Nathan Mazurek - Chairman, CEO and President Thomas Klink - CFO, Treasurer, Secretary and Director Brett Maas - IR

Brad Noss - Roth Capital Partners Siegfried Eggert - GeoInvesting Michael Potter - Monarch Capital Group

Good day, and welcome to the Pioneer Power Solutions, Inc. Third Quarter 2017 Earnings Conference Call. Today's conference is being recorded. At this time, I would like to turn our conference over to Brett Maas. Please go ahead.

Thank you, and welcome. The call today will be hosted by Nathan Mazurek, Chairman and Chief Executive Officer; and Tom Klink, Chief Financial Officer. Following this discussion, there will be a formal Q&A session open to participants on the call. We appreciate having the opportunity to review the third quarter financial results. Before we get started, let me remind you this call is being broadcast over the Internet and a recording of the call and the text of management's prepared remarks will be made available on the company's website. During this call, management will make forward-looking statements. These statements are based on current expectations and assumptions that are subject to risks and uncertainties that could cause actual results to differ materially. Please refer to the cautionary text regarding forward-looking statements contained in the earnings release issued yesterday and in the posted version of these prepared remarks, both of which apply to the content of the call. I would now like to turn the call over to Nathan Mazurek, Chairman and CEO. Nathan, please go ahead.

