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Commercial Metals Company (NYSE:CMC)

F3Q 2014 Earnings Conference Call

June 27, 2014 11:00 AM ET

Executives

Joe Alvarado - Chairman, President and CEO

Barbara Smith - SVP and CFO

Analysts

Sal Tharani - Goldman Sachs

Evan Kurtz - Morgan Stanley

Luke Folta - Jefferies

Timna Tanners - Bank of America Merrill Lynch

Phil Gibbs - KeyBanc Capital Markets

Nathan Littlewood - Credit Suisse

Nick Jarmoszuk - RBC Capital Markets

Brian Yu - Citigroup

Frank Duplak - Prudential Financial, Inc.

Alyssa Johnson - D.A. Davidson

John Tumazos - John Tumazos Research

Operator

Hello and welcome, everyone, to today's Commercial Metals Company third quarter fiscal 2014 earnings call. Today's call is being recorded. After the company's remarks, we will have a question-and-answer session and we'll have a few instructions at that time.

I would like to remind all participants that during the course of this conference call, the company will make statements that provide information other than historical information and will include expectations regarding political and economic conditions, future events and the company's future results, prospects, operations and capital spending. These statements are considered forward-looking and may involve speculation and are subject to risks and uncertainties that could cause actual results to differ materially from these expectations.

These statements reflect the company's beliefs based on current conditions but are subject to certain risks and uncertainties, including those that are described in the company's latest 10-K. Although these statements are based on management's current expectations and assumptions, CMC offers no assurance that events or facts will happen as expected. All statements are made only as of this date, except as required by law CMC does not assume any obligation to update them in connection with future events, new information or otherwise. Some numbers presented will be non-GAAP financial measures and reconciliations can be found on the company's earnings release or on the company's website.

And now for opening remarks and introductions, I would turn the call over to the Chairman of the Board, President and Chief Executive Officer of Commercial Metals Company, Mr. Joe Alvarado, please go ahead, sir.

Joe Alvarado

Good morning, and thank you for joining us to review the results of CMC’s fiscal 2014 third quarter. I’ll begin this session with highlights from the quarter, Barbara will then provide further financial details and I will conclude our prepared remarks with comments on our outlook for the fourth quarter of fiscal 2014 after which we will open the call to questions.

As detailed in our earnings release this morning, we reported net sales of $1.8 billion for the third quarter of fiscal 2014, which was 3% higher than our net sales for the third quarter of fiscal 2013. This increase in net sales is noteworthy as it marks the first quarter over quarter topline growth in over two fiscal years. For our third quarter of fiscal 2014 we reported earnings from continuing operations of $23.8 million or $0.20 per diluted share which is an increase of $0.04 per diluted share when compared to the same quarter in the prior year.

The results for the third quarter marked our 11th consecutive quarter of profitability and as anticipated, results for the third quarter improved over results for the second quarter by $0.11 per diluted share. As indicated in the earnings release the board of directors declared a dividend of $0.12 per share for shareholders of record on July 10th 2014, the dividend will be paid on July 24th 2014. There are a number of factors influencing our third quarter results and I would like to make a few comments on market conditions as well as comment on some of our strategic themes. The US economy has been trending up in recent months with strong job growth, further reduction in the budget deficit and improvements in construction and manufacturing activity. American manufacturing grew in May at the fastest rate of calendar 2014 with the Institute for Supply Management Index posting 55.7 points. 17 of the 18 sectors tracked by ISM reported growth in May compared to 11 in January. In light of these encouraging trends, we believe that projected GDP growth of 2.4% for 2014 appears achievable.

Many of the key US economic indicators that are rowed into our businesses remain strong. Construction spending increased in April primarily due to growth in non-residential construction. As it relates to the renewal of federal funding of transportation programs, we are encouraged by the dialogue currently taking place in Washington D.C to find a long term solution for the necessary rebuild of the U.S. infrastructure system.

We anticipate another short term extension of the existing bill while Congress debates the various funding alternatives. The Highway Trust Fund is running at deficit, however we anticipate that Congress will make a onetime transfer out of the general fund into the Highway Trust Fund prior to the expiration of the current bill at the end of September 2014.

As an update on the antidumping and countervailing cases before the U.S. Commerce Department, a preliminary ruling was issued on antidumping duties for Turkish and Mexican importers of reinforcing bar. The department ruled against instituting any meaningful antidumping duties on Turkish producers, we were disappointed with the ruling, as Turkish imports into the U.S. continue to negatively impact our business and capture market share in the markets in which we operate.

However, this was only a preliminary decision, we are hopeful that upon further review by the U.S. Commerce Department, Turkish margins will increase in the final determination. On the other hand the preliminary ruling instituted a significant antidumping duties on Mexican importers, Mexico has since essentially pulled out of the U.S. market.

