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Universal Stainless & Alloy Products, Inc (NASDAQ:USAP)

Q2 2010 Earnings Call

July 28, 2010 10:00 a.m. ET

Executives

June Filingeri - Comm-Partners

Denny Oates - President & CEO

Doug McSorley - VP, Finance & CFO

Chris Zimmer - VP, Sales & Marketing

Analysts

Michael Gallo - C.L. King

Tim Hayes - Davenport & Company

Phil Gibbs - KeyBanc

Gregory Macosko - Lord Abbett

Ralph Maresh - First Manhattan Company

Operator

Good morning. My name is Christie, and I will be your conference operator today. At this time we would like to welcome everyone to the Universal Stainless & Alloy Products Second Quarter 2010 Conference Call and webcast. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be question-and-answer session. (Operator Instructions). As a reminder this call is being recorded. Thank you. I would like to turn the call over to June Filingeri of Comm-Partners. Please go ahead June.

June Filingeri

Thank you, Christie. Good morning everyone. This is June Filingeri of Comm-Partners, and I'd also like to welcome you to the Universal Stainless conference call. We are here to discuss the Company's second quarter results, which were reported this morning.

With us from management are Denny Oates, Chairman, President and Chief Executive Officer; Bill Beible, Senior Vice President of Operations; Paul McGrath, Vice President of Administration and General Counsel, Doug McSorley, Vice President of Finance and Chief Financial Officer; and Chris Zimmer, Vice President of Sales and Marketing.

Before I turn the call over to management, let me quickly review procedures. After management has made formal remarks, we will take your questions. Christie will instruct you again on procedures at that time.

Also please note that in this morning's call, management will make forward-looking statements under the Private Securities Litigation Reform Act of 1995. I would like to remind you of the risks related to these statements, which are more fully described in today's press release and in the company's filings with the Securities and Exchange Commission.

With these formalities out of the way, I would now like to turn the call over to Denny Oates. Denny, we are ready to begin.

Denny Oates

Thanks, June. Good morning everyone. Thanks for joining us today. Before getting started with this quarter's review, I want to take a minute to introduce our new Chief Financial Officer Doug McSorley. Doug comes to Universal Stainless with extensive experience in financial management and excellent track record and strategic planning and business development and strong leadership skills.

He joined us after a 15 year career at PSC Metals, a metal recycling company with operations in the United States and Canada, which is now part of Icahn Enterprises. Before PSC, Doug worked with numerous industrial clients as a chartered account with Deloitte and Touche in Ontario, Canada. Since Doug is only been with us for a few days, we're going to let him love to hook fairly easily, but I know he has a few introductory comments he wants to make.

Doug McSorley

Thank you, Denny. It is a great pleasure to be here today and to be a part of the Universal Stainless management team. From the very beginning of the interview process, I was impressed by the level of the energy, the focus and the passion at Universal Stainless to move this company forward. Now that I'm here, I've discovered how pervasive that is throughout the whole company.

It is a very exciting time to be here. Let me add that I look forward to getting to know our analysts and our investors in the weeks ahead. I'm planning to keep the same open door policy that this company has always had. With that Denny, let me turn the call back to you.

Denny Oates

Okay Doug, thanks. Let's start with the second quarter of 2010. Sales are $51 million, were 48% higher than the 2010 first quarter, and 67% higher than the second quarter of 2009. Volume shift was up 40% sequentially and 72% from the year ago period. So, our robust sales growth was largely volume-driven.

Increased volume combined with cost reductions from process and quality improvements, and recently completed capital projects produced operating income of $6.4 million or 12.5% of sales, the highest quarterly operating margins since the third quarter of 2007. Net income was $4.2 million, or $0.61 per diluted share compared to $1.4 million or $0.21 a share in the first quarter of 2010.

Cash flow from operations was a use of $800,000 in the second quarter which includes a $4.1 million tax refund. Cash flow has decreased in 2010 due to our investment in manage working capital to support the sharply higher sales activity.

