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Universal Stainless & Alloy Products (NASDAQ:USAP)

Q2 2013 Earnings Call

July 31, 2013 10:00 AM ET

Executives

June Filingeri – President, Comm-Partners LLC

Denny Oates – Chairman, President and CEO

Mike Bornak – VP, Finance and CFO

Paul McGrath – VP, Administration and General Counsel

Analysts

Michael Gallo – C. L. King

Lance James – RBC Global Asset Management

Dan Whalen – Topeka Capital Markets

Lloyd O’Carroll – Davenport & Company

Philip Gibbs – Keybanc Capital Markets

Jon Evans – Edmund White Partners

Ethan Steinberg – SG Capital

Operator

Good day, ladies and gentlemen and welcome to Universal Stainless’ Second Quarter 2013 Earnings Conference Call. At this time, all participants are in listen-only mode. Later, we’ll conduct a question-and-answer session and instructions will be given at that time. (Operator Instructions) As a reminder this conference call is being recorded. I would like to hand the conference over to Ms. June Filingeri, ma’am you may begin.

June Filingeri

Thank you, good morning. This is June Filingeri of Comm-Partners and I also would like to welcome you to the Universal Stainless conference call. We are here to discuss the company’s second quarter 2013 results reported this morning.

With us from management are Denny Oates, Chairman, President and Chief Executive Officer, and Mike Bornak, Vice President of Finance and Chief Financial Officer and Paul McGrath, Vice President of Administration and General Counsel.

Before I turn the call over to management, let me quickly review procedures. After management has made formal remarks, we will take your questions. Saed, our conference operator will instruct you on procedures at that time.

Also, please note that in this morning’s call, management will make forward-looking statements under the Private Securities Litigation Reform Act of 1995. I would like to remind you of the risks related to these statements, which are more fully described in today’s press release and in the company’s filings with the Securities and Exchange Commission.

With the formalities out of the way, I would now like to turn the call over to Denny Oates. Denny, we are ready to begin.

Denny Oates

Thanks, June. Good morning everyone. Thanks for joining us today. As we announced in our earnings release this morning, second quarter net sales were $42.9 million, which is down 37% from the second quarter last year on a similar decline in tons shipped.

Compared to the first quarter this year, net sales were down 13% only 11% lower shipment volume. The gradual recovery in demand commonly projected for the second quarter simply did not materialized. Instead, destocking continued throughout the supply channel. In addition a 15% drop in nickel prices in the second quarter in combination with short industry lead times encouraged customers to delay placing orders.

As a result, our volume was sequentially lower in all of our end-markets with the exception of aerospace which remain in level with the first quarter. Our order backlog at June 30 was 17.9 million pounds and $49 million, an increase of 18% and 5% respectively.

Nonetheless with the slow summer months underway and continued low nickel prices, a meaningful improvement in order entry is not expected until the fourth quarter this year. Our gross margin improved to 12.4% of sales from 9.5% of sales in the first quarter, despite the 13% sequential reduction in sales. Three factors accounted for the improvement.

First our management team has done a great job executing on our short-term plans to flex spending and production down in the phase of lower business activity. Second, we are seeing the benefits of the prices improvements being achieved at our new North Jackson facility.

The yields are up, first time through quality metrics are moving in the right direction. Work previously done by third-parties as equipment ramped up as largely been brought in-house. Many of the more significant North Jackson start-up costs are behind us.

Although there will be added cost in the future as new alloys are developed for commercialization, we expect the gross margin improvement to continue. Third, one-time performance, one of our most critical operating metrics has been at new record levels all year. And nothing has been paid to customers under our universal commitment program.

Net income for the second quarter also increased sequentially to $0.06 per diluted share. Let me note two items.

Our selling general and administrative expenses were higher than normal in the second quarter due to severance cost incurred, but we also have positive income tax benefit, primarily related to R&D tax credits and a favorable state apportionment factor. Our new CFO Mike Bornak will cover these items in more detail during his review.

Cash flow from operations is a positive $5.3 million in the second quarter, up from a positive $4.4 million in the first quarter. We continue to control managed working capital in the quarter and capital expenditures at $3.4 million were down 7% from the first quarter. Total debt at June 30 was $103.4 million or 34% of total capital.

Turning to our second quarter operational highlights, as most of you know, we have been working intensively to attain industry certification of our processes as part of our plan to move to more technologically advanced alloys. That really began with our acquisition of North Jackson two years ago.

Through the end of 2012, we were successful in getting AS9100 certification for the new forge vacuum induction melting facility and the vacuum arc remelting facility at North Jackson. In addition, we earned ISO 17025 and Nadcap accreditation for our laboratory at North Jackson.

