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Albany International Corp. (NYSE:AIN)

Q3 2013 Earnings Conference Call

November 05, 2013; 09:00 a.m. ET

Executives

Joe Morone - Chief Executive Officer

John Cozzolino - Chief Financial Officer & Treasurer

Analysts

Jason Ursaner - CJS Securities

John Franzreb - Sidoti & Company

Steve Levenson - Stifel

JB Groh - D.A. Davidson & Co.

Operator

Ladies and gentlemen, thank you for standing by. Welcome to the third quarter earnings call of Albany International.

At this time all participants are in listen-only mode. Later, we will conduct a question-and-answer session. Instructions will be given at that time. At the request of Albany International, this conference call on Tuesday, November 5, 2013, will be webcast and recorded.

I would now like to turn the conference over to the Chief Financial Officer and Treasurer, John Cozzolino for introductory comments. Please go ahead.

John Cozzolino

Thank you, operator and good morning everyone. As a reminder for those listening on the call, please refer to our detailed press release issued last night regarding our quarterly financial results, with particular reference to the Safe Harbor notice contained in the text of the release about our forward-looking statements and the use of certain non-GAAP financial measures and associated reconciliation of GAAP and for purposes of this conference call, those same statements also apply to our verbal remarks this morning. And for a full discussion, please refer to that earnings release, as well as our SEC filings, including our 10-K.

Now, I’ll turn the call over to Joe Morone, our Chief Executive Officer, who’ll provide some opening remarks before we go to Q&A. Joe.

Joe Morone

Thanks John. Good morning everyone. As always I’ll start with some introductory remarks that amplify John’s and my commentary in the release and then we’ll get to your questions.

Q3 was a disappointing quarter due to weak sales in Machine Clothing. In many ways Q3 was similar to Q1, 2012, which was the last time we had a weak quarter. Then as now, seasonal softness was compounded by unexpected weakness in the key market. The unexpected weakness then was in Europe, this time it was in Asia.

In the typical annual Machine Clothing business cycle there are two seasonal soft spots; the beginning of the year when sales are dampened by weak shipments from late December because of holiday slowdowns in late December, and the first two months of Q3 when sales and margins are dampened by summer slowdowns.

The severity of these two seasonal soft spots depends on the strength of the overall economy. The stronger economy mitigates the softness and weaker economy exacerbates it. In Q3 all of the markets we served exhibited at least some economy weakness.

We do expect a quick rebound in Machine Clothing, just as we experienced in the months following Q1 2012. Even if Asia remains soft, the absence of a seasonal effect should result in improved performance in Q4, which is consistent with what we’re seeing through the first third of the quarter.

There will likely be a slowdown at the end of the year as our customers drive down their inventory and as we shut down our plants for the holidays, but unless our customers perceive a significant weakening of the economy and pull back even more than we are anticipating, this late December effect is likely to be reflected more in the typical slow start to the new year than in Q4 results.

And even with the slow start to the year, we expect that the first half of 2014 should be strong and for the full year 2014 Machine Clothing adjusted EBITDA and cash flow should be roughly comparable to 2012 levels.

Turning to AEC, the sales growth continued to be driven by the LEAP program, LEAP now represents half of total AEC sales. EBITDA strengthened beginning what we expect to be a long-term trend of steady improvement, and as we discussed in the release, three important recent developments in AEC that are mentioned.

First, the initial test of the LEAP engine, the so-called “first engine to test” have been very successful and our composites have performed well. Second, we expect to sign the agreement to create Albany Safran Composites very soon, probably later this week. As we discussed in the release, ASC, that is Albany Safran Composites will be a new division within, owned 90% by Albany and 10% Safran.

With this agreement ASC will be the sole source for all applications of our 3D weaving technology within Safran. Initially ASC will comprise all of the AEC people and equipment dedicated to the LEAP program. Any new parts that we’d make for Safran, whether on LEAP or on any other Safran platform will also be housed within ASC.

Excluded from ASC and housed in the other two divisions of AEC will be 3D woven parts for applications outside of Safran and all composite parts, whatever the application that utilize AEC technology other than 3D weaving.

Safran will pay $28 million worth of 10% stake, which puts the initial value of ASC at $280 million. Safran would have the option to purchase the remaining 90% of ASC, but only Albany were to sell AEC to a competitor of Safran or if ASC failed to perform and was unable to remedy the failure in a reasonable period of time.

