Feb 16, 2017
Executives
Bo Larsen - Manager, IR Dan Rykhus - President & CEO Steven Brazones - VP & CFO
Analysts
Brett Wong - Piper Jaffray Ben Hearnsberger - Stephens
Operator
Good day, ladies and gentlemen, and welcome to the Raven Industries Incorporated Third Quarter 2017 Earnings Conference Call. At this time all participants are in a listen-only mode.
Later, we will conduct a question-and-answer session and instructions will be given at that time. [Operator Instructions] As reminder, this conference is being recorded.
I would now like to introduce your host for today's conference Bo Larsen, Investor Relations Manager for Raven Industries. You may begin.
Bo Larsen
Good morning and welcome to the Raven Industries Fiscal Third Quarter 2017 Investor Conference Call. Today's call is being webcast live and will also be archived on the company's website for future listening.
On the call today will be Dan Rykhus, Raven's President and Chief Executive Officer; and Steven Brazones, Raven's Vice President and Chief Financial Officer. Before beginning, the company 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 the company's current expectations, actual results may differ. In addition, during today's conference call, the company will be discussing certain non-GAAP financial measures, specifically adjusted operating income, adjusted net income and adjusted earnings per share.
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 the discussion of these measures is useful to investors because it assist in understanding the underlying 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 with reported GAAP results in the company's earnings release and will be included in the company's third quarter Form 10-Q.
I would now like to turn the call over to Dan Rykhus, Raven's President and Chief Executive Officer.
Dan Rykhus
Thank you, Bo, and welcome, everyone. We are pleased to be with you today to discuss our strong third quarter results and the sustained improvements in both our Applied Technology and Engineered Films division.
But before we review this with you, I'd like to address our reevaluation of our internal control framework and the controlled deficiencies we identified. During the third quarter, we undertook a review of several specific controls within our framework and the overall framework.
As the company has grown through acquisition and experience significant changes over the past two years, the complexity of the business has grown. This necessitates a stronger awareness of risk and additional controls commensurate with these new risks that are calibrated for the changing dynamics the business has experienced and may experience in the future.
As a result to the reassessment of our internal control framework, we've brought in experienced external consultants including another large international and reputable accounting firm and we are adding additional resources to our team. The organization is aligned to re-mediate the material weaknesses identified and to enhance our internal control framework.
Re-mediation efforts begin in the third quarter fiscal year 2017, continue in earnest today and will be diligently executed until they are completed. We are committed to strong internal control.
We've always focused on maintaining high standards for ourselves and conducting business in a manner that exhibits these standards. And as you know, our corporate values are extremely important to us.
They drive how we do business. With respect to our internal control design, we are disappointed that we've not kept pace with the changing business complexity to maintain our own high expectations in this area.
We are responding with the utmost urgency and diligence to remedy the situation and to ensure that we maintain a more proactive approach to adapting the changes in the future, so that our framework design appropriate adapts to whatever changes our business may experience in the future or to changes in the regulatory environment. As we work to re-mediate these material weaknesses and enhance our control's framework, we will keep you fully informed and updated.
We are confident that the actions we are taking today and the actions we will take in the future will make the company stronger and better-positioned to identify and control the risks we face. Now I'd like to discuss the third quarter performance and update you on the progress we are making in driving growth.
Our third quarter financial performance was strong, led by exceptional improvements in both Applied Technology and Engineered Films. Combined, these two divisions grew sales and division operating income more than 10% and 40% respectively.
Both have exhibited strong incremental margins on improved sales volume. New product sales for Applied Technology were notable and nearly all end markets for engineered films exhibited growth in the third quarter.
Accompanying this growth in top line was a significant improvement in division operating income. The incremental margins for both divisions were both very high, driven by improved capacity utilization, pricing discipline and cost-control measures to contain the growth and expenses relative to sales.
Momentum continues to build through these two divisions and we are very pleased with the progress these businesses continue to exhibit. I'll now discuss the results of the third quarter in more detail, division-by-division and then turn the call over to Steven for a review of the financial statement.
