Tennant Co (TNC) 2018 Q3 法說會逐字稿

Good morning. My name is Cheryl, and I'll be your conference operator today. At this time, I would like to welcome everyone to Tennant Company's Third Quarter 2018 Earnings Conference Call. This call is being recorded. (Operator Instructions) Thank you for participating in Tennant Company's Third Quarter 2018 Earnings Conference Call.

Beginning today's meeting is Mr. Tom Paulson, Senior Vice President and Chief Financial Officer for Tennant Company. Mr. Paulson, you may begin.

Thanks, Cheryl. Good morning, everyone, and welcome to Tennant Company's Third Quarter 2018 Earnings Conference Call. I'm Tom Paulson, Senior Vice President and Chief Financial Officer of Tennant Company. Joining me today are Chris Killingstad, Tennant's President and CEO; Tom Stueve, Vice President and Treasurer; Andy Cebulla, Vice President of Finance and Corporate Controller; and Kristin Stokes, Deputy General Counsel.

Today, we will review our ongoing progress against our core strategies, our performance during the 2018 third quarter and our updated outlook for 2018. Chris will first brief you on our operations, and then I'll cover the financials. After that, we'll open up the call for questions. We're using slides to accompany this conference call. We hope this makes it easier for you to review our results. A replay of this conference call, along with these slides, will be available on our Investor Relations website at investors.tennantco.com following this call until November 24, 2018.

Now before we begin, please be advised that our remarks this morning and our answers to questions may contain forward-looking statements regarding the company's expectations of future performance. Such statements are subject to risks and uncertainties, and our actual results may differ materially from those contained in the statements. These risks and uncertainties are described in today's news release and the documents we file with the Securities and Exchange Commission. We encourage you to review those documents, particularly our safe harbor statement, for a description of risks and uncertainties that may affect our results.

Additionally, on this conference call, we will discuss non-GAAP measures that include or exclude certain items. For each non-GAAP measure, we also provide the most directly comparable GAAP measure. There were non-GAAP items in both the 2018 and 2017 third quarters. Our 2018 third quarter earnings release includes a reconciliation of these non-GAAP measures to our GAAP results. Our earnings release was issued this morning via Business Wire and is also posted on our Investor Relations website.

Now I'll turn the call over to Chris.

Thank you, Tom, and thanks to all of you for joining us. The core strategies we are pursuing at Tennant Company are designed to achieve one thing, build the top to bottom strength throughout our organization necessary to deliver sustained long-term value for our shareholders. These strategies touch every dimension of Tennant, while maintaining a robust new product pipeline, to driving operational rigor across our footprint, to broadening and diversifying our revenue streams, and to preserving the financial strength necessary to invest for future growth.

During the third quarter, we once again made solid progress across these core strategies. While we faced some challenges, many of which are shared by those across the U.S. manufacturing sector, I'm encouraged by our ability to make persistent progress and move the needle across our entire organization.

For the past several quarters, we've pointed to sales strength across our geographic regions and that continued during our third quarter. On a consolidated basis, net sales grew 4.3%, up 6.1% organically to more than $273 million during the 2018 third quarter. With the exception of sales in the EMEA region, which faced a very challenging year-over-year sales comparison during this period, Tennant again generated broad-based sales growth across our footprint. Notably, we are pleased with our performance in the Americas as well as our strength in the Asia Pacific region during the quarter.

We also remain pleased by our ability to execute across channels. As you recall, diversifying our go-to-market channels has been an essential component of our strategy. Thus far in 2018, we've demonstrated significant progress in all go-to-market channels, direct, distributor and strategic accounts. Our third quarter sales performance reflected particular strength in our strategic account sales channel.

Moving on to IPC and our integration efforts. We continue to be pleased with the underlying performance of IPC. During the quarter, we made substantial progress strategically aligning our operations across the EMEA region. Importantly, we achieved a significant organizational milestone by finalizing the structure of our future leadership team in EMEA, which will be effective early next year. We will maintain a combination of IPC and legacy Tennant leaders to drive the EMEA organization in the future. I am proud of our ability to unify the Tennant and IPC teams while preserving the stability and growth profile of our business in the region.

