Universal Stainless & Alloy Products Inc. (NASDAQ:USAP)
Q3 2013 Earnings Conference Call
November 4, 2013 10:00 am ET
Dennis Oates – Chairman, President, Chief Executive Officer
Michael Bornak – Chief Financial Officer
June Filingeri – Comm-Partners LLC
Michael Gallo – CK King
Good morning ladies and gentlemen and welcome to the Universal Stainless Third Quarter conference call. At this time, all participants are in a listen-only mode. Later we will conduct a question and answer session and instructions will be given at that time. If anyone should require assistance during the call, please press star then zero on your touchtone telephone.
I would now like to introduce your host for today’s conference, June Filingeri. You may begin.
Thank you, Mercy. 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 third quarter 2013 results reported this morning. With us from management are Denny Oates, Chairman, President and Chief Executive Officer; Mike Bornak, Vice President of Finance and Chief Financial Officer; Paul McGrath, Vice President of Administration and General Counsel, and Chris Zimmer, Vice President of Sales and Marketing.
Before I turn the call over to management, let me quickly review procedures. After management has made formal remarks, we will take your questions. The 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 these formalities out of the way, I would now like to turn the call over to Denny Oates. Denny, we are ready to begin.
Thank you, June. Good morning everyone. Thanks for joining us here today. As we reported this morning, net sales for the third quarter of 2013 were $48.5 million, an increase of 13% from the 2013 second quarter on 15% higher volume. Compared to the third quarter 2012, sales and shipments fell 21% and 15% respectively. The sequential improvement in our third quarter sales and volume came from three of our four key markets: aerospace, power generation, and oil and gas. The exception was the heavy equipment market where our sales and volume were down due to seasonally lower tool steel shipments.
Our sequential top line improvement in the third quarter was accomplished amid persistently difficult industry conditions that have included tight inventory management and destocking in the supply channel, soft raw material pricing, and short mill lead times that encourage customers to reduce and delay orders. Given market conditions, we took further actions to reduce spending, lower plant operating rates, and to reduce debt levels during the third quarter.
Despite our top line improvement, several factors took a toll on our profitability in the third quarter, namely the mismatch of falling surcharges versus material costs contained in shipments, a short-term shift in our product mix to lower margin semi-finished products, and reduced manufacturing utilization which drove more fixed cost through the P&L.
While we flexed production down in response to market conditions, we also made the decision to keep most of our newly trained workforce in North Jackson intact to continue working on customer approvals, cross-training in preparation for 2014, refining operating practices, and commissioning some recently installed finishing and testing equipment. Taken together, these were the primary factors that produced a decline in our gross margin to 5% of sales in the third quarter of 2013. The lower gross margins and flat selling, general and administrative expenses contributed to our operating loss of $2 million and a net loss of $1.7 million, or $0.25 per diluted share.
The actions we took to flex down our production along with initiatives to reduce spending and inventory levels were successful. We generated positive cash flow from operations of $11.5 million for the quarter. In turn, we paid down $8 million of bank debt.
Backlog before surcharges at September 30, 2013 was $40 million versus $49 million at the end of the second quarter. Bookings in July and August showed little improvement over the second quarter; however, bookings have improved over the past two months. We are pleased to report that our current backlog includes initial bookings under our long term agreement with Rolls Royce. Additionally, our backlog includes 17 customers who have placed orders for vacuum induction melted products produced at our North Jackson facility.
Turning to some additional developments in the third quarter, we continued to add to our customer approvals in the quarter and were pleased to announce a long-term agreement with Haynes International last week. The agreement leverages both North Jackson’s vacuum induction melting capacity and the hot working capabilities of the radial forge. In turn, we will benefit from the technology expertise of Haynes to accelerate the development of advanced alloys.
We also added to our critical industry accreditations in the third quarter with the achievement of both Nadcap and ISO 17025 certifications for lab testing in Dunkirk. With these latest certifications completed, we have demonstrated our competence in manufacturing and testing technologically advanced products in support of our long-term strategy. Our teams are doing an outstanding job at each facility in securing these certifications to prepare Universal to penetrate higher margin segments of growing markets.
