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A. M. Castle & Co. (NYSE:CAS)

Q3 2013 Earnings Call

October 29, 2013 11:00 am ET

Executives

Scott J. Dolan - Chief Executive Officer, President and Director

Stephen James Letnich - Chief Commercial Officer

Scott F. Stephens - Chief Financial Officer, Vice President of Finance and Treasurer

Analysts

Edward Marshall - Sidoti & Company, LLC

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

Luke Folta - Jefferies LLC, Research Division

Brett M. Levy - Jefferies LLC, Fixed Income Research

Philip Gibbs - KeyBanc Capital Markets Inc., Research Division

Operator

Good morning. Thank you, everyone, for joining us for A.M. Castle's Third Quarter 2013 Earnings Conference Call. By now, you should have received a copy of this morning's press release. If anyone still needs one, please call our office at (847) 349-2510, and we'll send you a copy immediately following the conference call. The press release and the company's filings are available on the company's Investor Relations website.

With us from the management of Castle this morning is Scott Dolan, President and CEO; Scott Stephens, Vice President of Finance and CFO; and Steve Letnich, Chief Commercial Officer. As a reminder, this call is being recorded.

Certain information relating to projections of the company's results that will be discussed during today's call may be characterized as forward-looking under the Private Securities Litigation Reform Act of 1995. Those statements are based on the current expectations and assumptions that are subject to a number of factors that could cause actual results to differ materially.

Additional information concerning these factors is contained in the Risk Factors section of the company's most recent Form 10-K, as amended for 2012, and also in the cautionary statement contained in today's release. The company does not undertake any duty to update any forward-looking statements.

This presentation also includes certain non-GAAP financial measures in an effort to provide additional information to investors. All non-GAAP measures have been reconciled to the related GAAP measures in accordance with SEC rules. You will find the reconciliation in the financial information attached in today's release, which is available on the company's website at www.amcastle.com under the Investors tab and in the Form 8-K submitted to the SEC.

And now, I'll turn the call over to Scott Dolan. Go ahead, Scott.

Scott J. Dolan

Thank you. Good morning, everyone, and thank you for joining the call today. Let me start by outlining how we have structured today's call. I will provide a brief overview of our third quarter 2013 results as well as a restructuring and operations update. Our Chief Commercial Officer, Steve Letnich, who joined us earlier in the third quarter, will speak to the status of our sales initiatives and commercial objectives. Scott Stephens, our CFO, will then discuss financial results and current business conditions for the third quarter. I will comment on our outlook for the fourth quarter, and then we will open up the call for questions.

The company reported third quarter 2013 EBITDA of $5 million or 2% of net sales. Net loss for the third quarter was $7 million or a loss of $0.30 per diluted share. Third quarter sales of $254 million were down 17% from the prior year and 7% from the second quarter of this year. The lower sales level in the current quarter reflects lower sales volume and pricing in the Metals segment compared to the prior year period and the second quarter of this year.

In terms of vertical and market performance, the third quarter results generally reflected a continuation of the trends that we saw in the first half of the year. Third quarter aerospace sales remained flat compared with the second quarter of this year. Industrial market sales were lower than the second quarter this year as pricing continued to be under pressure, and we saw smaller order sizes.

Oil and gas market activity in the third quarter was our weakest market when compared to the second quarter this year. In addition to uneven demand throughout the year, particularly in downhole bar product applications, third quarter results were impacted by our commercial integration that was completed during the quarter.

We generated $10 million of cash flow from operations in the third quarter and $66 million in the 9 months ended September 30, '13. Replacement cost inventory has been reduced by $65 million year-to-date and by $5 million in the third quarter. In addition, we achieved structural cost reductions from our restructuring activities consistent with the plan we communicated in January of this year.

We are committed to continuous improvement and we evaluate our opportunities daily to reduce cost and improve performance. We are focused on managing the aspects of our business that are within our control to mitigate the impact of the challenging market conditions. As part of our efforts to realize cost efficiencies, we are closing 4 plants and consolidating these operations into existing facilities located in the same city. These closures will begin in 2013 and continue through 2014. We expect to incur approximately $2 million to $3 million of charges in the fourth quarter of 2013 related to moving and relocation costs for these consolidations and anticipate $8 million to $10 million of annual operating expense savings related to these closures. We estimate $4 million of annual savings to be realized starting in the first quarter of 2014 and the balance of the cost savings to be achieved ratably across 2014.

