Dennis Bertolotti - President and Chief Executive Officer Edward Prajzner - Senior Vice President, Chief Financial Officer and Treasurer Jonathan Wolk - Senior Executive Vice President and Chief Operating Officer.

Edward Marshall - Sidoti & Company Tahira Afzal - KeyBanc Capital Markets Inc. Andrew Obin - Bank of America Merrill Lynch.

Good morning, ladies and gentlemen, and welcome to MISTRAS Group's Earnings Conference Call for its Second Quarter Ended June 30, 2018. My name is Brian, and I will be your event manager today.

[Operator Instructions] Participating on the call from MISTRAS Group will be Dennis Bertolotti, the Company's President and Chief Executive Officer; and Ed Prajzner, Senior Vice President, Chief Financial Officer and Treasurer; as well as Jon Wolk, Senior Executive Vice President and Chief Operating Officer, who will be available for questions.

I will now hand the conference over to Mr. Bertolotti. Please proceed..

Thank you, Brian. Good morning, everyone. During today's call, we will review MISTRAS Group's financial results for the second quarter ended June 30, 2018. The good trend that began in the second half of our prior year continued with a very solid performance in the second quarter of 2018.

Our consolidated revenues were up 13% over prior year, and adjusted EBITDA increased by 35%. Income from operations and net income increased 106% and 171%, respectively, over prior year, as we generated $0.20 of earnings per diluted share on a GAAP basis and $0.21 of earnings per diluted share on a non-GAAP basis.

Our operating margin improved by 250 basis points, driven by a 150 basis point improvement in gross margin and a 100 basis point improvement in our operating expense ratio.

We generated over $14 million of net cash from operations during the second quarter and paid down $22 million of revolving debt, and we also continue to strengthen our balance sheet.

We achieved a record level of quarterly revenue in our Services segment despite the impact of a large contract discontinuing using our services at the beginning in April 2018, as we previously disclosed.

Services operating income increased 35% over prior year on a 10% revenue increase, reflecting strong operating leverage and favorable sales mix and efficiencies.

International segment revenues grew 21% over prior year, driven by mid-teens organic growth and favorable foreign exchange translation rates, while operating income improved to a $2.5 million or 6% of revenue from a small operating loss in the prior year.

We believe we have turned the corner in our International segment, and we have begun to benefit from the many improvement actions that we undertook during 2017. Products and Systems segment revenues increased 6% over prior year, and the backlog and outlook are improving from this segment.

MISTRAS has demonstrated its ability to manage through the volatile oil and gas market. We have continued to operate profitably and to grow despite the sector's cyclical challenges. Our business is sound and gaining momentum, as demonstrated by our Q2 results.

More importantly, however, our strategy of diversification is gaining significant traction as our business is expanding nicely into aerospace and complementary mechanical services offerings.

We are gaining synergies with our product segment, and we have some exciting new proprietary products that we are launching this fall for our use in providing leading-edge services.

Our acquisition pipeline is very interesting as we continue to refine our acquisition criteria to achieve diversification into markets where we can use proprietary products and knowledge to provide future profitable revenue streams. We did sign one LOI during the second quarter, and we are actively looking at several other opportunities.

Ed will now take us through our financials for Q2 in more detail. Afterwards, I will summarize our initiatives and update our expectations going forward..

Thank you, Dennis. I'll remind everyone that remarks made during this conference call will include some forward-looking statements. The company's actual results could differ materially from those projected.

Some of the factors that could cause actual results to differ are discussed in the company's most recent Annual Report on Form 10-K and in other reports filed with the SEC. The discussion in this conference call will include certain financial measures that were not prepared in accordance with U.S. GAAP. Reconciliations of those non-U.S.

GAAP financial measures to the most directly comparable U.S. GAAP financial measures can be found in the tables contained in yesterday's press release and in our related current report on Form 8-K. These reports are available on the company's website in the Investors section and on the SEC's website.

