Sauer-Danfoss, Inc. Q4 2008 Earnings Call Transcript

Sauer-Danfoss, Inc. (SHS)

Q4 2008 Earnings Call

March 17, 2009 10:00 am ET

Executives

Sven Ruder – President, Chief Executive Officer

Karl Schmidt – Executive V.P., Chief Financial Officer

Ken McCuskey – Vice President, Chief Accounting Officer

Analysts

[Joe Mondolo – Sidoti & Company]

[Jamie Sullivan – RBC Capital Markets]

Marty Pollack – NWQ Investment Management

[Barry Hanes – Sage Asset Management]

Presentation

Operator

I would like to welcome everyone to the fourth quarter Sauer-Danfoss conference call. (Operator Instructions) I will now turn the call over to Sven Ruder, President and Chief Executive Officer.

Sven Ruder

Good morning, good afternoon ladies and gentlemen. Welcome to Sauer-Danfoss' conference call review of our fourth quarter 2008 results. Today I have with me Karl Schmidt, Executive Vice President and CFO of Sauer-Danfoss and Ken McCuskey, Vice President and Chief Accounting Officer of the company.

Before I 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 on file with the Securities and Exchange Commission provide a more detailed description of these risks and uncertainties.

Firstly, I'd like to introduce myself. My name is Sven Ruder. I'm the new CEO of Sauer-Danfoss and I joined the company on January 1 following the retirement of Dave Anderson.

These are very turbulent times for our industry and for our company. Our business had been developing very well in the first three quarters of 2008 and as we got into the fourth quarter, we were suddenly hit by what can best be described as a tsunami as our customers were impacted by a deteriorating global economy. Our customers' customers have been doubly impacted by falling commodity prices and by the increased difficulty in obtaining credit to finance their activities.

Let me begin with comments on sales by market and by region as well as the status of our new orders and current backlog. Karl Schmidt will then review the details of our overall financial results and then I'll follow Karl with comments on the actions that we are taking to get the size of the business right and I will also comment on the outlook for 2009. Following that then I will take questions from anybody who has any questions for us.

Our sales for the fourth quarter declined 25% and excluding the impacts of currency and divestitures sales were down 16% compared to last year's fourth quarter. With the exception of sales in Ag markets, and a few markets in Asia Pacific, sales were down in all regions and in all markets and segments. This is a sudden and dramatic drop from the record sales that we reported in the third quarter.

Sales in the America's were down 11% over last year's fourth quarter. While sales in agricultural markets were up 35% over last year, sales to all other markets were down significantly. Sales into the construction segment and road building were down 38%. Turf care was down 30% and material handling and specialty was down by 25%.

Sales into these markets were and continue to be affected by record low new housing starts, lack of funding for road building projects and declines in non residential construction. In addition, our customer's ability to export to Europe is down with that region's depressed markets. These export sales had been providing some growth in the America's in the past quarters.

In Europe, fourth quarter sales declined 23% year over year excluding the effect of currency and divestitures. Again, with the exception of sales into the Ag market, sales were down in all markets.

Sales to Ag was up 18%. Sales to construction and road building were down almost 50% and sales into material handling and the specialty vehicle market were down 26%. The recession in Europe including Eastern Europe and customers reducing their high inventory levels have contributed to this sudden drop in sales.

If we look at Asia Pacific, sales in that region were down 1% for the quarter. Sales increased in the material handling and specialty vehicle markets. They were up but these were offset by declining sales into construction and road building markets, and the weak export markets will affect our sales in this region also.

If we take a look at our order book, orders were down 62% from last year's fourth quarter and the back log that we have on our books right now is 18% down compared to a year ago. Plant shut downs taken by many of our customers over the holidays at the year end were extended in many cases, some of them well into February and we continue to see customers calling in and putting their orders out for later delivery in the year. We do not believe that we have seen the bottom at this point in time.

I will now ask Karl to comment on our financial results.

Karl Schmidt

As we stated in the press release, our results are preliminary. We have not completed the required step two analyses for the impairment of long lived assets. We have included a reasonable estimate in our preliminary results and expect to complete the analysis and file our audited financial statements on Form 10-K by the end of this month.

Let me walk you through the one time and other significant costs that impacted the fourth quarter. We had restructuring and severance costs of $25 million or $0.37 per share. Included in this amount are $8.4 million from the loss of the previously announced sale of the AC Electric business relating to the material handling market.

