TriMas' (TRS) CEO David Wathen on Q2 2014 Results - Earnings Call Transcript

Jul.31.14 | About: TriMas Corporation (TRS)

TriMas (NASDAQ:TRS)

Q2 2014 Earnings Call

July 31, 2014 10:00 am ET

Executives

Sherry Lauderback - Vice President of Investor Relations & Global Communications

David M. Wathen - Chief Executive Officer, President and Director

A. Mark Zeffiro - Chief Financial Officer and Executive Vice President

Analysts

Matt Koranda - Roth Capital Partners, LLC, Research Division

Kenneth Newman - KeyBanc Capital Markets Inc., Research Division

Karen K. Lau - Deutsche Bank AG, Research Division

Robert A. Kosowsky - Sidoti & Company, LLC

Bhupender Bohra - Jefferies LLC, Research Division

Sara Magers - Wells Fargo Securities, LLC, Research Division

Operator

Good day, everyone, and welcome to the Second Quarter 2014 TriMas Earnings Conference. As a reminder, today's presentation is being recorded.

At this time, I would like to turn the conference over to Ms. Sherry Lauderback. Please go ahead, ma'am.

Sherry Lauderback

Thank you, and welcome to the TriMas Corporation Second Quarter 2014 Earnings Call. Participating on the call today are David Wathen, TriMas' President and CEO; and Mark Zeffiro, our Executive Vice President and Chief Financial Officer. Dave and Mark will review TriMas' second quarter 2014 results, as well as provide details on our outlook. After our prepared remarks, we will then open the call up to your questions.

In order to assist with your review of our results, we have included the press release and PowerPoint presentation on our company website, www.trimascorp.com, under the Investors section. In addition, a replay of this call will be available later today by calling (888) 203-1112 with a replay code of 392-3586.

Before we get started, I would like to remind everyone that our comments today, which are intended to supplement your understanding of TriMas, may contain forward-looking statements that are inherently subject to a number of risks and uncertainties. Please refer to our Form 10-K for a list of factors that could cause our results to differ from those anticipated in any such forward-looking statements. Also, we undertake no obligation to publicly update or revise any forward-looking statements, except as required by law. We would also direct your attention to our website, where considerably more information may be found.

At this point, I'd like to turn the call over to Dave Wathen, TriMas President and CEO. Dave?

David M. Wathen

Thanks, Sherry, and good morning to everyone on this call. All of us at TriMas truly appreciate the attention and interest shown by your participation today.

My overall message is similar to many of our previous quarterly earnings calls: steady improvement in overall metrics, despite flat markets; some noteworthy successes in our pursuit of bright spots; and plenty of actions and opportunities to continue improving our company. We also continue to focus on improving the mix of our businesses in line with our strategic aspirations.

There is no doubt that the management effort and investment requirement for implementation can create short-term margin pressure, but the longer-term impacts are positive and support these actions. Much of my role at TriMas is to select the optimum balance between the two.

Overall, our Q2 sales increased 7% to a record level, with operating profit of 10%, and a margin percentage increase of 30 basis points versus Q2 2013, all excluding special items. This was accomplished in the phase of: continued challenges in the energy markets; choppy demand from our aerospace distribution customers, resulting in some inefficiencies; and EPS headwinds related to share count and tax rate. I am pleased with our many accomplishments in Q2, and margin expansion would have been greater without these headwinds.

Before Mark provide segment details on our second quarter results, I'd like to update you on 4 topics that we concentrate on: bright spots in our markets, our continued investment in innovation for growth, margin improvement, and portfolio management. We have included slides on each of these topics.

I've shared this list of bright spots on Slide 5 before; here it is with a few updates. The encouraging message here is that each of our businesses finds growth opportunities, despite the lack of tailwinds in most economies. Throughout this call, we will share how we are successfully pursuing these bright spots focused on faster-growing markets. We continue to ramp up our packaging capabilities in Asia, add content to our aerospace offering and leverage our manufacturing footprint around the world, to highlight a few.

We have also continued our focus on innovation and applied technology to support our customers' needs and drive top line growth. Organic growth by way of innovation is one of our strategic aspirations. So we work hard to strike the correct balance of innovation spending and productivity to keep TriMas growing profitably.

I've just traveled to each of our businesses for quarterly operating reviews and put together a list of some of our current innovation projects. A few highlights are here on Slide 6.

In Packaging, new product programs drive growth with our customers. If you shop for hand soap, you were not likely to see a freestanding, battery-powered dispenser that ejects foam into your hand automatically. We are now in full production on this higher-end pump. Our Energy team continues to roll out new higher-spec products, better tools for application and self-produced materials at better margins than previously outsourced materials.

Our Aerospace business is also focused on higher-spec products, including the shipments of new bolts that shear [ph] flush, so that our customers have less finishing work. Aero has launched a new higher horsepower engine line to help customers with tougher applications.

And even though our Cequent team has been busy with plant moves, they have launched several new products, redesigned our brake controllers, and updated some shipping processes and added capabilities to service increased Internet business.

Without sacrificing our growth efforts, operating profit margin improvement is a key priority for all of us at TriMas. We have many company programs and business-specific projects focused on margin expansion.

Two quarters ago, I shared Slide 7 with you, providing our tactics for long-term margin expansion. You have heard me say that this is an ongoing, multiyear work in progress. What matters to us is continuous improvement, balancing the short term versus the long term and leveraging the commonalities across our businesses to enhance speed.

