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Houston Wire & Cable Company (NASDAQ:HWCC)

Q4 2013 Earnings Conference Call

March 13, 2014 11:00 ET

Executives

Jim Pokluda - President and Chief Executive Officer

Nic Graham - Vice President and Chief Financial Officer

Analysts

Sam Darkatsh - Raymond James

Robert Kelly - Sidoti

Operator

Ladies and gentlemen, thank you for standing by. Welcome to Houston Wire & Cable Company’s Fourth Quarter 2013 Earnings Conference Call. My name is Kevin and I will be your conference operator for today.

Joining us today on the call are Mr. Jim Pokluda, President and Chief Executive Officer and Nic Graham, Vice President and Chief Financial Officer. Today’s call is being recorded for replay purposes and all participants are in a listen-only mode. At the end of the financial discussion, we will conduct a question-and-answer session and instructions will be given at that time.

Comments during today’s call may include forward-looking statements. Any such statements are based on assumptions that the company’s beliefs are reasonable, but subject to risk factors that are summarized in press releases and SEC filings. Forward-looking statements are not guarantees and actual results could differ materially from what is indicated in such statements. Any forward-looking statements speak only as of the date of this call and the company undertakes no obligation to publicly update such statements. If you did not receive a copy of the earnings press release that was distributed earlier this morning, a copy can be found under the Investor Relations page of the company’s website at www.houwire.com.

At this time, I would like to turn the call over to Mr. Jim Pokluda, President and Chief Executive Officer. Please begin when you are ready.

Jim Pokluda - President and Chief Executive Officer

Thank you, Kevin. Good morning, everyone and thank you for joining us on our call this morning. I will begin today’s call with an overview of our fourth quarter and full year 2013 performance, and then I will turn the call over to Nic who will discuss our financial results in detail. Kevin, we just received apparent sound on the conference. Is everybody still connected?

Operator

Yes, sir. Everybody is still connected.

Jim Pokluda - President and Chief Executive Officer

Okay, thank you. Fourth quarter seasonality, regional market strength inconsistencies, and lack of large capital projects resulted in a total sales decline of 10% from the prior year or approximately 7% when adjusted for deflation in the price of metals. We estimate that 70% of our total revenues resulted from maintenance, repair and operations activity and 30% from project activity. Despite the reduction in total sales, transactional volume which we measure as total invoice count increased approximately 7% during the quarter. We are encouraged by the latter as we believe this metric serves as an effective measure of share gains and our increasing ability to service customer demand.

Sales results in our core business, which services MRO demand, increased approximately 3% over the prior year or approximately 6% on a metals adjusted basis. Despite typical year end seasonality, this marks the fifth consecutive quarter for MRO quarter-over-quarter revenue growth and the second best MRO revenue quarter when compared to the company record set in the third quarter of 2013. Geographic fourth quarter MRO market recovery trends were more balanced than in prior quarters. We are encouraged by these results as the performance in slowly recovering regions such as the Northeast and the Southeast reach a post recession high. As in prior quarters, oil and natural gas-rich regions continued to perform well.

Fourth quarter sales results in the project area of our business were disappointing as sales declined approximately 30% versus the post-recession period – post-recession record experienced in the prior year period. Sequentially, when comparing Q3 2013 versus Q4 2013, project business increased approximately 4% on a metals adjusted basis. Although project activity in oil and natural gas-rich markets remained very good, our results in this area were unable to offset the project sales decline resulting from copper mines broad market conditions and reduced capital investment in new power plant construction.

Market optimism and the risk tolerance for investments and significant plant upgrades expansions in greenfields has been less than expected. Although United States industrial production has largely recovered to pre-recession levels, we continued to experience project holds and delays due to conservative capital allocation strategies, which have favored high rates of plant utilization over investments in facility expansion. As such, project activity in broad markets such as general and industrial manufacturing, have performed below expectations.

New coal-fired power plant construction, which is a large end market opportunity for our products and services continues to be negatively affected by proposed regulations that would require reduced emissions of CO2 and other toxins from new and existing plants. These regulations have stymied investments in new and existing coal-fired power plants. And as a result natural gas and alternative energy fuel sources have become the predominant technologies utilized in new power plant construction.

