Dialight plc (3HQ.F) Earnings Call Transcript & Summary

Good morning. I'm David Blood, Chairman of Dialight. Thank you for joining us, and welcome to the 2019 year-end reporting call. Before I turn the call over to Fariyal and Ronan to discuss our 2019 performance and expectations for our business in 2020, I would like to update you on our response to COVID-19. Our 2 highest priorities are maintaining the health and safety of our teams and safeguarding our operational resiliency to serve the needs of our customers. Four points. First, through last Friday, we are trading to our plan, and all of our factories are operating. We have high runner inventory in Tijuana to ship to our customers immediately. Our General Counsel is leading a daily review of health authority advice and taking action to ensure we stay ahead of the challenge. And lastly, we have identified robust actions to take in the event trading becomes impaired. It's worth noting, though, our products are fill -- excuse me, our products fill critical operating, safety and sustainability requirements for our customers. It is in the interest of governments and companies to keep their factories and facilities running. However, the situation is changing rapidly, and the virus impacts are exponential. Fariyal and I and the Board will stay in close contact, though remotely, going forward. I'd like to make a couple of other comments, though, regarding 2020. First, I would like to congratulate Fariyal on becoming the CEO of Dialight. The Board wholeheartedly and unanimously believes that she is the right person to lead us as we go forward in 2020 and has done an excellent job through the crisis of the second half of 2019. Also would like to thank Ronan for stepping in as the acting Chief Financial Officer. He too has done a terrific job over the course of the last 6 months. And lastly, I'd like to remind you all why we are excited about the long-term prospects of Dialight, 5 points. First, the business case for conversion to LED lighting is robust, and there is significant growth runway. Secondly, we have an extremely strong sales force, particularly in the United States, with important long-term distribution relationships. We have a strong in-house engineering capability, particularly as it relates to power supplies. We have a stable and rightsized manufacturing footprint that will allow us to grow. And lastly, the renewed product road map focusing on reducing costs and recognizing regional differences and increasing the addressable market will allow us to grow in 2020 and beyond. I'd like to turn the call over to Fariyal and then to Ronan, and we appreciate you joining us. Thank you.

Thank you. Thank you, David, and thank you, everyone, for dialing in to this morning's conference call. I'm Fariyal Khanbabi, Group CEO, and I'm joined here today by Ronan Sheehy, Interim Group Finance Director. I will start by providing you a brief summary. Ronan will then take you through 2019 financials. I will then come back and provide some comments on a review of the business and positioning ourselves for the future. If we could turn to the summary, Slide 2. Our operational performance has been improved during 2019. We ended Q4 back in control. The primary focus was on manufacturing and then delivery of products to our customers on a timely basis. Our technological leadership remains strong, our team of 60 strong engineers are focused on maintaining and extending our position. The significant sustainability benefits we offer our customers are becoming even more relevant today. Our largest sales team in the U.S. is doing a great job in recovering our historic position. We've made a number of changes within the EMEA team, and that is also starting to show benefits. This will take time, and the sales are coming from a low base. The APAC team is gaining momentum, and we're very encouraged by this. On product development, we have made some good progress, and we have more to come. In terms of 2020 outlook, most of our end markets are likely to remain challenging short term, exacerbated by the possible impacts of COVID-19 virus. Nonetheless, in 2020, we continue to target a materially improved trading performance and a reduction in year-end debt. I'll now hand over to Ronan for an overview of the 2019 financials.