Beginning with Applied Technology, the division is exhibiting a strong turnaround of performance. The business has benefited greatly from new product introductions and strengthening relationships with strategic OEM partners and end-users throughout the channel.
During the quarter, new product sales revenue from core application controls provided approximately $3 million in revenue with the majority being incremental to the prior year. Relatively strong sales revenues to key international markets including Europe, Canada and Latin America also contributed to the revenue improvement.
As we have predicted on our previous call, the positive impact of operating leverage from rising revenues in ATD delivered the sharply higher profit margins that we expected. Eventually as revenues increase, some step up in overhead expense will occur, but we will be careful, adding cost back into the business and we'll remain committed to our R&D investment in this division.
Our returns on new product development R&D will be our differentiator as we do not expect general market improvement during calendar year 2017 for ATD. We have promising new products progressing through the R&D pipeline that we look forward to introducing later this year.
Moving to engineered films with the exception of agriculture, all markets exhibited growth year-over-year. In the third quarter, sales under the geomembrane market which includes energy grew for the first time since fiscal 2015, increasing more than 35% year-over-year.
While geomembrane is a smaller portion of the overall sales for the division today, it contributed to the overall growth of the division in the third quarter. This growth has accelerated further in the fourth quarter with sales into the geomembrane market benefiting from significantly higher sales into the energy sub-market.
During Q3, land-based rig count in our key basins started to improve sequentially and our prior acquisition of Integra Plastics has positioned us very well for the future. The strength exhibited in the construction and industrial markets during the second quarter of this year continued into the third quarter.
Sales in these two markets in aggregate increased nearly 15% versus the third quarter of last year. We are capitalizing on the new industrial production line we installed earlier in the year which has opened up new opportunities for the division and we expect growth in the industrial market to continue.
Intentional efforts to drive improved operational discipline within the division are leading to improve profitability. The division has done a very good job in controlling expenses and driving raw material cost reductions through value engineering and reformulation efforts.
As a result, volume growth is leading to strong incremental operating margins which are driving even greater growth in operating income. Moving to Aerostar, the division's overall financial performance was below our expectations while the radar business grew sales year-over-year during the third quarter and progress is being made to reduce our thought structure, the timing of contract wins for radars and aerostat negatively impacted the profitability of the overall division.
However, business development activities leveraging our stratospheric balloon technology have led to success this year and we anticipate further success from these actions. Regarding our work with Google, on Project Loon, activity is picking up.
Through [Technical Difficulty] collaboration efforts between the Aerostar and engineered films division, our balloon design has been improved further and we're ramping up production of balloons in response to increased demand from Google. The partnership remains strong and we are encouraged by the increase volume and progress the team is making.
We are on-track for strong growth in fiscal year '17 with Google on Project Loon and we expect continued growth next fiscal year. Our expectations for both Applied Technology and Engineered Films in the fourth quarter is for each to show continued growth in sales and operating income.
Last year's Q4 for ATD was particularly challenging at the revenue line due to several OEM factory shut downs which did not repeat this year. New product development success and international revenue growth combined with sustained operating margin improvements are expected to provide for a very strong fourth quarter.
This will also be the formula for ATD throughout next year. The extent to which we are successful on these factors will determine our growth in ATD next year.
We do not expect market improvements. EFD is also expected to sustain increasing year-over-year revenue improvements through the fourth quarter, which will also drive stronger operating profit improvements due to leverage resulting in strong growth in operating income.
The geomembrane market which includes the energy market is rebounding. The growth of that market and our industrial market have accelerated in the fourth quarter and are expected to drive improved sales and operating income performance.
With that, I'll turn the call over to Steven for our financial review.
Steven Brazones
Thanks. On a consolidated basis, sales were $72.5 million in the third quarter, up 7.3% versus the third quarter of last year.
Applied Technology and Engineered Films both achieved growth year-over-year, increasing sales 18.1% and 4.4% respectively. Year-over-year growth for both divisions were stronger than in the second quarter.