Let me take a look at our end markets, beginning with aerospace. Aerospace remained our largest market in the third quarter, increasing to 59% of total sales from 58% in sales of the second quarter of 2013 and 53% of sales in the third quarter of 2012. While our aerospace sales and volumes were lower by 12% and 7% respectively compared with the third quarter of 2012, they demonstrated strong sequential growth. In total, aerospace sales were up 15% from the 2013 second quarter and volume was up 19%. In fact, both our sales and shipments to aerospace were at their highest levels since the third quarter last year, despite the destocking that has been particularly evident in the aerospace channel.
There are a number of factors supporting and potentially bolstering the metal usage rate in aerospace going forward. General Electric, for example, reported a four-fold increase in commercial engine orders in the third quarter, including orders for the CFM LEAP-X engine, which are engines for the 737 Max and the A320 Neo, as well as orders for the GE90 for Boeing’s 777. GE also reported a 25% increase in spare parts shipments and orders, a 23% increase in overhauls, and a 9% increase in parts bookings, all of which suggest increasing activity in the aerospace aftermarket.
News from Boeing was also very positive. Boeing booked an additional 200 commercial airplane orders in the third quarter, bringing their backlog to nearly 4,800 airplanes. Deferrals are lower than normal, requests to accelerate airplane deliveries are running at a, quote, healthy pace, end quote. There was good news on the production rates as well. Boeing confirmed being on track to increase the current production rate on the 787 from six per month to 10 per month by the end of the year, and they will move it from 12 per month in 2016 and 14 per month before the end of the decade. This past Thursday, Boeing announced a production increase on the highly successful 737 to 47 airplanes per month in 2017. That’s a 50% increase from its production level in 2010. The current rate is 38 airplanes per month and is scheduled to increase to 42 per month in the first half of the coming year. Clearly the move to replace aging aircraft with more fuel-efficient airplanes continues to be a key demand driver in aerospace.
Meanwhile, Airbus has exceeded its 2013 target to reach 1,000 orders, and they did it three months early. They also won an important victory with their first order from Japan Airlines. The order is for 31 A350s which will be powered by Rolls Royce Trent engines. Our agreement with Rolls Royce is for aerospace grades of steel, so we view this as good news all around.
Power generation was our second-largest market in the third quarter of 2013, representing 13% of sales compared with 11% in the second quarter of 2013 and 14% in the third quarter of 2012. We experienced strong sequential improvement in power generation sales and shipments in the third quarter. Sales were up 41% from the second quarter of 2012 on 48% higher shipments; however, sales and volume were below the third quarter last year by 23% and 5% respectively.
Our sequential growth was driven by a strong pickup in quick turn turbine maintenance business following peak level operations in the summer months. Unfortunately, there are still few signs of a meaningful recovery in new turbine demand. GE reported booking 27 new orders for heavy duty gas turbines, bringing their total orders for the year to 59. GE had 82 new orders by the end of the third quarter last year. One piece of good news is that GE won a 26 unit order for Algeria and they also confirm they are comfortable with their booking 100 to 115 industrial gas turbines for the year. GE also noted a pickup in quoting activity for gas turbines in North America. Even so, we continue to expect maintenance to be the main source of our power gen sales for a few more quarters.
Oil and gas market sales represented 10% of third quarter sales, which matched the second quarter 2013 but was below 19% of sales in the third quarter of 2012. Similar to both aerospace and power generation, our sales and volume in oil and gas demonstrated strong improvement over the second quarter of 2013 but declined from the third quarter of 2012. Specifically, our oil and gas sales were up 13% sequentially on 30% higher volume, but sales were 57% lower in the third quarter of 2012 on 45% lower volume.
There is also some good news from each of the majors in oil service. Schlumberger, Halliburton and BakerHughes all reported record third quarter revenues driven by strong international business and seasonal recovery in Canada. Schlumberger and Halliburton also reported increased deep water activity in the Gulf of Mexico, the kind of hostile environment where our products are needed. It is too early to say that destocking has finished in oil and gas, but inventories seem to be coming into better balance and the longer term outlook remains as positive as ever.
