Aug 24, 2017
Executives
Bo Larsen - Investor Relations Director Dan Rykhus - President and Chief Executive Officer Steven Brazones - Vice President and Chief Financial Officer
Analysts
Craig Bibb - CJS Tyler Etten - Piper Jaffray Jason Freuchtel - SunTrust Jon Fisher - Dougherty & Company
Operator
Good day, ladies and gentlemen and welcome to the Raven Industries, Inc. Second Quarter Fiscal 2018 Earnings Conference Call.
[Operator Instructions] As a reminder, this conference call is being recorded. I would now like to turn the conference over to Mr.
Bo Larsen, Investor Relations Director. Sir, you may begin.
Bo Larsen
Good morning and welcome to the Raven Industries’ second quarter fiscal 2018 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. I would now like to turn the call over to Dan Rykhus, Raven’s President and Chief Executive Officer.
Dan Rykhus
Thanks, Bo and good morning, everybody. And before we get started, just as a reminder, as you do recall we changed our format on these investor calls last quarter and you do have the quarterly results in front of you.
So, we are not going to dwell on those. Our focus at the company is on long-term performance and our comments are going to center on that horizon.
We will give a little color on our performance and our plans without giving too much insight to our competitors. This is unscripted hopefully short and then we will open it up for Q&A.
And first off, I am going to ask Steven to touch on our company performance at the midyear and then talk a little bit about our strategic plan and planning process.
Steven Brazones
Thanks, Dan. We are very pleased with our strong first half financial performance.
All three divisions achieved strong growth in both sales and division profit versus the prior year and they exhibited strong progress towards their respective long-term goals for revenue and profitability. For Applied Technology, R&D investments are resulting in continued product leadership and application controls and continue to drive market share gains.
In Engineered Films, our focus on specialty high value offerings to niche markets with attractive long-term growth potential are driving improved sales and strong operating leverage. In Aerostar, our focus on stratospheric balloons combined with expense reductions, have returned a division to profitability.
At the same time, we continue to focus on process improvements and reducing networking capital requirements in each division. These efforts have been going on for several quarters now and have driven significant improvement, particularly within Engineered Films and Applied Technology.
Together with improved profitability, we are seeing sustained strong cash flow performance. Each year, we conduct a 5-year strategic planning process to reassess and challenge our strategy for each of our divisions.
We recently completed this process. And in doing so, we reaffirmed our business model to serve diverse markets with attractive long-term growth potential.
Our model is strong and is expected to continue to drive strong returns over the long-term. For Applied Technology, in particular, continued R&D efforts will focus on new product development.
Returns on R&D spending in this division are very strong. At the same time, we will supplement R&D investment by aggressively pursuing acquisitions, while maintaining discipline on valuation.
Focus will be to expand our geographic footprint, enhance our precision ag product portfolio to service ag retailers and the OEMs. For Engineered Films, capacity expansion opportunities through capital expenditures will provide growth opportunities in our core markets and also allow us to potentially enter other niche markets, where our technology creates exciting new opportunities.
Larger capital outlays for additional production capacity are part of our 5-year plan and these capital expenditures will be greater than what we have seen over the last few years. For Aerostar, we will remain focused on our stratospheric balloon platform.
We have a strong market leadership position and we see a lot of opportunity to broaden our customer base. We have accomplished things in the stratospheric balloon market that were previously thought to be nearly impossible and the capabilities we have developed are garnering a lot of interest from new customers.
Over and indicated in the past, we would expect to achieve compound annual growth rates over the long-term greater than 10% for both sales and operating profit. There are a lot of things that we are doing this year to position ourselves for long-term success.
I am going to turn the call back to Dan to provide you with a summary of these actions. Dan?
Dan Rykhus
Thanks, Steven. And as of the last quarter, our growth strategy is organic first, but we do look for good acquisitions.
And we have been busy this year evaluating several acquisitions for both ATD and films that supplement their growth strategies. And earlier this week we announced the acquisition of Colorado Lining which we are very excited about.
I am personally excited about the strategic value to Raven and the financial potential of this investment. By acquiring CLI and this makes us a full service Geomembrane provider offering product design, manufacturing, fabrication and installation services.