Thank you, Brett. Good morning, and thank you all for joining us today for our conference call. Our third quarter results continued to demonstrate the consistency of our earnings power and the strength of our end markets. We generated $2.5 million of adjusted EBITDA during the quarter, despite slightly lower revenue than expected. This was our seventh consecutive quarter in which we generated more than $1.8 million of adjusted EBITDA, and the second quarter in a row exceeding $2.5 million. Today, we have a stable profitable platform with a number of exciting opportunities to organically grow our revenues and earnings. Our Transmission & Distribution Solutions group or our T&D segment remains robust. In the liquid-filled transformer portion of our business, we received significant orders for oil and gas, metals and mining applications to key market segments that have been largely dormant since -- the end of 2014. Additionally, during the quarter, we announced a 3-year contract with a municipally-owned power and utility provider for a large North American city for submersible transformers. We expect the contract, which became effective at the end of the second quarter, will generate up to $1 million in incremental annual revenue through 2020. We began receiving orders immediately upon the award of this contract, and expect to recognize about $400,000 of sales dollars in the fourth quarter of this year. In addition, during the last quarter, we signed a 30-month contract to supply liquid-filled network transformers to a large U.S. based electrical utility. We expect this contract to generate annualized revenues of up to $2 million through 2019. Initial shipments are scheduled to be delivered in the fourth quarter of 2017. Our dry-type transformer business continues to grow, primarily driven by the demand for special magnetic solutions for data center product applications. In fact, we are actively negotiating over $45 million of potential data center related product orders right now. At the same time, our traditional dry-type end markets remain healthy and continue to provide us with a strong book of business quarter-to-quarter. In our switchgear business, we are benefiting from the growing trend to deploy microgrids and distributed energy solutions. We have successfully positioned Pioneer as a key player in this space, with a proven offering, and we are being rewarded with meaningful revenue as this trend continues to grow. We are focused on managing this growth prudently, seeking an optimal product mix in order to secure margins that mirror the remainder of Pioneer's business segments. Turning to our Critical Power segment. In August this year, we introduced our own private labelled line of Pioneer Critical Power generation equipment, which we expect to become a significant source of revenue growth and margin expansion for us. Branded as Pioneer Critical Power, this complete line of engine generators, ranging from 9 kilowatts to 2 megawatts of output per generator set, diesel and natural gas, marks our initial foray into offering our own line of emergency and prime power generation equipment. The units which began shipping in the third quarter of 2017 significantly expand both our addressable product markets and product scope. Under our prior distribution agreement, we were limited by our manufacturing vendor to a 3.5 state territory and a more technically limited line of engine generators. To date, we have already booked more than $1 million of new orders. The majority of these orders are expected to shift before year's end. The service side of our Critical business continues to grow and indeed produced a lion's share of the division's profits. As we have stated many times before, we are focused on multi-location type users, primarily retailers and self-service providers as our target customers. Recently, however, we added a national portable power rental business and a Fortune 500 manufacturer of transfer switches to our service book of our business. These 2 awards are expected to generate an additional $1 million of incremental annual service revenue beginning in the first quarter of 2018. We are also actively bidding 2 large cell tower opportunities, representing about $8 million of additional service revenue beginning the second quarter of 2018. Finally, another new business win for the Critical Power business during the quarter was our selection by a leading home improvement retailer for a pilot program to provide a remote monitoring solution for the retailer's emergency power systems. The initial pilot program, which is expected to lead to a significantly larger opportunity across the retailer's approximately 2,000 locations nationwide, utilizes our proprietary solution to enable comprehensive asset management for onsite power generation. These solutions enable real-time tracking, as well as extended tracking and trend-identification over weeks and months, and provide remote test, start and stop capabilities for onsite power systems. Integral to the solution is the utilization of our network operations center that can help to anticipate identified potential failures or overloads before they occur through remote monitoring, often before a customer is even aware of the issue. We have not yet received a second purchase order, following this pilot program, adding to our initial roll out with this retailer, but we fully expect a second purchase order before the end of this year. Despite these tailwinds, we did experience some short term challenges during the last few months that suppressed an even potentially stronger quarter than the one we achieved. The first was related to weather. Hurricane Harvey impacted shipments into Houston, where our largest distributed generation customer had a hurricane related shutdown, halting shipments to them for approximately a month. This situation is now behind us and we were back to shipping approximately $1 million each month to this particular customer. In addition, the hurricane shut down the Port of Houston, temporarily halting our ability to source product through this key point of access. This situation too has been resolved. We estimate the lost revenue due to this weather was between $2 million and $3 million in the quarter to Pioneer. Third, we experienced unexpectedly high demand for our -- from our largest utility customer for a large number of lower priced, lower margin, small pad mounted transformers, which utilized an outsized portion of our manufacturing capacity in our liquid-filled transformer unit, decreasing production of higher margin products temporarily throughout the third quarter and into the first part of the fourth quarter. We have now returned to a more typical product mix at this facility. Lastly, we absorbed a nonrecurring charge at our dry-type distribution transformer operation in Canada. This $873,000 charge related to the write-off of obsolete parts inventory, which we are now sourcing from our partner in India. Since we are no longer actively manufacturing the product codes associated with these parts and components and are instead sourcing at a much lower cost, we scrapped the material in place and booked a one-time material charge. This charge, reflected as part of cost of goods sold, had a one-time 293-basis point impact on our reported gross margin as well as a negative impact on our net income. Nevertheless, demand for our custom power solutions is strong and our growth and profitability performance and outlook remain robust. I will now turn the call over to Tom Klink, our Chief Financial Officer, to discuss our financial results and review our 2017 full year guidance and underlying assumptions.