On June 13, 2014 we completed the purchase of substantially all of the assets of the small recycling facility in San Antonio, Texas. This acquisition supports our vertical integration model by protecting the raw material supply for our CMC’s steel Texas mill location. It also establishes a larger recycling presence in San Antonio and provides an opportunity for continued growth of our recycling operations in the Central Texas area.

The Texas market has seen increased competition with scrap exports to Mexico and offshore. In addition to our acquisition of the recycling facility we purchased a new shredder and we’re in the process of strategically evaluating alternatives for the location of this shredder.

At our South Carolina mill we experienced a 12 day unplanned outage in May, we were able to continue shipping during the outage due to safety stock as we were ramping up for the busy summer months. However, we depleted critical inventory stocks to support the busy summer season and we will be working hard to replenish safety stocks in the months ahead.

Shifting to our international markets, during the third quarter we successfully commissioned a new modern electric arc furnace in Poland. We are pleased with the performance of the furnace thus far which has met all certified performance targets to-date. We were able to leverage our knowledge from the start of the electric arc furnace in South Carolina and during the fall of 2012 to facilitate the start up in Poland. With this implementation we expect to realize efficiencies and improvement of the overall cost performance of our melt shop in Poland in fiscal 2015.

Poland’s economic growth has accelerated to the fastest pace in two years due to record low borrowing costs. While this improvement has revived investment and consumer spending, political uncertainty in the region has impeded business confidence and margin recovery.

We continue to monitor the situation in the region as well as the turmoil in the Middle East, meanwhile Eurozone growth is at a three year peak and the recent allocation of Eurozone funding to Poland will help support strong activity levels for the next several years.

We remain focused on reducing costs and improving working capital efficiencies, (inaudible) on our Australian operation which has faced difficult market conditions for the past year. We’re making solid progress and our Australian operations have reported improvements in profitability.

Anticipated economic stimulus by the new Australian government has been slow to materialize and we anticipate low levels of demand to continue. With that overview, I will now turn the discussion over to Barbara Smith, Senior Vice President and Chief Financial Officer. Barbara.

Barbara Smith

Thank you Joe and good morning everyone. As Joe mentioned for the third quarter of fiscal 2014 we reported earnings from continuing operations of $23.8 million or $0.20 per diluted share, which compares to earnings from continuing operations of $18.4 million or $0.16 per diluted share for the third quarter of the prior year.

This year's third quarter results included after-tax LIFO income of $5.3 million or $0.04 per diluted share compared with after-tax LIFO income of $10.7 million or $0.09 per diluted share during last year's third quarter.

Turning to our results by segment. Our Americas Recycling segment reported an adjusted operating loss of $1.1 million in the third quarter of fiscal 2014 compared to adjusted operating profit of $3.2 million in the third quarter of fiscal 2013. Although ferrous and nonferrous shipments increased 1% and 4% respectively an unfavorable change in pre-tax LIFO income and an increase in employee related expenses accounted for the decline in adjusted operating profit when compared to the third quarter of fiscal 2013.

Our Americas Mills segment recorded adjusted operating profit of $74.1 million for this year's third quarter compared to $46.6 million during the same period last year. As noted in our earnings release, this segment reported its highest quarterly adjusted operating profit in over five years.

Average selling prices for this segment increased 2% and tonne shipped increased 15%. Additionally the average cost of ferrous scrap consumed decreased 1% which contributed to a $15 per short tonne or 5% increase in the average metal margin. Our Americas Mills segment also recorded an 8.8 million favorable impact to pre-tax LIFO income when compared to the third quarter of fiscal 2013.

Our Americas Fabrications segment reported adjusted operating profit of 1.2 million for this year’s third quarter compared to the prior year’s third quarter adjusted operating profit of 13.5 million. The average selling price for this segment decreased 3% over last year’s third quarter average selling price while tonnes shipped increased 12%. Although net sales were up in the third quarter of fiscal 2014 when compared to the third quarter of fiscal 2013, adjusted operating profit declined due to margin compression from increased prices. Despite continued import activity, we were able to increase volumes. As of the end of the third quarter of fiscal 2014, this segment's backlog was up 16% over the third quarter of fiscal 2013.

Our International Mill segment continued to show improvement over fiscal 2013, adjusted operating profit for the third quarter of fiscal 2014 was $2 million compared to adjusted operating loss of 3.8 million for the same period last year. This segment’s average selling price increased 5% over the third quarter of fiscal 2013, with volumes remaining steady at 322,000 tonnes shipped. Additionally the cost of ferrous scrap consumed decreased 1% over the third quarter of fiscal 2013, contributing to a $31 per short tonne increase in metal margin. However adjusted operating profit from our International Mill segment declined 6.3 million over the second quarter of fiscal 2014 due to margin increases and margin pressures. Regional competitors attempted to grab market share as well as the shift in product mix from merchant products to rebar due to normal seasonality.

