Sun Hydraulics' (SNHY) CEO Allen Carlson on Q2 2014 Results - Earnings Call Transcript

| About: Sun Hydraulics (SNHY)

Sun Hydraulics Corporation (NASDAQ:SNHY)

Q2 2014 Earnings Conference Call

August 5, 2014 09:00 AM ET

Executives

Dennis Tichio - IR

Allen Carlson - President and CEO

Tricia Fulton - CFO

Analysts

Joe Grabowski - Robert W. Baird & Company

Jon Braatz - Kansas City Capital

Michael Romanelli - Sidoti & Company

Operator

Good morning, ladies and gentlemen and welcome to the Sun Hydraulics Corporation 2014 Second Quarter Conference Call and Webcast. Today’s call is being recorded.

At this time, I’d like to turn the conference over to Dennis Tichio. Please go ahead, sir.

Dennis Tichio

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

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

It is now my pleasure to introduce Allen Carlson.

Allen Carlson

Good morning. Overall demand in the second quarter was robust, pushing us to record sales levels. Geographically the largest gains came from the European region, up 15% driven by Germany, the UK, and Spain. North America followed, up 10% primarily from U.S. demand. Sales to the Asia-Pacific region were comparable to the prior year period. This was mostly attributable to China, which has impacted by destocking at distributor locations.

We anticipate year-over-year growth in China in Q3 as we continue to penetrate this market and grow market share. Sun has always taking a long term approach to business. We believe this provides the greatest return for shareholders. Long term, we’re focused on sustainable growth initiatives, and we plan to fund these initiatives with our incremental income derived from revenue growth. As mentioned last quarter, we are currently making investments which have and will impact earnings in the short term but will result in long term sustainable growth at Sun’s top and bottom line. We’re making significant investments in sales and marketing efforts in Asia, recognizing that this region holds great opportunities for growth and expansion. Our new Sarasota facility which was built to house our growing integrated package business has capability and capacity. Both of these initiatives are important to Sun’s future growth options.

Last quarter, we introduced our use of EVA as another decision making tool to provide a new and different look at our future investments. Sun has always taking a long term approach to running our business, and the investments that we’re currently making will provide sustainable and profitable future growth and ultimately EVA.

Other incremental initiatives which are underway include additional product development. Product development efforts are focused on electronics, electrically actuated valves and integrated packages. Our growth will come from these capabilities as the market evolves. Earlier this year we released an additional range of electrically actuated valves. This product expansion provides more options for our customs integrated package solutions and customer one stop shopping. In Q2, we enhanced Quick Design, our web based automated design tool for integrated packages. With this users create custom integrated packages in a matter of a minutes rather than days or even weeks. These are just two examples of developments in the first half of the year. New releases of our other innovative products are on the horizon. We expect to release these next generation products later this year.

Order rates are strong as we head into Q3 and economic indicators are positive. U.S. PMI released last week registered 57.1, the highest ratings since April 2011. PMI has remained above 50 for 14 consecutive months indicating expansion in the manufacturing sector. U.S. PMI has been a great leading indicator for Sun’s business.

Given these current trends, we expect the strength of our end markets to continue. We have the physical capacity in place and capabilities within our work force supply chain and sales channels to capture this growth. This is great news for Sun in the near term. In the long term, we are investing for continued growth to drive revenues and earnings throughout the next business cycle.

I’ll now turn the call over to Tricia to provide more detail on the quarter’s results.

Tricia Fulton

Thanks Al. We are very pleased with our record second quarter sales. Demand in the third quarter remains strong with expected double digit growth over the prior year period. As Al mentioned, we are investing in our business to drive future, sustainable top and bottom line growth. In the short term, these investments impact our earnings. Long term, they create value. These investments include brick and mortar, sales and marketing efforts in Asia and product developments. Our new facility which came online late last year adds 50% more physical capacity to our U.S. operations. Net costs associated with this facility continue to run at approximately $1 million annually. Sales and marketing efforts in Asia added approximately $200,000 to SEA in the second quarter. This was an ongoing investment and we expect it to continue through 2015.

