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SPX Corporation (NYSE:SPW)

Q3 2010 Earnings Call

November 3, 2010 8:30 a.m. ET

Executives

Ryan Taylor - Director of Investor Relations

Chris Kearney - Chairman, President and CEO

Patrick O'Leary - Chief Financial Officer

Analysts

Shannon O’Callaghan – Nomura

Stephen Tusa – JP Morgan

Bob Cornell – Barclays Capital

Nigel Coe - Deutsche Bank Securities

John Inch - BofA Merrill Lynch

Jeff Sprague – Vertical Research Finance

Deane Dray – Citi Investments

Operator

Good day ladies and gentleman. And welcome to the third quarter 2010 SPX Earnings Conference Call. My name is Alicia and I will be your coordinator for today's call.

At this time all participants are in a listen-only mode. We will be conducting a question and answer session towards the end of the conference. (Operator Instructions)

I would now like to turn the presentation over to your host for today’s call, Mr. Ryan Taylor, Director of Investor Relations. Please proceed, sir.

Ryan Taylor

Thanks, Alicia. Good morning every one. We appreciate you joining us today. With me today on the call are Chris Kearney, our Chairman, President and CEO of SPX, and our Chief Financial Officer, Patrick O'Leary.

This morning's call is being webcast with a slide presentation which you can also access in the investor relations section of our website spx.com. This webcast will be available until November 17, and I encourage you to follow along with the webcast as we reference the detailed information on the slides.

Please note that the slide presentation also includes supplemental schedules, which provide reconciliations for all non-GAAP financial measures discussed today. Our earnings press release was issued this morning and can also be found on our website.

Before we continue, I would like to point out that portions of our presentation and comments are forward looking and subject to Safe Harbor Provisions. The updated 2010 EPS and free cash flow guidance that we discuss today is on an adjusted basis, and also from continuing operation. Please also note risk factors in our most recent SEC filings.

And with that, I will turn the call over to Chris.

Chris Kearney

Thanks Ryan, and good morning, everyone. Thanks for joining us on the call this morning. The third quarter results marked our strongest operating performance of the year so far. We reported overall organic revenue growth for the first time since Q4 2008, driven by strong demand in many of our early-cycle businesses, growth in emerging markets, and solid project execution.

Recovering, our TM markets is progressing largely in line with our expectations. In Q3, we were encouraged by a sustained momentum, in our early cycle businesses. We also saw some modest signs of increased demand in our late cycle tower and energy businesses.

From a strategic perspective, we completed the acquisition of Anhydro, which we believe is in excellent strategic fit with our flow technology segment. We also refinanced a significant portion of our outstanding debt during the quarter.

I’ll begin this morning with an overview of the consolidated results for the quarter as compared to the prior year. Reported revenue increased 10% to $1.3 billion. Organic revenue growth was 7%. All four segments reported organic growth, led by test and measurement at 24%.

Geographically, sales into Asia-Pacific increased by nearly 30%, highlighted by sales into China, which grew by more than 50%. Revenue also increased 11% in the Americas and 1% in EMEA. Sales in emerging markets accounted for 26% of total revenue in the period, consistent with the first half of this year.

Segment income increased to $158 million or 12.2% of revenue. This exceeded our targets primarily due to stronger than expected operating results in our Thermal and Test & Measurement segments. Excluding one-time charges related to our debt refinancing, third quarter earnings per share increased 13% year over year to $1.11 per share.

We ended the quarter with our backlog at about $3 billion, up 8% sequentially. The backlog increase was due primarily to favorable currency changes, particularly the strengthening of the South African Rand. And with the Anhydro acquisition complete, it’s order backlog of $76 million is now included in our consolidated total as of the end of Q3.

From organic perspective, the backlog was stable from quarter to quarter; an encouraging sign.

Total orders grew sequentially and on a year-over-year basis. Orders for flow components were quite strong and we also saw an increase in orders for our Power Energy businesses.

Our transformer backlog increased 14% from Q2 driven by an increase in volume. Pricing, which remained in low levels, was stable from quarter to quarter. In our Thermal segment, we saw a nice pickup and large power project awards.

In the United States, we won awards on five large contracts totally more than $100 million in value. Three of these are cooling system retrofit projects at aged coal-fired power plants. The other two are projects in California where our Thermal technology will be used to increase energy efficiency, improve environmental outcome, and increase renewable generation.

We’ve been selected to supply a dry cooling system for a combined cycle power plant in California where water conservation is an important consideration.

Also, in California, we have been chosen to supply the dry cooling systems and critical heat exchangers for what is expected to be the world’s largest solar power plant when it’s completed.

This plant is scheduled to be constructed in the Mojave Desert, were access to water is limited, making SPX dry cooling technology the ideal cooling solution. This is a unique project and our selection as a provider of cooling and Thermal components underscores the breadth of solution that SPX can provide to solar and other types of power plants.

In India, SPX Sea Transfer, Inc. was awarded an $18 million contract to supply heat exchangers on two coal-fired power plants expected to be built over the next two years.

We were also awarded dry cooling contracts on power plants in Saudi Arabia and South America. This is the second large contract we’ve won in South America this year.

In our flow segment, we were selected to design and install a butter processing system for a leading global supplier of dairy products based in the U.K. This system will utilize a combination of SPX flow technologies, including the butter processing expertise of Gerstenberg Schroder. This project underscores the benefits of our acquisition strategy in the food and beverage market over the past few years.

The acquisition of APB at the end of 2007 provided critical mass in food and beverage markets, and expanded our geographic reach. APBs system’s business is concentrated in dairy processing.