So far this year, Packaging and Aerospace are significantly outgrowing the TriMas top line average. We have a project team leading monthly on acquisition margin expansion. As you will hear from Mark, our Engineered Components businesses are at the margin level, close to historical high; Cequent Americas margin level exceeded 13% in Q2; and our headquarters costs are on track. These are simple, straightforward tactics to grow TriMas' operating margin to the mid-teens. While we were at pluses and minuses in execution, I believe we are demonstrating progress.

Slide 8 summarizes some of our current shorter-term margin improvement activities from our recent operating reviews. We have taken many positive actions and also immediately addressed some negatives that occurred. A few highlights include: the successful ramp-up of our second China packaging plant, in combination with the 3 additional plants from our Lion Holdings acquisition announced this week; address our need for in-market capacity to support the rapid growth this business is experiencing in Asia. We can also use this capacity for currently outsourced volume.

We have many actions underway in Energy to improve our product mix and reduce costs in response to the market changes we have seen. The goal is to improve profitability of standard products, which has been on our to-do list for a while but has now moved way up in priority.

In Aerospace, we are working toward a more attractive product mix, freeing floorspace for new products and responding to the ongoing slowdown in defense businesses. On margin, Aero engine wins the most improved award, driven by actions including price increases and successful reentry to the compressor sales, after exiting compressor leasing earlier this year.

Besides the leverage Norris is getting from its 2013 small cylinder asset acquisition, they are also improving material yield in cylinder production. And in Cequent, the main cost-out action is capitalizing on our investments in new plants [indiscernible] warehouse. Gross margin started to improving in Q1; and now in Q2, we are starting to see operating profit improvement, as the warehouse and shipping systems adapt. Overall, we are committed to keeping a large list of margin improvement actions and executing well.

Shifting gears to portfolio management, on Slide 9. You know that I'm happy with the businesses we are in, yet always need a certain amount of fine-tuning around the edges to realign ourselves with changing markets and conditions. These actions include: divestitures, business combinations, closures, new capacity additions and acquisitions. Several of our more recent actions are listed here, starting with the packaging acquisitions of Lion Holdings we announced on Monday. We are excited about this acquisition, because it provides needed in-market capacity, high-quality plants with expansion opportunities and talented people with a track record of serving the customers we know.

I have committed -- I have commented for the past several quarters about our need for added opacity to serve our global dispenser customers, who are growing in Asia, and that we needed to either build or buy capacity. There is speed and ramp-up advantage in buying. Plant location matters due to cross-border duties, and permitting and approval processes are cumbersome for both greenfield plants and acquisitions. This acquisition of 3 plants checks these boxes for us. And in combination with our new packaging in-plant in China for in-country sales, we have become much more valuable supplier for our key customers throughout the faster-growing markets in Asia. The Lion plants in India and Vietnam are good, well-run plants, and will only get bigger and better with our volume and investments. I am proud of our team for their dedication to the transaction process and that they are going full speed in integrating the Lion plants into our business.

Moving on to other businesses. We have closed a less profitable Energy branch in China, and we configured and downsized our energy capacity in Brazil, as the offshore oil projects there had been delayed. In Aerospace & Defense, we are successfully winding down our ammunition shell making business such that, by next year, our only defense-related business will be the aerospace fasteners that we sell to distributors.

We also continued to adapt to the secondary facts [ph] at smaller distributors of this defense decline and Boeing switch to direct stocking. And we continue to work on our pipeline of strategic bolt-on acquisitions, geared towards Aerospace and Packaging businesses.

Most of these portfolio improvement actions do require people and financial resources, but all are focused on improving TriMas for the future. Overall, I feel positive about what TriMas people are accomplishing in the short-term versus long-term trade-offs we continue to make, particularly in the areas I've discussed. We owe to you and ourselves to continuously improve TriMas.

Now Mark will update you on our future financial and segment performance, then I'll be back to summarize what all this means going forward.

A. Mark Zeffiro

Thank you, Dave, and good morning. Before we move on to the financial results, I'd like to make a few comments to frame our quarter and to put our 2014 outlook in the context.

During the quarter, we made significant progress on several key initiatives, yet also faced some headwinds that impacted our results. I will discuss these positives and headwinds within 3 categories: end market, business operations and structural impacts, and provide a few examples of each.

First, on the end market front. All of our packaging markets experienced growth, industrial closures, and specialty dispensing systems in North America and Europe, as well as continued growth in Asia. Our energy end markets, while they appear to have stabilized, have not shown any significant signs of improvement in the quarter, nor are we expecting significant improvement in the back half of the year. As a result, we will continue to take actions to improve our short and longer-term profitability.

The aerospace distribution end markets has shown some pressure in order rates and demand choppiness, as commercial aircraft manufacturers changed their ordering practices. We also experienced lower demand for our Cequent products in Australia, as a result of uncertain economic conditions in that region.

Second, regarding business operations impacts. Our Engineered Components businesses delivered their improvement actions launched in 2013 quite well to drive higher margins and leverage their manufacturing facilities.

Packaging is operating well on all fronts. Also, Cequent Americas is now starting to see the positive impacts of the move to Mexico, as these production levels and distribution processes improve.

Aerospace & Defense experience supply challenges in the quarter, and this, combined with disruptive order dynamics, resulted in weaker profit conversion for the quarter. They continue to work on enhancing their ability to efficiently serve their customers choppy order patterns and smaller lot sizes. So some improvement is required here. And we have continued to execute on our acquisition, integration and optimization plans to drive long-term benefits from these investments.