HWC’s products and services support the demand requirements for all new power plant construction regardless of the fuel source. However, the impact of the proposed regulations has been strongest on overall industry investments utilizing coal as a fuel source. As the power industry receives additional clarification on the proposed regulations throughout 2014, producers will be better positioned to plan and execute new power plant and environmental compliance construction in the project pipeline that is building and ultimately required to service growing industrial and household demand. We remain encouraged by our continued success in small scale projects, particularly in the oil and gas space and in general and industrial manufacturing where, despite conservative business management practices, certain work can no longer be postponed.

As in prior quarters, strong upstream and downstream activity remain top performing markets due to the abundance of hydrocarbon resources now available as a result of fracturing technology. The substantial investments required to extract, transfer and refine the shale play feedstock, is expected to last for several years. For the entire year 2013, sales decreased 3% and were flat on the metals adjusted basis. We estimate the metals adjusted MRO sales increased 7% and project sales decreased 14%. Although we were disappointed that Q4 year end seasonality and less than expected project building hurt our overall 2013 performance, we were encouraged to see that our largest revenue stream which is MRO grew 7% on the metals adjusted basis. We are also pleased to see that our full year transactional volume increased approximately 5%. As mentioned earlier, we believe that transactional increases and continued growth with MRO sales serve as good proxies for measuring improvement in HWC’s market share.

Full year 2013 comments involving market strength largely follow those details in my Q4 comments. Certain geographic regions have underperformed our expectations. However, we are encouraged by the continued slow recovery of the Northeast and Southeast markets. The West Coast and Midwest markets remain the most challenging. We find these markets particularly in the Midwest most heavily affected by the low risk tolerance and aversion to large capital spend formerly mentioned. The nation’s pullback on coal-fired power production has most affected this region. Despite all the above, however, and largely driven by extensive oil and gas investment, our book to bill ratio remains positive as does our project opportunity pipeline.

As I move further into comments involving 2014, I like to highlight our recent announcements. Our new facility in Anchorage, Alaska expands our footprint in this under service market and our location in Odessa, Texas supports growing product demand from the oil and natural gas rich Permian Basin region. We also recently joined Affiliated Distributors. AD is a large buying group whose affiliate membership includes many of HWC's largest customers as well as members who did not formerly purchase from us. This new partnership will allow for increased collaboration between HWC and AD affiliates and provides an excellent opportunity for additional sales development.

Our outlook for the first quarter of 2014, despite the significant negative impacts from disruptive weather conditions is stable. We are off to a solid start and the overall market appears to be improving slightly. Based on the results of the first two months, we expect our net income for the first quarter of 2014 to be slightly less than the first quarter of 2013. For the full year, we expect low-single digit revenue growth and mid to high-single digit earnings growth. I would like to close my prepared remarks by reinforcing that the long-term fundamentals of our markets are intact. HWC’s value proposition remains highly desirable to its customers as they continued to pursue strategies to reduce working capital investments and increase reliance on partners such as HWC who supply critical, highly technical time sensitive items.

Finally, as in prior quarters, customer satisfaction, order accuracy and on-time performance were again outstanding and we are confident that we are properly positioned to execute in a still recovering economic environment.

I will now the turn the call over to Nic Graham, our Vice President and CFO for detailed analysis of our financial results. Nic?

Nic Graham - Vice President and Chief Financial Officer

Thanks, Jim and good morning, ladies and gentlemen. The results for the fourth quarter and the year as Jim mentioned were primarily impacted by the level of project sales, which has been a downward trend of the last several quarters. Comparisons to the prior year quarter are difficult as that quarter achieved record sales results, including strong project sales. Our gross margin held up reasonably well in the marketplace, but is still extremely competitive helped by the increase in MRO sales, which traditionally generate higher margins.

Operating expenses increased 4.4% over the prior year period principally due to headcount related expenses, temporary labor and healthcare costs and higher distribution network costs for Minneapolis, Anchorage and other facilities. For the year, excluding the goodwill impairment, cost increased 3.3% or $1.9 million principally due to the higher headcount, higher operating expenses related to the additional facilities, and higher inventory levels. Our operating model is one we have a greater level of fixed costs, EG facilities and personnel. And when sales levels fall short of target, our bottom line results are impacted.

