Exide Technologies' CEO Discusses F2Q2013 Results - Earnings Call Transcript

 |  About: Exide Technologies (XIDEQ)
by: SA Transcripts

Exide Technologies (XIDE) Q2 2013 Earnings Call November 12, 2012 9:00 AM ET


Good morning. My name is Brandy and I will be your conference operator for today. At this time, I would like to welcome everyone to the Exide Technologies Fiscal 2013 Second Quarter Results call. All lines have been placed on mute to prevent any background noise. After the speakers’ remarks, there will be a question and answer session. If you would like to ask a question during this time, simply press star then the number one on your telephone keypad. To withdraw your question, press the pound key. Thank you.

I would now like to turn the call over to Ms. Carol Knies, Senior Director, Investor Relations. Please go ahead, ma’am.

Carol Knies

Good morning and thank you for joining us. You may view the slide presentation for today’s discussion on our website at www.exide.com. The presentation is located on the Investor Relations homepage under Events.

On the call today is Jim Bolch, President and Chief Executive Officer, and Phil Damaska, Executive Vice President and Chief Financial Officer. At this time, I’ll review our Safe Harbor statement, then we’ll provide details of Exide’s fiscal 2013 second quarter results as of September 30, 2012, followed by a question and answer period.

Listeners should be aware that certain statements on this call may constitute forward-looking statements as defined by the Private Securities Litigation Reform Act of 1995. As such, they involve known and unknown risks, uncertainties and other factors that may cause the actual or expected results of the company to be materially different from any results expressed or implied by such forward-looking statements. These factors are enumerated in further detail in the company’s most recent Form 10-Q filed on November 9, 2012 with the United States Securities and Exchange Commission. Any statements made during this call are made as of today and the company undertakes no obligation to update any of these statements in the future.

At this time, I’ll turn the call over to Phil Damaska, Executive Vice President and Chief Financial Officer.

Phillip Damaska

Thanks, Carol, and good morning. Today’s presentation differs from our traditional quarterly earnings call format. I will begin by spending the next few minutes reviewing the fiscal second quarter financial results and then Jim will review several key strategic actions we have been taking to refocus our businesses which have the intended result of returning Exide to a positive earnings trajectory. We certainly hope you will find this useful in understanding not only the what but the why we are taking the actions we have announced. We will also endeavor to provide you with an understanding of the anticipated financial implications of these actions. Now please turn to Slide 4.

Net sales in the quarter were up slightly excluding the negative impact of foreign currency translation and lower lead-related pricing. Transportation Europe and rest of world enjoyed higher after-market sales and industrial Americas continued to see strong revenue, up 8.5% excluding lower lead-based pricing. Excluding the unfavorable impact of foreign currency translation, second quarter gross profit was lower than the comparable prior year period by approximately $15 million. Of this amount, the Americas region was negatively impacted by approximately $18 million, a result of continued high core costs and lower LME-based pricing.

Operating income declined versus the prior year period primarily as the result of higher core costs, compressed margins on third party lead sales, and much lower LME-based lead prices. Net loss for the current quarter was 13.9 million or $0.18 per share compared to a prior year period net loss of $3.6 million or $0.05 per share.

Please turn to Slide 5. Our year-to-date U.S. lead production was approximately 164,000 tons, down about 2.5% from the prior year period. As the pie chart indicates, 78% was used to satisfy internal demand. External lead sales decreased about 4,600 tons compared to the first half of fiscal 2012 as we began to phase out this volatile revenue stream. Higher core costs negatively impacted third party lead sales during the quarter, resulting in significantly lower profits as these sales of (inaudible) sales as compared to the prior year.

During the quarter, the average cost of purchased spent batteries as a percent of LME remained at record levels. Core supply in October was much improved and we have seen a corresponding softening in price while lead on the LME has increased slightly. If these factors would remain at these levels or improve further, operating income would benefit, everything else being equal.

We remain focused on improving our collection of spent batteries at more economical levels. Our captive core return volume is up 14% sequentially over the first quarter. Additionally as we reduce our transportation OE volume and our third party lead sales, our captive core rate should be further improved due to this customer mix change.

Turning to Slide 6, I’d like to review our operating segments. Industrial Energy Americas net sales, excluding the lead-related pricing, was up about 8.5% in the current quarter as compared to the prior year second quarter. The margin impact of stronger sales, however, was more than offset by $6 million of reduced lead margin, the result of historically high lead of spent batteries compared with lower LME-based price reductions. Expected price increases did not materialize as competition backed off previously announced price actions. Industrial Energy Europe and rest of world reported an approximate 2% increase in net sales excluding lower lead pricing and unfavorable currency translation. Operating margin held steady in the quarter. Our European business reported higher operating income for the second straight quarter while our import business in Asia Pacific continued to see margin pressures from local producers.

Transportation Americas net sales, excluding unfavorable lead-related pricing, decreased about 2% compared to the prior year second quarter. Both gross margin and operating margin were down as compared to the prior year period primarily due to lower aftermarket unit sales and continued higher cost of cores combined with lower LME-based lead pricing. Third party lead sales accounted for about $4.5 million of the reduced gross profit in the current quarter. Transportation Europe and rest of world net sales, excluding foreign currency translation and lead-related pricing, were flat in the fiscal ’13 second quarter versus the prior year period.