However, managed working capital per dollar of sales improved to 35% versus 42.5% in March, 2010 and 46.7% in December, 2009. Day sales outstanding and receivables improved by eight days during the quarter and our FIFO based inventory returns continue to improve reaching three turns compared to 2.5 turns last quarter.

Capital expenditures were $2.3 million in the second quarter including $1.2 million for the melt shop upgrade project which will be substantially completed in September. At June 30, our balance sheet remained very strong with cash balances of $34.7 million and total debt of $12.2 million.

The $600,000 per quarter principle payments on a $12 million PNC term loan began in May. There were four drivers in the second quarter sales improvement. First, end user demand in certain markets began to improve earlier this year. Second, supply chain restocking began to accelerate late in the first quarter and early in the second quarter.

Third, service levels are a critical determinant in the awarding a business from customers to remain following focused on minimizing their own inventories. Our gains and on time performance and shortened lead times enabled to us win additional business.

Fourth our progress and ongoing initiative is to penetrate new segments of our markets made a favorable contribution.

While sales increase 48% sequentially, operating income of $6.4 million nearly tripled over the 2010 first quarter of $2.3 million.

The process improvements and capital projects discussed in past calls including the elimination and (inaudible) bottlenecks, the cellular rising of bar finishing operations and our melt shop upgrade all contributed significantly to margin expansion.

Melt to ship yields increased 1.5% during the quarter. Interest in lay our upgrade to melt shop reduced more pounds in the first half of 2010 with first time true measures well up in the 90s then was produced in the entire year of 2009.

Melting cost fell 5% during the quarter, labor productivity is measured by pound ship or labor hour increased at double digit rates versus the first quarter.

These improvements are sustainable and there is more we can do. Turning to our end markets, aerospace, remained our largest market at 31% of second quarter sales compared with 33% of sales in the first quarter and 39% of sales in the second quarter of 2009.

Aerospace sales growth 41% sequentially and 35% over the year ago period. Aerospace bookings have increased for three consecutive quarters due to our marketing initiatives, supply chain restocking and end user demand improvement. Since, our last call positive momentum has continued to build. Farnborough Airshow is described as a revival of commercial aerospace with over $28 billion in orders.

International Air Transport Association forecast the global airline profitability now projects solid earnings in 2010 and revenue passenger miles continue to rebound in May.

Boeing has increased the build rate on several major programs, the production ramp up of the 787 program slated for 2011 will add to the demand for our aerospace stainless materials.

Airbus also has said they expect to increase their build rates to the growth in their order book. The probability of lower defense spending in coming years is one of the few negatives incurring aerospace trends. Despite the recent positive news our customers continue to project gradual improvement demand for the remainder of 2010 with accelerating growth in 2011. Customers are also being conservative in placing orders citing unstable raw material cost trends. The petro chemical market was our next largest market in the second quarter, representing 20% of sales, compared with 23% in the first quarter of 2010 and 19% in the second quarter of 2009.

Our petrochemical sales which are primarily for oil and gas exploration were up 34% from the first quarter of 2010 and up 78% from the second quarter of 2009. Halliburton and Schlumberger both reported strong growth in North America in the second quarter and recounts were up 13% for the period. However both companies also reported reduced offshore activity in the Gulf of Mexico late in the quarter due to the drilling moratorium.

Despite the moratorium it appears equipment and crews are being relocated to continue drilling. The majors and service companies along with our customers are generally positive about the second half. However we remain somewhat cautious. The metal supply chain in this market still appears to have excess inventory and the lingering effects of the BP disaster in the Gulf remain to be seen.

Power Generation represented 19% of second quarter sales compared with 17% in the first quarter of 2010 and 26% of sales in the second quarter of 2009. Our Power Generation sales were up 66% sequentially and up 22% from the second quarter of 2009.

We continue to benefit from maintenance activity in this market which our short lead times and quick turnaround. There also appears to be some life in the new gas turbine business. We use General Electric as a bell weather for the Power Generation market.