In addition, we continue to make progress on capturing the synergies from the business combination. Selectively finding ways to capitalize on growth opportunities in key markets remains a focus for Tennant. And during the quarter, we announced our agreement to acquire Gaomei Cleaning Equipment Company in China. Gaomei manufactures a full range of cleaning machines and equipment, including single disk scrubbing machines, vacuum cleaners, carpet extractors, blowers, high-pressure washers, sweepers and floor scrubbers. Gaomei is also a recognized R&D leader for small to midsized cleaning solutions for commercial and industrial applications. This acquisition extends our ability to serve the mid-tier APAC market, specifically in China. We are very impressed with their management team and enthusiastic about our potential together. We now expect to complete this transaction in the second quarter of -- sorry, the first quarter of 2019.

Turning now to margin and expense management, which, respectively, have been areas of challenge and success. Operational efficiency is an area of intense focus within Tennant to better manage both our margin and operating expense profile. It is helpful to break these focus areas into 2 categories: those directly within our control; and those which are a part of the current macroeconomic environment affecting U.S. manufacturers. Utilization of our field service capabilities and efficiencies within our manufacturing operations are 2 areas squarely within our control. And the investments we've made in these areas have improved the efficiency and effectiveness of both our service offerings and our manufacturing performance. We continue to execute on these initiatives, which are having a favorable impact on gross margins. There are, however, several macro factors impacting gross margin. These take the form of higher freight costs, raw material inflation, labor shortages that periodically impact productivity and tariffs. Given these factors, we are reducing our gross margin expectations by 50 basis points for full year 2018.

While we work to manage these challenges, expense management across our entire enterprise is, of course, a critical focus. And we're pleased with our ability to improve our year-over-year S&A expense ratio during the quarter.

Now before turning the call over to Tom, some color on our technology and new product update. We continue to invest in R&D at levels necessary to propel our clear technology leadership position. Notably, we've taken our first order for our autonomous T7 scrubber, a robotic cleaning machine from Tennant. We've committed to commercialization of this product offering by the fourth quarter of 2018 and are pleased to be on track with this promising new technology. We are excited by the interest we're receiving from customers related to this new product and are encouraged with the long-term prospects for growth.

As you know, we also track progress of our new product offerings and relevancy of our innovation to customers by our vitality index, which is the percentage of sales from products issued in the last 3 years. For the third quarter, we were once again well above our target of 30%.

Overall, we're confident in the underlying performance of the business and are pleased with the progress we are making across our various strategies. Given our continued strong orders and sales performance, actions and motion to offset external headwind affecting our margins, the underlying operational improvements we are seeing in the business and appropriate spending controls we have in place, we are confident in our ability to drive shareholder value.

Now I'll ask Tom to take you through Tennant's third quarter financial results. Tom?

Thanks, Chris. In my comments today, references to earnings per share, both GAAP and non-GAAP, are on a fully diluted basis. Also as a reminder, our organic results and regional reporting reflect IPC's results.

As Chris noted, we witnessed broad-based improvement in several areas during the quarter, most notably in revenue performance, expense leverage, cash flow and EBITDA expansion. These all illustrate our discipline and commitment to executing our core strategies.

For the third quarter 2018, Tennant reported net sales of $273.3 million, roughly 4.3% higher year-over-year with organic sales improving 6.1%. Organic sales results exclude an unfavorable currency impact of approximately 1.7%.

Looking at the bottom line, third quarter 2018 reported net income was $9.7 million or $0.52 per diluted share. Our reported results on the quarter reflected the impact of nonoperational items that reduced earnings by approximately $400,000 or $0.02 per share. Excluding these items, Tennant reported adjusted net earnings of $10 million or $0.54 per share. By comparison, Tennant reported adjusted net earnings of $5.8 million or $0.32 per share in last year's third quarter.

Now let's take a closer look at the 2018 third quarter. As a reminder, we group sales into 3 geographies: the Americas, which encompasses all North America and Latin America; EMEA, which covers Europe, the Middle East and Africa; and Asia Pacific, which includes China, Japan, Australia and other Asian markets.