Last quarter we talked about investments in R&D and product development that were expected to impact Q2. While R&D efforts continued throughout the quarter, there was no significant P&L impact. R&D costs for Q3 are anticipated to be $300,000.

Let’s look now at the numbers for the second quarter. Sales were up 9% driven by growth in Europe and North America. Pricing accounted for approximately 3% of sales and foreign currency had a positive impact on sales of 2%. Earnings per share were up 2%, compared to Q2 last year. Earnings were affected by the investments mentioned as well as by additional expenses, including increased overtime, losses on the disposal of assets and a change in our state tax rate which was retroactive back to the beginning of 2014. These non-recurring items totaled approximately $0.02 per share.

Gross profit as a percentage of sales was strong at 42%. The increased sales volume and pricing impact helped improve margins. With lower sales volume in Q3 consistent with our normal seasonal pattern, we expect gross profit margins to be slightly lower next quarter.

SEA expenses increased 11%, primarily related to compensation cost and investments in Asia. The provision for income taxes in the second quarter was approximately 34%. This rate was impacted by the change in our state tax rate and its effect on our deferred tax liability. We expect our rate in Q3 to be approximately 33%.

Net cash from operations was 17 million; inventory turns remains high at almost 10. Day Sales Outstanding came down during the quarter to 34 days. A quarterly dividend of $0.09 per share for the second quarter was paid on July 15th to shareholders of record on June 30th. Capital expenditures for 2014 are expected to be $10 million. This includes approximately $2 million for improvements to and reconfiguration of, our high volume cartridge valve factory. This reconfiguration will result in operational efficiencies and productivity gains. The remaining expenditures consist of purchases of machinery and equipment.

Looking ahead to the third quarter, demand is strong with sales expected to be approximately $55 million and earnings per share estimated to be $0.36 to $0.38. We stand ready to satisfy our customers and provide the right product where and when they need them.

I would now like to open the call for questions.

Question-and-Answer Session

Operator

Thank you (Operator Instructions). And we’ll go to our first question from Mick Dupre with Robert W. Baird.

Joe Grabowski - Robert W. Baird

This is Joe Grabowski filling in for Mick this morning. Can we want start out with talking about the sales trends in Asia? Obviously you guys have had double digit increases in the last three quarters, more flattish this quarter. You talked about destocking in China. Was that most of the reason for the deceleration. And then you talked about expecting growth in China in Q3. So maybe talk about the destocking and then it’s if sort of run its course.

Tricia Fulton

Yes, we did see destocking in Q2 in China specifically. We don’t expect that to continue into Q3. The indications are from our July order patterns that that region has picked up again into the double digit growth category.

Allen Carlson

Let me just add to that. There are lot of factors that enter into the equation. Money supply in China is another factor that drives behavior at our distributor. So from my view what you’re seeing in the first half of this year, second quarter specifically is strictly timing.

Joe Grabowski - Robert W. Baird

Okay, so it sounds like sort of a one quarter destocking and the trends seem like they’ve picked up again in the third quarter.

Allen Carlson

I think so.

Joe Grabowski - Robert W. Baird

Okay, great. And then maybe just switching to the Americas, sales were very strong there in the quarter. Could you just kind of remind us what your exposure is to Brazil and also what your exposure is to the Ag end market in the Americas and how those might be impacting the trends in the Americas?

Allen Carlson

In both of those markets we don’t participate very strongly. Our products tend to go into higher end, higher performance applications and in the hydraulics world, the opportunities in Brazil from what we’ve seen are lower end markets and the Ag also uses less complicated, less sophisticated hydraulic components.

Joe Grabowski - Robert W. Baird

Okay, so not really impacting our results too much?

Allen Carlson

Not at all.

Joe Grabowski - Robert W. Baird

Okay, and then you gave a little bit more detail on the non-recurring expenses that you had mentioned in the press release. It sounded like they might have sort of flowed through several lines of the P&L. I'm assuming the increased overtime -- was that sort of an SG&A impact?