We acquired Gerstenberg Schroder in Q1 of this year and Anhydro, our most recent acquisition, in the third quarter. The integration of these businesses is progressing as planned and we’re quite pleased with the results so far.

In a short period of time that we’ve owned these businesses we’ve already received orders that utilize the combination of these technologies, a clear validation of the top-line synergies we expected.

We have enhanced our product offering by expanding our engineering capabilities in to the processing of fats, oils, and powders.

Many large-scale projects in this industry have been delayed due to uncertain economic circumstances over the last two years. As a result, we’ve seen an organic decline in our food and beverage systems revenue this year. However, the order pipeline is quite strong, particularly in emerging markets where many of our key customers are focusing their capital investments on expanding capacity. We are well-positioned to serve our customers as they expand globally, and expect to see solid growth in our food and beverage systems business in the medium and long-term.

Looking at our updated guidance for this year, this morning we increased our 2010 EPS midpoint guidance by $0.12 or 4% to $3.52 per share. Our full-year EPS guidance range is now $3.45 to $3.60 per share. This reflects our Q3 results and increased expectations for the fourth quarter.

Our free cash flow guidance remains about 180 to $220 million and represents better than 100% conversion of net income. Patrick will provide more details on our updated guidance later on the call.

Our ending Q3 balance sheet reflects the refinancing that was completed during the quarter. Cash on hand at the end of the period was just under $400 million. Total debt was $1.3 billion. Our debt to cap was at 39%, and growth debt to EBITDA was at 2.3 times.

Our primarily use of cash during the period was the acquisition of Anhydro which had a net purchase price of $58 million.

During the quarter, we capitalized on favorable conditions in the bond market to refinance a significant portion our outstanding debt. We believe our new debt structure and stable financial position provide us with sufficient flexibility to continue to make strategic investments in our business as opportunities arise.

At this time, I’ll turn the call over to Patrick, to go over the details of the refinancing.

Patrick O’Leary

Thanks, Chris, good morning, everyone. We issued $600 million of senior notes at 6 7/8% during Q3. The new senior notes mature in 2017. We used the proceeds to pay down the outstanding balance on our term loan, which was scheduled to mature by 2012.

In conjunction with the refinancing of the term loan, we also terminated all of our interest rate swap agreements. We made cash payments of $25 million and recorded a onetime charge of $26 million or $0.33 per share associated with the early termination of the debt and related interest rate swaps.

In the new debt structure, approximately 90% of our debt is a fixed rate. The refinancing significantly reduced our mandatory debt payment obligations for next year, and increases our financial flexibility going forward.

Looking now at EPS for the third quarter, we reported $0.78 for EPS. Excluding the refinancing charges our third quarter EPS was $1.11 per share, modestly above the top end of our guidance range.

As compared to last year, adjusted EPS increased 13%, driven largely by stronger demand in our short cycle businesses. Consolidated segment income increased $0.02 year over year, this was net of a $0.24 decline in earnings due to reduced pricing on transformer shipments, versus the prior year period.

The aggregate operating improvement in our other businesses increased earnings per share $0.26. The most notable improvement was in our flow segment for increased operating income contributed $0.11 per share to year-over-year earnings growth. We also benefited from reduced restructuring expense, which increased EPS $0.13 as compared to last year.

Reported revenue for the quarter was $1.3 billion up 10% versus the prior year. We reported organic revenue growth as 7% and acquisitions contributed $56 million or 5% growth. Currency decreased reported revenue by 2%, segment income was $158 million up 1% from last year. Segment income margins were 12.2%;better than we had expected, however, lower than last year.

Margin improvement at the majority of our businesses was more than offset by reduced pricing on transformer shipments. Additionally; recent acquisitions, diluted margin [inaudible] 40 points.

Looking at the results by segment, beginning with Flow Technology, Flow reported revenue of $439 million in Q3, that’s up 8% from last year, driven primarily by acquisitions.

Organic growth of 1% was offset by a 1% decline due to currency. It is notable that this is the first quarter of organic growth flows to the Q4 2008.

Segment income was $58 million up 17% and margins increased 110 points to 13.3%. The core margin improvement is actually greater when you consider that recent acquisitions diluted the margins by 80 points. The strong leverage partially reflects the benefits we are achieving from the reduced cost structure and continues focus on our operating initiatives.

Margins also benefited from our solid execution on a few highly complex engineering projects in the quarter, one of these projects is related to [inaudible] that we are engineering and manufacturing for the nuclear power plant Westinghouse plans to build in China and the US.

Our production on this multi-year project increased in Q3 and is scheduled to continue in to 2011.

Flow’s backlog increased for the third consecutive quarter to $772 million, this is up 21% sequentially and 24% year over year. The addition of Anhydro’s backlog accounted for 12% of a sequential increase and currency changes were a 4% benefit.

Organically, the backlog increased 5% from Q2 driven by strong global demand for replacement components in our industrial, and food and beverage markets.

Orders increased across each region with EMEA showing the strongest growth, primarily on book-and-turn business. And demand in China remain strong particularly for food and beverage systems.

Moving on to our Thermal segment, our reported revenue for Q3 was $440 million up 10% as compared to last year. The SPX Heat Transfer acquisition contributed 5% growth, currency reduced revenue by 2%, organic growth was 7%, this was driven primarily by strong execution on power projects in China and South Africa.

Segment income improved 2% to $60 million. Segment margins were 13.7%, an excellent result for the Thermal segment; however, down 100 points versus last year due to a top comparison with Q3 2009.

The SPX Heat Transfer acquisition was 50 points diluted. Margins were also impacted by competitive market dynamics in our package cooling business; these are small cooling systems that are used to cool commercial applications.