Thank you, Nathan. Good morning, everyone. 2017 third quarter revenues of $29.8 million were up 1.4% compared to $29.4 million in the third quarter of last year. Gross profit for the quarter of 2017 was $5.4 million, or 18.3% compared to $6.5 million, or 22.2% gross margin in the year-ago quarter. Included in our cost of goods sold, that Nathan mentioned, was an $873,000 non-reoccurring charge related to the write-off of raw material inventory. This reduced our gross margin by approximately 293 basis points. Selling, general and administrative expenses for the third quarter of 2017 decreased 5.6% on an absolute dollar basis to $5 million compared to $5.3 million in the third quarter of 2016. As a percentage of revenue, SG&A expenses decreased to 16.9% of revenue in the third quarter of 2017 compared to 18.2% in the third quarter of 2016. Operating income for the third quarter of 2017 decreased 51% to $599,000, including these non-reoccurring expenses, compared to $1.2 million inclusive of non-reoccurring charge in the third quarter 2016. Our effective tax rate for the third quarter of 2017 was 226.5% of pretax income as compared to 17.9% for the same quarter last year. The change in tax rate was primarily due to additional expense for assessment by taxes authorities in Canada, a true-up of our provision to the income tax returns filed this quarter for 2016 and state income taxes on deemed dividends. Lastly, we absorbed a non-reoccurring charge at our [indiscernible] wait, I'm sorry. Net loss for the quarter was $764,000, or $0.09 per basic and diluted share compared to net income of $322,000, or $0.04 per basic and diluted share in the prior year's quarter. The decrease was due primarily to the impact of additional income tax expense, as I just described. Adjusted EBITDA increased to $2.5 million during the quarter, or 8.4% of revenue compared to $2.1 million, or 7.1% of revenue in the third quarter of 2016. Non-GAAP diluted EPS increased to $0.21 in the third quarter of 2017 compared to $0.17 in the third quarter of 2016. Turning now to the 9-month financial results for the period ended September 30, 2017. Revenues for the 9 months were $88 million, up 2.4% or $2.1 million from $85.9 million in the comparable period of 2016. Breaking this down by segment, T&D Solutions revenue increased $3.8 million, or 5.3% compared to the first 9 months of 2016. This increase was driven primarily by an increase in sales of our dry-type transformer product lines in the U.S. and a modest increase in sales of the automatic transfer switches. Critical Power revenue decreased $1.8 million, or 13.2% for the 9 months ended September 30, 2017 to $11.6 million compared to $13.4 million in the same period in the prior year. Equipment sales were down $3.1 million year-over-year and service revenue was up $1.3 million, due to an increase in our service business with multi-location customers. For the 9 months ended September 30, 2017, our gross profit was $17.5 million, or 19.9% of revenue compared to $18.6 million, or 21.7% of revenue in the year-ago period. As a reminder, the $873,000 non-reoccurring charge related to inventory was incurred during the current period. Year-to-date SG&A expenses were $14.5 million compared to $14.9 million in the year-ago period. As a percentage of revenue, SG&A decreased from 17.3% in the first 9 months of 2016 to 16.4% in the first 9 months of 2017. Operating income for the first 9 months of 2017 decreased to $3.4 million compared to $3.7 million in the first 9 months of 2016. Our effective tax rate for the 9 months ended September 30, 2017 was 36.9% of earnings before tax as compared to 45.3% for the first 9 months of 2016. The decrease in the effective income tax rate was primarily due to realized foreign exchange loss in Canada. Net income decreased $678,000, or $0.08 per basic and diluted share, down from $1.1 million, or $0.12 per basic and diluted share in the year-ago period. The decrease was primarily due to impacts in our effective income tax rate, as I just described, as well as lower revenue related to hurricane and the mix of products shipped during the quarter. Our adjusted EBITDA for the first 9 months of 2017 increased to $7.1 million, up from $6.2 million for the first 9 months of 2016. Lastly, our non-GAAP diluted EPS increased to $0.58 per share, up from $0.52 per diluted share in the comparable 2016 period. Turning to the balance sheet and statement of cash flows. Our total debt at September 30, 2017 was $31.8 million compared to $28.2 million at December 31, 2016. For the 9 months ended September 30, 2017, we used cash from operations of $473,000 compared to the prior-year period, where we also used cash in operations of $8.9 million. Turning to our guidance. We are reaffirming our revenue and adjusted EBITDA guidance and updating our net income outlook based on year-to-date results, expected shipments in the fourth quarter and non-reoccurring charges we have taken this year. Our guidance is based on expected business trends and current composition of the order backlog, excluding the impact of any potential acquisitions and any significant fluctuations in foreign currency exchange rates. For 2017, we expect to come in at the low end of our guidance range for revenue, which is $120 million. We expect net income between $1.8 million and $2 million for the year. This represents diluted earnings per share of between $0.18 and $0.23 based on 8.7 million shares outstanding. On a non-GAAP basis, we are expecting to generate adjusted EBITDA of between $10 million and $11 million, and non-GAAP EPS between $0.83 and $0.93 per share. This guidance assumes no further acquisitions, a foreign currency exchange rate of USD 0.74 per Canadian dollar, and effective tax rate of 28%, and a share count of approximately 8.7 million shares. And we also exclude the effect of any restructuring, non-reoccurring and non-cash charges arising out of our cost optimization plans. This concludes my remarks. I now turn the call back over to Nathan.