With respect to Aerostar, sales declined 4.8% year-over-year driven primarily by the timing of aerostat deliveries relative to the prior year. Operating income for the third quarter of fiscal 2017 was $7.4 million, versus an operating loss of $9.8 million in the third quarter of fiscal 2016.
This year's third quarter results include a pre-tax inventory write down of $2.3 million, related to certain radar inventory. Last year's third quarter results include a pre-tax, non-cash, goodwill impairment loss of $11.5 million, [indiscernible] asset impairment loss of $3.8 million, pre-contract cost rate up $2.9 million, internet liability reduction benefit of $2.3 million -- all of which related to the company's Vista Research business.
In aggregate, these items produced operating income by $16 million. Excluding the aforementioned charges related to Vista research, adjusted operating income for the third quarter of last year was $6.1 million.
On an adjusted basis, operating income increased $1.2 million versus the prior year or approximately 20%. Net income for the third quarter of fiscal 2017 was $5.7 million or $0.16 per diluted share versus the net loss of $6.2 million or $0.17 per diluted share in last year's third quarter.
This year's third quarter results include an after tax inventory write down of $1.5 million or $0.04 per diluted share, related to the company's radar business. Last year's third quarter results included the aforementioned items related to the impairment charges for Vista research.
On an after-tax basis, these items in aggregate reduced to net income in the third quarter of last year by $10.3 million or $0.28 per diluted share. Excluding these items, adjusted net income for the third quarter of 2016 was $4.8 million or $0.11 per diluted share.
The increase in Q3 earnings per share on an adjusted basis from $0.11 to $0.16 per diluted share was driven primarily by the improved operating performance in both Applied Technology and Engineered Films. Note that this year's third quarter diluting earnings per share would have been $0.20 per share excluding the inventory write down.
This represents an increase of approximately 80% in diluted earnings per share relative to last year's third quarter adjusted number. Although we chose not to add this back from our AG standpoint for this year's third quarter, the inventory reserve adjustment did have an impact on the year-over-year comparison.
For Applied Technology, third quarter sales were $25.2 million, up $3.9 million or 18.1% year-over-year. Growth in sales was driven by market share gains from the new sale from the sale of new products and progress from key international markets.
Geographically, domestic sales were up 14.3% year-over-year and international sales were up 33%. Division operating income for flight technology was $6.4 million up approximately 95% versus the third quarter of fiscal 2016.
The increase in operating income was driven primarily by higher sales volume and lower manufacturing costs versus the previous year. Operating margin for the division increase by 1,000 basis points versus the prior year from 15.5% to 25.5%.
The increase in margin was driven by fixed manufacturing cost leverage on higher volume and operating expense discipline which resulted in lower operating expenses as a percentage of sales. For Engineered Films, third quarter sales were $38.6 million, up $1.6 million or 4.4% versus the third quarter of fiscal 2016.
Volume is measured by accounts sold increased 5.9% versus the prior year. Increasing volume was rather widespread with only the agriculture market experiencing a decline.
Upsales volume was higher, average selling price decline somewhat year-over-year. From a market perspective, the industrial and construction market again achieve strong growth in the quarter and the geomembrane market return to growth once again.
I would like to point out that we have combining energy in geomembrane markets into one market and we refer to that market as the geomembrane market going forward. We have combined them due to the commonality of product offering and the alignment of our sales activities.
Division operating income for engineering films in the third quarter was $7.1 million, up $1 million or 16% versus the third quarter of fiscal '16. Year-over-year increase in operating income was driven principally by higher sales volumes and lower operating expenses.
Division operating margin increased to 190 basis points year-over-year from 16.6% to 18.5%, driven [indiscernible] by raw material efficiencies and improved capacity utilization. For Aerostar, third quarter net sales were $9 million, down $0.5 million or 4.8% year-over-year.
The decline in sales was driven primarily by lower aerostat sales year-over-year due to the timing of deliveries. Sales of stratospheric balloons and services to Google were up slightly year-over-year.