Heavy equipment market sales represented 9% of third quarter sales versus 13% in the second quarter of 2013, and 8% of sales in the third quarter of 2012. Sales in this category declined 25% from the second quarter on 26% lower volume, and sales were 13% lower than in the 2012 third quarter despite a 4% increase in volume. The third quarter normally slows due to plant outages. As was the case last year, tool steel products accounted for more than 90% of our heavy equipment sales in the third quarter. Tool steel consumption is mainly driven by automotive manufacturing, including model changeovers as I mentioned many times before. 2013 has been a good year for the oil companies, especially due to the demand for new orders in North America. On the other hand, the off-road market has been difficult this year, as witnessed by the weak third quarter results reported by Caterpillar last week. On balance, our customers are expecting continued solid demand for tool steel in 2014 due to the positive automotive end market.
Let me turn the call over to Mike Bornak for his financial review.
Thanks Denny. As Denny indicated, our third quarter 2013 net sales were $48.5 million, which is a decrease of approximately $12.9 million or 21% when compared to the third quarter 2012 net sales of $61.4 million. This decrease in net sales primarily corresponds to a decrease in our overall shipments as we shipped 9.8 million tons in the third quarter of 2013 compared to 11.6 million tons in the third quarter of 2012, a decrease of approximately 15%. Sequentially, our net sales increased by $5.6 million or 13% from the second quarter of 2013 primarily as a result of a 15% increase in tons shipped. On a year-to-date basis, our net sales were $140.5 million, down approximately 31% from the same prior period primarily due to the business climate we are currently operating in.
Our gross margin in the third quarter of 2013 was $2.4 million or 5% of sales compared to gross margin of $9.3 million or 15.2% of sales in the third quarter of 2012. The decrease from the prior period is primarily due to the higher shipment volumes in the third quarter of 2012 and lower operating activity in the most recent period. Sequentially, our gross margin as a percentage of sales decreased from 12.4% in the second quarter of 2013 to 5% in the third quarter of 2013. Our third quarter 2013 margins were primarily impacted by three factors: one, lower volumes on manufacturing activity; two, lower fixed cost absorption; and three, less favorable product mix and lower raw material surcharges.
Let’s take the first factor of lower volumes in manufacturing activity for the quarter to put things in better perspective. In response to industry conditions, during the third quarter of 2013 we made a conscious effort to reduce our inventory levels to generate cash and repay a portion of our loan obligations. As such, we reduced our overall melting operations. In addition, with major equipment commissioning now basically behind us, and with adequate inventory levels to pursue customer approvals, we deliberately ramped down our production at our North Jackson facility. Since we are have vacuum arc re-melting capacity at three of our four locations, at North Jackson during the quarter we ramped down both our vacuum arc re-melting and vacuum induction melting significantly as we feel we have adequate inventory on hand to complete customer requirements. We also saw a 24% reduction in pounds running across the dies in our forge operation compared with the second quarter.
Even at these lower levels of production, we made a tactical decision to maintain our newly trained North Jackson workforce, although at reduced work hours and by utilizing flexible schedules in order to further accelerate customer approvals of our newer products. Under these reduced operating levels, we were unable to absorb as much fixed cost as we would have if we would have been operating under normal production levels.
The second factor that impacted our gross margins is partially attributable to the reduced fixed cost absorption that I just mentioned. Because we planned to reduce both inventory and production levels while maintaining certain workforce levels to finish customer trials and approvals, we did not absorb as much of certain fixed costs in the inventory, such as depreciation expense, compared to the second quarter of 2013. Therefore, we incurred approximately $800,000 of period costs in the third quarter of 2013 compared to the second quarter.
The third factor was that approximately 60% of our product sold during the period was melted in prior quarters, including earlier this year and late last year when our material costs were higher, especially nickel. Therefore, we had a misalignment in the surcharges that we passed on to our customers. In addition, compared to the second quarter of 2013, we had a less favorable product mix of products sold in the third quarter that impacted us by approximately $900,000 compared to the second quarter of 2013. These three factors, coupled with normal selling and general administrative expenses for the third quarter of $4.5 million contributed to our operating loss of $2 million compared to $4.7 million operating income during the third quarter of 2012.