Thank you, Fariyal. Good morning, everyone. I'm Ronan Sheehy, Interim Group Finance Director. I've been with Dialight for 6 years, mainly as Group Financial Controller. Turning to Slide 4, the financial highlights for the year. As we guided the market in late November, group revenue was below expectations for Q4, and this has led to a year-on-year revenue reduction of 11%. We had an underlying EBIT of GBP 5.2 million, which was in line with the revised guidance. The increase in net debt reflects the one-off costs we incurred relating to exiting from our former outsource manufacturing contract and also the capital expenditure on new operating facilities needed for insourcing. By excluding the one-off costs relating to the exit from our outsource manufacturing contract, the underlying gross margin was in line with the previous year at 36%. Nonrecurring costs totaled GBP 16.5 million, and I will discuss these in more detail on a later slide. These costs were necessary to insource production and help position us better for the future. Moving on to Slide 5 and the bridge of EBIT. In 2018, the underlying EBIT was GBP 8 million. In 2019, with a lower revenue in both the Lighting and Signals and Components, this has led to a reduction of GBP 5.3 million in EBIT. We implemented cost management measures and achieved a year-in-year cost savings of GBP 2.5 million. So the 2019 underlying EBIT was GBP 5.2 million. Turning to the Lighting business on Slide 6. The summary numbers for the Lighting division were, the revenue was down 11%, gross margin of 37% was marginally down on the prior year, and the divisional EBIT was down 18%. It wasn't until Q4 that we had full operational recovery in Lighting, and we're in a position to offer the full suite of products to customers on a timely basis. Orders generally comprise a wide range of products, and customers want to buy a complete solution. This resulted in revenues being down in the first 3 quarters. As we entered Q4, we saw some softening in certain of our end markets. The combination of these factors led to a year-on-year reduction in revenue of 11%. Lighting gross margin was 37%. We move on to Slide 7, nonrecurring costs. The total of our nonrecurring costs was GBP 16.5 million, of which the total cash impact was GBP 11.8 million. These costs fall into 4 broad categories. The first and largest area were the costs associated with the exit from our outsourced manufacturer and the use of third-party vendors for machining and painting. These totaled GBP 10.2 million in total, as previously guided. The largest portion of these costs, GBP 6 million related to the use of smaller local third-party vendors to perform machining and painting services, where we had to pay a premium for these services. At the same time, we were ramping up our own facility in Tijuana, and therefore, we incurred dual-running costs. In addition, there were costs of moving materials from our outsourced manufacturer and the cost of relocating our equipment. The second area of GBP 1.1 million related to rightsizing our cost base. The third related to the previously announced disposal of our European obstruction business. And finally, there was an IFRS adjustment relating to a receivable write-off. Moving to Slide 8. The Signals and Components business had a revenue decline in the year of 11%, mainly in the high-volume commoditized component market where we have seen oversupply in the sales channel. We made cost reductions that improved gross margin by 200 basis points, and overall, the EBIT was similar to prior year. Moving to Slide 9, on inventory. Our inventory levels year-on-year were flat, but inventory reduced by GBP 4 million in the second half. In order to age your understanding of the inventory movements, it's helpful to separate these between subcomponents and finished goods. Starting with subcomponents, we achieved a reduction of GBP 7 million in the second half as we unwound some of our inventory buildup from earlier in the year. In the first 2 months of 2020, we achieved a further GBP 3 million reduction, and as we progress through the rest of 2020, we expect this trend to continue. Moving to finished goods. We have adopted a different approach in 2019. As part of rebuilding customer confidence and continuing to reduce lead times, we made a conscious decision to selectively increase the level of finished goods on hand. During H2, for the first time, we started to stock high running inventory items for the U.S. market. We currently hold circa GBP 4 million of finished goods in our Tijuana, Mexico distribution center. This has been very well received by customers and distributors, and it has helped to demonstrate to them that operationally, we are in a much better place than 12 months ago. During the year, we also reduced finished goods in APAC by GBP 3 million as our Malaysia facility has ramped up. So as we envisage, this has reduced the replenishment time to our distribution centers. Overall, we expect inventory levels to reduce during 2020, and I will quantify this in the planning assumptions. Moving to Slide 10, on net debt. In the year, we invested significantly in the future of the business. As previously mentioned, we spent GBP 10 million on the exit from our outsource manufacturer. In addition, we also invested GBP 7 million in 2 brand-new operational facilities, 1 in Mexico and 1 in Malaysia. This now gives the group enough capacity to support significant growth without the requirement for additional capital expenditure on new facilities. We continued to invest in new product development and spent GBP 6 million in the year on R&D. We launched 3 new products in 2019, which have all been well received. We also have a strong pipeline of new products and product upgrades for 2020 as we continue to focus the business on driving revenue growth. Year-end net debt was $16.5 million, and our net debt-to-EBITDA ratio was 1.6x against our revolving credit facility and well within our covenant levels. We have renewed that credit facility in February this year with HSBC, who continued to be very supportive. And this was on similar terms to the previous facility that runs to 2023, with the option to extend it for a further 2 years. Turning to Slide 11 on the planning assumptions for 2020. These are excluding any material impact from COVID-19. Net interest will be broadly in line with 2019, both on a cash and a reported basis in the income statement. So therefore, that includes the accounting treatment of IFRS 16 on leases. We expect the tax rate to be circa 26%. On CapEx, given the level of investment we made in 2019, we will see a much lower level of operational CapEx, which should be circa GBP 2 million. We will continue to invest in R&D, and we expect this to be in the range of GBP 5 million. The inventory unwind is expected to continue, and we are targeting a year-end position in the GBP 38 million to GBP 40 million range, with some of this already achieved in the first 2 months. Our trading performance will continue to be H2 weighted as in previous years. As we progress through the year, we will provide amendments to these planning assumptions should circumstances change. I will now hand you back to Fariyal, who will go through the business review.