The initial value for the remaining 90% of the AEC will be set at the current valuation of $280 million and will grow as the LEAP program grows to full production. After LEAP hits full production the valuation will be equaled to ASC EBITDA times 9.5.

The third major recent development in AEC pertains to new estimates of the size and timing of the market for LEAP. When we launched this program we had expected that the market would support 1,500 engines a year by the end of the decade. That estimate increased last year to 1,600 a year. Now CFM has publicly stated that it expects demand to grow to 1,700 engines per year by late 2018 or early 2019 and possibly to 1,800 engines per year by the end of the decade.

Boeing’s recent announcement that it plans to increase production of 737’s to 47 per month by 2017 is consistent with this larger number. Those same public statements by CFM suggest that the ramp to its larger number of engines will begin late in 2016 rather than in 2015 as I suggest in Q1.

The 2016 ramp start gives us a little more time to prepare, which is helpful, but it means that the ramp itself will be even steeper than we had anticipated, especially given the higher annual rate of production. Essentially we’ll have to ramp from very low rates of production to 30,000 blades per year in a little more than two years.

Of course all this could change again, but if it does not change the financial implications are roughly as follows. The spike in LEAP revenue and therefore AEC revenue is now expected to begin in the second half of 2016 rather than during 2015. Before the spike, that is between now and the second half of 2016, LEAP revenue should continue to grow rapidly. Full year LEAP revenue in 2016 has the potential to be roughly 80% higher than full year LEAP revenue in 2013.

Once the production ramp begins in 2016, LEAP revenue growth should accelerate sharply. Full year revenue in 2018 has the potential to be double that of full year revenue in 2016, with still more growth in 2019 and 2020. Revenue at full production should be at higher levels than we had previously estimated, reflecting the now larger estimates for the LEAP market.

Because the ramp begins late in 2016 rather than 2015, CapEx will be lower for the next two or three years than we had been anticipating. An annual average of $55 million of CapEx for the total company, that’s the total company LEAP plus other AEC plus Machine Clothing. An annual average of $55 million of CapEx for the total company rather than the $70 million annual average that we had previously estimated is now more likely for 2014 and 2015.

In sum this was a disappointing quarter because of soft sales in Machine Clothing. At the same time we do not believe the weak quarter for Machine Clothing results in a change in the outlook for this business, near or long term. Assuming the economy holds, we expect at least a partial rebound in Q4, followed by a healthy first half of 2014.

As for ACE, it continues to progress well towards that LEAP ramp, which now appears more likely to start in 2016 than in 2015 and to reach higher levels of production revenue sooner than we had been previously estimating.

Those are my opening comments. Cynthia if you could turn to our questions please.

Question-and-Answer Session

Operator

(Operator Instructions). And our first question will come from the line of Jason Ursaner with CJS Securities. Your line is open.

Jason Ursaner - CJS Securities

Good morning.

Joe Morone

Good morning, Jay.

Jason Ursaner - CJS Securities

Just excluding the customer contract change from last year, I’ve still been expecting sales performance in Machine Clothing to be closer to flat. You mentioned it came in lower due to the decline in Asia and it was across both, packaging and publication grid.

So my question is within the context of the long term positioning for the business. What’s still giving you confidence that there will be excess growth in developing markets like China that could offset secular declines when the business there now is already, I guess tracking more GDP driven.

Joe Morone

Well, as we have discussed before, the way we think about the long-term model and the reason we think this is a flat EBITDA business is – lets go beyond China.

In the Americas, growth in South America coupled with slow incremental growth in the packaging and tissue grades in North American should be sufficient to offset declines in the printing and writing grades, particularly given that we are over exposed to tissue and packaging and under exposed to printing and writing.

And then when you go over to Europe and Asia, we see essentially the same formula, while essentially Asia growth for us to have stability needs to be as fast as the European decline. If Asian growth is faster than European decline, then there is a little bit of upside, but all we need for that model to work is Asian growth to be roughly equal to European decline.

