KMG Chemicals Management Discusses Q1 2014 Results - Earnings Call Transcript

Dec.10.13 | About: KMG Chemicals, (KMG)

KMG Chemicals (NYSE:KMG)

Q1 2014 Earnings Call

December 10, 2013 10:00 am ET

Executives

Eric Glover - Investor Relations Manager

Christopher T. Fraser - Chairman, Chief Executive Officer and President

Hank Mullen - Director of Business Development

Analysts

Jay Richard Harris - Goldsmith & Harris Asset Management, LLC

Operator

Good day, ladies and gentlemen, and welcome to the First Quarter 2014 KMG Chemicals Earnings Conference Call. My name is Denise, and I'll be your operator for today. [Operator Instructions] As a reminder, this conference is being recorded for replay purposes.

I would now like to turn the conference over to your host for today, Mr. Eric Glover, Manager of Investor Relations. Please proceed.

Eric Glover

Thank you, Denise. Good morning, everyone, and welcome to the KMG Chemicals Inc. fiscal 2014 first quarter financial results conference call. I'm joined today by Chris Fraser, our Chairman and CEO; and Hank Mullen, our Director of Business Development and interim CFO. In a moment we'll hear remarks from them followed by Q&A.

During today's call, we will refer to financial measures not calculated according to generally accepted accounting principles. Please refer to today's earnings release available on our website for the reasons we are presenting non-GAAP financial information and for the appropriate tables that reconcile these measures to our GAAP results.

Before we begin, I'd like to remind everyone that the information on this conference call includes certain forward-looking statements that are based upon assumptions that in the future may prove not to have been accurate and are subject to significant risks and uncertainties, including statements as to the future performance of the company.

I'll now turn the call over to Chris Fraser, Chairman and CEO. Please go ahead, Chris.

Christopher T. Fraser

Thank you, Eric. Good morning, and thank you everyone for joining us today for KMG's fiscal 2014 first quarter conference call. Our earnings release was issued this morning and we plan to file our 10-Q later today. I'll begin by providing an update on our businesses and then I'll turn the call over to Hank for a review of the Q1 financials and our outlook for the second quarter and fiscal 2014 year. After our comments we'll open the call for questions.

As I indicated on our last conference call, one of our top priorities in fiscal 2014 is the integration of the Ultra Pure Chemicals business into our legacy Electronic Chemicals business. Thanks to the dedication of many of our team members around the globe, I can report that the integration is proceeding well, and we continue to focus intensely on this initiative to ensure a seamless transition for our numerous customers in the global semiconductor industry.

During the first quarter, we announced the manufacturing realignment of our global Electronic Chemicals business, involving the consolidation of our manufacturing operations, optimization of our supply chain. While these decisions are always difficult as it directly affects members of our worldwide team, we believe this restructuring is necessary to better align our production capabilities with global demand for our products. We are now transitioning production from our Fremont, California site, primarily to our larger facilities in the U.S., and we recently announced that we will shift production from our Milan, Italy site to our other European facilities, while maintaining our customer service operations in Milan. As previously disclosed, we've identified $4 million to $5 million of charges relating to this restructure in fiscal 2014, partially offset by $2 million to $3 million of incremental benefits during the year from restructuring-related synergies and commercial benefits. In addition, we anticipate spending an incremental $2 million in capital expenditure, primarily in fiscal 2014 to accomplish these plans.

One of our key growth initiatives in our Electronic Chemicals business is to more fully participate in the mobile semiconductor market, which is growing rapidly compared to the traditional PC and server markets. I'm pleased with the initial progress we're making in this area, where we are benefiting from our enhanced global presence and targeting marketing efforts. These initiatives, along with the recent UPC acquisition, have doubled our Electronic Chemicals revenue tied to the mobility market. We are confident our share will grow further over time, not only because our customers are migrating their businesses towards mobility, but because we are actively pursuing various growth opportunities this market with mobility-focused customers across North America, Europe and Asia.

