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Executives

David Sean Van Bibber - Chief Accounting Officer,Controller

Mark M. Comerford - Chief Executive Officer, President and Director

Daniel W. Maudlin - Chief Financial Officer, Vice President of Finance and Treasurer

Analysts

Edward Marshall - Sidoti & Company, LLC

Daniel M. Whalen - Topeka Capital Markets Inc., Research Division

Philip Gibbs - KeyBanc Capital Markets Inc., Research Division

Haynes International (HAYN) Q2 2013 Earnings Call May 3, 2013 9:00 AM ET

Operator

Greetings, and welcome to the Haynes International Inc. Second Quarter Fiscal Year 2013 Earnings Conference Call. [Operator Instructions] As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, David Van Bibber, Controller and Chief Accounting Officer for Haynes International. Thank you Mr. Van Bibber, you may begin.

David Sean Van Bibber

Thank you very much for joining us today. With me today are Mark Comerford, President and CEO of Haynes International; and Dan Maudlin, Vice President and Chief Financial Officer.

Before we get started, I'd like to read a brief cautionary note regarding forward-looking statements. This conference call could contain statements that are forward-looking within the meaning of the Private Securities Litigation Reform Act of 1933 and Section 21E of the Securities and Exchange Act of 1934. The words believe, anticipate, plan and similar expressions are intended to identify forward-looking statements.

Although we believe our plans, intentions and expectations regarding or suggested by such forward-looking statements are reasonable, such statements are subject to a number of risks and uncertainties, and we can provide no assurance that such plans, intentions or expectations will be achieved. Many of these risks are discussed in detail in the company's filings with the Securities and Exchange Commission, in particular, Form 10-K for the fiscal year ended September 30, 2012. The company undertakes no obligation to publicly update or revise any forward-looking statements whether as a result of new information, future events or otherwise.

Thank you very much for listening. And now, let me turn the call over to Mark.

Mark M. Comerford

Thank you, Dave. Good morning, everyone, and thanks for joining us today. Hopefully, you've all seen the press release and had a chance to review it. We'll follow our standard agenda in today's call. I'll open with comments about the business and our end markets, and then Dan Maudlin will give you greater detail on the financial results.

As we mentioned in the press release, the current economic environment for our products is somewhat muted and visibility is very poor. Whereas our second fiscal quarter was better than the first fiscal quarter with land-based gas turbines, chemical processing and our other markets showing a sequential increase, we were still negatively impacted as customers continue to be very conservative in their order patterns in light of global economic uncertainty in industrial markets and lower commodity price levels. I think it is best exhibited in the sequential decline in our -- the engine side of our aerospace business.

Haynes net revenue in the second quarter of 2013 came in at $129.2 million, down 18.7% from last year's $158.9 million. Net income in the quarter was $6.4 million, down 57.9% from fiscal '12's $15.2 million. Our net revenue in the aerospace market for the second quarter was $49.3 million, down just over 20% from last year's $61.9 million. Aerospace accounted for 38.2% of our total revenue in the quarter.

Activity in our structural aerospace tubing area continues to operate at full capacity. Demand for our products for aero engine applications remains slow as customers continue to manage their requirements very tightly. Also, several fabrication contracts are currently being negotiated, and it appears that commodity price adjustments are being negotiated and then renegotiated in light of the downward price pressure on commodities. In addition to the lower invoice level, our backlog in this area also fell during the quarter by 5%.

We remain very bullish on this market, especially in light of the delivery rates out of Boeing and Airbus, and we are in direct contact with customers and designers in the supply chain to discuss our concerns about how tightly they're attempting to manage their order patterns and inventory. We expect this market to rebound as the year progresses, but we are unsure of the timing of that rebound. I'll also remind you that the -- remember, in 2012, we shipped -- we equaled our record for shipments into the aerospace market, so some of this is -- was not unexpected that we would see a breather in this.