Consolidated revenues for Q2 of 2018 were $191.8 million, 13% higher than prior year second quarter. Services segment second quarter revenues grew to $147.7 million, up from $134 million for a 10% increase over prior year, attributable to high single-digit acquisition growth, coupled with low single-digit organic growth.

This was a quarterly revenue record for this segment, as Dennis mentioned earlier. Even more impressive is the fact that we had net organic revenue growth, even though, as previously disclosed, we had large contract discontinuance effective at the beginning of Q2. Organic growth for Services was double-digit excluding this impact.

International segment second quarter revenues were $41.1 million compared to $33.9 million, an increase of 21% year-over-year. This increase was attributable to mid-teens organic growth as well as mid-single-digit favorable impact from foreign exchange.

We expect a similar level of revenue for the remainder of 2018 versus a more difficult comparable prior year second half. Products and Systems revenue increased 6% in Q2 over prior year. Backlog has improved in this segment, and we expect that operational changes made in 2017 should continue to improve results further in 2018.

In terms of operating income, the Services segment increased its operating income margin to 11.1% from 9.1%, as Q2 operating profit increased by 35% to $16.3 million compared to $12.1 million in the prior year.

Drivers to the margin expansion of 200 basis points included increased revenue levels, an improved sales mix and cost reductions made in the prior year. The International segment generated approximately $2.5 million of operating income compared with a $200,000 operating loss in the prior year second quarter.

The double-digit organic revenue gain was the primary driver to improved results, as significant improvements were noted in each of our three largest European operations. As Dennis mentioned earlier, we expect this segment will continue to realize favorable margin comparisons for the remainder of 2018.

The Products and Systems segment had a smaller operating loss in Q2, and we are optimistic that the benefits of an improved sales backlog will drive this segment to profitability in the second half of 2018. On a consolidated basis for Q2, income from operations increased by 106% to $10.3 million compared with $5 million in the prior year.

Operating income margin improved to 250 basis points year-over-year, attributable to a 150 basis point improvement in gross margin, coupled with a 100 basis point improvement in our total operating expense ratio.

Second quarter net income was $6 million or $0.20 per diluted share compared with $2.2 million or $0.07 per diluted share in the prior year. Adjusted EBITDA for the second quarter was $21.1 million compared to $15.6 million in the prior year period, an increase of 35%.

Year-to-date net cash flows from operations were $20.1 million compared with $23 million in the prior year period, and year-to-date free cash flow was $8.8 million compared to $12.5 million in the prior year. This decline in our cash flow performance was primarily attributable to the timing of collections on accounts receivable.

Our cash flows did improve sequentially over Q1, and we anticipate cash flows improving further over Q2 in the second half of 2018. Total debt and capital lease obligations, net of cash and cash equivalents, which we refer to as net debt, was approximately $148.4 million at June 30, 2018, compared to $154 million at December 31, 2017.

We did pay down $22 million of revolving debt during Q2 using a combination of our free cash flow as well as additional excess on-hand cash balances. I will conclude with an update on our guidance, reaffirming our previously established outlook.

We expect that the present range for petroleum prices will persist for the foreseeable future, causing oil and gas customer spend for inspection services to be relatively stable.

Information obtained from our North American oil and gas customers suggests their spending in 2018 will increase modestly over 2017, and our results should reflect this dynamic despite our previously disclosed loss of a large contract within our Services segment commencing at the beginning of Q2, which we are working hard to offset with organic growth.

We expect continued growth in our aerospace and complementary mechanical services lines, driven by a combination of favorable market conditions and market share gains. Total revenues for 2018 are expected to be at the high end of the range between $715 million to $730 million. Net income is expected to be between $21 million to $24 million.

Earnings per diluted share is expected to be between $0.71 to $0.83. Adjusted EBIT is expected to be between $78 million and $83 million. Operating cash flow is expected to approximate $70 million, and capital expenditures are expected to be at the high end of the range of between $15 million to $20 million.

And with that, I will now turn the call back over to Dennis..