Thank you, Tom. Operator, I'd like to open the call for questions.

[Operator Instructions]. We will take our first question from Matt Koranda from Roth Capital Partners.

This is Brad Noss on for Matt. I just wanted to, first, start with the margins during the quarter and, I guess, specifically the inventory write-down. But what was the catalyst for recognizing the inventory write-down this quarter? And then is there any expected recovery or salvage value in the future from these write-downs?

The catalyst for taking the write-down is, as we completed the relocation of our production of these products to both our lower cost provider in Asia as well as Reynosa and reviewed the methods and files with which we use them and build under, it was determined that rather than build out this product, it was a better option to scrap out the product. The amount that you see is net of any scrap value realized.

Okay, that's helpful. And then, just if we adjust out the inventory write-down, it looks like gross margins were still a touch lighter than we would have expected and a little bit lighter than Q3 of last year. Can you just talk about the impact to margin from the mix of the lower margin pad mounted transformers from the utility customer? And what you think -- try to quantify what you think that impact had on your margins?

Yes, this is Nathan. I don't know what impact as a percentage or as a point it had on the margins. But you basically -- it's our second largest customer overall, it's our largest utility customer period and been with us for a very long time. So there was nothing I can do with their demand, but you're basically selling using a tanking slot for a $9,000 proposition that typically is going for $35,000 proposition, with the similar labor and overhead. How many units it was and so forth? We can go back and do that analysis. But it suppresses the revenue and then the margin of our liquid-filled business. So it did it in the third quarter and that's -- even that hangs over a little bit into the fourth quarter.

Okay, that's helpful. And then, just in regards to looking at 2018 and the types of contracts that you're currently winning, as well as the increase in service and the benefit from the private label engine generators. I mean, what level of gross margin expansion do you think is possible as we look to 2018?

Matt, Brad, I'm sorry, we're just in the process of going through the planning process for 2018. So I don't have a definitive number for you as to what we can expect. The service expansion will require us to open up a few nodes, as Nathan calls them, for service locations, there will be some additional fixed cost as a result of that. The other expansions we're talking about will not require any additional fixed cost. So we would expect gross margin enhancement out of everything. To what extent, I can't say at this point.

Okay, that's still a good detail there. And then thinking about the hurricane impact. I guess, for the potential opportunities there, have you sized the opportunities in Puerto Rico from the potential rebuild of the electrical grid there, and thought about what products would see the most benefit? And then additionally, just looking at Irma and Harvey impacting the pipeline for backup power, what are you seeing there?

