The Eastern Company (NASDAQ:EML) Q2 2023 Earnings Call Transcript

The Eastern Company (NASDAQ:EML) Q2 2023 Earnings Call Transcript August 9, 2023

Operator: Greetings. Welcome to the Eastern Company’s Second Quarter Fiscal Year 2023 Earnings Call. [Operator Instructions] Please note, this conference is being recorded. I will now turn the conference over to your host, Ernie Hawkins. You may begin.

Ernie Hawkins: Thank you, everyone, for joining us this morning for a review of Eastern’s results for the second quarter of 2023. With me on the call are Eastern’s President and CEO, Mark Hernandez; and Eastern CFO, Nicholas Vlahos. We issued an earnings press release yesterday after the market closed. If anyone has not yet seen the release, please visit the Investors section of the company’s website www.easterncompany.com, where you will find the release under Financial News. Please note that some of the information you will hear during today’s call 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 expenses, 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 review 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 SEC filings, including Form 10-K filed with the SEC on March 14, 2023, for the fiscal year 2022 and Form 10-Q filed with the SEC on August 8, 2023. In addition, during today’s call, we will discuss non-GAAP financial measures that we believe are 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. With that introduction, I’ll turn the call over to Mark.

Mark Hernandez: Thank you, Ernie, and good morning to those who have joined us by phone as well as those participating via the web. I’m going to begin today’s call with some high-level observations of our performance and actions during the second quarter. I’ll then turn the call over to Nick, who will provide a more detailed review of our financial results. After that, I’ll come back and update you on the progress of our plans to transform Eastern’s operations and enhance our portfolio of businesses. I’ll also provide some thoughts on what we are focused on for the rest of 2023. As you recall, when I became Eastern CEO 7 months ago, the company was facing severe supply chain disruptions and increases in freight and material costs that hurt the performance of all 3 of our divisions.

Our new management team immediately undertook a ground-up review of our businesses, their products, the markets in which they operate and the conditions in those markets. Based on that review, we initiated a wide array of changes to our operations, several of which I described in the last earnings call. In the second quarter, we continued implementing those actions and realized some initial benefits from our many improvement initiatives to show that our strategy is beginning to take root. Let’s take a quick look at some of the high points of the quarter. First, cash flow from operations for the first 6 months ending July 1, 2023, increased by $16 million as compared to the same period in 2022 as Nick will discuss in more detail. Our balance sheet continued to strengthen due to our operational actions during the quarter, which allowed us to pay down another $5 million in debt during the second quarter.

On a year-over-year basis, our backlog was down 9% to $75.3 million as we continue to improve our supply chain, transition from old to new programs with our vehicle and automotive customers and increased shipments to our customers. Our backlog is now in line with our current level of business, and we are focused on every order every day to make sure the backlog remains consistent to enable optimum performance. We took steps to enhance our portfolio of businesses, including closing Associated Toolmakers, our European mold tooling service facility and acquiring assets of Sureflex, a manufacturer of tractor trailer electric connection cable assemblies, which will vertically integrate our trailer hose business and enhance Velvac’s production facility.

We made — we also made asset allocations to install a tube laser, plate laser and a 5-axis CNC machine in our facilities. These projects have all — have met the new NPV payback and internal rate of return thresholds that are embedded within our new Eastern strategy. On a sequential basis, our gross margins rose to 22% in this year’s second quarter from 21% in the first quarter of 2023 as a result of focusing on margins within the commercial segments. We are very optimistic that our team’s hard work will become more evident in the second half of 2023. We established a new $90 million 5-year senior credit facility with expanded lender group. The new credit facility provides us with increased flexibility and will allow us to continue to drive improvements across the current company, execute our growth strategy and increase shareholder value.

Finally, demand as a whole remains consistent and in line with previous quarters. Although we do expect headwinds from macroeconomic factors, we are now better positioned to deal with these headwinds and to take advantage of tailwinds that may arise. With that overview, I’ll turn the call over to Nick.