In our Plastics business, we achieved 7% sales growth in the third quarter of 2013 compared with the third quarter of 2012, primarily due to increased volume in the automotive, life science and marine sectors. We expect continued growth from these businesses for the fourth quarter of this year. Overall, we expect the Plastics segment to contribute positively to free cash flow and earnings in the fourth quarter.

Now I will recap our observations of our key end markets for the third quarter of 2013 and what we have seen so far this year. When we look at our revenue decline year-over-year, the majority of the decline is due to the nature of our late cycle business and our customers' business being down. However, we also believe that we can do more on our end to improve our flexibility and product diversity, which will benefit our operations throughout the cycles.

Historically, we have been more focused on maintaining current business and GP percentage in softer markets, causing lower volumes and higher operating costs. Going forward, we need to focus on GP dollar growth, which will increase operating margins.

We have a plan to expand our business with existing customers as well as grow our customer base and product offerings. Moving forward, we believe that by getting even closer to our customers, we can expand our product offerings and leverage a more cost-efficient infrastructure. These ideas directly relate to our commercial realignment, and Steve Letnich will talk more about our commercial initiatives in a few minutes.

As we've spoken about before, we monitor 3 primary macro data points for our business: the PMI, rig counts and aerospace build rates. Average PMI for the third quarter was 56, indicating a substantial expansion in the U.S. manufacturing sector compared to the first half of 2013. Third quarter 2013 PMI was the highest quarterly average PMI since the second quarter of 2011. As we have said before, the late-cycle nature of our customers' business is such that historically, our net sales lagged the PMI trend line on a 6- to 12-month basis.

We've seen some positive signs in aerospace market for the past 9 months with new aerospace industry backlog order and delivery records being set during the first half of 2013, but many of the large commercial jet manufacturers are experience inventory overhang. We've also implemented several improvements in our aerospace business execution and we expect to see more positive results out of this part of our business going forward.

The industrial market for us is an area that has pockets of both strength and weakness. Several broad-based industrial customers remain active, while mining equipment and some heavy equipment customers remain significantly slower. As a quick reminder, our Metals business has very little exposure to the automotive industry. Therefore, our short-term market outlook on the industrial side remains cautious. But with our broad range of products and focus on specialty metals as well as the value-added nature of our business, we believe we are well positioned for success as the broader industrial market begins to recover.

Rig counts in North America improved slightly in Q3 compared to Q2 trends, but remain lower than trends were in the prior year. The year-over-year decline in rig counts is indicative of our lower oil and gas sales this year. However, we remain confident in our market position and the global opportunities in this key market and continue to position ourselves to capitalize when it rebounds. We have integrated our oil and gas commercial teams and we have solid commercial leadership in place.

Going forward, we are empowering our local sales team with more flexibility react to the market and ensure we are keeping volumes intact. In addition, we will be looking to expand our customer base and our product offering in response to our customers' needs. Greater product diversification should help us compete more effectively across all of our markets.

Nothing has changed structurally with our position in the market, and the restructuring activity that we have executed have had very little impact on our revenue performance this year. However, the actions we are in the process of implementing now across our commercial organization are designed to improve our performance in both the strong part of the cycle and to reduce the level of downside we have experienced during softer markets.

During the third quarter, we began to execute on a number of important commercial initiatives. These included the addition of Steve Letnich, our Chief Commercial Officer, who joined the company in July. We also were busy in the deployment of local market inventory to drive service levels and local market sales. Lastly, we drove a full Metals product rollout and executed on a number of training programs across our southern regions.

Let me now hand the call over to Steve, who will provide more insight into our sales transformation and commercial objectives.

Stephen James Letnich

Thanks, Scott. I'm honored and excited to have the chance to help lead A. M. Castle into the future. My past few months here have been busy with sales force evaluations and customer visitations, which have provided a foundation for our plans to profitably grow revenue and expand market share. I've been in the metals industry for 20 years, so I know this space very well and I'm committed to playing a role in expanding Castle Metals portfolio of customers, products and value-added services. I've inherited a great team with tremendous potential, and I'm confident in their ability to successfully execute our plans. We will continuously train and evaluate the team to ensure that we have the right people in the right roles that are empowered to make local decisions. We have established clear performance expectations supported with transparent daily metric tracking to ensure all levels of the commercial team are accountable for results.

As Scott mentioned, we need to improve our sales efforts to better position the company for the coming rebound in both the specialty- and commodity-grade metal markets. Castle Metals is a provider of innovative supply chain solutions across a diverse array of products and services. We aspire to be much more than a specialty metal distributor. We are improving our business diversity by empowering local commercial teams to be more flexible with pricing strategies, width and depth of inventories and delivery lead times inside their local markets.