Division operating loss for Aerostar was $1.4 million versus adjusted operating income of $0.5 million in the third quarter of 2016. This year's third quarter operating loss was driven by a pre-tax inventory write down of $2.3 million for certain radar systems.
Turning to the balance sheet, we ended the third quarter with $46.3 million in cash, up $6.2 million versus the previous quarter. Increasing cash was largely driven by free cash flow generation as a result of favorable working capital developments.
Throughout fiscal year 2017, the company has focused on controlling and improving what we can, given the ongoing challenging market conditions. As a result to very intentional efforts, networking capital as a percentage of annualized net sales improved nearly 500 basis points year-over-year from 29.9% in the third quarter of last year to 25.2% in this year's third quarter.
Improved networking capital efficiency was primarily the result of managing to lower inventory levels and an increase in payables balances as a result in improved timing of payments to suppliers. Inventory reserve adjustment at third quarter of this year lowered networking capital by 80 basis points relative to the prior year; excluding this reserve adjustment networking capital is down approximately 400 basis points year-over-year.
Cash flow from operations was $13.1 million in the third quarter of fiscal '17 versus $11.5 million in the previous year's third quarter. Continued reductions to networking capital sustained relatively strong cash flows again in the third quarter.
Capital expenditures were $1.7 million in this year's third quarter, down $1.7 million versus the third quarter of the prior year. For the first nine months of fiscal '17, capital expenditures were $3.9 million, down $6.9 million versus the first nine months of last year.
With that I'd like to turn the call back to Dan for our outlook going forward.
Dan Rykhus
Thanks, Steven. We're very pleased with our financial performance in the third quarter and the progress we are making and returning the company to grow.
While we are still working to finalize our fourth quarter results, it is clear that our performance in the fourth quarter will be strong. Year-over-year growth in sales has accelerated relative to the third quarter and incremental margins are robust.
Although we did not normally provide numerical financial guidance and we do not intend to do so in the future, we believe it is appropriate in this circumstance to provide an indication of where we believe fiscal year '17 will finish. At this time, we expect consolidated sales to be approximately $277 million with Applied Technology, Engineered Films and Aerostar sales of approximately $105 million, $138 million and $34 million respectively.
While we are not final with our results for fiscal year '17, it is clear that both Applied Technology and the Engineered Films will be finishing the year very strong and beginning fiscal year 2018 with good momentum. Incremental profits for these two divisions have done very strong and we expect strong profit contributions from each in the fourth quarter.
Lastly before I open up the call for your questions, I want to reiterate that we are committed to and focused on re-mediating the material weaknesses and making the company stronger to enhancing our control framework. We appreciate your patience as we completed the restatement process and we will continue to keep you informed of our progress on remediation activities.
With that, we'd like to open up the call for your questions.
Operator
Thank you. [Operator Instructions] Our first question comes from Brett Wong with Piper Jaffray.
Your question, please.
Brett Wong
Hey, guys. Thanks for taking my questions and congrats on a nice quarter in getting out of that internal audits period.
Great to get some market updates from you again. First, I just want to dig into the guidance.
You mentioned fiscal 2017 guidance and then implies strong growth in both Applied Tech and Films despite some potential easier comps. So first in Applied Tech, just wanted some additional color on what's going to drive that growth and it would be helpful to know how we should be thinking about growth in fiscal '18; and on Engineering Films, with expectations that energy activity continues to improve through calendar 2017, how can we be expecting or what should we expect for growth in fiscal '18 and does that continue to accelerate?
That's helpful. Thanks.
Dan Rykhus
Thanks, Brett. Good question.
In terms of your first question with ATD's Q4, we expect more the same, the good progression that we've had throughout the year in the areas where we've shown growth to our new products -- our OEMs, certain international markets -- that's going to continue in the fourth quarter. As for your broader question about FY '18 for both ATD and Films, what I really like about our FY '18 is how we're positioned.