And if you look at the dynamics of paper grade, and lets say with China, now they are going to go through the same process. Printing and writing is probably already overbuilt, but the growth that gets driven by – the growth in consumption of tissue and packing grades, take food containers for example, in a growing and long term economy like China should be more than sufficient to offset the slow demise of the printing and writing grades. So we are not seeing anything fundamentally changing in any of those markets, of plus long-term sectoral trends that we’ve really built this business around.

Jason Ursaner - CJS Securities

Okay. And on the AEC ramp, I understand the push out doesn’t impact the timing of the commercialization, but my understanding was that Safran could have used the balance sheet to minimize the risk of the production ramp as it moves too full production in a relatively short amount of time. So I guess, what’s changing there that would make that less attractive to try to eliminate that risk.

Joe Morone

I think you are reading this exactly right. That if you look at sales of the LEAP engine onto the 737 MAX and the neo, the Airbus A320neo, they’ve always said that entering into service for the Airbus version would start in the second half of 2016 and entry into service for the LEAP for the MAX would be in mid to third quarter of 2017, that hasn’t changed.

So from the commercial point of view the only thing that’s changed is they are now preparing for a prospect of selling even more engines than they’ve been saying before and getting there fast.

What has changed for the time being, and we’ll see the changes again; today it appears that they were going to build an inventory of engines in advance commercial introduction, and now they are backing away from that.

And you can guess the reason, once they actually do the math and realize the amount of cash that they would be carrying to hold an inventory of engines is just – it was a big number. So I would guess that that’s what’s driving them back towards a steeper ramp rather than a smooth ramp in the first couple of years, I think its cash.

Jason Ursaner - CJS Securities

And then just last question from me; on the steepness of the ramp. I understand the estimates that are being put out there for the peak of 1,700 to 1,800 engines, but that’s still 20% to 25% higher than the current mature production on the CFM 56. So I guess just trying to stay balanced on that, should we be taking those estimates with some reservation or do you really think investors could have a pretty high conviction in those targets being achieved in a relatively short five year time period.

Joe Morone

I think that’s a very fair question. So you look for calibration between what the CFM is saying, what we are seeing from internal projections that we’re hearing and then look at how Boeing and Airbus are behaving.

And so I think the announcement last week that Boeing made, that it is going to increase its production of 737 in 2017 to 47 planes per month, is very significant and completely consistent with these new number. So if you just do the math, 47 MAXs a month times two, because we are selling two per MAX times 12 and you get to something like 1,200 engines a year by 2018, because they are going to flip over from the traditional 737 to the MAX very quickly according to all their public statements.

There is also a lot of speculation out there, which they have helped fuel in some public conversations, that they are not done at 47, that they are looking at going higher and higher at 52 per month by the end of the decade.

And Airbus has been talking about the same kind of increases. They’ve been talking publicly about going from their current 42 a month to 44 and their slots are filled and they are still getting orders.

So if you look at this, the best way to gauge the market is to just do the math around how many of these re-engines, narrow bodies, Airbus and Boeing are planning to build per month and you can quickly get to a number of LEAP that way. Assume 100% of the Boeing narrow bodies and 50% of the Airbus narrow bodies and you will get to a number that’s very consistent, even without COMAC sales, you get to a number very consistent with what CFM is talking about.

Jason Ursaner - CJS Securities

Okay, great. I appreciate the details. Thanks.

Operator

Thank you. Our next question comes from the line of John Franzreb with Sidoti & Company. Your line is open.

John Franzreb - Sidoti & Company

Good morning Joe and John. Joe, it took a while to sign the Safran agreement. Have there been any material changes from that agreement that you initially negotiated in May to the one you expect to sign next week?

Joe Morone

No changes, but it’s taking so long primarily because this agreement creates a new entity and essentially all of our employees who are currently working on LEAP shift in to this new entity, so there’s a lot of detail on that side. But no its been grinding and grinding, but there has been no material change at all. We are excited about this agreement.

John Franzreb - Sidoti & Company

Okay. And shifting to PMC, you seem to suggest you expect the first half of 2014 to be a good one. You mentioned the normal seasonality that you’d expect in the beginning of the year and orders are up in Asia. What else gives you confidence that you’re going to have positive year-over-year growth in the first half of ’14, given the current environment?

Joe Morone

Well, you just go customer-by-customer and working with our customers, develop an understanding of what their production expectations are and so its really a bottoms up analysis of what our customers are expecting of us, when that leads us to that conclusion; that’s point one.