The sales strategy initiatives detailed in my comments are summarized on Slide 5 of the supplemental slides posted on our website. We made a lot of progress with the implementation of our sales strategy during the third quarter of 2013 and expect to complete most of our initiatives in the fourth quarter of this year. The sales team is being realigned into geographic regions and territories. The realignment creates efficiencies by not only increasing a territory manager's daily call density, but also expanding the time they have to engage all levels of our customers' business to improve our knowledge and provide customized solutions. I expect the realignment to result in an increase in active accounts, sales volumes, gross profit dollars and market share across a broader range of products and services. Additionally, I expect to see significant increase in the volume of calls to our core aerospace and oil and gas markets now that the whole sales team can sell to these accounts.

I'm excited to announce that we have successfully recruited Chris Sekella as our new Vice President of Strategic Accounts in the third quarter. Chris spent over 20 years at Worthington Industries in a progressive sales and general manager roles. Chris will lead our strength and strategic account team to leverage our global locations and provide large OEMs, who typically have centralized purchasing and multiple manufacturing locations, with a one-stop shop for innovative supply chain solutions.

The realignment to a geographic base sales structure will be supported by an improved collaboration with marketing, driving more customer touches and qualified leads for our sales team to develop into long-term, loyal customers.

Looking forward to 2014, we will continue to coach and delegate decision-making down to the local level. We will expand our efforts in aligning inside sales and outside sales and teams to deepen our customer knowledge and exceed our customers' expectations every day. This will enable our field sales teams to not only make daily decisions on pricing, inventory levels and customized service offerings, but will also provide them with the tools necessary to measure progress and make timely adjustments to our plans.

As Scott mentioned, it will take some time to recognize the full benefits of the sales force initiatives and continuous improvement plans, but they will position us to operate more effectively for our customers.

Now I'll turn the call over to Scott Stephens for a recap of the financials.

Scott F. Stephens

Thanks, Steve. Good morning, everyone. Third quarter consolidated net sales of $254 million were down 17% compared to the prior year period. Third quarter sales were lower in Metals and higher in Plastics compared to last year.

Net sales in the Metals segment of $220 million were down 19% per day compared to the third quarter of 2012, reflecting a 16% volume decline and a 3% overall price decline.

In the Plastics segment, third quarter 2013 net sales of $34 million were up 7% versus the prior year period, primarily due to increased volume in the automotive, life science and marine sectors. Operating income in the Plastics segment was $1 million in the third quarter of 2013, which was comparable to the prior year. To reiterate what Scott said earlier, the Plastics business continues to perform well and we expect it to contribute positively to our cash flow and profitability moving forward.

Consolidated gross material margins were 26.4% in Q3 of 2013 compared to 26.3% in Q2 of this year and 25% in Q1 this year and also compared to 28.3% in the prior year third quarter. We would expect gross margins to remain comparable to recent levels for the balance of this year.

Gross material margins for the third quarter included $2 million of LIFO income and $0.4 million from commodity hedge gains. The third quarter 2012 gross material margin included $4 million of LIFO income and $1 million of commodity hedge gains. Based on current projections for inventory levels, inventory mix and commodity pricing, we anticipate a full year LIFO credit of approximately $7 million, which would represent about $2 million of LIFO income in this year's fourth quarter.

Excluding $1 million of restructuring charges incurred in Q3 2013, consolidated operating expenses decreased 9% from $76 million in the third quarter last year to $69 million in the third quarter 2013.

Compared to a year ago, we achieved a 6% quarterly reduction in warehouse processing and delivery expense and a 14% quarterly reduction in SG&A expenses, primarily due to our restructuring initiatives.

There is minimal change in depreciation and amortization in the third quarter compared to last year. Third quarter operating expenses, excluding restructuring charges, were down $1 million or 1% compared to second quarter this year. Given the decline in sales, there was a deterioration in the operating expense to sales ratio from 25% in the third quarter last year to 27% in the current quarter.

We're achieving the majority of our structural cost savings that we anticipated, but we're not seeing this in the expense ratio due to the sales compression. We have realized approximately $13 million of structural operating profit improvement during the first 9 months of 2013 from our restructuring announced in January this year, which is in line with our expectations.

We expect to achieve the $20 million of annual structural operating profit improvement that we announced earlier this year. The announced restructuring actions were implemented to create a cost structure at 22% expense-to-sales ratio based on 2012 levels. Given the current year's sales declines, we anticipate the expense ratio for 2013 will be closer to 26%. However, when including the facility consolidations and other future planned efficiency improvements, we have a lower overall cost structure base to leverage as volume and revenue improve.