At the end of Q3, the Thermal backlog was $1.7 billion up 4% from Q2. This increase was due to favorable currency changes, particularly the stronger Rand. Thermal’s backlog is quite sensitive to the Rand at 45% for the backlog relates to the Thermal engineering manufacturing we are contributing to the Medupi Kusile Power Stations being built in South Africa.

Our production on these projects has progressed largely as expected this year. In recently public announcements by SCOM, management said it is finalized, the funding plans to enable a completion of these two projects. They also indicated that they are in the early planning stages of another build program.

From an organic prospective, the backlog declined 3%, this was due in part to strong backlog execution that drove the reported organic revenue growth in the period. We are encouraged by the increase in large project awards that Chris highlighted, and current quoting activity.

It is important, however, to remind you that order placement for large scale power projects with a below level in the first half of 2010. As we plan for 2011, we expect project-related revenue to be concentrated in the second half of the year.

Test and Measurement, reported another very strong growth quarter driven by continued recovery in the vehicle service market. Revenue increased 21% over the prior year to $228 million. Organic revenue growth was a robust 24% offset partially by a 2% decline due to currency. Organic growth was driven primarily by increased global sales of diagnostic and service tools to OEMs and their dealership networks.

Sales into the aftermarket also increased. Geographically, growth was strongest in the Americas where revenue increased 26%. Sales into Europe and Asia-Pacific also increased by 18 and 9% respectfully. Segment income increased 38% to $18 million and margins improved 90 points to 17.8%.

The margin expansion was driven largely by leverage on the organic revenue growth. We also benefited from cost savings associated with the restructuring actions taken in 2009. Order trends remain strong exiting the quarter and we expect year-over-year revenue growth to continue into the fourth quarter.

On the last earnings call, we mentioned that our Service Solution business has been actively supporting development in rollout of electric vehicles. Due to our focus in this area and strong customer relationship, General Motors has selected SPX as its exclusive provider of home-charging installation services for the new Chevy Volt. Also, the Service Solutions business will manage all aspects of home charging installation services. GM expects to manufacture about 10,000 Chevy Volts next year and up to 50,000 in 2012.

We are proud to be GM’s partner in supporting the loans for the Chevy Volt and we’re excited to provide new honors for the streamline program for installing their home charging equipment.

In conjunction with this program, we are also introducing SPX’s new 240 volt charging station. Our role in the launch of this electric vehicle underscores our organizational focus on innovation, and environmental sustainability.

Moving on to the industrial product segment, our reported revenue increased 3% year over year to $184 million. Organic growth was 2% driven by solid execution on large orders for solar crystal growers and high tech communication equipment, as well as increased sales of hydraulic tools. This growth was largely offset by the impact of lower pricing on transformer shipments in the quarter.

Segment income was $22 million, 11.8% of revenue. The lower transformer pricing had the greatest impact on the year-over-year decline of segment income and margins.

The total backlog for the segment declined 3% sequentially due primarily to the execution of the large orders in Q3. We saw signs of improvement in demand for transformers during the quarter. The transformer backlog increased 14% sequentially on higher order volume.

Pricing on new orders remain challenging but was relatively stable quarter to quarter. We are currently taking orders for the second quarter of 2011. While we are encouraged by these trends, we don’t expect to see any significant recovery in the reported results for this business in the near term.

Pricing in our ending Q3 backlog is at lower levels than it was at the same time a year ago. Accordingly, we expect the reported transformer margins to face tough comparisons in the first half on next year.

Moving on, we reported $6 million of equity earnings in the third quarter up 14% from last year. The increase is due primarily to end market recovery we have seen in our joint venture with Emerson Electric.

For the year, we expect equity earnings to increase 2% to $30 million or $0.40 per share. This represents approximately 11% of our 2010 estimated earnings per share.

Moving on to cash flow, we generated $33 million of free cash flow during the third quarter. This excludes $25 million of payments made in relation to the refinancing. During the quarter we invested $12 million in capital expenditures and $5 million on restructuring actions.

We also made a large investment in to working capital supporting the third quarter organic revenue growth. Over the past two years, our net investment in working capital has, to a large extent, been influenced by the shift in our organic revenue cycle. We are forecasting strong free cash flow generation in Q4 this year in line with our historical performance and we fully expect to meet our full-year free cash flow target of between 180 and $220 million.

At the midpoint, this represents 113% conversion of net income.

Before I turn the call back over to Chris, let me briefly review the revised assumptions for our fourth quarter and full-year EPS guidance.

For the fourth quarter, we are targeting revenue to be flat to up 4% versus Q4 2009. We estimate that revenue from acquisitions will contribute approximately 5% growth. We expect organic revenue to decline modestly due primarily to the timing of projects in the Thermal segments.

Segment income is targeted to between 147 and $157 million. We expect Q4 margins to be between 11 and 11 1/2 %. This is down versus last year due to lower pricing on transformer shipments and acquisition dilution.

We are modeling a 30% effective tax rate for the quarter, this includes a discrete tax credit we expect to book in the period.

Our EPS guidance for the fourth quarter is $0.95 to $1.10 per share.

Looking at the full-year targets by segments, these targets reflect Q3 results and are updated expectations for the fourth quarter.

For flow, we are targeting revenue growth between 2 and 3% with segment margins between 12.6 and 12.8%.

For Thermal, we have narrowed our revenue range and are now expecting revenue to increase 1 to 2%. Based on continued strong margin performance in Q3, we now expect the full-year margins to Thermal to approach 12%.

For Test and Measurements, based on the Q3 organic growth, the strong exit order rate, we have increased the target revenue growth to be between 12 and 13% with margins above 8%.