In our chemical processing market, net revenue for the second quarter was $33.9 million, down just over 10% from the $37.8 million we did in the second quarter of fiscal '12. CPI accounted for 26.2% of our total revenue for the quarter. As we've discussed, this market has experienced softness over the past few quarters as large project-related business went on hold. New application activity, including several related to natural gas applications, drove several new projects during the quarter and over the past 6 to 9 months. We've also seen some good activity in some of our proprietary materials' heat exchangers for what we would call traditional CPI applications.

Whereas this market remains very choppy, the large projects remain on hold. We've had some pretty good success winning some of these one-off specialty engineered applications. I wish I could tell you that these applications will be large, repeating business applications wins, but that isn't the case in this point in time. These are very specific wins, some involving new technology or wins for our materials based on reliability, which may have the potential for repeating. But right now, these are one-off wins by our field sales engineers with great support from our manufacturing and technical groups.

Our backlog decreased about 11% in the quarter after increasing 31% in the first quarter. We expect this market area to remain very competitive throughout 2013. But as I mentioned, we're seeing some requirements out there for new design work using new materials. We expect that trend will serve us well when the economy begins to strengthen.

Net revenues in the land-based gas turbine market totaled $30.2 million in the quarter, down 6% from the same quarter last year. As you may recall, we shipped a record level of product to this market in fiscal '12, and we then saw a drop to about $22 million to $23 million in the first quarter of this year. The increase in the second quarter to $30 million plus was unexpected as we had anticipated the supply chain to be overstocked from 2012 shipments. However, activity was strong in the second quarter. As an addition to the higher ship level over the first quarter, we also saw the backlog in this market increase 9.5%. The land-based gas turbine market accounted for 23.4% of our revenue during the quarter.

Similar to what we saw in CPI, our distribution and manufacturing groups responded well to some quick delivery requirements, and we believe that has helped us secure our position with several key accounts. Looking ahead, we're still very cautious about this market and the state of the supply chain. On a very positive note, we're continuing to see more activity in this market with new designs and new applications seeking better materials for more efficient engines. Design and quote activity is very strong.

Finally, our other markets category had net revenues of roughly $12 million in the quarter, down almost 48% from the second quarter of fiscal '12. This market accounted for 9.3% of our net revenues during the quarter. Key components in this area, like solar energy, industrial heat treating and flue-gas desulfurization, remained very sluggish. Our HASTELLOY C-22HS material remains in testing. We're working through some specification changes right now. But as we said previously, we do not expect any significant shipments for that application in fiscal '13.

Finally, on the commercial side, you may have seen that we introduced a new nickel-chrome-moly alloy during the quarter. This is HAYNES HR-235, which has targeted industries where metal dusting failures occur. We're currently scaling the alloy up in plate, sheet and tube for prototype work with some alpha customers. This is not a 2013 or a 2014 story. This will likely be 2015 or beyond by the time we see the scale-up, the testing, the field test results, et cetera. But I thought it'd be important to highlight this material and give you some insight on how the application engineering side goes in our business.

With respect to our capital investments, the projects are proceeding well. The Kokomo flat roll upgrade and expansion, we've got one of the new 4 high furnaces in place. It's undergoing validation. In fact, I think they're surveying it right now. Foundation work, wiring and substation work construction has begun for some of the new larger pieces of equipment that are going in to support that expansion.

On the tubular products side down in Arcadia, the new heat-treating addition is in process with significant portion of the furnace pit walls poured. We've also relocated several pieces of equipment and improved the layout of the facility in preparation for the second structural addition, which will house the finishing process. Also, we had an OHSAS 18001 safety audit about a week ago with a lot of attention directed towards the new construction area, and we were very pleased that there were no findings by the auditors.

On the distribution side, during the quarter, we're continuing to review our in-house process capabilities and how we stock material based on customer demand and general market conditions to determine areas where we might improve our next-generation supply and product quality capabilities. We expect to be assessing those capabilities as we better rate our current distribution and light manufacturing capabilities in North America.