Right. So this is Nathan. So there's a lot of layers to that. So, overall, they had the obvious or the more apparent effect is that the certain businesses are up for equipment. Things get destroyed, people need equipment, they need it in the short term and they need it in the medium term, so things get rebuilt. So that's having a positive effect really across all our equipment in South Florida and in the Houston area, which is way more industrialized and has bigger effect on us. In Florida, it typically does. From the service point of view, we have a service business located in Miami and that business is full out busy. Really through the first quarter of 2018, we have to actually move service people from Minnesota to Florida to help them handle the workload that they're being given. In Puerto Rico, we have an affiliate service group, it's -- they're not our people but they work closely with us, especially on some of the -- on our large drugstore chain that we deal with from a service point of view. Puerto Rico is slow to do anything. Primarily there's a huge money issue there. So those groups that have the money, like the resorts and other parts and drug companies and so forth, are getting work done. The rest of Puerto Rico is really waiting for somebody to pay for all this equipment and service to get done. So I don't know if that helps. The last thing I would add is that, from a deeper longer term perspective, if this weather in -- what happened in Houston and Florida, if that changes the behavior of industrial utility and even commercial, industrial and commercial customers to grid-harden or to pay more attention to emergency power, to pay more attention to their electrical usages, and distributed generation and things like that, that's a big benefit to us. In particular, our #1 distributed generation customer, which is headquartered in Houston, they had done -- we had done, together with them, a whole bunch of supermarkets in Houston prior to the hurricane. All those were working and were great, and were featured on the news and so forth. So they've gotten a tremendous amount of mileage out of it and so have we. All the disaster recovery people and FEMA and so forth were using these supermarkets as their headquarters, because they were not affected, they had power and water and air-conditioning all during this crisis. So if that has a longer term effect, which we're hoping through our customers and distributed generation will, that only really propels and impels our equipment and service business into 2018 and further. Sorry for the long answer.

No, that's helpful. And just looking at the backlog, it looked like there -- per my calculations, there was a decline in orders year-over-year as well as sequentially. But I was just wondering if you can give some more color on orders there, and if there might be some timing at play and anything else that may impact that cadence of orders.

Yes. I mean, it was a little bit -- what you say is correct. I mean, you're not dealing with a lot. We don't see any abatement that the distributed generation customers that we're dealing with as opposed to giving us the big orders all at once have been rolling them out or parsing them out in smaller bits. So we don't get that big $3 million order for transfer switches like we did a year ago. The rest -- really the backlog is emblematic of our switchgear in liquid-filled business. The rest of the business doesn't really operate on much of a backlog, it's a much more here-and-now. For most of the service work that we do, which is up this year, we don't -- it doesn't reflect itself in any kind of backlog number for us. So if the decline was -- if the decline was steeper would be important. If an increase would be higher, it would be more significant, but it's pretty much steady as she goes right now.

Okay, that makes sense. And then just maybe one last housekeeping item for me. I know you had -- I think you had ran through the numbers, or Tom did earlier, but if you could just, just real quick, break down the revenues from T&D versus Critical Power as well as just the sub-segments there for transformers and switchgear and equipment for service.

Yes. Transformers for the quarter were about $21.5 million, that's combined liquid-filled and dry-type. To split that further, approximately $8.2 million from dry-type, the balance from -- I'm sorry, $8.2 million from liquid-filled, the balance from dry-type, I said that backwards. Switchgear was $4.3 million of sales. Critical Power, the breakdown on there, $3.9 million in volume, was $2.7 million of service, and $1.3 million -- $1.2 million due to rounding of equipment.

Our next question comes from Siggy Eggert from GeoInvesting.

My first question is regarding the service business in Critical Power. And you commented that you expect that to double during 2018. Do you see the higher margin service component of Critical Power trending up relative to equipment sales over time? And what are actually the reasons that you see for that trend?

Yes. We definitely see it trending up. We are in a good spot there in the service business right now, a lot of the large self-service providers, one who is our customer is asking us to expand our footprint with them. That's part of it, part of it is some of the other self-service providers that we finally have taken some route in. And we're just success to get success. We are doing good job for the self-service providers that we service right now, and continuing to push, and that's our validation, and we know how to do it and we're continuing to push with the others. That's what it is right now.

Okay. My next question is about the newly launched line of power generation equipment. Can you give us some color -- and I think you already mentioned here on the call that you got $1 million in new orders from that new line. Can you give us some color on how the customer receives your newly launched product line? And is there a lot of demand for customization?

