Aug 20, 2015
Executives
Shaylee Healy - Director, Investor Relations Daniel Rykhus - President and Chief Executive Officer Steven Brazones - Vice President, Chief Financial Officer and Treasurer
Analysts
Ben Hearnsberger - Stephens Andrea James - Dougherty Company
Operator
Good morning, and welcome to the Raven Industries fiscal second quarter 2016 investor conference call. Today's call is being recorded.
And at this time, I would like to turn things over to Shaylee Healy, Raven's Director of Investor Relations. Please go ahead.
Shaylee Healy
Thank you, Carmen, and welcome, everyone. Today's call is being webcast live and will also be archived on our website for future listening.
Joining me today are Dan Rykhus, Raven's President and Chief Executive Officer; and Steven Brazones, Raven's Chief Financial Officer. Before beginning, I would like to inform everyone that certain matters discussed during this call will include forward-looking statements, as that term is defined under the Private Securities Litigation Reform Act of 1995.
Since such statements reflect our current expectations, actual results may differ. In addition, during today's conference call, we will be discussing certain non-GAAP financial measures, specifically net sales, excluding contract manufacturing sales.
All of the non-GAAP measures discussed today should not be construed as an alternative to the reported results determined in accordance with GAAP. Management believes that a discussion of these measures is useful to investors because it assist in understanding the operating performance of the company and its operating segments.
The non-GAAP information discussed today may not be consistent with the methodologies used by other companies. All non-GAAP information is reconciled and reported GAAP results in the fourth quarter earnings release.
With that, I would like to now turn the call over to Dan.
Daniel Rykhus
Thanks, Shaylee, and welcome, everyone. The second quarter was a very challenging quarter for the company.
The weak end-market demand conditions continued for Engineered Films, with the energy market off approximately 75% versus the second quarter of last year. For Applied Technology, the end-market demand situation deteriorated a bit more, with sales to OEMs off approximately 50% versus the prior year.
The magnitude of the downturn in each of these key markets is something that we've never experienced before in the history of the company, let alone having them both occur at the same time. Unfortunately, it's looking more and more likely that these difficult conditions will be more drawn out than we were previously expecting.
In times like this, it's important that we protect the core business of our fundamentally strong company by managing our expenses very closely and continuing to prudently invest for future growth. We are not pleased with the current financial results of the business, but we are proud of the resiliency and the courage of the team to address the conditions, and to preserve the foundation for the enterprise.
While we can't predict exactly when end-market conditions will improve, we are confident that they will return. And when they do, we will be well-positioned for growth.
On a consolidated basis, sales were $67.5 million in the second quarter, down 28.5% versus a year ago. Excluding sales from contract manufacturing activities, sales were down 25.3% versus the second quarter of last year.
Operating income for the second quarter of 2016 was $6.4 million, down $4.3 million or 39.9% versus the second quarter of 2015. The decline was principally due to the significant volume weakness impacting Applied Technology, but all three divisions reported lower operating income year-over-year in the second quarter.
Now, let me provide you a little more color on each division, starting with Engineered Films. Net sales for Engineered Films were $35.8 million, down 15.4% year-over-year.
The decline in sales was driven by the substantial drop in demand in the energy market. While oil prices rebounded to $60 level earlier in the quarter, these gains were not sustained.
Instead the market reached new lows and is now in the $40 per barrel range, a level we haven't seen since 2003. Sales within all other EFD market, in aggregate, were up nearly 20% versus second quarter last year, on particular strength within the ag and construction markets and the acquisition of Integra Plastics.
As we've noted before, the ag market served by Engineered Films is unlike the market that is served by Applied Technology. The ag sales for the Films division are driven by strong sales of grain covers, which was part of the Integra acquisition; and broadcast film, used for high-value crops such as strawberries.
Operating income in this division was down about 8% versus the second quarter of fiscal 2015. The decline in operating income was primarily the result of the decline in the energy market volume, which constituted approximately 35% of the division sales in the last year's second quarter.