Overall, I'm pleased with the operational progress we are achieving on our Electronic Chemicals business. The integration of UPC business is proceeding smoothly and the long-term strategic value inherent in this transaction remains compelling. As discussed on our most recent conference call, we expect that the restructuring we are now undertaking will generate annualized benefits of $6 million to $8 million for our Electronic Chemicals business, excluding onetime projected charge of $7 million to $9 million on a cumulative basis over fiscal 2014 and fiscal 2015.

Now turning to our Wood Treating Chemicals business. Our first quarter sales increased 13% over last year, reflecting higher volumes to the rail tie treating market. However, segment operating profit margin declined from last year's first quarter due to a less favorable product mix and lower prices on Creosote sales. As we look forward, our creosote business faces a challenging and dynamic market environment. And we are responding by optimizing our supply chain and cost structure to best maxim ours -- our cash flow within this segment. While we continue to address the issues impacting our creosote business, we've identified several specific factors that may adversely affect the financial performance of Wood Treating Chemicals segment.

First, although industry rail tie replacement rates have remained at relatively high levels, there remains an oversupply of creosote in the market. The current oversupply largely resulted a continued adoption of oil treatments that reduce creosote retention in treated rail ties.

Second, we project that rail tie replacement activity may decline as some railroads have recently stated plans to reduce tie insertions in calendar 2014. Given these market dynamics, we believe competitive activity in the Creosote market will increase in calendar 2014, exerting downward pressure on creosote prices.

While creosote market continues to post challenges, I would note to the Wood Treating Chemicals segment also includes our Penta business, which stands to benefit from rising demand as western U.S. utilities upgrade and replace the utility pole infrastructure. KMG is the sole manufacturer of Penta in North America, enabling us to fully capitalize our market demand for this specific industrial wood preservative. Overall, the outlook for our Penta business remains very favorable, though sales can be somewhat uneven in any particular quarter depending on the timing of customer orders along with the impact that severe weather events can have on demand. Nonetheless, the positive cash flow characteristic of this business continued to benefit the financial performance of our Wood Treating Chemicals segment.

Now I'd like to update you on our CFO search. As we announced in October, John Sobchak, our long-time CFO, has departed KMG. And on behalf of KMG, I'd sincerely like to thank John for his many years of service to KMG and wish him the best in his future endeavors. Over the past few months, we've been conducting an extensive search for a new CFO, and I'm pleased to say that we've made considerable progress. We've narrowed our short list down to a handful of exceptional candidates and we expect to announce our next CFO soon.

Before I turn the call over to Hank, I would like to comment on a significant corporate overhead cost we incurred in the first quarter. The coincident timing of the close of the UP acquisition with our fiscal year end filing caused our first quarter audit, tax and SOX testing fees to increase by approximately $1 million on a year-over-year basis. To the extent this cost increase was not fully anticipated. While our newly expanded size and global scale will require a higher level of corporate overhead expense, I want to emphasize that we remain resolute in our focus on managing costs and operations as efficiently as possible.

Hank, please proceed with a review of the Q1 financials.

Hank Mullen

Thank you, Chris, and good morning to everyone. In my remarks, I'll focus primarily on adjusted or non-GAAP numbers as we believe non-GAAP information can provide useful insight to the underlying operating performance of our business. The non-GAAP numbers I reference are reconciled to the corresponding GAAP numbers in today's earnings release.

KMG achieved consolidated net sales of $93.6 million in the first quarter, up 43% on a year-over-year basis, reflecting the acquisition of the UPC business. Electronic Chemicals sales were $64.5 million, up from $39.5 million last year, while the year-over-year increase was largely driven by the addition of the UPC business. Sales within our legacy Electronic Chemicals business improved on a sequential basis from the fourth quarter of fiscal 2014 due to an increase in global semiconductor production. Adjusted operating profit in our Electronic Chemicals segment was $3.8 million or 6% of sales, compared to operating profit of $5.1 million or 12.8% of sales in last year's first quarter. The decline in operating -- adjusted operating income and adjusted operating margin reflects depreciation and amortization expense of $3.2 million, compared to $1.6 million in last year's first fiscal quarter. The increase is attributable to the acquired UPC assets. Going forward, we anticipate the Electronic Chemicals segment quarterly depreciation and amortization expense will increase to approximately $3.5 million per quarter, reflecting a higher valuation of the physical assets acquired from UPC and increased amortization of intangible assets. While D&A expense is noncash in nature and, therefore, does not reduce cash flow, the higher projected level of D&A expense will dampen reported operating profits.