Finally, we experienced some headwinds and tailwinds from a structural standpoint as well. Our share count this quarter was 13% higher than Q2 2013, which had an impact of $0.09 for the quarter. Our tax rate guidance for the year was 27% to 29% but appears to be trending closer to 30%, as the mix of our income shifts from forecasted levels between businesses and more towards domestic versus non-U.S. geographies. This could represent up to $0.10 per share headwind for the year, if current mix trends continue.

On a positive side, our work to reduce our debt levels and interest rates continues to pay off, as we had lower interest expense in Q2 2014 as compared to Q2 2013 by $0.03 per share.

I will now provide additional color on total company performance for the quarter, on Slide 11. Our record quarterly sales were $404 million, a 7% increase compared to second quarter 2013. Our bolt-on acquisitions contributed significantly, with the remainder of the sales increased driven by our expansion in international markets and new customer wins. These increases were offset, or at least partially offset, by the impact of $4 million decrease related to the sale of our Italian rings and levers business in Packaging in Q3 2013; and in Energy, decline of more than $6 million in sales due to the delay in turnaround activity and low sales to our engineered -- engineering construction customers. We're pleased that our growth initiatives were able to substantially offset these headwinds in the quarter.

Q2 operating profit was $48 million, excluding special items, with a related margin percentage of 11.8%, an increase of 30 basis points compared to the prior year period. As Dave discussed, we continue to focus on margin improvement actions on all fronts.

Second quarter 2014 net income would have been $29 million, excluding special items, an increase of 7% compared to Q2 2013. We achieved a Q2 EPS, excluding special items of $0.65, down from Q2 2013. The benefits of higher operating profit and lower interest expense were more than offset by the 13% higher weighted average shares outstanding and a higher effective tax rate in Q2 2014.

Second quarter 2014 free cash flow and working capital were in line with expectations. During Q2 2014, we generated more than $36 million in free cash flow and are ahead of our 2013 year-to-date performance.

We ended the quarter with $368 million in total debt, a decrease of more than 23% compared to June 30, 2013, and an increase compared to prior year end due to the seasonality of working capital to support our businesses, as well as the use of $51 million in cash to acquire the remaining interest in Arminak in our packaging business.

At quarter end, our leverage ratio was 1.8x, and we had more than $394 million of cash and aggregate availability under our credit facilities.

On a year-to-date basis, the numbers and trends are fairly consistent. Sales increased almost 8% during the first 6 months of 2014. Operating profit increased 11%, an improvement of 40 basis points. And income increased 8%, excluding the special items.

At this point, I'd like to share a few highlights on our segments, beginning with Packaging on Slide 13. Packaging has had a strong start to the year, with a sales increase of nearly 10% for the quarter. Excluding the impact of the Q3 2013 divestiture, packaging sales would have increased more than 15%. Our sales efforts continue to ramp up. And our second manufacturing facility in China, combined with the Asian plants of Lion Holdings, provide additional low-cost facilities and support local commercial expansion in this growing market. These new facilities will have a positive impact on margins over time, as we use less outsource capacity and automate for efficiencies.

Packaging remains focused on sustainable operating profit margins in the mid-20% range. End-market growth prospects remain positive for this segment and will continue to support the launch of new dispensing and closure products.

Moving on to Slide 14, Energy. Second quarter sales decreased 11%, compared to the record level a year ago, due to the continued end-market challenges that started during the back half of 2013. This weaker shutdown activity resulted in a less favorable product mix towards standard builds and gaskets. During the quarter, we also experienced lower demand of approximately $4 million of our engineering and construction customers, who experienced a higher than normal demand in Q2 2013.

We took, and will take, more actions to improve profitability and reconfigure our business in Brazil to better reflect the current demand. We continue to focus on the items we can control, improving the cost structure and optimizing our expanded geographic footprint and expect that these efforts will strengthen [indiscernible] moving forward.

On Slide 15, Aerospace & Defense sales for the second quarter increased 38%, as compared to a year ago period, of which approximately half was driven by organic initiatives and half as a result of acquisitions. We continue to leverage the 2013 acquisitions of Martinic Engineering and Mac Fasteners, which has expanded our content on aircraft.

As I mentioned earlier, we continue to see choppy order demand and smaller lot sizes in aerospace distribution channel, which -- along with the supplier issue resulted in significant manufacturing inefficiencies in the quarter. We also experienced a less favorable sales mix within our product line and as a result of lower profit margins associated with our acquisitions. We expect that the overall margins of this segment to increase, as we improve our lead times and by leveraging our investments in facilities and equipment and also driving margins of our acquired businesses to our integration efforts.

Moving on to Slide 16, Engineered Components. Sales increased nearly 9%, primarily due to small -- the small cylinder assets acquired during 2013. Sales of engines decreased, which was partially offset by increased sales in gas compression products. Although, Engineered Components did not experience significant increases in demand, the recent actions we have taken in these businesses improved operating profit and margins significantly, up 470 basis points year-on-year due to price increases, cost reductions and favorable product sales mix shift.

On Slide 17, we show the performance of Cequent split into 2 segments. Q2 sales for Cequent Americas reached a record level due to increases within the retail and aftermarket channels. While our production moved to Reynosa, Mexico, was completed as we entered 2014, we continued to ramp up the productivity and efficiency of this facility, including efforts to optimize new production, supply chain, and distribution processes for this business.