Through 2010 second quarter General Electric reported shipping 31 gas turbines versus 42 last year. However GE orders improved to 46 new turbines compared to a total 25 turbines in the year ago quarter. I've said before that the market for new turbines is not expected to recover until 2011. My recent conversations with foraging customers confirm this outlook despite what may be some promising signs at GE.

Our service center plate sales were 17% of second quarter sales versus 18% of sales in the first quarter of 2010 which is 5% in the 2009 second quarter. We continue to see positive momentum in our service and our plate sales which rose 44% from the first quarter of 2010 and were up five fold from the 2009 second quarter. This further ramp up is being driven by the recovery in the domestic automotive industry, offer equipment and the general industrial sector. Last Friday Ford reported that their second quarter revenues rose 30% and they're expecting further improvement in 2011.

Earlier this week Caterpillar reported better than expected results with machinery and engine sales up 34%. Cat noted that their challenge has been to increase production rapidly enough to fill orders. This is obviously welcome news and helps explain why our business level and backlog and service center plate remain strong and why our customers remain optimistic about the second half of 2010.

So in summary, there was robust improvement in our sales and profitability in the second quarter of 2010 which levels obtained that we have not seen since early 2008 and late 2007 respectively. Continued demand recovery and the success of market initiatives and product expansion drove the growth in sales. The accelerated profit growth was due to substantial volume increase, discipline pricing, further execution and processing quality improvement efforts and increasing return on past capital investment projects.

Recent economic uncertainty in raw material pricing have caused customers to remain cautious as evident in our backlog which well from $53 million on March 31st to $46 million on June 30 although it remains well above last year. Therefore sequential sales should continue in the second half of 2010. However at this point it is expected to be modest. Our effort to achieve higher service levels, further process improvement and cost reduction and to derive benefit from the melt shop upgrade will continue relentlessly. Lastly, let me close by saying again we're pleased to have Doug in certainly on the Board to fill the important role of Chief Financial Officer of our management team.

And with that I'll close my formal remarks and open up to your questions.

Question-and-Answer Session

Operator

Thank you. (Operator Instructions) And your first question comes from Michael Gallo of C.L. King.

Michael Gallo - C.L. King

Hi. Good morning. Congratulations on the good quarter.

Denny Oates

Good morning, Mike. Thank you.

Michael Gallo - C.L. King

Question I have just as I know you noted the -- you expect the some of the sales growth obviously, really sequentially to flatten out or be up modestly in the back half. Was there anything unusual that you saw in the gross margins in the quarter in terms of mix of business, or would that be a reasonable gross margin expectation for the back half of the year as well?\

Denny Oates

That would be a reasonable number, Mike. There is nothing unusual in the second quarter, stronger volume and solid improvement from the cost performance standpoint.

Michael Gallo - C.L. King

All right, okay.

Denny Oates

We expect that to continue.

Michael Gallo - C.L. King

And you would expect I think from your commentary obviously you've had very good maintenance business on the Power-Gen side, you'd expect that portion of it to moderate somewhat, but that Power-Gen business start to pick up more meaningfully in 2011. Is that a fair characterization?

Denny Oates

Yeah. As we look at our bookings, we would expect the sales to decrease in the third quarter in the Power-Gen area and the only caviar I would put on that is this maintenance business requires quick lead times and fast turnarounds, so you won't see in our backlog at the end of June, come in July or August and then we will turn it around and get it back out the door before the quarter ends.

Michael Gallo - C.L. King

All right.

Denny Oates

So we expect that with our lead times, right now. We would expect to continue to see that maintenance business, but the true underline growth in that market which as you well know is very cyclical. From all we can see the only real positive that we've seen new turbines is been that GE incoming business. All of our customers universally feel that this will be something that will hit in the fourth quarter, the first quarter of next year.

Michael Gallo - C.L. King

Okay, great and then just final question that the -- most, I don't know, maybe I missed it in the prepared remarks but what was International as a percentage of the sales in the quarter?