Over the past year or more, we have talked about our investment in additional personnel principally on the sales and marketing side. In light of the revenue uncertainty and the ongoing competitiveness of our business in the present operating environment, we took steps in late December and early January to reduce operating expenses. We estimate the total savings from this operating expense reduction, including a reduction in headcount to be approximately $1 million to $1.5 million on an annual basis. Our commitment to rigorous expense management will continue in 2014 with the goal of finding value driven sources for all our third-party expenditures.

We continue to benefit from the current low interest rates and minimize rates where possible by maximizing the amount of LIBOR debt that we carry, which attracts a lower rate. The effective tax rate for the quarter increased slightly due to higher state taxes, but the annualized tax rate, excluding the impact of the impairment, remained consistent at 38.4%. We want to remind everybody HWC is a full rate taxpayer with minimal opportunities to reduce rates.

Turning to the balance sheet, our working capital investment moved slightly, up 2.3% over Q3 2013 levels, but down 2.5% from December 2012. Accounts receivable decreased from year end 2012 as collections in the fourth quarter were higher than expected while sales were lower. Receivables metrics such as aging, uncollectible accounts and day sales outstanding, all remained within recent historical levels. Inventory levels increased to $96.1 million from $84.7 million at December 31, 2012. We made a business decision to increase our inventory investment in Q4 to take advantage of some favorable vendor terms, which at our low cost of borrowing made economic sense. This investment will help us fill more of our customer’s orders from our stock and assist in driving opportunities for increased market share. We continue in our efforts to refine our regional inventory profiles to satisfy local demand and to maximize the effectiveness of our inventory investment. Other component parts of working capital moved minimally during the quarter.

Capital expenditures for the quarter were $2.6 million higher than normal the bulk of which was the purchase of a new facility for the Southwest Wire Rope division for $2.5 million in Houston. As previously discussed, we will merge the four existing Houston Southwest Wire Rope locations into this facility, which will allow a more effective workflow and a base to drive future sales. This is scheduled to happen in Q3 of 2014 once the building has been refurbished and modified. The annual CapEx spend was $3.4 million during the year, or $0.9 million excluding the building purchase, which is a lower run rate than the previous year’s $1 million spend.

Q4 cash flow was positive at $1.2 million and for the year operation generated $20.7 million, which compares favorably to 2012, where we used $3 million of funds. Debt levels increased $3.4 million during the quarter primarily to fund the purchase of a new facility for the year after financing the capital expenditures and the dividend of $5.5 million, we paid down our debt by $10.6 million from closing 2012 level, a decrease of almost 15%. Our year end debt to equity ratio is now 43.3% and included in the bank overdraft of – is 47.5%. These are very manageable levels and this is after the impact of the impairment charge.

Interest coverage on our debt on a trailing 12-month basis excluding the impairment charge was almost 25 times. While our debt levels rose from Q3, we still have more than adequate capacity for our current needs. Availability under our $100 million credit facility was $50.7 million, up from the $41.4 million level at December 2012. We remain in full compliance with the covenants of our loan and security agreement which expires in September 2016. We were pleased to announce to our shareholders the $0.11 per share dividend for the fourth quarter and as you notice the Board approved a $25 million stock buyback program which will be effective Monday, March 17, 2014.

That concludes the prepared remarks. At this time, I will turn the call back over to the operator. Kevin?

Question-and-Answer Session

Operator

(Operator Instructions) Our first question will come from Sam Darkatsh with Raymond James.

Sam Darkatsh - Raymond James

Jim, good morning, Nic can you hear me okay.

Nic Graham

Good morning Sam, yes.

Jim Pokluda

Yes Sam.

Sam Darkatsh - Raymond James

Good morning. Three questions if I could, first off, this is a bit of clerical question, but with the inventory, I am guessing and you are going to be working that down as the year progresses, so should we anticipate free cash flow for the year to exceed net income?

Nic Graham

I think we are working that inventory level down Sam, but it will be down quite a bit by the end of first quarter. I am working it down obviously that could change as circumstances if sales volume increases. We are projecting a cash flow slightly in excess of net income for this year.

