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Executives

Murray McClean – Chairman, President and CEO

Bill Larson – SVP and CFO

Analysts

Kuni Chen – Bank of America Securities-Merrill Lynch

Timna Tanners – UBS

Michael Gambardella – J.P. Morgan

Chris Olin – Cleveland Research

Brian Yu – Citi

Rob Moffitt – Longbow Research

Gregory Macosko – Lord Abbett

Wayne Atwell – Casimir Capital

Tim Hayes – Davenport

Sanil Daptardar – Sentinel Investments

Sal Tharani – Goldman Sachs

Commercial Metals Company (CMC) F2Q10 (Qtr End 02/28/10) Earnings Call Transcript March 24, 2010 11:00 AM ET

Operator

Hello and welcome to today’s Commercial Metals Company Second Quarter 2010 Earnings Conference Call. At this time, all participants are in listen-only mode. After management's remarks, we will conduct a question-and-answer session. (Operator Instructions). Please be advised this call is being recorded today, March 24th and your participation implies consent to our recording this call. If you do not agree to these terms, simply disconnect.

Your host for today’s call is Murray McClean, Chairman, President, and Chief Executive Officer of Commercial Metals Company. Mr. McClean, please begin your call.

Murray McClean

Hi, good morning and welcome to CMC’s second quarter fiscal 2010 conference call. With me this morning is Bill Larson, our Chief Financial Officer. As usual, I’ll begin the call with an overview of the second quarter and then ask Bill to provide further details. Finally, I’ll comment on the outlook for our third quarter fiscal 2010.

With respect to an overview of the second quarter and I just like to also talk about background going into the second quarter of 2010, but firstly as highlighted in our previous call, our second quarter, which includes the winter months of December, January, and February, is always our weakest quarter. Obviously, they aren’t the winter months of Australia, but for the most – the large markets where in U.S. and Europe, they are the winter months.

Our results from continuing operations were worse than we had anticipated based on the combination of weak non-residential construction markets, prolonged and harsh winter both in the U.S. and Europe, plus a major jump in ferrous scrap prices, which outpaced finished goods prices, that is steel products, mainly rebar and merchants that we manufacture.

Now, Bill will talk in further detail about our discontinued operations, that's mainly joist and deck. During calendar 2009, most of our prices, that's rebar and merchant products, trended down almost monthly in the U.S. and Europe as extensive de-stocking occurred. Ferrous scrap prices on the other hand, while volatile, trended higher creating a margin squeeze at the mills. The markets appear to have turned with the large ferrous scrap price increase in December of 2009, resulting in January the 1st, 2010 price increases for rebar and merchants.

Now, further scrap price increases in January and March of this year have resulted in significant price increases of rebar and merchants in February and next month, April respectively. Now, why do I mention this? The reason is that we believe the market psychology has changed as raw material price increases, in this case, scrap, have been passed on in finished goods prices. We did not see this in 2009.

It is clearly a good trend for 2010, in particularly going into the spring and summer months, which are the peak periods for construction. As well, inventory levels at all levels in the supply chain remain relatively low. Any seasonal pickup in demand including restocking will be a positive.

Now, just reflecting back on the second quarter by segment, our recycling segment, the business here was somewhat disappointing as despite the higher ferrous scrap prices, we did not see the flows that we had anticipated. Now, this was mainly due to the harsh weather conditions that I mentioned earlier in the U.S. and Europe, which made collection of scrap very difficult.

In our mills segment, they had a margin squeeze due to the big ferrous scrap price increase in December and January. Also it impacted negatively billet shipments. We had substantial billet shipments during the quarter. U.S. fabrication segment was caught with a low price backlog and rapidly increasing steel prices. This was a similar story for our international mills, in particular Poland where finished goods prices lagged well behind ferrous scrap price increases, resulting in significant losses.

The final segment is our marketing and distribution segment, that's our global trading businesses. These, overall, were profitable, reflecting improving market conditions, in particular in Asia and Australia.

I will now ask Bill to provide details on the second quarter.

Bill Larson

Thanks, Murray. Good morning. Let me call to your attention to detailed Safe Harbor statement included in our press release and our August 31st, 2010 10-K that in summary says that in spite of management’s good faith, current opinions on various forward-looking matters, circumstances can change and not everything that we think will happen always happens.

In addition, we’ve given qualitative guidance regarding our outlook for the third quarter of fiscal 2010 in our press release. Subsequent to this call, we will not be updating our outlook until later in the quarter.

In accordance with Regulation G of the Securities and Exchange Commission, you are aware of non-GAAP financial measures, some of these have derived fairly straightforward from our financial statements or in common business use can be the subject of our discussions today and in our investor visits, but there are other items that may be outside of our ability for discussion. You may need to be patient with us if we defer comment. Our website has additional information at www.cmc.com.

Well, as Murray said, in December earnings call we mentioned that we still had one tough quarter ahead of us and this certainly has come to pass. No one is going to look back on this quarter with any degree of nostalgia. Sure enough that the second quarter is historically our weakest, but it seems as if all my favorite answers, China, the weather, product mix, and LIFO, all came into play with a vengeance on top of the already weak economy. We had to make some tough calls in operations, the highest profiled one being joist and deck in order to size the business to the expected level of demand in the midterm.

But we've come through the worst recession in decades in good shape. There are many positives to point to. Our balance sheet, capital resources, and banking relationships remain strong; our cash and short-term investments totaled $297 million at February 28th; our inventories are conservatively valued on LIFO, the reserve is $232 million; and a substantial amount of our accounts receivable are credit insured or backed by letters of credit. This in addition to the $41 million allowance for doubtful accounts. Working capital ratio is 2.2. At February 28, 2010, goodwill and intangibles totaled $129 million, representing only 3.6% of total assets.