Thank you, Ronan. If we turn to Slide 13. Operationally, we have made significant strides in 2019. We have successfully opened 2 new plants in Mexico and Malaysia. Our operational performance improved. We eliminated the use of third-party vendors and moved away from the hybrid model that we had utilized to exit from Sanmina, and we've ramped up our own facilities. The majority of our processes are insourced in Mexico. This gives us flexibility as well as ultimately driving costs down. We now have enhanced capability and capacity within our operational footprint, and I would recommend that you view our operations video on our website to see what progress we have made. Both the level of late orders and on-time delivery is better than it's ever been in Dialight's history. On average, our lead times are between 2 and 3 weeks. We have decided to hold finished good inventory for the U.S. market. This allows us to meet customer demand immediately on high-running product lines. In the second half of the year, our focus turned to rebuilding customer and distributor confidence. We are achieving strong win rates for projects in the U.S. with former customers returning and requesting retrofits of customer -- competitors' products, showing that our quality proposition remains strong. Signals and Components had a tough year in 2019 with a downturn in the component product lines. We did see the decline stabilize in Q4. However, we do not expect to see much recovery in this business till the second half of 2020. In terms of 2020 outlook, and as I mentioned earlier, most of our end markets are likely to remain challenging short term, exacerbated by the possible impacts of COVID-19. Nonetheless, in 2020, we are targeting a materially improved trading performance with a strong focus on sales and new product development. If you can move to Slide 14. Given the operational upheavals of the last 3 years, I think it is appropriate to just step back and reaffirm our strong investment case. This is what I value and so do, I believe, our very talented employees. We have a diverse customer base across 3 global regions. We operate within the heavy industrial space of oil and gas, power gen, pulp and paper, to name but a few. Our new product launches have broadened our offering to other sectors such as automotive and give us a wide offering to our existing customer base. Even considering the 3 years of operational pain, we have maintained our technological leadership. A number of customers have and are coming back to us to retrofit where our competitors' products have failed in the field. Our lighting fixtures have integrated controls and that is becoming even more relevant to the space that we operate within. We recently completed a project for one of our major customers. This project was 1,000 Reliant High Bays, all control-enabled, which we interfaced with their Rockwell Automation system. Our products help our customers meet their carbon emission targets. Also now that our new products have field replaceable parts, it further establishes our commitment to sustainability. The work we've done in 2019 gives us significant capacity without any further major investment required for the foreseeable future, enabling us to meet the growing demands of the market. The strength of Dialight lie in being the only pure-play LED lighting company in the hazardous industrial market. We have an established track record and as trusted in the field, and this positions us well for the future. Moving to Slide 15. Dialight's business model is built on the sustainability needs of our customer base. Industrial companies are investing in economically viable sustainability initiatives to reduce energy consumption, reduce waste and improve the well-being of their workforce. Dialight's products offer valuable solutions to the corporate sustainability goals of our customers. We see this as supportive long-term driver for Dialight. Moving on to Slide 16. We believe the LED conversion in the Industrial segment is at low levels of conversion. Some of the significant industry trends that will continue to shape the LED lighting industry will be requirements for products to be smaller, denser in form factor, easier to install, to be connected. And the quality of lighting will become a major influencer on the health and safety of the workforce. If we look at the left-hand side of this slide, Dialight has traditionally focused on the high-tier segment. This segment values high performance, durability and environmental protection, while this segment differentiates on design and delivers a high-price premium with limited price deflation. The market size is limited. Part of our future growth is coming from the mid-tier. Dialight has previously competed in this space, using high tier -- our high-tier product portfolio at the expense of lower margins due to the fact that we did not have specific products to fill this tier. Industrial customers require lots of different types of fixtures to serve different parts of their sites, not fulfilling this need inhibits Dialight's opportunity to grow. Our focus is on developing new products for this adjacent tier and lowering the cost of our existing products to compete in this segment profitably. This gives us a much enhanced market size, and more importantly, we're able to achieve our target gross margins. In contrast, the low-tier market segment caters to the light industrial applications with low performance products. This is not a market that Dialight is -- will be focused on. If we turn to Slide 18. Our investment in 2019 with the 2 new plants has given us significant capacity to support future growth. We have made substantial investment in equipment, and from here, ramping up capacity is just a function of adding additional labor shifts and managing our supply chain effectively. We have improved our on-time delivery, significantly improved lead times and now approximately 70% of our orders are shipped within one day. As I mentioned previously, one of the key actions to demonstrate to the market was to hold finished good inventory. These are high-running product lines that we are able to ship quickly, improving our service levels to our customers. If we turn to Slide 19. On a statutory basis, we achieved a gross margin of 29%. This