive reduction in outstanding borrowings, putting us on pace to achieve a net leverage ratio between 1.5x and 2.0x by the end of 2024. Since the announcement of the MSA acquisition, we have received numerous indications of interest from potential acquisition candidates, many of which fit nicely within our acquisition criteria for lightweight materials and high-growth end market exposure.

While we will continue to build a solid funnel of high-quality acquisition candidates, our chief focus over the near term will be on using net leverage to ensure continued balance sheet optionality through the cycle. In summary, as I have highlighted today, we delivered on several important strategic growth milestones during the third quarter, all of which play a role in building a leading integrated solutions platform equipped to take share in higher-value, underserved growth markets. As a team, we remain highly focused on delivering a high say/do ratio, one where a continued focus on program execution is at the center of all we do. Collectively, we remain focused on delivering a superior return on invested capital, whether through organic investments, acquisitions or the repurchase of our own common equity.

As we look to the coming year, we will continue to hone and refine our approach to capital allocation as we seek to maximize value for all of our shareholders. With that, I will now turn the call over to Todd to review our financial results.

Todd Butz: Thank you, Jag. I’ll begin my prepared remarks with an overview of our third quarter financial performance, followed by an update on our balance sheet and liquidity. Total sales for the third quarter increased 16.1% and a year-over-year basis to $158.2 million, driven by a combination of the MSA acquisition and improved organic sales volumes, partially offset by softening demand in our Construction and Agricultural end markets. When excluding the MSA acquisition, organic net sales growth was 6.2% on a year-over-year basis. Our manufacturing margin was $19 million in the third quarter as compared to $15.5 million in the same prior year period. The increase was primarily driven by increased organic volumes, MBX initiatives and the acquisition of MSA, offset by unabsorbed fixed costs associated with new project launches and an $891,000 negative impact from the inventory valuation step-up associated with MSA.

Our manufacturing margin rate was 12% for the third quarter of 2023 as compared to 11.3% from the prior year period or an increase of 70 basis points. When excluding the impact of the unabsorbed fixed costs and the inventory adjustment, our manufacturing margin would have been 13.7% or an increase of 240 basis points as compared to the prior year period. Profit sharing, bonus and deferred compensation expenses increased by $2.2 million to $2.3 million for the third quarter of 2023, which was driven by the lower stock-based compensation expense in the prior year period due to forfeitures of unvested awards. Other selling, general and administrative expenses were $8.6 million for the third quarter of 2023 as compared to $6.5 million for the same prior year period.

The increase was driven by $1 million of legal expenses relating to our former fitness customer, $500,000 of transaction costs associated with the MSA acquisition and increased salaries, wages and benefits. As we highlighted at our Investor Day in September, we believe that SG&A expenses in the near term will be between 4.5% to 5.5% of net sales as our public company costs increased as we work through meeting SOC compliance requirements. In the longer term, we expect operating leverage will drive our SG&A down to between 4.5% and 5% of net sales by 2026. Interest expense was $3.9 million for the third quarter of 2023 as compared to $830,000 in the prior year period due to higher interest rates and higher borrowings under our credit facility.

The increases in borrowings is due to the acquisition of MSA, which closed on July 1, 2023. Given our current net leverage, we are subject to a higher spread on our floating rate debt, combined with higher sulfur rates resulted in the elevated interest rate during the quarter. As we continue to pay down our debt, we expect that interest expense will continue to decline, not only due to lower borrowings, but also because of the step-down in our spread as a result of declining net leverage. Adjusted EBITDA increased to $19.2 million versus $16.1 million for the same prior year period. Adjusted EBITDA margin percent increased by 30 basis points to 12.1% in the current quarter as compared to 11.8% for the same prior year period. The increase in our adjusted EBITDA margin was primarily due to increased organic volumes, MBX initiatives and the MSA acquisition, partially offset by $0.5 million of higher underabsorbed fixed costs at Hazel Park.

Adjusted EBITDA margin progression is evident and demonstrates early advancement towards our 2026 goal of 14% to 16%. Turning now to our statement of cash flows and balance sheet. Free cash flow during the third quarter of 2023 was $16.1 million as compared to $5.2 million in the prior year period. As Jag mentioned, free cash flow generation for the quarter was the highest in any quarter since the IPO and represented a conversion rate of 84% of adjusted EBITDA. The improvement in free cash flow year-over-year was primarily due to the $8.9 million decrease in capital expenditures resulting from the completion of the Hazel Park facility and improved inventory turns as we continue to implement lean inventory management processes. With the heavy capital investment cycle in 2022 behind us, we are focused on improving working capital, and we were able to generate strong free cash flow results that put us on pace to meet our second half of the year free cash flow goal of $25 million to $35 million and show a significant progress towards our 2026 free cash flow target of $65 million to $75 million.