In the first quarter of 2013, we gained Nadcap heat treat certification for North Jackson. In the second quarter of 2013, we attained it for Bridgeville and Dunkirk, so we can now heat treat our new advanced products in all of our main plants.

Currently, we are working on Nadcap lab certification for Dunkirk, which will essentially complete the major industry certification work. Meeting industry standards is essential for our next objective which is to qualify our products and processes with our target list of leading OEMs in aerospace, oil and gas and power generation.

On the last call, I was able to report our first ever contract with Rolls Royce. We have continued to make progress with OEM approvals in the second quarter, although we are not able to mention specific names at this point due to customer requests for confidentiality and for competitive reasons.

The last item on my list of operational highlight is the new labor agreement we reached for our Bridgeville facility. It’s a five year agreement. It maintains the flexible work rules and profit sharing incentives from the prior agreement and was ratified nearly two months before the former agreement expired.

Turning to our end-markets. Aerospace remained our largest market in the second quarter, representing 58% of our total sales, compared to 50% of sales in the second quarter of 2012 and 52% of sales in the first quarter of 2013.

Compared with the second quarter of 2012, aerospace sales were down 26% on 15% lower volume. Sequentially, our shipment volumes to aerospace remain leveled with the first quarter, while sales dollars were down slightly by 20%, that’s consistent with what we have seen for the past three quarters. Our aerospace volume and sales were moving along at about the same level.

Tightly managed inventory control, coupled with outright destocking by the metal supply chain, as well as by the OEMs and airlines are the main contributors to this trend. New aircraft production schedules and industry prospects remains strong, if not somewhat improved.

Global passenger traffic has recovered from the fall back in 2009 and grew by 4.3% while capacity grew at a lower rate of 3.4% in the first five months of 2013. This morning I saw a report that it actually grew by 6% in June, compared to 2012 June.

In addition, there was a lot of enthusiasm as well as strong aircraft sales at the Paris Air Show, with Airbus coming away with new orders and commitments for 466 aircrafts and Boeing taking home orders and commitments for 442 Boeing airplanes. Boeing and Airbus continue to signal ramp up in monthly production levels over the next several years.

With aircraft backlog to both Boeing and Airbus continue to represent six to seven years of production, the future growth rate of metals consumption in this sector remains as strong as ever.

The aftermarket is also showing some signs – of some promising signs. Clearly the focus on MRO inventory reduction from airlines and the changing dynamics behind parting out of retired planes, the decisions to retire or continue the service of the existing fleet and lower useful airplane lives has had a negative impact on metals consumption.

However, double-digit growth in orders for spares announced by several major OEMs in the second quarter leads us to believe that destocking is subsiding and things are falling in place for increased activity and the mill level as we move into 2014.

As you know our strategy to add advanced nickel alloys to our product portfolio to further penetrate this growing market.

Oil and gas market represented 10% of second quarter sales versus 13% of sales in the first quarter and 21% of sales in the second quarter of 2012. Our oil and gas sales were down 29% sequentially or 19% lower volume and sales were 68% lower than in the second quarter of 2012 on 65% lower volume.

On the last call, I noted along with others that inventory destocking was underway in this supply channel. That destocking increased during the second quarter. While Schlumberger, Halliburton and Baker Hughes all reported strong international business and deepwater drilling activity in the Gulf, the picture of North America was mixed.

In fact, Canada rig counts temporarily fell more than 70% during the spring breakup to a four year low, plus some expected modest increase in the US rig counts did not materialize in the second quarter and Baker Hughes are now projecting a total rig count for the year of 1765 rigs, which is an 8% reduction for 2012. As a result, supply channel caution is understandable.

However, a fair amount of inventory destocking has already taken place in this channel. So we feel we have a couple more quarters before it comes back in balance and demand normalizes in 2014. The longer term picture for oil and gas remains as positive as ever as further confirmed by the Thursday’s US Energy Department report. We are working to gain a larger share of that opportunity through the advanced alloys we are planning to add.

Power generation represented 11% of second quarter sales compared with 12% in both the first quarter of 2013 and the second quarter last year. Power generation market sales were down 21% sequentially on 8% lower shipments and down 45% on 38% lower volume than our second quarter of 2012.

Quick turn maintenance business continues to constitute the majority of our power generation business. The new turbine business continues to be weak. That’s in line with GE’s second quarter report, that their US power generation service drove with 13% increase in their non-European service business, but they noted they are continuing to see headwinds for heavy duty gas turbine demand.