Wood Treating Chemicals sales were $29.1 million, an increase of 13.1% from $25.7 million in the comparable quarter last year. The year-over-year increase in Wood Treating Chemicals sales reflected higher volumes to the rail tie treating market. Wood Treating Chemicals operating profits were $2.5 million or 8.6% of sales versus $3.4 million or 13.1% of sales in last year's first quarter. The decline in segment operating profit and margin reflects a less favorable product mix and lower Creosote prices.

Consolidated adjusted EBITDA for the first quarter was $8 million, compared to $9.3 million last year. Adjusted EBITDA in the first quarter of fiscal 2014 excludes $500,000 of UPC integration expense and $1.28 million of CEO transition expense, while adjusted EBITDA in last year's first quarter includes $577,000 of UPC acquisition expense. First quarter 2014 adjusted diluted earnings per share was $0.22 in line with our adjusted earnings per share guidance range of $0.22 to $0.25.

Now I'll review our outlook for the second quarter and fiscal 2014 year. While overall semiconductor industry production has slowly picked up following the industry correction that persisted into mid-calendar 2013, we anticipate a typical seasonal slowdown in our second quarter. In addition, the PC market remains a drag on overall semiconductor industry growth. As a result, we project second quarter Electronic Chemical sales will decrease slightly from the level we reported in the first quarter.

In our Wood Treating Chemicals business, the second quarter is often the seasonally softer period, as colder weather can limit routine maintenance demand for poles and cross ties and some customers may temporarily shut down their wood treating facilities for maintenance. At the same time, conditions within Creosote market remained challenging due to reduced demand and excess supply, resulting from the adoption of borate treatment for cross ties. Consequently, we project second quarter sales on our Wood Treating Chemicals segment will decline on a sequential basis.

As we indicated in our October conference call, fiscal 2014 will be a transition year in terms of our overall financial performance, given projected charges related to the integration and restructuring of our Electronic Chemicals business.

At this time, we reiterate our prior guidance for fiscal 2014 consolidated net sales to exceed $350 million, benefiting from a full year contribution from the acquired UPC business. While we had previously projected flat to modest GAAP net income growth in fiscal 2014, compared to fiscal 2013, we are now updating this guidance to account for an increased depreciation and amortization expense in our Electronic Chemicals business, as well as higher corporate overheads for outside services. We are also taking a more cautious view with respect to our creosote business in light of the current market environment. Taking all these factors into consideration, we believe it's prudent to expect that fiscal 2014 GAAP net income will decline from last year's level.

Although we are not providing fiscal 2014 GAAP EPS guidance, we anticipate higher projected D&A expense in our Electronic Chemicals business will negatively impact fiscal 2014 GAAP operating income by approximately $3 million more than we had estimated in our previous guidance.

Now let's take your questions.

Question-and-Answer Session

Operator

[Operator Instructions] Our first question comes from Jay Harris with Goldsmith & Harris.

Jay Richard Harris - Goldsmith & Harris Asset Management, LLC

Is it reasonable to assume that when the restructuring is completed in Electronic Chemicals, that you'll be sometime in 2015 -- that you'll be reporting operating margins of 12% or higher?

Christopher T. Fraser

So our previous guidance in regard to that, Jay, was that the full year benefits that we would experience after the transition is complete would be $6 million to $8 million, and that would be the operating income.

Jay Richard Harris - Goldsmith & Harris Asset Management, LLC

Well. All right. So did you -- I'm sorry, I may have missed it. Did you say how much revenues you had expected this year in Electronics?

Christopher T. Fraser

No. We didn't break that out, Jay.

Jay Richard Harris - Goldsmith & Harris Asset Management, LLC

All right. So that's about as close as I can get to a margin objective looking out a couple of years, right?

Christopher T. Fraser

Yes, yes, I would think so.

