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

Edward Marshall - Sidoti Tahira Afzal - KeyBanc Capital Markets.

Good morning, ladies and gentlemen, and welcome to the MISTRAS Group Earnings Conference Call for its Third Quarter ended September 30, 2018. My name is Kevin, and I'll be your event manager today.

[Operator Instructions] Participating on the call for MISTRAS will be Dennis Bertolotti, the Company's President and Chief Executive Officer; Ed Prajzner, Senior Vice President, Chief Financial Officer and Treasurer; as well as Dr.

Sotirios Vahaviolos, Executive Chairman; and Jon Wolk, Senior Executive Vice President and Chief Operating Officer who will be available for questions. I want to remind everyone that remarks made during this conference call will include forward-looking statements. The company's actual results could differ materially from those projected.

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

Reconciliation of these non-US GAAP financial measures to the most directly comparable US GAAP financial measure can be found at the tables contained in yesterday's press release and the company's related current report on Form 8-K. These reports are available in the company's website in the Investors section and on the SEC's website.

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

Thank you, operator, and good morning, everyone. During today's call, we will give you an update on MISTRAS' business performance and outlook, as well as review MISTRAS Group's financial results for the third quarter ended September 30, 2018.

I am pleased with our results as MISTRAS continues to drive executional improvements and operating excellence, with margins expanding and becoming more consistent and predictable as well as expanding period over period. For the quarter, revenues were up, margins reached a two-year high and profitability.

As measured by adjusted EBITDA, it was up by more than 20%. At the same time, we also implemented a number of strategic actions. Although we did record a gain on the sale of a noncore subsidiary in our Product segment, we also recognized a net special charge that impacted our GAAP results.

Strategically, these actions are all peripheral to our core operations and more importantly, should add certain low margin services so that they will have a positive impact on operating margins, respectively. Ed will walk you through specific actions taken in detail shortly.

The positive trend in our core end market that began in mid 2017 has continued into the third quarter of 2018. As a result, revenues were up from a year ago, more than overcoming the previously disclosed large customer contract loss last quarter such that we achieved modest organic growth in the quarter. Margins did even better.

Our consolidated gross margin in the third quarter was 29%, a 200 basis point improvement over the year-ago quarter. This was our highest gross margin level in two years. As a result of our strong margins and continued cost discipline, third quarter 2018 adjusted EBITDA increased 22% to nearly $21 million and the adjusted EBITDA margin was 11.4%.

Our best margin in two years. We believe adjusted EBITDA provides the best measure of the year-over-year improvement in our core operations.

So it is clear we achieved significant progress in the third quarter, consistent with our long-term vision, improving lower-margin services, maintaining discipline in the pricing of contracts in our core markets and continuing to diversify our business toward more of a midstream, oil and gas, aerospace and complementary mechanical service focus, while incorporating new digital technologies into our broader capabilities.

Looking more closely at our segments, we are pleased with results in our Service segment where we were able to effectively replace $10 million of lost revenue and generate overall segment revenue growth.

The stability and demand from the oil and gas market that we saw earlier in the year continued into the third quarter, with Services particularly strong in oil and gas as well as complementary mechanical services and aerospace. We also benefited from market share gains and acquisitions.

Profitability in this segment also improved, reflecting a better mix of higher-margin contracts as well as increased efficiency. I would also add that over the course of the year, we have not consummated any acquisitions which have historically been an integral part of our Services business.

Consequently, this makes our ability to overcome the revenue loss in April 2018, all the more remarkable, and the promise for a stronger, future performance even greater. The International segment also delivered strong operating results in the quarter.

Our operation in France is particularly strong, gaining market share in the aerospace, oil and gas and power generation markets. Our German business has benefited from strong turnaround activity, and our UK business has rebounded and is showing significant improvement compared with last year.

We suggested in the second quarter that the International segment has turned a corner and that our back half of 2018, the second was up against what was a weak second half fiscal 2017.

The third quarter bore that out as non-GAAP operating income increased to $2.1 million from $1.4 million with operating margins reflecting a 220 basis point improvement. In our Products and Systems segment, we achieved 170 basis point improvement in gross profit margin and modest growth in revenue for the quarter.

Adjusting for the disposition of the noncore subsidiary, this segment had several large system sales in the quarter and backlog remained strong in this segment. So overall, we had a solid performance in our core operations with continued revenue growth, strong margins and a better than 20% increase in adjusted EBITDA.

In addition, we made steady progress divesting of noncore operations and exiting low margin contracts which we believe will contribute to improved future performance.

And although increasingly prudent in our selection criteria, we remain actively engaged in several acquisition opportunities which we believe fit our profile as we'll have the potential to accelerate our end market diversification efforts. In the near term, we continued to demonstrate our ability to grow in the oil and gas market.