We're not going to get a lot of help from the egg market, we're not expecting that and who knows what oil prices will do in this coming year. What we have done is position this company extremely well for whatever those market conditions are.
In ATD in particular, our new products are contributing well this year and we've got a great pipeline of new products that we'll be introducing in calendar 2017. We've invested in our relationships with our customers during this down period in the market and that's paying dividends and that positions us really well.
The relationships with our OEMs are stronger than ever. We have reached out and connected with end-user customers in new and different ways and then strengthening those relationships.
In ATD, our quality and our service, our customers tell us that truly differentiates us which puts us in a great position. We've got strong leadership in place in the division today.
Our comp structures are appropriate and we're focused -- for all those reasons for ATD, I'm bullish on the position that we've carved out for ourselves in FY '18 and we'll see what the market opportunities provide. With EFD, I feel the same way in terms of our position, the investments that we've made, the industrial production line which is a line to serve what we call our industrial segment has been up and running for a year now and has this well-positioned for the business development activities that that division has teed up for ourselves.
The investment we made in Integra Plastics back in late '14 positions us extremely well in the energy sub market to the geomembrane market, in particular in the Permian basin, we're positioned very well. Again, our cost structures are in a good position.
Our quality and our service, we continue to separate ourselves from our competition and we've positioned well. From a company's standpoint, our cash continues to be in a strong position.
We're very active on M&A, looking for opportunities to bolster organic growth that we're accomplishing already. So I think we're in a strong position as a company and we'll see what the market opportunities provide in FY '18 and of course the back draft against all of this is the U.S.
macroeconomic in political environment and we'll just see how that all pans out.
Operator
Our next question comes from [indiscernible]. Your question please.
Unidentified Analyst
Thank you. Good morning.
I wanted to focus on just the new product cycle in applied tax. Obviously that cycle kicked off very well last spring in the momentum has just accelerated obviously through the year.
You highlighted $3 million in revenue contribution from new products in Applied Tech. So I just wanted to get a feel with the current new product cycle that started last spring in [indiscernible] and a couple of others.
Where are we in that life cycle of introduction of the new products, uptake of the new products, penetration with OEM relationships and international? And then before you kind of had to go radio silent, you were starting to highlight that you had another incremental new product cycle coming here in calendar 2017 -- two or three meaningful new products.
And just wondering how you expect the introduction of those products to play out and contribute as we go through calendar 2017, your fiscal year 2018? Thank you.
Dan Rykhus
Thanks, John. Yes, as you all know, I hope new products development and successful introduction is a life blood of ATD.
It always has been and we've seen good result in FY '17 from those efforts. It's really driven the growth that we're seeing as a division.
I'm not going to provide specifics on each of the different new products in terms of the sales revenue that we've seen, but I will tell you that we're exceeding our expectations on those new products and where early stages, these are products that we consider more platforms -- which means they have a much longer duration than particular product that might have three or four-year product life cycle. We view the products that we introduced in FY '17 and even in late FY '16 as being platforms that will provide continued growth opportunity for many, many years.
So we're early stages on those. As it relates to FY '18's new product channel for ATD, we have a couple new products that we're very excited about.
I can talk in some generalities, but again for competitive reasons, I'm going to be a bit opaque on this so that we can capture the vast opportunity for ourselves and for our shareholders with that. I will tell you that it's a mix of products.
It's not exactly the same types of products that we introduced in FY '17. These are organic efforts that have been under way for multiple years and we do expect that introductions probably won't have the same kind of immediate pop that we saw with the FY '17 new product introductions, but have very good long term, a more traditional ATD new product introduction life cycle.
Operator
Thank you. Our next question comes from Ben Hearnsberger with Stephens.
Your question, please.
Ben Hearnsberger
Hey. Thanks for taking my question.
I guess this is maybe one for Steven, but what are the appropriate incremental margin assumptions to use for ATD and EFD and then how much incremental expense do you expect to be associated with the new control framework?
Steven Brazones
Sure. Good morning, Ben.