Gross margin and operating income declined as a result of lower carryover pricing implemented in the second half of fiscal 2012, as well as an escalation of core costs as a percent of LME. Although not as dramatic as we’ve seen across the Americas, the cost of spent batteries has been rising in Europe. Such cost increases are beginning to result in higher premiums paid for lead. We expect these increases to be passed through in the form of escalators.

Please turn to Slide 7 for an update of our liquidity position. At September 30, 2012, we had total liquidity of $211 million versus $228 million at September 30, 2011. The current year includes $74 million in cash and approximately $135 million under the revolving credit facility. As is typically the case, to meet seasonal demands we added inventory in the period, albeit at a lower rate than in the prior year comparable quarter. We used $99 million of free cash flow in the first half compared to a use of $87 million in the prior year period. Consistent with the prior year, we expect third quarter free cash flow to be close to break-even and to generate free cash flow in the fourth quarter sufficient to offset a substantial amount of the year-to-date burn.

With that, I’ll turn the call over to Jim. Jim?

James Bolch

Thanks, Phil. As Phil mentioned earlier, my comments are focused on key strategic issues and actions for each business for both the near and long-term. Let me begin with a focus on our Americas region. Slide 8 is summary view of the important issues facing our Americas business. We’re disappointed with the quarter and year-to-date results for the Americas segment. This business has been faced with a rapidly changing economic environment and we are aggressively adapting the business to deal with these new external realities. This involved continuing to execute the strategic actions we have already announced plus accelerating new initiatives. I’ll cover the actions we have in place to address these issues during the next few slides.

Please turn to Slide 9. As we’ve discussed in the past, our Americas transportation business has carried approximately one plant of excess capacity for quite some time. About a year ago, we announced the planned shutdown of our Bristol, Tennessee flooded battery plant to right-size our transportation capacity. We have been executing on this initiative since then and continue to be on schedule to transfer all flooded battery assembly from Bristol to Salina, Kansas and Manchester, Iowa by the end of our fiscal third quarter. I’m pleased to report that we are on track with certification from our OE customers, a key milestone for the transfer. Formation of the process to charge batteries will follow over the next three to six months as we complete installation of new state-of-the-art formation equipment in the receiving plants.

Following the complete closure of Bristol, we expect to have two plants at substantially full capacity. As consistently stated, we anticipate an annual improvement of 20 to $25 million in operating income as a result of this initiative. A portion of this will be realized as early as this fiscal fourth quarter with an anticipated full run rate beginning in the early part of fiscal 2014.

Turning to Slide 10, I’ll brief you on our lead recycling capacity situation and the revised strategy relating to our North American lead supply chain. Approximately 400,000 metric tons of recycling capacity will have been added to the North American market by 2013. Core supply and product demand have not kept pace. This imbalance has likely contributed to high spent battery costs. While we still believe that our recycling assets continue to offer us a competitive advantage, we believe in this environment it is no longer prudent to maintain capacity in excess of our internal needs. Some of the excess capacity was historically sold profitably at LME-based prices to third parties. As core costs have increased and LME has declined, profit from this business has been reduced and become quite volatile.

In addition to our previously announced transaction with respect to our Frisco, Texas recycling operation, we have decided to idle lead production in our Reading, Pennsylvania plant. As shown on the chart, we will reduce our capacity by roughly 150,000 tons by these actions. As a result, we are exiting third party lead sales and will now procure 25% of our lead needs from external tolling and primary lead suppliers. This supply equation will offer us more much flexibility to optimize supply sources and freight logistics as conditions change.

While we believe taking this combined capacity offline should relieve some of the pressure on core costs, this was not the only reason for the decision. In addition, we will avoid capital spending of as much as $50 million that would have been required to bring Frisco and Reading into compliance with new regulatory air emission requirements. The Frisco closure remains on schedule and we continue to anticipate net proceeds of 35 to $38 million in mid-calendar 2013. We expect to cease production in Reading by the end of this fiscal year. Cash restructuring charges related to Reading are expected to be 4 to $5 million and a charge related thereto will be recorded in our fiscal third quarter.

As with our Frisco workforce, we regret the impact this decision will have on our Reading-based employees. They are a dedicated group of employees and we will attempt to relocate those who have an interest and will work with state and local officials to support the remainder.

Please turn to Slide 11. As we have described on previous calls, the fundamental dynamics of lead recycling in North America have changed. Historically core prices and LME have been correlated; or said another way, the core price to LME ratio has been fairly constant. Over the last year, this ratio has trended much higher and become less predictable. As previously described by Phil, core cost in the Americas coupled with lower relative LME lead prices continue to pressure margins significantly - $38 million year-to-date. Clearly there has been a shortage of spent batteries and increased demand with the new smelting capacity I discussed previously.

To adapt our business to this new market reality, we are exiting or reducing our exposure to customer segments without corresponding core returns, namely third party lead sales and automotive OE customers. Equally as important is to obtain a higher percentage of captive cores at less than market pricing. We’ve taken a number of steps to address this and are seeing steady progress. Examples include utilizing our transportation branch network to focus on industrial captives, up 19% in Q2 versus Q1; achieving better transportation aftermarket customer mix with customers such as Pep Boys; and core collection programs through our branch locations with core purchases up 50% in Q2 over Q1. Results of these activities are promising. In particular, our return of spent industrial batteries in the month of October was at an all-time high.