Tricia Fulton

No, that would be cost of goods sold.

Joe Grabowski - Robert W. Baird

Cost of goods sold, okay. And that was -- could you maybe give us a little more color on that and if that was sort of isolated to the quarter?

Tricia Fulton

We believe that it was isolated to the quarter, just a normal -- the change in order patterns throughout the quarter but we have seen going forward that we do not anticipate that same level of overtime.

Joe Grabowski - Robert W. Baird

Okay, and then I think you mentioned the disposal of property. Did that sort of flow through other income and expense?

Tricia Fulton

Yes, it was a couple of pieces of equipment that were disposed.

Joe Grabowski - Robert W. Baird

Okay, I see. And again…

Tricia Fulton

Yes, it did flow through the other income.

Joe Grabowski - Robert W. Baird

Okay, and again sort of a one quarter impact?

Tricia Fulton

Yes.

Joe Grabowski - Robert W. Baird

So when you kind of put it all together, I think that the thing that we’re trying to figure out is in Q2 you had a 9% sales increase but the operating margins were flattish and the new guidance for Q3 is an 11% sales increase but also sort of at the midpoint of the earnings guidance, flattish operating margins. You’ve talked a lot about the increased sales and marketing and increased product development, increased R&D. When you kind of look out maybe past Q3, when do you think we kind of get back to growth in operating margins on the robust sales trends?

Tricia Fulton

As we said, particularly related to the Asia sales and marketing, those are going to be ongoing expenses Sun at least through 2015. So some of these investments that we’re making are going to continue to hit the P&L for a period of time. But as the sales go up, obviously we have the abilities to absorb the fix cost and add incremental margins pretty quickly when we don’t have some of these other expenses.

We believe the R&D portion that we’ve talked about that will impact ‘14 likely will not go into ‘15 on ongoing basis, but that’s going to depend on what other new products we decide to develop and whether we decide to outsource those or not.

You'd be pleased that the investments that we're making this year and in the next year are going pay off and add value to the business down the road. We've always taken a long-term approach and really what we’re trying to get across with these investments is they are long-term investments for long-term sustainable growth of Sun.

Joe Grabowski - Robert W. Baird

No, I understand, definitely I understand. Maybe a little more detail on the R&D project. It sounded like you said it didn’t have a significant impact on Q2 earnings but it was going to cost about $300,000 in Q3. Did I get that right?

Allen Carlson

That’s correct. We originally anticipated that to be in Q2 but from a timing perspective it’s pushing Q3.

Joe Grabowski - Robert W. Baird

Okay, all right. And then maybe just one last question from me. Early in the year, you mentioned being assertive with M&A or wanting to be assertive with M&A in 2014. Any update there on the acquisition pipeline as we're kind of half way through the year?

Allen Carlson

We couldn’t talk about that at this point in time.

Operator

And we’ll go to our next question from Jon Braatz with Kansas City Capital.

Jon Braatz - Kansas City Capital

Allen, I really don’t have an operational question, but I’d like to turn maybe to the balance sheet, capital structure. At quarter end you had a $110 million in cash and I think one could argue by at the end of this year you might have a $120 million and making some assumptions for next year you could maybe have close to well over $5.5 per share in cash.

And your capital spending isn’t big and you haven’t been that accusative and I guess I’m wondering, how the board is thinking about the capital structure, because when I look at it, if you were 20 times larger, Warren Buffet might be calling you every day and I guess my question is, what’s the Board, how is the Board looking at the capital structure of the Company because it just seems like there is too much cash, too much equity in the business and every year since 2011 your return on assets has been coming down, your return on equity has been coming down. Can you talk a little bit about the capital structure and where the Board might be on that issue?

