Fathom Digital Manufacturing Corp

NYSE:FATH

Good morning, everyone, and welcome to the Fathom Digital Manufacturing Third Quarter 2023 Earnings Conference Call. [Operator Instructions]

I would now like to turn this conference call over to our host, Investor Relations, Vanessa Winter. Please go ahead.

Thank you, and good morning, everyone. Welcome to Fathom's Third Quarter 2023 Earnings Conference Call. Before we begin, I'd like to mention that today's presentation and earnings press release are available on Fathom's website at fathommfg.com, where you will also find links to our SEC filings, along with other important information about our company.

Turning to Slide 2, we note that this presentation contains forward-looking statements within the meaning of the Securities Exchange Act. We encourage you to read the risk factors contained in our filings with the SEC, become aware of the risks and uncertainties in our business and understand that forward-looking statements are only estimates of future performance and should be taken as such. The forward-looking statements represent management's expectations only as of today, and the company disclaims any obligation to update them.

We also note today's presentation includes non-GAAP financial measures to describe the way in which we manage and operate our business. We reconcile these measures to the most comparable GAAP measure, and you are encouraged to examine these reconciliations, which can also be found in the appendix to our press release and the slide presentation.

With us today are Carey Chen, Fathom's Chief Executive Officer; and Mark Frost, the Chief Financial Officer.

I will now hand out the call over to Mark.

Thanks, Vanessa, and welcome to Fathom's Third Quarter 2023 Conference Call. As you're all aware, we recently announced that Carey Chen was appointed CEO of Fathom. We are happy to have him join us today for his first earnings call. Carey has been an active member of Fathom's Board for the past 2 years and previously served as a Director of Fathom's predecessor company for the past 4 years. He is an accomplished business leader with experience in global manufacturing and an extensive background in the industrial space.

I will hand the call over to Carey for some introductory remarks, and then I'll return to provide a review of our operating performance and financial results. Carey?

Thank you, Mark. It's a pleasure to be here today as Fathom's recently appointed Chief Executive Officer. My remarks today will include a brief summary of my background, some high-level observations of where we are today as well as the growth opportunities I see for Fathom moving forward. I will also discuss our long-term goals and objectives to rebuild shareholder value as well as my top priorities and key areas of focus as CEO to achieve those goals. I'll then turn the call back to Mark for a review of our operating performance and financial results for the third quarter of the year as well as our full year outlook.

Before I begin, I would first like to recognize Ryan Martin's leadership role in guiding Fathom through the company's transition to becoming a publicly traded company and establishing Fathom as an industry leader with strong prospects for the future. My experience in manufacturing includes almost 3 decades of operational and management leadership with several growth-oriented tech companies in a wide variety of industrial sectors. As Mark mentioned, I have been on Fathom's Board since 2021 and a Board member of its predecessor company since 2019. I believe this experience over the past 4 years has provided me with an understanding of Fathom's strengths, the current challenges we face as well as the opportunities that exist in the on-demand digital manufacturing arena, including additive manufacturing, metal cutting, CNC machining, injection molding amongst many other service capabilities.

I firmly believe that we have a significant opportunity to partner with quality manufacturers across a wide variety of end markets given our superior manufacturing capabilities and reputation for delivering unique value-added solutions.

At a high level, Fathom remains a formidable leader in an evolving industry with significant underlying strengths. Our customer base represents high-quality enterprise customers, many of whom represent a reliable recurring revenue source. We have superior manufacturing assets across a wide variety of complementary solutions. Our Evolve STEP technology and our new product introductions reflect a strong culture of innovation, problem solving and creativity that is focused on providing market-leading customer solutions. We service a wide variety of end markets, which include health care, defense and other growth verticals.

And looking at our third quarter performance, we have several key wins, including an EV manufacturer for injection molding and a defense contractor for CNC machining. Both of these new customer examples represent 7-figure ones. As you know, we have taken several steps earlier this year to add experienced talent to our operating and sales teams. Doug Beaton recently joined us as Chief Operating Officer and Kurt Bork as Vice President of Sales. Both Doug and Kurt have done a great job in repositioning our resources to respond to the current operating environment that exists today. I am confident that we have the internal resources in place to successfully execute our growth plans.

This leads me to my comments on our approach to building shareholder value. Our goal is to position the company to deliver sustainable revenue growth and leverage our operations to deliver meaningful profitability and margin expansion over time. We've already taken decisive actions to reduce our cost basis through our optimization plan. We still have room to go, but believe we are headed in the right direction. I am a firm believer that a solid capital structure built to generate free cash flow is critical for a tech company like Fathom to invest, innovate and deliver strong sustainable earnings.

