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Sun Hydraulics Corporation (NASDAQ:SNHY)

Q1 2014 Earnings Conference Call

May 6, 2014 09:00 ET

Executives

Dennis Tichio - Investor Relations

Allen Carlson - President and Chief Executive Officer

Tricia Fulton - Chief Financial Officer

Analysts

Jon Braatz - Kansas City Capital

Operator

Good morning, ladies and gentlemen and welcome to the Sun Hydraulics Corporation 2014 First Quarter Conference Call and Webcast. Today’s call is being recorded. At this time, I’d like to turn the conference over to Mr. Dennis Tichio. Please go ahead, sir.

Dennis Tichio

Good morning. Thank you for joining us for Sun Hydraulics’ 2014 first quarter conference call. Allen Carlson, Sun’s President and CEO and Tricia Fulton, Sun’s Chief Financial Officer, are participating in today’s call.

Please be aware that any statements made in today’s presentation that are not historical facts are considered forward-looking statements. For more information on forward-looking statements, please see yesterday’s press release. We will take questions once we have completed our prepared remarks.

It is now my pleasure to introduce Allen Carlson.

Allen Carlson

Thanks, Dennis. Good morning, everyone. First quarter demand was strong in all geographic markets, with order rates accelerating throughout the quarter. The most significant gains came from the Asia-Pacific region, up 20% driven by sales in Korea and China. This was followed by a nice rebound in Europe of 17% with the biggest gains coming in Germany, the UK, and Australia. North America was up 4% primarily from U.S. demand.

Order rates are strong as we head into Q2 and economic indicators are positive. U.S. PMI released last week registered 54.9 clearly indicating expansions in the manufacturing sector. This is consistent with most global PMI numbers. Given these current trends, we expect the strength in our end-markets to continue. There is a lot to be optimistic about today at Sun, but our focus remains on strong long-term goals.

As we stated last quarter, we continued to make investments, which will be funded from earnings throughout 2014. These investments will drive future growth. To give you examples of these types of investments we are making, we will elaborate on three areas of significant investment. The first is bricks and mortar. Late last year, we brought online a third facility in Sarasota. This new facility provides us the capacity to double our business over time. This was a significant investment for the future of Sun, specifically in our integrated packaged business.

The second area of investment is in product development. In the first quarter, we introduced 17 new products that were well received by the marketplace. We are investing in additional research and development that will result in significant new products that are expected to be released later this year. We are still in development phases of some of these products.

And third, we are focused on sales and marketing efforts to expand our global reach. Asia has and will continue to be a market that provides many opportunities for future growth. This market has evolved for us over the past 15 years. In 1998, we created a joint venture in China with our Taiwanese distributors and bought our distributors in Korea. We recognized them that these will be important markets for us going forward.

We have continued our investments in this region. In 2007, we opened a sales office in India and have since partnered with five distributors throughout the country. In 2011, we sold our JV in China to our partner, who then became our first distributor in the country. Concurrently, we opened the rep office to better cover the full geographies of China. And in 2012, we acquired (San Juan), a supply chain partner in Korea to continue to develop and help us fully realize the potential of these important markets. (Indiscernible) member of our leadership team is relocating to Shanghai, China with his family.

(Dennis) worked at Sun for over 20 years and in many capacities, his vast notes of our products, customers, operations and markets. His leadership will enhance our sales and marketing efforts and accelerate growth in the region while remaining connected to the leadership team in Sarasota. We are making investments to remain a leader in our field and deliver long-term value to all stakeholders. Sun’s end-markets are strong and we have the capacity and capabilities in place to meet growing demand. We are focused operationally on the common goal of satisfying our customers.

Last month, we mailed our Annual Report titled creating value. We believe value creation is important to all of our stakeholders. To help make decisions that will ultimately grow shareholder value to communicate that value creation, we introduced the use of the economic value-added concept also known as EVA. We view EVA as another decision-making tool that provides a new and different look at our future investments. EVA encourages investing and managing the business for long-term sustainable and profitable growth. This is very much aligned with how we run our business.

I will now turn the call over the Tricia to talk a little bit more about EVA and about the quarter’s results.

Tricia Fulton

Thanks Al. EVA measures economic profit with the notion that we create value by consistently earning our return on capital employed that exceeds our cost of capital. The main difference between economic profits and accounting profits is that our cost of capital which is the required return to shareholders is taken into account. As Al mentioned we view EVA as another decision making tool and the one that is very much aligned with how we operate. For every dollar of EVA we are increasing shareholder value. Please reference our Annual Report for further explanation on our calculation of EVA.

We are making investments throughout 2014 that will benefit Sun for the long-term. The new facility on our Sarasota campus adds approximately $1 million to our annual fixed overhead costs. The planned investments in Asia and new product development are expected to total at least $1 million in 2014. These investments will provide a foundation for future growth and create economic value.

Let’s look now at the numbers for the first quarter. Sales were up 11% driven by growth in all geographic markets. Earnings per share were up 18% compared to Q1 last year. In 2014, pricing accounted for approximately 2% of sales and foreign currency had a positive impact on sales of 1%. Gross profit as a percentage of sales was strong at 42%. The increased sales volume, pricing and leverage of fixed overhead costs helped improve margins. We expect similar margins next quarter.