During Q2, we started to see the benefits in our margins with a 210-basis-point improvement, as the new distribution hub improved efficiency and backlog was significantly reduced. We will remain focused on making these facilities more efficient.

Cequent APEA, representing our business in Asia Pacific, Europe and Africa, sales increased 14% compared to a year-ago period, primarily due to the 2013 acquisitions in Europe. This increase was partially offset by lower sales in Australia and the negative impact of currency exchange. Second quarter operating profit margin decreased, primarily as the impact of higher sales was more than offset by the incremental cost related to the acquisitions and less favorable products and regional sales mix.

Global Cequent continues to leverage its full product line, commercial relationships and strong brands around the world. We expect to capitalize on our new lower cost structures around the world by supporting our customers in those regions.

In summary, Q2 represents another quarter of high single-digit sales growth, in line with our strategic aspirations. Our businesses continue to find organic growth opportunities in these uncertain markets and augment our growth through bolt-on acquisitions. Margin improvement remains a prominent topic for TriMas and our businesses, with a bent towards focusing on what we can and should control.

That concludes my remarks. Now Dave will provide some comments on our outlook. Dave?

David M. Wathen

Thanks, Mark. Now I'll turn more forward-looking and share our expectations for the second half of 2014. While I'm pleased with the progress on our growth and margin improvement initiatives, we continue to face challenges in a couple of our businesses and the demand environment continues to be extremely choppy overall. We have not experienced and are not counting on a significant improvement in our energy markets, and we are taking the appropriate actions to enhance the margins going forward. And as Mark mentioned, Aerospace margins were lower than anticipated in Q2, as we managed through the channel disruptions with our distribution customers and the inefficiencies it causes.

Our sales growth guidance remains at an increase of 6% to 8%, as compared to 2013, as our planned growth initiatives are offsetting weak economies in the lack of turnaround activities in the Energy end market. While we are sticking to the EPS guidance of $2.15 to $2.25 a share that we've provided at the beginning of 2014, the headwinds continue to offset all of the positives we are achieving.

In addition, the recent Lion Holdings acquisition has a short-term negative impact on the remainder of the year, and our tax rate is drifting higher due to the mix of countries where the income is being generated. So overall, we have many improvements offset by several headwinds. I am quite cautious about the end markets in the next couple of quarters and expect full year 2014 EPS to be closer to the lower end of this range. However, we continue to focus on capturing the opportunities and mitigating the risk we face. And therefore, we are sticking to this range, as I mentioned previously.

And regarding free cash flow, we are off to a solid start and are outperforming 2013 so far, and see continued opportunities. At this point, we are also sticking to our original guidance of $55 million to $65 million.

Before I close, I wanted to remind everyone of the financial aspirations we are working toward on Slide 20. No changes here. We balance our efforts and make ongoing trade-offs and prioritizations to achieve this balanced set of metrics over the longer term.

In summary, our value proposition is: our balanced portfolio, multiple growth programs and continuous productivity to fund programs in approved margins. We are all here to continue to improve every part of TriMas.

At this point, we'd be glad to take your questions.

Question-and-Answer Session

Operator

[Operator Instructions] And we'll go first to Matt Koranda with Roth Capital.

Matt Koranda - Roth Capital Partners, LLC, Research Division

Just wanted to start out on the Packing segment and the Lion Holdings acquisition. I know you guys have mentioned how it helps with end-market capacity and continued growth in Asia with existing customers. And I know that facilities in India and Vietnam that you mentioned, location matters due to cross-border duties. So I was wondering are these the primary end markets that you're going after with the acquisition, or are there other end markets that you can serve from these locations. Where do see the opportunity?

David M. Wathen

There is no doubt, India is a primary end market that we are targeting. And you also know we have already -- are up the ramp curve in China and kind of starting up that ramp in India. But you'd almost have to ask one of our customers who really makes the plans for growth of the middle class. But you would say that the statistics say India is -- [indiscernible] who wins the horserace on the size of those markets. India is mighty attractive, and there is a big change going on in what -- in the middle class expanding fast in India. So I would just say, our job -- our choice is to follow our customers. So you got to put India -- China is well started and ramping, and will for a while. India is just getting started. Vietnam is also just getting started nicely. It's just playing somewhat smaller. And then you got to look at the rest of the places too, Malaysia, Philippines, all the other places that we all know that middle class is growing 5%, 6%, 8%. And so it's attractive. And these plants do -- they are in the right places to mitigate a lot of that duty problem. There'll still be a little of it. You may see us talking about another one down the road. But these fit well. That's why we worked so hard to get this acquisition done.

A. Mark Zeffiro

And, Matt, I would add one thing for you as well is: as you think about production and production efficiencies across the region, the implication of being solely China-based versus having our footprint in multiple locations in Southeast Asia, and Asia at large, gives us the opportunity to be able to shift volumes as necessary. So this is really -- it hits many of the strategic imperatives, as David mention, in terms of growing emerging markets, but also in terms of giving us flexibility in terms of the production.

Matt Koranda - Roth Capital Partners, LLC, Research Division

Great. That's very helpful, guys. And just as a quick follow-up to that. How do you guys think about valuations for fast-growing packaging business in Asia? Obviously, it's going to be different in some of the other segment acquisitions, given different growth and margin profiles there. But just could you frame out your thinking a little bit for this on -- so what are you looking for in potential other acquisitions in Packaging in Asia, aside from sort of the growth and margin profiles?