In the industrial segment, the timing of certain projects we had previously forecasted for this year have shifted into 2011. We now expect 2010 revenue to decline 12 to 13% on the year and we have reduced the full-year margin target to 10% at the midpoint.

On a consolidated basis for the full year, we are targeting total revenue of $4.9 billion up modestly from last year. We are expecting organic revenue to decrease between 1 and 3%. Acquisitions are expected to increase annual sales by about 4%.

Currency fluctuations are now projected to have about a 1% negative impact on full-year revenue. We have increased our segment income margin target range to 11.1 to 11.3%. We are using a 34% tax rate for the full-year. Our earnings per share guidance range is now $3.45 to $3.60 per share.

In the appendix of this presentation, we have included a full detail model to the midpoint of the range.

The free cash flow guidance of 180 to $220 million reflects approximately 40 to $50 million of cash restructuring, a $35 million to pension funding, and about $90 of capital investments.

Certain events noted on this chart could occur and have an impact on our actual EPS and free cash flow results. Please note that we have about 50 million shares outstanding, this makes our EPS model highly sensitive to changes. $750,000 of operating profit is equal to approximately a penny earnings per share.

With that, I’ll turn the call back over to Chris.

Chris

Thanks, Patrick. So in closing, we’re pleased with our results for the third quarter, which included broad based organic revenue growth and a double-digit increase in earnings per share.

Orders were up sequentially and year-over-year, and our backlog increased by 8%.

Global expansion was a key driver of our Q3 performance and continues to be in an important area of focus throughout our organization. In China, we have purchased land and are moving forward to consolidate our manufacturing in to one location. We expect to begin manufacturing at this facility by 2012.

We have appointed a managing director to lead our development efforts in India and Africa where we believe there are strong growth opportunities for many of our businesses. And in Europe we have established a shared-service center that has begun supporting our European operations.

The acquisition of Anhydro and Gerstenberg Schroder have strengthened our global position in food and beverage market. The integration of these businesses is progressing as planned and we’re very excited to have them as part of our global technology team.

We continue to monitor additional strategic investments and believe our financial position provides us with sufficient flexibility to execute on future opportunities as they arise.

We have seen recovery in many of our early cycle businesses throughout the first nine months of the year. However, with probably 2/3 of our business being mid to late cycle, our recovery has lagged a broader economy as we anticipated.

Naturally, the economic recovery in 2010 has driven an increase in electricity demand, a positive indicator for our late cycle power businesses.

In the second half of this year, we have seen modest signs of improvement in the order activity in our key power and energy markets. If this improvement continues, we believe we can see some level of recovery in these businesses in the latter part of 2011, and into 2012.

We remain confident in the long-term outlook for our key-end markets and plan to continue to execute our long-term strategy. So thanks for joining us on the call this morning, and at this time, we’re ready to take your questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from the line of Shannon O’Callaghan from Nomura. Please proceed.

Chris Kearney

Hey, Shannon. Good morning.

Shannon O’Callaghan – Nomura

Morning, guys. Hey, just a question on the retrofits in the U.S. and I guess developed markets broadly on the Power Gen side in Thermal. You know, it seems like we keep hearing more and more and more there. Do you feel like this is a wave of pent-up demand that has some legs to it, or just a feel for what you’re hearing in the projects that have happened?

Chris Kearney

Well we know, Shannon, that that retrofit market has been underspent during the recession. We know that the dynamics would logically support improvement, and particularly improvement focused on greater efficiency and environmental awareness in that area. The recession has been part of the cause. You know, another has been, we talked about this before, uncertainty, particularly in the U.S. around economic policy going forward. We’ve always felt that the underlying dynamics were very positive and that sooner or later those had to start coming through.

We’re encouraged by the couple of projects that I mentioned on the call this morning and if you look at the market overall, it would support the need for more of that. But the nature of this business, as we know, is that it is, you know, project related, it tends to be choppy, but when we look at our business, medium to long term, we like and we’re encouraged by the drivers out there.

Shannon O’Callaghan – Nomura

Okay. And then, you know, this is the first time I remember you mentioning this – the competitive dynamics in the package-cooling side. Can you just fill that out a little bit and let us know what’s happening?

Chris Kearney

That business, we actually talked about that before. That part of the business has always been more competitive because there are more players in that wet-related business, the package cooling business. That’s true in the United States, it’s true in Europe, it’s true in the Asia-Pacific market.

We think that one of the things that makes us attractive overall in that market is the innovative concept that we’re engineering into those products and the broad technology that we offer as a solution. And on the operating side, we’ve made terrific progress, you know, over the last several years in terms of leading our operation, particularly our facility in Alatha, Kansas and rationalizing our footprint around the world, focusing our production in developing markets in best-cost countries. And Drew and his team really streamlined their organization.

It’s always been competitive. We’ve been reactive to that situation in terms of how we’ve structured our organization and how we focused on operations and efficiency. And we’ve been proactive in terms of our focus on innovative new project solutions.

So we think, over time, that business will continue to get better for us under the leadership that’s there and we’re pretty confident in terms of the product offering we have out there.

Shannon O’Callaghan – Nomura

Okay. So I should read the call-out on the slide as sort of intensifying pricing pressure or something like that?

Chris Kearney

I think it’s a continuation of a market that’s always been pretty competitive.

Shannon O’Callaghan – Nomura

Okay. Just last one. Patrick, have you taken a look at Pension for you guys next year and where it might head?