Nicholas Vlahos: Thank you, Mark, and good morning, everybody. I’ll provide a quick review of the quarter’s financial highlights. Net sales from continuing operations declined 2% to $68.3 million from $69.5 million in the second quarter of 2022, primarily due to lower demand for returnable transport packaging products. Price increases and sales of new products contributed 2%. New products included various truck mirror assemblies, rotary latches, D-rings and mirror cams. Price increases primarily reflect our efforts to recover increases in raw material and freight costs. Gross margin as a percentage of sales was 22% in the second quarter compared to 23% in the last year’s period but up from 21% in the first quarter of 2023. The quarter-over-quarter increase reflected improved price/cost alignment and easing of some raw material and freight costs.

Product development expenses were up $0.5 million in the second quarter of 2023 when compared to the corresponding period of 2022, reflecting increased investment in new products at Eberhard and Velvac. As a percentage of net sales, product development expenses were 2.1% compared to 1.4% in the quarter — second quarter of 2022. Selling and administrative expenses were $11.3 million compared to $10.1 million for the second quarter of 2022, an increase of $1.1 million or 11% primarily due to legal, professional and selling costs and payroll-related expenses. The increase in selling expenses reflects our investment in sales capabilities. Other income decreased $300,000 to $200,000 in the second quarter of 2023 compared to the corresponding period in 2022.

This decrease primarily reflected unfavorable pension costs of $300,000 in this year’s second quarter, while in the prior year period, the company had a favorable pension cost adjustment of $400,000 and a $1.4 million expense associated with the closure of Associated Toolmakers, partially offset by $1.6 million favorable adjustment for the final settlement of our swap agreement with Santander Bank. Net income from continuing operations for the second quarter of 2023 was $1.4 million or $0.22 per diluted share compared to $3.4 million or $0.59 per diluted share for the comparable period of 2022. Adjusting for related closing expenses with Associated Toolmakers, net of tax, which totaled $1.1 million or $0.18 a share, adjusted net income from continuing operations was $0.40 per share.

Adjusted EBITDA from continuing operations, a non-GAAP measure, for the second quarter of 2023 was $5.9 million compared to $7.2 million in the second quarter of 2022. During the first 6 months of 2023, we increased our cash flow from operations by $16 million when compared to the same period in 2022. The improvement reflects a reduction in cash used to support working capital, primarily a $7.7 million increase — decrease in inventory. By comparison, last year, cash was used to ensure the availability of inventory to meet customer demand in light of the supply chain constraints. With this cash flow, we paid down $5 million of debt during the second quarter and nearly $10 million year-to-date. At the end of second quarter, our senior net leverage ratio was 1.95 to 1, down from 2.05 at the end of the first quarter.

In addition, we have invested $2 million in capital expenditures and paid dividends of $1.4 million in this first 6 months of 2023. For the second quarter, cash flow from operation — operating activities was $6.7 million compared to $1.1 million for the second quarter of last year. As a result, inventory turnover improved from 3.8 compared to 3.2 for last year’s period. That completes my financial review. I’ll now turn the call back to Mark.

Mark Hernandez: Thank you, Nick. Because our team strategy is so key to everything we do, I want to briefly reiterate it for you today. As you recall, it’s made up of 4 categories: First, disciplined operations that deliver consistent results. We continue to scrub the cost side of the business making sure that the cost of goods sold and operating expenses meet internal profitability targets and shifting Eastern’s focus to high-volume, high-margin products. These efforts are evidenced by the reduced working capital and increased cash flows, enabling us to pay down debt. Second, a strong commercial business focus. In this area, we are focusing on improving return on investment — invested capital through pricing actions and margin discipline.

During the second quarter, we continued our evaluation of the margin of each product as part of our overall portfolio optimization exercise and have been pinpointing areas where we’re missing opportunities to enhance margins through pricing or where we need to change our approach. We have been renegotiating pre-pandemic contracts rationalizing SKUs and making sure every segment has positive margins. We’ve begun to see some of the fruits of these efforts as evidenced by the start of the sequential improvement in gross margin. Third, effective capital allocation and utilization. Our divestiture of Associated Toolmakers announced in the beginning of May shows that we won’t go on doing business whose ROIC is not favorable to Eastern. Fourth, value-added acquisitions.