In the Americas, 2018 third quarter sales rose 8.9%, up 10.6% organically. We are pleased with the breadth of performance in this region during the period, which reflects a combination of expansion in our strategic accounts, continued sales strength in our Service and Parts and Consumable business, higher industrial equipment sales in South America and continued broad-based strength in Brazil.

Turning to EMEA. Reported sales were down 5.8% or 4.5% organically. We need to recognize the significant outperformance in this region during last year's Q3 of 14.6% organic growth, which led to the challenging comp in this year's third quarter. As Chris mentioned, we remain optimistic about the overall growth profile of this region and our recent integration milestones within IPC.

Looking at the Asia Pacific region. Sales were 7.4% or 10.6% organically. Sales in industrial products in China led the way during the period. Our acquisition of Gaomei and our comp combined product lines are exciting new avenues for further expansion in APAC.

Turning now to gross margins. Tennant's adjusted gross margin in the 2018 third quarter was 39.6% compared to an adjusted 2017 third quarter of 40.8%. Of course, these gross margin levels are not satisfactory, and we continue to aggressively tackle the margin drivers within our control and find ways to navigate the macro factors. Namely, tight labor markets, tariffs and raw material price factors and high freight and logistics costs. These items combined to negatively impact our year-over-year margin rate by approximately 110 basis points.

In addition, as I previously mentioned, we continue to experience robust growth in our strategic account channel, which negatively impacted our margins in the quarter by approximately 70 basis points.

We are pleased with the improvements we're seeing related to field service utilization and the underlying performance of our manufacturing operation, both of which partially offset the negative margin pressure we experienced in the quarter. However, given the significant macro factors we continue to experience, we are recalibrating our margin expectations for the full year to reflect current dynamics. We are reducing our anticipated full year gross margin rate to 40.5% from 41%, primarily related to the external factors that I just mentioned.

Research and development expense in the 2018 third quarter totaled $7.5 million or 2.7% of sales. We are confident that we are investing at levels that reinforce our technology leadership position and allow us to maintain a robust new product pipeline.

Selling and administrative expense in the 2018 third quarter adjusting for onetime costs was $84.3 million or 30.9% of sales compared to the prior year quarter of $84.8 million or 32.4% of sales. It's worth reminding that our third quarter of 2018 included a noncash amortization expense related to the IPC acquisition of $5.4 million or 2% of sales compared to $7.3 million or 2.8% of sales in last year's third quarter.

Clearly, our expense leverage progress demonstrates our commitment to business efficiency and driving the bottom line in a challenging operating environment.

Moving on to EBITDA. As we discussed previously, earnings before interest, taxes, depreciation and amortization is now an important measure for Tennant, given the impact of noncash amortization expense and our increased level of interest expense as a result of the IPC acquisition.

Our 2018 third quarter adjusted EBITDA was $29.3 million or 10.7% of sales, which was flat compared to the prior year quarter. Overall, we are pleased with our EBITDA performance given the headwinds we're facing related to gross margins.

We continue to focus on initiatives that can help us improve across every profitability measure. These include driving organic revenue growth across all geographies, continuing to control fixed costs in our manufacturing areas as volume rises, managing inflation of the gross profit line and standardizing and simplifying processes globally to continue to improve the scalability of our business model while minimizing increases in our operating expenses.

Shifting to our tax rate. Our as adjusted effective tax rate for the 2018 third quarter was 5.6% compared to 21.7% in the year ago quarter. This illustrates the impact of new tax legislation of the U.S., discrete favorable tax items impacting the quarter and a favorable geographic mix of profitability we experienced. Based on those higher-than-anticipated benefits, we are updating our forecasted tax rate to 15% for the full year 2018.

Tennant's cash from operations for the third quarter was $17.5 million, bringing our year-to-date cash flow from operations to $43.5 million compared to $32.1 million in 2017 in year-to-date performance, which marks a significant increase.

Looking at other aspects of our capital allocation. Tennant also paid cash dividends of $3.8 million in the third quarter of 2018 and reduced debt by $12.1 million.