Point two, with this shift in contract that we keep referring to, in the Americas now more than two-thirds of our sales are essentially just in time and three or four years ago only 25% worse. So this is a major shift. In Europe and Asia its almost always just in time.

The net result is, with our customer now holding the inventory, we are going to see more volatility, because they are going to drive their inventory down at the end of the year and then once the new cycle begins, they are going to scramble to refill their inventory, there is some real economic weakness and you get a reinforcing effect.

If the economy is ticking up a bit, then not only are they restocking, but they are having to restock more, because of expectation of more sales on their plan. So you get greater volatile once we shift from essentially us holding consignment and by far our largest most important market, to now everywhere the customer is holding inventory. So you get this slow down at the end of the year and then quickly ramping up at the beginning of the year.

So it’s a combination of bottoms up analysis customer-by-customer, coupled with an appreciation of the significance of the shortened order cycle of our customers, and then you lay on top of that, do we see anything fundamental happening in the macro economy? Do we see Europe taking a step down? No, it’s been stable. Did we see Asia taking a step down? No, I mean there’s a pulse.

So there is a chance it could tick up a bit and do we see the Americas taking a step down and again, if you’re looking at the same data we are, but we are not seeing any signs of a further slowdown. So all of those together lead us to a conclusion that we should see a strong first half.

John Franzreb - Sidoti & Company

Okay. And in regards to restructuring actions that you’ve taken, could you just outline the benefits to the core structure that you see playing out in 2014?

Joe Morone

I think we publicly said there’s about $10 million of lower costs from the restructuring that we took on in France and those should start flowing in the mid and a little bit in September, but they should start flowing in Q4 and then being fully realized in Q1 and Q2 and that’s one of the reasons despite softness in Asia, despite big shutdown in international paper, despite price erosion late last year, early 2013 in Europe.

One of the reasons we have confidence that year-over-year EBITDA, EBITDA full year and cash flow full year from Machine Closing in 2014, it should be pretty comparable to 2012. We think the annuity is healthy.

John Franzreb - Sidoti & Company

Okay. Do you have much more room to cut or right now is the capacity equilibrium pretty much set for what you expect the market to be going forward?

Joe Morone

I think there’ll always be a gradual process of aligning capacity to the way the market shifts, but every time I say this publicly it comes back to haunt me, but we’re not seeing any need for major capacity moves in the near term.

John Franzreb - Sidoti & Company

Okay, thanks for taking my questions.

Joe Morone

Thanks John.

Operator

Thank you. Our next question comes from the line of Steve Levenson with Stifel; your line is open.

Steve Levenson – Stifel

Thanks. Good morning everybody.

Joe Morone

Hey Steve.

Steve Levenson – Stifel

You talked about the terms of the joint venture and how the price ramps up with lead production, but are there provisions in there for additional amounts if you win other business on newer versions of CFM or GE or other engines in which Safran is involved or other 3D woven parts or is it pretty much just tied to LEAP.

Joe Morone

Well, by the time LEAP hits production, full production, the valuation method would shift to EBITDA times the multiple of 9.5. So that would – as EBITDA grew beyond because of new programs beyond LEAP, it would get reflected in the valuation.

Remember, I think we talked about this last time, we don’t anticipate major increments in revenue from new program hitting before 2019, 2020, so that’s when the next couple of S-curves are likely to hit and that’s when LEAP is flattening and hitting full production, so…

Steve Levenson – Stifel

Its pretty much covered therefore.

Joe Morone

Exactly.

Steve Levenson – Stifel

Okay, thanks. And second your getting in a slug of cash here and you don’t need as much for capital expenditures. Could you tell us about what the plans are? Is there going to be debt repayment, stock repurchases, dividend increases, acquisitions or some sort of balance of all those uses?

Joe Morone

Well, never say never, but I would say we’re not – we view this as an organic growth play, and the acquisition space, which we always look at, as you all noticed this industry, had really consolidated and what’s available for acquisition is either way too big or something that doesn’t really make much sense. So I think it’s probably safe for investors, at least based on what we see today to take that option off the table.

As for the others, it’s a topic that we constantly review with the board and we’re driven by the combination of making sure our balance sheet is absolutely in the best possible shape to take advantage of growth opportunities in AEC and then whatever excess cash remains, its about maximizing shareholder value.

