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Sun Hydraulics Corporation (NASDAQ:SNHY)

Q2 2010 Earnings Call Transcript

August 10, 2010 9:00 am ET

Executives

Dennis Tichio – IR

Allen Carlson – President and CEO

Tricia Fulton – CFO

Analysts

Chris Weltzer – Robert W. Baird

Jon Braatz – Kansas City Capital

Operator

Good day, ladies and gentlemen, and welcome to the Sun Hydraulics second quarter 2010 conference call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session and instructions on how to participate will be given at that time. As a reminder, today's conference call is being recorded.

I would now like to turn the conference over to your host, Mr. Dennis Tichio. Sir, please go ahead.

Dennis Tichio

Good morning. Thank you for joining us for Sun Hydraulics 2010 second-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

Thank you Dennis and good morning to all of you. We met both our second quarter revenue and earnings estimates and continued to see strength in the economy. Sun has been able to easily meet increased demand without systematically adding people. We have ample capacity to deliver expanded output.

One of the highlights of last quarter was the beginning of shipments to some new customers. We added a number of new customers that we began working with during last year’s recession. While each case is different, there are at least five things that have helped us secure this business. These include new products, timely and reliable delivery, smaller packaged solution with increased functionality, our differentiated product performance, and our global footprint.

There is nothing new about this model. It is the model that Sun has used for 40 years and is what allows us to consistently grow faster than our industry over the long term. We continue to release new electrically actuated cartridge valves that help to expand our addressable markets. The ability to communicate digitally with system controllers is a necessary capability.

As I have said before, many of these new products mimic expensive legacy industrial products, but do so at more affordable prices and with all the benefits that cartridge valves offer. Reliable delivery is increasingly important to OEMs all over the world. Production, supply chain, timing assumes more and more of a just-in-time orientation. Large stockpiles of inventory at any stage of the supply chain are now the exception rather than the rule.

Sun has been scheduling orders to customer requests for 10 years, and we have built our business to operate efficiently in this type of environment. Because of the inherent design advantages of our cartridge valves, we routinely develop integrated package solutions that are smaller and more efficient than equivalent competitive offerings. Smaller footprints provide machine designers greater flexibility in where to place hydraulic control solutions.

Enhanced operating performance translates to energy savings and efficiency. A lot of what I’m describing here is fundamental. It is like blocking and tackling in football. I believe a company needs to be sound in the fundamentals to be sustainably successful for the long term. If an organization does all the little things right, satisfied customers, market share and financial performance are the long-term result.

I mentioned in the opening that we continue to see strength in the economy. Our third-quarter forecast reflects what we believe to be our historic seasonal order pattern. Sales [ph] are expected to be down a bit sequentially, but are projected to be up 59% compared to this time last year. Estimated Q3 earnings demonstrate the operating leverage we are able to achieve on these higher revenues.

I will now turn the call over to Tricia for some more of the details.

Tricia Fulton

Thanks Al. As Al mentioned, we came in where we expected for the quarter. Sales were helped by a number of new customers in Asia, North America and Europe. You heard some of the reasons for gaining this new business. They are the same reasons Sun has consistently gained market share during cyclical upturns.

July’s PMI, which was released last week, came out at 55.5. There has been a steady softening of the PMI numbers since its high in December last year, but it continues to indicate economic expansion. Remembering that Sun lags the PMI by about six months, we expect business will continue to be strong in the near term.

All geographic segments saw an up tick in demand in the second quarter. On a year-to-date basis compared to the first two quarters of last year revenue was up 48% in North America, 101% in Asia, and 28% in Europe. Despite some fluctuations in currency early in the quarter, on a consolidated basis there was little effect compared to Q2 last year. Translation gains related to the Korean Won were offset by losses related to the Pound and Euro.

We have a lot of flexibility to adapt our environment to current conditions. We’re using light overtime to meet the increased demand, but don’t expect to have to increase our headcount anytime in the near future. As demonstrated by some of the things we did last year, Sun is structured to be agile to respond to any demand levels. While we have some define fixed costs, once we reach the inflection point, we get great operating leverage and our margins expand quickly.