$1 million related to the closing of the Hillsboro, Oregon valve plant with the operations moving to our plant in Easley, South Carolina, and finally we recorded $15 million of parts reduction costs. We incurred an unusually high amount of $7 million in Fields recall or retrofit costs relating to a control segment product.

Accounting rules require to test the value of good will and the recoverability of long lived assets of property, plant and equipment each year if there is a significant change in the company's business. As a result of the challenging market conditions and the decline in the company's market capitalization; we incurred $22.9 million non cash charge in the fourth quarter related to good will impairment.

Of this amount, $17.4 million relates to the work function segment and $5.5 million relates to the control segment. We have also recorded a preliminary estimated impairment charge of $49.3 million for long lived assets relating to the work function segment.

The continued decline in our markets and market capitalization since year end require us to test these values again at the end of the first quarter and throughout the year. And I do want to emphasize that these charges here are all non cash.

Our effective income tax rate for the fourth quarter was only 18%. The amount of income tax was even more unusual for the full year with $10 million of taxes spent recorded on a $29 million pre tax loss.

Let me address the amount of the full year which then drives the unusually low effective rate for the quarter. The pre tax laws include $72 million of impairment costs much of which is not tax deductible, and therefore a tax benefit cannot be recorded. This had a negative impact on taxes of approximately $10 million.

Tax reserves and allowances related to deferred assets were not able to be recognized along with various expenses that are not deductible for tax further negatively impacted the tax expense by approximately $6 million.

Cash flow from operations for the full year was $185 million compared to $98 million in the prior year. Although strong cash flow from operations did not fully cover the $199 million we invested in the purchase of property, plant and equipment which compares to $136 million we invested in 2007.

Our free cash flow after accounting for the proceeds from the sale of property, plant and equipment was a negative $2 million. This resulted after the payment of dividends in our leveraged ratio increasing to 51% compared to 43% at the beginning of the year.

As a result of the sharp and dramatic drop in our sales, the significant good will impairment charges and the costs related to the plant closure and work force reductions, we determined that we would not be able to maintain compliance with the leverage ratio covenants in our credit agreements by the end of the first quarter.

Therefore, in order to insure we have adequate liquidity over the course of the recession which we are planning to last well into next year, we have taken the following three specific actions.

First, the Board acted to suspend dividends until further notice, conserving approximately $35 million of cash annually. Second, we are aggressively reducing our capital expenditures from a high of $199 million last year to nor more than $60 million this coming year, 2009. This is significantly below our annual depreciation and amortization rate of approximately $110 million.

Finally, the company has entered into a $490 million multi-currency term loan and revolving credit facility with our majority shareholder, Danfoss AS. This will allow us to repay the company's currently outstanding borrowings before we are in violation of the financial covenants.

We believe this will provide us with adequate funds to see us through the recession. At that time, with the credit markets hopefully functioning normally again, we would plan to go back to the markets for our credit needs.

I will now turn the call back over to Sven.

Sven Ruder

Since joining Sauer-Danfoss, my focus and the focus of the entire management team has been to size the business in line with the markets, and we are planning that markets and thereby sales will be depressed well into 2010.

As a result of this, we are aggressively reducing our work force and other costs. While this is painful, it's absolutely necessary for the well being of the company, and to be quite honest, it is forcing us to take actions that perhaps should have been taken over the past few years.

We have taken the following actions; we are closing our site in Hillsboro, Oregon, and we are relocating these operations to our Easley, South Carolina facility, and this should be completed by the end of June 2009.

We are exiting from the unprofitable electric dryers business and this includes closure of our facility and this should also be completed by the second quarter of 2009.

We've aggressively reduced our travel costs in the company. To date we have asked 2,200 of our colleagues to leave the company and this is about 23% down from the amount of employees that we had in the company at the end of the third quarter of 2008, and we are continuing with these actions as the markets develop so that we get into line with the volume of business.

We are instituting temporarily plant shut downs and shortened work weeks where this is possible. We have frozen salaries of all our employees for the year. We've suspended all management incentive plans both short and long term and we've reduced all senior leadership salaries between 10% and 15% for the year. This includes myself, and our executive vice presidents and all vice presidents. In addition, our Chairman of the Board and the Vice Chairman took a 25% reduction in their fees.

I am confident that the actions I have just listed along with the actions that Karl has just reviewed will get us through these difficult times no matter how long they last and will allow us to come out of this downturn a much leaner, and a much stronger company.