There was $1 million of pretax restructuring charges incurred in the third quarter related to the final shutdown costs for the facilities consolidated earlier this year. Cumulative pretax restructuring charges incurred through September 30 were $10 million and was consistent with our plan announced in January of this year. During the third quarter, we identified 4 additional facility consolidation plans, 1 of which will be executed within 2013 and the remainder to be implemented in 2014. These consolidations are expected to result in $8 million to $10 million of annual cost structure savings when fully implemented. We expect to incur $2 million to $3 million of charges in the fourth quarter of this year related to one of those facility consolidations.

Third quarter 2013 interest expense was $10 million and was comparable to third quarter of last year. Equity in earnings of the company's joint venture was $2 million in the third quarter 2013, which is an increase of $500,000 compared to the same period last year.

The company reported an operating loss of $3 million and a net loss of $7 million or $0.30 per diluted share in the third quarter 2013. Net income was $3 million or $0.13 per diluted share in the prior year period.

EBITDA was $5 million or 2% of net sales in the third quarter this year compared to $20 million or 7% of net sales in the third quarter 2012. Please refer to the earnings release posted earlier today for a full reconciliation of non-GAAP items.

I'll now provide a brief summary of our working capital and balance sheet results. During the quarter, we reduced inventory by $5 million, which brings our total inventory reduction during the first 9 months of this year on a replacement cost basis to $65 million. This follows the $65 million decline in inventory achieved in the second half of last year.

Earlier, we indicated our expectation for second half 2013 inventory reduction to range from $30 million to $40 million, and we are on track to achieve this reduction. Due to the decline in total sales compared to our initial projections, our inventory reduction, although consistent with our expectation in absolute dollars, is expected to result in a higher average day sales and inventory rate of 170 to 180 days at year-end, rather than our 150 DSI target. Average day sales in inventory was 177 at the end of the third quarter.

Average receivable days outstanding was 51 days for the first 9 months of 2013 compared to 49 days for the first 9 months of last year. Accounts payable days was 39 days for the first 9 months of 2013 compared to 56 for the first 9 months of 2012.

Cash provided by operations was $66 million for the first 9 months of 2013 compared to a cash used in operations of $13 million in the prior year period. Cash paid for capital expenditures was $8 million during the first 9 months of 2013 compared to $9 million during the first 9 months of last year. We're projecting annual capital expenditures to be between $10 million and $12 million for this year.

During the first 9 months of 2012, $40 million of cash generated from operations was used to pay down the remaining revolver balance to 0. We will continue to evaluate uses of cash from operations while working to improve our capital structure. Our improving balance sheet and liquidity position provides support for opportunities to create shareholder value.

Total debt net of unamortized discounts at the end of the quarter was $260 million and down 13% from the year-end balance. Cash and equivalents were $41 million at the end of the third quarter. The net debt-to-total capital ratio at the end of Q3 was 38% compared to 43% at the end of 2012.

Now I'll turn the call back over to Scott Dolan to comment on our outlook for the fourth quarter.

Scott J. Dolan

Our outlook for the fourth quarter in terms of overall end market demand is similar to what we experienced in the first 9 months of this year, and we expect typical end-of-year seasonality with our customers. Our fourth quarter sales outlook is comparable to the third quarter with opportunities for modest growth, primarily in the oil and gas and aerospace businesses and better overall sales execution. We believe we are making the right strategic decisions to compete more effectively during challenging market conditions like today and to grow the business faster and more profitably as our end markets improve. We are also confident in our ability to continue to generate positive cash flow in the fourth quarter and further enhance our liquidity and balance sheet. We remain excited about the new leadership we have added to our team in 2013 and expect that our restructuring activities and continuous improvement plans will better position the company to prosper through all market cycles.

We have achieved our inventory and structural cost reduction goals to date and now we are looking forward to executing on our commercial initiatives.

Operator, we can open up the call for questions.

Question-and-Answer Session

Operator

[Operator Instructions] We have Edward Marshall online with a question.

Edward Marshall - Sidoti & Company, LLC

My first question, I guess, is as we look at maybe some of the disruptions that you've had in the business patterns as you've shifted the verticals, et cetera and even some of the consolidation, I want to know if you could parse between maybe what the disruptions were and maybe -- what maybe is structural losses in market share that you may have had because you seem to be falling quite faster than the market itself. And that's looking at some of the closest peers and also looking at some of the service center data that's out there from a volume perspective.