That's a multi-layered question. So the response has been very strong. Our goal with the equipment business and our goal in having our own line of power generation equipment was not just to put our names on things and feel good about it. The idea was to take a business that was constricted by territory and really not contributing any earnings to us at all, and try to reverse those situations, both making an earnings contributor and growing more dynamic business. We're trying to concentrate the areas. The way it falls out is that the areas where there is more customization, where there is prime power type opportunities, more negotiated type opportunities, we're finding more success and higher margin, and that's where we're going to continue to gravitate. So we are slowly moving away from our old bid-spec type operation of just trading equipment or trading dollars. This case, we received a largest single order really in the history of the business was a prime power application. It was custom, it was Tier 4 final, with the ability to meet both the emissions and sound level requirements that the customer had, deliver on the dates that they needed it. That is enabling us to ship the order actually this month now in November. And that -- those are the kinds of opportunities that we're going to be seeking throughout the territories that we're going to be looking for business.

All right. So I understand that this was pretty much the type of all of that you were aspiring...

Exactly. This would be the paradigmatic type of situation that we look for.

[Operator Instructions]. Our next question comes from Michael Potter from Monarch Capital Group.

Another solid quarter. Lots of good opportunities it seems that we're executing on and hopefully in front of us as well. Nathan, just I want to follow up on, I guess, the lost revenue, I shouldn't say lost revenue but the revenue that we weren't able to realize in Q3 from the hurricane in Houston. How much was -- I guess, how much revenue did we lose out on from product not being able to get into the Port of Houston, or us unable to be -- ship products to the other customer also in Texas?

Right. So we're estimating probably about $3 million, give or take is about what we lost out, which for us is a lot. I mean, that's a 10% differential on our quarterly sales. So that's a pretty substantial amount for us. And we are working -- yes, I'm sorry, go ahead.

Sorry, go ahead.

And we are working, I mean, we're in the midst of our fourth quarter and we are working day and night really to make up for that. So we are looking for a record fourth quarter, both in revenue and in EBITDA going forward. I mean, those things -- I'm not going to use the word earlier [indiscernible] they're not lost, they were mixed during our third quarter. So deferred to the fourth quarter and we were actively recapturing them, as we speak.

So the $3 million will be over and above what our budget was for the quarter?

Correct.

So we're going to make up -- we're going to make up for, we didn't lose it and it should be made up for, I mean I'm assuming the bulk of it -- the bulk of that $3 million in orders has already been shipped.

I would say it's about midway, especially the transfer switches that we're shipping at the Houston, we can only make for a week and we're trying to increase that as we try to make up for what was on hold. But yes, we're in the midst of it and we fully expect to recapture it in the fourth quarter. It's not being deferred, it's not lost and it's -- and we don't expect any hangover into the first quarter of 2018 either.

All right. Excellent. And can you give us a little sense of the -- are we seeing continued consolidation in our sector? And there's been a lot of consolidation. Obviously, you have acquired a lot of companies over the years. I would assume, though, there is continued consolidation going on in the sector. And I'm assuming, at our size at this point, we're becoming an attractive target ourselves.

That would be true. There is a lot of consolidation. On the big level, you have the big announced deal, where ABB is buying GE's electrical business. So the big get bigger and definitely we are, of course, in the industry and we have been a very, very busy or serial acquirer in the past, haven't the last year or so, 2 years. But yes, we think that we are very attractive. We think that even parts of our business are very attractive. We're in end markets. If you look at distributed generation, if you look at Critical Power, if you look at the data center parts of our business for the reasons that we like them, we think -- and I think we have some validation too, we think that they're found attractive by others as well.

[Operator Instructions]. There appears to be no other questions at this time.

All right. Thank you all for your time and your support, and we look forward to updating you again on our next call.

That does conclude our conference for today. Thank you for your participation. You may disconnect.