On the operational front, as Murray has stated, pricing is on an upward trend. The winter is finally giving way to the spring construction season and shipments will improve. We have initiatives underway at many locations to continue to capture the working capital savings we have experienced over the last year. Our new micro mill in Arizona is ramping up on schedule and we will be near full production capability by the end of this fiscal year. Our flexible rolling mill in Poland is nearing completion, as is our melt shop overhaul in Croatia. These projects will afford us expanded product lines at lower cost and bode well as the recovery continues.

Yesterday, to the good work of our Treasurer Lou Federle, we entered into an interest rate swap that covers $500 million of our long-term debt in this period of historically low rates and with the anticipation of continuing low rates. We believe this is a prudent move. In addition, it balances our fixed and floating debt to a ratio of 50-50 so we are not taking a view on future interest rates. The interest savings for an entire quarter should approximate $3.5 million if current interest rates hold.

Overall, the trends are positive and we've positioned the company to take advantage of them. It's been a tough slog and I want to express my continual thanks to the employees of CMC who continue to perform exemplary work during this period. I am proud to be part of their team.

In reviewing sales trends, recycling is the beneficiary of higher prices in our mills of higher volumes. But with the continued decline of commercial construction, our fabricators will definitely have unfavorable comparisons on sales. The decline in sales in international marketing and distribution is mainly due to the reclassification of our CMC Dallas Trading operations here. As you will recall, imports in the United States are off substantially.

When you look at adjusted operating profit, the significant factors in the swing between last year's second quarter and this year's second quarter, among our American mills, it's both the trend in LIFO, as well as the margin compression Murray mentioned. In the fabricators, it's unquestionably the margin compression and we have the exact opposite of the situation we had last year. The fabricators do much better in periods of declining prices and get hammered in periods of rising prices. And again, in international fabrication, the reclassification of our import steel business in the United States into international marketing and distribution has caused an unfavorable comparison there.

LIFO for the quarter decreased net earnings $4.8 million or $0.04 per share in comparison to – stark comparison to last year's income of $80.7 million or $0.72 per share. Year-to-date, it – it increased net earnings $6.4 million or $0.06 versus last year's $154.6 million or $1.36 per share. We had depreciation and amortization for the quarter of $44.681 million [ph].

We also include for purposes of covenant test, the impairment charges as part of EBITDA. Those totaled for the quarter at $32.4 million and so you will see in supplemental information the figure $127.47 million [ph] for depreciation and amortization. And absent impairment charges, I would continue to believe that D&A for the year will be about $177 million.

If you look at SG&A, there is a little bit of a disguise here. SG&A is down a little bit, but because of a classification effect, the real change is being masked. I'm going to explain a little bit of P&L geography here. We have assets and liabilities in a non-qualified retirement plan and the expense is in SG&A, but the income from the assets is up in revenues.

So we mark both of these to market each quarter and really, these two generally offset each other. And so if these were – if this was stripped out of SG&A for the six months, SG&A would have declined another $32 million plus. And the main components of that are lower payroll, lower professional fees as we no longer have as an aggressive rollout of SAP, and lower bad debt expense.

Book value at 2.28 is $11.49 a share. Average shares diluted are 113,275,457 and the actual shares outstanding are 114,128,067. We had CapEx of about $40 million during the second quarter that puts at $87 million year-to-date. I've mentioned before that although we have a budget of roughly $150 million to $155 million, it's broken out into about $100 million of committed spending, $20 million of safety and environmental, and the rest will be spent if and when we see that it's appropriate. I suspect we are not going to reach the $150 million levels in CapEx for the year.

Regarding joist and deck, the major items that enter into the discontinued operation for the second quarter, the largest would be the impairment charges on fixed assets and goodwill and intangibles. That would be followed by some inventory, some orphaned inventory, obviously severance costs for the employees, and the operating loss that they incurred during the quarter.

Finally, you all know I'm an advocate of giving as much information to our investor base as possible and part of that is to give an estimated earnings range each quarter. But I just must reiterate what was noted in the release, the factors that are most indicative of earnings are in huge flux right now, particularly pricing on both ferrous scrap and finished goods and the timing of inventory flows, the recovery of Poland from a terrible winter, how all these affects LIFO, there are just too many variables right now to give a good faith estimate. But as soon as the quantification of these trends is clear, we will be back with you.

Murray McClean

Okay. Thanks, Bill. Just the outlook for the third quarter. We anticipate our recycling segment to be profitable based on increasing flows of all types of scrap, plus higher prices. As well, we have further reduced our cost structure in the segment.

Our U.S. mills segment, overall, should improve based on high capacity utilization rate. You will see that we mentioned 67% as our forecast for this quarter, which is substantially upside. Also, there would be higher prices, higher shipments, and improving margins by quarter-end. There is a bit of a margin squeeze early in the quarter with scrap prices moving faster than the rebar and merchant prices, but in April they will catch up the finished goods prices.

Unfortunately, our U.S. fabrication segment will have a very difficult time due to a low price backlog and faced with rapidly rising steel prices. On a positive note, however, backlogs have expanded significantly in the last few weeks and these new orders are based on higher steel prices.