Patrick O’Leary

Yeah, I mean, it’s a little early for us for pension. As you know, we’re sort of out of the pension business, so we don’t offer any pensions anymore. All of the people in the main U.S. plant aren’t invested in the plan. So the drivers of the accounting outcome are really the investment performance and discount rate.

We do expect that pension will be a headwind for us next year, maybe in the $0.10 or $0.15 range. From a funding perspective, we’re putting about 35 million-plus into pensions this year, as shown in my remarks. Sorry, I meant to say $0.05 to $0.10 earnings per share headwind for next year.

For funding, you know, certainly funding will increase next year. You know, at a minimum in the 30 to $35 million range, we are right around 80% funded. So we are monitoring the overall funding situation of the plans very, very closely.

Shannon O’Callaghan – Nomura

Okay. Thanks, guys.

Chris Kearney

Thanks, Shannon.

Operator

Your next question comes from the line of Steve Tusa with JP Morgan. Please proceed.

Stephen Tusa – JP Morgan

Hi. Good morning. Can you hear me?

Chris Kearney

Good morning, Steve. We can hear you.

Stephen Tusa – JP Morgan

Great. I just wanted to get a little bit more information on transformers. The margin looks like it went down sequentially to kind of a mid-single digit range. You know, you gave us the EPS year-over-year hit, does that – am I calculating that correct?

Chris Kearney

Yes, you are.

Stephen Tusa – JP Morgan

So the dynamics of the cycle, when you guys start to see that volume pick up and you say pricing is stabilized, you know, from a – on a sequential basis, how much further, you said they have tough margin comps year over year obviously, but on a sequential basis where do these margins go over the next couple of quarters given that price is now stabilized?

Patrick O’Leary

Well, they should be [inaudible] based on the fact that we’ve seen flattish pricing. What’s actually happening here is that, you know, we’re going through the cycle down to and it’s not against the calendar year. It was really sort of mid-year to mid-year.

We did publish a chart at EPG that showed the sort of peaks and troughs that were allowed to cycle. What actually happens, which is where we are now, you get to the point where you are at the bottom of the cycle on pricing you see the demand coming up. Price recovery typically lags demand improvement by a couple quarters. The demand improvement was noticeable in September in particular. And so you know, what actually happens then is you work off the backlog at the lower pricing.

And right now, you know, as demand comes up, obviously lead times comes up and the delivery dates are moving out somewhat. We are right now probably in the five-to-six month range so we’re, you know, sold out to Q1 and working on filling out Q2 on average.

So I think you’re going to see similar margin deployments in Q1 as we work off that backlog, and certainly in the second half of the year, we’ve got easier comparisons. And if volume remains moving in the direction that it is, we should see some price improvements.

Down cycle isn’t necessarily an indication of what this recovery will be because we reached higher peak margins in this last cycle than in the previous cycle. But if you look at what happens, it really – it steps up over about three years where we get nice sequential improvement three years in a row on both volume and pricing and then kind of comes back out to the top of the cycle again.

Stephen Tusa – JP Morgan

Yeah, we’ll worry about three years from now three years from now. So given that this business is put in a firm bottom here, you know, this is the function of kind of the maintenance budget coming back for the use and then some of these transmission and distribution projects that we’ve been hearing about? Is that what you’re seeing for your utility customers?

Chris Kearney

Yes. I think in terms of what we’re seeing in terms of median transformer demand now, what’s driving that is replacement business and reflecting a market that’s been underspent during this recessionary period and down cycle.

And then with respect to new power generation coming on, particularly in renewables, we think at the transmission end that will drive some additional demand, which certainly we think should happen and is part of our plan in terms of the new capacity that we’re adding to Waukesha.

Stephen Tusa – JP Morgan

And then one last question. Just on the fourth quarter numbers, [inaudible].

Chris Kearney

I’m sorry? I think we lost him.

Operator

Your next question comes from the line of Bob Cornell from Barclays. Please proceed.

Bob Cornell – Barclays Capital

Following up on Steve’s point on transformers, I mean, so the pricing that you’re experiencing is better or worse than the pricing in the current revenues?

Patrick O’Leary

Pricing has been about flat quarter-on-quarter, Bob. But if you look at going back over the last, you know, if you looked at comparing pricing in the backlog today versus a year ago, it’s down. So what’s actually going to happen is you’re going to see that backlog move out at the kind of low-single digits margin performance you saw in Q4. And I expect that to continue into Q1, through Q1 and into the early part of Q2. And then you know, obviously we need to see how orders develop. There’s some spending in advance of budget expiration, but looking at the orders we’re taking, they’re for delivery in 2011 and so there clearly is signs across the market of some elevated level of customer spending for the majority of the customers in 2011 over 2010.

Bob Cornell – Barclays Capital

Okay. I think you got it. So on a thermal business, you know, just give us – you talked about the South African project, but you also talked about the – the firming up of the financing, and you also referenced the next potential build. Maybe if you could just give us some more detail on what’s going on there.

Chris Kearney

Well again, the nature of the thermal business is, you know very well, Bob, it is project oriented. So the order trends tend to be very choppy. Orders on dry cooling trends were very light in the first half of the year. What we’ve seen in recent months is what we talked about this morning, some significant new thermal orders in the U.S. power market coming on for more than $100 million. That phenomenon is really repeated in different parts of the world. We see that overtime in China where the contracts tend to come in waves. And order activity in 2010, in China for instance, was lighter than 2009, but you know, the China market is just really absorbing the contracts that we’re recognizing as revenue right now. The demand, we believe is still very, very healthy.