A. Mark Zeffiro

Yes. Now let me try this is, is that -- we benchmarked and always look outside-in in terms of what the market is currently trading at. And indeed, that's one of the things we considered in the valuation associated with Lion. We also look at what this means to us financially and the implications of what we wanted to do to ramp this structure. So we look at it from a net present value perspective. We look at it in terms of the return on capital implications. And so that's where we come up with what we think this is worth to us as a corporation. So outside-in is the most important thing I want you to remember is thinking about those traded multiples is one of the most important things we use sense.

David M. Wathen

And of course, for us, this is kind of a double. It's currently well-run plant, serving customers and making money at it. And then capacity that is we know from experience, quite difficult to build from a greenfield, both from a -- everything, permitting, and approvals and all that, right through the time it takes to ramp up. So this allows us to hit the ground running. And you full know we have a quite a bit of outsourced volume still from the Arminak acquisition, so this checks that box too. So yes, this is a good one.

Operator

And from KeyBanc Capital Markets, we'll go next to Steve Barger.

Kenneth Newman - KeyBanc Capital Markets Inc., Research Division

It's Ken Newman on for Steve. You generated about $2.5 million of free cash flow in the first half and you maintained your full year guidance for $55 million to $65 million. So using rough math, that suggest the back half net income is going to equal about your expectation for the back half free cash flow. So is that run rate of getting back toward a 100% net income conversion, is that sustainable, in your mind, in 2015?

A. Mark Zeffiro

One of the things that we look at, Dave hold us accountable, is being more asset-efficient and return on invested capital is part and parcel of that metric. That's what we're striving for. Remember though, the back half is when we liquidate cash out of our balance sheet. We use cash in Q1. We use less or generate cash in Q2. And Q3 and Q4 is exactly when you should see those kinds of dynamics.

David M. Wathen

So there is always going to be that, for us, seasonality curve in cash flow.

Kenneth Newman - KeyBanc Capital Markets Inc., Research Division

Great. And just a follow-up, speaking of seasonality. I mean, as you think about the cadence of earnings in back half, you expect year-over-year growth in each quarter? Or is there anything else, seasonal or structural, that will cause one quarter to outperform or underperform the prior year?

A. Mark Zeffiro

When you think about our earning streams, Q2 is typically the largest, Q3 is second largest, Q1 is third, and Q4 is the lowest level of profit for us as a company, just to our seasonality. That's kind of our historical trend.

David M. Wathen

And of course, acquisitions mess up the math on that. Making your job difficult and ours too, but it's what we all do.

A. Mark Zeffiro

I'd also remind you that in Q3 of last year, there was a gain that was realized as part and parcel of the sale of that Italian business. So that's an important thing to consider when you're thinking about Q3 profitability.

Kenneth Newman - KeyBanc Capital Markets Inc., Research Division

Okay, and just one last one from me. You've guided the lower end of $2.15 and $2.25 EPS range. What was the primary factor that changed during the quarter to cause that view? From a sensitivity standpoint, I mean, what are the 2 big or 3 big variables that we should be thinking about like it swing in other the direction?

David M. Wathen

Well, we're -- I'd try to specifically say we aren't counting on a return of the energy markets. Yes, it's out of our control. So we are making sure we've got that business configured at, to run at current kind of market sizes. There could be -- so that's the variable. The other one that -- that has drifted against this is the tax rate. And I've gotten an education recently. I always knew tax was complex, and it's even more complex with all the things -- moving parts [indiscernible] going on. And we can't count on driving tax rate down much. And so I would call those are the headwinds. The variables, it really comes down to -- what will affect us on the upside is, order rates particularly in the business is that leverage up fast. Aerospace, Packaging, in Engineered Components, we tend the leverage up further quickly, too. And so I'd say that's the variable. And you know me. I am not going to count on some upturn until it's in place.

Operator

And we'll go next to Karen Lau with Deutsche Bank.

Karen K. Lau - Deutsche Bank AG, Research Division

Just a quick question, a quick follow-up on Lion. So how much -- are you expecting any dilution this year from -- you mentioned higher tax rate, but any dilution from integration cost and so forth? I guess, beyond that, I guess, we should see as more of a sales synergy play, because you are expanding your capacity. So if you think out 1 year, what would be sort of the accretion that you are looking at?

A. Mark Zeffiro

Karen, when you think about it, we are still in the process of doing the final valuation to understand the implications in terms of intangibles and purchase counting and those kinds of things. So that's clearly to have an effect in Q3 and, obviously, a burn-off in inventory in Q4. I'm at a point whereby I'm not saying it's dilutive, but it's likely not to be accretive in the year. As for go-forward, there is clearly -- it's not just sales synergies, but it's also production and production cost synergies that in terms of gross margin are opportunity here for the 3 key businesses. So with that said, more to come in terms of how we leverage that business in terms of 2015, unless you want to go further, Dave.

David M. Wathen

No, I just -- I would just remind you that after a decade of China being the go-to place for low-cost manufacturing, we're now -- here isn't everybody. Cost is climbing in China. Mexico is more than cost compared with China. You can also say that for sure about Vietnam and India. So you take the short-term bumpiness out of integration and move in all that, and this is good stuff for our cost base in manufacturing from these kinds of products.