In Europe, I think you know our activity has picked up quite a bit over there in the past 5 years as we've -- in support of the land-based gas turbine and the aero engine business in Europe. So our U.K. facility, we're expanding the footprint for more value-added processing equipment. Also, in Zürich, where we also handle quite a bit of land-based gas turbine and a lot of the chemical process industry, we're reroofing that facility right now.

Our IT project, our European locations have run their facilities on the new system for just over 4 months now. Fine tuning is still underway to support user request for minor modifications to help with workflow and reporting. The great thing in Europe is that we have taken 3 different systems, none of which was consistent with our U.S. system, and we've migrated our operations to a single system, which, in the future, is the same system we'll be using in the U.S.

The focus right now is shifting onto the upcoming implementation for North American -- North America for order fulfillment, the service center operations, the accounting and purchasing. The final phase involving the manufacturing locations is also in the planning and training stage for implementation.

With that, let me turn it over to Dan for more details on the financials.

Daniel W. Maudlin

Thank you, Mark. Let me begin the financial review with a year-over-year comparisons of the second quarter of fiscal 2013 to the second quarter of fiscal '12. Net revenues were, as Mark mentioned, $129.2 million, which is an 18.7% decrease from the second quarter last year. This represents a decrease of $29.7 million, of which $21.9 million can be attributed to volume with pounds sold lower by 13.8%. We believe this decrease in volume is primarily due to the continued reductions of inventory within the supply chain and customers delaying orders as the price of nickel decreases. Also contributing to the sluggish demand is the continued uncertain macroeconomic conditions, which is slowing industrial production in the U.S., and soft European economic data. We continue to see delays and lower order levels for large project-type orders.

The amount of the net revenue decrease attributable to price is $7.8 million with lower average selling prices by 5.7%. We continue to experience increased price competition in the marketplace relative to fiscal year 2012, particularly in the commodity-type alloys. This competition requires us to aggressively price orders, which has unfavorably impacted average selling prices, as well as gross profit margin and net income. As note, direct lead times are decreasing, the downward pressure on prices for service inter-transactional business is also occurring.

In addition, the lower metal prices primarily nickel, put downward pressure on prices. We also had a lower valued product mix compared to last year that contributed to lower average selling prices. Net revenues were down across each market compared to Q2 of last year.

Gross profit margins and margin percentages declined in the second quarter of fiscal 2013 compared to the second quarter of fiscal '12, due to the combination of lower volumes, weaker pricing and a less profitable product mix have we -- as we have discussed. Gross profit margin as a percentage of net revenues was 15.5% in the current quarter compared to 21.7% a year ago.

Selling, general and administrative expenses, including research and technical expenses, were $10.3 million, which is a decrease of $1.2 million compared to the prior year second quarter of $11.5 million. The reduction is due to reduced costs for incentive compensation programs and certain cost-management initiatives to reduce costs. SG&A as a percentage of sales increased from 7.2% to 7.9% compared to a year ago due to the lower level of revenues. Looking forward, full year fiscal 2013 SG&A is forecasted to be approximately $43 million.

Tax expense in the second quarter of fiscal 2013 was $3.4 million or an effective tax rate of 34.5% versus $7.9 million or a 34.2% effective tax rate in the second quarter of fiscal '12. The effective tax rate for the full year is anticipated to be between 34% and 34.5%.

Net income for the second quarter was $6.4 million or $0.52 per diluted share compared to the net income of $15.2 million or $1.23 per diluted share in last year's second quarter.

To comment on the sequential quarters, comparing the first quarter of 2013 to the second quarter of 2013, the second quarter of FY '13 achieved higher revenue in gross profit dollars than the first quarter. However, the gross profit margin percentage declined to 15.5% from 16.4% of the prior quarter. Average selling prices per pound was negatively impacted during the quarter by items previously discussed, such as lower-valued mix, lower metal prices and increased competition.

Net revenues in the aerospace market declined by $3 million. However, net revenues increased in the chemical processing market by $7.6 million, increased in the land-based gas turbine market also by $7.6 million; an increased in other markets by $1.4 million. The other revenue increased $1.2 million. Overall, the second quarter of fiscal '13 net revenues increased $14.9 million from the first quarter of fiscal year '13. Volume increased by 0.9 million pounds, and net income increased by $0.6 million during this period.