The integration of CLI with our Engineered Films division expands our value proposition and our overall product and service offering into the Geomembrane market. The vertical integration brings us closer to the end customer and allows us to better understand the applications so we can develop better and more innovative solutions.
Post acquisition and the integration, we will have fabrication operations in Colorado, South Dakota, California and Texas. And these are key regions across the U.S.
for the Geomembrane market. And this constellation of different fabrication facilities will allow us to better service and support our customers.
And as you have heard me say before outstanding service is one of the key differentiators for Raven Industries in all of our divisions. So having that footprint of fabrication capabilities is very important to us.
We know the company and the owners well and have great respect for them. We have done business with CLI for many, many years.
We have similar cultures and share the same values of integrity, quality, service and continuous improvement as well as innovation. So we are very encouraged and pleased with the potential fit as we put these two businesses together.
We expect next year that this acquisition will generate at least $30 million in annual revenues. And we believe we can grow this segment nicely within EFD and that there is a lot of synergy potential in this acquisition.
Finally, we negotiated what we consider a very fair deal that will produce good financial returns and propel our films core strategy. That’s the first item that we focused on during the last 90 days.
Second, we revealed two new products to our ATD customers to be released this quarter. Every year we have annual customer summit event here for our applied technology customers here in Sioux Falls in July.
And during that event we had great conversation with hundreds of customers, resellers, OEMs, ag retailers, large international farm operations. And we are very encouraged with the conversations around our new products that we introduced to the market.
They affirmed the strong interest in our new products. The first being our – what we call our RS1, it’s an advanced autosteer solution.
The RS1 has enhanced out autosteer performance, but it also combines scalable GPS and Slingshot telematics and connectivity into one package. And to me the compelling features of this product line or the integrated nature of the design, but also the service capabilities that this product offers us as we will be able to proactively message and interact through our Slingshot technology with those in the cab.
The CR7 is a midsized field computer. This fills a gap in our product line and provides all the standard Raven functionality for standard applications, but it can also function as an ISO virtual terminal and task controller and that’s of critical importance in the markets we serve.
This expands on our already strong position in implement controls. So we are excited about those new products that we have introduced into the market, they will start to generate some revenue this year, but significant revenue changes will come as we get into first quarter and second quarter next year.
We also continued to invest in building out our channels to markets in ATD during the year. This year we have restored our precision ag specialist team across the U.S.
and some of our global markets. And this role is key in our field service and our whole service offering.
These team members have ag background. They have usually spent time in our service department here in Sioux Falls and then they move out into one of the regions.
And their role is to help our resale partners and our OEMs with training and to better understand our product line so that they can gain confidence and in selling those products. This has been a strong competitive differentiator for many years and really enhances our service we provide our channel partners.
We also during the last 90 days continued to invest in R&D for the long-term across the organization with that strong emphasis in ATD. These investments historically generate strong product pipeline opportunities for Raven.
And we will continue to aggressively invest in R&D for both our core technology to solidify our market position, but also for the long-term. But as we do this, the overall percent of sales will moderate in the coming quarters as our sales volumes increase.
And finally, during the quarter we expanded our key stratospheric balloon customer base. We added a significant new contract in the defense industry.
And this test is another indicator of strong interest in this technology driven by our ability to control and steer the balloons in the stratosphere using Raven developed technology and systems. And all these actions and others represent the work and the progress accomplished in the recent months, but in pursuit of our long-term vision.
Before we open up the call for questions, I would like to give you my perspective on our full year outlook and beyond. And as you know we don’t give numeric guidance, but I will say we are off to a great start and we expect the post strong the full year.
We also expect the momentum we have created in all three divisions to carry forward into next year due to the broad nature of our growth drivers occurring now across the company. But as you know we do serve markets that are prone to cyclical patterns ag, energy, construction and defense.
For several years these markets have performed in cyclical lows. We are not planning for significant improvements during 2017, but we do see some indicators for improving conditions in 2018.
Over the next year we will continue to drive margin expansion. Net income after tax margins have been improving throughout this year for the trailing 12 months are up to 9.6%.
We can continue to expand our margins further though through value engineering, continuous improvement activities and pricing discipline. We will continue to work on M&A.