Let me turn to my initial top priorities and our areas of immediate focus. My first priority is to work with our lenders and large shareholders to delever our capital structure to free up cash and improve liquidity. We will also continue to limit nonessential capital expenditures. Mark will offer more details on this in a bit.

My next priority is to reposition our new business development efforts to put resources against more recession-resilient industrial sectors with a focus on those with positive megatrends.

In terms of our expense maintenance and reduction, we will continue to execute on the optimization plan we initiated earlier this year, and we will further identify opportunity to better align our expenses with sales and order flow. To date, we've reduced overall expenses by approximately $13 million and have eliminated redundant operating facilities.

My fourth priority is to create a flexible and nimble workforce that can accommodate both our low- and higher-volume business while maintaining adequate [indiscernible] capacity for incremental needs.

A final priority is to build scale throughout our entire operations to be in position to capitalize on new growth opportunities as business conditions improve.

In summary, I'm excited about the opportunity to lead Fathom during this pivotal time in the company's short history. My excitement and optimism is based on our inherent strengths, superior manufacturing capabilities, excellent customer relationships and talented workforce, combined with the large opportunity that exists now and going forward in the on-demand digital manufacturing industry. We will continue to provide outstanding service to our customers and deliver value-added solutions that help them grow and compete efficiently in their respective markets. I look forward to meeting you, our public investors and analysts and sharing our progress along the way.

Now I'll turn the call back to Mark for a review of the financial results. Mark?

Thanks, Carey. I'll begin my remarks on Slide 3, where we provide our quarter 3 highlights. Our performance for the quarter was mixed. We experienced order softness in several of our key end markets including precision sheet metals and CNC. In the third quarter, we delivered revenue of $31.5 million, in line with our expectations, and adjusted EBITDA of $3.1 million, representing a margin of 9.8%. Orders were $29.1 million, down from $38 million in the prior quarter.

Now on Slide 4, we highlight some of our key business wins during the third quarter and year-to-date. Staying close to our customers, especially during this uncertain time remains a key priority for us. As Carey mentioned, one of his new initiatives is focusing on markets that are less cyclical or performing well. One market that is performing well is electric vehicle manufacturing. During the quarter, we received a $1.5 million order for injection molding and additive manufacturing for an EV client as the sustainability that electric vehicles offer has proven to be a resilient market. On the less cyclical side, we had 2 wins in power generation, one for $400,000 in sheet metal and another for $300,000 for injection molding and additive manufacturing. The last one I'd like to highlight is a notable win with a global defense contractor for CNC machining. As we mentioned last quarter, this customer has the potential to be a recurring customer contributing up to $3 million annually over time.

I'll now move on to the financial results for quarter 3, which begin on Slide 5. Our revenue for the third quarter totaled $31.5 million, which was within our guidance range and down from $40.2 million in the same period a year ago. While we continue to make progress in ramping up our commercial activities and strengthening our go-to-market strategies, we have had some headwinds impacting our business in the near term, impacting both our orders and shipments. Some customers are ordering more conservatively and reducing inventory as they lower their safety stock. Other customers are responding to the uncertain environment by pushing out orders, which is delaying our shipments and lengthening our sales cycles.

Our revenue by product line for the quarter was as follows: CNC machining totaled $12.5 million or 40% of revenue, slightly down from $13.2 million sequentially, but a higher percentage of overall revenue. Precision seat metal was $9.5 million or 30.3% of total revenue. While this business was roughly flat with $10.2 million sequentially, it remains the main drag of our year-on-year decline. Injection molding was $5.4 million or 17.1% of total revenue. Additive manufacturing totaled $2.7 million or 8.6% of total revenue. With the launch of our new technology center, we expect to build a more robust pipeline for Evolve. And finally, ancillary technologies, our smallest product line, was $1.4 million, representing 4.3% of total revenue.

Turning to Slide 6, we provide our adjusted EBITDA performance for the third quarter. In quarter 3, adjusted EBITDA totaled $3.1 million, representing a margin of 9.8%. This compares to adjusted EBITDA of $7.1 million or 17.5% in quarter 2 2023. As noted, profitability was impacted due to lower orders as our customers work through their excess inventory. We've taken significant action to reduce our cost structure so we are positioned for improved operating leverage. During the quarter, we realized cost savings of approximately $4.7 million from the continued execution of our optimization plan. This included approximately $2.5 million of general and administrative savings and $2.6 million in COGS. The savings were an improvement when compared to cost savings of $4.3 million realized in the second quarter, bringing the cumulative amount of the first 9 months to approximately $14.7 million.