In the third quarter of 2013, we recognized as other income a benefit of approximately $400,000 as the result of a final settlement of an escrow account for the North Jackson facility as well as a tax benefit of $652,000 related to our pre-tax loss. Our net loss for the third quarter of 2013 was $1.7 million or $0.25 per diluted share on approximately 6.9 million diluted shares outstanding. In comparison to the third quarter of 2012, we posted net income of $2.7 million or $0.38 per diluted share on approximately 7.4 million of diluted shares outstanding.
As I mentioned previously, we made a strategic decision to reduce our inventory and repay a portion of our bank obligations during the third quarter. If you look at our balance sheet compared to the end of the second quarter, our overall inventory levels are down approximately $12.5 million while our accounts receivable balance is up $5.2 million on the higher sales level for the quarter. During the third quarter, we generated cash from operations of $11.5 million and repaid approximately $8.8 million in long term debt obligations.
During the third quarter of 2013, we spent $3.4 million on capital expenditures compared to $10.7 million during the third quarter of 2012. Over the first nine months of 2013, we have spent $10.4 million in capital expenditures compared to $30.7 million over the first nine months of 2012. The lower capital spending when compared to the prior year is primarily due to the completion of assets placed in service during the latter half of 2012 and early 2013 related to our North Jackson facility, as well as delaying certain capital projects until market conditions improve.
Lastly, as we expect weaker industry conditions to persist through the remainder of 2013, we are in the process of finalizing a new amendment to our credit facilities with our bank group which will provide us greater flexibility as we move into 2014.
That concludes my report. Denny, I’ll turn the call back over to you.
Okay, thanks Mike. In summary then, we saw sequential improvement in our sales and shipments to three of four key end markets in the third quarter despite continued challenging industry conditions. Bookings in July and August indicated little improvement in market conditions and supported our plans to take additional steps to reduce spending, lower work in process inventories, and generate cash. A short-term shift towards lower margin semi-finished product sales, the mismatch between surcharges and raw material costs, and reduced manufacturing levels took a substantial toll on our gross margin in the third quarter.
The third quarter was also a period of tangible progress in the execution of our long-term plan and our strategy to move to technologically advanced alloys. That progress included the lengthy and costly process of achieving industry accreditations. We also earned important customer approvals in the quarter and we were pleased to announce our new long-term agreement with Haynes which will leverage our vacuum induction melting capacity and forge capability in North Jackson. We kept our North Jackson workforce intact in the third quarter to continue to pursue customer approvals, even as we flexed down production where we could match industry conditions.
So where does that leave us at this point? In September, our bookings increased 5% over the trailing three months. In October, our bookings were 36% higher than the trailing three months and 23% higher than October of 2012. Many of these new orders have 2014 shipping dates; therefore, we see continuing challenges in the fourth quarter with expanded customer closures for the holidays and aggressive year-end inventory management. However, our current bookings clearly reflect early signals of improvement as we move into 2014.
A potential headwind for the positive customer and market trends in 2014 is the recent announcement by a customer to begin in-sourcing requirements currently provided by Universal. The exact impact and timing are not yet known. At this point, we will keep you posted and we are working cooperatively with our customer on a smooth transition for both companies. In the meantime, we remain focused on operational improvements, customer approvals, and preparing for a stronger 2014.
We’re now ready to take your questions.
Question and Answer Session
Thank you. [Operator instructions]
Our first question is from Michael Gallo from CL King. Your line is open.
Michael Gallo – CK King
Hi, good morning. Denny, a couple questions. You mentioned some business you’re doing that’s going to be in-sourced, it looks like, by a customer. Can you give us some framing around how much revenue there is right now, what the timing of a transition might be? Would this be something that would start to come out of the revenue in the first quarter of next year?
I don’t have a great deal of clarity on that. We saw the announcement – this is basically Carpenter’s Talley operations that was announced last Tuesday, so it’s targeted for 2014.
Michael Gallo – CK King
And about how much revenue are you still doing with Talley at this point?
If you go back historically, it’s in the range of $20 million a year.
Michael Gallo – CK King
Okay. And you expect that all that will be in-sourced, or there will be a period where it will transition?
I think both companies need to work together to figure out how that’s going to work at this point in time.