Given the 75% decline we realized in the second quarter, energy sales now only constitute around 10%. Despite the lower volume, the division expanded its operating margin both sequentially and year-over-year.
Sustained efforts toward value engineering, favorable raw material development and cost controls are driving the improved margins. In addition, I am very pleased with the team for their efforts on reducing inventory by $3 million.
Now, let me cover our Applied Technology division. For Applied Technology, the challenging end-market demand conditions worsened during the quarter.
Net sales for Applied Technology in the second quarter of fiscal 2016 were down 43.7% versus the second quarter of 2015. The decline in sales was primarily driven by continued lower demand, OEM shutdowns and customers reducing inventory levels.
Sales to the OEM channel were down approximately 50% in the second quarter and sales to the aftermarket were down approximately 35%. This compares to declines of 40% and 30%, respectively, for the two channels in the first quarter.
Operating income for the division was down 54% versus the second quarter of 2015. The decline in operating income was driven primarily by the steep decline in sales volume year-over-year.
The significant restructuring actions that we took earlier this year are meeting our expectations, and we do not believe that another restructuring is required at this time. As demand has continued to wane, we have responded with additional cost reduction measures and we will continue to scrutinize all expenses.
While our external markets remain difficult, there were some encouraging developments in the business that give us confidence. In July we saw an increase in order for our Hawkeye sprayer control system into the aftermarket.
This was the result of a reemphasized focus on our core sprayer control business. In addition, new sales efforts targeting ag service providers with fleets of leased self-propelled sprayers is uncovering technology upgrade opportunity.
Many three year leases on equipment that would be typically turned over for a new lease on a newer equipment are being extended. Although, this creates a drag in our OEM business, it gives us good opportunities in the aftermarket, which we are actively pursuing.
Now, let me turn to Aerostar. Net sales for Aerostar for the second quarter of 2016 were $11.3 million, down 41% versus the second quarter of 2015.
Excluding sales from contract manufacturing, second quarter net sales were $9.8 million, down 14.3% versus the second quarter of 2015. The decline in sales was driven primarily by lower sales of Vista radar systems and stratospheric balloons, offset somewhat by higher sales of aerostats and related services.
Operating income was $1.3 million versus $1.6 million in the second quarter of 2015, and operating margin expanded by 310 basis points versus the second quarter of last year. Excluding the impact of contract manufacturing, operating income increased significantly year-over-year.
The second quarter for Aerostar developed generally as we anticipated. We had a key contract win for two aerostat systems and we continued to enhance our balloon capabilities for Google's Project Loon.
Although Vista radar sales were below the prior year, we are very pleased with the program pipeline the Vista team continues to build. While the ultimate timing for Loon and Vista programs is not certain, the long-term break-out potential of both are intact.
Consequently, we remain focused on successfully executing our strategy regarding these opportunities. And with that, I'll turn the call over to Steven.
Steven Brazones
Thanks, Dan. As Dan mentioned, net sales for the second quarter were down 28.5% versus the prior year.
Unfortunately, all three divisions experienced declines in sales year-over-year. For Applied technology, the commodity cycle continued to unfavorably impact topline demand, and sales to both OEM and aftermarket customer segments deteriorated further versus the first quarter.
Foreign exchange was also a slight negative for the division, negatively impacting sales growth by approximately 1.2 percentage points. Like Applied Technology, Engineered Films also faced significant commodity cycle challenges with pronounced weak end-market demand in energy.
Although this dampen the sales contribution from the acquisition of Integra Plastics, given its similar exposure to energy, the acquisition still positively contributed to sales year-over-year and has greatly improved our overall product offerings, particularly within the agricultural market. For Aerostar, sales of proprietary products were down largely due to a decline in sales of Vista research, but also due to lower sales of stratospheric balloons.
As the Vista team continues to pursue substantially larger contracts than it has in the past, the timing of contract wins plays a big part in its year-over-year sales development. Securing a contract win in the second half of the year is paramount to achieving growth for the fiscal year for the division.