Jim Pokluda

I would just additionally comment that the significant majority of what we put into stock remains fast moving items and items that really don’t have the shelf life or in anyway are at risk as becoming obsolete. And in addition, we were very low, far too low in the Q3 of 2013, almost a little bit over $9 million if I remember correctly as well compared to where we were in 2012. And I think that that negatively impacted sales to some extent in Q4. On the – with the forethought knowing that we are going to be moving into Alaska, Odessa and favorable channel feedback involving increased MRO spend and as Nic mentioned favorable offers from the suppliers, we thought it was in the best interest of the company to bring that inventory up. And as Nic has commented, we will – already have made progress in moving it down in the first quarter.

Sam Darkatsh - Raymond James

Second question if I could, your expectations for low single-digit sales growth for the year, I am guessing that’s inclusive of whatever happens with commodity pricing and with copper moving pretty sharply, what is your assumption for inflation or deflation as the case maybe for the year and for the near-term and what were the effects of that as we look at our models?

Jim Pokluda

Right. Well, that I think it was five business days ago, seven maybe copper was $3.27 and we know what it’s done now. That’s been a very recent move. There is a lot of speculation in the market about why that’s really happening. The comment that I made for low-single digit growth does not contemplate a catastrophic drop in copper, very rarely in our experience have we seen that. We are hopeful that that doesn’t occur. So this news is very new news. I think that the prudent thing to do is observe for the next several weeks to see what’s going on. We hope its temporary, but to specifically answer your question, my comments for full year performance contemplates a generally flat copper market. We don’t get granular to the extent that we model out high risk and low risk scenarios for copper.

Sam Darkatsh - Raymond James

Flat topper market 2013 versus 2014 or flat topper market versus where it is presently?

Jim Pokluda

The former 2013 versus 2014.

Sam Darkatsh - Raymond James

Okay. And then last question before I defer to others, your gross margin I am guessing even though it was a little bit better than it could have been certainly the MRO mix helped. I am guessing because of the sales shortfall on your mix or you had to have some negative adjustments to your vendor rebate allowances in the fourth quarter. Should we then expect in the first quarter that the gross margins should net higher sequentially or because the project business maybe coming back a little bit more that there maybe some pressure on gross margins?

Jim Pokluda

I will expect gross margins to remain flat.

Sam Darkatsh - Raymond James

Okay. Flat sequentially.

Jim Pokluda

Yes.

Sam Darkatsh - Raymond James

Okay, thank you Jim. Thank you Nic.

Jim Pokluda

You are welcome.

Operator

Your next question comes from Robert Kelly with Sidoti.

Robert Kelly - Sidoti

Good morning, Jim. Good morning, Nic.

Jim Pokluda

Good morning.

Nic Graham

Good morning.

Robert Kelly - Sidoti

Just wanted to follow-up on the last question about gross margin, especially around the outlook from the channel for industrial MRO that’s your higher mix business, it sounds like the new project is going to be choppy for at least a couple of quarters. Why wouldn’t gross margins improve? Is price competition intensifying in the industrial MRO category?

Jim Pokluda

Well, yes. Given a fulsome market and a market that is experienced what I would describe as consistent regional growth, which do not have. I would definitely agree with you statement, all things being equal, MRO margins are higher than project spend. However, the market just isn’t allowing for that. The data that I review the feedback – channel feedback, I get from supply partners and distributor customers, is that organic performance has been pretty tough. The competition has not abated. And as a result, we just have to really maintain an aggressive posture in order to assure number one, we don’t lose share position and two, do what I think we have been doing grow share. So that comes at the expense of a few basis points for margin. Fortunately, we have held our head and the margin has been acceptable should broad market conditions continue to improve as I believe they will and the evidence supports that statement, I think we will continue to have opportunities to raise gross margin.

Robert Kelly - Sidoti

Okay. So I mean just based on what you are seeing or what you are seeing over the past couple of quarters is the competition, is it stabilizing just remaining intense, or is it starting to get more intense with signs that industrial MRO is picking up?