It's very difficult to project results for the full year with all the uncertainties that we are facing with the situation of the world economies and the credit markets and in our own businesses. However, based on what we know today, based on the actions that we're taking, the outlook for 2009 looks as follows.

We expect sales to be down between 30% and 40% from the fully year 2008 numbers. We expect our earnings to be a loss of $1.06 to $2.04 per share and this includes restructuring and other one time costs of approximately $0.40 to $0.60 a share. The projected loss does not include any possible further non cash charges for good will and other impairments. Our capital expenditures will not exceed $60 million for the year.

As I stated in the beginning, these are very difficult times for the industry and for our business, but as I look forward, I cannot but be optimistic for the future of Sauer-Danfoss. We have very many unique and profitable products that are leaders in their markets and we have a global footprint that is unmatched in the industry.

We are very well positioned to take advantage of the economic upswing that will certainly come and the accelerated growth that we will experience in the developing markets.

I would now like to turn the conference call open for questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from [Joe Mondolo – Sidoti & Company]

[Joe Mondolo – Sidoti & Company]

I'm having difficulty seeing, and I know it's very difficult with the lack of visibility, but could you give us some more color on how you think with now we're at least half way into March how you think the rest of '09 is going to play out being that your sales are more heavily weighed or seasonally weighed towards the first two quarters of the year, how you think earnings will be play out during the year. Are you going to be realizing a larger loss in the beginning of the year with the downturn so severe right now, but your sales are usually seasonally higher. Could you just give us more color on how you think it will play out throughout the year?

Sven Ruder

The way we see it right now is that we're seeing no season if I can put it that way, but of course this is untypical circumstances. And the way we look at it right now as we feel that we'll get from a revenue perspective relatively flat year from a quarter on quarter perspective. So this is different to the way the business has been in previous years where we've seen very strong sales in Q1 and Q2 tapering off in Q3 and Q4. We think that this will be a much flatter year this year than last year.

[Joe Mondolo – Sidoti & Company]

What about earnings? Same sort of thing?

Sven Ruder

We don't comment on earnings quarter by quarter. We give you the outlook for the full year and we stay away from the quarters but obviously you can model what the sales are more flat. You can kind of model that. We'll stay away from any comments on earnings for the quarter.

[Joe Mondolo – Sidoti & Company]

How is your working capital going to play out throughout this downturn? It looks like inventory only decreased by about $7 million in the fourth quarter. Is that going to come down significantly or how's your working capital going to look like?

Karl Schmidt

Well first of all we did have some improvement in the overall working capital situation from the fourth quarter and we are working that angle significantly. Obviously we see it come down as sales have come down, but we have some very definite items on the way to match the inventory with the lower level of activity that we have and we have also approached our vendors on some of the terms of our payable activities.

So we expect that working capital will improve certainly over the course of this year, and then we have to see where we end up in the fourth quarter. That always depends as to what momentum we have at that point in time depending on where the 2010 swing bill season is.

Additionally we have been building up inventory in the fourth quarter again as Sven mentioned. We do think this will be a much greater curve this year so at the moment I reserve judgment on where we end up at December 31.

But over the course of this year, we would expect to work our working capital in particular with the inventories down.

[Joe Mondolo – Sidoti & Company]

Do you think, is it $250 million low point of inventory? Is that possible or where can we look at that?

Karl Schmidt

We have traditionally turned inventory less than four times on the aggregate company. I think it's a challenge to hold that number and follow the reduced sales levels to bring it back in line with that. I would expect to be around four turns or slightly better than that.

[Joe Mondolo – Sidoti & Company]

I notice your CapEx increased for the fourth quarter even though, I know you're expecting to reduce it, I was just wondering what the CapEx being that it was so high, what it went into for the fourth quarter.

Karl Schmidt

Let me bring you back to where we were third quarter. Over the course of 2008 we had capacity charges for three quarters before the sudden drop and we had lead times of machinery that stretched over a years time, so we had a lot of equipment on order and were installing over the course of the year and some of these activities clearly went into the fourth quarter and we were finishing up on installing some of the capacity.

Again, many of these orders have been back from 2007 and early 2008 so that substantially exceeded to the fourth quarter from our perspectives. Let me emphasis you had the number of $60 million, we have targeted for 2009 and I think you should expect these numbers to be down significantly from the first quarter going forward and then even further tapering as we are finishing the projects and have a very different now approach on the capital expenditure part.

[Joe Mondolo – Sidoti & Company]

What does your maintenance level of CapEx?