Nonetheless, they did report receiving orders for 24 heavy duty gas turbines during the second quarter which is down 30 received last year. But it’s an improvement of eight orders compared to the first quarter. As I said last quarter, we expect maintenance to be the main source of our power generation sales for the next few quarters.

Heavy equipment market sales increased to 13% of second quarter sales from 11% of sales in the first quarter of 2013 and 10% in the second quarter of 2012. Our second quarter sales in this category match those of the first quarter on 5% lower volume, whiles sales were 16% lower than in the 2012 second quarter on a 12% decrease in volume.

The majority of our heavy equipment sales in the second quarter were for tool steel products. The automotive market is the main consumer of tool steel and it continued to be a positive driver during the quarter. Earlier this month, GM reported that June sales were the highest monthly sales since September 2008, while Ford said that June sales were the best since 2006.

On the other hand, in the off-road market, Caterpillar reported a lower than expected results last week caused by sharp reductions in dealer inventories and a decline in mining activity. They also brought down their forecast for full year 2013.

On balance, we expect stable demand for our heavy equipment products over the next couple quarters. With my end-market review complete, I would now like to introduce our new Chief Financial Officer, Mike Bornak.

Mike has extensive experience as a public company CFO and a track record of streamlining financial operations, supporting overall operations, building strong relationships with financial institutions and the investment community and accomplishing organizational transformation during his career.

Given where we are in a transformation of Universal Stainless, I am very pleased as somewhat Mike’s caliber joining our team. Mike, let me turn the call over to you for your financial review.

Mike Bornak

Thanks, Denny. I am very pleased to be part of the Universal team. As Denny indicated, our second quarter 2013 net sales were $42.9 million which is a decrease of 25 million or approximately 37% when compared to the second quarter 2012 net sales of $67.9 million

This decrease in net sales primarily corresponds to the decrease in our overall shipments as we shipped 8.6 million tons in the second quarter of 2013, compared to 13.3 million tons in the second quarter of 2012, a decrease of approximately 36%. Sequentially, our net sales decreased by $6.2 million or 12.7% from the first quarter of 2013, primarily as a result of 11% decrease in tons shipped.

The decrease in net sales from the prior period and from the first quarter of 2013 is primarily due to the business climate we are currently operating in. Our gross margin in the second quarter of 2013 was $5.3 million or 12.4% as a percentage of sales, compared to gross margin of $11.6 million or 17% as a percentage of sales in the second quarter of 2012.

Sequentially, our gross margin as a percentage of sales increased from 9.5% in the first quarter of 2013 to 12.4% in the second quarter of 2013 on an 11% volume decline, primarily due to a combination of margin improvements at our North Jackson facility, establishing flexible production schedules and aggressively managing our overall costs.

I also would like to point out that the sequential increase in our gross margin quarter-over-quarter that I just noted, include an increase in our depreciation expense to approximately 8% of our total net sales for both the second quarter and first half of 2013, as more North Jackson assets have come into service.

When compared to the same periods last year, this increase in depreciation expense in 2013 has negatively impacted our gross margins by approximately 4% compared to each prior year period.

Selling, general and administrative expense for the second quarter were $4.9 million, which included severance cost of approximately $0.4 million related to the departure of a senior executive.

Excluding the severance costs, our SG&A cost was $4.5 million or in line with Q1 spending levels. As a percentage of net sales and excluding severance costs, SG&A expense was 10.6% in the second quarter versus 6.1% in the same quarter last year. The increase to 4.5% is primarily due to the maintaining our staffing levels on lower sales volumes we strive to achieve our strategic objectives in 2013 and beyond.

We posted operating income of $439,000 in the second quarter of 2013, compared to $7.3 million in the second quarter of 2012. Again, this decline is primarily the result of lower shipment levels over the same period last year.

In the second quarter of 2013, we recorded a tax benefit of $841,000, this benefit is primarily the result of a reduced state apportionment factor that accounted for a $248,000 benefit and positive research and development tax credits of $306,000.

We also recognized a discrete research and development tax credit in the first quarter of this year of $368,000 as a result of the passage of the American Tax Payer Relief Act of 2012 passed in early 2013, that reinstated the research and development tax credits retroactively to 2012.

Our net income for the second quarter of 2013 was $478,000 or $0.06 per diluted share. This included to the tax benefit recorded in the second quarter of 2013 of $841,000, which amounted to approximately $0.11 per diluted share.

In comparison, in the second quarter of 2012, we posted net income of $4.5 million or $0.62 per diluted share. I would also like to mention that as we drive our strategic focus on developing higher margin products and to provide more sales visibility into our end-markets, we have added two tables to our earnings release and 10-Q since the beginning of the year.

