Executives
Dave Anderson – President and CEO
Karl Schmidt – EVP and CFO
Analysts
Marty Pollack – NWQ Investment
Ross McKenzie [ph]
Joe Mandalo [ph] – Sidoti & Company
Stephen Ely – Haven Capital Management
Amit Daryanani – RBC Capital Markets
Steve McNeil – Jennison
Sauer-Danfoss Inc. (SHS) Q3 2008 Earnings Call Transcript October 30, 2008 10:00 AM ET
Operator
Good morning. My name is Kerry, and I will be your conference operator today. At this time, I would like to welcome everyone to the Sauer-Danfoss third quarter 2008 results conference call. (Operator instructions)
I would now like to turn the conference over to Mr. Dave Anderson, President and CEO of Sauer-Danfoss. Thank you. Mr. Anderson, you may begin your conference.
Dave Anderson
Thank you, Kerry. Good morning and good afternoon ladies and gentlemen. Welcome to Sauer-Danfoss' conference call to review third quarter 2008 results.
Participating with me on the call today are Karl Schmidt, Executive Vice President and Chief Financial Officer, and Ken McCuskey, Vice President and Chief Accounting Officer.
Before we begin, I'd like to inform you that this conference call contains forward-looking statements that involve risks and uncertainties that could cause actual results to differ materially from those in the forward-looking statements. The Company's reports are on file with the Security and Exchange Commission, provide more detailed description of these risks and uncertainties.
I’ll begin by reviewing our third quarter highlights sales by market region as well as the status of our new orders and current backlog. Karl will then review the details of our overall financial results and I will follow with comments on 2008 outlook before opening the call for questions.
Given the current economic, global economic environment, we are pleased to report record sales and earnings for the third quarter, doubling our earnings for the quarter over last year. At the same time, we continue to see an improvement in our margins reflecting the positive impact of the initiatives we’ve taken over the last few years.
We’ve seen sales growth, although, at a lower rate in both the Americas and the Asia-Pacific. However, our European sales were lower than last year’s third quarter reflecting and overall slowing in that region. Sales in our Propel and Work Function segments increased while our Controls segment experienced a decline in sales for the quarter.
Our sales for the quarter increased normally by 8%, excluding the impact of currency translation rate changes in divestitures, sales were up 3% over last year’s third quarter. The slower rate of growth is reflection of the general economic headwind that we are experiencing in many of our markets.
Sales in the Americas were up 6% over last year’s third quarter. This compares favorably to the sales growth of 5% we reported last quarter, and 8% for the first quarter of this year. The continued growth was driven primarily by a strong demand in the Ag equipment segment and double digit growth in our Brazilian market.
The Ag market was by far the strongest market in the Americas with sales up 32% for the quarter over last year. This market continues to be driven by high commodity prices in North and South America and particularly the strong Brazilian market. New business wins have also added to our growth in this segment.
Sales in our turf care market were up 9% for the quarter, compared with last year. While this market showed negative growth overall and continues to be negatively impacted by low housing starts and lower levels of consumer spending, we have been able to grow winning additional business in the Zero Turn Mower market.
Sales in the construction market were down 14% compared to last year, reflecting the depressed level of home construction in the US. In addition, our customers’ export of machinery to Europe which had been providing growth in prior quarters are down significantly this quarter as the European markets have weakened rapidly. On the positive side, construction remains positive in Brazil due to their strong economy and non-residential construction continued its strength through the third quarter. However, we are beginning to see some weakness in this market as well.
Road building was up 9% compared to a rather low 2007 levels. High energy and asphalt costs during the quarter kept road building sales from growing even more than the 9% level.
Sales in the material handling market were down 29%, particularly driven by the large declines in the Aerial lift business resulting primarily from weakening non-residential construction, rental companies restrained their capital spending and low US machinery exports into Europe.
The specialty market which is smaller and made up of OEMs primarily in on-highway, forestry and municipal maintenance applications recorded a strong sales increase of 19%. This was also driven by the Brazilian market and strong demand for marine and oil and gas related applications.
Our Distribution segment continued to outperform the overall OEM market with sales up 19%. Our distributes continues to increase our growth at small to mid-sized OEMs with new products that are particularly suited for this market such as our proprietary PLUS+1 software solutions.