If we look to the other developing markets, what really gets us really excited about opportunities there is when you look at markets like India, for instance, we believe that those markets with new power generation capacity coming on, the need to develop that creates a very similar opportunity for us that we’ve seen in China over the past decade. And you know, we’re encouraged by the business we’re picking up in South America. We mentioned, you know, our second large contract there, in the Middle East, and we’re also encouraged with respect to South Africa and the fact that the SCOM has resolved the funding issues with respect to the project that are ongoing and are now beginning to talk about next generation projects.

So the dynamics are very positive. The contracts tend to come in waves.

Patrick O’Leary

As for South Africa, I mean, what we’re engaged on, we’ll be engaged on for the next couple of years.

It’s really about 25% of what their new power need is. And so there clearly is additional demand that’s needed there. I think the question of timing is still a very big question.

Bob Cornell – Barclays Capital

What’s percent of completion on the two big projects at this point?

Patrick O’Leary

Two-hundred-and-some million [inaudible] revenue, which is about 100, so out of $800 million, we’ll have about 300 and some done by the end of this year.

Bob Cornell – Barclays Capital

Okay, thanks.

Chris Kearney

Thanks, Bob.

Operator

Your next question comes from Steve Tusa from JP Morgan. Please proceed, sir.

Stephen Tusa – JP Morgan

Hey guys, sorry about that. I just, very quickly, just on the fourth quarter guidance, you know you haven’t changed your below-the-line expectations for the year so there’s no real change there. And they were actually a little bit higher than we were expecting this quarter, so a pretty high-quality operating result. So when I look at the fourth quarter, given you haven’t changed those below the line, it looks like those should be, you know, a bit of a tailwind, you know, relative to the model. That also – that being said, when I look at the thermal numbers or industrial margins for the fourth quarter, they just – for a business that’s usually seasonally okay, up in the fourth quarter, I’m just really struggling to see how we get to this EPS number. Is there something wrong in the business, did something take a step down? It doesn’t sound like it’s transformers. I’m just curious what’s going on.

Patrick O’Leary

Sequentially, from Q3 to Q4, I mean, at the margin, the step down is really elevated restructuring in Q4 versus Q3. You know, we do have a decline in the higher margins by cooling revenue coming out of them. That segment is project driven. And then we had strong project execution in industrial in Q3 that you’re not seeing in Q4.

But as I said, the margin there is really elevated restructuring of about $0.08 a share. You know if you look year on year, what we had was a $1.55 last year and we’re – you know, it really is the transformer pricing that I talked about and then project – lower level of dry cooling projects in the thermal segment.

Below the line, Q4 to Q4, there is actually some headwind from pension and other income.

Stephen Tusa – JP Morgan

Total revenue is down year over year? Organically?

Patrick O’Leary

Yes. And it’s basically lower –

Chris Kearney

It’s just the timing of the dry cooling project.

Stephen Tusa – JP Morgan

Right. Okay. And then on the industrial margin, 7%, is that a good baseline that we’re using now? That’s the implied fourth quarter margin?

Patrick O’Leary

It’s about 6 ½% in the numbers that we published this morning.

Stephen Tusa – JP Morgan

Okay. All right, thanks a lot. Appreciate it.

Chris Kearney

Thank you.

Operator

Your next questions come from Nigel Cole from Deutsche Bank. Please proceed.

Nigel Cole – Deutsche Bank Securities

Thanks. Good morning, guys.

Chris Kearney

Good morning, Nigel.

Nigel Cole – Deutsche Bank Securities

Yeah, I just want to pick up from Steve on the industrial margins in 4Q. So 2.5%, I just want to understand the move between 3Q and 4Q. It sounds like you had a good mix of large project shipments in 3Q, along with a couple of others. And then 4Q is a better representation of current pricing. I’m actually wondering, 2.5%, is that a good baseline for first half of ’11?

Patrick O’Leary

It’s a good baseline for Q1.

Nigel Cole – Deutsche Bank Securities

Q1, okay. That’s good enough. And then looking at the full backlog, that was really encouraging. You may just talk about, I mean, you did address in some of your prepared remarks, you know, where you saw some strength, but maybe if you could just stick into the vertical some of the puts and takes of the major verticals?

Chris Kearney

Yeah, sure Nigel. I think, you know, what’s encouraging about flow is that first of all we’ve seen three consecutive quarters of backlog build. And when you look at, you know, the year-over-year increase and the sequential increase, it I think, represents a significant shift in the trend in that business. And what’s encouraging is that in the early part of the year, we saw the components business starting to pick up and now across geographies that’s true. And while the systems business has lagged, we have picked up some nice orders, particularly in Europe. We mentioned those in the prepared remarks today and the quoting activity, the front-line activity we’re seeing in the system’s business is encouraging to us.

And you know, the two acquisitions, Anhydro and Gerstenberg, the two most recent acquisitions that we’ve done have really fallen in nicely to the strategy and have contributed in a big way, particularly with respect to a couple of big systems orders that we did in Europe this year.

Nigel Cole – Deutsche Bank Securities

Are there any major variances between verticals; food and beverage, oil and gas, chemical?

Chris Kearney

Food and beverage has been particularly strong and that’s what driving much of the growth, that’s where we have focused a lot of our investment opportunity in terms of the acquisitions that we’ve done. Oil and gas has been slower this year and so –

Patrick O’Leary

The industrial market placement has been strong and obviously we’re starting to work on the Westinghouse Power and Energy Project. We’re getting very positive customer reaction to the broadening of technology in the food and beverage market, which is opening up more bidding opportunities. Some opportunities that were too small for niche technologies on their own and where we were big enough to do them but we didn’t have the depth of the technology prior to Gerstenberg and Anhydro.