Our international mills segment should improve significantly this quarter and steel price increases, that is mainly rebar and wire rod in Poland outpace scrap price increases. In addition, shipments are picking up quite strongly at a Polish mill. Our mill in Croatia will show some marginal improvement, but realistically, Bill mentioned it before, it won't be until all the CapEx projects are completed in Croatia that we will see a significant turnaround. We don't anticipate this to occur until towards the end of our fourth quarter.

Our international marketing and distribution business should steadily improve as we experience seasonal pickup in demand in many markets. China and the rest of Asia are already showing stronger growth in 2010 than in 2009. And since Chinese New Year several weeks ago, there have been significant price increases in a number of raw materials including those who follow iron ore, the spot iron ore prices, scrap, as well as steel costs.

There is likely to be some price correction in our view over summer, led by scrap and flowing through to some steel prices, but we believe this will be relatively modest as inventory levels in all parts of the supply chain remain relatively low. We are starting to see some stimulus funded projects being awarded in the U.S. In addition, there are some other major projects and the prices have been awarded.

At the same time, as we mentioned in the release, the private sector of our non-residential construction market remains very weak and we think this is likely to continue certainly through this year 2010 into 2011. We continue to lower the cost structure in all our businesses.

And while we are somewhat more optimistic about market conditions for the next three to six months, we do realize, however, apart from China and Asia, most markets remain fragile. At this time, we are not giving a range, as Bill mentioned, for our third quarter because there are just too many variables which can significantly impact results. We will, however, give guidance, as Bill mentioned, closer to quarter-end when there is more certainty.

With those comments, I'll now open up the conference for questions.

Question-and-Answer Session

Operator

Thank you. (Operator Instructions). We will pause momentarily to assemble our roster. The first question comes from Kuni Chen of Bank of America Securities-Merrill Lynch.

Kuni Chen – Bank of America Securities-Merrill Lynch

Hi, good day, everybody.

Murray McClean

Good morning, Kuni.

Bill Larson

Good morning, Kuni.

Kuni Chen – Bank of America Securities-Merrill Lynch

I guess just to start off, obviously the charges in deck and joist are pretty straightforward. But as you go through some of these other charges that you've broken out here, about $93 million pretax, can you give us an after-tax number on that? Should we be using a 30% tax rate on that?

Bill Larson

You know what I always do, Kuni. I always just use the marginal tax rate of 35%. That way, all the numbers are consistent from release to release. I mean, we are in fact targeting a 30% annual rate, but on the margin, each new item is 35%. So I just do that for use of comparability from release to release.

Kuni Chen – Bank of America Securities-Merrill Lynch

Okay. And can you just give us some more detail on the charges for the backlog in Poland?

Bill Larson

Yes, it's not – theoretically, it's not dissimilar to what we have in the United States. The mill has given their fabricators a set price on finished goods in order to allow the fabricators to bid and prices have gone up in Poland and they will have to send to their fabricators and the fabricators eventually to the outside customers steel that – it will cost more to produce. It's the same type of margin squeeze Murray was talking about the fabricators here in the United States.

Kuni Chen – Bank of America Securities-Merrill Lynch

I see. Okay. And then just one last question. Just overall, when you – obviously, in a rising raw material environment, both in the U.S. and Europe and I guess globally, when you look at pricing trends in the U.S. versus Europe, which in your view is sort of the structurally more challenged market or do you see them as about the same?

Murray McClean

I would say probably maybe here in the U.S. because of the private sector. But clearly, the funds are coming through and to be honest, we don't care where the funds come from as long as they come through, if it's but from the stimulus package or if it's from the normal highway and other programs. And so we are seeing some positive signs here.

In Poland, structurally it's a little bit better we believe, because the infrastructure of the public side is certainly strong and will get stronger there. But there are some signs of residential and even small signs of commercial coming back. Just – I'm just talking Poland now. So that is a bonus because Poland and those markets use a lot of rebar and we are actually pricing twice a week now in Poland on finished goods prices since March. So that's a real turnaround.

Kuni Chen – Bank of America Securities-Merrill Lynch

Okay. I guess my question was more from a mill standpoint. So – kind of in line with your overall macro comments, you think Poland has better pricing power at the mill level?

Murray McClean

Yes, we believe so. There is obviously not as many producers in Poland as there are here in the U.S.

Kuni Chen – Bank of America Securities-Merrill Lynch

Got you. I'll turn it over. Thanks.

Operator

The next question comes from Timna Tanners of UBS.

Timna Tanners – UBS

Yes. Hi, good morning.

Bill Larson

Good morning.

Timna Tanners – UBS

Why don't you just drill down a little bit on some things that you talked about? With regard to the tax benefit reversal, is this – a view that you might have on the timing of eventual profits on Croatia? From the language here, I'm just clear, it's say the timing of the limited tax carryforward position or operating loss carryforward. So if you can elaborate on that?

Bill Larson

Yes. You are going to be sorry you asked this question, Timna. But you'll be able to get continuing education credit afterwards. There is a bright line test in the accounting literature on accruing for deferred tax assets. So what do we have here? If you have a loss carryforward and you think you are going to make money in the future, you are allowed to anticipate that, take the benefit, and of course the other side of the entry is an asset.

Timna Tanners – UBS

Right.

Bill Larson

What the literature says is if you have had three consecutive years of losses, there is almost no evidence – there is almost no evidence under the sun that can convince anybody – it doesn't matter whether we – if all the stars were aligned and we could make $100 million on September 1st, what the literature says is if you have three years of losses, it is incredibly debatable whether you can maintain that asset or not. And we looked at it and knowing the forecast for Croatia and that they would lose money in a 8/31/10, that will be the third consecutive year we went ahead and took the – where we reversed it.