Our international marketing and distribution segment recorded adjusted operating profit of 1.5 million for the third quarter of fiscal 2014 compared to adjusted operating profit of 7.7 million during the third quarter of fiscal 2013. The primary driver of the decrease in adjusted operating profit for these divisions was 11.2 million unfavorable change in pre-tax LIFO income from the third quarter of fiscal 2013. Our Australian operations recorded an improved performance year-over-year partially offset by a decline in performance at our European operations. Despite continuing aggressive competition in Australia, cost improvements have resulted in the improved operating results for this division.

Turning to our balance sheet and liquidity. Our balance sheet remains strong, cash and short-term investments totalled 437.2 million as of May 31, 2014 an increase of 58.4 million over the balance as of August 31, 2013. 94.3 million of this increase came from operations. As the spring construction season moved into full swing during the third quarter, our previous inventories build over the winter months began to convert to sales and receivables. Over the remainder of the fiscal year we anticipate these receivables will convert to cash.

Total liquidity was approximately 1 billion as of May 31, 2014, or added flexibility we continue to maintain significant unused credit lines. Yesterday we amended the terms of our U.S. revolving credit agreement which increased (steadfast the) [ph] under this agreement to 350 million and extended the maturity date to June 2019. Additionally the amended agreement provides for more favorable covenant terms.

Capital expenditures were 31.5 million for the third quarter of fiscal 2014 as compared to 21.2 million in the prior year’s third quarter. We estimate that our capital spending for fiscal 2014 will be in the range of 130 to 140 million.

Thank you very much and now I’ll turn it back to Joe for the outlook.

Joe Alvarado

Thank you Barbara. We anticipate that our operational results for the fourth quarter of fiscal 2014 will remain consistent with results for our fiscal 2014 third quarter. The American Institute of Architectural Building Index, ABI, (from it) [ph] rose a full three points over April to 52.6, indicating positive directional growth in the U.S. construction markets.

On the rebar import front we saw a slowdown from Mexico during the third quarter of fiscal 2014 and we plan to continue monitoring the volume of rebar imports from Turkey and other European and Asian countries until the pending countervailing and antidumping decisions are finalized by the U.S. commerce department which we expect to take place in the latter part of 2014.

Lastly, as a result of the new electric arc furnace that our Polish operations successfully commissioned during the third quarter of fiscal 2014, we anticipate that our international segment will begin to benefit from productivity and cost improvements in fiscal 2015.

Thank you very much for your attention. We will now open the call to questions.

Question-and-Answer Session

Operator

Thank you. We will now begin the question-and-answer session. (Operator Instructions). And our first question comes from Sal Tharani of Goldman Sachs; please go ahead sir.

Sal Tharani - Goldman Sachs

Couple of things on your guidance, when you say operational performance would be the same, do you generally talk ex-LIFO, because LIFO could change quarter-to-quarter or you include that in your outlook?

Barbara Smith

Yes. Typically Sal, we don’t include LIFO in the outlook unless we have a pretty good sense of what direction it’s going to move, and it’s a little too early to have a good indication of that. And so, that’s without considering any impact of LIFO.

Sal Tharani - Goldman Sachs

And how is -- I don’t know if you have made a comment, I’m sorry I missed the earliest part of your prepared remarks, in terms of backlogs at your downstream business, have you seen any changes coming out of the winter going into the summer over the last few months and the order rate, so forth?

Joe Alvarado

Last quarter, we reported record backlogs and backlogs have remained steady. One of the things that we’re doing, Sal, is obviously to shore of the business and take advantage of demand, is we’re being more discriminating about the kinds of businesses or projects that we're booking. So, we're good with the backlog and our objective is continue to improve the quality of the backlog.

Operator

And our next question comes from Evan Kurtz of Morgan Stanley; please go ahead.

Evan Kurtz - Morgan Stanley

Good morning Joe and Barbara. My first question is on the Tree case. So, I guess this is kind of a parallel situation right now with OCTG in Korea, and lot of the petitioners here in the U.S. have kind of dug through the details on the questionnaires and kind of incorporate that, they are being quite aggressive with what they were using for home market pricing, using of the products at much lower quality, that sort of thing. I was wondering if you guys have done any sort of analysis and have you been working with the Department of Commerce at all to try to help them work through the questionnaires with regards to rebar in Turkey?

Joe Alvarado

Well the DoC is in a discovery phase, so we had our chance to respond to the preliminary determination and yes, we gave them a lot of input on what we believe to also be some discretionary calculations which didn’t seem to be consistent with past president. So, yes, we've given guidance and we’ve commented and we've worked through our lawyers on that. And of course DoC through their discovery process will hopefully take some of that into consideration. And that’s one of the reasons why we anticipate that there could be some adjustments to the Turkish preliminary, because of concerns we had about some of the calculations particularly I'll user as an example on energy.