So we’re actually, although we’re organically down on systems as we talked about on the call, we’re actually getting to the nice onies-twoies larger systems opportunities that we’re quoting on. And then the – in China, we have strong systems demand, but they’re not in the sort of 10 to 20 million range, they’re more in the 2 to 7-8 million range. But noticeably, noticeably strong.

And then for components, really components are very strong in food and beverage and the industrial markets. As you gather from the call, the execution and the margin development is really strong in the call when you take the lower margin acquisitions out.

So we’re pretty optimistic about the way that the future revenue is developing from the order strength, and I think you see that too across other competitors in the market in terms of a noticeable improvement in order development.

Nigel Cole – Deutsche Bank Securities

And then a question on thermal outlook. You mentioned that SCOM to look at the next phases of the project. Can you maybe just put that in content of the $800 million of orders you won? What kind of science could this be and then put some comments on timing around that as well.

Chris Kearney

It’s difficult to say, Nigel. As Patrick mentioned in response to a previous question, the projects we’re working on right now, which are two very large projects, you know, each one of them six times the normal size of a cold-fired plant. Those are massive projects that when completed will represent 25% of the goal. So there’s a long way to go, but that build out is expensive and it will be, I think, a mixture of power-generating sources; probably for the most part cold, but nuclear will be certainly an alternative.

I think it will be interesting to see as we move into next year where SCOM is and what timing expectations are. I think the important thing for people to remember about our business is that, you know, we are very well positioned in the South African market. We’ve been there, as you know, for a long time. And you know, because of the local content and local BE partner requirements, I think we’re very well positioned to be a significant part of those projects going forward.

Patrick O’Leary

And we’re very focused on power and energy in that market, but logically in the median term, it should also be a good market in the petrochemical industry and we would have some technology to offer there as well. So you know, for the power market, obviously, we’re selling three broad product lines; the tooling line, critical components, and then environmental management. So depending on the mix of that product mix and whether or not the next project in South Africa is nuclear would significantly impact what the revenue development is. But when you step back and just look at what their needs are, you know, they clearly are the early stages, as we said, about a quarter of the needs identified through the two projects that are underway.

Nigel Cole – Deutsche Bank Securities

Great color. Thanks guys.

Chris Kearney

Thanks, Nigel.

Operator

Your next question comes from the line of John Inch, from Banc of American. Please proceed.

John Inch [Alana] – BoA/Merrill Lynch

Hi. Good morning. It’s Alana on behalf of John. I wanted to dig a little deeper in terms thermal guidance. What kind of top-line growth are you [inaudible] for your personnel comfort hitting business in the fourth quarter? And can you remind us what percent of sales this business typically represents in the fourth quarter?

Patrick O’Leary

It’s stable to last year in terms of the top line and the comfort rating. As you know, it is seasonal, a seasonable business. But the orders are slightly better than our expectations, particularly in the boiler business.

John Inch [Alana] – BoA/Merrill Lynch

Okay. And then I just wanted to circle back to the industrial margins. You see sequential decline between third quarter and fourth quarter. Can you bridge the – let’s say the five-point drop, can you allocate that to the various business, how much is Waukesha versus some of the other smaller business? Is there any way to do that?

Patrick O’Leary

Waukesha was basically flat quarter to quarter. And the change is really a larger project, particularly solar [inaudible] growers and high-end telecommunication equipment.

John Inch [Alana] – BoA/Merrill Lynch

Okay. Thank you very much.

Operator

You next question comes from the line of Jeff Sprague from Vertical Research Finance. Please proceed.

Jeff Sprague – Vertical Research Finance

Hi. Good morning, it’s Jeff Sprague.

Chris Kearney

Hi, Jeff.

Jeff Sprague – Vertical Research Finance

That’s a new one. Just a couple of questions on Thermal. How is kind of the price dynamic playing out there, you know, orders starting to pick up, but still a relatively slack environment. Just kind of the whole price-cost balance in that business currently?

Patrick O’Leary

It terms of the execution of total margins, we’re actually really happy with it. We managed the input costs in different ways. Obviously, the amount of risk we take on each project varies and we deal with that contractually. At the time we bid contracts, we also build in some contingencies. If you look at the level of execution, it’s lumpy based on projects but we’ve been very much more disciplined in the project that we’re taking on and of the contract terms that we expect on those projects.

So as you saw in Q3, we were sequentially up over 100 points from the Q2 execution and you know, we’re showing about 12% margins in Q4. So you know, the issue really here, Jeff, is this hiatus that we had for orders for particularly a couple quarters early this year.

If you look at the book to build, it was noticeably stronger in Q3 than Q1 and Q2, still not coming to one, but coming close. And so there’s a decent list of opportunities for Q4, so we do expect the order trend to continue to be much better than it was in Q1 and Q2, and the issues that it will raise of us, as I mentioned on the call, is really just how the first half of next year pans out. But if you step back and look at the segment over four years, you know, particularly since Drew has been there, you know, we’ve got on an annual basis, we’re sequentially executed better and so the margins have improved and are frankly all in the range of our median term targets.

Jeff Sprague – Vertical Research Finance

But separate from the issue of maybe a little bit of revenue slack in the first half given the orders, is price and backlog weaker in that business now than what we’ve seen come through on revenues the last couple of quarters?

Patrick O’Leary

Pricing remains competitive across the board. We haven’t seen an significant change in the embedded margin in the backlog. And obviously, a big part of our backlog is the South African business and you can see that we’ve been executing that pretty well with a couple hundred million dollars of revenue in there for this year.