We've always traditionally said that incremental margins within ATD are in that 50% to 60% range. So when we saw that hold true for us here in the third quarter of fiscal '17, strong incremental margins, strong volume leverage within the facilities, we took a fair amount of cost out of that division in fiscal '16 and the restructuring efforts that we put in place early in that year.
So those are also flowing through here nicely with the increased volume. With respect to EFD, incremental margins are a little bit lower than that -- maybe in the 40% range, but there, too, with increased volume within the energy sub-market growth in the industrial, we're seeing a strong pull through there of profit.
Incremental costs related to the enhanced control framework and the actions that we're taking in the third quarter of '17, those cost for about $200,000, those are full on through SG&A and going forward on an annualized basis, I would expect those incremental cost to be in about $0.5 million range going forward.
Operator
Thank you. Our next question comes from [indiscernible].
Your question, please.
Unidentified Analyst
Yes, thank you. Just to kind of follow-up to my previous question.
I just wanted to expand that to the international markets. The business momentum that you had in Europe and the business momentum that you had in Latin America, I guess how sustainable is that?
Where are we in the leveraging of the SBG acquisition and the profitability driving the market share gains that's right in Europe? And then obviously, currency fluctuations have benefited some of the Latin America momentum that you guys, then people in process improvements in your Latin America operations, too.
So just wondering how much life you expect in the momentum in those two geographies?
Dan Rykhus
Okay, I'll take them one at a time. In Europe, we've had good success leveraging the SBG presence that we have gained there.
We're still early stages there, really. We're taking advantage of the product lines at SBG, provided in how they integrated well with what we had within ATD, but we're still just scratching the surface in terms of our ability to bring the full suite of Raven products across Western Europe and even into Eastern Europe.
So there's lots more opportunity there. We've got just a tremendous team on the ground in Europe.
I have complete confidence in the team that we have with SBG, the people that are associated with SBG and the team that we built out in addition to that. As far as Brazil and Latin America, for some of you who have been with us a while, you know what we have done in Brazil and Argentina in the past.
While we're showing some recovery, we're far, far from where we were at a peak down there when we had a stronger presence and before the product quality problems and warranty issues that we have down at Brazil. That's becoming ancient history.
We've recovered from that nicely and we are positioning ourselves in a better way in Brazil today and we have plenty of opportunity there, but it's going to be -- I'm not looking for big revenue increases in FY '18 out of Brazil or Argentina. That's not what we're counting on carrying the company in terms of growth.
Was that both of your markets? Do you have any other questions?
Operator
[Operator Instructions] Again, we have a follow-up from John Fisher [ph].
Unidentified Analyst
Sorry. I guess I should have just asked this one when I was on prior.
Looking at the current fiscal year, the tax rate obviously is balanced all over the place. Can you provide some guidance going forward on where the tax rate should be falling out here, given growth that the business is experiencing plus as you've gone through all the adjustments and restatements that you needed to make?
Steven Brazones
Sure, John. In the fourth quarter, we're expecting an effective tax rate of about 29% and year-to-date through third quarter, were at 27%.
So for the full year, it will probably be around 28%; so 29% in the fourth quarter and 28% for the full year.
Unidentified Analyst
And 29-ish, is that good for next fiscal year?
Steven Brazones
Yes. I would say so.
The next 29% range is a good estimate for us next year.
Unidentified Analyst
Okay, good. Thanks.
Operator
I am not showing any additional questions. I would like to turn the call back over to Mr.
Rykhus for closing remarks.
Dan Rykhus
Thank you. Thanks for all the good questions today and thanks for your patience with Raven.
You know we're a strong company and we're pleased to deliver the results that we did in Q3 and we look forward to updating you at the time that we finish our Q4 results, which probably isn't going to be too long from now. So we'll be having another call some time before a couple of months are over.
Thank you very much and we look forward to the call.
Operator
Thank you. Ladies and gentlemen, that does conclude today's conference.
Thank you for your participation. You may now disconnect.
Have a great day.