Evan Kurtz - Morgan Stanley

And second question may be also on (fab) [ph], it seems like backlogs are up, non-res seems to be showing a little bit of improvement and the profitability is coming down year-on-year in fab, and we're pretty far away from pre-crisis levels. It seems like in rebar we're on this (dismal) [ph] side, we’re almost back to kind of pre-crisis levels on profit per ton. Is there anything that's changed in that business, and what’s it going to take to kind of get back to the $50 a ton type of profitability levels in that business?

Joe Alvarado

Evan, I'd answer that question by saying that it’s going to take stronger demand across the board. We see -- we are particularly fortunate in Texas to see an awful lot of construction activity and projects. Initially, or for the most period, for most of the time recently that’s been restricted to North Texas but the Eastern market has picked up considerably. California market has picked up, and I've mentioned before, South Florida and the Beltway. But there is still a lot of points in between where there aren’t as many projects, so there isn’t as much construction activity particularly in the desert states for example. So it takes a stronger demand overall for margin expansion. And that’s why I commented that we’re holding steady on our backlog because we're being more discriminating and trying to (call) [ph] through projects that make more economic sense for us to fill our facilities with those kinds of activities as opposed to taking marginal business. So that demand is improving, but as you said, Evan, it’s incremental and it's not across the board but all the indicators in terms of non-residential construction forecast as well as the ABI index would suggest that there is continued demand and growth for construction activity.

Barbara Smith

The demand materialize and you have stronger market condition, fab is going to be chasing higher rebar prices up, and that will pressure them initially but with stronger demand they will be able to then catch-up to the higher rebar prices and expand margins.

Operator

And our next question comes from Luke Folta of Jefferies. Please go ahead sir.

Luke Folta - Jefferies

I am having trouble understanding something on the International Mill business, it looks like shipments are up, prices are up, metal margins are up and there is no LIFO issue obviously there. So, I guess what’s changed in terms of -- I mean is there something on the cost side; may be the ramp up in the new furnace or something that’s impacting profitability there sequentially?

Joe Alvarado

Yes, so let me distinguish between start-up of the mill which has really gone very well and start-up related costs. Prior to the build-up or prior to the shutdown of the furnace, we built inventory and unfortunately concurrent with that inventory build there was very competitive pricing on rebar in Eastern European regions. So, we didn’t have any chance for margin expansion. We had -- our costs were buried or sunk in prior period and there was also a mix element associated with what we call seasonal activity. Rebar shipments increased as a percentage of our total shipments and so that’s where we absorb most of the margin compression. Market activity is good and as you note year-on-year much better in Eastern Europe certainly, we reversed the losses from a year ago and the market continues to strengthen but the economic uncertainty is what creates, I'll say, hesitancy and lack of confidence.

So it’s a very aggressive market, iron ore prices tend to influence thinking as new scrap prices and regionally there is a mix of competitors have become more aggressive on supplying rebar and we just have to deal with that competitively and as the market strengthens or confidence improves, we'll see and expect increased margin. But not sitting still, part of the reason for the upgrade of the furnace was to improve our cost efficiency and effectiveness.

Barbara Smith

And Luke, last quarter I tried to indicate when you have that long outage, our conversion cost bottom-line this quarter is up substantially over the prior quarter and you have a lot of unabsorbed burden when you have the mill shutdown for an extended period of time. So, it’s really in a lot ways related to the installation of new furnace not as Joe pointed out due to any difficulty with the installation but just the sheer fact that the mill shop was not operating and our conversion costs consequentially was higher and we do expect that to come back in line in the coming quarters.

Luke Folta - Jefferies

Okay. But to dig in a little bit on that, so if we look sequentially and I hear what you say on the competitive side, but the metal spread as reported was up $12 a ton quarter-over-quarter, EBIT was down from 8 and changed to 2. Should we think of virtually all the deterioration in margin there being related to that conversion cost which should ultimately kind of reverse or was there any other factor there or is that kind of 6 million sort of the number to think about or something beyond that because metal spreads are actually higher?

Barbara Smith

Yes, basically conversions costs were up from $25, $26 a ton quarter-over-quarter.

Luke Folta - Jefferies

Okay.

Barbara Smith

And we may not get all of that back in the fourth quarter but overtime it will come back down inline.

Luke Folta - Jefferies

Understood, okay. And then I guess any color on what’s happening with the international trading or the marketing distribution segment. FIFO margins were also a bit lower than what we've seen in a while. Was there any sort of -- was there any one-time kind of factors there or is it just a more competitive situation, any color there will be helpful.

Joe Alvarado

No, there is no one-time factor. We've commented in the past about tighter and tighter margins in Asia in particular and trading activity really throughout the world is really very competitive. So, I think it’s come in any trading business in this kind of environment when there is excess capacity or supply and short lead times in domestic markets that it becomes a more competitive business not only in price but in margin. So, there is nothing extraordinary. It’s a one-time. This is something that we've been working with for really the last two years, may be exacerbated a little bit by the situation in China continuing to -- well not improve I guess I'll say as opposed to deteriorate.