Now moving to our outlook for the full year 2018. As Chris stated, we are pleased with our broad-based progress across our strategies. Our updated guidance takes into consideration several factors: our current sales momentum, macro factors impacting gross margins, progress on our operational efficiency initiatives, continued tight management of controllable expenses and our updated forecasted tax rate. Accordingly, we are increasing and narrowing our 2018 full year guidance range for both the lower and higher end for net sales by $15 million and $5 million, respectively. We expect net sales to be in the range of [$1.15 billion to $1.25 billion], (Sic-see press release $1.115b to $1.125b) up 11.2% to 12.2% compared to the prior year and reflecting organic growth of approximately 5%.

At this sales level, taking into consideration reduced gross margin rate, appropriate spending controls and the impact of lower-than-expected tax rates, we are increasing the low and high end of adjusted earnings per share to a range of $2.05 to $2.15. We are also adjusting our 2018 full year reported GAAP earnings to a range of $1.75 to $1.85 per share and increasing our adjusted EBITDA to a range of $119 million to $122 million.

Our revised 2018 financial outlook includes the following additional assumptions: strong growth in most regions, especially strategic accounts in North America; gross margin performance of approximately 40.5%; R&D expense of approximately 3% of sales; capital expenditures of approximately $20 million; and an effective tax rate of approximately 15%.

Before we open the line for Q&A, I want to briefly discuss our approach to strategic planning and what you can expect from Tennant as we move forward. Earlier this year, we committed to providing our revised long-term financial targets by the end of fiscal 2018. We are now deeply involved in our strategic planning exercise and will share the results of our findings in early 2019.

Cheryl, please now open the line for Q&A.

(Operator Instructions) Our first question comes from Marco Rodriguez from Stonegate Capital.

I was wondering if you guys can maybe talk a little bit more in detail where you can on some of the drivers or some of the growth rates that you saw in the Americas, if you can kind of maybe parse it between your different channels, direct distribution and then strategic accounts.

The nice thing about North America was obviously strategic accounts was the key driver as it has been for most of the year, but we also had success in direct and distribution. So it's very balanced, which is what we like to see. With 11.1% organic growth in America, that's -- we may have hit a higher number than that once or twice in our history, but that I think is one of the highest numbers we've ever seen. And you can only get there with strength across the entire portfolio.

Got you. And the strategic accounts, obviously you've called that out throughout the year-to-date period as far as finally reaccelerating some of your organic growth rates there. Are there any particular strategic accounts that, maybe, close a little bit earlier than you were anticipating? I know that a lot got pushed from '17 into '18. Or are these just kind of like normalized growth rates you think that you might be able to sustain perhaps at some similar level in '19?

I mean, the thing is every year we see strength in strategic accounts. Over the last 7 or 8 years, this has been the fastest-growing part of our business because we focused more intently on it. We continue to focus intently on it. We have great relationships with many global players. Some of those pieces of business tend to hit every year and they go in cycles. So while we had, I think, an exceptionally strong year with strategic accounts this year, I think because we have to push some business from 2017 to 2018, I don't think we've accelerated any of the deals. So I think everything else is pretty much rolling out according to plan. And our opportunity and challenge is to do the same in 2019.

Got it. And then maybe if you could talk a bit more about the drivers you saw in Brazil that gave you the growth there? And then also talk a little bit about China with their industrial product growth there. Wouldn't have thought that you'd have such strength there just kind of given their macro situation.

Yes, I can make a couple of comments on that. We really have 2 brands of importance in Brazil. We have the Tennant brand that we've had for many, many years, and we also bought Alfa in 2008. We're seeing broad-based strength across our entire portfolio in Brazil and continue to have a really strong #1 market position in that market. So it just continues to consistently outperform in the Latin American market in Brazil. In the case of China, I would say, it's been a long time coming. We haven't performed as well in China. We've made some people changes. We made some strategy changes. And I think we're finally, starting to get on the right side of where we're headed and we're, obviously, extremely excited about the acquisition that we announced in that key market, which we're hoping to get it closed as early as possible in Q1 next year.

And just to build on what Tom is saying, in Brazil, the other thing we did this year is, we expanded our mid-tier product portfolio through bringing in some IPC products and basically, branding them Alfa to fill out that line and those products have done extremely well. So that's helping driving sales. The other thing in China is one of the things we've said before that we've been working on and it's a tough slog or it has been a tough slog where we started to make good progress now as to build out our direct sales organization in key metro areas, and I think what you're beginning to see is the benefit of that.