SCA expenses increased 12% primarily related to increased research and development expenses and marketing costs related to product launches. The provision for income taxes in the first quarter was approximately 33%. We expect a similar rate for Q2. Net cash from operations was $10 million. Inventory turns remain high at nine. Day sales outstanding were 38, up from the prior year due to heavier sales this March and a higher mix of international sales in the current year, which tend to have longer payment terms.

A share distribution dividend of $0.09 per share was paid on March 31 to shareholders of record on March 15. Additionally, a quarterly dividend of $0.09 per share for the first quarter was paid on April 15 to shareholders of record on March 31. Capital expenditures for 2014 are expected to be $10 million. This includes approximately $2 million for improvements to and reconfiguration of our high volume cartridge valve factory. This reconfiguration will result in operational efficiencies and productivity gains. The remaining expenditures consist of purchases of machinery and equipment.

Looking ahead into the second quarter, demand is strong in all geographic markets. Sales are expected to be approximately $60 million with earnings per share estimated to be $0.44 to $0.46. Top line growth and profitability are funding investments that will benefit Sun for the long-term. In the short-term, these investments will impact SG&A and therefore earnings throughout 2014.

I would now like to open the call for questions.

Question-and-Answer Session

Operator

(Operator Instructions) And we will take our first question from Jon Braatz with Kansas City Capital.

Jon Braatz - Kansas City Capital

Good morning everyone.

Allen Carlson

Hi Jon.

Tricia Fulton

Hi Jon.

Jon Braatz - Kansas City Capital

Allen, first of all let me say it’s my – it’s been my experience that the companies that adopt EVA make a lot of the right decisions not that you have made wrong decisions, but I think that’s a good benchmark and my apology for doing that?

Allen Carlson

Thank you.

Jon Braatz - Kansas City Capital

Anyways, with the issues in Europe right now are you seeing any disruption in order patterns coming out of Europe was there some – any uncertainty that might be developing in that market?

Allen Carlson

Well, I think if you take a look at Europe and its entirety and perhaps maybe more of a chronological view, Europe followed the U.S. in the downturn of what we saw it first in 2008-2009. And then I think Europe saw the downturn happened in, let’s say, late ‘10, ‘11, early ‘12. Most of that uncertainty that resulted in this downturn was, I will call it, the Latin part of Europe from alliance somewhere in France through Europe through the southern part of France, which would include Italy, Greece, Portugal, Spain etcetera. The industrial engine of Europe remained strong throughout this time. There were some flutter associated with the downturn, but overall, it was okay.

Today, we have the Crimea situation and the Ukraine situation. At this point in time and I think as we look forward, I don’t see it having a major impact on our business. That part of Europe is a small percentage of our total, although it does represent some growth opportunities that we were seeing and I think we will continue to see that. I think that this will two or three years from now play out and things will resume to normal. So, overall, I am optimistic about Europe, I am optimistic about the industrial part of Europe, and I don’t see any major concerns going forward at this time.

Jon Braatz - Kansas City Capital

Okay, thank you. And then secondly on the increased marketing and let’s say, development expenses associated with their further expansion to Asia, was that something that a decision that you made here in the first quarter or was that a process that had been evolving over a period of time trying to get a sense as to when you opt to decide and say, hey, let’s move, let’s do more aggressive in the Asia, huge market there. How did that decision come about?

Allen Carlson

It actually started in 2012 thinking about where we were positioned and what our opportunities are. We looked at some potential acquisitions along the way in ‘11 and ‘12. We ultimately decided the best step forward was to make internal investments or organic investments as opposed to an acquisitive investment. So, it kind of played out over a period, I would say, starting in 2011, but the foundation of it really went back to 2009-2010 when we decided to sell our 50% interest in the JV to our JV partner to open up a rep office and to get more aggressive in that part of that world. And then of course as I mentioned 2012, we acquired a Korean channel partner. So, it’s been – it hasn’t been a knee-jerk reaction, it’s been a kick up sequentially as we looked at the market and looked at the opportunities explored alternatives. It has played out that way. And I think as we look forward, you will see us be even more aggressive in some of our Asian initiatives with having a senior leadership team on board in the area.

Jon Braatz - Kansas City Capital

Yes, obviously you like to see growth accelerate in Asia, do you have any expectations about what these investments might be able to generate in terms of, let’s say, additional top-line growth?

Allen Carlson

It’s hard to tell. And it’s very difficult to put a timeline associated with it. We do know that the overall market for hydraulics in the Asia region is equivalent to the overall market in the other sectors of North America and Europe. So, fundamentally, if Asia was just a strong play for us as the other markets, it should be approximately a third of our business. And at this time, it’s falling short of that. So, but we entered that market later as well. So, it’s not that we are not performing at a high level we are, but that market is developing very rapidly going forward. So, we think investments in that from sales marketing makes a lot of sense going forward.

Jon Braatz - Kansas City Capital

Okay. Alright, Allen, thank you very much.

Operator

(Operator Instructions) It appears there are no further questions at this time. I’d like to turn the conference back to Mr. Tricia for any additional or closing remarks.

Tricia Fulton

Great, thank you. Thank you for joining today’s call. I just wanted to remind everyone that our annual report and proxy statement were mailed to shareholders on April 21. Sun Hydraulics Corporation will host an Annual Meeting of Shareholders on June 2 at 10 AM Eastern Time at our newest facility located at 803 Tallevast Road in Sarasota. We look forward to seeing you there. Thank you.

Operator

This does conclude today’s conference. We thank you for your participation.

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