Given the sales declines in the second quarter, operating income was down approximately 40% year-over-year. Restructuring efforts announced in the first quarter are meeting expectations across divisions, and we continue to aggressively manage our cost structure to protect operating margins in the midst of the demand challenges we face.
Overall, SG&A expenses were reduced by more than 20% year-over-year, including a measured reduction in corporate expenses. Second quarter net income was $4.2 million or $0.11 per diluted share versus net income of $7.7 million or $0.21 per diluted share in last year's second quarter.
Last year's second quarter benefited by approximately $0.02 per share from a discrete tax benefit. The impact of this quarter's EPS from share repurchase activity was slightly positive, relative to the first quarter.
Over the course of a full year, the benefit from the 550,000 shares repurchased to date will be approximately $0.01 per diluted share on that same basis. Turning to the balance sheet.
We ended the second quarter with $47.6 million in cash, essentially flat with the prior quarter. Cash flow generation during the quarter offset the reduction in cash due to the repurchased activity.
Net working capital, defined as net accounts receivable plus inventory less accounts payable, was 32.2% of annualized sales in the second quarter, down 160 basis points versus the first quarter. Net working capital benefited from reductions and accounts receivable and inventory.
Our inventory reduction efforts across all three divisions were successful with each division lowering the inventory levels relative to the first quarter. We continue to expect further reductions in inventory in the second half of the year.
Regarding our share repurchase authorization, we continued executing the plan during the second quarter and brought back approximately 400,000 shares at an average price of $19.40, equivalent to approximately $8 million. Year-to-date Q2, we have bought back approximately 550,000 shares at an average price of $19.66, equivalent to nearly $11 million.
In total, we have repurchased approximately 36% of the shares we issued, when we completed the acquisition of Integra Plastics last November. Cash flow from operations was $14.5 million in the second quarter of 2016, up $1.6 million versus the second quarter of 2015.
The increase in cash flow was primarily driven by favorable working capital developments, offset somewhat by lower net income. Capital expenditures were $2.3 million in this year's second quarter, down a little over $2 million versus the second quarter of last year.
The reduction in CapEx year-over-year is due primarily to the completion of the company's headquarters renovation. For fiscal year 2016, we continue to expect capital expenditures to be between $13 million and $15 million, but most likely at the lower-end of this range.
Lastly, I would like to mention that we sold our vacant Huron, South Dakota manufacturing facility in the second quarter. Cash proceeds from the sale totaled approximately $850,000.
As we continue to dispose off non-productive assets and redeploy the capital back into the business, we expect to complete additional property sales in the next 12 months. With that, I'd like to turn the call back to Dan, for our outlook going forward.
Daniel Rykhus
Thanks, Steven. Market conditions continue to remain quite challenging in the second quarter, and in some instances, as I said, deteriorated even further.
Although we have been cautiously optimistic for improved end-market conditions later in the year, this is not likely to happen. The tough environment has required us to be extremely cost conscious.
In the first quarter we announced significant restructuring actions to address the market conditions we were facing. In the second quarter, we continued to manage expenses very closely and took additional costs out of the business.
With the situation unlikely to improve in the second half of the year, we will continue to be vigilant on expenses. With that said, it's equally important for us to maintain a balance perspective between the short-term and the long-term.
And as a result, we will continue to invest for the future of the business by funding key R&D initiatives and growth related capital projects to maintain our competitive advantage in the marketplace and preserve our growth potential for when conditions improve. These key growth initiatives span all three of our divisions.
In Engineered Films, we're in the final stages of completing a new cast line that will enable us to provide industry disrupting technology to the industrial market segment. This line is expected to be operational in the fourth quarter and we've already begun pre-selling a portion of this capacity.
In Applied Technology, we have recently introduced our new Hawkeye sprayer control system and the initial feedback has been exceptionally strong. Important aftermarket resale partners are purchasing and installing initial systems and are excited with the excellent value proposition delivered based on improved spraying effectiveness.