Scott J. Dolan

Yes. Thanks, Ed. This is Scott Dolan. In terms of -- when we look at the MSCI data and we parse out our products, first of all, it's not quite apples-to-apples because we are more highly into specialty and some of the commodity grades that are in there, and that's part of what we're talking about in terms of diversification. But we think about 2/3 of the revenue with those products is really due to the market in terms of the products we play in. And then from there, a little bit less on the actual tons but -- when you look at the revenue associated with that. The second biggest part, I believe, in terms of the difference year-over-year is what I referenced in my comments, which I don't think -- well I know, we're not set up to participate in softer markets like we need to be. And while we want to maintain our current business and the margins on that business, if there's opportunity to get new business at lower margins to grow GP growth, we don't necessarily take advantage of that like we do today. Also, by focusing on trying to keep the margin percentage so high, we basically go to a lower order size or line item size which, from an operational perspective, increases our cost per line item. And so, we need to drive larger orders, no matter, across the cycle. The third piece is really what you alluded to, which I think is by far the lesser amount of the reduction. I'll -- as I spoke in here, we did, in third quarter, finally move forward with the full integration of Oil & Gas, have a full-time Vice President down in Houston now leading that group and have made some turnover in that group to have a real -- a fully staffed commercial group going forward. So that definitely had an impact in third quarter. As far as the verticals and sort of integrating those, we actually have seen nothing but positives where we've done that, and that's mostly been in the Southeast region where we piloted that work and we've seen the number of quotes and activity across all of our verticals really increase with that work. So when you look back at our performance, this isn't that -- and that's why we say, structurally, we believe we are in a relatively same place. When you look back historically in these types of markets, we're performing pretty typically of how Castle has performed, but that's -- one of the main objectives we have with the sales transformation is to get out of sort of being at the whim of the market or our current customer base and taking more control over not having such a downside in soft markets.

Edward Marshall - Sidoti & Company, LLC

Okay. The inventory drawdown that we anticipated, that was communicated in the second quarter, I think it was $30 million to $40 million of inventory reduction in the second half of 2013. And I think Scott Stephens, in your commentary, you mentioned that the days sales is going to fall short of what you're anticipated expectations were. Is that to say that, that $30 million to $40 million is off the table and we'll see a kind of flattish run through the rest of the year? And does that get pushed off into 2014, that additional reduction in inventory?

Scott F. Stephens

No. We've said that, in our prepared remarks, that we anticipate hitting that $30 million to $40 million in the second half. So clearly in the third quarter it was not a pro rata achievement there, but our projections have us achieving that dollar reduction in the fourth quarter. So part of that was intentional. We've made some inventory deployment decisions during the third quarter that we thought made sense for certain markets. So we expected a bit more of the reduction for the second half to be back-end loaded and in fact it is. So we'll anticipate hitting that $30 million to $40 million goal for the second half.

Edward Marshall - Sidoti & Company, LLC

And you can do that without sacrificing the -- on the gross margin? I mean, you mentioned it's kind of this, the weakness in sales that would continue into the fourth quarter. I'm assuming there's some headwinds there as far as getting that inventory off the books.

Scott F. Stephens

Right. I mean, that's the balance. Always, right? And as we said, we -- all the way back to January, we felt like 150 days, given what we anticipated in market conditions, would be a reasonable target for year-end and further improvement beyond the 150 in terms of DSI. So at the current levels, just in terms of the numbers, we don't look at our overall inventory position and feel like we're short on inventory. There's always the specific local product management going on but, no, we're anticipating hitting that reduction in the second half given the current market.

Edward Marshall - Sidoti & Company, LLC

Okay. And finally, one of the OEMs on the aluminum plate side had mentioned general and aerospace plate being a significant pricing pressure especially on the spot market for 2014. And I wanted to kind of get your two cents based on the fact that I think there's some contract negotiations both from the customer and the supplier level that you're facing right now and kind of how 2014 shapes up maybe from the different markets that you plan, and I think you're a big player in both aerospace plate as well as general engineering plate.

Scott F. Stephens

Yes, Steve will address.

Stephen James Letnich

Ed, it's Steve Letnich. We absolutely recognize that there is going to be pricing pressure on aluminum plate in general due to some inventory overhangs that several of the mills have talked about publicly. But it does play into our long-term strategy in the aerospace of going after complex subsystems that tend to be less dependent on aluminum plate unlike the main body structure manufacturers are. So hopefully, as we progress and continue to make head roads into the tiered suppliers that go into those more complex subsystems, that we can offset any pricing deterioration.