In the first quarter, we added a table that shows the breakout of net sales by specialty alloys, premium alloys and conversion services and other sales to show the progress we are making in our premium alloy shipments. During this quarter we added another table, as shown in today’s earnings release, that breaks out our estimated net sales to our end-markets.

Although we do not sell the majority of our products directly to the end-markets, this table represents our best estimate based upon the greater products sold to our customers and in term where we believe the end-markets are products to ultimately be sold into by them.

These tables will also be included in the 10-Q which we are anticipating filing by the end of this week. Turning to the balance sheet, our managed working capital as of the end of 2013, second quarter which by definition includes accounts receivable and inventory less accounts payable, was $105.4 million, a reduction of $1.3 million or 1.2% from the first quarter of 2013, primarily as a result of overall lower inventory levels.

During the second quarter of 2013, we spent 3.4 million on capital expenditures, compared to $11.5 million in the second quarter of 2013. Over the first half of 2013, we spent $7 million in capital expenditures, compared to $20.1 million over the first half of 2012.

The declines in capital spending when compared to the prior year are primarily related to the completion of assets placed in service during the latter half of 2012 and early 2013, related to our North Jackson facility.

At the end of the second quarter of 2013, we were in compliance with all our debt covenants under the recently amended credit agreement and we decreased our overall debt by $1.3 million to $103.4 million compared to the end of the first quarter debt level of $104.7 million.

That concludes my reports. Denny, I’ll turn the call back over to you for closing remarks.

Denny Oates

Okay, thanks, Mike. In summary, supply channel destocking exacerbated by the drop in nickel and record short lead times, took a toll in our sales and shipments in the second quarter. The expected gradual recovery in industry demand has not yet materialized.

We realized strong sequential improvement in our gross margin in the quarter by controlling spending and flexing production in line with market demand. Our gross margin further benefited from process improvement and the elimination of major start-up costs in North Jackson.

We also made important progress in our plan to move to technologically advanced alloys in the second quarter by adding to our list of industry accreditations and customer approvals. While we saw an uptick in order entry and backlog in the second quarter, market demand is not expected to begin to meaningfully recover for the fourth quarter.

In the meantime, we will continue to drive improvement in our operations and pursue existing market opportunities, while executing our strategic plan to transform Universal Stainless that began with the acquisition of North Jackson.

I’ll end my formal remarks now. So we have adequate time for your questions.

Question-and-Answer-Session

Operator

(Operator Instructions) And our first question comes from Michael Gallo with C. L. King.

Michael Gallo – C. L. King

Hi, good morning.

Denny Oates

Hey, Mike, how are you doing today?

Michael Gallo – C. L. King

Good. A question Denny, I was obviously going through this now for some time with the inventory destocking and alike. I guess particularly on the aerospace side, it seems like your volume declines certainly seem to be larger than what some of your peers have seen. So, I was wondering if you can comment at all.

And I know it’s hard for you guys to tell exactly where it goes, but how much of your business that you are doing right now you think is aftermarket related on the aerospace side, versus newbuilds?

And it would just seem that the fairly large declines that you are seeing, given what’s going on, on the newbuilds cycle, I guess, it’s just somewhat surprising, I know you talked about inventories, but it seems like we’ve talked about inventories now for three or four quarters. So, help me reconcile that. Thank you.

Denny Oates

All right, that’s how much goes to the new guys versus the aftermarket in my mind is the nature of the channel that we are serving. When you look at our current and legacy channels to market, Mike, we are about 55% 60% through distribution, very little in a way of contract business. When you compare to some of the other peers in our group they are the much larger percentage of contractual business. Contractual business being either, one year, two year sales price and volume type agreements.

As we move into some of the higher value products, the more technologically advanced products that we are talking about, we will be talking about multiple year contracts as well and I’ll address some of this fluctuation you are seeing.

But right now, we’ve got far and away the highest exposure to the distribution chain, service centers and actually we are seeing the biggest fluctuations in terms of destocking and that’s why you are seeing larger fluctuations in our quarter-to-quarter changes in sales volumes.

Michael Gallo – C. L. King

Okay, great. Well, just a follow-up to that, I guess, so given the lack of visibility on that, given what we normally see at the end of the year around service centers and alike managing the year-end inventory, what gives you confidence that you will see an improvement in demand in the fourth quarter? Is it possible that that just gets pushed out to next year, given again the service centers general year end reluctance to – commit to orders and inventory? Thank you.

Denny Oates

Well, I think on the new side, product that’s going to the Boeing or Airbus for new airplanes, I think the two operators, the consumption of metal has remained very strong and will continue to grow. And that we knew it last year as you said, inventories are coming down, if you look at the service center inventories in our products, and I believe we are getting leaner. When I visited the warehouses I can see it visibly.