Backlog was $207 million at March 31, 2013, a decrease of $4.7 million or 2.2% from December 31, 2012. Backlog dollars declined during the second quarter of fiscal year '13 due to an 8.3% decrease in the backlog average selling price for the quarter, largely offset by a 6.6% increase in the backlog pounds. The reduction in backlog during the second quarter resulted from reduced order entry pricing and lower-valued mix of products in the backlog. Backlog for aerospace and chemical processing markets declined in the second quarter of fiscal '13. The backlog for the land-based gas turbine market increased in the second quarter fiscal '13.

To comment on our April backlog, the balance of the backlog increased from the $207 million at the end of March to $210.5 million at April 30, 2013, and the backlog pounds were approximately 7.1 million pounds with an average selling price of $29.57. The increase in backlog in April includes a large blanket order for aerospace tubing, which we'll ship in 2014. We received these blankets from time to time. But in light of the current economic slowdown, we felt it important to let you know about this specific increase in the backlog.

Capital investments. Management continues to believe in the long-term growth of potential of our core markets. Therefore, we are continuing to implement the previously announced capital investment projects. The proper execution of these capital projects continues to be a major focus area for the management team. Capital investment in the second quarter of fiscal year 2013 was $13.7 million, which brings capital investment to $22.7 million for the first half of fiscal '13.

The forecasts for capital investment for fiscal year 2013 and fiscal year '14 are $70 million and $39 million, respectively. It is possible that we could be light on the $70 million spend this year due to the timing of cash payments. That amount would carry into 2014. The actual and planned capital investments over the 3-year period of fiscal 2012, 2013 and 2014, it's approximately $135 million, are expected to allow the company to increase capacity, enhance product quality, reduce costs and improve working capital management. The company anticipates that these significant investments will help the company improve efficiency and meet the expected long-term customer demands for volume and quality improvements.

Cash flow. During the second quarter, the company's cash balance declined from $65.5 million at December 31, 2012, to $48 million at March 31, 2013. Cash flow from operations was $29.1 million in the first 6 months. There was a slight use of cash of $0.5 million in the second quarter alone.

In the first quarter, cash collections from accounts receivable was strong from the high levels of accounts receivable that we had at the end of our fiscal year ending September 30, 2012, that was collected in the first quarter of this year. In the second quarter, accounts receivable increased $14 million from December 31, 2012, which we expect should contribute to a stronger cash collections in the upcoming third quarter from accounts receivable.

Inventory decreased in the second quarter as a source of cash of $13 million. Uses of cash included the capital expenditures in the quarter of $13.7 million and a dividend payment of $2.7 million.

Our liquidity remained strong with a 0 balance on our revolver. In addition to the $48 million cash on hand, the company has a credit facility of $120 million, which can be increased to $170 million at the company's option. This, combined with cash on hand, provides total liquidity of over $235 million, which is expected to enable the company to fund the capital program as well as take advantage of future economic recovery and any other growth opportunities that may become available.

Outlook for the third quarter of fiscal '13. Management continues -- I'm sorry, management currently expects that net income for the third quarter of fiscal '13 may be lower than net income for the second quarter as it is expected to continue to be unfavorably impacted by weaker pricing similar to that experienced during the first and second quarters. Visibility in the marketplace remains poor. And based upon the continued economic uncertainty, level of bookings to date and feedback from key customers, management does not anticipate a significant recovery during the third quarter of fiscal 2013.

We believe this period of uncertainty, low visibility and sluggish consumer demand is temporary. As we navigate through this period, we continue to focus on the long-term demand drivers and growth potential of our markets. When the economy recovers, we feel we are well positioned to capitalize on those future opportunities.

With that, let me turn the discussion back over to Mark.