Lastly, we continue to negotiate with customers on pricing to better match our lead input costs. We already achieved agreement from certain key customers on escalators that consider both LME and core cost factors.

Please turn to Slide 12 for a discussion on the Americas industrial business. As you are aware, industrial Americas has been our most profitable business. Although margins have been pressured this year due to lead, this business remains a significant opportunity for profitable growth. We remain excited about the continued adoption of our Tubular motor power products. To support increasing customer demand, we added a second line of Tubular capacity at our Kansas City plant, which is already operating at a high utilization level. Plans for a third line are under development and will be installed as demand dictates.

With the recent AGM capacity coming online in Columbus, Georgia, we’re now positioned for further penetration in multiple industrial applications requiring basic AGM block batteries. We are under-represented in this product offering with market share of 6 to 7 points less than our overall share position. This incremental capacity will allow us to be more responsive with respect to product needs and faster lead times.

Finally, our position in South America has been on an import-only basis to date with mostly network power products. We are in the final stages of establishing a partnership arrangement which we believe will position us for further growth in industrial products in this region.

If you turn to Slide 13, you’ll see a summary of what we view as major issues for our European business. With the next few slides, I’ll cover the strategies and actions we have identified to address these issues.

Please turn to Slide 14. The chart reflects our current view of the OM evolution to micro-hybrid batteries on a pan-European basis. This evolution will potentially present a pricing and margin challenge for traditional flooded batteries and a significant opportunity for those like us adding capacity to meet the emerging micro-hybrid market. As demand for flooded batteries diminishes we are taking aggressive cost reduction action to mitigate price and margin erosion. More importantly, we are executing a well-managed transition of flooded capacity to our MHF, or micro-hybrid flooded product, to take advantage of this technology shift. At our Manzanares, Spain plant, we are already transitioning from flooded to MHF by replacing 750,000 units of flooded capacity with MHF production. We are substantially complete with our AGM capacity expansion in Romano, Italy and are well underway in terms of adding more than 1.5 million units of AGM capacity in Poznan, Poland.

We are committed to continuing to invest in innovative solutions to meet our customers’ evolving needs for these micro hybrid batteries. This will involve not only technology development but also focused project management to ensure customer approval (inaudible) this new capacity once online.

As you can see on Slide 15, transportation battery growth rates in eastern Europe are expected to be significantly higher over the next several years than in western Europe. This ongoing shift in demand by geography is causing OEMs to move production east and they are encouraging their component suppliers to do likewise. Our Poznan, Poland plant will support some of this migration. To serve the CIS region and Russia, we have plans to expand our 75% owned joint venture in Pinsk, Belarus. The planned investment will allow us to meet demands of a major European OE as it expands car assembly into Russia. The Pinsk expansion will take place over the next 24 to 36 months, supporting CIS unit growth from roughly 500,000 in FY13 to approximately 1.5 million units in FY16.

With Slide 16, I’ll focus on our actions to improve profitability of our European industrial business. We’ve had some success with pricing in certain targeted markets, but the vast majority of Europe remains very competitive. With the economy softening in many countries, we expect the market to remain in a competitive state. Driving profitability of the business continues to be a primary focus. Through the use of lean six sigma and VAV initiatives, we are seeing reduced product costs. At the same time, we are targeting capital spending to allow greater productivity.

We are nearing the completion of an extensive project in our Lille, France plant which will provide a more efficient production flow with reduced indirect cost. We will be committing resources to redesign and approve network power products, improving performance as well as extending the range of our offerings. In Motive Power, our Tensor product has completed several successful trials with many customers as we ramp production of this higher margin product. We are also finding good success driving solution sales with our more efficient high frequency chargers paired with Motive Power batteries. Our service platform is being revamped to allow it to become a profit generating activity. A reduction of our service technician population is already underway and we intend to make our workforce substantially more efficient using new automated service tools.

If you’ll turn to Slide 17, I’d like to recap our strategic focus for our businesses. Starting with transportation Americas, we will limit growth and continue to focus on return to profitability and cash generation. Limited capital spending is anticipated with earnings improvement resulting from the closure of Bristol, maximizing utilization of Salina and Manchester capacity, optimized lead supply chain, and ongoing productivity initiatives. With limited capacity, we will look to manage our customer portfolio for maximum return on investment.

For transportation Europe, we are managing micro hybrid battery capacity ramp-up carefully with demand. This will involve bringing innovative technology to market for both advanced AGM and MHF solutions. We are carefully selecting the right opportunities to meet growing demand in the CIS region, the Middle East and North Africa.

For industrial Americas, we are re-deploying resources to allow this business to grow profitably at a faster rate. We have great products with more new offerings on the horizon. We’re in the process of adding more feet on the street, including sales and service personnel, utilizing our existing branch network. Additionally, we look to expand in South America via relatively small investments to gain local content to serve this growing market.