Margins have grown nicely over the last four quarters as revenues increased. Incremental rises in revenue dropped quickly to the bottom line as fixed costs are absorbed. As a result, we have posted positive gains in both growth and operating margins sequentially over each of the last four quarters. Effective July 1 of this year, we implement a price increase that will affect revenue in the third quarter. These pricing actions will add about 2% to the top line.

Now I will move on to some details. Compared to last year, second quarter sales were up 81% to $39 million. Earnings increased from a loss of $0.03 per share last year to earnings of $0.36 this year. Sequentially sales increased 25% compared to the first quarter. Foreign currency had no impact on second-quarter sales.

Gross profit as a percentage of sales increased 16 points to 36% compared to 20% in the second quarter of last year. We were able to further leverage our fixed costs and pick up substantial gross profit on the incremental sales increase. Our operations are running very efficiently and this is the point in the cycle where our training, cross training and productivity improvements, which were implemented throughout the downturn really pay off.

SG&A expenses were flat compared to second-quarter last year, and were down 6% sequentially. The sequential drop from Q1 to Q2 is due to decreases in compensations, outside services, and fringe benefit accruals related to self funded health plans. The provision for income taxes for the second quarter was 34.4% compared to tax benefit of 40.6% for the second quarter last year. The prior year provision included a tax benefit recognized in the US.

The current period provision was affected by discrete items related to a reserve for uncertain tax provisions from previous years. Excluding these discrete items, the effective rate would have been approximately 33%. We expect the Q3 effective rate to be approximately 34%.

Net cash from operations for the quarter was $7.5 million. Inventory turns were nearly 11, up 2.5 turns over Q2 last year. Days sales outstanding were down 6 days to 38 compared to Q2 ’09. Our quarterly dividend of $0.09 was paid on July 15 to shareholders of record as of June 30. As you may recall, our normal seasonal pattern reflects a very strong second quarter, with some softening in the third quarter. This year appears to be no different.

Third-quarter sales are expected to be $37 million, 59% increase over Q3 last year. Earnings for the third quarter are projected to be $0.32 to $0.34 and continue to demonstrate our operating leverage at these revenue levels. Demand ramped up fairly quickly in the second quarter, and we were able to swiftly adapt to the changing order rates. We have the infrastructure and capability to easily acclimate our business model to meet all levels of demand.

The steps we took during the down turn, as well as the quick recovery, give us the confidence to continue making necessary investments for the long term success of Sun.

Thank you. We will now open the call for Q&A.

Question-and-Answer Session

Operator

(Operator instructions) Our first question comes from Chris Weltzer from Robert W. Baird.

Chris Weltzer – Robert W. Baird

Good morning guys.

Allen Carlson

Good morning.

Tricia Fulton

Good morning Chris.

Chris Weltzer – Robert W. Baird

You mentioned against some meaningful shipments to new customers you gained throughout the down turn, can you may be give us a little color on may be the scale of these wins, how much of your revenue in the quarter may be came from some of the new customers you have?

Allen Carlson

I don’t have the exact number. Maybe we can do a quick calculation. Chris we will try and get back to that one between now and the end of the call, but it is a matter of collecting all the information and trying to do some math.

Chris Weltzer – Robert W. Baird

And does something – I mean is it a point or two, is it five points. I am just trying to get sort of a rough scale, I don’t need an exact number, but following up on that same vein, are these mostly relationships with completely new OEMs, are the running them as OEM relationships, are the sales still going through your distribution network, are there more opportunities with some of these customers as you continue to design and engineer things for them?

Allen Carlson

Yes, I will add a little color of what I know, and we will see if we could come up with some numbers, but for example, you saw that Asia was up 101%. A big piece of that is a channel to market that we have established in Asia called systems integrators, where we are working with. That is very much like a distributor, but they don’t carry inventory, and they’re working with larger OEMs in China, for example.