We have several potential candidates in the pipeline. We are always evaluating for ATD and films, but we will be careful to find the right fit at the right value to us.
We will continue investing thoughtfully throughout the rest of the year and beyond in our divisions to differentiate them from their competitors based on outstanding service, quality and innovation. And as I talked about last quarter and Steven touched on in his review of our strategy, we know we have a winning business model that served us well for years and we continue to fine tune it.
And we know we have a tremendous team in place to execute it and that gives me great confidence in our future. And with that, we will turn it over to the operator and take a few questions.
Operator
Thank you. [Operator Instructions] Our first question comes from Craig Bibb with CJS.
Your line is now open.
Craig Bibb
Okay. Keeping on the big picture theme here, with the Colorado Lining acquisition I mea you are vertically integrating into installation, why is that that’s a change in your business model why does that make sense or why is it attractive?
Dan Rykhus
Well, Craig thanks for the question. For us we believe that being able to have a presence at the installation level will do several things for us.
One, it gets us closer to the customer as I have said so we can better understand the actual applications that are necessary in the field. But two, we believe it’s going to generate a lot more pull-through demand for our core products that we design and manufacture in our extrusion process and our fabrication process.
Craig Bibb
And are you likely to lose other installers who compete with Colorado Lining…?
Dan Rykhus
No.
Craig Bibb
Alright. Our sales to installer is a big piece of the pie at Engineered Films?
Dan Rykhus
No.
Craig Bibb
Okay. And was Colorado Lining profitable during the downturn, what’s that kind of the cost structure look like in margins etcetera?
Dan Rykhus
We are not going to get into that, Craig, in detail. I will say that they have been profitable for the entire history that we reviewed in the due diligence process, which was extensive, but we are not going to get into publicly talking about those margins.
Craig Bibb
Okay. And then just I guess final one and then I will turn it over to someone else, but Aerostar, the margins have continued to be nice.
This reflects your – I assume your prior cost-cutting efforts and reengineering of our production process, is this kind of the new sustainable margins that we should look for going forward other than when the cycle is against you?
Dan Rykhus
I think we are getting closer to what we would expect long-term. I start comments on margin and I expect there would be several questions about margins, but I believe that we are making progress this year on restoring margins in all the divisions during the second quarter.
The margins were good, but they can improve better more in the future, but long-term, we expect to have margins in ATD, operating margins in the low 30s to mid 30s that we have achieved that historically and we have line of sight to getting back to that at mid-cycle conditions. For films, we think our operating margins will typically be long-term around 20%.
And for Aerostar, we think we can operate in the high-teens.
Craig Bibb
Okay. And just related with deployments in Afghanistan, if that were to increase with aerostat sales increase or they have packed away by the military somewhere to reuse?
Dan Rykhus
That’s hard to predict. The use of aerostats has been spotty and difficult to predict.
I guess I wouldn’t have a whole lot more comment on that. We stay unprepared to provide aerostats if the need is there, but I am not counting on that in my plan for the next year.
Craig Bibb
Okay. Alright, thanks a lot.
Dan Rykhus
I am not counting on significant growth in that area over the next year.
Craig Bibb
Alright, thank you.
Operator
Thank you. And our next question comes from Tyler Etten with Piper Jaffray.
Your line is now open.
Tyler Etten
Good morning and thanks for taking my question. I was wondering how the films business be impacted as we moved through the rest of the year now that we have declining rig counts and if those rig counts would continue to decline through the remainder of the year?
Steven Brazones
Yes. As we look forward, we see energy prices holding in this range at $45 to $55 level.
We don’t – we are not expecting a significant change in rig counts over the intermediate term unless we see a step change in oil prices below $45 or above $55. So, as we mentioned earlier in the year, the comparisons for us in the geomembrane side of the business for films do get more challenging through the year as we anniversary the significant increases in rig counts that we have seen over the last 12 months, but we do expect the business to be stable and despite short-term changes in rig counts.
Tyler Etten
Okay. And do you think that’s construction infrastructure and ag can offset any weakness in energy although again would be stable?