With respect to Europe, we saw a downturn in the quarter with sales declining 2% year over year excluding the effect of currency and divestitures. The primary reason for this decline was the slowing in the major European economies, which led several customers’ to extend their summer holiday periods in reduced production levels.
Material handling were down 22% with demand slowing most significantly in the aerial lift (inaudible) markets, while sales in the construction and road building markets were down 15%. In each case, the declines were generally driven by the weak market conditions across Europe.
On a brighter note, the European ag market provided significant growth in the quarter with ag related sales up 21% based on the strong economic environment for farming and our market share gains in the Eastern European markets.
Specialty and distribution market sales in Europe were also up 4% and 6% respectively. Asia-Pacific sales were up 13% for the quarter driven by sales increases in all of the countries. Our largest market segment in the region, Construction and road building recorded a sales increase 7% for the quarter, coming primarily from China and Japan.
Sales in the Specialty market also reported strong growth, increasing 56% driven by demand in railway maintenance, mining, and marine applications. New customers’ in China also contributed to this growth.
Looking at our order book, we now see orders down 22% from last year’s third quarter. Our backlog were still up 20% compared to a year ago, thus shows signs of weakening, some of which note down is the result of our improved deliveries and reduced lead-times for our products.
Karl will now provide some additional comments on our financial results.
Karl Schmidt
Thank you, Dave. For the third quarter, we reported our earnings doubled to $0.22 per share compared to $0.11 per share for the third quarter 2007, which was affected by some non-operational costs. While sales for the quarter was $490 million compared to $452 million for last year’s third quarter. Both sales and earnings are a new record for any third quarter.
Our operating margins for the quarter improved to 5.2% which compares to 4.9% last year with margin improvements coming from two of our three segments. During the quarter, we incurred higher material surcharges from our suppliers. They exceed our recovery from customers’ by about $1.5 million.
Our goals in operating expenses is partly driven by exchange rate differences as the euro exchange rate to the dollar was still 11% higher in average in this quarter compared to a year ago. It also reflects an increase in executive retirement accruals and $1.6 million write-off of acquisition costs in the third quarter as a result of our decision not to pursue an acquisition at this time.
Capital expenditures for the first nine months of this year of around $130 million are in line with our planned capacity increases for the year.
Cash flow from operations for the first nine months of this year was $141 million compared to $99 million for last year’s comparable nine-month period. This strong cash flow result in our leverage ratio improving to 42% at September 30 compared to 43% at the beginning of the year. And as I noted on last quarter’s conference call, this improvement has been made even as we continue to invest in expanding our capacity mainly in our European plans.
This expansion is important to us in meeting both current and future demands as we continue to win new applications and provide more content on highly engineered vehicles that will come online in 2009.
In some of our plants, we have announced selective personnel reduction in response to the slowing growth and uncertain outlook.
And now I will turn it back over to Dave.
Dave Anderson
Thank you, Karl. Given the current economic environment and the impact that is having on our many markets, we are pleased with our accomplishments so far this year.
Sauer-Danfoss is a Company with a broad base of mostly unrelated applications across the mobile equipment industry, and a geographic balance between the Americas and Europe with a solid and growing position in Asia, and such our largest single market segment by region accounts for less than 11% of our total sales volume.
Historically, our diversification has enabled us to grow through regional or segment specific cycles by virtue of our new product introductions and our market share gains. The current situation, however, is one of softening demand in several of our segments in both the Americas and Europe. Since seeing the first signs of buying reductions in July, we have been taking steps to address the potential impact. We’ve selectively shorted our work weeks and will extend holidays – holiday shutdowns as appropriate.
Many locations have adjusted employment levels by implementing a higher increase of work force reduction. Actions taken since mid-summer and those still ongoing will reduce our workforce in our non-seasonal businesses by 6% to 7% at the end of this year. At the same time, we are committed to keeping our sales force at the current level in order to pursue available opportunities. We will also keep the focus on our procurement activity and not reduce the resources committed to the many opportunities of our procurement program.