Karen K. Lau - Deutsche Bank AG, Research Division

Okay. If I may go to Aerospace for a minute, do you see the order pattern, the smaller lot size, do you see that pattern to persist, or is it a one-time transition thing? And if it's going to be more structural phenomenon, what -- can you tell us what kind of steps you have taken to adapt to those kind of order sizes? And then what type of margins should we be expecting in the second half for Aerospace?

David M. Wathen

I think, in every business, lot sizes keep getting smaller. And that's I've been -- we've heard say that for most of years. It's probably hitting a little later in Aerospace than it has in other businesses. It's particularly -- I'd say particularly intense right now for a few reasons. Obviously, defense macro continues to kind of slow down. And we don't -- we basically sell the Boeing and Airbus the OEM stuff; and then, basically, our other stuff goes to -- through distribution. Not quite that simple, but if you think of it way; in the distribution channel, they're getting battered by that ongoing -- the flow-down in defense that they're used to selling our products to, like a defense application of helicopters and like that. They are also getting the secondary effects of Boeing go into a lot of direct stocking programs. And I've told you before we will have the effect. We built -- had to fill stocking programs direct for a few quarters. Now we're there. And now Boeing has to burn off what they had in the distribution channel. So that stuff flushes out in a quarter or so and gets better. I mean, the outcome of all that is, you learn to run smaller lots sizes with machines tools that set up faster, and everybody calls it lean, but it's really about learning how to run. It's not lot size of one in fasteners, but to run a lot size of hundreds instead of thousands efficiently. And we all know the truth and tactics for that. We've got people that help with that. [indiscernible], Evans and all would just keeping chip in. The last I comment, because you are seeing the change in the profile of our Aerospace business via acquisition. Mac Fasteners is a distribution supplier. So the mix of distribution kind of has gone up. And you throw that altogether, but the effects of Boeing going direct flushes out kind of over a few quarters and the -- we get better and more cost efficient at small lot sizes over the course of few quarters. So the upsides will occur. And whether it takes 1, 2, or 3 quarters, it's that kind of range. The ramp will -- it'll increase. Margins will increase.

Karen K. Lau - Deutsche Bank AG, Research Division

So structurally, we are still looking at the 20-something percent margins, but you won't expect to get back up there in the next 2 quarters, given the dynamics that we talked about?

David M. Wathen

Well, if you set an operating review, you hear me talking about doing that faster, and -- but realistically, it takes a while. New equipment, new tools, new layouts, yes, they take a couple of quarters.

Karen K. Lau - Deutsche Bank AG, Research Division

Okay. And if I could squeeze one more in, on Energy, could you provide us with more granularity on how you plan to improve your margins over time? I know you have talked about you have closed some of facility or capacity in China and introducing new products. But in the absence of improvements in, or pickup in, refinery MRO, how should we think about the timeframe in terms of margin getting back to the high-single or even low-double digit?

David M. Wathen

Several -- multiple quarters is the timeframe, because -- I mean, the tools and tactic you've seen every one of us and our peers using, deciding where you build, deciding how you make purchase/buy decisions, all that kind of stuff. And we've got a nice list of that stuff going on. We -- I had my headquarters ops people help them. There is a work through that. We brought in some people that help in all that. And whether you see the effect and pretend I could preannounce any of those kind of programs, but I can assure you, we've done it before and we know how to do it, and we will keep at it.

A. Mark Zeffiro

I would like two parallels for you, Karen. Obviously, we -- Dave supported the transformation of the production capabilities of the Cequent business at large. That -- and the realities of it are: we did that in terms of better manufacturing facilities in Australia, as well as other activities. And I would also point to the actions that were taken as the result of the lean-related efforts and cost-related actions in the Aero business. So this is not a foreign concept. It's just a -- this is a multi-quarter effort to be able to make this business more profitable in the long term.

David M. Wathen

The last thing I'll remind you about that: If you went back and listen to me over the last several years and search for the words, "I grit my teeth with the margins on the standard products, but I put up with it, because we're building the footprint out in Energy," then you would find I said that many times. It was absolutely true. I grit my teeth. But I was willing to live with it. Now the pendulum has swung away from building the footprint out and making sure we get customer coverage to now turn it a little more internally and work in margins. So I -- over the trend and life of manufacturing, that's where we're at right now.

Operator

And we'll go next to Robert Kosowsky with Sidoti.

Robert A. Kosowsky - Sidoti & Company, LLC

I was wondering, on Aerospace -- Mark, maybe you will be able to do this to kind of bucket of bridge the differential. Because operating income was flat versus last year, sales were up $9 million, and I was wondering if you could just break out what was negative mix, what was acquisition-related expenses or 10P-related expenses? Any better way to conceptualize where the negative contributions to not having the operating margin expansion?

A. Mark Zeffiro

I would point to about little more than $1 million with the overtime and inefficiencies in the core business and then the mix shift associated with -- margin rate associated with the acquired businesses. That's a teenager contributed, Rob.

Robert A. Kosowsky - Sidoti & Company, LLC

Okay. And as far as $1 million overtime, that's basically to react a smaller lot sizes and not be able to run [indiscernible].

David M. Wathen

Yes, it's a combination think. Reacting to smaller lot sizes, choppy demand is accurate. Things get accelerated and pushed back, as everybody runs with lower inventory. And so it's just smaller lot sizes, it's time-shifts. And then we mention the word "supplier issue". We did have a particular problem with a feedstock. And in a slower world, we go find a replacement and -- but not in this world. You run it, take losses, run overtime to make it work and sort and all that sort of thing to serve your customer and then you deal with the consequences of it. And we had a lot of that. But that's manufacturing. That's the way it will work, and I'll give a lot -- I'd give the team a lot of credit for adapting faster.