Timna Tanners – UBS

So it's an accounting law, but your forecast for continuing losses would be what for the next quarter or so?

Bill Larson

Well, our – yes, the point is very well taken. There are two different dynamics going here. One is what does the accounting literature have to say and the other is what do we think will happen down on the ground. Yes, we think the operations will turn around and that a significant portion of the NOLs will be used successfully and of course, it will happen then. You can see what will come up, every time you use one of those NOLs, our effective tax rate is going to drop significantly because we are going to get a benefit because we've never approved it before. So yes, it's a distinction between just what the literature says and what we think will actually occur.

Timna Tanners – UBS

Okay. On Arizona, you mentioned that the capability would be up by the end of your fiscal year. But I don't know if that was a change from what you've said about the production being up. So are you expecting to be able to run full out by the end of your fiscal year or just talking about your assets being in shape?

Bill Larson

No, we would anticipate being near full out by the end of the fiscal year.

Timna Tanners – UBS

Okay. And then finally, I hate to ask this, but we are getting so many queries about potential M&A. If you would give us your latest thinking or reiterate your thinking on your potential candidacy, whatever, I know you are getting questions as well.

Bill Larson

No one is questioning whether my health is any good. I was kind of disappointed when I had to back out of those conferences. Nobody asked if I was going to die. Look, we – standard response, as you know, we don't comment on questions and rumors and speculation about M&A activity.

Timna Tanners – UBS

Okay. Thank you.

Operator

The next question comes from Michael Gambardella of J.P. Morgan.

Michael Gambardella – J.P. Morgan

Yes, good morning.

Murray McClean

Good morning.

Bill Larson

Good morning, Michael.

Michael Gambardella – J.P. Morgan

Two questions. One, are you seeing any demand from the stimulus package here?

Murray McClean

Well, it's very mixed that we are seeing some signs. We are just seeing a number of larger projects coming up, Michael, and some of these a lot of highway work, et cetera and it's a bit of a gray area. Some say it's – the stimulus funds – fund is involved, some say it's – like Marcos [ph] like here Texas bringing for projects because the stimulus funding is coming in behind. But certainly, the second half of this calendar year, we believe more projects will be awarded based on stimulus funds. And what – as I mentioned earlier, we don't care where the funding comes from as long as it comes and as you know, it's been very slow over the last few months.

Michael Gambardella – J.P. Morgan

And what is the current spread between your fabricated rebar and rebar pricing, say in Texas versus where it normally is?

Bill Larson

Well, I don't know that we are going to give you Texas specifically. That would probably be – did one of our competitors ask you the – ask that question, Mike?

Michael Gambardella – J.P. Morgan

No. I mean, I have heard that for a while, I don't know if this is still the case, I has heard for a while that fabricated rebar was being sold in the Texas area for rebar pricing or less.

Bill Larson

Well, we are not going to get into specifics. I will tell you that margins are tight.

Murray McClean

Well, certainly, Mike, last year as I mentioned, where prices dropping, there was a big difference between list prices and transaction prices and rebar fabricated prices dropped steadily as well. So there is a huge margin squeeze. But that situation has really reversed in the last several weeks and so we will see a margin expansion.

Michael Gambardella – J.P. Morgan

And just last question. Just – we are projecting – continue to project very high scrap prices and I would think scrap prices would continue to go high for the next several months. Even in your long – in the long products business, just the rebar business, under that scenario, shouldn’t you see an increase in your metal spread with much higher scrap pricing?

Murray McClean

It will eventually come through. We think scrap will probably move up again in April. But we think the finished goods prices will hold. But as I said earlier, I mean our view is and time will tell is that there will probably be a correction on scrap around middle of the year, May, June, maybe July period.

The last two years, it didn’t happen, but they were two I would say of normal years, but historically it does happen. We think it will be a little more, not so much here in the U.S., but what happens overseas, we think, in China there could be some pullback and some of that's seasonally related to the middle of this year and scrap prices will grow. We don't see scrap prices continually climbing forever. We think, as I said, there will be some correction in the middle of the year.

Michael Gambardella – J.P. Morgan

Couldn’t you get an offset to that with a very large settlement on iron ore prices though?

Murray McClean

Yes. I mean, clearly, the iron ore prices – well, they haven't been settled. I know you follow it as well as we do, Michael. The – it looks like it may to go quarterly pricing, but the huge delta between the spot iron ore prices and the current – last year's benchmark prices, clearly the benchmark prices have to move from $60 to over $100 a ton, because with spot iron ore prices close to $150 a ton, something has to give.

So – and clearly – we would believe that some of the Chinese steel mills will start cutting back production because they won't be able to pass on the full price increases to their customers. So there will be – as I mentioned, there will be some correction and scrap is related to iron ore. There is a close correlation as you know. So we think there will be some settling down on our view, as I mentioned, in the middle of the year.

Michael Gambardella – J.P. Morgan

Okay. Thank you very much, Murray.

Operator

Our next question comes from Chris Olin of Cleveland Research.

Chris Olin – Cleveland Research

Good morning.

Bill Larson

Hi, Chris.

Chris Olin – Cleveland Research

Bill, ironically, my first question was actually how is your health?

Bill Larson

Chris, it's great. Thank you. I always liked you.

Chris Olin – Cleveland Research

Okay, good, good. Looking at the potential demand drivers for rebar in the second quarter and I guess first would be stimulus, second would be the weather pushing out projects that weren’t delayed, just postponed, and then the third would be residential. If you would look at each of those, would you have, I guess, more confidence in taking place for next few months?