These are opportunities which will be having increasing positive impacts and ongoing effects on our marching going forward. With the uncertainties in the world economy and the expected impact in our recent growth patterns in mind, we are cautious concerning the outlook for the remainder of 2008. We now expect our earnings to be approximately $1.15 to $1.25 per share on nominal sales growth of 8% to 9%.
This reduction in earnings of approximately 25% also takes into account the rapid softening of the European currency value versus the US dollar, which will lead to lower nominal earnings numbers when translated – translating process turned overseas. Capital expenditures will be monitored closely, but at this time are still expected to run 7% to 8% of sales.
I would now like to open the conference call for questions.
Question-and-Answer Session
Operator
(Operator instructions) Our first question comes from Marty Pollack of NWQ Investment.
Marty Pollack – NWQ Investment
Hi, gentlemen. If I may, just couple of questions, on pricing, going to the fourth quarter, what are you seeing as far as pricing for your product and also how do you see pricing develop next year? And secondly, with regard to fourth quarter based on what you are suggesting of overall growth sales out-front 7% to 8%, it sounds like sales in the fourth quarter will be down dramatically 15% or so, if you can confirm that. And lastly with regard to the initiatives you are taking this year right into fourth quarter, what kind of cost benefits do you see in mitigating to the slowdown – so do we here some cost savings that will help next year’s development?
Dave Anderson
Yes. Good morning, Marty. The first question was regarding what are we seeing in the fourth quarter for pricing? Typically our approach for pricing has really been to announce those changes effective at the beginning of the year. So, it’ll be something that would have an impact going forward into 2009. We do have in place surcharges that relate to commodity costs, commodity price increases as those have started to come down a bit. But the reality of putting those in place as we tend to lag the effect. We will also lag the effect in taking them out. A number of those surcharges have been put in place as price increases. Net effect though is that we expect – we are able to capture in surcharges to be neutral to what we get from our suppliers. Your second question related to the sales being down in the fourth quarter. They will be down. I have to do a quick calculation here to – I think Karl can you help out here on that question here. You have that in front of you the exact number?
Karl Schmidt
Yes. We are projecting sales to be down. And the big variable here for us, Marty, is the exchange rate. If you look at the third quarter numbers, I had mentioned that we were up 11%. Since that time the euro has dropped. It varied by about 25% at the low exchange level we saw two years ago. So, we are very susceptible to how these European sales translate back and to our nominal top line and that will have an impact. And that’s why we have lowered our margin. It’s not completely a volume reduction but it carries a significant expectation of exchange rate being lower when we translate these European sales into our books. So, that is – that’s the technical effect we have to keep in mind. But definitively we do see some softening in volume as well, but certainly at least half of this impact that we are foreseeing is the exchange rates are as low.
Marty Pollack – NWQ Investment
Cost benefits on some of the activities this year?
Karl Schmidt
Yes. I mean, we have kept a rather flexible workforce over the last few years working at the peak of our operations. We know we had very high demands in the first half of the year in many of our plants. We had implied a number of our locations with temporary people. Those are rather flexible to move out of operations again. We also have some rather flexible environments also in Europe that allows us to de-step pretty quickly and we are doing that. I think that will mitigate any major effects from volume but obviously we certainly have the fixed cost to absorb with less volume in the future. But all the operations are rather flexible at the moment in response to the change in peak demand we have seen. On the cost side, as Dave was mentioning to the (inaudible) project, we have been investing over the last – almost two years now and some major initiatives and we have projected that this at the end of the program which takes a few years to implement will give us definitely some margin improvements to the tune of 1% to 1.5% definitely. And that is now peaking in. So, we see some small effects in the fourth quarter coming through the net off the expenses we are still occurring, and we definitely have the impact for support of our margins in ’09.
Marty Pollack – NWQ Investment
Okay.
Operator
Your next question comes from Ross McKenzie [ph].
Ross McKenzie
Can you give us an update on Poland, which I think is part of what you were just taking in your last comment. And is there a chance that in the slowdown you are seeing right now and obviously the impact it’s having on margins going into Q4 that you can accelerate the expansion in Poland to try to get the work functions and Controls margins up?
Dave Anderson
May be I can – this is Dave. May be I can address the Poland issue. Obviously we have some currency effects there that are having an impact on the profitability. As far as the accelerating the activities in Poland, that’s a challenge. I think the biggest difficulty there is getting the capital equipment delivered in place and operational, and we are trying to accelerate that as much as humanly possible. But that tends to be the pacing element.