Steven Brazones
Well, I mean, our focus is to grow in all of those markets, but I think the one that you left out in particular is our industrial market, which has seen significant growth, particularly this year as a result of the investments we have made in the past for new capacity expansion, but also success we have had at improving our market share position in the industrial market, particularly in the flexible tanking niche market that we have grown substantially this year.
Tyler Etten
Got it. And then on project balloon, excuse me, Aerostar, obviously great to see the margin positive and improving and you mentioned that you have pulled in on another contract.
I was just wondering if you had any new developments on project balloons. Any color there would be helpful?
Dan Rykhus
It’s pretty much business as usual. Say if she goes and we are satisfied with the progress and really have nothing different to report.
Tyler Etten
Okay, great. Thanks.
Operator
Thank you. And our next question comes from Jason Freuchtel with SunTrust.
Your line is now open.
Jason Freuchtel
Hey, good morning.
Dan Rykhus
Good morning.
Jason Freuchtel
And I guess in terms of your operating margins, they were a little bit lower than I was projecting, as they decline on a year-over-year basis, did your incremental margins in your Engineered Films and Applied Technology businesses declined or was it really an impact from the non-incremental margins, could you kind of clarify that, what was the biggest driver of maybe the decline in margins on an annual basis?
Steven Brazones
Yes. I would say the numbers we are looking at we have got division profit margins up year-over-year in all of our divisions.
Within Applied Technology we did have them one-time costs in R&D and selling associated with the new product launches that we announced recently. In EFD, obviously we had some due diligence costs and preplanning on integration related to the CLI acquisition that we announced this last week.
But just to reiterate what Dan said earlier, as we reviewed our strategic plan and really pressure tested the strategy of each of our operating divisions, our long-term expectation is to achieve margins in the low-30% range to mid-30% range for ATD, high teens to 20% for EFD and 15% to 20% for Aerostar. And there is nothing that we see that will preclude us from achieving those.
Jason Freuchtel
Okay, great. And then I guess in terms of the recent business review, can you discuss the strategic rationale for operating your ag precision business with your other more films related businesses, is there anything from a cost perspective or other characteristic that makes those businesses more attractive together rather than separate, I mean outside of shared overhead costs?
Dan Rykhus
We like all three businesses that we operate in. And we don’t really think of it as a portfolio, we never have.
Raven as over 60-year-old business that has grown and evolved and taken advantage of technologies that we develop and different applications for that technology. So in our strategic review, no we don’t – we didn’t come to any conclusions that that made us believe that we would be better off to from an overall performance standpoint to operate without one of our divisions.
Jason Freuchtel
Okay. And then I guess in terms of that how do you view the different businesses risk profiles or cost of capital, do each of the businesses support a different optimal capital structure and how does that impact the company’s overall view of operating at – in the net cash position?
Steven Brazones
Yes. I would say we have been pretty clear in our messaging that our focus is to grow organically, but augment that with being aggressive in pursuing acquisitions.
And as we look at our capital structure today, we are in a very good position to pursue a number of transactions in various sizes. We have the capability to execute a very large strategic transaction.
And we are actively pursuing transactions of size in both ATD and EFD. So I look at our capital structure today as more of a short-term capital structure and over the long-term, I can see us having debt on the balance sheet and responsible amount of leverage.
Jason Freuchtel
Okay, great. Thank you.
Operator
Thank you. And our next question comes from Jon Fisher with Dougherty & Company.
Your line is now open.
Jon Fisher
Thank you. Good morning.
Just in Applied Technology, can you discuss the competitive dynamic that is going on right now and when you look out over the next couple of years, obviously there is still not really much of a positive ag macro environment at least in North America, Trimble acquired Müller, they announced this week cooperation with American Vanguard, so they seem to be stepping up their activity not to focus on one primary competitor there, but if you could just discuss the competitive dynamic going on in applied tech and in the ag field?
Dan Rykhus
Well, it’s been a market that’s been consolidating for many, many years Jon. And at the same time there is – every year there is new entrants with new technology and startups that want to run into our space here.
So we have been dealing with this kind of dynamic landscape for quite a while. As we have said we are – we have made acquisitions in the past that supplement our growth strategy and we are continuing to evaluate several right now that fit in.