Mark M. Comerford

Thanks, Dan. The economic environment is cloudy right now and I think one of the best evidence points of that is I think it's probably the first time in 6 months or a year that we've been able to talk to you about an increase in the backlog. However, as Dan mentioned, quite a bit of that was blanket orders that'll be out into 2014.

We've also -- I mean, Airbus and Boeing, at the pole end of the commercial aerospace supply chain, are doing well. They've got great backlogs, and they're ramping to higher levels. As a result, we'd expect demand for our aerospace products to firm up over the next few quarters.

Our land-based gas turbine market has showed surprising resilience over the past 18 months, and we're pleased with where we have positioned our products and service capabilities. However, because of our high shipment levels into this market area, as we mentioned, 2012 was a record level, we remain very cautious as we look forward in land-based gas turbine.

In the chemical process market, we see pockets of specific strength, both geographic and application driven. But the overall larger project market remains very slow.

As we mentioned in the press release and we reiterated in this call, we have excellent growth opportunities: geography, new alloys, new products. We're expanding in areas where we have constraints, for instance, in the aerospace tubing area, and we're associated with excellent end markets. However, at this point in time, we still have not seen any rebound to our order books.

Broader economic indicators in the U.S., automotive and housing seem to be doing well. They appear to be signaling that the consumer is gaining confidence. Japan is also doing well, and showing greater strength. Hopefully, we'll begin to see Europe work through their issues. And we'll begin to see China, as well, maintain a reasonable level, such that we can see industrial demand increasing globally as we move through the balance of 2013 and into 2014.

Rob, if you will, let's turn the call over to questions.

Question-and-Answer Session

Operator

[Operator Instructions] Our first question is from the line of Edward Marshall of Sidoti & Company.

Edward Marshall - Sidoti & Company, LLC

So let me -- correct me if I'm wrong. It sounds like to me that -- so look -- at least, sequentially, it looks like the only -- the, really, only the large of the 3 segments that fell was aerospace. And it doesn't seem that the aerospace supply chain, when you listen to the OEMs or you listen to some of the suppliers, are really seeing the decline. It sounds like to me that maybe the -- because of penalties in the supply chain, if you miss shipments, that they restock well in advance of the rate hikes. Now that the rate hike is out of the way, I think that there's a somewhat of a destocking going on. Is that kind of aligned with what you guys are seeing in the supply chain there?

Mark M. Comerford

That's pretty much what we're hearing. That and that there is some destocking occurring. And we're also hearing from -- as I mentioned, some of these second-tier, third-tier fabricators, that there's quite a -- people are being rewarded right now for putting off purchasing by the fact that nickel keeps going lower. So there is -- people are playing a little bit of a nickel game right now, and that's where we've expressed a lot of concern to people that you can't keep doing this. We can't just turn the faucet on and off.

Edward Marshall - Sidoti & Company, LLC

What happens to -- how do I think about -- kind of coming off that question. How to think about maybe your lead times and how fast could you ramp up if the supply chains starts to tighten again? I mean, I'm assuming you're pretty short lead times right now. And how -- if the supply chain tightens up, how fast can you get back to, say, full production?

Mark M. Comerford

It depends a lot on the product. But for instance, we're still running pretty much at capacity, as I mentioned. Aerospace tubing, we are at capacity. But premium melting, vacuum melting is also still running pretty close to capacity. So -- now that's also -- that's restocking and making sure we have product on the ground. But it's anticipation of what we're seeing if the order book starts to get heavier. As far as people, we're still in good shape with people. We've cut back on overtime hours and things like that. Watching the cost structure. But we haven't gone through any major cost-reduction efforts at this point in time as far as personnel or anything like that. So we think our ramp-up time should be relatively quick. And you're right, right now, lead times across-the-board are very, very short. I think we're pretty fortunate in that we own our own distribution system, and we've picked up a lot of transactional business, which helped us a lot in the second quarter. That's the big wildcard as we talk about view for the third quarter. We don't know what that transactional business will look like in the third quarter.