Ross McKenzie
Are you against the delivery schedules and the suppliers of the equipment are taken?
Dave Anderson
Yes, exactly.
Ross McKenzie
Okay. And is it fair to assume that somewhere during the course of next year you have the chance to start taking up more of the production in Poland, may be late in the year?
Dave Anderson
Yes, late in the year.
Ross McKenzie
Alright, and then secondarily or secondly I guess everybody is going to ask this question, with the crunches out there in the credit markets right now, you guys have about $300 million between revolvers and debt in the year. Any comments, we got facilities lined up, enough cash flow for a lot of operations, will you be able to cover that of course for next year?
Karl Schmidt
Yes. We have our lines in place. We have the syndicated loans in place. We do have term loans that all of which are unaffected by the current crisis. We have no problems drawing down on our syndicated loan arrangements. So, – and we still have reserve. We use it only to – right now. On the funding side, we don’t see any big impact on us at the moment. All fundings in the syndicate are providing cash when needed. So, we don’t experience any kind of impairment at this point, and I don’t have an expectation that it will get any worse assuming we don’t see any negative impact for us.
Ross McKenzie
Then lastly – I apologize. I’ll just stop for a second. If you look at the decline in revenues from Q4 of ’07 to Q4 of ’08, that’s anticipated by the overall revenue growth. Without having to go out and give a 2009 forecast right now, would you say that what you are seeing in that magnitude of decline is more – are the temporary phenomenon from the credit tightness or should we be looking at a comparable rate of decline going into all of 2009, the first half of 2009? Just generally without going too specific, can you comment on what that might be on in the December quarter?
Dave Anderson
This is Dave. I’d really like to do that. But importantly we are forming [ph] up our forecast and projections right now. And so, I really don’t want to be talking about that here until we have a chance to do it our conference call. But I think in general when you take a look at the market segments we are serving and what their drivers are. If you take a look at Turf cares, pretty heavily driven by housing starts and consumer spending. Our ability to outgrow the declines in that segment has really been because of the new product developments and market share gains. If you look at the Ag market, it’s been holding very strong for quite some time. There’s been some talk that the Ag market can soften especially as commodity prices have come down and cost of production have gone up. And so I think that would be where we would like to see whether or not net farm income continues as it has in the past. That’s been a strong driver for us both in North America and in Europe. When it comes to construction, there’s two parts of it I guess that’s related to housing and commercial building. And then there’s the infrastructure Road building kinds of activity, and I guess it’s going depend heavily on where our government starts to put some of its money going forward and start spending on infrastructure and some of these initiatives will start to restart housing construction. Otherwise, failing that I think some of the declines we are experiencing now we could see carry through to 2009 without giving any specific numbers I guess.
Ross McKenzie
All right. Thanks a lot.
Operator
Your next question comes from Joe Mandalo [ph] with Sidoti & Company.
Joe Mandalo – Sidoti & Company
Hi, guys. Two questions, both involving costs. First of, SG&A expenses as percent of sales did increase, is this mostly due to the operational improvement expenses that you made and how much operational expenses were made in the quarter? And then secondly, the R&D expenses seem to be staying pretty flat. Do you expect to reduce these expenses going into ’09 at all?
Karl Schmidt
Let me try to answer that. The operating expenses for the quarter, first of all in comparison to the prior quarter, you should figure out that about half of those have occurred in Europe. So, again we have a currency effect if it is 11% nominally, that means along 5% of the expense increase is attributable to adjust the currency factor. When you look at the nominal number, we know we have some extra cost in here that are higher than the prior year both on pension or retirement accrual and an unusual item for us as we have been so active in the M&A activities. We ahead of $1.6 million from stopping our activities and pursuing an acquisition, I – what is going on right now which we are continuing is our focused activity in procurement. I think that’s probably less than $1 million down in the quarter of consulting and other expenses that’s – that is reflected here, and we will take more and more of that activity in-house in the next year. So, on the R&D side, that your question – there I think there is – our tendency is not to sacrifice R&D significantly. We will try to stay between 3% and 4% because we see all these opportunities where we can still gain market and penetrate vehicles with our new products. So, we are not out to make that a short-term sacrifice because we know it will come – increase the rate of sales as we have shown over the years. So, that delivered [ph] the management decision to stick to that.