In industrial Europe, we’ll be unrelenting in executing margin improvement via pricing, new product introductions, and continued productivity initiatives. In addition, we are in the process of exiting our small industrial business in India as we focus on more attractive markets in Asia Pacific. Cash restructuring charges to this will be fairly significant and we are finalizing an impairment charge which will be recorded in our third quarter.

Please turn to Slide 18 for a brief summary and wrap-up. The fiscal 2013 second quarter was significantly impacted by continued high core costs combined with lower LME lead-based pricing. However, as Phil mentioned this morning, we began to have more adequate supply of spent batteries in late September, and this has continued through October. We currently expect this trend to continue as we enter the fall and winter battery season.

We continue to focus on improving profitability in all businesses, and the completion of several new initiatives is in the near future, specifically the closures of Frisco and Bristol and the idling of lead production in Reading. Our targeted growth plans and actions in transportation Europe and industrial Americas is underway and sets the stage for top line growth and improved financial performance.

Today we mentioned several strategic changes in our business model and corresponding footprint, shrinking in some, expanding in others. We believe these important changes will allow us to more effectively target resources and capital to drive improved returns in our business.

Thank you for your attention, and now we’ll open the call for your questions.

Question and Answer Session


Thank you. [Operator instructions]

Your first question comes from William Bremer of Maxim Group.

William Bremer – Maxim Group

Morning Jim, Phil. Good morning Carol. Did I hear you correctly, Phil, when you said third quarter we’re looking for a restructuring charge in the neighborhood of 4 to 5 million?

Phillip Damaska

It’d be 4 to 5 million for the Reading idling, and then as Jim indicated late in our remarks, we’ll be formulating a charge for the closure of our industrial business in India. The cash restructuring or severance related to that will be fairly insignificant, certainly less than 700,000; and we’re in the process of determining what, if any, asset impairment charge would be associated with that.

William Bremer – Maxim Group

Okay. And as we look over the segments, how should we look at the back half of this year for each one of them? I mean, if we look at, say, the transportation Americas, you’ve seen very little growth top line first and second quarter here. How do we look at the back half there, and then if we go into the industrial side, a little bit in terms of the margins here on the Americas. Year-over-year, we’re still down, pretty much flat-lining from the first quarter. How do we look at it in terms of the operating metrics for these segments going forward?

James Bolch

So Bill, let me try to take a crack at that one. To start with, if you look year-over-year, we saw unit growth up in every segment except for transportation Americas. Obviously there has been a currency and lead escalator impact that suppressed the top line growth in the others.

As we look forward – and I’ll take them in the same order you asked the question – transportation Americas, we saw this quarter down slightly, about 1.5%. We actually saw the OE volume up, but as we indicated on the call, we’re looking to change that ratio and drive more aftermarket sales to OE. We’re starting to see good demand as we move into the season. You’ll recall it’s a seasonal business. We would expect much higher demand, although there is certainly a weather component and you can probably predict the weather as well as we can. But it looks like at this point we’re moving into somewhat of a normal season. We also saw in this last quarter some attrition in the aftermarket due to the pricing actions that we took in the market, and again we’re working that side of the equation. We’re starting to see some of that come back.

Moving to transportation Europe, again we saw pretty solid performance in the quarter aftermarket unit sales, up about 4%. OE was up about 6. Certainly the European market is a watch market. We believe this will be more impactful on the OE side than on transportation. Again, the big indicator in Europe is going to be the weather, and we’re seeing a strong start to the quarter. October sales were quite robust there.

Moving to the industrial side, industrial energy Americas, we saw strong sales in the quarter; and from what we’re seeing from a backlog there, we’re up 25% year-over-year and continuing to see orders strong there. The most recent ITA statistics in Motive Power, which tends to be an indicator, second quarter shipments were up 4% and orders were up 5. The numbers that we have out of September for us are saying that sales of electric trucks in the market are up about 14% and our October orders continue to be strong.

All that said, with the fiscal cliff out there, the data we have today is good but we’re certainly going to be very cautious here because I think this is a place we’re going to have to watch our costs very carefully and we’re monitoring inventory levels and costs very closely.

And then finally, industrial Europe – again, strong orders and backlog. Our backlog in Europe and rest of the world was up about 37% year-over-year, and although we’re seeing some signs of moderating in especially the Motive power side – and again, I think this is a watch and see with the economic issues that are in Europe today – we’re going to have watch the costs very carefully, but at this point lines are still solid.


Your next question comes from Kelly Dougherty.

Kelly Dougherty – Macquarie

Hi, thanks for taking the question. Just wanted to see what you intended to do with the—I think you said maybe up to $50 million you won’t have to spend to upgrade Reading and Frisco. Is that cash you want to keep to bolster the balance sheet or do you intend to plow that back into CAPEX in Tubular or Start-Stop. How should we think about maybe CAPEX over the next few years, given what you’ve outlined today?

James Bolch

Well Kelly, good question, and I’ve stated pretty consistently that this company needs to spend around $100 million a year. That statement was based on our prior footprint. Certainly I would expect the reduction of capital that would have been required for both Frisco and Reading and the fact that we’re going to have one less plant in Bristol, Tennessee that our going forward spending certainly won’t be at that $100 million level. We’re evaluating the fiscal ’14 budget at this point in time in terms of prioritizing capital requirements.