Daniel W. Maudlin

As we manage through this kind of uncertainty, it is -- that's the challenge, is how much inventory to keep on hand and if you have the right inventory for the upturn. So as we manage through this, keeping inventory levels at a place where we can respond quickly is always going to be a challenge.

Edward Marshall - Sidoti & Company, LLC

So extrapolating from what you just said, it sounds like to me that I don't think this is a surprise, looking at the release and kind of your commentary already -- but I just want to make sure that I'm right. You're running at full capacity in several different lines. You saw a gross margin contraction, and that was really just a function of price. I think your gross profit per pound fell about $0.47 or so in the quarter. It's just about a function of just pricing, and what that decrement in pricing is doing to you.

Daniel W. Maudlin

A lot of that is occurring, yes, especially as we comment that with production lead time shortening, that puts a lot of price pressure on the service center transactional business. So we may be getting some transactional business but there's a lot of competitive pressure on that price, that impact.

Mark M. Comerford

If I could also too -- if you look at it as a broad statement, absolutely true. I think one of the things to look at, too, on the pricing side is with aerospace erecting itself more so than anybody, I'll say, in the supply chain, as evidenced by the decreased revenue levels and decreased backlog, that's a big mix issue. When you look at the overall price, that's one of the areas -- one of the reasons price is dropping is we're seeing that change in mix so dramatically in the past, I'll say, 6 months.

Edward Marshall - Sidoti & Company, LLC

And again, that's not something systemic. That's just a destocking because we went up in rate hikes.

Mark M. Comerford

That's exactly what we believe, yes.

Edward Marshall - Sidoti & Company, LLC

Okay. So I guess that confirms the reason why you're continuing to expand -- the expansion plans and you're not looking at further restructuring and so forth, that this is strictly a temporary situation and not something more systemic.

Mark M. Comerford

Yes. I think if you take a look at the 2 big expansion projects, one is the aerospace tubing, that is still operating at capacity. And if you take a look at the Kokomo flat roll operations, those are -- that's an area that has run into very severe constraints twice in the last 5 years.

Daniel W. Maudlin

And the benefits of those projects, especially in Kokomo, are reduced costs, better inventory management and some of the better efficiencies that we would gain even at these current volumes.

Edward Marshall - Sidoti & Company, LLC

Yes. So I think you said that there was a couple of large orders that hit. And was it chem processing that you mentioned in the quarter? Is that what you said?

Mark M. Comerford

Yes. That's right. We've seen project work. I -- again, I -- what we define as large is not what some of these -- the other people in the space might define as large. But yes, we get some nice things associated with heat exchangers and also the -- rather than just assets and things like that, we saw some things in the -- natural gas area that were very helpful to us in the last, I'll say -- we've been working on it for 9 months a year, but some of them hit in the last 2 quarters, which helped us out quite a bit.

Edward Marshall - Sidoti & Company, LLC

So this follows a 30% increase in the backlog in chem processing last quarter, if I remember, so it seems that there's some momentum building in the backlog. I understand you're cautious about how you're phrasing some of the chem processing discussion, but it sounds like -- knowing that there's a big advantage to lower gas prices here domestically, it almost sounds like we're starting to see the trickles of maybe what would be a rebound in that cycle.

Mark M. Comerford

That -- I don't know where it'll come short term. But I mean, if -- in the last couple of months, if you take a look -- I mean, I think it was Methanex and Sasol, both announced big plants coming into the U.S. So yes, I'd agree with you. What that looks like short term versus long term, I think long term, it's very good. We'll see where things go, but I do think those are direct results of what we've seen with the natural gas prices.

Edward Marshall - Sidoti & Company, LLC

So if I could sum up just the way I see it, the chem processing, maybe even some of the gas turbines, on a sequential basis saw some improvements, year-over-year as well, and with temporary aerospace destocking and who knows what happens with nickel. But looking at the demand scenario, I mean, going forward, after we get past this temporary situation, I think not much has changed. Is that the right way to think about it, and that you see the improvements in the other markets kind of filling in where aerospace left off?