Joe Mandalo – Sidoti & Company
Actually one more question also thanks for that. In terms of the tax rate, I might have missed this before but could you comment on the tax rate, it seems a little higher and what do we expect for the rest of the year and going forward?
Karl Schmidt
Obviously the tax rate is affected by the mix of the countries where we create earnings are not. We would still advise you to take 34% to 35% because that would be our expectations for this year and also going forward.
Joe Mandalo – Sidoti & Company
All right. Thanks a lot, guys.
Karl Schmidt
You are welcome.
Operator
Your next question comes from Stephen Ely with Haven Capital Management.
Stephen Ely – Haven Capital Management
Hi, guys.
Dave Anderson
Hi, Steve.
Stephen Ely – Haven Capital Management
With regard to this next quarter, you said there is going to be a small softening in volume. Given your backlog why would that be the case? And then the second question is as far as the currencies go, it seems as if you are being affected by currencies in a number of ways. You are talking about SG&A and the adverse effect there, and now you are going to have an adverse effect as far as translation coming back. And so would you comment a little bit on that and so how you expect to handle that going forward?
Dave Anderson
Steve, this is Dave. Let me address the backlog question and Karl can talk a little bit about the complexities of the exchange rate changes. Regarding the backlog, typically we have an excellent picture of the backlog, in some cases where the major OEMs have a view into their production schedules reaching out nine or more months. In those schedules where there’s some flexibility within and they tend to give us a good view of what holds forward. I think the reduction in incoming orders that we mentioned here for the third quarter though is a different signal, and so it sends a message that even though backlogs are up 20% when the incoming orders are dropping down, there could be a couple of dynamics taking place and might be that the OEMs are knee jerk reacting to the current situation in the marketplace, and addressing their production schedules for the near term and haven’t got around to adjusting their production schedules and their forecast and projections going out further and that may be yet to come. There’s another dynamic in the marketplace which some of the suppliers and in some cases we’ve won extended lead times and deliveries. And under those situations, the customers’ tend to place orders much further out and there could be a tendency for them to inflate their order levels, like insurance policies and that doesn’t get shaken out until the time when the market does soften a bit and then they get around to adjusting what their backlog position is and what their order book is. I guess another factor there would be the translation to less dollars, as the dollars strengthened relative to the euro, we can see an impact there as well as having an impact on incoming orders as well as our backlog. So, there’s a number of dynamics at play here. Our sense is though when we take a look at the slowing in the general economy and the reduction in incoming orders that the backlog is overstated.
Karl Schmidt
With regard to the currency picture, I think we have to keep three different views in mind here when we look at the currency dependency. First of all the number of translation as I made reference to when you compare operating expenses had it’s nominal level a year ago. So, we will have to take into account that half of them occurred outside the US dollar region. So, it is susceptible to translation and that makes the comparison of the absolute numbers a little more difficult. And as I said while the third quarter still shows an increase of 11% compared to the prior year, we now are figuring about up to 25% drop of the comparable number from the exchange rate effect to the euro in the fourth quarter. So, that creates distortion in comparability. But the economic effect is somewhat different. It is on two levels. One is the translation side of the profits that we earn there. I made reference to that. That again can change the nominal amount of US dollar profits that we see on our books as we publish them here in US dollars. But those dollars will be calculated against what we are projecting lower sales, against lower because the translation of these sales into US dollars is also lower. And that leads me into the margin effects we expect from the currency. Based on the fact that we have more European products sold in the US than vice versa, we would expect a margin pickup going forward if these currencies stay as they have changed recently. That will help us particularly in one function which is (inaudible) past is affected by filling into the US dollar territory with Danish produced products. These margins should see an improvement. Now to size this is a little more difficult because what we also have in the foreign exchange scenario is hedges. We have been active in protecting these transactions across the oceans in different currencies. With hedge contract, our policy is not hedge more than 50% of the projected volume. So, we have contracts that go as long as 18 months into the future. So, they will help mitigate the effect at the transaction level and at the margin level to some extent. In summary, I think what we should expect if the currencies stays this way is that we can show relative margin improvements going forward. But we have to be mindful that translation of profits will reflect from some absolute dollar numbers somewhat lower rate. I think it wasn’t too complicated.