Denny Oates

International was 7% in the second quarter.

Michael Gallo - C.L. King

Okay.

Denny Oates

So we are down somewhat. We were up to 10% if you remember last year. It was one of our initiatives and that has to do not so much with the loss of international sales at a more rapid growth of domestic sales over the last two quarters.

Michael Gallo - C.L. King

All right, and then I guess one more final question. The melt shop sounds like that that will be substantially complete in September. Should we start to see more the benefit of that in the fourth quarter, or probably you won't get much of it till 2011?

Denny Oates

Well, a lot of the savings you're seeing already attributed to net capital project. I mean basically the equipment has been in place for a while, and we've been refining our practices. We're talking about completing in September that are the control systems. So, you're already seeing some of the savings. I would say probably seeing two thirds of the savings.

Michael Gallo - C.L. King

Okay.

Denny Oates

The remaining you will start to see in the fourth quarter.

Michael Gallo - C.L. King

Right, okay, great, thanks a lot.

Denny Oates

You are welcome.

Operator

Your next question comes from Tim Hayes of Davenport & Company.

Tim Hayes - Davenport & Company

Hey good morning.

Denny Oates

Good morning. Just referring to the question on the margins in the second quarter. We are calculating that gross margins as a percentage of value added sales for the USAP segment was 35% for Q2. Now you're -- you had a say to go long-term of that being 30% should we be taken that long-term goal are higher based on this Q2 performance or what?

Doug McSorley

We had not upped our goal but we have already achieved the goal so I think as I said to Mike a few minutes ago, I would look at our second quarter margins and I don't see any reason for those to fluctuate going forward subject to any wild swings or raw material cost that we are not seeing today.

Tim Hayes - Davenport & Company

I guess one follow-up there; maybe the margins got a little help in Q2 from a nickel going up in price earlier in the quarter. Was there any that FIFO gain that may have been in there at least a little bit?

Denny Oates

I think the company has changed a lot and with our cycle times as short as they have gotten over the last couple of years I don't think you have that long lag time. We get a big pop, so there were some of that. He asked me to quantify it. I am not sure I could because it was so small.

Tim Hayes - Davenport & Company

Okay. Thank you.

Doug McSorley

And keep in mind that also nickel has come down over the last month and half, it has actually peaked in April.

Operator

Your next question comes from Phil Gibbs of KeyBanc.

Phil Gibbs - KeyBanc

Hi guys good morning.

Doug McSorley

Hey Phil, how are you doing?

Phil Gibbs - KeyBanc

Pretty good, I just had a question on how we should be viewing the pricing realizations in the third quarter. I know that typically depends a lot on mix and timing of surcharges but should we be looking at that somewhat coming in and some better sequential volume and some carrying through to the third quarter?

Doug McSorley

Our base pricing is essentially unchanged as we look at the third quarter versus the second quarter. However, you mentioned surcharges, and surcharges are clearly coming down. We price based up on a two month lag, so if you think about nickel prices it is a proxy for surcharges and total and they peaked in April, came down in May and June. So, as again in July and August you are going to start to see lower total pricing due to the lower surcharge but not due to lower base prices.

Phil Gibbs - KeyBanc

Okay great and can you just give me a feel for how your customers are feeling in the aerospace channel and how much of the recent upside in volumes do we see in there have been due to just lack of de-stocking that we saw in the second half of '09 and just to catch up and do you expect aerospace volumes to tick up in the back half of the year with these new programs and are we seeing a pull through from the new programs in your view at this point.

Denny Oates

I think we saw somewhat of a spike in aerospace demand late in the first quarter and early in the fourth quarter. A lot of that was through restocking, when people realized that the world has not come to an end in aerospace world and they were seeing some demand. So, there was some clearly some restocking I think that would come back closer in the balance and customers are buying closer to what they perceive to be their end user demand. They are very cautious because of raw material, pricing and volatility for one thing and just the general economic climate.