Scott F. Stephens

I think what I'll just add is that the -- what we've -- relative to your comments in the market, what we've seen is the pressure, I'll say, more focused on the general engineering products rather than -- as opposed to -- or more severe than, I'm sorry, more severe than what we've seen on the aircraft quality plate, kind of not the same.

Edward Marshall - Sidoti & Company, LLC

Right. And plate is roughly how much of the overall business?

Scott F. Stephens

Well, it's roughly 30% of the aerospace business in terms of the aircraft grade heat-treated plate.

Edward Marshall - Sidoti & Company, LLC

And the general engineering is...

Scott F. Stephens

We haven't really parsed that out but it's in the grand scheme of our industrial business. It's not significant, put it that way.

Operator

And we have a question from Dan Whalen.

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

Just my question was very related there, just on the aerospace overhang. Certainly, we've heard from the aluminum plate side. But what about more on the alloy side, is there similar overhang there? And then secondarily, is that kind of expected to be completed in kind of year-end time frame? More on the alloy side not the aluminum plate.

Stephen James Letnich

Dan, it's Steve Letnich. Based upon our supplier relationships and general market feelings, we are not seeing the significant downside on the alloy and the extrusion market that we are in the plate.

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

Okay. So this is specifically the plate. Okay. That's helpful. And then secondarily -- I apologize if you already mentioned this, got on a little late here, but can you comment about just what you've seen in the October trends so far? Just broadly speaking here.

Scott J. Dolan

I mean, I think in my comments, I would say that we're seeing a lot of what we've seen in the first 9 months of the year. So not a whole lot has changed as we've gone into -- just in terms of what we see here in Q4 versus the first 9 months.

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

Right. I'm just -- I mean, first quarter were certainly a lot stronger than third quarter. Are we somewhere in the middle there or...

Scott J. Dolan

Yes, I think the trend is kind of what we've been trending along here for the 9 months.

Operator

We have a question here from Luke Folta.

Luke Folta - Jefferies LLC, Research Division

I guess firstly, just related to the facility closures, are these all inventory-carrying, like, production type facilities? And when you think about the $8 million to $10 million cost savings, how much of that is going to be SG&A versus cost of goods sold?

Scott J. Dolan

Yes. They all are inventory-carrying locations with processing. I'd say, just to kind of break it down, 3 of them are directly due to acquisitions over time, 2 being with the TSI integration, so Edmonton and Houston, and then 1 was an acquisition that we did 15 years ago that we've just never consolidated. And then the last 1 being, I guess, you could look back to an acquisition as well in terms of Wichita with aerospace. So all very close to one another, 10 to 15 miles max, all carrying inventory. Main cost reduction is around, obviously, overhead facility costs and then better utilization of the inventory and less touches back and forth that we're having to do today in those markets.

Luke Folta - Jefferies LLC, Research Division

So most of that...

Scott F. Stephens

Luke, I would just add in terms of the income statement line items, if you want to sort of call it to that, it's predominantly warehouse processing and delivery reductions, right, because the sales folks, by and large, are going with or relocating to the new facility or staying part of the territory. So the cost reductions that we mentioned would flow through the plant and delivery expense primarily, not a significant impact on cost of material or GP.

Luke Folta - Jefferies LLC, Research Division

Okay. All right. And then just secondly, I guess the comments around going after gross margin dollars or maybe not being so stuck on gross margin percentages, I guess when we look back in the service center industry, at which models have worked and which models haven't, it seems like the -- maintain discipline on pricing, don't chase orders, stay away from large volume transactions and customers and things like that, it seems like the "seeking greater volume at the expense of pricing" approach has a long history of not working. And I just want to understand the context of what you said. I mean, I imagine that you're somewhere in the middle in terms of -- maybe you just haven't been aggressive enough. But I guess I just want to understand how you think about that trade-off and how are we positioning to not go too far in the other direction.

Scott J. Dolan

Right. No, I can appreciate the concern. One is, from our specialty business perspective, we're not -- on current business, obviously, our goal is not to reduce GP percentage on that business unless we can create operating efficiencies by getting larger orders and moving more volume through the system. But anything that we would lose in GP percentage would more than be offset in terms of efficiencies and having to handle it less times as you go through the system. Secondly, I will just say, from a pricing perspective, I think we want to make sure that we're reacting to what customers need. And so a lot of what we're talking about here is diversifying our products to more commodity type grade, that we would be at market pricing, it will generate new GP dollars that we're currently not getting in the system. So if you look at the overall kind of issue, while we've been very focused on cost takeout, we have an infrastructure and we believe a great footprint globally. We need to figure out how to fill up that footprint a lot more and really leverage the fixed cost across more volume. And that's what we're trying to do here. But we have trucks that are only being -- and are run today, are only being utilized about 30% to 40%, and we have facilities that are only being utilized 50%. And we have a lot of opportunity to grow. So those next dollars of growth that we have will be done at a significantly lower cost structure as we go forward. But we really need to mirror up the commercial side with the operations side to focus in on operating margin rather than just being so hell bent on GP percentage, which has driven a lot smaller order size and inefficiencies in the company in these softer markets.