We are developing OEM agreements for Hawkeye at the factory and look forward to finalizing these over the next six months. Lastly, in Aerostar, the breakout potential of Google's Project Loon and Vista Research are intact, and we continue to realize meaningful progress.
After nearly three years working with Google X Labs on Project Loon, the relationship remains very strong. The project continues to reach significant technology and business development milestones and will be an exciting part of our future as the project becomes commercialized.
I'm proud of the organization and how we've rallied to face the challenges the commodity cycles have created. All these conditions are expected to persist longer than we previously anticipated, we're stead-fasting our focus on protecting our core business and creating sustainable long-term growth and we're prepared for that challenge.
With that, we'd like to open up the call for questions.
Operator
[Operator Instructions] And we have a question from the line of Ben Hearnsberger from Stephens.
Ben Hearnsberger
I wanted to start in EFD. And Steven, I'm wondering if you can give us the Integra contribution in quarter?
Steven Brazones
Yes, we estimate topline contribution from Integra to be around $5 million in the second quarter.
Ben Hearnsberger
And then, I think we can do the math, but maybe I'll just ask, if you've got it handy. Can you give us how much legacy EFD grew, excluding oil and gas and excluding Integra?
Steven Brazones
Yes, our estimates are that legacy business grew in total about 2%.
Ben Hearnsberger
And then maybe, Dan, if you could take us through, obviously, energy is a headwind, and going to remain a headwind. But if you could kind of take us through the construction ag piece, the industrial piece, how they performed in the quarter?
And then your outlook on how those performed in the back half?
Daniel Rykhus
Well, ag and construction have been historically very important segments for us. And we were able to generate some good growth there.
We've worked a lot on value engineering with those products that we use to serve those markets. That's helped our margin improvement and that's going to continue to be an important part of our focus going forward.
Really our customer base in ag is what it was, in terms of our legacy business, and that again is focused on high-value crops, as I mentioned before. But the customer base that we brought on with the Integra acquisition to provide grain covers and other products into the traditional commodity crop market segment has been important for us too.
And we're really just working our way through the first year of that opportunity and that's been good and it's promising going forward.
Ben Hearnsberger
So that sounds like your ag business grew nicely, did your industrial piece grow?
Daniel Rykhus
For the quarter, I think we were pretty flat on industrial. On a reported basis, we're down mid-single digits.
Ben Hearnsberger
And the construction piece is kind of flattish to slightly down?
Daniel Rykhus
No, construction was up, above at 20%-plus.
Ben Hearnsberger
Maybe we can move on to the Aerostar piece. It sounds like you've got a lot of confidence in the pipeline.
The question for me is really around visibility on how the pipeline materializes. Can you just give us what insight you have into Loon and in Vista and when they start to deliver maybe in the back half of this year or into next year?
Daniel Rykhus
I'll talk about Loon for a minute and Steven maybe you can touch on the Vista pipeline. I was out for one of our -- every two or three times a year we meet with the Google X executives that are leading the effort.
And from the very beginning, it's our challenge and the program challenge has been about balloon endurance and altitude control. And we've made tremendous strides on both of those over the last couple of years.
And as we've reported, we've had balloons that have met and exceeded the 50-day challenge and ten the 100-day challenge for endurance. We've also met all the program requirements for altitude control and the resulting navigation that's allowed as a result of that.
So now over the past several months, we've moved into a phase of designing our balloon solution that takes what we've learned in terms of endurance, and really applies that to a balloon solution that is designed more for high-volume manufacturing and meeting the commercial needs of the program, as it does become commercially viable. And that's why you've seen a bit of a flattening, because we're in a phase where we're refining the design.
We've got a really good design that's met the criteria, now we're refining it for high-volume. Now, as to when the actual program will be meaningful volume for us, we're looking for that to be next year.