Operator

And the next question comes from Timna Tanners of Bank of America. Please go ahead.

Timna Tanners - Bank of America Merrill Lynch

So, I just want to clarify on the guidance, may be this wasn’t clear to me, its Friday, but it seems to me like you are talking about an ex-LIFO kind of similar fourth fiscal quarter from the third quarter but at the same time may be some of these outage costs in the international mill side are going to rollover, I know more about it’s going to show in your fiscal 2015 environment but you are also talking about non-rev improving. So, why wouldn’t it be an improvement quarter-over-quarter? What do you think that might empty that?

Barbara Smith

Well I think I'll make a comment and then Joe can embellish. We are not suggesting that it’s going to be precisely a $0.20 quarter and that there might not be some improvement, but clearly I think the street expectations have gotten out a little bit ahead of the true recovery, and clearly the import situation is continuing to pressure margins, and until this is ultimately resolved and if Turkey is allowed to continue at pace that they have been, that’s going to be a headwind in the future.

Joe Alvarado

Okay I guess what I’d add to that Timna is that, the growth in rebar demand while we’ve seen some growth ourselves, so the growth in rebar demand overall in the U.S. has mostly been observed by imports. So I think everyone in the rebar business is challenged to grow market share because of the share volume of imports. And while the licensing is down presently, imports are kind of lumpy anyway. They don’t come in consistently month after month; it's sometimes just a timing issue. So, we don’t anticipate there is any difference to be expected from Turkish imports. We monitor it, but with the preliminary orders, there is no reason for them not to shift product.

Timna Tanners - Bank of America

Okay, that’s super helpful. And then my other question was really on CapEx just because the guidance maintains a 140 million for your fiscal yearend, on the run rate we need to see a big increase in the fourth quarter, so if you can just remind us about your CapEx plans and your vision for the growth there? Thanks.

Barbara Smith

Yes, well, we are anticipating higher expense in the fourth quarter and we’ve struggled to spend our CapEx guidance over the last couple of years. And it’s a function of two things, one just building the momentum of getting the projects and moving and keeping that spending sustained quarter-over-quarter, and second is being very discriminating on the project.

And one major project that was in our 2014 CapEx plan was a similar project to the downstream recycling project that we installed in Seguin last year, which has been highly successful and were generating a number of benefits from that; however, as you know nonferrous prices have fallen off dramatically and so we slow that project down to assure ourselves that it made good economic sense. And so that’s an example of a project that probably would have started earlier in the year, we still think it’s a good project, it’s still part of our plan but it’s one that we have delayed the actual start of the project to rerun the economic analysis and make sure the returns are up to our expectations.

Timna Tanners - Bank of America

Okay, so is that (same) [ph] might not spend it all or that there is projects that we have to wait and see what happens with them. I am sorry I am not following.

Joe Alvarado

So let me try and build upon that a little bit Timna. We reprioritize projects all the time and the downstream project that Barbara is referring to in South Carolina was in our plan, and we’ve deferred that. And in all likelihood, we would do that at a later day. But it was a significant project and we didn’t throw other projects right behind it, so that would moderate some of our spending.

So it’s really a function of timing and our prioritization as well as recognition of market conditions and so -- but we are really successful with the Texas operation and building and starting it up in about eight or nine-month period, so within one calendar year we defer that projects.

So, we have lots of projects but we don’t go at them willy-nilly. They got to be prioritized. They have to be justified and there was nothing the same size or magnitude. There were other smaller projects. So we continue to spend capital as required and continue to believe in the business and growing the business. So, our capital spending is up year-on-year and has each year and our plans for next year would be at or above current projected levels even if we don’t make them at least above the $150 million level.

Operator

And our next question comes from Phil Gibbs of KeyBanc Capital Markets. Please go ahead.

Phil Gibbs - KeyBanc Capital Markets

First question was just on Joe's prepared remarks, Joe, was a safety stock piece just related to Poland or were you referring to the domestic business as well? I think I missed part of your comments.

Joe Alvarado

Yes, that was referring to safety stock in South Carolina. We had an extended outage in South Carolina. It was equipment related in mill shop and so we depleted what is essentially a safety stock for the summer and so we’re continuing to work hard to replenish that stock. But when you lose two weeks production, it just makes things tight. So I don’t think we had any issues with delivery or maintaining good performance with our customers. It’s just a comment that we had an outage and obviously when you work through inventory, it’s more hand to mouth to the mill particularly when the mill is busy as it normally is in the summer season.

Phil Gibbs - KeyBanc Capital Markets

Okay. And Barbara in IM&D any reason why there was a LIFO charge in the quarter. I thought that was just a bit unusual for that segment?