Murray McClean

Well, certainly the public works, the highway work, we've seen a big pickup in backlog just in the last few weeks. I mean, here in Texas, it’s very strong. But see some pickup in markets like Florida and the Gulf states as well. Anything energy related is good, health care is good. So these are leading the way. And – well, on the – the private sector is weak. We just don't see any recovery, as we mentioned early, until next year sometime.

Chris Olin – Cleveland Research

Would you say it’s still weak taking out the weather impacts – ?

Murray McClean

Yes, it's still weak. I mean, it's just a matter of funding and in some cases, it – there is just too much capacity over – things are overbuilt and that was one of the reasons we got out the joist business. With the downturn on housing, shopping centers, big warehouses, et cetera, there is just too much build during that boom period.

Chris Olin – Cleveland Research

Understood. I guess, one of the concerns I would have then looking at some of these public projects coming up would be the surge in scrap and then the inevitable movement in rebar. Would that shelve a number of projects just because of the cost once again? Is that an issue that we need to think about?

Murray McClean

I don't think so when you look where rebar prices are now, where they were on the boom period a couple of years ago. I think we've got a long way to go, but – I mean, it's possible, but I think as I mentioned earlier in the call, the psychology has changed.

I mean, last year, customers were just sitting on their hands and rebidding and rebidding and rebidding. Now, people have to take action because they see prices are moving up and if they've got a viable project or job, they need to award it earlier rather than late because they know the price is going to be high. Now, some people might be a little bit cute and think prices are going to coming off, but I think that's a dangerous strategy. Prices may stabilize, but we don't see them dropping dramatically.

Chris Olin – Cleveland Research

Interesting. Okay and then just lastly, just because of something I'm thinking about, I've been focusing on this micro mill, which is interesting to me. If you wanted to build one on the West Coast, like California or anywhere around there, could you get the air permit for that facility?

Murray McClean

Well, I think California would be out of the question. I mean, it’s just too tough a stake. But we might look at other areas in the U.S. where it makes sense, but California would be hard.

Chris Olin – Cleveland Research

Okay, good. That’s all I had. Thanks a lot.

Operator

Our next question comes from Brian Yu of Citi.

Brian Yu – Citi

Good morning, Murray and Bill.

Bill Larson

Good morning, Brian.

Brian Yu – Citi

My first question, it's regarding Americas mills. We've seen a fairly close correlation between your profitability there versus metal margins and I just noted that in the second quarter, metal margins were up sequentially, yet profitability or the loss widened further. Were there any lumpy expenses that showed up?

Bill Larson

No, I think it’s just the metal margins just didn’t allow it. I mean, there is always some severance here and some closure expenses there in various operations, but nothing particularly significant.

Murray McClean

We did get caught a little bit, Brian, with being a quieter period of the year, you tend to produce more billets and that's a good thing if scrap prices are relatively stable, but clearly not a good thing if scrap prices jump sharply like they did in January and – December and January.

Brian Yu – Citi

Okay.

Murray McClean

The jumped $105 a ton in two months. I mean, that – we hadn't anticipated that.

Brian Yu – Citi

Yes. Well, I was looking at just the metal margins, which I thought would already account for any movement in scrap and metal margins were up. So – but it sounds like a shift, so maybe some small items in there, nothing significant.

Bill Larson

Yes. Let me add one thing, Brian, that Kuni and I were talking about. The mills also have a backlog that goes out to our own fabricators and they have to grandfather those prices. So some of those job loss reserves are at the mill level.

Brian Yu – Citi

Got it. Okay. And – well, I guess that just takes us to my second question. With regard to your various fabrication projects, it – I tried to make a distinction between where margins are coming in because you bid them well versus they actually come in because of rebar prices, they move against you now. Now, we've been kind of just anecdotally hearing about contractors or fabricators trying to bake into their futures bids, some sort of an indexing on the rebar side so that you don't get caught. Is that type of bidding gaining any traction in the marketplace, are you attempting to build that into your bids?

Murray McClean

No. Not to analogy [ph].

Brian Yu – Citi

Okay. All right, great. Thank you.

Operator

The next question is from Rob Moffitt of Longbow Research.

Rob Moffitt – Longbow Research

Hey, good morning, guys.

Bill Larson

Good morning.

Murray McClean

Good morning.

Rob Moffitt – Longbow Research

On the fab side, I was wondering, how deep is the backlog there?

Murray McClean

Well, it's very significant. As I mentioned, it's jumped quite sharply in recent weeks. I mean, our backlog is now stronger than they were over 12 months ago. Obviously, they declined for a number of months, but they've come back and they are growing at a good pace now. Obviously, as I mentioned earlier, we've got issues for a quarter anyway of low price backlog that clearly when the higher price work comes through, that will be a benefit.

Rob Moffitt – Longbow Research

Is there any way to kind of quantify maybe the average lag time between when a – I guess, the contract is signed and it's actually delivered?

Bill Larson

I wish I could give you an exact figure on that. I always hate answers that start off it depends or facts and circumstances. But you have some jobs and a lot of these jobs are relatively small jobs. It used to be – you would hope – you may not even look at jobs below 1,000 tons, but lot of these jobs are 400, 500, and 600 tons and will get delivered next month. Other ones, large highway jobs, will go out two or three years. The engineering hasn't been done on them and they probably don't start for the better part of three or four months.

So I think there is a direct correlation between size and starting date. I think anything under 1,000 tons probably starts within a month or two, much beyond that you are talking three or four months minimum.