Allen Carlson

We do that every quarter in our Board meetings and we take a look at where we’re at, where we’re positioned, how much is the right amount and just generally speaking our Board is very comfortable with where we're at. It gives us the flexibility to do what we think is necessary going forward and over the market cap of 1 billion plus to have 10% of that in cash, 15% of that in cash is not unusual. So we’re comfortable with where we’re at but it is looked at and is reviewed every quarter.

Jon Braatz - Kansas City Capital

Okay, all right. Just wanted to hear your take on it. The other thing was operationally you talked about spending more on developing the Asian market. Tricia, on an incremental basis are you going to spend more next year than you have been spending this year, do you think?

Tricia Fulton

We expect the spending next year to be about what it is this year, which is $500,000, $600,000, $700,000, something like that.

Operator

And we’ll go to our next question from Michael Romanelli with Sidoti & Company.

Michael Romanelli - Sidoti & Company

Just a quick question regarding the third facility in Sarasota, when do you guys estimate that plant to be up to small capacity? I guess what else need to be done here and then do you guys have any expectations to what that facility could bring in terms of additional sales and perhaps the impact of margins?

Tricia Fulton

From the sales perspective we believe that with the additional capacity that we’ve added that could potentially double the business that we had last year over time. That doesn’t mean it’s going to happen in the specific period of time but we know that we have the capacity to potentially double up to $350,000 to $400,000. When we get to those levels obviously we’re taking some hits to margins as a result of the additional million dollars in expenses being added for that building this year. As we increase the sales, the margins expand pretty quickly once we are able to absorb those fixed costs with the additional revenue.

Allen Carlson

What we’ll see in that facility is that we will incrementally grow into it. There is no expectation that we were going there to flip switch and still like it's like overnight. I think I mentioned in our previous webcast that this was very much like building a facility that’s equal to pair of size 12 shoes and we only had size six feet. And so we will continue to sort of grow into that facility but it’s gives us the opportunity to take on new business, new opportunities that we wouldn’t be able to without it. So it’s all about adding capacity [indiscernible] and they will come and that’s where we’re at with that facility. I think we probably -- we've already grown it to size seven feet but we have a pair of size 12 shoes to fill.

Tricia Fulton

We also have capacity available in the building where we’re doing the refurbishment for the high volume cartridge. So part of that building was vacated and moved into 803. So we not only have some additional capacity in the new facility but also in the one that’s next door which is really what gives us the ability to believe that we can grow pretty substantially with our current footprint.

Michael Romanelli - Sidoti & Company

Okay, great. And I guess are there any areas geographically perhaps outside of China as mentioned where you guys would like to maybe add facilities or continue to grow your distribution network. Is there anything else out there on the horizon for you guys?

Allen Carlson

We continue to look at Korea as a market. We’ve got a facility in Korea now and a lease facility in Korea. So that’s an area that is a major focus us it has been since we acquired our first company in Korea in 1998. So, when we look at Asia, we think of Asia as a lot of opportunities with a manufacturing facility and operation on a lease facility in Korea and a sales and marketing office in China. I think what will happen as we go forward, we will uncover other opportunities that we’ll be addressing in that region. And that’s why we’re investing and having more feet on the street in Asia.

Michael Romanelli - Sidoti & Company

Okay, and I guess just a question surrounding your product line. Is the plan at Sun is to continue innovating and expanding the current product base or would it be possible to bring a completely new product or products for end users? I guess kind of what’s the breakdown there and has Sun’s vision sort of changed?

Allen Carlson

I think that the best way I can answer that question is that we manufacture hydraulic cartridge valves and related products, specifically high performance cartridge valves. So I think that we’re going to stay in that arena. As I said in my commentary, our investments in R&D are going to be electrically actuated valves, electronics and related cartridge valve components. I don’t think that's going to change. It’s pretty much the same as what it has been.

Operator

(Operator Instructions) And we have no further questions at this time.

Allen Carlson

Thank you. We want to thank you for joining us on today’s call. We look forward to speaking with you again after our third quarter release in early November. Thanks.

Operator

And that concludes today’s conference. We appreciate your participation.

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