Understood. And then, in terms of the acquisition that you announced for Gaomei in China, can you maybe kind of walk through -- I think you said you're expecting a close in Q1 '19, are there any sort of regulatory hurdles you need to surpass? And I'm assuming just when you made the announcement, I didn't see much in terms of financial information, so is it safe to assume that from a material standpoint, from a revenue standpoint, it's not exceptionally material?

That would be a fair assumption. I mean for competitive reasons, we really -- we're unlikely to disclose the revenue side. We don't -- it's still is a little complicated to get things done in China, but we don't feel there's any major hurdles to get ourselves through. And this is, we believe, of significant strategic importance for us going forward as it is a large market and might be the market that will have the most growth over the next 10 to 15 years, and we think the acquisition of this brand and businesses are going to be one of the key things that gives us the ability to capitalize on that growth in the future.

Yes. The other thing is, remember, we've been working with Gaomei now for 4-plus years. So we know them and the business pretty well. It's been a very thoughtful, systematic process. And the beauty with the Gaomei acquisition, we think it can do for us what the Alfa acquisition did for us in Brazil, took us really from nowhere to being by far the leading player. It will do for us what IPC is starting to help us with in Europe in terms of taking us into the mid-tier market. The mid-tier market in China is big, by far the biggest segment of the market today and the fastest growing, which makes sense because they're just starting to transition from labor cleaning to mechanized cleaning because of wage rate growth. And they don't tend to go right to the premium products right away, they tend to go to more cost-effective products and the Gaomei product portfolio fits that need to a tee. So we are extremely excited by our ability to continue to grow hopefully aggressively in China for years to come.

Got it. And can you help us understand what is the size of that market in China for the mid-tier and then what do the growth rates kind of look like?

Yes, we haven't commented publicly around the specificity around the mid-tiers, so I'm hesitant to do that, but the market itself, from a mechanized cleaning and aftermarket support is somewhere between $350 million and $400 million. I mean, the numbers in China are a bit imprecise and the mid-tier side of that is not only the largest but also the fastest growing. So I would leave it at that. The quality of the data is, it's not that great anywhere in the world than China, so it's a little bit tougher, but it is a very large market that we think is going to -- we do believe will be larger than the North American market and the European market.

And while we can't say it, it is by far larger than the premium markets, which is where we play now.

Yes. Good point.

Got you, got you. And last question, just kind of circling back on the gross margin guidance. Obviously, you pointed out the headwinds that are affecting that line item for you guys starting last quarter. Obviously, it seems as if perhaps some of those headwinds may have accelerated a bit or perhaps were a little bit stronger than you were anticipating. Was that even or broad against all those headwinds or there one, in particular, that might have been a little bit stronger than you were anticipating?

You know it really, I would say, the 2 things that did affect us the most were tariffs and higher freight and logistics cost, if I was to look at the pieces that affected us by about a 110 basis points. The labor and raw material shortage were less. So we'd like to believe we're making some progress in those areas, but frankly, particularly the freight and logistics costs were a bit higher than we had anticipated.

Got you.

And that did accelerate in the...

Of all of them, that's the one accelerated probably the most in the third quarter.

Yes.

The freight and logistic costs?

Yes.

Yes.

Or both?

Both.

(Operator Instructions) Our next question comes from Brett Kearney, Gabelli & Company.

Just want to ask, it looked like there's perhaps a smaller business sale during the quarter. Just wanted to ask about that. And then with Gaomei coming into the organization, if you could just talk about future capital allocation priorities from here.

Yes, we'll continue to keep our pipeline open, we will continue to pay down debt. I mean, it's a much smaller acquisition. We haven't noted the price of that, but we'll keep our pipeline alive, but we won't really change much in our capital allocation strategy currently as we go forward. And commenting on the divestiture, I mean, it's a small non-core asset that's immaterial to our results. So I would call it inconsequential, but we did have a modest gain from it, and we did call it out.