Barbara Smith

We’ve had fairly significant LIFO movements in M&D in the past, so it’s not unusual and it’s just a function of the inventory valuation method that we’ve selected. If you look at M&D on a FIFO basis, year-over-year the segment is up, quarter-over-quarter it’s about flat or even so when we look at it on a FIFO basis, that’s where we expect it to be. And I think as Joe said earlier, there is parts of that business where activity level is good such as our steel trading. And then there is parts of the business that are weaker like our Australian piece of the business. But the reason for the improvement year-over-year on a FIFO basis is the work that’s being done to improve the business in Australia.

Phil Gibbs - KeyBanc Capital Markets

Just have a real quick one. I appreciate that Barbara that non-ferrous scrap business and recycling, how much of that would be stuff like the by-product coming out of this operation downstream equipment versus other metals meaning how much is stuff like Zorba versus maybe some of the cleaner stuff you pick out of the front end? Thanks.

Joe Alvarado

Phil, I am shaking my head (inaudible). I am not sure that I could measure the difference, or I’ll give you data on the measured difference I know we have data that we could look at but it would be the increment over what we've been processing before we had the downstream. Perhaps we get back to you on that one. I’d rather give you good information than guess and we would be guessing right now.

Phil Gibbs - KeyBanc Capital Markets

Joe I was just curious on -- not even the split but is it, call it mild portion and things like Zorba versus a major portion and if you had just any general color that would be fine.

Joe Alvarado

Yes, the general color, best I would describe it generally is that the downstream allowed us to pick up another 8% to 9% in metallic recovery from what we had been collecting and that was the justification for the investment. So we think of it incrementally as the additional recovery and the economics associated with that recovery as opposed to a separation to Zorba or other categorizations.

Phil Gibbs - KeyBanc Capital Markets

Thanks for taking my question.

Joe Alvarado

At the end there is always still some material left over that ends up going to landfill, we recover as much of the metallic is conceivably possible. So if you have more questions, we can follow up on that too.

Operator

And our next question comes from Nathan Littlewood of Credit Suisse. Please go ahead.

Nathan Littlewood - Credit Suisse

Yes, good morning guys, thanks for the opportunity. Just wanted to ask a point of clarification on the guidance, am I correct in saying that that embedded expectation with the guidance that you've given is that the Turkish import volumes and rebar will continue at current levels and therefore by implication the guidance is based on an unfavorable final assessment on those antidumping JDs?

Joe Alvarado

Well I haven’t thought it in those specific terms Nathan, our guidance is really to give an indication of where we think the market is and today the Turks are a significant importer. I guess what I would say is that if the Turks weren’t in the market, they would certainly be a different opportunity for margin spread. But there is always inventory, Nathan and inventory needs to worked off, so I can’t tell you where some of the distributers are with the Turkish inventory. I don’t know that we’d see something have an immediate impact with the different ruling and the final ruling doesn’t come until later in the year I believe. Well September is the next hearing but the final ruling is late October, early November time table. So we’re already talking about 2015 fiscal year. So with the preliminary determinations we expect to see imports at a high level and we expect them to be disruptive.

Barbara Smith

We’re not making any indication of where we think the final ruling will come out, it’s hard to predict as you know and we’re doing everything we can to present the fact.

Nathan Littlewood - Credit Suisse

Sure, absolutely. And you guys usually have pretty good insight through your international marketing business on sort of trade flows and that sort of stuff. What can you see heading here on rates at the moment, in terms of long product tonnage?

Joe Alvarado

So what I’ll do is talk in little more general terms about trade flows. Obviously and this pertains to flat products as well as long products. Import activity has picked up considerably and lot of that owing to the fact that there is significant margin opportunities in North America where business activities seem to be more stable and level and prices have tended to be higher, that’s particularly true in flat products whereas in long products I think market was reflective more of our cost structure and competitive nature in North American long products including rebar.

Generally speaking the excess supply and availability in Japan is -- I am sorry in China is disruptive, to overall trade flows and continues to show up in different markets. But at the same time lead times from China are quite long. So there is a risk associated with those lead times. There is still excess availability in Europe and while demand is improving and forecast for general economic growth are also improving in Europe, the excess supply would not reflect that same sort of improvement in operating rates and availability and lead time is much-much shorter on domestic basis in Europe including deliveries from Russia, one to six weeks is what’s been reported, so its depending on product. I guess a positive note is in our raw materials trading activities, there are some indications of improved demand and discreet products, some products in particularly are stronger than others and so for the first time in quite a long time we’re seeing a little bit stronger demand and longer lead time on some products which to us is always an encouraging sign of increased or improved business activity and certainly continues to improve in North America, at maybe a little bit better rate than the rest of the world.

Operator

And our next question comes from Nick Jarmoszuk of Royal Bank of Canada, please go ahead.

Nick Jarmoszuk - RBC Capital Markets

Hi, most of my questions have been answered, I just had one remaining about inventory. It came in a little higher than I was looking, can you talk about what’s going on there and whether it’s indication of increased demand in terms of how you’re looking at the market or how we should think about inventories going forward, thanks.