The Sureflex assets we added in June are a small acquisition but smartly done, in addition, will have a very positive impact on Velvac. Our Eastern M&A committee is currently reviewing additional opportunities. Our goal for this year remains to ensure that all aspects of Eastern operations, our cost structure, capital management and pricing strategy meet profitability, return on invested capital thresholds so that each business contributes to building overall shareholder value. Of course, there can be some puts and takes to this process, such as offsetting increases in health care expense, pension portfolio performance and ERC tax credits. So we are not yet at a stage where we can share the target financial metrics with you. But as I mentioned last quarter, successful OEM suppliers, which is what we intend Eastern to be, proactively respond to changes in cyclical demand while returning 10% to 12% return on sales and working capital sales ratios of less than 22%.

We are optimistic about our performance in the second half of 2023 as our strategy has time to show its impact. A final note before we open the floor to questions. In the coming months, we plan to expand our Investor Relations activities. In July, we developed a new investor presentation and posted it to our Investor Relations website. We are updating the presentation now that we’ve announced second quarter results. I invite you to take a look when you have a chance. We’ve also had an early round of conversations with members of the investment community who follow microcap stocks and plan to continue those conversations in the future. We’ll also participate in investor conferences in the fall.

Ernie Hawkins: Thanks, Mark. Operator, I’d like to open the line for questions. I see that we have questions from the webcast. We will address those questions first and then turn to questions on the line.

A – Ernie Hawkins: First question. How much of today’s backlog reflects the old pricing versus current renegotiated pricing?

Mark Hernandez: So approximately 80% of our current backlog reflects our new pricing strategy.

Ernie Hawkins: Second question. There were a lot of moving parts in the income statement in the second quarter. Should we expect more of the same in Q3?

Mark Hernandez: As we move forward in Q3, the bulk of the adjustments that we had to make to operations have been undertaken and been reflected in our results. However, there will be no other future impacts of the order of magnitude of what we’ve seen on our balance sheet so far.

Ernie Hawkins: And the third question from the web. EV impact on commercial trucking. Overall, is it good or bad?

Mark Hernandez: The impact of electric vehicles in the commercial vehicle space continues to move forward. We don’t see signs of softening as the total cost of ownership of certain segments within the commercial vehicle space, particularly Class 5 through 7 begin to take hold, starting with school buses, getting into small delivery trucks, distribution deliveries and regional hauls. The biggest drain on the implementation of EVs across the commercial vehicle segment is the infrastructure to charge the vehicles. So it’s really picking and choosing those segments that can take advantage from a total cost of ownership perspective. It’s my opinion that we have not slowed down or nor have we sped up. It’s just going through the course that it’s been going for the last 2 or 3 years.

Ernie Hawkins: I’m not seeing any other questions via the webcast. So operator, I’ll turn it over to you.

Q&A Session

Operator: At this time, we will take phone questions. [Operator Instructions] Our first question comes from Ross Davisson with Banneton Capital.

Ross Davisson : Sorry about that. A couple of questions on growth. So what is driving — what are you seeing in the returnable packaging segment that you think is driving the lower demand? Is it more about just a strong year last year that you’re comping? Or what are you seeing in terms of end market demand?

Mark Hernandez: On returnable packaging, it has a lot to do with the new program launches as new automotive assemblies, vehicles come out, electric vehicles, ICE vehicles going forward. We haven’t seen signs of the automotive OEMs or the commercial vehicles OEMs delaying the launch of these products. So we’re seeing consistent demand through the transition of the programs. When you launch a new vehicle, they require unique racks that are made specifically for those programs. So we’re looking at a strong demand going as these programs get launched at the OEMs.

Ross Davisson : Right. And that makes sense. But then it sounds like in the most recent quarter, you — the business was down, I think, it sounds like from what you said. Is that right?

Mark Hernandez: Yes.

Ross Davisson : And what’s changing, if anything?

Mark Hernandez: So there was some fears out there of a recession in 2024. So some of the larger OEMs delayed some of their releases of their purchase orders but that is behind us now as the fears of a strong recession are put aside and now it looks to be just a softening, not a full-on recession. So they’re more positive about what’s going to…

Ross Davisson : Great. And then the other segments beyond just Big 3, beyond the returnable packaging business, are those growing? Or are those facing challenges of their own in terms of growth?