And it's hard to tell what part of next year that will be, but really that's more for Google to announce. I know several of you have probably noted the deal that Google announced with the country of Sri Lanka.
And they continue to meaningful progress on programs with specific countries and other entities to give us confidence that the program is strong and viable and we're counting on it. We're preparing on this end.
We're spending a lot of R&D on the balloon solution. We're spending significant R&D on our film solution to develop, stronger lighter films that are integrated into the balloon design.
And that will allow us to, again, have a balloon design that will meet the requirements, not just of the endurance and the altitude control, but of the cost and durability and reliability requirements as we move to a much higher volume.
Steven Brazones
And Ben, on Vista, as I mentioned in my prepared comments, this has really kind of shifted their focus this year to pursuing substantially larger contracts than they had in the past. And those contract negotiations with various international customers continue to progress.
And there are various stages, as you can imagine. We're hopeful for a sizeable contract win in the second half of the year.
But as you deal with these international countries, timing of these is not as certain as we'd like to see. And it can get pushed out from time to time, but we are very confident in the pipeline development that the team has put together and the opportunities we're continuing to pursue.
Operator
And our next question is from the line of Andrea James from Dougherty Company.
Andrea James
You had nice cash generation in the quarter. I know some of that was inventory drawdown.
I guess my question is, what are your thoughts on the cash generation in the back half? Do you think it will be similar to the first half?
Steven Brazones
Andrea, I think we did a really good job this quarter, managing our networking capital down. So although, our net income has declined year-over-year, we're pursuing additional opportunities to reduce working capital further in the second half of the year, particularly on the inventory side, so the cash flow generation of the business is strong.
And also relative to last year, our capital expenditure requirements are notably lower this year. So we would expect cash flows to continue to be strong in the second half.
Andrea James
Do you think you will continue to use them for buyback or kind of what are your thoughts on use of cash priority?
Steven Brazones
I think our number one focus is on growth for acquisition in terms of utilizing our capital and investing in R&D to protect our core and our long-term growth prospects. But obviously, that cash is available for other purposes, as you mentioned, including share repurchases and dividends.
Andrea James
So I guess the question, is there an acquisition out there you think, that could change the sales landscape? What are you seeing?
Daniel Rykhus
We have a handful of acquisitions that we're currently looking at. There is a lot of technology companies available or entering into the precision ag space.
And we have several that we're looking at, nothing is eminent. And as you know, we've always been active and we're doing acquisition every couple of years on average.
And I believe that a lot of the acquisitions that we look at that will continue to be pretty overvalued. And we're looking for the right acquisition that can deliver synergy potential that would allows us to pay what it may take to buy a small technology company in the precision ag space.
We do have some that we're looking at and are very interested in.
Andrea James
And forgive me, you might have said this, but I just want to make sure I got it. What's the status of your buyback relative to the amount of authorization there is?
Steven Brazones
Andrea, our authorizations were $40 million. And year-to-date through the end of the second quarter, we've repurchased approximately $11 million of that $40 million.
Daniel Rykhus
I just want to jump in on the cash comment, that the team has done a tremendous job of driving down inventory, especially in Engineered Films division. And we've got a tough set of market conditions, but we are controlling everything we can.
We're controlling our expenses, we're controlling our inventory. We're investing in customer relationships in ways that we haven't before.
We're narrowing our R&D focus, but we're going deep on those R&D projects that matter the most. And we made special note of selling our Huron facility.
It wasn't a big deal from a financial standpoint, but it's indicative of turning non-strategic assets to cash that can be plowed into something more strategic. And we'll continue to do that and that's part of our story.
Andrea James
How has the reorganization of Google affected you? I wondered if it almost could be beneficial with Google X reporting only to Sergey and having sort of that being an isolated segment, Google X being an isolated segment within the larger company.
I don't know if that gives them more focus or -- just curious if you've seen any change as a result of that?
Daniel Rykhus
We see it as a positive. And we've talked to the right people at the right levels about what this reorg means as it relates to Project Loon.