So, from a firsthand standpoint, that gives me some confidence that the inventories are coming down, they are starting to see some holds in our inventory which gives me some confidence as we exit this year, so that I am clear I am talking about business levels picking up as we go through the rest of this year, starting to see some pick up in order entries, we exit the third quarter into the fourth quarter, with clear improvement in 2014.

On the aftermarket side, there is a whole range of issues that have come into play over the last couple of years. The airlines and sales have had a concerted effort the last 18 months to reduce their inventory of parts. It has the whole phenomena that the new airplanes which are so much more economical than the older ones, they have changed the economics in terms of parting out of the planes becomes more economical to part them out than it does to continue them in service.

When planes come off lease rather than transferring them into transport applications or turning them over into another lease, people are parting them out and I think the supply chain and the aftermarket side has had to absorb some of that and adjust to that new reality if you will.

But as I look at the spares business, at some of the large OEMs and I see it’s growing double-digit improvements in their order entry that’s telling me that that supply chain, that aftermarket supply chain is beginning to buy again. And I’ll take a quarter or two for that to rattle through to the mills, but that gives me optimism on the aftermarket side. So I put those two together and that’s why I look at the fourth quarter as a quarter we’ll see improvement in activity, going into a much stronger 2014.

Michael Gallo – C. L. King

Okay, thank you.

Operator

Our next question comes from Lance James from RBC Global Asset Management.

Lance James – RBC Global Asset Management

Hi, Denny. A quick question and I think, you may have touched on it with your response to Mike. I am just trying to get a feel for your market share whether there is, whether the drop in volumes are just all end-market related or whether there is some loss of market share.

I think I understand from your remarks that you are going through the service centers, that is an element in itself that would have had a tougher effect on your overall volumes. But if you can touch on that anymore that would helpful to us.

Denny Oates

It’s very difficult for me to answer that question in a macro level because of the range of product forms and grades of steel and the industries we serve. So it really depends upon your definition on what the market is. I would tell you that if I look at the business other than normal competitive give and take over the last two quarters, I don’t see any significant deterioration in our market share. It’s been a tough market out there.

There has been a lot of aggressive behavior. Every order is precious to everybody at the mill level. So it’s been a very strong competitive environment. Our philosophy is we feel we deliver value to the marketplace. We price accordingly. So we are not willing to nose, dies and wafer some business and that would be places – cases where we have perhaps missed a few orders here and there. But I don’t view there is any sustaining big decrease in share.

I look at this and say, we have a very significant, there is still way in-house that’s got 55%, 60% of their sales volume going through distribution. And as we see the biggest fluctuations in inventory and that’s what I think you are seeing with Universal.

Lance James – RBC Global Asset Management

Great and I could throw one other question, do you think the trigger for the service centers to increase their orders will be a pickup in the nickel prices or just that they’ve gotten to the point that they are so lean on their inventories with the hopeful increase demands from various sectors that they just got to improve things or do you think nickel is going to be the bigger trigger?

Denny Oates

It’s a bit of a checking in the – but I believe finding holes in the inventory and realizing in order to meet demand, they’ve got to buy is going to be the primary driver that should go through the rest of the year. Typically, whether it’s happen stance or whatever, historically nickel prices seem to trend at the same time. So clearly, stabilization in nickel prices for a few months would clearly help that all situations.

Nobody on the buying side of our products wants to be the last person to buy a high priced product and if they can look down the road two months and see declining surcharges, you and I will both do the same thing they are doing. So some stability there, where there is no incentive to delay orders or to push things off would be a plus for many mills perspective.

Lance James – RBC Global Asset Management

Perfect. Thank you very much.

Operator

Our next question comes from Dan Whalen from Topeka Capital Markets.

Dan Whalen – Topeka Capital Markets

Hey, Denny.

Denny Oates

Hi, Dan. How are you?

Dan Whalen – Topeka Capital Markets

So, thanks for your added level of detail here. So premium alloys is about 5% of revenue in the quarter. Can you refresh us in terms of where you think that will be at year end 2013, 2014 in terms of percentage of revs?

Denny Oates

Our objective is to get that number north of 25% by 2015 to start there, that’s the strategic objective that we’ve set and published.

Dan Whalen – Topeka Capital Markets

So yearend 2014?

Denny Oates

As you look it to play out over the next couple quarters, we are in a process of getting approvals. We talked about the Rolls Royce approval, we’ve gotten some other approvals. Both of this business is annual type business where customers make commitments for a year for a certain percentage of their requirement. They are already covered through the end of 2013.