That said the general feeling and part of the customers as we'll see a gradual improvement in aerospace in the third quarter and in the fourth quarter in terms of underlying demand but 2011 is really the year they expect to see growth accelerate and that's a function that some of these larger programs ticking in.

Phil Gibbs - KeyBanc

You think any of the new programs have kicked in thus far?

Denny Oates

I think we are starting to see the beginning of it on some of their traditional planes. I think people are looking at 787 as that starts to go operational it will get into late first quarter, second quarter of next year. I think that's what they are looking at as the real driver of growth in 2011.

But there has already been an increase in build rates in some of the more common models.

Phil Gibbs - KeyBanc

Perfect, it's good to see all the progress you guys are making with your capital upgrades and I wish you the best going forward. It looks solid.

Denny Oates

Thank you very much.

Operator

(Operator Instructions). Your next question comes from Gregory Macosko of Lord Abbett.

Gregory Macosko - Lord Abbett

Yes, thank you. Just a follow-up on Tim's conversation about the gross margin et cetera. I think earlier you said that you've realized about two thirds of the savings from the restructuring. Is that correct?

Denny Oates

From the melt shop upgrade, yes.

Gregory Macosko - Lord Abbett

Okay, so we still should be seeing some savings which I would assume would flow through to the gross margin line right?

Denny Oates

Yes.

Gregory Macosko - Lord Abbett

So perhaps in other words you said the gross margin, you see no reason for it to fluctuate from this current level. Does that not mean it couldn't go up from some from some of the more savings to be realized?

Denny Oates

No if I said let me clarify. We would expect to see further cost savings as we move through the year 2010 and into 2011, okay? That would drive our margins up. The only caveat I would put on that is any wild swings in raw material cost that we're not currently projecting. Our view is that a nickel for intents and purposes is going to trade between 8 and $10 a pound for the remainder of the year. So that's the only caveat I would put on it Greg.

Gregory Macosko - Lord Abbett

Okay but in terms of, you've got others costs I assume, scrap and the like too that could fluctuate, that could have a more direct effect from the fluctuations in nickel?

Denny Oates

Yeah its pretty well tied to nickel. My comments are kind of an umbrella comment about raw materials. I always use nickel as a proxy. Whether we get the nickel unit from virgin nickel or we get it from scrap you get the same fundamental trends.

Gregory Macosko - Lord Abbett

Okay, and I think I heard you just generally talking about the conversation over restocking. Do you feel like restocking is done in aerospace, people backed off so much? Is that kind of leveled off by the end of the second quarter or so?

Denny Oates

Yeah, I believe restocking is basically leveled off and our customers are buying more towards what they perceive end user demand coming down the pipe towards them.

Gregory Macosko - Lord Abbett

Right, sounds right. Now, and then with regard to restocking and petrochemical Power-Gen and service centers, just generally can you -- how do you feel about those industries? Have they completed their restocking at this point or….

Denny Oates

No. If you look at the oil and gas business in particular we still feel that there is excess inventory in the metal supply chain feeding the oil and gas business.

Gregory Macosko - Lord Abbett

So it's the opposite. There is still excess there?

Denny Oates

Excess. I think last quarter on my call I said they are six to nine months behind aerospace business in terms of destocking. I think they still have some destocking, another quarter or two to go, based upon current levels of demand and there is a wild card there with this whole situation in the Gulf which all of customers would indicate don't worry about it because the rigs and so forth are going to be moved around cruiser being moved. So you will see the same level of demand that we should be able to work our inventory down and get them in line with demand over the next quarter or two. But that's the current view from the oil and gas side.

From Power-Gen we've been able to pick up quick turnaround business. That's you see our sales going up. But if you look at underlying demand for new power units, its still rather anemic and are foraging customers are looking at that and essentially they're planning is for a strong 2011, but we should be expecting additional metal buys as we get into the fourth quarter of 2010 and first quarter of 2011.