Thank you, Ed. I'll wrap up by providing a brief update on our ongoing initiatives and summarize our positive market outlook. During the first six months of 2018, we were particularly strong in the Services segment in oil and gas, complementary mechanical services and aerospace. Our International segment rebound was expected and welcomed.

Compared with one-year ago, the level of market activity for projects and turnarounds that we are experiencing is healthier. As we thought at that time, there was definitely a level of pent-up demand from deferred work, and what we experienced in the spring of 2018 represents a catch-up on some of those deferrals.

Customer indications suggest that we should see a relatively normal remainder of the summer season and fall for 2018 comparable with the prior year fall season, which had been returning to normal.

So our expectations for the North American oil and gas market for the remainder of the year are positive, with the first half results having been quite strong compared with the weak prior year's spring and second half prior year comparables that were positively impacted by the improving market.

As I've stated, our second half Services results will be compared against a prior year that included more than $20 million of revenue from a large former contract site, so it is possible that our second half revenue comparable could decline year-on-year.

However, we are confident in continuing margin expansion in our Services segment for the remainder of 2018 over the prior year second half comparable. As we continue to diversify our business, we expect less dependence on the downstream oil and gas sector as we pivot toward more of a midstream oil and gas and aerospace focus.

To this end, we are excited about two important new products that we have developed, enabling our move to high-value-creating business lines.

Each of these new products underwent successful field demonstrations last month and have been internally developed using automated, real-time radiography technology for our Services segment to deploy at customer sites.

The first involves our new real-time radiography crawlers, which we will use to inspect wells that join sections of newly constructed pipeline. The second involves our new automated radiography unmanned system that detects corrosion under insulation along extended length of horizontal pipeline.

We will apply for patent protection for several aspects of this second new product, which has already won an award for innovation from the Construction Industry Institute. These two developments reinforce our belief that there is significant opportunity for growth in providing products and services to operators focused on pipeline integrity.

Speaking of innovation, we are in the process of implementing MISTRAS Digital, our tablet-based platform that enables our technicians to electronically receive their work assignments, electronically generate reports based on their inspection findings and interface with our industry-leading PCMS software and database.

Both our customers and we, as a company, are excited about the potential for meaningful efficiencies to be gained. We expect to begin implementations of our platform at several of our existing customer sites over the next few months.

One final point on the innovation front comes from our Products and Systems segment, which has some exciting research and development activities underway with some important customers. As previously disclosed, we have actively marketed a subsidiary within our Products and Systems segment and are nearing a favorable outcome for those activities.

Our International segment is poised for continued margin growth against a relatively weak second half prior year comparable. Our operation in France is particularly strong, gaining market share in the oil and gas and power-generation markets.

Our new French aerospace lab that was built primarily to support Safran continues to ramp up, serving not only Safran, but also some of their suppliers. Our German business has benefited from strong turnaround activity, and our U.K. business has rebounded and is showing significant improvement compared with prior year.

In summary, we are pleased with the first half results from our Services segment.

We believe second half results will be strong despite the aforementioned loss of a large customer contract and that we will grow profits above prior year levels, driven by cost reductions and an improved sales mix, due in part to the beneficial impact of our 2017 acquisitions.

More importantly, we are becoming increasingly optimistic with our potential to create incremental value and drive future growth, driven by our new pipeline products and our new digital platform. We are likewise pleased with the first half 2018 results from our International segment, which has resumed its organic growth and delivered strong results.

We continue to assess our international portfolio and seek opportunities to grow in some areas and to potentially contract in others, all with an eye toward creating the strongest possible ongoing value to our customers. We are confident that we have turned the corner in this segment and that we are on the right path.

And in our Products and Systems segment, we expect to improve profit margins and grow in our core business and that we will complete the divestiture of this non-core subsidiary in the near future. In closing, we believe we are expanding the MISTRAS brand, and we are very optimistic about its future.

Our reputation for delivering evolving, value-added services is growing, as we capably add service lines and broaden our offerings. Our acquisition pipeline is very active and provides avenues for both healthy diversification and growth.