So as we go through 2013’s fourth quarter, we’ll be negotiating with them and looking at 2014 business levels. We now have the approvals, but they’ve already got commitments to other players.

So, as you look at the – back to the original question, 25% is our long-term objective, to get north of that number by 2015. I expect gradual improvement in that percentage as we move through the rest of this year, but a significant increase in 2014 moving up to 25% or north of 25% in 2015. Does that help?

Whalen – Topeka Capital Markets

Yeah, that is, thank you. And then, so it sounds like we’ve got the major start-up costs behind us in North Jackson. Can you kind of frame up for us what they were this quarter and how much they should decline next quarter and the following quarter?

Denny Oates

I don’t know, I give you a specific number on how much the decline in each quarter going forward. Let me just say that I think in the last call, I indicated we expected to see improvement in margins, because we had some start-up costs are ploughing through out P&L.

We saw that went to 12.4% from 9.5%. As you look down the road and you look back historically, we’ve typically been in the 15% to 19% range. So, my expectation is, as we go down through 2014, you should see us continue to improve towards that number as volume comes back. And actually exceed that number because we are putting higher margin products into our mix.

Dan Whalen – Topeka Capital Markets

So, you think it’ll be north of 19%?

Denny Oates

Because I historically look our gross profit margins there in the 15%, 19% range. I am giving you the broad range, but if you go back and look that expense we’ve been, all right?

So, we’ve got more room to go and the main reason why we are down we are at is, there is two reasons really is the startup cost of North Jackson, we had a depreciation which we are doing over time, not over production and then we’ve got fundamentally very low volumes going through the rest of the facilities.

Dan Whalen – Topeka Capital Markets

Gotcha. Okay, thank you.

Operator

Our next question comes from Lloyd O’Carroll from Davenport.

Lloyd O’Carroll – Davenport & Company

Good morning Dennis.

Denny Oates

Hey, Lloyd.

Lloyd O’Carroll – Davenport & Company

Can you give us numbers on orders, $1000 for Q2 and then what it would like for July?

Denny Oates

July, right now we are having close, we’ve got a boat load of orders, I know are being put in as we speak, but when I look at the July, I think it’s going to be very comparable to what we saw over the last couple of months.

The general wrap – I would share with you, I had a meeting with two of the best inside sales people in the industry this morning. They both said lot of activity on the phones. A lot of requests for fast turnaround on increase, but in terms of actual bookings which is what really counts there has not been a significant improvement since the turn of the quarter.

Lloyd O’Carroll – Davenport & Company

Okay, what were the Q2 numbers?

Denny Oates

Hang on one second. The order entry was 20.3 million pounds in dollars at $41 million I remember you got to add surcharges to that.

Lloyd O’Carroll – Davenport & Company

Right, and so, you’ve always talked about the legacy business as a 12% operating margin operating higher over time. I was assuming as you get better volume and fixed cost absorption that would help. And then the premium in the 20 plus or minus margin business as we move forward. Is this is still the right metrics?

Denny Oates

Yes, that’s the right metrics. The metrics I was quoting on the last answer with Dan was, I was talking gross profit margin there. Just so I am clear on what point in the P&L you are talking about, but you are right. I typically look at operating results, you include the SG&A numbers.

Lloyd O’Carroll – Davenport & Company

Okay, all right and whoever was doubling your stock this morning when you were down 200%, seems backed off. So that’s good news.

Denny Oates

Thanks, Lloyd.

Lloyd O’Carroll – Davenport & Company

That’s okay.

Operator

Your next question comes from Phil Gibbs from Keybanc Capital.

Philip Gibbs – Keybanc Capital Markets

Good morning.

Mike Bornak

Hey Phil.

Philip Gibbs – Keybanc Capital Markets

Hey, Mike. Welcome.

Mike Bornak

Thanks, Phil.

Philip Gibbs – Keybanc Capital Markets

On North Jackson, Denny, can you give us a feel for the change in start-up costs, maybe 2Q versus 1Q?

Denny Oates

In terms of what, in terms of dollars or cents?

Philip Gibbs – Keybanc Capital Markets

Yeah, just dollars, kind of on an absolute basis if you had $1million in the first quarter, $0.5 million in the second, that’s the difference?

Denny Oates

I would do that, and I don’t have a specific number here to throw out to you, but if you look at our margins of 12.4% versus 9.5%, three quarters of that do, I would three quarters of that and call that the North Jackson improvements.

And the reason why I am a little hesitant is understand, as we have start-up costs that’s flowing through inventory. So some of those costs we incurred in the first quarter, if you remember the discussion we had then, related to things that were happening during the second half of last year, so some of this is happening and flowing through the P&L.