However, our long-term strategy is to grow MISTRAS into a more diversified business, serving both existing and emerging markets. In the third quarter, we achieved progress towards both objectives. We will continue to leverage our strength in the oil and gas market as the engine funding and fueling our expansion into new growth areas.

Ed will now take us through our financials for Q3 in more detail. After which, I will update our future expectations..

Thank you, Dennis. Before I summarize our current operating results, I will provide more detail on the special items recorded during the third quarter, as Dennis referred to earlier. As reconciled in the tables in our earnings release, these special items have been separately added back to non-GAAP operating income per segment.

I will not reiterate the non-GAAP reconciliation in this discussion, but please refer to such reconciliation when analyzing our operating income on a GAAP and non-GAAP basis.

During the third quarter of 2018, the company sold a subsidiary in the Products and Systems segment, addressed a number of issues and made provisions for the cessation of certain activities in its International segment.

The company recorded a net pretax charge of $7.1 million or $5.4 million on an after-tax basis or approximately $0.19 per diluted share. The special items consisted of the following, all on a pretax basis. In the Services segment, we recorded a $5.9 million pension withdrawal liability related to the large contract we exited in April, 2018.

In the International segment, we recorded a $2.8 million reorganizational charge primarily due to the impending exit of approximately $20 million of relatively low-margin, staff-leasing services attributable to a German legislative change.

The reduction of these services is anticipated to have relatively little, if any, impact on segment operating income. This charge also includes employee settlement obligations in Brazil. In the Products and Systems segment, we recorded a $2.4 million gain on the sale of a subsidiary, which we had previously disclosed as having been marketed for sale.

We recorded an additional $800,000 of special items across all three segments.

The majority of these items will have a positive impact on our operating margins in 2019 as we prune the underlying noncore, low margin services which has either already commenced or in the case of the International segment, will commence at the beginning of the second quarter in 2019.

The company also recorded an additional 2017 Tax Reform Act adjustment in the third quarter of 2018, which resulted in an increase of $1.3 million of income tax which had the effect of a reduction of $0.04 in diluted earnings per share. The reorganization expense in our International segment related primarily to our staff leasing business in Germany.

Due to a legislative change, we decided to not renew several contracts related to low margin services when they expire beginning in April 2019. As a result, we expect the reduction of approximately $20 million of annualized revenue beginning in the second quarter of 2019.

We do not anticipate the nonrenewal to have any impact on this segment's operating income as margins were relatively low and we feel can be recovered through overhead reductions.

Separately but not reflected in our financials, we are expecting a bad debt recovery in the range of $1 million to $2 million in either the fourth quarter of 2018 or early 2019, partially offsetting the funding requirements of the aforementioned charges. Turning to our core results.

Consolidated revenues for Q3 2018 were $182 million, up roughly 1% from a year ago. Third quarter Services segment revenues grew 3% to $141.3 million, attributable primarily to acquisitions. Services revenue would've been up approximately 8% excluding the large contract loss.

Excluding special items, Services non-GAAP operating income was $14.6 million compared to $11.7 million in the prior year period, an increase of approximately 25% or a 180 basis point margin improvement, reflecting strong operating leverage and a favorable sales mix.

International segment revenues declined by $1.5 million or 4% in the third quarter compared to a year ago. However, operating income excluding the special items impacting the International segment did improve significantly for this segment to $2.1 million from $1.4 million.

This reflects a non-GAAP operating margin increased to 5.9% from 3.7% or a 220 basis point improvement attributable to improved execution and efficiencies from changes implemented last year.

Products and Systems segment revenues decreased by $600,000 from a year ago primarily due to the $1 million of revenue reduction attributable to the subsidiary divested this quarter. Products and Systems segment non-GAAP operating income was breakeven in the third quarter of 2018 compared to a modest operating profit a year ago.

Backlog is strong and outlook continues to improve for this segment especially as we continue to launch new technologies in 2019. On a consolidated non-GAAP basis, operating income was $10.1 million compared to $6.9 million in the prior year period which was an increase of approximately 46%.

SG&A as a percentage of revenue was approximately 21% in both the third quarter of 2018 and 2017 after excluding reorganizational cost in both years, evidencing our focus on cost containment as we grow our business to scale. GAAP net loss was $1 million in the third quarter compared to a net loss of $7 million in the prior year period.

On a non-GAAP basis, net income was $4.4 million compared to $4 million in the prior year period. The company also recorded an additional 2017 Tax Reform Act adjustment in the third quarter of 2018 which resulted in an increase of income tax of $1.3 million, which had the effect of a reduction of $0.04 per fully diluted share.