Mark M. Comerford

That's pretty much the story of what has been occurring.

Daniel W. Maudlin

I think it's just that short-term visibility is low, and we just can't quite see past it on when the upturn may begin.

Operator

[Operator Instructions] The next question is from the line of Dan Whalen of Topeka capital.

Daniel M. Whalen - Topeka Capital Markets Inc., Research Division

You addressed a lot of my questions there, but maybe we could touch on the capital projects and where you're actually adding capacity there. Is that going to require additional certifications from some of the key customers? And if that is the case, where does -- where will we kind of stand in terms of the timeline from that perspective?

Mark M. Comerford

The Kokomo flat roll, not so much. I think we'll be in real good shape there. Now obviously, we have to commission and get it through our quality standards and things like that. Now on the furnaces and production equipment down in Arcadia, the product is what's certified as opposed to the process or the equipment. But again, it'll be a very rigorous testing procedure that we'll go through internally. It's almost like the automotive guys with PPAP. I mean, it's not a formalize thing, but we'll run it internally through very rigorous. So giving a timeframe on it, the equipment will be in by the end of the next fiscal year. So let's call then in the September, October timeframe of next year, and then we'll probably spend about 3 months commissioning that. So by the time you start talking about calendar '15, we'll be up and running. In fact, we've had a meeting -- just this last week, I talked to some of the commercial guys about the product. And we start talking a little bit about, okay, when should we start booking that equipment, and we're starting to talk to our suppliers of things like shells and tube hollows as to what their lead times will be and when they'll able to firm a price, et cetera. But if you think about it -- if I were to give you a timeline, I'd say October of next year, we expect to have all the equipment run in place, and we'll start commissioning and doing surveys and evaluations of the equipment, getting it qualified. And then I'd say by first calendar quarter of '15, we should be up and running and booking that equipment.

Daniel M. Whalen - Topeka Capital Markets Inc., Research Division

Great. And then certainly, this is a bit out here, but in -- I mean, these initiatives certainly have a lot of potential leverage here to the gross margin line. How should we kind of be thinking in terms of a ramp process in terms of when that will start flowing through here, just given -- it seems like there's tremendous levers that will be taken from these initiatives.

Daniel W. Maudlin

Yes. We are expecting some leverage on the gross margin line. As we previously mentioned, we're hoping for 2% to 4% improvement in our gross margin percentage, kind of based on 2012 levels. And when that will start occurring, of course, we need the whole program to be up and start utilizing that capacity. There'll be a few pieces of equipment that will come online prior to that, and we can start seeing some cost benefits. So I do expect a little bit of leverage prior to the entire program being completed, but it really will be most of it after the full project is complete and we start increasing the volumes across that equipment.

Operator

Our next question is from the line of Phil Gibbs of KeyBanc Capital Markets.

Philip Gibbs - KeyBanc Capital Markets Inc., Research Division

I had a question on the aerospace business. How much of the -- of what you're seeing now is purchasing managers just being cute with nickel versus guys just maybe having too much inventory on the ground? How do you parse out between those 2 things?

Mark M. Comerford

I'll tell you what, if I were to take a look at it, what I'd say is we anticipated some of this, if you ask my opinion that -- and we mentioned it last call and we may have even put it in the shareholder letter that we had the record output in aerospace last year. So we expected some level of a pull-back. If you ask me, I'd say the destocking would be 2/3 of the issue right now, and maybe 1/3 of the issue is transactional, people putting off ordering or at least putting off blanket ordering until we see a change. I think if we start to see a change in the nickel market, we're going to see people starting to rush to get contracts done and get blankets put back in. I think it'll be something maybe not as dramatic as what we saw in the early part of 2011, but I think we will see a rush at that time. So I'd say it's about 2/3-1/3.

Daniel W. Maudlin

And if you're looking at the nickel LME, it is now below $7 per -- $7 a pound. So I think the room to go down further than that, we would think we're getting close to the bottom. So hopefully, that will start abating soon.