Jay Richard Harris - Goldsmith & Harris Asset Management, LLC

All right. I have some -- if I might, I have some questions, there were some transition -- CEO transition expenses in the fourth quarter of $1.6 million. And I see in the first quarter, there was additional of $1.3 million. Could you explain that?

Hank Mullen

Well, sure. Much of that was related to bringing on -- in first quarter of 2014 was bringing on Chris Fraser as the CEO. In the fourth quarter, it was -- it had to do with Neal Butler's severance costs and associated fees and the associated search for the new CEO as well.

Jay Richard Harris - Goldsmith & Harris Asset Management, LLC

All right. So the change caused the company a little less than $3 million. And then, I wonder if you could -- what will be the interest expense in the second quarter?

Hank Mullen

In second quarter? It looks like it's going to be about a little less than $700,000.

Jay Richard Harris - Goldsmith & Harris Asset Management, LLC

All right. And I presume it will grow a little on a quarterly basis as the year progresses because of your capital investments?

Hank Mullen

No. We are not projecting for it to grow. As we are making these investments, Jay, a big reason we're making them is we're looking to get some synergies out of these investments. And we would expect that based on the free cash flow that we're getting, we would be able to reduce...

Jay Richard Harris - Goldsmith & Harris Asset Management, LLC

Slowly, slowly reduce the debt levels. All right. And could you explain a little more detail the items in operating expenses? How they're or the reasons for their growth?

Hank Mullen

So you're referring specifically to my comments on outside services?

Jay Richard Harris - Goldsmith & Harris Asset Management, LLC

Well. If I am -- bear with me for a second, I think I wrote something down.

Hank Mullen

Yes. So there has been some growth there, Jay. And let me just talk about, talk about that in general. We have a significantly larger and more complex business that we brought on as a result of this acquisition. And there are a number of things that we need to complete in order to meet our obligations as a publicly traded company. And a lot of those has to do with our obligations for compliance under Sarbanes-Oxley and audit. And one of the things that we failed to anticipate was the ramp-up in costs around those services. The net result of that in the first quarter was an overage that we had not anticipated of about $1 billion.

Jay Richard Harris - Goldsmith & Harris Asset Management, LLC

And what caused this recent run-up in these Sarbanes-Oxley compliance costs? So, why didn't you have those costs last year or the year before?

Hank Mullen

So a lot of that has to do with the increasing requirements we're seeing from the PCAOB. In addition, we -- as part of the larger organization, we're looking to build out our documentation and our ability to continue to properly comply with those -- to do our internal testing.

Jay Richard Harris - Goldsmith & Harris Asset Management, LLC

And that will run what, $1 million a quarter this year or is it onetime?

Hank Mullen

No. No, we expect -- a lot of that, Jay, was related to the fiscal 2013 audit. So a lot of that hits in the first -- in the last quarter of the year or the first quarter in the -- of the following fiscal year. So we would expect that to moderate in the coming quarters.

Jay Richard Harris - Goldsmith & Harris Asset Management, LLC

All right. I guess my question was really referring to distribution expenses.

Hank Mullen

Okay.

Jay Richard Harris - Goldsmith & Harris Asset Management, LLC

The acquisition, I presume, added the bulk of the increase in distribution expenses?

Hank Mullen

Yes, it did. And distribution expenses were up $5.5 million, and we would expect that to continue.

Jay Richard Harris - Goldsmith & Harris Asset Management, LLC

And the -- are there any savings in distribution expenses as you complete your reorganization of that business?

Hank Mullen

Yes. Yes, that's actually a really good question, Jay. The way we distribute products the EC business in North America and in Europe and in Singapore, our acquired businesses are somewhat different. So in North America, we use a hub-and-spoke system. And we have -- through the years, we've been able to optimize that system and then bring down our distribution expenses. I think at one time, we were running close to 20%. I think in this quarter, we were running at a much lower level. In Europe, we run our own fleets, our own dedicated fleets, and we typically optimize. We have an optimized distribution system throughout Europe to deliver our product to customers, but also to bring back returnable containers, bring back raw materials to the plant. Europe is a much smaller size. We would expect some synergies as a result of our reorganization, supply chain savings through this reorganization in Europe. And in Asia, we have a much larger portion of our operating expense that's due to distribution. And Singapore as you know, is a very small area. We would not expect a whole lot of savings in that part of the world. We believe that there are distribution abilities in Asia already fairly well optimized.