Stephen Ely – Haven Capital Management
Thank you very much.
Karl Schmidt
You are welcome.
Operator
Your next question comes from Amit Daryanani with RBC Capital Markets
Amit Daryanani – RBC Capital Markets
Yes. Thanks a lot guys. Just a quick question, actually with the orders declining the way they are, you guys obviously see what you can buy reducing the work fleet and hiring. Can you guys give any thought on potential consolidating some of the high cost manufacturing size of this one?
Dave Anderson
No, we have not – do not have that on our agenda at this point in time. What we are doing and the following the discussion we had here earlier is moving significant amounts of production from some of the sites that are somewhat larger sites into an area it’s a higher value production area and the move to Poland is part of that. We also have had a number of closures in the recent past. We divested a business in England and sold that off. We closed a site in the US in Illinois and moved that production to other US locations and as well as some outsourcing within North America. So, we’ve taken a number of those steps in the past. But today there isn’t anything that’s on our agenda to close up the sites. We are really in a point to where the sites that we do have are operating at a pretty high level of capacity. And so in summary, I think we are continuing to grow in those areas that are high-value production areas and we are pretty well holding the employment level and letting attrition reduce employment levels in high cost areas.
Amit Daryanani – RBC Capital Markets
Got it. And then the order is down about 22% I think in this quarter. Could you just talk about what you guys find in this quarter and the bottom fall off in September or was it a steady degradation, and also just how things have been in October so far for you guys?
Dave Anderson
It began in August in a significant way, and so we did see a big part of that. It’s holding at this level. So, – but I wouldn’t say we are at the bottom. It’s still too early to say that for sure.
Amit Daryanani – RBC Capital Markets
Got it. Thanks a lot.
Karl Schmidt
May be I’ll add a flavor here. In terms of how good the visibility, I think you made a reference to that in some of the comments. It is very tough to say that some of this dropping of orders is a (inaudible) effect where the OEMs are taking down incoming material in order to startup again at a later point in time. So, it’s basically – and we see this coming back or this is really an all out reduction in complete market volume. This is pretty tough to predict particularly in Europe at this juncture. So, it isn’t easy for us to really get better visibility on the behavior here and then the different signals from different areas that I think in general remain up. It hadn’t bottomed yet, and that’s part of what we are projecting with our fourth quarter.
Operator
(Operator instructions) Your next question comes from Steve McNeil with Jennison.
Steve McNeil – Jennison
Good morning.
Dave Anderson
Good morning.
Karl Schmidt
Hi, Steve.
Steve McNeil – Jennison
Just on the FX issue, I just wanted to revisit, I realize there is lot of moving pieces here. But is there a way you could articulate what the benefit – has effects that benefit the bottom line this year or has it been a detractor from the bottom line?
Karl Schmidt
I think it has been somewhat positive on the bottom line, and again I have to differentiate here that the margin effect from the bottom line effect because of the translation effect that has impaired our goals to drive the margins higher because of it – two things, if you want to translate what we see going forward here is a range of maybe $2 million or something for the quarter that would come through and affect us on the translation side and we may get some pick up on the gross margin and may even end up neutral. It’s just a very difficult picture to predict between these moving elements right now.
Steve McNeil – Jennison
I’m sorry Karl that $2 million number you referred to, is that in a normal quarter or what is that?
Karl Schmidt
Yes. That would be the impact that we could see from margin improvements in the second quarter, and then we have impaired against some translation differences that will come through. But that would be a quarterly number here, positive on the margin.
Steve McNeil – Jennison
Okay. Thank you.
Operator
At this time, there are no further questions. Gentlemen, do you have any closing remarks?
Dave Anderson
If there are no further questions, I'd like to thank all of you for taking your time to join us today on the conference call. And if you do have questions that come up later on I hope you'll feel free to call Ken, Karl, or myself directly. And again thank you for joining us today.
Operator
This concludes Sauer-Danfoss third quarter 2008 results conference call. You may now disconnect.
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