You mentioned certainly the need to continue to invest in AGM and MHF. We’re certainly going to continue to do that with respect to the projects that are ahead of us – that’s Poznan, Poland and the conversion of MHF in Manzanares, Spain. But in summary, I would expect to spend at levels lower than we’d previously indicated as being required, so below the $100 million level.


Your next question comes from Craig Irwin of Wedbush Securities

Craig Irwin – Wedbush Securities

Morning everybody. I wanted to pick through the results of transportation Americas a little bit more. So I noticed the gross margins in that segment were up about 270 basis points sequentially, but when I look at the lead cost metrics you’ve disclosed and the lead metrics trading on LME, the delta or the gap between junk and LME – and junk being the number you disclosed – widened from about 25% headwinds in your first fiscal quarter to around 35% headwind in your second fiscal quarter, a very substantial deterioration but you still came through with 270 basis points of margin expansion. Can you walk us through really what’s having the most material impact there, and I know you mentioned 50% increase in core purchases for your branches this quarter but can you maybe give us a little bit more detail around that?

Phillip Damaska

I think the other piece that needs to be discussed is the pricing we did get in the aftermarket. It’s about $5.5 million, and that’s kind of on the run rate that we talked about a quarter ago, recognizing that volumes are going to likely be stronger in the third and fourth quarter than the second quarter. So the price that we were able to have stick in the aftermarket was beneficial. You’ve probably seen, Craig, the purchase core cost, but as Jim indicated we’ve had great success in terms of improving our captive core returns in the industrial space. There’s a lot of lead in those industrial batteries. That drives down the average cost of cores in our total lead equation.

So I would suggest that the aftermarket pricing of 5.5 million and the improvement in captive core rates are what’s driving the improvement we’re seeing.

Craig Irwin – Wedbush Securities

Okay, excellent. So when I look at core costs, to me – and this is my opinion – it appears that you’ve really thrown a wrench in the machine of your major North American competitor, disrupting the way they get their junk back and influencing the market by your more successful procurement of cores through captive recovery. Now, I had always expected that we would see a little bit of hoarding of cores in the market going into this coming winter because we’re going to see—or at least again in my opinion, it looks like we could easily see a 10 or 20-year peak in unit demand given the prior very weak selling season from the winter, and if we have some more favorable weather this winter, and hoarding is a real impact when I talk to some of the people out there.

Can you comment on whether or not you’ve seen hoarding of cores out in the market and whether or not that’s influenced your ability to buy at prices that you see as reasonable, and whether or not you see that as something that could potentially come to an end?

James Bolch

So Craig, let me try to give you perspective this way. It’s obviously pretty difficult for us to understand what our competitors’ core inventory levels might look like. Certainly scarcity of cores through this year has been an issue for us, not only in the price we had to pay for those purchased cores but also from time to time we were running very thin, which has operational issues – you have to have short cores in front of the smelters. What we are seeing today, as we indicated on the call, is we have seen the market free up a bit with cores. We now have an ample supply and we’re seeing better pricing in the market. It could be that the overall market demand is down. It could be we’re more effective in the way we’re going after it – likely a combination of the two.

As we go into the winter peak demand season where we’re now ramping up capacity, we feel very comfortable with our core supply situation right now and what’s coming in. And I’ll reiterate – it’s incredibly important as we change this mix going forward, once we are no longer having to supply the third party lead sales and we have reduced demand for OE customers, just by math our captive core rate will go up dramatically so there will be a lot less pressure on us to go out and buy those purchased cores.

So in summary, I think we’re feeling pretty comfortable with our position going into the winter season from core supply.


Your next question comes from Kirk Ludtke of CRT Capital Group.

Kirk Ludtke – CRT Capital Group

Hi, good morning everyone. You mention that the price of cores has softened so far this quarter. If they stayed where they were, what kind of year-over-year increase would you expect, say, in the second half of this fiscal year?

Phillip Damaska

Yeah Kirk, you’re aware we’re not providing guidance. That’s moving well into that direction. All I would suggest to you is that if we see a normal winter season, we ought to see some tailwinds, and as I said in my comments, if core costs stay where they’re at today or improve and if LME stays where it’s at or firms even further, certainly we’ll be positive on a sequential basis to our second quarter. And that’s all I’m prepared to say at this point in time.

James Bolch

One point I would add there just to keep in mind from a timing standpoint as we talk about lead escalator pricings, which tend to be a quarter in arrears, a similar phenomena on input costs is if we saw the lead prices coming down with about two months of inventory, it would be about a two-month lag before we would see that in the income statement.


Your next question is from Sean Britain of Bayside.

Sean Britain – Bayside

Good morning. Wanted you just to talk about market share in the aftermarket in the U.S. It looked like, looking at the BCI data, that the negative 1.5% you guys realized in volumes kind of lagged a low single-digit market growth. I also think your large competitor kind of posted positive numbers. In this segment, do you have a sense if you are losing share, and if so, in terms of what customers or what specific types of customers?