was heavily impacted by the use of third-party vendors as we ramped up our own facilities. We now have our painting and machining in-house, and this eliminates 700 basis points of the gross margin headwind we saw in 2019. We developed a number of new technologies as part of the 3 products we launched in 2019. We're integrating these into some of our existing product lines and these will be launched in the first half of 2020, resulting in an additional 200 basis points of gross margin. Our work on operations is not complete, and we aim to optimize and focus on our supply chain and continue to improve efficiency. We are targeting a further 200 basis points to full recovery, thus exiting 2020 with gross margins of 40%. On to Slide 21. In 2019, we have further developed our product strategy based on the market attractiveness of product segments and Dialight's ability to win. The technologies we developed in 2019 such as new power supply, optics and controls are being used to upgrade some of our existing product lines. This not only improves performance, but reduces the costs of our existing product lines. These product modifications will help protect our core markets and provide enough differentiation between products to protect against cannibalization as we enter adjacent markets. For example, our recent launch of our GRP linear fixture offers one of the widest ambient temperature ranges in the marketplace. I have merged the technology and engineering functions within Dialight, and we have shifted the focus to developing the next generation of technologies in advance of the next generation of fixtures. As the market moves to high energy efficient, low cost, smaller weight and size and easier to install fixtures, we have centered our technology around achieving these market drivers. The 2 areas I'd like to highlight here relate to the power supply and integrated controls. We are enhancing our technology to reduce the size of our power supply and enable it to be field programmable, hence, reducing the overall size of our fixtures and reducing the number of SKUs. We still believe that controls will be a major driver in accelerating market adoption. However, the cost of adding connectivity remains a barrier to adoption. We are focused on offering control capability at a similar price to a fixture without controls, while maintaining our gross margins, hence, making the buying decision for the customer irrelevant. By making our controls feel programmable, we can enable the controls after installation. If you look at the right-hand side of this slide, just a reminder of what the key building blocks for Dialight's technology are: our optics, our materials and mechanical systems, our power supplies and battery backup systems and sensors and controls. And just to remind you, our engineering team has 70 years of design experience. Our optical teams have 50 years of experience. The software development team has over 50 years of experience. We have state-of-the-art electronic labs with significant in-house capability. Turning to Slide 23. I'd like to cover Lighting order intake. Our largest market remains the U.S., with 75% of revenues coming from this team. We were down 7% year-on-year, but this region has very solid foundations with a well-established channel strategy and a strong sales team. It is important as we grow regionally to continue to invest in our largest market, where there remains a significant amount of growth opportunity. Orders in EMEA were 21% lower than 2018. We have specific products being developed for this region to support growth. However, the key to success in this region is developing a better route to market and emulating the channel strategy we have in the U.S. We have deployed additional resources from our U.S. team to help execute these initiatives. Asia achieved 8% growth at constant currency. The Australian market is heavily driven by mining, and the downturn in this end market had a significant impact on orders for the year. Australia was down 11% year-on-year. Our obstruction business consists of lighting systems for cell phone towers in the U.S. We are currently in the process of upgrading our beacons and our integrated obstruction software systems, which is scheduled to launch in Q2 2020. These are necessary steps to rejuvenate the obstruction business after insufficient investment in prior years. This is also in conjunction with the revised sales strategy aiming at widening our customer base as we have a very high customer concentration within this business. Orders were down 10% compared to 2018. Moving to Slide 24. As our operational performance stabilized, we have been heavily focused on sales, and we will continue to be in the future. We have taken a number of tactical steps to ensure that this remains our top priority. I have personally visited a number of our customers in each region and will continue this along with the rest of my executive team. The key is ensuring we continue to be consistent with lead times and holding finished good inventory in each of our regions. Moving to Slide 25. In conclusion, I would like to say a lot of hard work has been done. Operationally, we have taken all the necessary steps to ensure we are industry leading in our delivery to our end customers. The focus of the group is on sales, rebuilding customer and distributor confidence and above all on execution. One of the key actions we took in the second half of 2019 was our finished goods strategy. This will be a key part of our strategy going forward. Product development and technology is part of our DNA. We will continue to upgrade our existing products in terms of features at reduced costs, and we will continue to fill our portfolio gaps and widen our market reach. I cannot promise we will not have any missteps due to the level of global uncertainty. But I can confirm, we now have solid operational foundations, great products, a real customer need for our products in the coming months and years ahead, a growing market opportunity and a very committed executive team and Board of Directors. Above all, it's all about delivering those sales numbers. That is all Ronan and I wish to say as comments to this slide, and we'll be -- now be happy to take any questions from those that have dialed in. Any questions?