Karl Schmidt

I think we'll have to say about 3% is the maintaining level for existing install machinery.

[Joe Mondolo – Sidoti & Company]

What about a dollar amount? It has to be less that $60 million I imagine if you're projecting $60 million.

Karl Schmidt

Right, so it's between $30 million and $40 million of maintenance CapEx.

Operator

Your next question comes from [Jamie Sullivan – RBC Capital Markets]

[Jamie Sullivan – RBC Capital Markets]

Just wanted to follow up on the orders and the comment that you mentioned that haven't hit bottom yet. Just wondering what you saw in the trends throughout 4Q and into January/February thus far in March, are you expecting orders throughout the year to get worse, just some color there would be helpful.

Sven Ruder

What we're seeing now is that the orders are shifting daily because of the change in inventories of our customers and this is not giving us clear guidance as to what's going to happen from an order perspective. What we see was that the customers started in December pushing the orders out and they were first pushing them out into January and then pushing further out into February and we saw a weaker February than we did in January, and March isn't looking that strong either.

So this is why we have said we haven't seen bottom yet. But it is, the big fall was in December and in January, so it is tapering off, but we don't think we've hit bottom yet.

[Jamie Sullivan – RBC Capital Markets]

Are you seeing any cancellations or is it purely deferrals and any additional color on where the majority of these deferrals are coming from?

Sven Ruder

Most of the customers have pushed it out because I think customers wait for an upturn and they don't want us to unready is they suddenly get a rush of orders to come in, but of course it's a mix between cancellation and just pushing out of the orders.

[Jamie Sullivan – RBC Capital Markets]

A question on the product recall expense that happened in the quarter. Can you give a few more details on what happened there?

Sven Ruder

It was an electronic circuit that failed and actually there was a risk this might, could harm somebody physically, so we actually went out and recalled all these products in the market and are working with the customers to replace the products.

[Jamie Sullivan – RBC Capital Markets]

Which product was that?

Sven Ruder

It was a valve product.

[Jamie Sullivan – RBC Capital Markets]

On your, you mentioned the use of temporary workers, just wondering what percentage of the force is temporary.

Sven Ruder

It varies from country to country. In some European sites we had up to 15% temporary workers and in other markets we don't use the temporary workers. I'd guess on average across the company between 7%, 8%, 9% are temporary.

Karl Schmidt

And maybe one particular business is very seasonal which is really the business for the turf care market so they have temporary people in the high season. It can be up as much as 300 people which we need for that business. It's a significant amount. It's almost 60%, 70% of variability which we then would have in the spring season, but I think the temporary workers that were subject to the reduction were about the size that Sven quoted here and they have been taken out pretty much across the globe.

[Jamie Sullivan – RBC Capital Markets]

Just on materials costs and how those are flowing through, I think last quarter you talked about catch up at the beginning of the year on the pricing side. If you could just comment there.

Karl Schmidt

On the material, you're referring to material surcharge environment we were exposed to? We have basically seen our complete research of these materials surcharges certainly tapering off from consumption of inventory by the end of the fourth quarter and in return we have ceased to invoice customers for material surcharges if they specifically spell out separately by over the course of the first quarter now. So basically we are material surcharge environment in an outgoing now.

Operator

Your next question comes from Marty Pollack – NWQ Investment Management.

Marty Pollack – NWQ Investment Management

On the forecast for '09 you're suggesting an operating loss of about $1.20 to $1.80, in that band. I'm just wondering when you look at that forecast, how much of that is in fact going to be affected by much higher interest expense in this credit agreement. I would imagine that would be a meaningful amount relative to what that interest is today. Could you give us an idea of what that refinancing?

Karl Schmidt

I think you're right. That forecast includes higher interest. I think order of magnitude I would expect that our interest expenses almost double from 2008 levels, taking into account that we still went to some of the lower interest environment for a portion of the first quarter but as we now have entered into the refinancing agreement, we have yet to recognize that market rates for our business if at all available, significantly different from the past environment that we lived under.

So you would have to, and we are talking about a doubling of the interest cost for the company in 2009.

Marty Pollack – NWQ Investment Management

With regard to the actions that you've described in terms of lowering cost this year, the actual cost saves you might say this year and what might flow though next year, because in a sense you are lowering it looks like to break even point and the benefit could of course be when market conditions recover, but implicit in this estimate is in a sense cost being taken out of the business which are expensed through the, in a sense being expensed out of the current income statement. Is there a way to think about some of these as maybe more like one time items even though you don't include them as one time items but as a readjustment towards the lower levels of revenues should have the benefit of course for next year, but even this year as you're taking out more heads etc. Is there a way to describe that portion in this forecast that is not easy to find charges but real cost benefit.