Rob Moffitt – Longbow Research

Okay. And then in your recycling segment, have scrap improved much over the last maybe month or a couple of weeks, whether it's gotten a little bit better?

Murray McClean

Yes, we see a pickup this month in March. I mean, it was terrible in January and February. So it is improving. And then we had snow in Dallas on the – on Sunday. So just when you think things are getting better, the weather strikes again.

Rob Moffitt – Longbow Research

If flows continue to improve with the weather, is that a risk to pricing near term?

Murray McClean

Yes, I mean, it is at some stage. Clearly, when we see this – each year that if flows really pick up strongly, yes, it will impact prices.

Rob Moffitt – Longbow Research

Okay.

Murray McClean

But we don't see that – I mean, our view is maybe April prices and more led by international demand this time, will move up again. May – obviously, you don't know, it may come off in the May, June period as I mentioned earlier.

Rob Moffitt – Longbow Research

Okay. And just one last question. Regarding your billet sales, do you have an ASP number for that?

Bill Larson

No. Well, it's – not today, I haven't run the math, I have to do a little homework.

Rob Moffitt – Longbow Research

Okay. All right. Thanks a lot, guys.

Murray McClean

Okay.

Operator

Our next question is from Gregory Macosko of Lord Abbett.

Gregory Macosko – Lord Abbett

Yes, thank you.

Murray McClean

Hi, Greg.

Gregory Macosko – Lord Abbett

Good morning. Just wondered with regard to the joist business and the write-offs, et cetera there, are you looking at any of the other fabrication operations and are there any other small pieces? I know you've made acquisitions over the years in that area. Is there any other pieces that you are looking at and could we see something in the next year or two?

Bill Larson

Which way, Greg? Plus or minus?

Gregory Macosko – Lord Abbett

Minus.

Bill Larson

Oh, minus? Look, we've been and I think we've discussed this in other calls. I mean, in selected operations and selected geographies, we have closed down capacity in recycling, we've done it in various fabrication operations. So yes, I would say there is a continuous – continuing look to see whether we are positioned appropriately versus what the market demand is. But it – there isn’t anything on the banner of the size of joist and deck.

Murray McClean

No. Selectively, there maybe one or two sites, Greg, but realistically, anything that with multiple – we would hope to bring back up again, particularly in rebar fabrication as market conditions improve.

Gregory Macosko – Lord Abbett

But with regard to joist, that is not possible.

Bill Larson

No.

Murray McClean

No, that's the end of the line.

Gregory Macosko – Lord Abbett

And then with regard to the balance between scrap and mill capacity, et cetera, does that change the balance in terms of how you internally supply from the mill to the fabrication and is that an opportunity near term or is that going to create some imbalance for a short period?

Bill Larson

It's a great question and the answer is yes, things are changing in terms of the way the supply chain is set up. You would like theoretically to maintain the inventory at its cheapest point in the cycle and that would be at the recycling level and we are unquestionably looking at a system that will not start the inventory flows until a fabricator has an order and that will work its way back to the mill and then result in the demand from the recycler. So that is part of the initiatives I mentioned in terms of maintaining the low working capital in working ever closer and of course (inaudible) to get resource and being able to get that information.

Gregory Macosko – Lord Abbett

So we could perhaps see some modest impact on margins, maybe sequentially going forward from that?

Bill Larson

Yes. It's always difficult to ascribe what came about by way of process versus what the market gives you. I'm – I've tried it in the past and it's very difficult at times to be able to say, yes, this definitely was because we got the supply chain in line versus well, that was just what the market gave. But yes, we would certainly hope that that would be the case. I'm just not dead certain I will be able to quantify it for you.

Gregory Macosko – Lord Abbett

And then with regard to the backlog in fabrication, you mentioned that you still have some lower margin backlog in there. When do you expect that to clear through and I'm sensing that kind of given the move in scrap prices and just generally speaking that the mills may have to take a – another modest hit from that dislocation.

Bill Larson

We would anticipate that to roll through during this third quarter and of course, we set up reserves at 2.28 to offset any of those losses. If pricing continues to go up, you are right, then there will be – until the time as they are delivered, there could be another charge.

Gregory Macosko – Lord Abbett

Okay. And then, I mean – I'm assuming that's the same situation that happened in Poland in the second quarter, correct?

Bill Larson

Yes. That's exactly the situation, Greg.

Gregory Macosko – Lord Abbett

Is it more difficult in Poland to manage that than it is here in the United States?

Bill Larson

Yes, in the sense of the recycling industry isn’t as well developed, it's not a sophisticated – it still has a certain element of the Wild West. There is a large portion and it’s not just the Polish market, scrap is pulled from Slovak, from Czech, from Germany as well. There is still – I will be kind to them and say entrepreneurs, others might recognize them as speculators, in the – in that market. And so it's a little bit more difficult and we don't control as much in terms of percentage flow as we do here in the United States. We certainly are heading in that direction, but we don't have as much dominant position as we do here.

Murray McClean

They are also heavily influenced by export markets, even exporting as far as Asia and Poland. So there is more variables, I would say, in that market.

Gregory Macosko – Lord Abbett

And then finally, perhaps with regard to the previous question regarding California, would you say that you are looking towards another micro mill perhaps somewhere else in the United States and examining that maybe seriously and does this tie in maybe to the making available of more cash and then investment capability to do that?

Murray McClean

Well –

Gregory Macosko – Lord Abbett

From the write-off of – from the sale of the joist operation, I'm sorry.