[Operator Instructions] We will now take our first question from Emily Ritchie from Progressive.

Actually, it's Emily's colleague, Gareth Evans, here. Two questions, if we may. First of all -- first of all, thank you for the comments on COVID-19. I think it all makes absolute sense. And obviously, we'll keep it under review going forward. But specifically around the product range, you talked about the field program of all integrated controls. And I wasn't quite clear whether that's -- is that across all the lines -- all your product lines? Or is that part of what differentiates between the high tier and the mid-tier in terms of the offering?

All of our new product ranges going forward will have field programmable controls because we believe it will be a major driver for market adoption going forward.

So that's across all of them. And so in terms of what's differentiating between high tier and mid-tier, that's more to do with other aspects of the certification?

It's more to do with certifications, the range of certifications. Obviously, we don't play in that very low tier. So all of our products have to be vibration tested and dust proof. But obviously, the protection and the certifications required for that very high tier, they have to be explosion proof. It's mainly around the durability and certifications that distinguishes the mid- and the high tier.

Great. Okay, that's great. And then second question related to the EMEA channel strategy, and obviously, there's work to be done there that, presumably, you can achieve various sort of milestones along that route as time goes on. What sort of things might we expect to see by, say, partway during the year? Or do you have any particular milestones in mind that we might be able to see from a public market perspective?

So the milestones for EMEA is to hit their numbers and continue to hit their numbers. I mean what we're doing is, in APAC and in the U.S., they operate within a wide number of distributors. The EMEA team hasn't really developed that. So we're working with them to widen their reach. So we will be able to give numbers around -- the number of distributors that we've managed to sign up. But at the end of the day, it's all about them hitting their numbers, which we're confident...

Okay. But you might be able to disclose specific numbers of distributors as you bring them on board?

Yes.

[Operator Instructions] We will now take our next question from Christian Hinderaker from Liberum.

I have 2, but perhaps we can just start off with the first one, if I may. I just wanted to talk about your gross margin ambitions and sort of guiding towards the 40%-plus target, which would take you back to the levels seen around 2013. And clearly, you've had opportunity with the return sort of normal in-house manufacturing. But I just wondered what sort of top line assumptions are built into that. And whether those were made pre, obviously, the recent shocks of COVID-19, which obviously are outside of control, but how we should think about it?

I mean we are targeting what is great for 2020. But obviously, the situation is changing on a daily basis. A number of our customers are stopping installers from visiting their premises. A lot of sales calls are not being done in person but via telephone. The -- so it's just changing daily.

Sure. And maybe on -- secondly, just on inventories, which I think I've got here at 30% of sales around sort of 156 days. I guess just in terms of the comps in recent years, given you've had sort of dual manufacturing footprint, obviously, trying to model that is a bit tricky. Just trying to get a gauge of how we should think about inventory levels going forward and why they should normalize and then how that feeds through in terms of your expectations for sort of cash conversion targets?