James Bolch

I think the numbers you stated are accurate, and as I said earlier, we did see some attrition in the aftermarket predominantly in these independent battery suppliers who tend not to be very loyal and are price-shoppers. So as we increased prices, we saw some attrition in that segment. To counter that, though, we are seeing ramp up in some of our larger customers. We talked about Pep Boys last quarter and we’re now fully supplying them. As we move into a two-plant scenario where we have Salina and Manchester, our intent is to be very selective with customers. We want to fill those plants up, run then at an optimal rate, but that will give us the opportunity to really pick the customers that are most beneficial to us from a margin standpoint, and that includes not only gross margin on the initial sale but core returns.


Your next question comes from Stan Manoukian of Independent Credit.

Stan Manoukian – Independent Credit

Good morning. Thank you for taking my questions. I have several questions about smelters. I was wondering if you can tell me—and I’m trying to sort of get this into one question in order to avoid standing back in the queue, what is the capacity in your remaining smelters in Missouri, and what is the capacity in your smelter in Pennsylvania that you are shutting down? And then if I understood you correctly, the $50 million of CAPEX savings, is it only related to Bristol or it is also 50 million included in Reading? And then finally, how much you are paying now for junk batteries per pound, if I may ask this.

James Bolch

Okay, let me see if I can take those going through. I think the best way to describe the capacity in the smelting is on Slide 10 that we shared in the prepared remarks. The combined capacity of Frisco and Reading was about 150,000 tons. That will be coming out by the end of this year once Reading is done—in fact, Frisco is already in the process of ramping down as we speak. Once that happens, we will then be below our internal demand which you can see on that chart is something in the nature of 270,000 tons of demand, and we’ll be buying about 20 to 25% of that outside.

The $50 million number that was referenced, that is the capital costs we will not have to spend in the Reading and the Frisco plants to meet the new stricter air emission standards. That has nothing to do with the Bristol plant. Any savings from not having the Bristol plant would be incremental to that going forward.

And lastly your question on pricing that we pay for purchased batteries, it’s really a spectrum depending on the type of battery and the channel, and that’s not a number that we typically disclose.


Your next question is a follow-up from Kirk Ludtke of CRT Capital Group.

Kirk Ludtke – CRT Capital

I was just curious – you talked about your strategic plan with respect to AGM and MHF. Is that just in Europe or are you planning on rolling that technology—I mean, what are your plans for that technology here?

James Bolch

Kirk, we’ve talked about this one pretty extensively on previous calls, and I would tell you it remains pretty consistent with what we’ve disclosed in the past. The market for transportation for these advanced batteries, for micro hybrid or also called Start-Stop batteries, is much more robust in Europe today than it is in North America. It’s actually still just beginning to materialize in North America, so most of the volume today and most of the capacity that we have put in place has been for that European market. I would point out, though, that we very strongly believe, and it’s supported by what our customers tell us, that it’s not a single solution; it’s not just AGM, that there’s many applications that they prefer the MHF technology, which is why we continue to pursue both.

In the case of North America, the capacity we brought online in our Columbus plant is for the flat plate and we’re in the process of bringing online Bristol, Tennessee for the spiral wound, is aimed at the transportation market. In fact, we’ve launched it in the form of the Edge product for the aftermarket, which is now starting to show up on store shelves around the country. But we also are using that capacity to support increased industrial production, especially in the flat plate side, these so-called AGM blocks; and as we talked about in our call today, as this market matures in the U.S., which we believe is going to be much slower than in Europe, we can also utilize that capacity to go into the industrial markets, which in many cases is actually a higher margin proposition.


Your next question is from Michael Guarnieri of Nomura.

Michael Guarnieri – Nomura

Thank you. Good morning, folks. I had a couple of questions. One is coming back to the question of margin, and there was a fellow earlier who was very specific about transportation Americas, but would you be comfortable giving us a view on what your gross and operating margin is by segment if you exclude currency and lead? What I’m trying to get at is I think—we’ve done a back of the envelope analysis, and it appears that we’re starting to see material improvement, but we think our analysis is less than perfect and I was wondering if you could just give us at least some indication and some thoughts about margin by business, excluding the effects of lead and currency.

Phillip Damaska

So let me give that a shot, Michael. There are a lot of moving parts, certainly; but as I look at the industrial energy Americas business, strong growth, should have expected margins to improve as a result of that growth, but $6 million of reduced lead margin – the definition of that being higher core cost, lower LME – certainly impacted that business. That business has historically been a business that’s generated mid-20s and higher gross margins. It’s a business that’s historically operated at, call it 10% of operating income or higher, and we believe that those are numbers that are certainly attainable once we get this lead equation back in sync, and we think we have the right strategy and right plans to accomplish that.

Transportation Americas business, certainly we’ve seen operational improvements in that business; but the big evolutionary change of that is to take a plant of excess capacity and take it out of the equation, and the 20 to $25 million operating income improvement, we continue to confirm that. It’s a number that we can now see on the near-term horizon with assembly being transitioned between now and Christmas and then formation transitioning in the next three to six months thereafter. That’s a business that we’ll see operating income dip over the break-even point, and then as Jim indicated we focus on continued productivity in a smaller footprint, we don’t focus on growth. We focus on better management of our customer portfolio with the intent of driving much higher return on investment than we have today. So that’s a business that we think we have the right strategy in place. We’re executing on that strategy, and again as I said, we see the light on the horizon with respect to getting that business back into the positive and then building on that as we move into ’14 and beyond.