Michael Gallo – CK King
Okay, so still kind of to be determined.
Yes. These are semi-finished billet sales that typically are in a lower quartile of our profit profile.
Michael Gallo – CK King
All right, okay. Second question I have, just on the fourth quarter. Would you expect sales to be down sequentially, given the holiday shut-downs and things, or would you expect with a little bit better order entry that you’d see some improvement? What should we look for in the fourth quarter sales?
I think sales will be somewhat below where we were in the third quarter. The wild card in that, you already identified, and that is how severe will the shut-downs in December be on the part of our customers as they manage inventory. On the one hand from a positive standpoint, there are several instances given our short lead times where we’re getting orders that we can still deliver in the fourth quarter. We’re not out of the 2013 fourth quarter shipping window. On the other hand, there’s increasing signals that you’ll see an expanded effort to basically shut down receipts early in December on the part of several of our customers.
So as we look at the fourth quarter, we’re not planning on sales going up. We see sales coming down relative to the third quarter, but there is still an opportunity to make that delta a lot smaller.
Michael Gallo – CK King
Right. And in terms of just the gross margins, obviously a lot of reasons – Mike highlighted some difficulties in the quarter. But some of those reasons, I guess look like they’re obviously going to recur in the fourth quarter, particularly lower volumes and obviously maintaining the work force at Patriot. So what kind of gross margin expectations should we have, that it will be somewhat better than the third quarter but maybe not as good as the second quarter?
Well, let’s take it one piece at a time. As far as the mix issue goes with heavier semi-finished, that should be less significant in the fourth quarter than in the third quarter. As far as the mismatch of surcharges, if you look at nickel prices, nickel prices have come down but tended to stabilize over the last several months, so you’ll see less of a delta there. From an operating standpoint, we’ll be operating at or better than what we did in the third quarter, so our expectation is you should see—we should be at or slightly better than the gross margins you saw in the third quarter, but not back to historical levels.
Michael Gallo – CK King
So kind of a high single-digit number? Would that be a reasonable expectation, Mike?
Michael Gallo – CK King
Okay, and then final question for Mike – I mean, obviously the trailing 12-month EBITDA number’s come down quite a bit. You mentioned amending the credit facility. Are there any add-backs that you could call out? I guess looking at the numbers on the surface, it would look like you would have been above the 3.75 coming out of the third quarter, so any framing around what the credit facility EBITDA calculation is and whether you think you can liquidate more inventory in the fourth quarter in order to bring the consolidated leverage down? Thank you.
Yes, the trailing 12-month EBITDA was right around $19 million. We fell a little short on the leverage ratio at the end of Q4, and then we approached our banker given the weaker conditions that we see in Q4. What this basically is going to do is provide us a little bit more flexibility on the timing of certain covenants while allowing us better borrowing capacity to meet working capital requirements as business conditions improve. So that’s the two things you should see in the amendment to the new agreement.
Michael Gallo – CK King
Okay, so it sounds like it’s basically done at this point; it’s just a matter of hammering out the final details?
Yes, we’re hoping to finalize it before we file our 10-Q, either later this week or early next week.
Michael Gallo – CK King
Okay. And in terms of inventory, can you bring that down further? Should we expect that to come down further in the fourth quarter?
I don’t think you’re going to see a material decrease in inventory in the fourth quarter, given the pick-up in our bookings that we’ve seen over the last month and a half, two months, and we’re beginning to get vacuum induction melting orders for 2014 as reported on the last call, Mike.
Michael Gallo – CK King
Okay, so we should expect that to kind of flatten out.
Michael Gallo – CK King
All right, okay. Thanks very much.
As a reminder, if you have a question at this time, please press the star then the number one key on your touchtone telephone.
Thank you. I’m not showing any further questions in the queue. I will now like to turn the call back to Dennis Oates for closing remarks.
Okay, well thank you very much for joining us this morning. Obviously it was a very challenging third quarter. As we look at the business, we do see some improving trends from a booking standpoint. As we work through the fourth quarter, we’ll be working on further customer approvals, getting ourselves ready for a better 2014. Have a good day.
Ladies and gentlemen, this does conclude today’s conference. You may now disconnect. Thank you.
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