Mark Hernandez: So on the other businesses, we’re closely tied with the commercial vehicle space and the demand — the replacement demand is still there and it’s very strong. We’re getting indications from all the commercial vehicle manufacturers that they want to increase capacity. Now whether other suppliers like frame rails, which is a commodity across the commercial vehicles can keep up, we’re going to be paced along with them. But the demand is there to replace the vehicles that have been in the field for 3 years going forward. So we see a modest 5% to 10% increase in segments of the commercial vehicle space going into next year.

Ross Davisson : Okay. Great. And then in terms of pricing and just cost recovery actions, it sounds like you’ve had some real success there. As you think about the sort of inflection or the improvement you’re saying we’ll see in the second half of 2023 in terms of the efforts coming to fruition, are these actions that are done like they’ve been agreed to? It sounds like the backlog is largely priced already. But I just wanted to check, like is there a risk that some of the actions you’re still pursuing won’t come through? Or do you feel like a lot of this is baked because you’ve had success in going back to customers and recovering some of those costs?

Mark Hernandez: Yes. So from a customer perspective, we’re probably 95% done and the customers have agreed. There’s still some stragglers out there that we’re working on. And those customers are priced into our backlog currently. And so it’s really, really difficult to take existing business and increase pricing. It’s easier to do it when you’re launching a new program or a new product for a new model. So we took — we undertook this effort and it’s an emotional drain doing these negotiations and talking about macroeconomic factors and how they affect the business. But the customers are professional, and we treat them professional, and we just want to be a good, strong supplier for the customers, and they appreciate that.

Ross Davisson : Yes, no doubt. And I’m sure it’s been really tough for the team and so congratulations on realizing that. And given this 95% done with the customers, I don’t know if the — it doesn’t seem like the dynamic with these raw materials and freight are anywhere close to the swings you’ve seen in the past, do you feel like you’re going to see some recovery in the second half year as you’ve said based on these conversations based on these new programs you’re rolling out with new pricing? And after that, you expect more stability in gross margin? Or do you see opportunities beyond just these near-term actions you’ve taken to sort of keep improving gross margin as you go forward into 2024 and 2025?

Mark Hernandez: Yes. So the — we factored into the price increases the current situations in logistics and raw materials. Raw materials are going to continue to fluctuate, and we’ll work with the OEMs on how to deal with that going forward. This doesn’t preclude us from kind of making that a neutral to our gross margins. We do see opportunities on the onshoring side to reduce our transportation costs and be less exposed to long distance shipments of parts as we onshore our materials. So we think there’s opportunities on the transportation side that will add to or reduce our cost of goods sold as well as add to our gross margins.

Ross Davisson : Okay. Great. And last question. You talked about the sales capability investments that you’ve made as part of the increase in SG&A. I’m just curious if you could elaborate a little bit on what those are and kind of what you’re seeing or how you expect those to help, I guess, sales going forward.

Mark Hernandez: So we take a look at the SG&A and also the R&D side of it, and we’re investing in new models that are coming out. So you see our engineering costs are slightly higher than they have been historically. But we have quite a few programs that are going to launch in 2024 going forward. Once they get off the ground and we’ll start seeing the revenue, and you’ll see the percentages of SG&A and R&D actually go down as we — we reflected an incremental revenue growth and the percentage of SG&A and R&D will actually fall as a percentage of revenue.

Nicholas Vlahos: And just to add to that a little bit about the SG&A percentage as well, we did incur cost during the quarter for our contract renegotiations, and we view those more as a onetime cost that we will not have consistently going forward.

Ross Davisson : So that’s like costs that you might — that might — like customer costs like some sort of concession in order to realize the renegotiation that kind of cost or legal costs — incurring legal costs renegotiated?

Nicholas Vlahos: Correct.

Operator: There are no questions remaining in the queue. So at this moment, I will turn the call back over to Ernie Hawkins.

Ernie Hawkins: Okay. So with that, I’ll turn the call over to Mark for closing remarks.

Mark Hernandez: Thanks, Ernie. Thanks again for joining us today. To sum up, I’m confident that our strategy and focus will bring positive changes and improved results in 2023, putting Eastern on a strong path for the future. We look forward to sharing more signs of progress with you after the third quarter. If you need more information in the meantime, please reach out to us. Thank you for joining the call.

Operator: This concludes today’s conference, and you may disconnect your lines at this time. Thank you for your participation.