So many of the improvements that I am alluding to in the second quarter actually started to occur here as we came into 2013.

Philip Gibbs – Keybanc Capital Markets

Okay. What’s your inventory stock is going forward? Should we expect further reduction in the back half of the year, relative to how you guys are looking at the world?

Denny Oates

Yeah, you’ll see further reduction as we go through the rest of the year. If you look at that on two fronts, remember we’ve got about $14 million, $15 million worth of vacuum induction melted produced products in our inventory that we produced as we train crews, worked on approvals and debug the equipment. All right, that’s sitting in our inventory right now, also saleable material.

So as we start to get approvals and get releases on that, we can start to work that inventory down. If you look at our basic electric arc melt shop operation we are running about two weeks out of every month, which is not replacing what we are shipping. So we are going to get to the reduction on both sides of that.

Philip Gibbs – Keybanc Capital Markets

Okay. I think that largely takes care of my questions at this point. Thank you.

Operator

(Operator Instructions) Our next question comes from Jon Evans.

Jon Evans – Edmund White Partners

Denny, can you just help us think about how you think about revenue sequentially, should they be down, just because backlog has continued to go down from a visibility standpoint? Or do you think the turns business will help you enough, where you’ll actually be able to grow revenues sequentially?

Denny Oates

I think, you’ll see some improvement in revenues sequentially. We typically don’t give specific guidance, but I think you’ll see some improvement.

Jon Evans – Edmund White Partners

Okay, and so basically…

Denny Oates

And just remember, I keep saying this, but just remember the backlog numbers, I think we are the only folks in the industry to publish backlog numbers. We really don’t know what the surcharge is going to be on those shipped pounds. So when you look at our backlog and order entry and everything, you got to remember that, okay?

Jon Evans – Edmund White Partners

Okay, and then the other question I would have for you is, can you talk a little bit about Rolls Royce and then potentially ramping with you and I think they talked on their call about trying to take their inventories down to PCP alluded to that. Is there a risk that more of the supply chain will continue to destock, like you are or I am just curious your thoughts on that?

Denny Oates

We announced last quarter , we have a five contract with Rolls Royce. We should begin shipping against that contract in January, February timeframe of 2014. We’ve continued to work very closely with them, in fact, I’ll be going over there in a week and a half to fine tune some arrangements logistically.

So everything is going along pretty much as planned from our standpoint there and serves as grades of the steel we’ll be making for their supply chain and the volumes of those steel that they’ve estimated they will give us. So we have no indication whatsoever there will be any decrease in that, but it has already started up.

Jon Evans – Edmund White Partners

Okay, thank you.

Operator

And our next question comes from Ethan Steinberg from SG Capital.

Ethan Steinberg – SG Capital

Hey guys. Thanks a lot for taking the call. I was hoping that you could help me understand a little bit better as some of these qualifications start to hopefully ramp like Rolls Royce in next year. How does that work from a P&L and balance sheet standpoint? Do those come in profitably or do you have to put up some expense at first, or build inventory first? Just help us understand how that flows through.

Denny Oates

We will make some inventory in advanced – actually shipping the product obviously. We price the product, so that we make an adequate profit. So I am not expecting any – I mean we are talking about any leaders or anything like that at this point in time. We will be selling that case to their supply chain which is a group of forgers.

Ethan Steinberg – SG Capital

Okay.

Denny Oates

That will be fairly businesses as usual, other than…

Ethan Steinberg – SG Capital

It comes on at pretty good gross margin right away like the first dollar?

Denny Oates

There will be some learning curve obviously, so the first groups of products going out, we won’t come out of the shoe perfect, but it’s not – I am not looking. There are no loss leaders and anything that we cited. But I’d be disappointed, if we don’t see improving margins as we make the product and further refine our procedures.

Ethan Steinberg – SG Capital

How long does it take to start to get ramp? Like Rolls Royce, you said you think you can start to get some sales at the beginning of the year for other big programs, opportunities, how long does it takes once they qualify you to get in there and actually generate revenue with you?

Denny Oates

In the case of Rolls Royce, I am thinking a couple quarters, all right? But typically what you are talking about is it’s a new program, whether there is no other supplier which is very, very rare.

There is usually someone else is supplying the material. If you are one of our customers, you got to wean that incumbent out of your supply chain and wean us into it. And that process happens typically after you are approved, so it’s usually talking a couple quarters.

Ethan Steinberg – SG Capital

Okay, so we shouldn’t really think about any kind of ramp other than with Rolls Royce until maybe the second half of 2014, is that….

Denny Oates

No, we are getting some approvals from other people as well who have annual commitments and I would expect to start to see business from those folks in the first quarter of 2014, but it should build over the course of 2014.