Transportation Europe is clearly an invest-to-grow business. There’s an evolutionary change in technology. We’ve committed to making that evolutionary change. We’ve talked historically about AGM and MHF being higher price and higher margin products. We expect to see that business return to much higher profitability approaching, call it the high single digits on an operating income perspective. And then industrial energy Europe rest of world is really a tale of two tapes there. We’ve got a European business that has struggled over the last 18 months or so. We think we have the right plan in place to begin to enhance the operating margins and improve those to levels that our industrial competitor enjoys, and you can see what they’ve reported most recently out of their European business.

The other piece of that that we don’t disclose separately is our Asia Pacific business. It’s an import-only business today. Those margins which have historically been quite robust remain under attack from local producers and the evolution that customers are taking to buy local product as opposed to imported product from elsewhere in the world. We need to address the fact that we are not a producer or manufacturer in that area of the world, and we don’t have anything to report at this point in time but it’s certainly something that we’re working on strategically as we move into fiscal ’14 and beyond.

That’s about as much color as I’m willing to give at this point in time.


Your next question comes from Max McGregor of McGregor Enterprise.

Max McGregor – McGregor Enterprise

How you doing? Thanks for taking my call. I appreciate it. I just had a few questions basically about Pep Boys’ sales. How are sales going right now at Pep Boys with that whole deal, and how soon do you think that’s going to impact your overall profit revenue?

James Bolch

Well in terms of Pep Boys, we are now fully at run rate. As you recall, we previously provided product to them for the premium lines through another supplier, Bosch. We’re now supplying across the lines. We’re moving into the winter selling season, so that’s really always the telling tale in this business. We believe that Pep Boys has a good position there. They seem to value the marketing firepower that we bring their business to help them grow, so a lot of it will still come back to weather-dependent on the overall aftermarket but that contract is running very good and we’re also continuing to see high core returns in that particular customer, which is also very beneficial.


Your next question comes from Joe Von Meister of Bennett Management.

Joe Von Meister – Bennett Management

Hi guys, thanks for taking the call. I don’t know if I got this right, but lead gross profit in the first quarter was down 5 million year-over-year, and 38 million year-to-date. Is that correct?

Phillip Damaska

No, lead margin was down about 18 million in the second quarter, most of that being in the Americas region, and it’s about $38 million globally on a year-to-date basis.


Your next question is from Craig Irwin of Wedbush Securities.

Craig Irwin – Wedbush Securities

Sorry about that. Thank you for taking my follow-up question. So two questions – first one is really a housekeeping issue. In the past, you talked about environmental maintenance CAPEX being somewhere in the range of 30 to 35, just for environmental; but you’ve brought down—well, Bristol is almost done. Frisco and now Reading are on their way down. Can you talk about the environmental maintenance CAPEX and then the rest of the maintenance CAPEX, how you expect that to shake out? Is it still going to be in the sort of $60 million range, or is this going to bring it down as far as the base level of annual spend that we should see in the business?

Phillip Damaska

Craig, let me try to take a crack at that. The 35 to 40 million of what I’ll call replacement maintenance capital that we’ve historically talked about included that for moderate environmental projects. It certainly didn’t encompass all of the 50 million that we’ve talked about in terms of Frisco and Reading. But taking the footprint from where it’s historically been at to where it’s going to be, that 35 to 40 million of replacement maintenance capital will come down. I don’t have a precise number to share with you today, but it’s certainly a number that given a smaller footprint is going to come down, and certainly as we finalize our fiscal ’14 budget and get a better sense of what capital looks like for fiscal ’14, we’ll share that at the appropriate time.


Your next question comes from William Bremer of Maxim Group.

William Bremer – Maxim Group

Yes. On the inventory levels, can you help us decipher a little bit of the breakdown of the inventory that you’re carrying? I mean, given the events up here in the northeast, I must assume that you’re going to have a significant draw-down on both reserve and then follow up a little bit on the aftermarket, given the events up here with Hurricane Sandy. Can you provide a little color on that, please?

James Bolch

Well Bill, we don’t break out the product level. Certainly you can see by the overall inventory positions for industrial Americas and the like. Let me maybe just go to the hart of the question, which is around Storm Sandy. Certainly it’s been a pretty horrific event. We have had a lot of inquiries already from our customers, and interestingly enough it’s really come across all segments. Network power is probably the most pressing one, and we’re looking to finalize what that might look like. The most common discussion with those customers right now is we’re going to need your help, and when we ask what kind and how much, they say we don’t know yet – just get ready. So we are trying to really guess what those inventory requirements will be, but we’re prepared to ramp up production especially in our network power plants to meet that demand.

We would also expect to see some increased demand, though, on the Motive power side. From a material handling standpoint, you can imagine there’s going to be a lot of need to move goods and the like into that area. And then finally it’s probably a little longer lag, but there’s been obviously a lot of damage to the car park in the northeast and so we’ll expect to see some replacement to not only components but even whole vehicles going to that area.

So it’s a little too early to tell yet what that demand is going to look like, but I can tell you both from an inventory position but probably more importantly as we’re trying to look at run rates and the capacities to spin up, we’re going to be prepared there.