Robert A. Kosowsky - Sidoti & Company, LLC

Okay. And I'm also just kind of confused too on the all of a sudden change into smaller lot sizes. Is this something that just happened in 2014? Did you see this in 2013 but you were able to handle it a little bit better? And just kind of why the sudden change in buying patterns all of a sudden this year?

David M. Wathen

The shock to the system is Boeing going direct. And it used to be distributors stocking Lion's for them, and now us and other OE providers stocking the Mac's bims [ph] in-plants. That's the shock to the system. Other than that, it's the -- distribution is a tough business nowadays. And there has been just so much change in it, then acquiring each other and all that, and it winds up kind of coming back on suppliers like us. I would say, it's been an ongoing trend. It came more later to this industry than we've seen it in some other industries.

Robert A. Kosowsky - Sidoti & Company, LLC

Okay. That's helpful. And then also kind of an operating profit bridge with Cequent, because sales were up a little bit this year, you saw a nice almost $4 million increase in operating profit. And I'm wondering how much of that was just efficiencies that you saw from the New Mexican plant, and how close that whole system is to running optimally or where you would like it to be?

David M. Wathen

It's substantially occurred both in -- because of the Mexican plants -- but I did comment, we saw a gross margin improvement, which is Mexican plant effect in first quarter. Now we're seeing operating profit, meaning we're getting it through the supply chain in the warehouse systems, the shipping and all that, which had been a real bottleneck for us. Our run rate through our big warehouses doubled in second quarter over first quarter. You can imagine that we will jump up your hoops [ph]. Now that said, are we there yet? No. I mean, the other thing I've learned to look at is, how many split shipments are you making. We are still making a lot of split shipments, meaning: we've got an order for X, we have to ship it from 2 different warehouses or ship it in two lots, pay more shipping and packaging and transaction costs. And so, yes, it's -- there is plenty of improvement to come yet.

Robert A. Kosowsky - Sidoti & Company, LLC

Okay. But would you say that maybe half of or more than half of the operating profit growth could have been just due to Mexico?

David M. Wathen

Oh, yes. Oh, yes. Easily. Or else we call it the move, because we move the whole ship. We move the whole warehouse at the same time, too. Now that's coming online. But it's not -- like I say, it's not optimum yet.

A. Mark Zeffiro

I would also tell you that the another chunk of that is the improvement in the acquisitions that we made in this business, both on the retail side of the house as well as the performance product side of the house. So more work to do, but that's a clear improvement year-on-year.

Robert A. Kosowsky - Sidoti & Company, LLC

Okay. That's helpful. And then two last questions. One is on the Lion acquisition. I'm wondering, what the revenue opportunity from the manufacturing base that you bought at Lion is like: if you bought a few plants, if you run those plants at full capacity, what is the revenue capacity of that system?

David M. Wathen

Our view is the plants can double in revenue with minor CapEx changes.

Robert A. Kosowsky - Sidoti & Company, LLC

Okay. And then finally, just to make sure I have the tax rate right. So previously you were looking for 27% to 29%, and now you are looking for 30%. Is that right, Mark?

A. Mark Zeffiro

Of course, trending, Rob. The reality is, the current outlook in terms of income would support that kind of rate.

Robert A. Kosowsky - Sidoti & Company, LLC

Okay. And so just doing the math right, at 28% tax rate to 30%, that's like a $0.06 headwind? Is that kind of ballpark correct math?

A. Mark Zeffiro

Yes, you are in the neighborhood. A little than that.

Operator

And from Jefferies, we'll go next to Bhupender Bohra.

Bhupender Bohra - Jefferies LLC, Research Division

So the first question, I just wanted to go back to the Energy segment here. I believe you mentioned you are going to take some cost restructuring in the business to improve margins. Can you give us some color on that?

David M. Wathen

Not yet. You know how that is. You don't preannounce. So I'll just say stay tuned.

Bhupender Bohra - Jefferies LLC, Research Division

I believe you did -- actually you mentioned Brazil in that, so I just wanted to get a sense of...

David M. Wathen

Those have already occurred. We have changed the footprint some in the Brazil and done some restructuring. Really, as we look -- took a hard look at what's the real ramp-up of the Brazil market, which is at the front-end driven by all this new offshore oil, then how fast is that coming onshore through the refineries that are built to -- and us serving those refineries. And it is just playing way slower. Again, they are still fine. You change things to adapt to that.

A. Mark Zeffiro

So Bhupender, to put a final point on it, the special items that you see in the formal reporting, you see about $2 million of special items associated with that specific move in Brazil. We're not ready to talk about anything else on a go-forward basis.

Bhupender Bohra - Jefferies LLC, Research Division

Okay. So let's switch to the demand. Now I believe Dave actually mentioned about, like, stable demand in that business right now. Could you give us some color on how the demand actually trended during the quarter?

David M. Wathen

There could be -- you could look at weekly order rates during the quarter and say, "you know, maybe it's getting better." I'm not -- you know me. I am not the kind of guy who says, "Great, I am going to straight line that forward." We are -- we're running with the premise that there has been a structural shift. We have shipped more and more products that have -- we sell them on the basis longer life, that's starting to kick in. So the turnarounds just aren't as offering as they used to be. And so be it. We will make sure we can make money on the normal standard product that gets used all the time, and we'll keep bringing up the high-end products. I mean, you could speculate a lot of stuff. There has been 2 new LPG plants announced in the U.S. That's a big deal for a company like Lehman's. But they are long-cycle projects. So I am obviously in the mode to look a little bit inward and go after costs and now count on some market rebound. If it comes, it'll be great, because they will only leverage up better. But I say, we don't count on it.