Mark M. Comerford

Yes. And, Phil, putting it in your terms, if you sit back and say, would it have been reasonable to see maybe a 10% to 15% drop in volume year-on-year because of the destocking? I think that would've been reasonable. And then seeing another 5% to 10% drop because of what's happening in the transactional environment with people playing nickel games, I think that's reasonable and that's where you come up with that -- essentially, the 20% year-over-year drop.

Philip Gibbs - KeyBanc Capital Markets Inc., Research Division

Okay, got you. And then on the MRO front for the engine business and how do we think about some of these headwinds from aircraft retirements? I'm sure you've been reading the same things that I have, Mark, on that issue.

Mark M. Comerford

Yes. We don't have the visibility. I mean, we have estimates for MRO versus OEM. We don't have the visibility because, essentially, we're supplying customers -- the same people doing OEM are the same people doing the MRO work at our level. So we don't have that same level of visibility through this. So it's tough for me to really come out and say -- I mean, I've read the same things you have that the MRO issue is a major part of what's occurring right now. I think for me to speculate on something like that, I just don't think it'd be responsible right now. Just what we're seeing right now is a big -- pretty fair size of destocking in the aerospace industry, and we just don't know when that's going to start bouncing back for us.

Philip Gibbs - KeyBanc Capital Markets Inc., Research Division

Okay. And this is the last one, if I could. I really appreciate it. Your initiatives to restructure your service center footprint and some of your IT upgrades, can you give us an update on those 2 major items?

Mark M. Comerford

Yes. On the IT, as we mentioned, Europe's been up and running for 4 months now. We went through the usual bugs in getting that going. But frankly, going from 3 systems, none of which matched up with the U.S. system, now down to a single system, I think is just going to be fantastic for us. And by the way, that's also going to be a system that will match the U.S. system, which we'll start implementing here in the October, November timeframe. And just think about it, I mean, from the point of view of supporting people, the tech support on it, we'll be able to do those things internally now. We'll have everybody seeing the same data. We'll be able to see data real time as opposed to getting monthly reports or weekly reports. I think it's going to be very, very helpful to everyone in the company as we go through it. So we're very excited about the IT system. With respect to the distribution, and I think I've said this before, a lot of people when they think of distribution, they think of pick and pack, and that's not Haynes. Haynes distribution is really light manufacturing. We're cutting a lot of the parts these days. So the location of those pieces of equipment, some of the computer programs for optimizing yields, a lot of that is going into what we're discussing now. Also, our European operations have done a real nice job of consolidating the back-end operations for certain applications. So a lot of the aerospace parts, regardless of where they go in Europe, are now cut out of the U.K. facility. So we're seeing gains in that area, but we need more floor space to continue in that program. And we'll be doing the same type of thing here in North America, making sure that we're optimizing those types of operations on the back end as we go through. Dan, anything to add to it?

Daniel W. Maudlin

Well, I would add to the -- on the IT side, especially, we have our U.K. service center, which is kind of a nice model of a service center for us, and in implementing the IT system there, first, we're able to kind of work out all the issues, all the normal bugs that you would expect, and we'll be able to bring back everything we learned from there to implementing it for the domestic service centers here. So it's kind of nice the way we've done it in Europe first, a little smaller footprint. We'll bring it back to the U.S. and get a nice running start. So I think -- I've been very happy with what I've seen in the system so far. Anytime you implement a -- an ERP system, it's a challenge, and it certainly is. But I think we're progressing well, and I think we're going to get some great benefits in production planning and visibility and some of the other things Mark said. So pretty excited about it, but we still have quite a bit left to go on it.

Operator

At this time, we've reached the end of our Q&A session for today. I will turn the floor back over to Mr. Mark Comerford for closing comments.

Mark M. Comerford

Thank you, Rob, appreciate it. Thanks very much for your time today, everybody, and thank you for your interest and support of Haynes International. We'll look forward to updating you again next quarter.

Operator

This concludes today's teleconference. You may disconnect your lines at this time. Thank you for your participation.

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