Barbara Smith

Yes, I think as we indicated in our prepared remarks, I mean first of all, inventory levels are higher because activity levels are higher in certain parts of the business and so that all naturally make your inventory levels drift up, we’re still in the process of working down inventory that we built up in Poland for the outage and they did see a decrement this past quarter but we expect that to continue on into the fourth quarter. And we do expect a nice working capital release between now and late fall when you know the business activity level drops seasonally and then again it’ll pick back up going into the New Year.

Operator

And our next question comes from Brian Yu of Citigroup, please go ahead.

Brian Yu - Citigroup

First question is just on the Fab business. I think you had mentioned that there was some margin compression and some pricing lags, and that impacted profitability. Would you help us quantify or something to think about what that pricing lag impact is?

Joe Alvarado

Well, I’m trying to make sure I give you the answer. There’re different -- in each of the regions in which we operate there are different economic conditions and scenarios, you know, where you sit in San Francisco, business activity and levels are strong and you've seen increased construction and fab bidding activity. There was a freight component associated with what we do in Northern California, but in general, the fab market is picked up in the stronger on the West Coast than it might be on the East Coast. The central regions remain strong, so if you could rephrase the question maybe, I can give you a little better answer but I’m not sure what you asked Brian.

Brian Yu – Citigroup

Sorry. You guys talked about the fab profitability, despite the volume improvement, it did not increase much. And I think mentioned in there was two things, one of them which is just the impact on margins from higher input costs. And I took that to mean increase in steel prices while your selling prices on an average basis actually declined. So I thought there was a negative margin impact from those two components, input prices up, while your selling prices came down a little bit.

Barbara Smith

Absolutely, therein lies the margin squeeze, so it’s as Joe indicated, still really competitive out there and we found it harder to continue to maintain the progress that we had been making in raising fab prices on an overall average basis, so you see average fab pricing is down some $25 a ton, at the same time for a portion of the quarter you saw rising rebar prices so you know you get a fairly significant margin squeeze associated with that.

Joe Alvarado

So Brian, maybe one other thing to add is, when we’re booking our fab business, some of that -- those projects can be booked a year out and we live with that cost and part of the better scenario as we see it looking forward, is the fact that the level of our private bidding activity which normally has a much shorter lead time from order intake to order delivery, thus less exposure, continues to expand bidding activity in the private sector as well as our booking activity is stronger and that mix has shifted significantly towards a better mix. It takes time for all that to work its way through the system and at the same time we are chasing raw material cost, the costs of rebar into the fab shop, so some of the degradation in scrap pricing or the change in scrap pricing creates some uncertainty in the fab business and can cause margins to be a little bit upset one way or the other. And the same is true when the prices are going up, there is a little bit of a chase but in the aggregate those margins can expand.

Barbara Smith

And we are in favor of rising rebar prices, right, and you can see the effect of that in the mill segment. It takes fab a while to catch up to that rising price environment.

Brian Yu - Citigroup

Yes. And that is what I was trying to separate, is there is the competitive pressure on margins and then there is also just a lag affect where you might be bidding projects with greater profits built into it, but because rebar prices are going up, it takes time to -- for that business to catch.

Joe Alvarado

Yes.

Brian Yu - Citigroup

So in this quarter result, would you say most of it was just due to that timing and lag effect? Or it almost sounded, Barbara that you mentioned maybe there is even additional competitive pressures, more than maybe what we saw in the last few quarters.

Joe Alvarado

Yes, there is the additional pressure of all the rebar imports that we talked about end up in fabricators hands and so those fabricators will bid projects more aggressively because they have a price advantage. So, when we talk about rebar imports not just the rebar but the fab business that's impacted and that’s part of why we have been more discerning about the order book because we are not going to chase orders that are based on import pricing as that takes us nowhere but there are plenty of fabricators who will use imported rebar as their raw material and have an advantage. And in those cases where we have had the mix situations it causes compression but that’s why we'll continue to work the order book in our fab business to be more discerning as activity picks up.

Brian Yu - Citigroup

Okay. Can I get one more question in on fab?

Joe Alvarado

Sure.

Brian Yu - Citigroup

In the results, there was a very meaningful pick up in volumes, about 12%. And in the press release, you called out a 14% increase in labor cost. And I was wondering, the slight mismatch, is that because you are ramping up on the labor force, given the increase in backlog, so you got some negative short-term fixed cost leverage? Or is that maybe a reflection of some additional overtime and catching up from the polar vortexes during the winter?

Joe Alvarado

I am sure it’s a combination of both depending on the shop but we have had to add personnel to retire the backlog and to take care of our customers. So, I would say a significant portion of the increase is related to adding staff and then power to meet the demand.

Operator

The next question comes from Frank Duplak of Prudential. Please go ahead.

Frank Duplak - Prudential Financial, Inc.

Good morning. Just one for me, Barbara can give us any more detail on what the covenant changes were on the revolver?