I am confident in our new vision and strategy for improvement and have strong conviction in the path we are on and our ability to manage in both up and down economic cycles. We believe macro-level economic drivers will remain positive, and we are confident in maintaining the forward momentum that we have built over the past several quarters.

We will now take your questions. Brian, please open up the phone lines..

[Operator Instructions] And our first question comes from the line of Edward Marshall from Sidoti & Company. Sir, your line is now open..

Good morning, guys.

Dennis, Jon, how are you?.

Good morning, Ed..

I wanted to talk about, in the release; you talked about the momentum continuing. In your prepared remarks, you talked about that as well. And I'm curious about the turnarounds into the second half of the year, in particular, the fall, which I think is typically stronger than the spring.

Do you anticipate it staying at the relative same strength that you saw in the first half?.

Yes, this is Dennis. We believe that the market is coming back. We see a strong fall year. All we're trying to say is that we did have a strong fall of 2017 as well. So comparably, it may not look as differential as first half to first half. But we see a strong 2018 finish, going into 2019 as well..

That's kind of the point of my question, I guess. When I look at your guidance and I'm looking first half to second half – second half to first half – the first half of this year, second half of this year, the midpoint of the guidance shows maybe a 10% decline into the back half of the year.

And I'm curious, is it fair to assume that you guys are just being a little bit conservative? I know you've come off a pretty severe downturn, kind of just thinking about the back half of the guidance for the second half of the year.

Or is there something in that contract that might be hitting in the second half of the year that we're not aware of?.

Well, the only thing that's different for the second half is we have two quarters of missing that large contract versus the one that we had in the first quarter – or in the first half. Because in the first half, we had a full first quarter of the contract and only missed it in the second. In the second half, we'll have two full quarters of it.

So that's a little bit more of a headwind. That's another $22 million that we're calling out of headwind. But we do believe we'll overcome it as well..

Yes, I mean, yes, this is Jon. I'll just tack on to what Dennis just said. I think that we certainly are going to grow organically, excluding that contract. Really, the big question is where does it all net out? And I think that's what you're getting at with your question, Ed.

I'd say that, in general, we're forecasting a little bit conservatively, particularly for the fourth quarter. Right now, I mean, fourth quarter workloads are moving a little bit, and we could end up a bit better than what we're forecasting it right now.

But I'd say that, probably, we're erring on the conservative side in this guidance right now, on the revenue side, particularly..

Got it. I mean, coming off the downturn, so it's kind of understandable. You paid some good – the capital allocation in the quarter, you paid some debt down. I know acquisitions is a priority. I'm kind of curious about maybe order of priority in that, between acquisitions and where the cash might go.

Is debt a priority for you to reduce? Or I mean, I guess some would argue that you're underlevered. I'm just curious of your thoughts..

I mean, this is Ed here, Ed. We will continue paying down debt. In lieu of the acquisition, the acquisitions will – as they happen will get funded. We're making them a priority, and they'll be closed. And they would be superior to debt paydowns. An acquisition comes, we're going to do that and fund that.

In the absence of those, we'll continue the debt service..

Got it. And the final question on the international, I'll be remiss if I didn't say something about that. Looking at the difference in the businesses relative to aerospace, I understand the drivers there.

I'm curious, is there anything specific going on the infrastructure side, whether it's public infrastructure or other, that you're seeing, that initiated within the international? Or is it all aerospace right now that's really driving incremental growth in that business?.

Ed, I think the market really hasn't changed so much for them. I think it's just a difference of utilization that really made the difference in the gross margins because aerospace and oil and gas are different in international.

We have a lot more aerospace than we do oil and gas, but we're bringing the oil and gas portion of it up, especially in France and Germany, bringing it up a little bit in UK as well. So we don't really have so much difference in that. It's just when we have a strong utilization, their margins are very, very good.

It's really what we have to be careful of, is making sure we can forecast going forward and watch our utilization to make sure we don't have a dip again..