We have responded quickly to the lighter order volume this quarter and expanded our cost savings in September to include an additional $4 million. This will bring our total cost savings initiative to $23.1 million, up from $19.5 million communicated previously. Going forward, as Carey stated, we will continue to focus on less cyclical markets and those are positive megatrends to ensure our operational activities align with our customer commitments.

For quarter 3, our SG&A totaled $8.1 million, a year-over-year decline of approximately 32% and a 14% sequential decrease. This decrease represents a 400 basis point improvement from last year's third quarter. The decrease was largely driven by the impact of our optimization plan along with lower professional costs associated with the business combination, reduced stock-based compensation expenses and lower headcount. Now excluding stock compensation, our recurring public company expenses in quarter 3 decreased to approximately $0.9 million compared to $1.1 million a year ago.

Now on Slide 7, we show our liquidity and cash flow. We ended the third quarter with available liquidity of $15.8 million. This includes $7.8 million in cash and cash equivalents and $8 million of undrawn commitments under our $50 million revolving credit facility. As discussed in the past, we have continued to pursue actions to deleverage our debt near term. Yesterday, we signed an amendment to our credit facility. More details of the agreement are available in our 10-Q.

As of September 30, our total gross debt, excluding cash, was $159.2 million and net debt totaled $151.4 million with no debt maturities before December 2026. Now cash provided by operations in quarter 3 totaled $2.3 million, up from $1.7 million in quarter 2, reflecting continued improvement in our working capital management. In addition, supported by our working capital improvements as well as our optimization plan, we improved free cash flow by $3.8 million year-to-date.

In quarter 3, our CapEx year-to-date was $4.3 million. This was comprised of $2.3 million equipment purchases and approximately $2 million for investments in IT systems to support future growth. As we mentioned last quarter, we continue to make progress with our ERP and EDP systems. In the quarter, another site went live on our ERP platform and we soft launched our EDP program -- application, I should say, which we are in the process of fully rolling out in quarter 4.

Now turning now to Slide 8, we provide our forecast for the fourth quarter of 2023. We expanded our cost savings actions, consolidated our footprint and lowered our expense base as we position ourselves for scalability. For the fourth quarter, we anticipate realized cost savings of approximately $4 million from our optimization plan. We expect to recognize the balance of $4 million further of the optimization plan in fiscal 2024.

Now we continue to see orders taking longer to convert to revenue. We remain optimistic market conditions will improve as lead times come down and customer inventories returned to more normalized levels. Currently, we expect quarter 4 revenue and adjusted EBITDA to be in line with our quarter 3 performance. The continued execution of our optimization plan coupled with upgrading key operational team members positions us well as the environment improves.

I would now like to turn the call back over to the operator for questions. Operator?

[Operator Instructions] So our last question comes from the line of Jim Ricchiuti of Needham.

I wanted to go back to some of the commentary around improving the growth and profitability. And maybe before we get specifically to that, can you talk about the sequential decline in gross margin? How much of that came from volume and how much came from pricing? And I guess my question is just related to more to when the volumes begin to recover, and I'm wondering what a realistic range of gross margins might look like for the business?

Sure. I'll take the call. So the primary reason was our revenue dropping from $34 million to $31.5 million. So that we have, as we've talked in the past, 30% of our cost would be considered overhead purely fixed. But we have another 40% coming from labor where unless you can immediately take actions, Jim, as we've talked about, it acts like a fixed cost. So basically, what happens is we lose 70% unless we take actions to resize particularly our labor force. And that's indeed what we announced on the call. So the primary issue was absorption.

So to answer the second part of your call, our expectation still is if we can get back to sort of a mid-30 revenue levels that we should be back to the low 30s to mid-30 type of gross margin. But coming to this level, now I'll step back and we are taking actions that we hope even at this level of $31 million, $32 million, we can get back towards 30%, and that is our expectation and hope for quarter 4 is we'll be able to do that. So does that give better color, Jim, on the situation?

It does, Mark. Yes, it does. Appreciate that. Carey, if we think about your strategy, the focus you have on some of these more resilient markets, when I hear even EVs, I mean, how much resiliency is there? Potentially, we're seeing some signs of weakness, even pockets of weakness in that market. And I wonder, as you think about the business, is the focus going to be more on generating business with newer customers or really expanding the presence with existing. I'm sure it's probably both. But near term, where do you see the opportunities to maybe drive some revenue growth?

Yes, Jim. So I think you answered my question for me. So it is answer C, all of the above. So we have very key strategic account managers that will continue to maintain and cultivate our existing enterprise-level customers. But as you mentioned, from a new business development standpoint, I'm a fan of Wayne Gretzky, and he always said, what made him great wasn't skating to where the puck was but to where it's going. So as discussions of recessions and things of that continue to loom on, there are some industries regardless of what the economy does, I think people still need electricity whatever the economy does, I think people will still need medical attention and whatever the economy does, the country will need to remain safe. So those are examples where we might shift our new business development focus.