Karl Schmidt

Let me try to frame those a little bit here. We have made reference to severance costs and reduction costs of the work force that we had already in the fourth quarter recorded and to the extent decisions were made that activity happened in the first quarter, those numbers have been included in the 2008 numbers.

But we are continuing to move forward on further reductions and you saw my reference that we do expect further cost of $0.40 to $0.60 per share which are really mainly related to work force reduction activities.

I think the running rate, your question there is it depends on the severance times we have. Obviously the European countries are requiring us to give longer notice periods and this downsizing activity takes longer, so it takes longer to get the real running rate down and to adjust the plan to operate at this lower level of output, so we would expect that the initial quarter here still has some remnants of that.

But all what we are eyeing on is to get that running rate down so that by the end of this year, we really stand a chance to go back into overall break even or better, at the operational size when we look beyond 2009. But the ones that we record separately, we sized at 40% to 60%, the inefficiencies that we expect until all this is brought back into balance. That is part of the guidance from operations.

Marty Pollack – NWQ Investment Management

How much would you say then if you look at operating rates being very low if you had to say well part of this forecast relates to significant undue absorption type problems? In some ways can you define that as how much that is impacting that forecast? What is that operating rate currently across the company?

Karl Schmidt

We don't have a number to quote on what you call the operating rate. I think yes, there is a fixed cost element here recognizing that 40% of our fixed costs are depreciation for existing PPME so that is certainly fixed to that extent we are picking up some under absorption.

On the other end, everything else on the fixed cost area we are working aggressively down as well. So if you look at the projected turning down of employee numbers, they are also coming out of the planned overheads, but we certainly cannot maintain the fixed cost as a percent of sales that we had consistently so you lose a number of percentage points there.

Operator

Your next question comes from [Joe Mondolo – Sidoti & Company]

[Joe Mondolo – Sidoti & Company]

With the ramp down of your costs and CapEx and stuff, I was just wondering even with the depressed earnings how you see your cash flow looking like in 2009? Is it going to be severely negative, or how is that going to look?

Karl Schmidt

Yes we would expect in the aggregate if you include all the one time costs that we are still going through, we would expect the cash flow overall to still be negative in 2009 and I think that builds in some expectations of our working capital that I commented on before, so I think to really turn that positive for 2009, that would be a very, very unfortunate circumstance we have to face.

[Joe Mondolo – Sidoti & Company]

So even with working capital being ramped down and CapEx reduced by over $100 million still be negative?

Karl Schmidt

I would say the likelihood that it's negative is larger than that. It's not for sure.

[Joe Mondolo – Sidoti & Company]

Any ideal on what the good will write down is going to be in first quarter?

Ken McCuskey

We have $86 million remaining of good will. We wrote it down by $23 million. We were at about $110 million, so that $86 million is what's at risk. One of the things you get into, the trap that you get into with U.S. Cap accounting is your share price determines that and at the end of the year our share price was $8.75. That infers a market cap of about $450 million.

With the share price now in the $3.00 to $4.00 range at the end of the quarter, now you've got a market cap of $150 million applied and that would drive the accounting for good will impairment so I don't know. I don't know if I could say it could all be written off, but we'll see.

Operator

Your next question comes from [Barry Hanes – Sage Asset Management]

[Barry Hanes – Sage Asset Management]

You gave the CapEx number for '09. Do you have the depreciation number you expect for '09?

Karl Schmidt

$110 million, roughly in that neighborhood.

[Barry Hanes – Sage Asset Management]

On the pricing and materials cost issues, could you describe the pricing environment in general now, what you're seeing out there with the environment having gotten tougher and secondly, in the '09 guidance could you give us some sense of your assumptions for price benefit or detriment in raw materials. I would assume benefit with the lower raw materials, how the price for cost is working out.

Sven Ruder

I think there is pressure on prices from a sales perspective and there's also pressures on replacing on the supply market. In our projections we have projected that these will pan out so they will match each other. So this is a neutral environment in our projections for 2009.

Operator

There are no further questions at this time.

Sven Ruder

I'd like to thank you taking your time to join us here today for this conference call, and if you do have any questions that do come up later, please feel free to contact Ken, Karl or myself directly. Once again, thanks very much for joining us today. Have a good day.

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