Our next question comes from Chris Moore from CJS Securities.

Maybe go back to the gross margin just for a second. So those kind of the 4 discrete areas that you talked about. Can you kind of compare and contrast the impact in Americas versus EMEA on those pieces? For example, are freight costs really just an issue in North America or is it something you're seeing all over the place geographically?

It's definitely far tougher in North America than we're seeing anywhere else in the world.

And how about on the tariff side, if you look at kind of the potential impact on the IPC and the EMEA business versus some of the unknowns in the U.S.? How do you guys view that?

Yes. Given the amount of business, we certainly see opportunities with IPC as we move around the world, but it is still a business that's manufactured in Europe and predominantly sold in Europe. At the time of the acquisition, that was 80% of the product line. So we don't feel that there will be a material effect there. And the bulk of the effect on tariffs is going to be squarely in our North American business we believe, but if -- there is lot of uncertainty too, we want to make that really clear.

Sure. Maybe just in terms of the strength that you're seeing on the Americas sales. Is that kind of from a competitive standpoint? Do you get the feeling that you're taking share? I mean, Nilfisk talked about challenges in Q3 with their strategic accounts, and some delayed orders being canceled. Just kind of trying to get a feel for what the landscape looks like, specifically in North America?

All right. I can't remember Nilfisk's exact growth rate, but I think it was basically 0 in North America in the third quarter while we grew by 11.1%. If we grew by 11.1%,we're definitely taking share. So -- and remember, our advantage in North America is we have, by far, the largest and most experienced sales and service footprint. And I think that's our secret sauce, it's a huge competitive advantage, and we're leveraging it to the fullest right now. And competition is struggling to catch up with that.

Understood. And is the flip side in EMEA is that -- is it fair to kind of talk about Nilfisk having the -- they seem to do a little better Q3? Is that kind of a similar situation to kind of that core strength you have here?

Obviously they are a European player and they are stronger in Europe. So historically, I would say, yes. But the IPC acquisition for us finally gives us the scale to get on the kind of the platform, the awards platform with the key players and have a chance to compete on a much more level playing field. So that advantage for them and others is diminishing, although it's still there. But remember in -- we've said that our European business continues to perform strongly. The only reason you're seeing a decline is because we grew by 14.6% organically last third quarter.

Understood. If you look at that kind of the rough revenue split, 60-percent-plus America, 30% EMEA, little less than 10% in APAC. You think that 2 to 3 years from now that split stays roughly the same? Or you expect much change there?

No. I think -- we have an -- internally, we are shooting to get closer to a 50-50 split. We realized that having a balanced geographic portfolio causes the business to be much more stable over time because not all geographies hit on all cylinders at the same time. So that is our goal is to get to a much more 50-50 split. And with the acquisition of IPC in Europe and now Gaomei in Asia Pacific and the strength of our Alfa business in Brazil, I think we're well on our way.

Helpful. Last question just in terms of -- I know the strategic plan will be out early next year, but from a kind of fiscal '19 tax rate expectation, in the 20% range, is that probably a better place to start at this point in time?

Yes. I mean, we're certainly not ready to give guidance. There's so much uncertainty in how the tax regulations are finding their way. I -- definitely you can't count on another tax year of our rate being around 15% and certainly we'll be somewhere north of 20%, so we're not ready to be more specific than that at the current time.

And there are no further questions in the queue at this time. I'll turn the call back to management.

All right. Thank you. So before we conclude, I again want to thank the team members of Tennant, who are central to creating the broad-based momentum we're experiencing and our leadership position in our industry. We remain committed to enhancing long-term shareholder value by diversifying our revenue streams by expanding our sales growth drivers across all geographic regions, channels and product categories; reinforcing our technology leadership and supporting our robust new product pipeline; striving for global operating effectiveness; strengthening our financial position and cash flow characteristics as well as balancing our capital allocation strategy across growth investments, debt reduction, dividends and share repurchases; successfully completing the integration of IPC; and looking holistically at our growth plans, both organic and strategically targeted inorganic growth opportunities. Thank you for your time today and for your questions. Take care, everybody.

Thank you very much, ladies and gentlemen. This concludes today's call. You may now disconnect.