Phillip Damaska

Bill, let me just add some details around that. You’re aware of the seasonal nature of obviously our transportation business. So we build inventory from March to September. September is likely and historically been our peak period of inventory. We’ve got about 80 days of inventory on a global basis. That compares to 77, 78 a year ago, so very similar inventory position coming into the winter selling season. Last year, we didn’t have one of those. This year, we certainly have every expectation that we’re going to have a selling season more normalized and would expect to obviously bring that inventory level down, sell through, and then collect the receivables in the second half has historically been the cash pattern of this company.


Your next question is a follow-up from Sean Britain of Bayside.

Sean Britain – Bayside

Hi guys, just a quick follow-up on the liquidity position. First, if you could give me an approximation of the amount of your cash that’s in North America, and the second part of the question relates to just your overall working capital position. When I look at accounts receivable relative to this time last year, relative to the balance of the year, it looks like your receivable days had moved up. Is there any kind of change in the working capital profile, or it is just kind of an anomaly in the numbers this quarter?

Phillip Damaska

Let me address the liquidity in the cash position. In terms of how much cash is in North America, I basically look at cash between Europe and North America, we can bring cash back and forth without much issue as a result of intercompany lending that exists between the U.S. and Europe. The only amount of cash that would have a cost to repatriate, if you will, would be about $20 million of cash that we have in China. At this point in time, it’s our sense and our view that we’re going to use that to invest in China, but if push came to shove we could get the cash back with a minimal amount of cost.

In terms of receivable days, certainly a bit higher than it’s historically been. I think some of that is driven by customer mix change. As many of you on the call are aware, these aftermarket automotive retailers, certainly part of the price of entry is longer terms than we have seen with other customers like the OEs. We certainly weigh that into—take it into account when we price the product, so obviously the adding of Pep Boys has lengthened our days here. Although with that said, I would say that our days sales outstanding in our Americas business, particularly the transportation business, is a pretty solid statistic vis-à-vis the overall aftermarket.

Certainly it’s something we’re looking at very closely. Obviously the economic issues that we’ve faced in Europe provide potential credit risk, and we’re keeping a very watchful eye on that. But overall, I’m not particularly worried about the days sales outstanding, and we expect, as I said earlier, to sell through and collect a significant amount of our receivables in the third and fourth quarter as we historically have.


Your next question comes from Randy Gaulke of Muzinich.

Randy Gaulke – Muzinich

Yes, hi. Just going back to the chart on Page 10 and your decision on exiting the capacity, as you looked at this and as you looked at the possibilities—I mean, for the last little bit we’ve had the core costs that the mismatch, shall we say, of core prices and LME prices. But under what scenarios does your decision to reduce this capacity and rely on external supply not work, or when does that move against you, so to speak, if we get a recovery or if we get a change in some of this relationship?

James Bolch

Randy, let me take a shot at that one. Part of the answer to this is you have to look at where the company has been historically. We’ve had quite a bit of recycling capacity in this company, and because of where it came from historically and what’s happened with the markets, actually more than we need internally. If you were to look at the competitors in our space, the major competitors anyway, we believe their internal recycling capacity goes from none at all to perhaps something like 50%. After this change, assuming that Reading were to stay idled, we would still be at 80%, so we would be as a percent of our internal demand still the most highly vertically integrated of anyone in our space, at least certainly of the major players.

If you can imagine when could it go against us, well, if in the future I suppose this core price to LME ratio was to go back down to very low levels, at that point this external lead sales business could again become a profitable, steady business. At this point, we believe that’s not our core business. I mean, our core business is to make and sell great batteries to our customers and drive margin there. And if you think about what the investment decision looks like, they would say we would have to go invest these very large amounts of capital to go into really a speculative third party metals business, and we’ve decided that that’s not the best place to put our capital today if we want to be a great battery company.

Having this 20 to 25% dependence on the external market actually gives us some very interesting abilities to go optimize our supply chain. Certainly from a tolling standpoint, there is still excess capacity in the industry right now. That tends to make for competitive tolling rates, and should we choose to also go buy some of that from a primary metal supplier – that is virgin lead – over this past year, we’ve actually seen situations where that could be less expensive than recycled lead. So we actually feel very good about this position in terms of deployment of capital and as well as our ability to optimize our cost structure.


Your final question comes from the line of Scott Vogel of Davidson Kempner.

Scott Vogel – Davidson Kempner

Does your Q3 free cash flow guidance include the sale of Frisco?

Phillip Damaska

No, the Frisco proceeds, as I attempted to indicate, aren’t going to be accessible until mid-calendar 2013. They’re in escrow at this point in time. There’s a number of steps that have to transpire to get that money out of escrow, and ultimately we expect to have those proceeds, call it in the July-August time frame.


And that concludes the question and answer session. I’ll now turn the call back over to management for closing comments.

James Bolch

Thank you. I’d like to just thank everyone for their time on the call this morning. Hopefully the format that we’ve chosen this morning has been helpful. We really wanted to, as Phil said at the outset, convey not only the what but the why we’re taking the actions that we are. We believe that we’re moving this company toward a position of improved financial performance, but it involves a lot of hard work and we believe we’re on the path. Again, thank you for your time this morning.


Thank you. That concludes today’s conference. You may now disconnect.

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