Luke Folta - Jefferies LLC, Research Division

Okay. So just to be clear, you're not talking about reducing your margin ask on the products that you're currently stocking, you're talking about stocking more baseload type products that will drive greater efficiencies throughout the system. So it's something that's more incremental as opposed to something that's changing on your core product lines, is that right?

Scott J. Dolan

That is correct. But I would also say, on our core product line, if there's ways we can drive costs out of our system by selling it differently with maybe a larger lot size or something that can create efficiencies in the operation, we would be -- from a pricing perspective, we may do some things differently on that. But only if we could more than make up for it on the operational cost side and generate the volume we need, not just lowering it, to lowering it to be more competitive.

Luke Folta - Jefferies LLC, Research Division

Okay. All right. And on the industrial side of your business, can you talk about -- and this might be something that you've disclosed somewhere -- what the breakout is in terms of like mining versus heavy equipment versus ag and like just kind of the main pieces there?

Scott F. Stephens

We have, Luke, in reference to 10-K type of volumes. So as of a point in time, we've occasionally put that out there. On the industrial side, mining has been from typically 10% to 15% of our industrial business, heavy equipment somewhere in 8% to 10%. So heavy equipment would include the ag component that you mentioned.

Luke Folta - Jefferies LLC, Research Division

Okay. Last question. In terms of the fourth quarter margin outlook. Firstly, I didn't get catch what the hedging gain was in the third quarter. And I think you said flat gross margins in 4Q, is that on a LIFO-reported basis?

Scott F. Stephens

To the second question, yes, as reported, with $2 million of LIFO anticipated for Q4. The third quarter commodity hedge gains was $400,000, Luke, or $0.4 million.

Operator

And Brett Levy is online with a question.

Brett M. Levy - Jefferies LLC, Fixed Income Research

So if you do generate additional cash of $35 or so million, you're sitting on about $41 million of cash, it leaves you in a position where you could acquire a lot of inventory, you can make a strategic acquisition, you got 0 drawn on your revolver. Are you looking to grow organically? Or are you considering acquisitions that are sort of good tuck-ins as well?

Scott J. Dolan

Yes, I mean, our focus right now, obviously, is to fix the core business, and we believe there is significant potential here to grow organically. Our main focus in terms of the balance sheet and the cash and the capital structure is to put us in a position at sometime in 2014, as you know, the high-yield bonds, first callable in December, we want to figure out what is the right time in 2014 based on our performance, based on what interest rates are at to really finance that. We're not concerned about the level of debt but, obviously, we want to refinance that debt at a lot lower cost. Once we get all that done, then I think it will leave us flexibility to look at other alternatives. And maybe that would be in organic growth as well.

Brett M. Levy - Jefferies LLC, Fixed Income Research

I mean, would you consider doing something to take the bonds out earlier than December of -- I mean like a T-plus 50 tender or something along that line?

Scott J. Dolan

I mean we just have to balance where the rates are, where our performance is and what the make-wholes are.

Scott F. Stephens

Yes, the make-wholes are in there, Brett, so it's kind of -- it could make sense, right? It's kind of our option based on the market and NPV and all that kind of analysis. So we'll certainly be looking at that in advance of December of '14.

Brett M. Levy - Jefferies LLC, Fixed Income Research

All right. And then the last question is more of a general question. I mean, clearly, the overall volumes are down, and I'm guessing the SKUs are down. Was there a significant amount of customer breakage? And as you sort of take these steps to kind of bring back the sales, I mean, have you identified customers who have already said, "If you want to do business in this particular product" -- if you build it, will they come?

Stephen James Letnich

It's Steve Letnich, I'll take this one. What's interesting is that our SKUs really aren't down, the weight per SKU is down. So that's a direct indication that our core customers' business activities, they're only buying what they need, they're not buying in the quantities that they used to. And in terms of expanding the business, we do believe, both on a contractual and a transactional basis, the customers are buying more commodity items from our competitors and there's no reason why they can't be buying those from us. And whether we establish that as a contract or we start stocking it for general inventory locally, those are all decisions that we'll let our local people make because, ultimately, we're going to hold them accountable for growing their business in those local markets.