Murray McClean

Well, in this environment, we will remain conservative. But we – that doesn't mean to say that we are not doing our homework. And I'm very, very pleased with that Arizona mill and the startup and also the acceptance of the marketplace. So yes, that – that's – it's too early to comment on that.

Gregory Macosko – Lord Abbett

Thank you.

Operator

Our next question comes from Wayne Atwell of Casimir Capital.

Wayne Atwell – Casimir Capital

Good morning.

Bill Larson

Good morning, Wayne.

Murray McClean

Good morning, Wayne.

Wayne Atwell – Casimir Capital

Some of what I'm going to ask you has already been sort of touched on. But instead of asking you about possible M&A activity involving you on the receiving side, how about consolidation? Some of the stocks in this – in the market haven't really been that strong and this might be a time to look outside for something that would fit in well with your business. Any thoughts about your ambition in terms of making an outside acquisition?

Murray McClean

Well, I think, following on the previous question, Wayne, I think it's just too early. I mean, we want to be conserve that we just got through our worst ever quarter. I mean, liquidity is very important to us and we will just see how the market develops over the next few months. But we think it would be more when markets start to show consistent recovery patterns, if you may, we may be tempted to look seriously.

Wayne Atwell – Casimir Capital

So for the foreseeable future, next few months anyway, you probably are not going to be out there doing your due diligence and making an offer somewhere?

Murray McClean

Well, I mean – maybe one or two isolated things, I'm not saying just here in the U.S., but for strategic reasons or other reasons, we might look at something. But it's not top priority, that's for certain.

Wayne Atwell – Casimir Capital

Okay. And then if we could just maybe go to the 40,000 level for a second and talk about scrap, with the net coal pricing where it's at and with iron ore prices where they are at and the fact that the general market has grown and the new scrap and old scrap really is not going to provide the same share as it has in the past, I guess there is every reason to believe that scrapping – scrap pricing over the next few years, three to five years, is going to be quite strong compared to where it was in the past. Would you agree with that?

Murray McClean

We would agree with that. I mean, I just recently came back. As you know, I travel frequently to Asia and there is still a lot of capacity even in this environment. Admittedly, their recovery is happening faster and earlier than here in the U.S. and Europe. But there is still lot of – if – production going into Asia, various countries and including countries like Vietnam and yes, scrap demand is going to remain strong. Supply could be an issue with some markets around the world and we would agree with you. We would think that prices would tend to stay high.

Wayne Atwell – Casimir Capital

Now, in terms of managing your business, well, I think that there is a high probability that that's going to be the case. I guess the volatility is going to be fairly high, so I guess if one weren't careful in running their business, you could have very strong pricing and that could end up being a problem instead of an advantage because you could get whip sought on your inventory and your pricing in the fab area and such. So I guess – am I right in assuming that it's going to take a lot of skill in managing your business to avoid getting hurt with a strong pricing and volatility – volatile environment?

Murray McClean

Yes, I think that's a good assumption. You need to be more careful than the past, but as Bill said earlier, we've got SAP now, we have got much better visibility than we've ever had from the fabrication through the mills back in the recycling and we – just because we did things in the past, doesn't mean to say that we will do them in the future. So we look at inventory at all areas in the supply chain and where it makes more sense where we can reduce the volatility, we will do it. And fortunately being vertically integrated, we have the mains of doing it better than some that are not.

Wayne Atwell – Casimir Capital

Okay, thank you.

Operator

(Operator Instructions). The next question comes from Tim Hayes of Davenport.

Tim Hayes – Davenport

Hey, good morning.

Bill Larson

Good morning, Tim.

Tim Hayes – Davenport

Just some housecleaning items. In the quarter, what were the start-up costs at the Arizona mill?

Bill Larson

Well, actually we don't consider it started up anymore. They just had losses.

Tim Hayes – Davenport

Very well. And the merchant bar premium?

Bill Larson

Hang on a second. I think it's 173, Tim.

Tim Hayes – Davenport

Okay. And then lastly, on the job loss reserves, that $57 million, what segments are those going into? Is there a couple that are bigger and what amount might that be?

Bill Larson

Yes, there is undoubtedly there are one – hang on. The biggest adjustments, no surprise here, on the job losses were in the fabrication operations in the United States and in – as I said, in the mills in international. Same thing, price protection on grandfather jobs

Tim Hayes – Davenport

And do you have the amount for, say, fab, just to get an idea?

Bill Larson

Yes. It was predominantly about $24 million roughly.

Tim Hayes – Davenport

Okay. That's helpful. Thank you.

Bill Larson

Okay.

Operator

The next question is from Sanil Daptardar of Sentinel Investments.

Sanil Daptardar – Sentinel Investments

Thanks. I think this time, the scrap prices are increasing on back of the iron ore prices, which was not in the cost cycle. Is the scrap supply not simply available in the marketplace or there is significant amount which is there, but scrap prices will continue to go higher on the iron ore prices?

Murray McClean

Sanil, good morning. Now, definitely, the supply is down on what it was for two or three years ago and for obvious reasons. Clearly, manufacturing is down, so there is less scrap being generated from manufacturing in the U.S. Demolition activities are down on two or three years ago.

So there is less scrap from that source and the biggest source of scrap is obsolete and there is less obsolete from two or three years ago. People hanging on to cars longer, not trying out refrigerators and washing machines and getting new ones, et cetera. So end-of-life scrap definitely is down in terms of supply. And I think that situation will remain until such time as the U.S. economy strongly recovers. So you are just not going to see the flows that you saw two or three years ago.