Final one for me. As I look into 2019, and I know it's really early and you're still getting your arms around the 2018 guidance. But I'm curious, what are your customers talking about specifically in the U.S.

in North America refineries? Are you hearing similar strong language into 2019 as you are in, say, to the second half of 2018?.

Yes, this is Jon. I'll take that one. I'll start it, anyway. I think, as Dennis said, for 2018, the back half; certainly, there's an expectation that market activity will continue roughly as it's been. And I don't think anybody's stepping on the breaks for 2019, as near as we can tell.

But to your point, Ed, it's early in the cycle, so I don't think that we're anywhere near ready to give any kind of definitive statement to that effect. But just a general feeling that things should continue reasonably well..

Got it. Thanks very much guys. I appreciate your comments. Have a great afternoon..

Thanks Ed..

And our next question comes from the line of Tahira Afzal from KeyBanc. Your line is now open..

Hi folks. Congratulations on a very good quarter..

Thank you..

Thanks Tahira..

I guess, first question, as you talked about in your commentary about your changing mix.

If you look three years out, Dennis, what do you see your mix being in terms of end markets?.

It's a good question. What we're trying to do is stabilize what we're doing in gas and oil, but emphasize the pipeline section, emphasize the aerospace. And with that mechanical bridge, those Services can bridge over all those sectors. So we're not really looking to diminish our gas and oil presence in any way.

We're just looking to emphasize a couple of the other sectors. So what we'd like to see is a meaningful gains in aerospace and the pipeline as a percentage of sales while the rest is staying and growing, just not as fast as a percentage.

So I wouldn't say I have an exact idea what the percentage would be, but we really want to emphasize aerospace because we believe it's got a longer run. It's got a little bit more stability to up and downs, less cycle. So we like the visibility, what that market brings us..

Got it. Okay.

And would that have an impact on your DSO profile, by any chance, as you move more to midstream and aerospace customers, Dennis?.

Tahira, it's Ed. No, that customer base should be more or less at the average of where our DSO has been. We would not perceive any changes in that dynamic, in that metric..

Got it. Okay. And I guess, third thing I just wanted to ask you, as you look at into the second half and into 2019, I know your UK business is rebounding.

But can you provide us some idea and color of how much thought you put into Brexit and how much conservatism you really bid around that rebound?.

Yes, Tahira, it's Jon. I'll take that one. I don't know that Brexit's going to impact us very much. Basically, in the UK, our business, we're providing services primarily within the UK. We're not really selling products from the UK to other countries and so forth. So I don't know that it's going to have that much of an impact for us..

Got it. And I've got a couple more questions, but I'll hop back in the queue..

Thank you..

[Operator Instructions] Our next question comes from the line of Andrew Obin from Merrill Lynch..

Hi guys. Good morning..

Hey Andrew..

Good morning..

Just a question on cash flow. You sort of talked about receivables collection.

Could you just tell us what specific set of customers it is? And is it going to be sort of weighted towards Q4? Q3? How should we see about working capital release in the second half?.

Andrew, it's Ed. It was just generally across the board. It's the AR balances and the WIP a little bit. It'll be equally recovering over the second half. Q2 recovered strongly from Q1. We're making a hard push here in Q3 to get back on our normal trajectory of good working capital, and you'll see that play out over the second half..

And as you read about in the newspapers, there's a lot of talk about inflation.

I was just thinking, how should we think about your cost structure into the second half? Should we worry about labor inflection – labor inflation? And how are you guys countering it?.

Andrew, it's Dennis. We do see that in some segments. We don't see it across the board in the United States. There are some regions that are already starting to talk about, not much in the NDT spectrum, but in other parts of the labor market, in the skilled labor market, that there's getting to be some contraction of availability.

We haven't seen customers adjusting their schedules like a few years back, when it was really tight in the labor market, they were moving schedules around. So we haven't seen anything like that. But we do see some regions where it's getting busier, that we'll see that in the later half of the year.

Right now, we don't perceive that as any type of restraint to our growth whatsoever..