Well, I think with inventory, I think you've got to look at the GBP 38 million to GBP 40 million that we're guiding towards. I think what we've done with inventory, clearly, the finished goods strategy means we'll probably hold slightly more, but we really are doing a lot of work on our supply chain to make sure that the raw material subcomponent level, we're actually minimizing that as much as possible. So I agree it's quite a balancing act, but I think all we can guide you towards at the moment is that GBP 38 million to GBP 40 million in the short term.

And -- sorry, and is it -- that's million, is it?

Yes.

Okay. Rather than percent of sales?

Yes, yes, sorry, million, as in the inventory -- the...

Sorry, I came in to the call halfway through because there was some timing issue.

[Operator Instructions] We will now take our next question from Kevin Lapwood from Progressive Equity Research.

If I could perhaps just follow up from Gareth and Christian there. I mean it's clearly quite important in achieving your gross margin objective that you do expand in the mid-tier segment. Can I just ask how much approximately are -- business are you doing in that segment at the moment? And where do you think you need to be in percent of sales terms in order to achieve the gross margin objective?

So the gross margin objective, actually, we achieved the same gross margins in our higher-tier products as we do in the mid-tier. And if you just go back to my voice over on that particular slide, actually, the high tier, there is very little pricing pressure in, I mean, customers demand products that are explosion proof and based on performance. So actually, our margins are stronger in that tier. But we have a target...

And roughly how much are you doing at the moment?

Pardon?

Roughly how much are you doing in the mid-tier segment at the moment?

I mean we've only launched the 3 new products for that in the second half. So very little.

We will now take our next question from Andrew Shepherd-Barron from Peel Hunt.

Just a quick question from me on sales split. Can you remind us how -- well, for this last year or maybe for the second half, how revenue split between particularly oil and gas obstruction and the other lot, oil and gas, particularly, obviously because the oil price is doing interesting things at the moment and then -- that which might have not gone to your business?

So oil and gas is -- I've actually included just for you, Andrew, on Slide 29 because I knew you would ask me this question. A split of the vertical segments, so oil and gas was 24%, obstruction 3%, and well, does that…

Okay, fantastic. And what do you -- okay, since I can't see it because I'm on the webcast and I can't see that page, but -- and do you -- what do you -- okay, so comment, I suppose, what do you think about oil and gas? The history hasn't been great when oil prices have come down. What do you think?

No. I mean obviously, we're not as dominated by oil and gas as we were in 2015, where an excess of 35% of the group revenue was oil and gas. We think it will -- just because of the type of products that we have, it will always hover around the 20-odd percent. Moving from upstream to downstream, depending on where the market is.

Okay, okay. So shouldn't change too much, okay. And I had another question on the order -- incoming orders. So you've talked quite a lot about orders. I've always in the past thought that orders were, frankly, not that useful for you because, of course, there isn't really an order book in the business. Should we be focusing more on incoming orders?

I mean it's a metric personally that I monitor on a daily basis obsessively because it gives me -- and especially during the operational issues that we had where those orders were not getting converted as quickly to revenue. I mean I do focus on orders because it gives early indications of the sentiment of the market.

And was there much of an order book at the end of the year?

I mean our order is never more than 6 to 8 weeks. I mean I focus on pipeline for each of the regions and how much that overall pipeline covers what my forecasted revenue is. So right now I have a strong pipeline for all regions. And we're -- as David said, we're tracking where we need to be up until the end of February.

We'll now take our next question from Scott Cagehin from Investec Bank.

Most of my questions have been asked. But I just wondered if you could spare a little time to talk about Signals and Components. Where do you see the key growth areas? Are there any businesses within that, that may be noncore? Just if you can give us a few words on that division, please?

Yes. I mean Signals and Components operates in a very competitive space. There's a lot of price erosion. The team does a very good job of taking cost out of this business. It generates cash. We spend little management time on this business, and there's very little investment right now. It has shared facilities with the lighting production. We see it to be steady notwithstanding any of the market drivers that we're seeing at the moment.

[Operator Instructions] There appears to be no further questions. I'd like to turn the conference back to the host for any additional or closing remarks.

So thank you all for your time today. We're next scheduled to speak to the market at our AGM update before the half year results, and thank you for your time and goodbye.