As of the end of the third quarter of 2023, our net debt, which includes bank debt, financing agreements, finance lease obligations and cash and cash equivalents, was $169.6 million as compared to $74 million at the end of the third quarter of 2022, and resulted in a net leverage ratio of 2.46x as of September 30. As we have stated previously, it’s our intention to use free cash flow generation to reduce our net leverage ratio to between 1.5 and 2x by the end of 2024. And during the third quarter alone, we repaid approximately $17 million of borrowings using available free cash flow. In light of our third quarter results and the outlook for the rest of the year, we are reiterating our financial guidance for the full year 2023. For the full year 2023, we continue to expect the following: net sales of between $580 million and $610 million, adjusted EBITDA of between $66 million and $71 million, capital expenditures of between $15 million and $20 million.

Our current full year 2023 guidance does not include any impact from the ongoing strikes within the CV and auto industries. Beginning in November, we estimate these strikes could negatively impact net sales by approximately $6 million to $7 million per month and adjusted EBITDA by $1 million to $2 million per month. With that, operator, that concludes our prepared remarks. Please open the line for questions as we begin our question-and-answer session.

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Q&A Session

Operator: [Operator Instructions]. We have the first question from Vlad Bystricky from Citigroup.

Vladimir Bystricky: So thanks for the information and the update today. Maybe just since you’ve given some initial thoughts on ’24 here, any color on how we should be thinking about raw material pass-throughs impacting ’24 just given where raws are today?

Jagadeesh Reddy: Sure. I think a week ago, Vlad walked into this call on Friday, I would have said, “Hey, no change. We have stable steel prices, and we’re expecting some price stability given that almost in the past year, right, steel prices have stayed relatively calm.” But as markets have shown in the last few days, as steelmakers continue to curtail supply, we are seeing a bit of a spike in our steel prices. We don’t expect that to last through 2024, but we are seeing a bit of a spike in the last — in a week or so. We’re expecting things to stabilize in 2024.

Todd Butz: And Vlad, I would just comment that we wouldn’t expect it to have the impact that it did in ’21 and ’22. Certainly, there’s been a little bit of an uptick, but the fluctuation isn’t as steep as in previously. So again, as we look into ’24, we don’t see that as a real large impact. But again, it’s a pass-through, and we’ll disclose it going forward each quarter.

Vladimir Bystricky: Okay. Great. That’s helpful. And then just on the quarter and into year-end here. You talked about supply chain constraints still impacting some customers. So can you just talk about sort of how you’d characterize visibility from your OEM customers in the current environment? And if you’re seeing changes in their order patterns or any increasing stability that could be helpful to your own manufacturing operations?

Jagadeesh Reddy: Sure. I would say that in Q3, we did not see any significant customer supply chain disruption. So for us, it feels like things have calmed down. And we saw relatively normal order flow. Coming into — sorry, coming into Q4, we are not expecting any significant changes on that front either. Having said that, probably the last sentence on Todd’s — in Todd’s remarks, right, if you caught it. We have, obviously, exposure to some customers who are experiencing some UAW strike disruptions. I would say that by — through the end of October, our impact has been minimal. And auto exposure we have now, we can say that in rest of Q4, will be again minimal, given that the strikes have been at least looks like they’re going to be settled.

Other CV customer that continues to be down because of the UAW strike. We’re optimistic that given the conclusion of the other big 3 contract negotiations, that our CV customer could also wrap up their negotiations in the short term. But if that continues on, we expect some impact, as Todd mentioned in his prepared remarks, in Q4. Outside of those events, we do not expect any disruptions from any supply chain issues or otherwise going into 2024. We have not seen any indications of softness per se in orders or purchase orders or any of EDI feeds we normally see. But the conversations have been a little muted from some of our customers, even though the order flows haven’t changed, the demand picture hasn’t changed. So given the discussions about macroeconomic conditions, high interest rates, consumer demands slowing with all of these, we’re walking into 2024 on a cautious mode.

As we mentioned, we continue to expect to perform our revenue growth to be above market growth next year, given our market share gains and new program wins and start up of multiple long-term programs in both Hazel Park, Atkins and other locations within the company.

Operator: We now have the next question comes from Mig Dobre of Baird.

Mircea Dobre: I want to talk on the last point that you made there, Jag, about ’24 and about your specific outgrowth drivers. Is there a way to update us or kind of quantify knowing what you know today in terms of business that you guys have booked or programs, incremental programs that you have booked as to what the revenue benefit in ’24 relative to ’23 would be from the business that you already kind of have visibility on?