Barbara Smith

There’s some relief on, I think we (inaudible) some of our subs and that was removed and some lightning on the interest coverage ratio, so not significant. The biggest being no longer pledging the stock of the subs.

Frank Duplak - Prudential Financial, Inc.

What’s the new level for interest coverage in the document?

Barbara Smith

It flexes but I think it goes to 2.5 from 3.

Frank Duplak - Prudential Financial, Inc.

And then the CAD number stayed the same?

Barbara Smith

Yes.

Operator

And our next question comes from Alyssa Johnson of D.A. Davidson. Please go ahead.

Alyssa Johnson - D.A. Davidson

Good morning. Within the flat volume number for Poland, can you talk about the demand trend internally within Poland versus the region you export to from the mill?

Joe Alvarado

Demand in Poland is strong. Typically as we go into summer months there, starting with the spring, demand does increase significantly particularly for rebar product. Merchant is a little bit less volatile but this is a typical season when demand picks up, we are seeing good order demand. We haven’t had the same problem that we had a year ago when (inaudible) imports were a prevalent problem and consuming large market share. So, we are not seeing anything abnormal. There is good business activity. There is lots of projects and good funding from Eurozone money to continue to support infrastructure projects in Poland. So, we are confident that the Polish economy will continue to expand and grow and that we'll have a significant role in supporting that construction activity.

Alyssa Johnson - D.A. Davidson

Okay. Then just one more, can you talk about how volumes in the Americas mill developed during the quarter particularly month-to-month? Do you think there were some pent up demand following the difficult winter or more so than you seasonally tend to see?

Joe Alvarado

Well on account of the fact that there is more shipments in the aggregate on a month-to-month basis looking at it right now, Barbara is getting the numbers, but traditionally there were two things. One is overall demand, the other thing that influenced monthly shipments is amount of shipping days that we have in a given month. I will say that this is not an uncommon phenomena that our shipments are also being impacted by transportation availability and transportation cost, so I think that’s something we are working through can also cause fluctuation. But generally speaking, our third quarter will be stronger on a volume basis and our second quarter has been because of the outages and because of the winter issues. So I don’t think we’re seeing anything extraordinary, Barbara has the month-to-month numbers, so she can give you an indication directionally.

Barbara Smith

Yes. The total tonne ship did increase each month within the quarter and is very difficult for us to distinguish if there are -- how much of that was catch up from the difficult winter. I guess I would say that we’re not seeing a downward shift in the current month shipping rate. So I think it's reflective of continued good demand.

Operator

Our next question comes from John Tumazos of John Tumazos Research. Please go ahead.

John Tumazos - John Tumazos Research

Thank you very much for taking my question. And I apologize in advance if there is two that are too much to the point. First question, why do you think US scrap prices are not something like $100 lower, given that iron ore has fallen about $100 over two years in spot markets and met coal has fallen $200 in three years.

And second, do you think that your business would be healthier if scrap was lower and the finished steel price lower, reflecting world markets?

Joe Alvarado

So no need to apologize John, for asking a good question, we’ll just try to answer them as best as we can. First on the iron ore and scrap relationship, there is no doubt there is a correlation in metallic pricing overtime. And some of that is influenced in fact obviously by availability. Remember that scrap pricing can be very regionally different and there are significant regional differences. So what I expect that with ore prices at low levels will continue to decline that there wouldn’t be a correlation of course not, there'll be continued movement.

I guess the question is of expectation what happens with ore pricing. So and there are arguments both ways that will improve that will weaken and I guess time will tell and over time iron scrap prices would reflect that metallic cost.

From a spread perspective in terms of whether it’s a $100 a ton or $100 a ton higher -- lower or higher, we price our product according to our cost and at least in North America there’s a strong correlation between raw material cost and scrap and the electric furnaces and selling prices. And I don’t anticipate that that’s going to change dramatically expect there can be some expansion in margin when demand increases. So we’re off for a higher scrap prices and higher selling prices at rebar and higher selling prices of fab, but it's incumbent upon us to manage our margins and manage our costs and that’s one of the reasons that we’ve improved our EBITDA margin per ton is because we’re working the shop hard to improve our cost competiveness. And whether it’s in raw material or alloys or labor cost or productivity, not a lot of the CapEx that we invest is intended to keep us cost competitive.

Operator

At this time there appear to be no further questions. Mr. Alvarado I’ll turn the call back over to you.

Joe Alvarado

Okay. Well, thank you Betty for moderating this for us and thank you everyone for joining us on today’s conference call. We appreciate your interest and your questions and we look forward to speaking with many of you during the weeks ahead as we schedule investor visits and our calls with individuals. Thank you very much for your attention and time and wish you a safe and happy holiday season.

Operator

This concludes today’s Commercial Metals Company conference call. You may now disconnect your lines.

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Source: Commercial Metals Company (CMC) CEO Joe Alvarado on F3Q 2014 Results - Earnings Call Transcript
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