Jim Pokluda

The best way to answer that question I would have to say is on a regional basis. The competition in markets where we have had difficulty, the West Coast and the Midwest, I would say is worse. The competition in strong markets, oil and gas markets is intense, but I wouldn’t say it’s getting any worse, alright. The Southeast, mid-South and Northeast has remained very competitive, but I believe our additional investment in inventory and our business development plans have helped us grow share there.

Robert Kelly - Sidoti

Okay, that makes sense. Thanks. As far as the exposure to the regions the Texas, the oil and gas markets are improving more strong? Northeast and Southeast are seeing a recovery, West Coast is weak and Midwest is weak. Can you just talk about what’s driving the improvement in the Northeast and the Southeast? And then just kind of review your exposure whether it be percent of sales, percent of operating income that are coming from the distant regions that you have called out in your prepared remarks?

Jim Pokluda

Well, we have never got as specific as you have described in the latter. So I wouldn’t be able to comment on that in any specific detail. But I am certainly comfortable talking about it in more of a macro sense. Again, I believe our success on Eastern seaboard has been a function of a couple of strategic business decisions. One is putting more product out in the channel. Two is the reality is that the end use customer simply cannot procrastinate any longer the work that had been deferred post recession. And we are thankful for that. We are starting to see a higher inflow of let’s call them big MRO orders or small project orders typically in the O part of MRO, which is operation.

So I would say that the – generally speaking despite unfavorable market conditions, maintenance can only be deferred for so long and repair can only be deferred for so long, but some of the smaller scale operation work can be pushed out a little bit further. We are seeing resurgence in that space. And I think we most substantially benefited from that along the Eastern Coast. And then you will note that I commented in a broad sense about outlook for 2014. And I mentioned our new relationship with Affiliated Distributors. That relationship was not in place at the end of 2013. However, I will say that we are excited about that opportunity. And the benefits from that relationship have started to manifest themselves into some of the performance we have seen into the early part of 2014.

Robert Kelly - Sidoti

Okay, great. So if you would – is there a way you can give a percent of sales or from each region?

Jim Pokluda

That’s – I am sorry Robert, that’s just an area that we have never been as specific as you are requesting. So that’s just something that we don’t disclose.

Robert Kelly - Sidoti

Okay, fair enough. And just one final one, with the new facility in Alaska and Odessa, what kind of revenue impact could that potentially bring in 2014?

Jim Pokluda

Well, Alaska is a, we believe a smaller market opportunity than would be Odessa. And the strategies are a little bit different. So Alaska is a strategy that leverages the fact that accessing that market is difficult. There is a limited supply in the space. So we made a strategic decision to invest in the channel and support market demand in that space because it’s just hard to get product out there. The total sale opportunity though in fairness would not be the same I believe as it will be in Odessa. In Odessa we – in Midland Odessa, Eagle Ford, Permian Basin with expanded geography, we have enjoyed success for decades, okay. But given the increased market demands coming out of that region, we wanted to make sure that we had product availability for same day demand and that’s why we are there. Again though we will have to say we don’t disclose branch performance or regional performance. So I won’t be able to quantify for you the actual revenue outlook for those two locations.

Robert Kelly - Sidoti

Okay, great. Maybe if I can just sneak in one final one with the buyback authorization you had strong free cash flow on 2013, looking to be strong again in 2014, will you be opportunistic with the buyback I mean how do you approach the buyback?

Nic Graham

Yes, that’s we are just talking about the – we are just really coming about the overall plan Robert. Its two years through December 2015 $25 million there is some specific guidelines in there which we are going to administer the plan. But I don’t really want to get into specifics at this time. We will be buying on a regular basis as appropriate.

Robert Kelly - Sidoti

Okay, thank you.

Operator

(Operator Instructions) I am not showing any further questions at this time. I would like to turn the conference back over to our host for closing remarks.

Jim Pokluda - President and Chief Executive Officer

Thank you, Kevin. And thanks to our valued team members for their continued hard work and dedication to the company. To our shareholders, we extend special thanks as well. We appreciate you joining us on the call today and look forward to success in the period ahead. Good day everyone.

Operator

Ladies and gentlemen, this does conclude today’s presentation. You may now disconnect and have a wonderful day.

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