Ethan Steinberg – SG Capital

Okay, and you already know with them that they are switching to you from their existing supplier?

Denny Oates

I know we are approved and the delicacy here is they don’t like to talk about, you can understand and quite frankly we are in a very competitive business. So we don’t like to talk about it and so our competitors where we are headed. So that’s I want say, I’m mysterious, but I am doing it for the benefit of them.

Ethan Steinberg – SG Capital

Sure and then the covenant with the bank, I guess, can you help us understand how much cushion we have on that before something might get tripped or we have to go back and renegotiate?

Denny Oates

Actually we are not expecting the trip any, that’s right now for the balance of the year.

Ethan Steinberg – SG Capital

Okay, how much more is there, if revenues drop or what are sort of the key variables or metrics we should keep an eye on that would get us closer?

Denny Oates

It’s going to have improving the EBITDA over the next couple quarters. So that should keep us within the range of compliance. There is two other leverage too that I would mention. One is, our capital spending is coming down and also we have control over our inventories and we’ve got room to continue with these inventories.

Ethan Steinberg – SG Capital

Okay, thanks guys.

Operator

And our next question comes from (inaudible)

Unidentified Analyst

On the inventories, are you comfortable with the current level right now, given the level of business?

Denny Oates

Yeah, I would project that our inventories will come down as we go through the rest – through the third quarter and we’ll see how business levels are at looking towards 2014. Some of our products had lead times of north of 20 weeks.

Unidentified Analyst

Right and what is the current level of availability on the revolver?

Denny Oates

$45 million, $50 million.

Unidentified Analyst

Okay, so in other words, it’s the same as it was at the end of the first quarter roughly?

Denny Oates

Yes, $40 million to $50 million, yes.

Unidentified Analyst

Okay and given the way nickel and some of the other raw materials are bouncing around in price, do you anticipate any inventory charges in the LIFO or anything that charges in the rest of the year?

Denny Oates

We are not a LIFO company, we are an average close company. So we take reserves for inventory as it ages and we do it lower cost to market type calculation.

Unidentified Analyst

Okay, thank you. That’s it.

Operator

And our final question for today comes from Phil Gibbs from Keybanc Capital.

Philip Gibbs – Keybanc Capital Markets

Thanks, just had a couple of follow-ups. Your capital spending, Denny in the second half and in 2014, I guess it’s a two-part question, how should we think about the asset level and are there some cost efficiency projects that you will be looking at?

Denny Oates

The rest of this year, I would say $6 million, $7 million in capital in the third quarter and fourth quarters together not individually. We haven’t completed a hard budget for 2014, but at this point in time, obviously we’ve got significantly lower capital requirements with North Jackson’s build out largely completed at least the first phase of it.

So we are going to be somewhere around depreciation. If you push me for a number right now, but we may change that, just you know in the third quarter when we go through our formal budgeting process and take a look at things.

In terms of the capital projects that we are actually spending money on right now, we are focused on strategic capital projects, by that I mean things that we really need in order to support our growth that we anticipate in 2014. So for example, we need some homogenization in heat treating capacity in order to support the volumes we expect.

So we’ve got a $1.7 million homogenization furnace coming in. That’ll be an example of a strategic capital investment and other capital investments, I would characterize as more reliability. So on our bloomer here in Bridgeville which is a very critical part of our manufacturing process.

We have the new control package and some other improvements and upgrades will take place. But we are talking about, in the case of the homo furnace about $1.7 million and in the case of the Bridgeville upgrades, about $2.3 million , $2.4 million. So they are not super-duper large projects. But that’s the kind of things we are investing in. Otherwise, we are kind of pulling in our horns and waiting and seeing how business to play out.

Philip Gibbs – Keybanc Capital Markets

Okay, and Mike, should we see any more of these tax benefits going forward or should we start to bake in a more normalized kind of mid 30 tax rate?

Mike Bornak

I’m – bake in more normalized tax rates going forward.

Philip Gibbs – Keybanc Capital Markets

Okay. Thank you very much.

Denny Oates

You are welcome.

Operator

Thank you. This concludes our Q&A session. I would like to hand the conference back over to Mr. Oates for any closing remarks.

Denny Oates

Okay, I’d like to thank everybody for joining us today. While market conditions have been challenging thus far in 2013, I want to ensure everyone, we are continuing to pursue all available opportunities while moving relentless forward in executing our strategic plan. And we’ll look forward to updating you on our performance over the summer months this fall. Have a good summer.

Operator

Ladies and gentlemen, thank you for participating in today’s conference. This concludes our program. You may all disconnect and have a wonderful day.

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