Exclusive of this item, non-GAAP earnings per diluted share would have been $0.19. Adjusted EBITDA for the third quarter was $20.8 million compared to $17 million in the prior year period, an increase of 22%. Our adjusted EBITDA margin was 11.4%, as Dennis said, our highest level in two years.

Year-to-date net cash flows from operations were $24.2 million compared to $35.2 million in the prior year and free cash flow was $8.4 million compared to $19.9 million in the prior year. This decline in our cash flow performance was primarily attributable to the timing of collections on accounts receivable.

We anticipate cash flows improving significantly in the fourth quarter of 2018 although not to the extent originally anticipated. Nevertheless, our balance sheet is strong and will enable the funding of our growth objectives.

Total debt and capital lease obligations net of cash and cash equivalents, which we refer to as net debt, was approximately $146.6 million at September 30, 2018, compared to $154 million at December 31, 2017. And with that, I will now turn the call back over to Dennis..

Thank you, Ed. I'll conclude with an update on our outlook and guidance. 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 as we finish up 2018 and start to look towards 2019.

In the fourth quarter, we'll be comparing against a year ago quarter that benefited from the release of pent up demand from earlier deferred work. In addition, our Services segment will be lapping the year ago quarter that included more than $10 million of revenue from the large customer former site.

So although our Q4 Services revenue comparable could decline year-on-year, we are confident that results will be led by continuing margin expansion in our Services segment. In our aerospace and complementary mechanical service lines, we expect continued growth, driven by a combination of favorable market conditions and market share gains.

On the whole, therefore, we believe Q4 results will be strong and that we will grow profitability levels above prior year, driven by cost reductions and an improved sales mix.

I am extremely confident in our new vision and strategy for improvement and having strong conviction in the path we are on and our ability to manage in both up and down economic cycles. Over the long-term, we expect to grow our oil and gas business through new product innovation and market share gains.

We believe macro level economic drivers will remain positive. And we are confident in maintaining the forward momentum that we built over the past several quarters.

I am optimistic in the progress we have achieved in growing our aerospace and complementary mechanical services business and excited about our growth plans to expand further into pipeline integrity by leveraging our industry experience and technical know-how.

Based on our strong year-to-date performance, we are reaffirming key metrics, revenue, adjusted EBITDA and capital expenditures guidance for fiscal 2018. Due to the impact of the various strategic actions, we believe GAAP earnings guidance no longer provides a meaningful indication of our financial performance.

Total revenues are expected to be between $725 million to $730 million. Adjusted EBITDA is expected to be approximately $78 million. Capital expenditures are expected to be between $17 million and $20 million. With that, we will now take your questions. Operator, please open the phone lines..

[Operator Instructions]Our first question comes from Edward Marshall with Sidoti..

So I wanted to talk about the comments made about stable and steady demand for the remainder of the year. Looking at the fourth quarter, it's a sequential slowdown. Looking at the year-over-year comp, it looks like it's slowing as well even if you add back that contract loss.

So as I think about your guidance range for the fourth quarter, there's a considerable drop in the fourth quarter. I just want to talk about the dynamics maybe of the guidance and where the decline is coming from, maybe what segment, maybe you can walk me through that..

Yes, Ed, it's Dennis. I don't know if it's much of a drop we believe it's consistent with what we've seen in 2018. We believe that the quarter is going to keep going from what we're seeing in the last couple of months. But I think we just had a really strong comp in 2017 because there's a little bit of that catchup work that was going on.

So right now, we believe that the quarter will be strong. We don't really see anything different in the customers, the capital spend, the maintenance, everything is on par. We're just not sure how long turnarounds will last versus expectations and all that. So we're maybe a little bit conservative. But we don't see it as being a downward cycle at all..

Got it. Because if I do the math at the high end of the range, it suggests about $170 million in revenue, which is $10 million to $15 million even $20 million lower than any quarter this year.

I would've thought, especially with some of the fall turnaround work that it could be a little bit it could have - it might be at least on par with the remainder of the businesses. So that's what I'm trying to get with or that's what I'm trying to understand..

Yes, I guess if you will look at it from last year, we think it's going to be close to what it was last year and maybe a little under. But again, that was just because last year was exceptional. We think that the numbers are going to continue. We're always going to have a December drop off, we're just worried about how fast November drops off, really..

Got it. I guess with that context in mind, I'm curious if you can kind of talk about maybe what the customers are saying as they are looking at their 2019 budget cycle? What are the discussions around certain projects at 2019? Maybe you can compare that to what you heard going into 2018, etcetera, just so we get a sense of what that looks like..

Yes. We haven't completed our budget yet. But the customer expectations are pretty much the same for 2019's going to grow a little bit over 2018, maybe not as much as what we've seen over the previous year. So we think it's consistent with what we've been seeing.