And so, I believe we have now placed orders in the second quarter for five new of these systems integrators, who are all calling on small and mid-sized OEMs in China that we did not have. I think I mentioned at a previous web cast that we hired a sales manager, an application engineer in China in September, October last year. And this is some of the early results of what he has been doing in China.

Tricia, you have any numbers.

Tricia Fulton

Yes. It is probably about a point or two on the Q2 revenue, and probably a couple of points of what we are looking at so far for the Q3 revenue from those new orders.

Chris Weltzer – Robert W. Baird

Okay. That is fantastic. Can you give me a little bit of – I mean historically, eventually you have returned some cash to shareholders in the form of a special dividend. Have your thoughts on how best to do that changed since 2003; are there any sizeable opportunities sort of in your acquisition purview that you might be looking at as a use of cash?

Allen Carlson

Chris, we continue to look for opportunities to expand our base. A number of discussions are going on, have gone on. I don’t think anything is imminent right now in terms of acquisition, but we continue to look and it is these times that acquisition is good. Relative to returning special dividend to the shareholders that is obviously a board decision.

We discuss that at board meetings on a regular basis. Relative to our current situation no decisions have been made, but I think management and the board now look at having cash reserves to be a very favorable thing in this economic environment. And companies that didn’t have reserves going into 2009 found themselves to be in bad situation. So, I think the whole mood on having cash reserves is completely changed compared to what it was four or five years ago.

Chris Weltzer – Robert W. Baird

Okay. That is helpful. And with such a large sequential revenue increase and such a large year-over-year revenue increase, have you had any issues with suppliers being able to get you components quick enough, or any issues with your supply chain?

Allen Carlson

You know that has probably been the stress point in trying to keep up with demand, and we have worked very closely with our suppliers. We have shifted some parts around to good suppliers who had capacity, who didn’t have capacity. We have turned down some of the capacity in-house ourselves to assist some of our suppliers. We work very proactively with our suppliers. So, when we began to see an upturn late ’09 and early January, February our suppliers were keyed in and dialed into that increase.

All of our suppliers have screens that they actually see minute by minute demand of the parts that they make. So the communication pipeline between us and our suppliers is very close, and the relationship between us and our suppliers is tight, however, with all that we still had some scrambling to do to keep our supplier base up to speed with us. But they did, there were quite capable of seeing an 81% increase in demand, and following through and meeting delivery.

Our past due during this timeframe was very, very small. In fact as we speak this morning, I think it is like two minutes of production, the amount of past due that we actually have, and that is past due to customers request, not our own internal scheduling.

Chris Weltzer – Robert W. Baird

That is really fantastic. Can you give us a little color on how the order trends have progressed into July, and if you are seeing any difference, anything changed geographically. You know, everybody is worried about Europe at this point?

Tricia Fulton

Sure. Order rates are pretty steady or were pretty steady throughout Q2 month over month in all of the segments, and that really has continued into July. If anything, we have seen a small bit of softening in North America and Korea sort of going into the third quarter. But some strength in the European numbers, which is kind of different from what everyone, expects I think. But overall we have been pretty steady.

Chris Weltzer – Robert W. Baird

And a little bit of sequential softening would be sort of normal seasonally in North America and Korea, right?

Tricia Fulton

Yes.

Allen Carlson

And also in Europe because it is this time of the year that the Europeans take a month off.

Tricia Fulton

Right.

Chris Weltzer – Robert W. Baird

Right. And then, anything interesting in the latest quarterly distributor inventory survey, any change to attitude towards adding some inventory at the distributor level?

Allen Carlson

I don’t believe so. I think our distributors constantly look at their inventory numbers, and see what they can do. But they also know that they don’t need to carry a lot of inventory on Sun products to be able to keep demand, because they can get products direct from the factory, although it is expedited prices, they don’t have to carry the inventory to protect their customers.

Chris Weltzer – Robert W. Baird

Okay. Thanks guys.

Tricia Fulton

Thank you.