As far as EV is concerned, I guess we were a bit different from the current trends with our recent win, but we are hopeful that as markets fluctuate up and down that 2024 will be a good rebound for that particular sector.

Our next question comes from the line of Greg Palm of Craig-Hallum Capital.

Carey, I just wanted to maybe follow-up a little bit with your line of thinking around the strengths, the opportunities, some of the challenges. Maybe if we can just start off giving us a high-level review of maybe what went wrong or what the company encountered as some of the most significant challenges over recent -- maybe the recent year? I know macro and sort of overall economic conditions have been pretty uncertain. But just from a strategy standpoint, is there anything that you can point out that maybe is top of mind?

Sure. So the way I look at the business and coming into the role of CEO, I still remain very bullish about Fathom going forward. As I mentioned before, I believe the company has amazing manufacturing capabilities. That's one key asset. And as I've gotten to be re-acquaintanced with some of the employees and get to know others, just amazed at their attitude, their creativity and innovative spirit. As we also mentioned, we do have a very strong collection of high retention enterprise customers and a very strong capable management team that's ready to take the company to the next level.

As you mentioned, we have had some macroeconomic difficulties that haven't necessarily been in our favor since we've gone public. So my approach isn't to necessarily focus on the things that aren't going our way but instead to focus on the things that we can control. So as Mark discussed, we are still focused on our cost optimization plan, which has, as you mentioned, increased by about $4 million. And then as I also just talked with Jim about, we intend to focus on markets that are either more recession-resilient or have positive megatrends going forward.

Got it. Okay. Makes sense. And Mark, I know you mentioned the amendment from the lender's perspective. I think you said it's disclosed or will be disclosed in the Q. I know that's not filed yet. Can you give us any sense on that amendment and what it entails? And any update on when the Q will be out?

Sure. The Q will be out this afternoon. Yes, let me give you some high level. As we've discussed the last couple of quarters, we have continued to pursue actions, and Carey mentioned this in his opening remarks, to deleverage Fathom. And we think this amendment should accomplish that fact. So a couple major elements. I think first, we appreciate the support our lenders have given us. We think this will give us a lot of flexibility, and it works through a long-term solution, we think, for the forward future of Fathom. So the first element is a resetting of various covenants, including leverage and liquidity. The largest element actually is a commitment from our majority shareholder or other players to pay down $50 million of our debt at the end of first quarter or within the second quarter either from a form of equity capital or a guaranteed letter of credit structure. So that element, we think, will accomplish our ability to significantly progress deleveraging the business.

There are some other elements that you'll see in the 10-Q, and we'll file, of course, the full amendment. So you'll be able to see that when we file our 10-Q later. So hopefully, that provides enough detail, Greg, on the amendment.

Our final question comes from the line of Jacob Stephan of Lake Street.

I just kind of want to focus, you kind of noted the stronger end environments for your solutions. But maybe can you just talk about some of the end markets you thought were weaker than you had expected originally?

Sure. Let me -- I'll take a shot at that, Carey. So the largest one has been the semiconductor side of our business Jacob, and that hits particularly our precision sheet metal, but it also hits some of our CNC activities. The other one actually started off well, I'd say, the first quarter, but the last few quarters, we've actually seen weakness in Medical and more specifically in the diagnostic imaging side of Medical. Now talking to those customers, Jacob, the sense is this is a pause and they expect this to reenergize as we go into 2024. And we actually have recently seen some orders would suggest that. That is our largest end market for the business in the high 20% level. So that particularly contributed in quarter 3 to the lower order rate and lower shipment rate for the business.

Okay. And maybe just on that point. When you think about the more resilient markets, you noted Medical being one of those, are you focusing more on kind of the medical device side? And have you kind of pursued the qualifications for these applications? Could you just kind of talk about your strategy around Medical?

Sure. So we have a medical certification at 2 of our sites, Jacob. So we continue to be highly focused on medical. I think we had, as I said, a pause, but we have a significant -- because of our certification, if you all probably understand that industry, it makes you sticky with your customers. So we will continue to focus on that as we move forward. And as Carey indicated, EV, we will continue to focus on. We've built some very good relationships with a lot of the significant EV customers and I would say electric vehicles are here to stay, particularly in the United States. So that will be -- continue to be a big focus area for us, Jacob.

As there are no additional questions waiting at this time, I'd like to thank you all for joining us on the Fathom Digital Manufacturing Third Quarter 2023 Earnings Conference Call. Have a great rest of your day. You may now disconnect your lines.