Gregory Macosko - Lord Abbett

But with regard to non-maintenance side of that business, the idea is that that the inventories are in shape.

Denny Oates

Right, yes.

Gregory Macosko - Lord Abbett

And then service centers?

Denny Oates

Service centers generally are saying that they feel comfortable with their inventories. There is different, different service centers have different things to say, but in general that they are comfortable with inventories. Some of the largest service centers have made comments in their conference calls. We were listening about reducing inventories in the second half of the year. I would just caution you to that they are talking in broad terms. In our products, I don't know if any service centers that are looking towards liquidating inventories in the second half of the year.

Gregory Macosko - Lord Abbett

Okay, very good and then finally back to the restructuring and the melt shop, if we look at all the things you are doing on the manufacturing side of the business and the melt shop is two thirds, Denny you are saying, is just remind me are there sort of activities or things that are in process, or that you're expecting to execute over say the next 6 to 12 months other than normal ongoing kind of things?

Denny Oates

There are -- well, I guess you would call process improvements normal and ongoing, but I think there is tremendous opportunity for us to continued increase yield and reduce crop rates by making just simple process improvements. Not that they are easy, but very straightforward. In terms of additional capital spending, we're working very hard at our re-melt facility, looking and incorporating some new technology in our remelting. That would be the next place we looked to spend some sizable capital dollars.

Gregory Macosko - Lord Abbett

And what about forging I know there has been sort of back and forth discussion of that area. Is there the possibility of some greater involvement in the forging area?

Denny Oates

In terms of investing in the new forge ourselves, our valuation is that at this point in time is we are better off to work with partners to do our forging work for us rather than spend the capital to install our own forge. So, that's the best when we basically undertaken over the last few years to get closer relationships with our forging partners, so they can work with us to get the quicker turnaround we need to service the market.

Gregory Macosko - Lord Abbett

What acquisition or anything like that is kind of not considered?

Denny Oates

Well we always considered those things, but at this point in time, nothing would be imminent.

Gregory Macosko - Lord Abbett

Okay, thank you very much for all your answers.

Denny Oates

Okay, great.

Operator

Your next question comes from Ralph Maresh of First Manhattan Company.

Ralph Maresh - First Manhattan Company

Good morning.

Denny Oates

Hey Ralph, how are you doing?

Ralph Maresh - First Manhattan Company

Okay. How are you?

Denny Oates

Good.

Ralph Maresh - First Manhattan Company

Good. On starting with gross margin and moving down P&L, you've said a lot about gross margin, but would it be fair to assume that the progression down the P&L with the other margins would also carry through?

Denny Oates

Yes. Maybe additional amount of leverage been depending upon the volume.

Ralph Maresh - First Manhattan Company

Okay. And to your segments, this is one of your smaller segment, but the wire redrawers segment is down quite a bit this quarter. Could you comment on that?

Denny Oates

It is a small part of our business, relatively small part of the business. Chris, you have any comments on that. I'm turning it to Chris, our VP of Sales.

Chris Zimmer

Yeah. The purchasing in that segment does tend to be a little bit more cyclical than others. So I attribute that more to a timing issue of shipments falling into one quarter or another. We see the business there continuing to move forward to stable.

Ralph Maresh - First Manhattan Company

Is that mainly from medical?

Chris Zimmer

That would be one of the major markets.

Ralph Maresh - First Manhattan Company

Okay, and so it's nothing more really than just timing at this stage?

Chris Zimmer

I believe so yeah.

Ralph Maresh - First Manhattan Company

Okay. Thanks.

Operator

(Operator Instructions). At this time there are no further questions. I will turn the call back over to Mr. Oates for concluding remarks.

Denny Oates

Okay. Thanks again for joining us today. We are pleased to see the level of recovery in the second quarter of 2010 and we expect to make further progress in the balance of the year. I look forward to updating each of you on our next call. Have a good day.

Operator

Thank you. This concludes today's conference call. You may now disconnect.

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