Operator

Thank you. (Operator instructions) Our next question comes from Jon Braatz from Kansas City Capital.

Jon Braatz – Kansas City Capital

Good morning.

Tricia Fulton

Hi Jon.

Jon Braatz – Kansas City Capital

Good morning Tricia. Good morning Allen. Allen, you have always talked about your business sort of following the PMI index, and obviously it has declined a little bit. In your commentary you suggest having made the comment that you seem to lag that. Are you actually at this point seeing anything, any anecdotal evidence that suggests that we may see some softening as we approach the New Year, or enter the New Year, are you seeing and feeling anything from your customer base that would sort of corroborate what we have seen in the past?

Allen Carlson

No. The general mood in the marketplace is very much the same. I think there is a tendency by just about everybody to treat the PMI numbers with great precision. And I’m not sure there is a lot of difference between a PMI number of 57 and a PMI number of 55.2.

Jon Braatz – Kansas City Capital

Sure.

Allen Carlson

So, you know, as long as you are in the mid to high 50s, the economy is still expanding at a pretty rapid rate. Now if we start getting down to 50.3, right on the border line and there is a huge difference between 50.3 and 57. But there hasn’t been that big a swing in PMI, although a lot of people talk about the PMI softening. I think the other thing you have to look at is how the PMI numbers are made up. Is it new orders, is it employment, you know, what is the make-up because there are four components in PMI.

And, I think, when you study it a little bit in greater detail, and also recognize that there is not a lot of precision in that end number. I think you perhaps have a little bit different twist on it.

Jon Braatz – Kansas City Capital

Okay, thanks. In the second quarter, when you look at your incremental operating margin on the incremental sales it was 55%, and you know a great number. As you look forward, and hopefully generate additional revenue in 2011, do you think you can maintain that level, or are we going to start adding some additional cost back that will reduce the incremental margin that we are seeing on the additional revenues?

Allen Carlson

I think it could probably go either way. It also depends upon how quickly it accelerates or ramps up. If we see a 15% to 20% kind of number in revenue growth, I think the margins will stay there because we will continue to see the productivity gains and the efficiency gains at those kinds of levels. If we see that the revenue ramps up significantly fast that is when we have to throw additional overhead on it to keep up with demand.

So I think it kind of depends, but my guess would tell me that we’re going to continue to see the same strength in operating leverage that we saw during the last six months. Tricia, do…

Tricia Fulton

Historically Jon, we have seen incremental margins go about 35%. It is what they dropped to the bottom line, 35% to 40% in normal periods. I don’t know that we are really in a normal period right now. And I think as you start to grow there may be some incremental costs that come in there as part of your growth pattern that could reduce that number back down to our historical, but I think as Al said, it will take us a while to get there.

Jon Braatz – Kansas City Capital

Okay. One last thing Tricia, you talked a little bit about SG&A costs, did I understand correctly, there were some one-time items in there that reduced the expense ratio?

Tricia Fulton

Yes, on the SG&A there are really three big factors. One was compensation, and that is really related to variable compensation from the board deferred stock. So that is a variable compensation piece every quarter that actually caused a sequential decrease, as well as some fluctuation in our reserves for our self-funded health plans. And outside services was the third item that is something that fluctuates quarter to quarter, as well as depending on what the needs of the business are.

Jon Braatz – Kansas City Capital

And they were all helped this quarter, they were all credit so to speak. Okay.

Tricia Fulton

Yes.

Jon Braatz – Kansas City Capital

Okay. Thank you very much.

Operator

(Operator instructions) I show no further questions in the question queue. So, I would like to turn it back over for any further remarks.

Allen Carlson

Very good. Thank you all for dialing in and listening. Your questions are good, and we look forward to the rest of the year continuing to see improvement. Thank you.

Operator

Ladies and gentlemen, thank you for participating in today’s conference. This concludes the program. You may now all disconnect. Everyone have a great day.

Allen Carlson

Thank you.

Tricia Fulton

Thank you.

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