Sanil Daptardar – Sentinel Investments

Now, does any kind of – any news from – does that news from Vale yesterday that they are looking for now 100% increase in iron ore prices and China disputing that – disagreeing with that because the big three are trying to corner the iron ore market, it will have an impact on the scrap prices and scrap prices will continue then to go up. Are your customers comfortable if you increase the prices on maybe the surcharges to recover the scrap charges or are they not comfortable with the kind of surcharges you levied in the past?

Murray McClean

Well, if you look at the markets, the export markets were quite strong up till October-November period last year. But the more recent price increases are being caused by demand here in the U.S. Now, the Asians are coming back again this month quite strongly from the last few weeks. So yes, definitely there is a strong correlation with iron ore prices, but as – our view is still that these prices are not going to go up forever. There will be a correction and our view is around midyear.

Sanil Daptardar – Sentinel Investments

Good to hear that the demand is coming back in the U.S. Do you plan to increase the utilization rate to 80%, 90% in the forthcoming quarter?

Murray McClean

Well, we mentioned 67%. That's rolling capacity. Last year, fourth quarter was our best quarter for calendar 2009; that was 68%. So fourth quarter, we don't know, but we would hope we will be in the 70s. So yes, it is coming back slightly, but it's coming back.

Sanil Daptardar – Sentinel Investments

Okay, thanks.

Operator

The next question is from Sal Tharani of Goldman Sachs.

Sal Tharani – Goldman Sachs

Good morning, guys.

Bill Larson

Hi, Sal.

Murray McClean

Good morning, Sal.

Sal Tharani – Goldman Sachs

Good morning. I got a little late. So if any of these things you have touched upon, I apologize. But in Poland, how is the competitive landscape in terms of inflows from Germany or so – is there a problem besides obviously the margin squeeze, which is happening across the – well, in the long products?

Murray McClean

Well, there was a real problem. The finished goods prices were way too low and we are getting negative margins in the last quarter or two. But that seems to be reversed and very strongly in the last few weeks, particularly this month.

Some of – we know one of our competitors is – has got some major export business and there is actually a temporary shortage of rebar, would you believe, in Poland at this point in time. But that – we think that will be resolved the next few weeks, but prices have moved up sharply. We've seen this before, Sal.

Poland is a funny market, it's almost like a spot market, it can move from one month to the other and some of their competitors have been pricing direly, rebar price is (inaudible). We are doing now twice a week, we used to do a monthly. So there is a quite change there and – but as I mentioned earlier, the infrastructure work there is quite strong and will get stronger this year over spring and summer. And a little bit of a comeback in the residential, which is a good thing. So we are quite positive.

In terms of competition from outside, we are not seeing a lot so far and these big iron ore price increases and coal, the integrated guys and someone can produce rebar like in the Czech Republic. They are going to – until scrap moves up more strongly, you are going to be at a competitive disadvantage. So we don't see that in the short term. Clearly, if rebar prices get too high in Poland, we've seen it before, imports will go back into that market and we'll – prices will stabilize. But hopefully, the next few weeks will continue to be positive.

Sal Tharani – Goldman Sachs

Okay. And Murray, you just came from Asia. How are you seeing things over there? You have a physical presence, big presence in China also. In terms of on the ground, any concerns about tightening, property markets, bubbles people are talking about over there or how you saw this time when you went there?

Murray McClean

Well, I think there is clearly speculation in major cities in China. The Chinese – well, the banks at all levels lent about 9 trillion RMB last year, but they forecasted to reduce that to 7.5 trillion, which is still the second highest on record. And clearly, the central government through monetary policies so far is trying to slow things up. But they still want a GDP growth rate of 9% to 10%, which is very healthy. But virtually, all sectors remain quite strong in China.

The (inaudible) to automotive, obviously infrastructure construction is good and will remain. May be things will come off in the middle of this year, second half of this year. But it seems pretty firm and other parts of Asia are also strong. Singapore is growing in strength, even Vietnam has got some short-term financial or currency issues, but they seem to be getting through that.

So our strong view is Asia, led by China, most countries, maybe not all, will be stronger this year than last year and the peak period is really now through until September. We saw prices in China jump $30 to $50 a ton last week and steel prices, so – that's a sharp increase. So things are still quite bullish in that part of the world.

Sal Tharani – Goldman Sachs

Okay. And in the U.S., if you look at – if you look at the lag issue, at the moment whatever the price of rebar or merchant bar you are asking in the market, has it fully taken into account the current scrap price, whatever we have seen so far increase?

Murray McClean

Yes, the – well, the April price is, which effective 1st of April, they will go past (inaudible) to outpace the scrap price increase. There has been a lag, there has been a catch-up so far. Clearly, we don't know what April scrap price is going to be, but we think they will be firm, a bit – maybe, I don't know, $20 to $30 a ton, not $50 or $60 a ton. Time will tell, because the U.S. scrap price has outpaced international price and their international scrap prices are starting to come catch up with the U.S. prices. So April will be an interesting month.

Sal Tharani – Goldman Sachs

Great. Thank you very much.

Operator

At this time, there appear to be no more questions. Mr. McClean, I'll turn the call back to you for closing remarks.

Murray McClean

Okay, thanks very much. In summary, clearly we are very disappointed with our second quarter results. Looking ahead, we see slightly improving market conditions and with a lower cost structure, we anticipate improving results. Next week, Bill and I will be on our investor visits and we will be happy to take further questions during these visits. Thank you for your attendance.

Operator

This concludes today's conference. You may now disconnect your lines.

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Source: Commercial Metals Company F2Q10 (Qtr End 02/28/10) Earnings Call Transcript
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