As far as growth, the turnaround some customers are going to have some very large loans, it's just a matter of who you're talking to. There's no real expectation of softening or shortening at this point. So turnaround activity is the same. Aerospace, we continue to see that growing.

The other segments, power and everything else, we see a bit very strong just in casting out. We just don't have a good enough answer yet to be able to say anything about 2019. That's all..

And what are you seeing from a labor perspective? Any higher labor costs or that you can kind of talk through with and so we can think about the margin?.

Yes. The labor by region, there are areas where it's getting tight, and those customers already recognize it because it's not just the NDT, it's all the labor that they're dealing with.

So in certain areas of the Gulf and West and other areas where there's a lot of large projects already being announced, those customers know what's going on and they're willing to talk about increases to the pricing that is pushed down to the labor so that they can maintain their manpower needs. So that, to this point, doesn't seem to be an issue..

Got it. Thanks very much..

The next question comes Tahira Afzal with KeyBanc Capital Markets. Tahira, your line is open. If your line is muted. Can you please unmute the line..

Yes, I'm sorry. I was on mute I apologize. I guess, I had a couple of questions for you. In terms of International, just want to fully understand some of the softness there. I know there's some FX in there, but I would love to get a sense if the underlying markets are not being disrupted by all the BREXIT movements..

Tahira, it's Jon. We feel really good, as Dennis said in his comments, about France and our market share gains there. We feel very good about all the sectors that we're in France.

In the UK, we deliberately contracted, compared to last year and some of the growth initiatives we had because we got a little bit outside of our swim lane in terms of projects and scope of projects that we had taken on. So we've deliberately curtailed activities to an extent, and we've improved operating results substantially there as a result.

In Germany, we had good turnaround activity, as Dennis alluded to, this year which offset a couple of other things that fell off a little bit in Germany, so that was kind of a push. So overall, we're really not impacted by BREXIT per se. We're not really seeing impact there. I think it was really those dynamics that we see reflected in the results..

Got it. Okay. And then I guess the other question I had, Jon, was really on the mechanical side. Have your initiatives played out as per plan? We've heard some mixed elements around the turnaround season, some folks have seen a positive one, some haven't. Would love to get a sense how those headwinds are playing through as you push your initiative..

Yes, I'd say from my perspective, Tahira, we feel very good about our mechanical services that are embedded within our Services segment. We're very strong offshore, and we're strong in Canada which are two biggest areas of business. We feel like we're doing very well in that business..

It's Dennis, quickly on that. Customers especially in gas and oil are still looking for any kind of cost reductions they can find.

The mechanical embedded with the inspection, trying to make the project quicker and easier and more importantly cheaper for them is still a very good conversation to have with the customers because they can see where there's a real cost savings to them.

So we feel our strategy of having the mechanical that is complementary to what's going on for the activity to get the inspection started or completed has worked out very well. So that part is really, is still on a course for us..

Got it. Okay. And are you folks seeing any impact or should we be looking at some potential movements on how turnarounds typically happen, as we go into next year for a couple of reasons? Number one, IMO 2020 and really refined this planning ahead of any disruption there, and then some union deliberations that are happening potentially in California..

Yes, a couple of good questions in there. The 2020, I think, from what we're hearing right now and that's talking about the bunker diesel that's going through the ships and all that.

We hear that's a lot more of an activity in the West Coast refineries than anything in the Gulf or East that we've seen that could change, but right now we're seeing it more West. The California unions, is very much a point that everyone's keeping an eye on. Right now, we don't see that as affecting our business.

But if it does, we know that the refiners will recognize that first as they're the ones responsible for keeping that current, so they would be the ones moving that along. So at this point, we don't think that's going to affect our business either. There was a third part to your question, I forgot.

Or was that it?.

Those were Dennis, those were actually the two main parts. I guess, I was just trying to see obviously, there's still some deferred maintenance. You're still a little upbeat in general. I was just trying to see how we should, in a sense, model activities next year given there's some interesting wins coming up..

Yes, I think it's consistent. I mean, to your point, there might be some regional differences of certain regions pushing in the Gulf where there's fracking and there might be more activity in some of those places, LNG or something like that. So there's still going to be some regional variances.

But overall, I mean, we see 2019 as being a consistent year where things will be good in the oil and gas. It just may not have that kind of spring that you've seen from 2018 to 2017..

Okay, thank you very much..

[Operator Instructions]And I'm not showing any further questions at this time. I'd like to turn the call back over to Dennis..

Okay. With that, I'd like to thank everyone for listening in today's call. Wish you all a safe and productive day. We appreciate your interest in MISTRAS, and we look forward to hearing from you again on our next call. Thank you..

Ladies and gentlemen that concludes today's presentation. You may now disconnect, and have a wonderful day..