We look for companies that add complementary technology and/or geographic region to markets that are important to us. So it’s the changing marketplace out there, but to me it’s always been dynamic for the last 10 years, 15 years anyway.
Would you have internal rate of return hurdles that we are just always going to uphold and sometimes that means we say no to deals. And we are okay with that.
But do stay tuned as I have said there is a lot going on here and there is a lot of potential for us in terms of acquisitions there.
Jon Fisher
And as a competitor to Müller, can you give competitors 30,000 foot view of the competitive dynamic that they bring to Raven?
Dan Rykhus
Well to Raven?
Jon Fisher
Yes. I mean are they top competitor or is there not much overlap, do they do anything differently or uniquely that you can’t offer customers that type of kind of 30,000 foot view?
Dan Rykhus
Yes. Müller has been a strong sprayer control and implement control company in Germany or in Germany and in Europe for many, many years.
We have known him, I have known him for probably 15 years to 20 years. So I am very well aware of Müller.
As far as the product offering there are similarities with our product offering, so as far as them as a candidate for us, I wasn’t interested in that. We have the vast majority of the technology that they offer today.
So I am very comfortable with what we have.
Jon Fisher
Okay. And when you look at Engineered Films, just the non-oil and gas end markets, industrial and construction end markets have picked up for you as we have gone through the year, are there any kind of specific sub segments or sectors within your construction end market customers or within your industrial end market customers that you would like to especially highlight that you are seeing really strong performance whether it’s market share gains or just broad end market demand that really stands out?
Dan Rykhus
Yes. Jon as I mentioned earlier we have seen substantial growth in the Flexitank market.
We have been working with one of the largest providers of Flexitanks in the world for several years now and coupled our R&D resources and technical talent with theirs and really generated some substantial improvements in that market from a market share perspective. We talked about energy with the rig counts coming back up here over the last 12 months.
We have seen in energy subset substantial growth driving the Geomembrane market. In ag it’s been positive as well and construction has been positive as well year-to-date.
All of our markets within films are up.
Jon Fisher
Okay. And final question just looking again ATD and EFD, you highlighted operating margin targets long-term operating margin targets for those segments, should we think about the segments differently now going forward from an incremental margin standpoint Applied Tech had been performing in the 50% to 60% range and Engineered Films in the 30% to 40% range and obviously this quarter neither hit those metrics, so when we look at those segments over the long-term and going forward should we view them from an incremental margin standpoint that was less than what has been generated here recently?
Dan Rykhus
Yes. Jon I think you have got to not just take one data point and extrapolate that into forever.
We had some unusual expenses this quarter in both divisions due to the CLI acquisition and the new products that we introduced. We have got strong incremental margin profiles in both of those divisions and we feel very comfortable with where we are at today and what the potential for each of those divisions is in the future.
Jon Fisher
And thank you. And one final question on Colorado Lining, were the kind of the due diligence and preparation in legal accounting, all the incremental costs in doing an acquisition, were all of those captured in Q2 or will there be some overflow of those costs into Q3?
Dan Rykhus
Well, we are expecting to close in September. So, integration costs will be in Q3, due diligence and preplanning costs were in Q2.
Jon Fisher
Okay, thanks.
Operator
Thank you. And our next question comes from Craig Bibb with CJS.
Your line is now open.
Craig Bibb
Alright. Just kind of back on Applied Tech, how penetrated is your direct injection product relative to how penetrated that combo is and how big can that market grow?
Dan Rykhus
There is low penetration rates with direct injection. And as for the market size, I wouldn’t want to put a dollar value on that.
Craig Bibb
Are you keeping pace with the growth of Dicamba or is there still any growing need?
Dan Rykhus
The demand for injection is not singly tied to the demand for Dicamba. We have seen good growth in injection this year.
Craig Bibb
Okay. That’s fine.
I will leave it there and talk to you guys after the call.
Operator
Thank you. And our next question comes from Jason Freuchtel with SunTrust.
Your line is now open.
Jason Freuchtel
Hey, guys. Thanks for taking my follow-up.
Can you expand on what the underlying trends that you are expecting for next year to be positive are?