Jay Richard Harris - Goldsmith & Harris Asset Management, LLC

In Europe and the U.S., is that all by truck?

Hank Mullen

In Europe and the U.S., yes, it is. In Europe, it is by our dedicated fleet and by the -- in the U.S., we have a number of carriers, who we contract with.

Jay Richard Harris - Goldsmith & Harris Asset Management, LLC

And come -- and on selling and general administrative expenses, how much of that increase is completed? And is it all due to the acquisition?

Hank Mullen

Yes. $1.5 million, it is due to the acquisition.

Jay Richard Harris - Goldsmith & Harris Asset Management, LLC

All right. And obviously the $1.3 million is in that $10.4 million.

Hank Mullen

Yes.

Operator

[Operator Instructions] We have no -- actually, we have a follow-up question from Jay.

Jay Richard Harris - Goldsmith & Harris Asset Management, LLC

Talk a little about your -- the way you're going to pursue your acquisition interest, and how that may differ from what had been done before? If it does differ at all.

Christopher T. Fraser

Jay, this is Chris. The -- as I mentioned in our last call, our strategic direction remains unchanged, so our intent on growing the company through acquisition remains intact. And so our discipline in approaching acquisition opportunities remains the same as it has been looking at niche markets that we can go into, it provide us an opportunity to consolidate and bring value and create value in that industry. Additionally, we continue to look at opportunities to build out our Wood Treating business as well as our Electronic Chemicals business, whether it be geographic or market specific. So we continue to pursue those and look at those opportunities. Hank has been foundational in providing a good pipeline for us to look at. Having said that, as we've talked about with 2014 is a busy year from a transition standpoint. We've got a lot of things to do. We've commented before about us implementing a new ERP system, building out our infrastructure to manage and optimize the company in size and complexity it has now. So we're going to be prudent in any acquisitions we make to make sure it is -- we can add the value in that acquisition, it that brings value to our shareholders. So we're not stopping from our direction or moving from our direction, but the same time we're going to be prudent in our pursuit of those.

Jay Richard Harris - Goldsmith & Harris Asset Management, LLC

When -- what would be the earliest that, from an organizational point of view, you would be prepared to make an acquisition?

Christopher T. Fraser

Yes...

Jay Richard Harris - Goldsmith & Harris Asset Management, LLC

I'm sort of wondering whether the reorganization of Electronic Chemicals would slow down or cause you to pause in terms of your acquisition strategy?

Christopher T. Fraser

Yes. It really is -- I won't say it would -- it will cause us to pause. We don't necessarily create the timing of acquisition opportunity. So we need to be prepared as they present themselves for us to react. But as I said, we are building out our systems, our capability. So we want to make sure we're prudent as we pursue those. This realignment of our manufacturing both in North America and Europe is going to take time, as we've talked about. We -- the full benefits we realize will be in about 18 months to get us to a steady state. You talked about logistics and supply chain earlier. A lot of that distribution expenses is where we're looking to optimize that. So the organization has capabilities now. What we're doing now is optimizing it. So if the right opportunity present itself in Electronic Chemicals, we will pursue that.

Jay Richard Harris - Goldsmith & Harris Asset Management, LLC

Well. In terms of adding a new leg to the stool, are we at a point in the business cycle where the opportunities are declining simply because business is getting better?

Christopher T. Fraser

I don't see that at all. We have a lot of things to look at right now. And certainly, there are a lot of opportunities coming out there in the market, things that are being sourced from both our contacts and investment banks, but also things that we've been able to pursue independently. So there's no dearth of opportunities out there right now.

Operator

At this time, we have no further questions. I would now like to turn the call back over to management. Please proceed.

Christopher T. Fraser

We appreciate your participation today and your interest in KMG. We look forward to speaking with you on our second quarter conference call. Thanks, and goodbye.

Operator

This concludes today's conference. You may now disconnect. Have a great day.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

If you have any additional questions about our online transcripts, please contact us at: transcripts@seekingalpha.com. Thank you!