Bhupender Bohra - Jefferies LLC, Research Division

And just last question on the corporate expense. I saw it was down, actually, year-over-year. Was there something specific in that or -- and what should be the run rate, actually, for the next second half?

A. Mark Zeffiro

One of the things that we're trying to, obviously, is Dave put programs in place across every functional costs of the company. The reality of it is, is that goes for corporate as well. I would also tell you that, that also includes, obviously, the long-term incentive and other incentive programs across the corporation. So that's what you're seeing otherwise effect that.

David M. Wathen

I try to plug my ears when I hear the word the scrooge. That's part of my job is to be scrooge. And then, therefore, part of Mark's job is to be scrooge.

Operator

[Operator Instructions] And we'll go next to Sara Magers with Wells Fargo Securities.

Sara Magers - Wells Fargo Securities, LLC, Research Division

This is Sara on for Andy Casey. Most of our questions have been asked. But I was wondering if you could kind of walk through the demand or order trends by segment for Q2 and then what you're seeing so far in Q3, and kind of relate it back to book-to-bill and letting us know if segments are running above one level for that.

A. Mark Zeffiro

Well, let me take a crack at it and then Dave can steer over the top. Order rates obviously been very strong in terms of Q2 in the Packaging business. There has obviously been good support of new products that they've won, new customers that they've won, but the core demand has also been good. Specifically, we've seen improvements in industrial side of it and the beginnings of a Europe rebound. As far as the view towards the future, our order rates, we're expecting some more kind of dynamics here between now and year-end. Energy, Dave already spoke extensively about order rates with Bhupender's question. I would tell you that we saw, within the quarter, I would consider nonmaterial but slight improvement through the quarter. We're not expecting a rebound for the remainder. As Dave may mention, the realities of it are: if it becomes, that'll be great; but what we're going to do is, we're going to force ourselves to deal in this lower volumetric environment. As far as Aerospace & Defense up double digits, excluding the implications of certainly acquisitions, I mean, the front half, I would tell you that, that volume trend is, I would consider, heavier growth in the front half than we expect in the back half. So that's kind of what we're seeing there. Engineered Components is a mixed bag, but basically, a flattish kind of environment with really no impetus for immediate or direct change. Cequent Americas, showing good continued share, as well as order rates, that are outstripping POS at the retailers as well as distribution. Remember, there is seasonality that comes with the front half versus back half of that Americas business. So make sure that you're thinking through what that means for the remainder of the year. And Australia, I would tell you that Australia had a tough quarter. And Australia, I want to tell you is that the cap-year business in terms of volumes. They had, obviously, the Ford strike in South Africa that shut down basically the country for the labor strikes across the country. We had, obviously, disruption in Thailand in terms of those labor activities as well, and it had a clear effect on demand. So to that end, I would expect that, as they enter their season here in Q3 and Q4, we should see uplift in terms of relative demands.

Operator

And we'll go next to Patrick McClure [ph] with Orion Investments [ph].

Unknown Analyst

I was wondering if you could talk about the energy side of the business and if you could go into the weakness we're seeing there. The energy sector has been very strong in the U.S. for the last few years. And even if there has been slower maintenance activity, there's still been a significant growth in project spend in chemical and petrochem companies. Is it possible you are seeing a loss of share in the U.S.?

David M. Wathen

It's always possible. But we watch it mighty close, and it doesn't feel like that. Remember, our -- we do some project work. We have not traditionally concentrated on project work. And so, while we have added a few people, concentrated on project, but it's not a big part of the business. It's probably upside for us but more effective by our own efforts. Our business is really both small and big rebuilds of plants, and they are still more spread-out in time than they used to be. It affects us in particular, because we really make standard products which are we're going after our costs in. And then we do a lot of special products that are used for applications like fire and all that, which are more profitable for us. But we have not seen that kind of thing with much of a pickup. So I agree. The overall -- and you see that overall energy affect us in the aero engines business too. But the part we go after, really the maintenance business is pretty flat. That's not all -- in some parts of the world, there is some real strength. We have seen -- you pick hotspots and bright spots for that in some parts of Southern Europe and then a lot of new -- you get some rebuilds going on and things. But we like it over the long haul, but we're not counting on much of the pickup over the short term.

Unknown Analyst

Then I just have one more follow-up question regarding energy margins. They've been declining since 2012. Are there longer-term or structural issues affecting this beyond turnaround activity?

David M. Wathen

Yes, we are spending money on taking costs out, and that's -- in the long string of what we do in a business like that, we were sort of in that mode and will be for a while. And so, yes, you see it effecting margins.

Operator

And at this time, there are no further questions in the queue. I'll turn the call back to our speakers.

David M. Wathen

Okay. Thank you, everybody. We appreciate it. I always like the questions, because it helps me understand what's on your mind and what you see and your perspective of us versus others and all that. So thank you for that. And again, there is -- we truly appreciate your attention, and interest and help in this company. We're here to keep improving the place. It feels like we are, and you can count on us to keep at it. Thank you.

Operator

And ladies and gentlemen, that does conclude today's conference. We thank you for your participation.

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