Steve Levenson – Stifel

Great, thank you. And last question, do you have an update on the ceramic engine tailcone and what’s going on with the testing?

Joe Morone

No new update. There’s a flight test scheduled I think next year. I would say the best update I can give you is we are just – the pipeline of opportunities on the airframe continues to grow. There’s a lot of interesting possibility on the airframe side. Basically everywhere you see – on the skeletal structure of the plane, anywhere you see a joint or a fastener for the skeletal structure that’s bearing an out of plane loads, that’s good for our mill and so we’re pretty excited about that.

Steve Levenson – Stifel

Okie doks, thank you very much.

Operator

Thank you. (Operator Instructions). And we’ll go to the line of JB Groh with D.A. Davidson & Co. Your line is open.

JB Groh - D.A. Davidson & Co.

Hey, good morning guys. I think you said that LEAP was roughly half of AEC in the quarter, is that correct?

Joe Morone

Yes, today, currently yes.

JB Groh - D.A. Davidson & Co.

And could you kind of talk about the non-LEAP stuff for a bit.

Joe Morone

Well, JB the most important non-LEAP programs we have to say as opposed to development projects would be the work we’re doing with Rolls Royce. We’re making components for the LiftFan of the Harrier version, the STOVL version of the joint strike fighter and we’re also making parts for Rolls Royce’s business jet, the RB725.

So if you look at our operation in Texas, which represents a quarter of our sales, 40% going to 45% thereabouts of those sales are Rolls Royce related. I think that would be our second biggest and most important cost and that program should be going; both those programs should be going through the decade.

The other large program we have had, which we’ve talked about before is the landing braces for the 787, but as discussed, at the end of the year that program ends and they go back to metallic braces on the 787. Technically that program’s been working very well and we met our targets, but economically that program is not working for the Messier-Dowty, so they have gone back to metallic braces.

So we’ll see LEAP – as LEAP grows it will become a larger and larger part of AEC over the space of the next few years.

JB Groh - D.A. Davidson & Co.

Got you, okay. And then in this new ramp, obviously the total amount is bigger and it’s steeper. What are the biggest challenges you think that you’re going to have with that steeper ramp? Obviously you had one plan kind of in place for the original ramp and now your probably got to re-sharpen the pencil.

Joe Morone

Yes, its going to be more like the kind of ramp you see in the automotive industry, where you have to run, you have to do some essentially full rate test runs periodically before you hit the ramp.

Maybe take a module of the plant, even before the plant is fully equipped, but enough of a strip of all of the production equipment and run it flat out for a week or twp weeks or three weeks on two shifts and just really test where you are, and you have to do that periodically in order to identify any weak spots in your system, any places where your getting sources of variability and low yield that you weren’t anticipating.

Whereas before so you do these test runs all our, whereas before if we’re going to build inventory ahead of demand, then you would use that inventory build to identify the weak spots that you could then fix. So it’s going to be a very deliberate process that we’ll go through. It will be more like what the automotive industry goes through and it just flips a switch with a ramp.

JB Groh - D.A. Davidson & Co.

Okay, and then could you maybe address pricing in the MC world?

Joe Morone

Pricing has been stable around the world. You’re new to us. It is the pricing – the window for pricing and stability opens widest when there is a new round of contract negotiations and we won’t see one of those for at least another year and that will be in Europe.

And the sensitivity to pricing is the greatest in the markets where the industry, our industry is least consolidated and our customers have the most over capacity and that would still be Europe and to a lesser extent Asia. In Europe now we’re about 20% exposure. So exposure to pricing right now is not that great right now.

JB Groh - D.A. Davidson & Co.

Okay, good. Thank you sir.

Joe Morone

Thank you JB.

Operator

Thank you. And we have no further questions. Please continue with any closing comments.

Joe Morone

Well, thank you all for participating on the call. I know John and I will be seeing many of you over the next few weeks and months and we’ll look forward to answering any questions you have then when we see you or before then if we talk to you on the phone.

Thank you and we’ll talk to you soon.

Operator

Thank you. And ladies and gentlemen, a replay of this conference will be available at the Albany International website beginning at approximately noon Eastern Time today.

That does conclude our conference call for today. Thank you for your participation and for using AT&T Executive Teleconference Service. You may now disconnect.

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