Dan Rykhus
Well, I mean, a lot of that depends on what happens within the ag market and the energy market, not solely on those two, but within energy market as I mentioned earlier, we see stability here as long as oil is in the $45 to $55 range. If it drops below that, there could be some negative headwinds for us.
If oil goes above the $55 range and sustains that, we could see incremental demand as a result of the improved rig count environment that would ensue from that. And on the ag side, a lot of it has to do with how this crop comes out this year and a lot of variables that it’s very hard for us to predict.
We do see incrementally on the margins, a better ag environment for further ATD next year at this point in time.
Steven Brazones
Hi, it’s Steven. Those market condition outlines are – I share the same view, but as I said the momentum that we have built in the first half of this year across the whole enterprise is impressive.
And as far as what we expect is going to generate growth next year, it’s going to be the same thing we see today regardless of the market conditions and that’s our new product crop from ATD that we introduced last year and is supplemented by these two new products this year and then we will have another set of new products coming online in fall of next year. So, that will continue to generate growth for us.
Expansion in key international markets will continue to generate growth for us in ATD next year. In films, we are reaping the harvest from several years of investment of new lines to support our industrial market opportunities of the Integra acquisition to support our energy and our ag in our geomembrane and construction markets.
Additional lines to support our ag marketplace that we invested it several years ago. And those trends are going to continue next year.
We are going to benefit from the CLI acquisition with synergies and the revenue growth and the profit growth on that next year. And then finally, we have broadened our base of stratospheric balloon customers from one to several now and we continue to build that out and that’s going to give us stability in that product line I believe as well as lots of growth potential.
Jason Freuchtel
Okay. And so just to clarify in regards to, I think the commentary that you had in the opening of the call, I think you mentioned that you did see some positive trends next year, are all those more company specific or driven by company specific actions rather than macro, is that fair?
Dan Rykhus
I would say that the vast majority are company specific. But as Steven said and as I alluded to we are in the cyclical lows and we believe in ag.
We are starting to creep out of that in ‘17 and we think that the conditions should be marginally better in ‘18.
Jason Freuchtel
Okay. And then I guess is there a potential for Raven to benefit in the Engineered Films division from a large supply of polyethylene capacity coming online in the back half this year and next year, does Raven have the potential to potentially buy it at a discount to its historical costs?
Steven Brazones
Yes. I would say generally speaking we do buy a wide swath of the petrochemical based raw materials within Engineered Films.
And generally speaking additions in capacity from our suppliers is generally favorable for us. But there is a lot of market conditions that can – it can impact things from of the supply and demand perspective.
But incrementally we would think there would be a positive.
Jason Freuchtel
Okay, great. Thank you.
Operator
Thank you. And our next question comes from Jon Fisher with Dougherty & Company.
Your line is now open.
Jon Fisher
Thank you. I have two follow-ups one on Colorado Lining, you mentioned an expectation of roughly $30 million revenue contribution in next fiscal year from Colorado Lining, is there – on a quarterly basis is there much seasonality to that or one or two quarters more skewed than the other quarters so to speak or is it kind of relatively smooth throughout the fiscal year?
Steven Brazones
Yes. Jon as with our Engineered Films division there will be some seasonality to the revenues.
AND that seasonality may not be consistent from year-to-year. So it’s not something that we can pinpoint down for you.
A lot of it is project based revenues and those than those tend to flow in and out at different points in time through the year and that can impact your seasonality from year-to-year.
Jon Fisher
Okay. And I don’t mean to nitpick here, but in the press release on the fly tech there was no mention of Hawkeye, you mentioned direct injection, so just wondering has there been I mean the product has been in the market for a year now, has there been kind of a drop off in momentum in Hawkeye or how does that new product line continue to perform?
Dan Rykhus
Drop off whatsoever.
Jon Fisher
Okay.
Steven Brazones
Strong performance from Hawkeye in Q2.
Jon Fisher
Okay. Thank you.
Operator
And that does conclude our Q&A session. I would now like to turn the call back to Mr.
Dan Rykhus, President and Chief Executive Officer for any further remarks.
Dan Rykhus
Okay. Thanks for all your questions.
Operator
Ladies and gentlemen, thank you for participating in today’s conference. This concludes the program and you may disconnect.
Everyone have a wonderful day.