Got you. And just a last question on Europe. Seems that Europe has sort of stabilized. Can you just outline what changes have you made organizationally to stabilize Europe? And how much visibility do you have on execution there into second half of the year? And that will be it for me. Thanks a lot..

All right. This is Dennis again. Yes, we have made changes in, really, three out of the four segments that we operate in internationally. Within Europe, we've made changes to all those within the past, I don't know, 12 to 18 months. And we feel good about the people operating it. We feel good about where they're going.

But we are helping to work with them to build out the infrastructure, make sure that they have the latest visibility, looking at manpower and working with them to bring sales support from the United States and management to help internationally as well. So we are looking to build all that up.

We don't see anything right now that's standing in their way. As long as the market's going the way we've seen it, we feel they should be solid contributors as well..

Fantastic. Thanks a lot guys..

Thank you, Andrew..

And our next question comes from the line of Tahira Afzal of KeyBanc. Your line is now open..

Hi Dennis. So I know you've talked about a bit your new product innovation. And I think a lot of investors and even myself are still getting used to the innovations and putting them in context of predictive maintenance and, really, where the business is headed.

So if you can provide a little more color in terms of as you look at the products here in the waiting and bringing in, like, the two you mentioned, what the target is at? And how do you think it will play out in terms of market share numbers?.

Sure. I'll attack it two different ways.

The first was MISTRAS Digital we're talking about, naturally speaking to efficiencies, speaking to making sure that we can do things with customers and for customers and help them predict average hours consumed on a type of project and improve the safety and quality and all the metrics that we do, get the reports done.

The other product developments we talked about were specific to the pipeline segments. One of them is to compete in what is considered a larger construction pipeline work, and it's just digitizing all the radiography. The reason you want to do that is it speeds up the information. It makes information transfer much better.

Again, all this is really based around the new age enhancing what we're doing.

There's really no issue with any wholesale replacements or changes to the way we do work, but we do believe the way we process data, how data gets to a customer, making it smart as opposed to just something written on a piece of paper, those types of things are going to make us much more valuable to the customers we serve and make them want to be able to use our services in a faster way.

The CUI crawlers, those were, again, just another way of preventing from having to rip off a lot of insulation to see what the pipeline looks like and only tear off what is needed, where the repairs need to be made. And it's just a faster, smarter way to get the data, uses less manpower, less chance of injury and safety on their sites.

So it's really a win-win, using this digital to enhance what we're doing..

Okay. And Dennis, when I read articles in some of the industrial magazines, they've shown that some of these factors can improve the ROIs fairly substantially for your customers.

Is that the case with some of the innovations you're seeing? And what has been the traction as you've gone to customers with that so far?.

Well, I'll answer the last part. The traction is still fairly in its infancy. So what we believe is, so far, we've been showing up. But we don't have enough empirical data to say for sure.

The first half is – your question was asking, what it can do for the customer on return on investment, you're saying?.

Yes..

Yes. We believe that the inspection spend should be really where the damage is. And there is ways to use this new information to find it. In the old days, when I grew up in the business, you'd just throw a lot of bodies at it and hunt and peck and try to find it.

And now we're getting much smarter about trying to locate it, trying to spend less money to access it, be it rope access or drones or other ways to get to it, and having the customer spend the money exactly where it needs to be, even using engineering and our software to pinpoint where the highest expectation of damage is.

So what we're trying to do his work with the customers to be a good value-added. We know there's always going to have to be inspection spend, it's just a matter of how and where and helping them spend it smarter..

Got it. Okay. Thank you, Dennis..

You got it. Thank you. End of Q&A.

I am showing no further questions. And I will turn the call back to Dennis Bertolotti, CEO, for any further remarks..

Okay. I would like to thank everyone for listening to today's call. Wish you all a safe and productive day. And we appreciate your interest in MISTRAS. I look forward to updating you on our next scheduled call. Thank you..

Ladies and gentlemen, thank you for your participation in today's conference call. This concludes today's program and you may all disconnect. Everyone, have a great day..