Jeff Sprague – Vertical Research Finance

And I was just wondering, on a, I mean, your China business sounded terrific in the quarter but to what extent are you seeing indigenous Chinese competition intensify? This Reliance-Shanghai deal in India kind of rattled the market a little bit. Are you seeing those Chinese players kind of flex their muscles a little bit more where you’re playing, and how are they behaving on price?

Chris Kearney

It’s actually – it’s been pretty consistent, Jeff, with what we’ve seen in the China market over the last couple of years. In fact, we described it broadly stable. The same is really true, I think in China. And actually, you know, with respect to some of the things that you’re reading about, the expansion of some of those larger EPCs going into different parts of the world, that actually presents some pretty good opportunities for us because we supply some of those customers and would like to supply those customers as they expand to different parts of the world, like India and Africa, and other places.

So the competitive dynamic really hasn’t changed. It’s consistent. I think the lighter-order year that we’ve seen in China is just really reflecting a pause in the contract award activity. Our competitive position in that market really hasn’t changed.

Patrick O’Leary

Yeah. We see a lot of interest in our niche technologies around heat exchange and pollution abatement. We’ve had a lot of interest from Korean EPCs as they expand out into the Middle East and elsewhere. And I think the same is going to be true for the larger Chinese EPCs as they look for providers of various components of the project.

So I would describe the overall market as still competitive. But in terms of where our offering is, again, EPCs [inaudible], none of the large European EPCs offer cooling towers of the core technology.

Jeff Sprague – Vertical Research Finance

And then just finally one just housekeeping item. Patrick, you’ve indicated taxes as a swinger positive or negative in Q4. Just give us a little more color on what might play out there. And then is tax kind of a wildcard for next year also or do you have some visibility on the tax rate next year?

Patrick O’Leary

Well, if you look back to last year, we used 33% and we’re using 34% in the core model of this year, Jeff. And the reason for that increase was simply lack of government action on the R&D credit and the impact of the healthcare bill. And going forward, our long-term loan right now, we’re using 34%. But obviously, U.S. tax law is – has been up in the air with a significant number of things being considered and some of those, particularly foreign-tax credits in companies like ourselves doing business U.S. based, but doing business heavily internationally.

So I think there are regulatory questions that really need to be answered before we have a really good bead. I actually feel with our, you know, with the rate of 34% in our long-term model, that we’ve got a relative to other multi-industry – we’ve got more upside than downside than looking at the 34% rate we’re looking at right now. But we really have to see what the approach to funding the deficit in the U.S. is as it relates to the corporate tax rate.

Jeff Sprague – Vertical Research Finance

Okay. Thanks a lot.

Chris Kearney

Thanks, Jeff.

Operator

Your next question comes from the line of Deane Dray of Citi Investments. Please proceed.

Deane Dray – Citi Investments

Thank you. Good morning everyone. I was hoping Patrick could take us through some of the dynamics on the debt restructuring in terms of in particular what the assumed payback is on the early retirement charge and terminating the swaps?

Patrick O’Leary

Sure. I mean, the – as a tax payer, obviously we get a tax deduction for our interest and at the time we look at managing interest pretty much depicts rates. The primary instigator for refinancing was the amount of pending debt we had coming due two years out, and the fact that rates prevailing in the market right now finally came within our target range.

So that large payment isn’t, you know, I don’t look at that as a payback, but as simply, we had our existing barrier bill rates swapped in the [inaudible] and that was just an acceleration of the payments that we would have made under those swap agreements. Obviously because they’re related to underlying core debt, we don’t speculate in derivatives; having settled the underlying debt we settled the –

Deane Dray – Citi Investments

How about the – I see gross leverage at 2.3 times, so in terms of –

Patrick O’Leary

As you know, it’s above – it’s all above our target range, but the reality is that you know, with the prediction of a half a billion dollars of cash at year end, when you look at our overall leverage, it really is motive. The issue that we have is our, you know, our core facilities are priced below market and so in terms of paying – further paying debt down at these rates, it doesn’t really make a lot of sense to us in a business that we see growing going forward and potentially growing through acquisitions.

So what we’ve really been doing, Deane, is taking net cash, much which resides in Europe and using it to fund acquisitions in the core platform.

So from the point of view of our overall leverage situation, the net leverage in the ones I feel very comfortable with were we are. And now that we have substantially eliminated the refinancing risk with the bonds out through 2017, I feel we can go back to focusing on expanding the business and improving operations and not have to worry so much about the balance sheet.

Deane Dray – Citi Investments

Great. And just – does that assume you’re not focused on the debt pay down, excess cash swings to buybacks?

Patrick O’Leary

Well, we look at buybacks side by side with acquisitions. As you’ve seen from the acquisitions that we’ve done this year, pricing has changed fairly significantly in the acquisition market to where now we’ve seen some very attractive EPA models on the [inaudible] acquisition. These are mostly companies we’ve been looking at in the 50 to I’ll say $200 million range. So the acquisition pipeline really is full and the pricing is attractive if we can come to terms and conditions.

So I think, you know, in the median term, if the acquisition market remains as attractive, you might see more. On a longer period of time, we will continue to follow exactly the same financial strategy and we will look at share repurchases and acquisitions side by side and do what we think is in the best interest of the long-term orders.

Deane Dray – Citi Investments

Thank you.

Chris Kearney

Thanks, Deane.

Ryan Taylor

Okay. Thanks, Deane. This is Ryan Taylor again. Thanks everybody that joined us today. We’ve reached our time limit so we need to conclude this call. I’ll be available in the office today; if you have any follow-up questions, feel free to give me a ring.

We thank you for your time and we’ll talk to you again soon. Thanks.

Operator

Ladies and gentlemen, thank you for your participation in today’s conference. This concludes the presentation You may now disconnect. Have a great day.

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