And I'm convinced that it's a net positive in terms of focus and attention and the accountability throughout Google. And I think it's going to be really good.
The players that we've dealt with don't really change at all. And again that's good for us.
Operator
And we have a follow-up from question from the line of Ben Hearnsberger from Stephens.
Ben Hearnsberger
Dan, I wanted to follow-up on Loon. You mentioned you expect meaningful volume to begin next year.
I think Loon revenue is running in the $5 million to $10 million range now. When you say meaningful volume, is that a -- could you give us what multiple of what you are doing now that represents 2x, 3x?
Just kind of help frame up the opportunity there, I guess.
Daniel Rykhus
Ben, that's a tough one to answer for you. I know you really want that number.
Let me just put it this way. The revenue number that you're citing is right, and this has just been a development project.
There is nothing about the revenue that we're seen today that have anything to do with commercial volumes. So think of it that way that we're generating $5 million to $10 million as a development project, and we haven't even touched anything related to commercial volumes.
So it will be interesting to see how the ramp goes. It will be a gradual ramp or if it will be a significant step up.
We're preparing for both of those scenarios.
Ben Hearnsberger
In the sense that you're preparing for those scenarios, is that a big chunk of your CapEx budget or potential CapEx budget over the next two quarters to a year?
Daniel Rykhus
No. Not in the next year.
As we model out the range of potential impact from Loon, from a CapEx and a facilities and equipment standpoint, it will be insignificant over the next, I would say, 15 months, and beyond that it won't be out aligned with what we've spent. As we go forward, we won't need to spend money in the next couple of years in Films' new capacity in the ways that we have over the last three to five years.
We'll have maintenance CapEx, but we're going to be pretty good on the types of capability and capacity in Films that we need for our general growth in our non-energy segments, but also in our development and production of Loon film. So that will give us some freed-up CapEx spending.
And of course, the headquarters building has been done now for a couple of years, and that big chunk is behind us. So I don't think there shouldn't be concern that there is going to be an enormous step up in CapEx required in the next couple of years to support Loon.
Ben Hearnsberger
One last question. On the earnings outlook, I know the prior expectation was for improved earnings in 3Q, based on the full effect of the cost cutting and then some improvement in the Engineered Films business.
As we stand today, based on what you've seen unfold in 2Q and early 3Q, is that still the expectation?
Daniel Rykhus
It's going to be tougher, Ben, than we expected when we talked earlier in the year. The energy market, we really weren't expecting oil to fall to where it has, and there is just not going to -- we don't expect much recovery there through the rest of the year.
Our ATD business has continued to suffer with the low commodity prices. Again, we had a little corn rally, and then it just dropped off significantly.
So it's going to be -- our outlook for third quarter is lower than it has been in the past. I would look for increasing operating margins on a relative basis.
Our cost control have been tremendous, and our ability to actually make money at these lower run rates has been, to me, impressive at the levels that we have. So those things will help us.
But our revenue just isn't going to be where we expect it to be. So as I look at our third quarter, I think we can expect some sequential improvement, but not what we were expecting in the past.
Operator
And I'm not showing any further questions in the queue. I would like to turn the call back to Raven's President and CEO, Dan Rykhus.
End of Q&A
Daniel Rykhus
Thank you. I just want to wrap up and remind you that we really feel good that we're controlling everything that we can here at Raven today.
We're controlling our expenses, our inventory or as I said, we're investing in customer relationships in key R&D projects. And we feel like, despite these really difficult market conditions, we're in a good place that we're controlling the things that we can control.
We have three strong businesses with great products and customers, and we've got a strong and dedicated Raven team standing behind those. Our markets are challenging, but they will return, and we're protecting our core and preparing for our future.
And I am very confident in our future and our ability to optimize the present. And I look forward to discussing this with you again in November.
Thank you.
Operator
And ladies and gentlemen, thank you for participating in today's conference. This concludes the program.
And you may all disconnect. Have a wonderful day everyone.