Operator

[Operator Instructions] And we have a question here from Phil Gibbs.

Philip Gibbs - KeyBanc Capital Markets Inc., Research Division

Just had a question from a real high level. As far as the import situation, what are you seeing there from the industry or, anecdotally, heading into the later stages of '12 and maybe into '14?

Scott J. Dolan

Yes. I mean, in the markets we play and the products we play in, I can't -- we don't see the imports having a direct effect on our business to a large degree. But I would say, clearly, it creates a cloud over the whole industry and creates weakness. And obviously, if we had a stronger market in general, not our specific markets, that would be helpful as we go forward.

Scott F. Stephens

Yes. I think that summarizes it.

Philip Gibbs - KeyBanc Capital Markets Inc., Research Division

And how are you seeing scrap prices shape up for November at this point in the U.S. market?

Scott F. Stephens

I haven't seen a November indication unless you have.

Scott J. Dolan

No, I haven't. I don't think that with -- you look at the PMI and you look at manufacturing numbers, there's not going to be an excess amount of scrap. So I don't see things changing, really going on a large upside or a large downside, I just kind of see a steady flow.

Scott F. Stephens

Phil, I just -- I'm sorry, just to go back for 1 second on the imports because that question came up before on -- or the question came up on the aluminum plate. I think that is one market, sort of to Scott's example, where we wouldn't necessarily be importing aluminum plate the way we've historically done business and for the grades that we're typically in. But we know that -- or we've -- yes, I guess, we know that the imports around the general engineering plate have been a big factor in the pricing pressure in that market and some of that overhang in inventory that was mentioned earlier. That's kind of a classic example where imports are impacting our market and impacting our business without necessarily directly impacting the way -- our supply chain, if you will. So that is one area where it's had an impact. There are some other products where that can be the case. They're kind of more exceptions than the rule, but that's one example that we have seen where we have seen an impact.

Philip Gibbs - KeyBanc Capital Markets Inc., Research Division

So Scott, on that, if pricing maybe a bit weaker on the spot side for aluminum plate, does that have any spillover effect on -- into your JSF business? Or how do we think about some of the things that may be in more contract?

Scott J. Dolan

Yes. Not so much, right? I mean, indirectly and a few steps removed, again, to the extent that it impacts the overall mill environment then, potentially, year-to-year, that's an impact. We certainly will sort of work through that. But clearly, the immediate impact is more on the transactional business and more on the, say, commodity grade, the more traded products, and we have seen that.

Philip Gibbs - KeyBanc Capital Markets Inc., Research Division

Okay. And I really appreciate all that color. And just a last one, from a high level on the oil and gas business. How should we think about that business? How it has trended through 2013? And how we should be looking at it into 2014, maybe from a volume perspective?

Scott J. Dolan

Yes, I'll take that. I'll take a -- start and Steve can add any color. But it's obviously been very choppy this year. We've seen the downhole completion side has been stronger, which is kind of the tube side. The bar, which is primarily for drilling, has been definitely softer. I think -- both Steve and I have been down in Houston, quite a bit here recently, and when you look at how we think about the demand down there, there is a viewpoint from not just sort of our customer base, but the entire industry down there that we're going to see more sort of slower but predictable growth rather than maybe the huge up and down, huge demand and then troughs and real -- a lot of variability. But we see a little bit more even growth as we go forward, which clearly positions with our size, our inventory. How we're positioned down there with a complete line of products positions us, I think, extremely well compared to maybe a lot of the smaller type startups who are more opportunistic on those really, really good periods and can't compete as well, can't compete on a steady growth perspective.

Operator

And at this time, I'm showing no further questions. Speakers, did you have any final remarks?

Scott J. Dolan

This is Scott Dolan. I think as we look at the quarter and the first 9 months of the year, I think we've clearly made progress in a lot of areas and we've really done what we said we were going to do and -- but we're -- and I hope it came through very clear. We know we need to change our front end of our business, our top line revenue, to be more reactive to whatever the market is and not just rely on good markets going forward. And we're -- once again, we're 3 months into this with Steve, lot of great changes, a lot of work going on, and we're comfortable that we'll start to see the positive results here in the future. So thanks again and appreciate your time.

Operator

And thank you, ladies and gentlemen. This concludes today's conference. Thank you for your participation. You may now disconnect.

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