Schnitzer Steel F1Q08 (Qtr End 11/30/07) Earnings Call Transcript

Jan. 7.08 | About: Schnitzer Steel (SCHN)

Schnitzer Steel Industries, Inc. (NASDAQ:SCHN)

F1Q08 Earnings Call

January 7, 2008 11:30 am ET

Executives

John D. Carter - President, Chief Executive Officer,Director

Richard D. Peach - Chief Financial Officer, Vice President

Analysts

John Rogers - D.A. Davidson & Co.

Sal Tharani - Goldman Sachs

Eric Prouty - Canaccord Adams

Phillip Gibbs - Keybanc Capital Markets

Operator

Good day and welcome to the first quarter 2008 Schnitzer Steel IndustriesIncorporated earnings conference call. (Operator Instructions)

Before we begin, we need to remind you that the company’spresentation and discussion today contains forward-looking statements subjectto the Safe Harbor provisions of the federal securities laws, includingestimates of future performance and views on future market trends. Actualresults may differ materially from those projected in the forward-lookingstatements. Examples of factors that could cause actual results to differmaterially from current expectations are listed in our earnings press releaseissued this morning and are described in detail under the headings factors thatcould affect future results in the management’s discussion and analysis sectionof the company’s most recent quarterly report on Form 10-Q and most recentannual report on Form 10-K.

I would now like to turn the presentation over to your hostfor today’s conference, Mr. John Carter, President and Chief Executive Officer.Sir, you may proceed.

John D. Carter

Thank you and good morning. Welcome to Schnitzer SteelIndustries’ 2008 first quarter earnings webcast and conference call. I amjoined on the call this morning by Richard Peach, our Chief Financial Officer.After a few introductory remarks, we will be available to answer yourquestions.

We put out a press release this morning with the details ofour first quarter results. On our call today, we will be hitting the highlightsof what occurred during the quarter and key trends in each of our businesses.

In the quarter, all three of our businesses performed well,both operationally and financially, despite continuing pressures ontransportation costs in our metals recycling business and on raw material costsin our steel business.

On a consolidated basis, our revenues were up 18% andoperating income and earnings per share increased 23% when compared to thefirst quarter of last year. The higher revenues were reflective of both ourcontinued focus on maximizing throughput as well as positive market conditions.

We continue to see signs that the long-term fundamentalssupporting our businesses remain strong. Worldwide steel production figures inthe use of [electric] furnace technology continued to rise, which in turncreates demand for scrap metal.

Coupled with a relatively tight supply of scrap, we believethese factors should support pricing, which has been sustainable athistorically high levels. That’s not to say there won’t be also marketvolatility. That’s why we continue to emphasize it is important to evaluate ourbusinesses over several quarters.

I mentioned earlier that we perform well despite somesignificant challenges. Let me elaborate. In the metals recycling business, itis certainly no secret that ocean freight costs have risen dramatically overthe last few months not just for scrap but for all commodities. Not only havethe costs been increasing but the supply of ships has also been tight.

In a market where the demand is strong, particularlyoverseas, it is reasonable to expect that over time, these increased freightcosts could be passed through to the customer. As we discussed on our lastcall, it takes the market time to adjust, particularly when the changes aredramatic and rapid.

Much of the increase in freight costs during the quarteroccurred after we had negotiated our sales prices. As a result, margins onthose export sales in which we took the freight risk were squeezed.

While gross sales prices did increase compared to the fourthquarter, they were more than offset by the rise in freight costs and net exportprices in our processing business declined $12 a ton. This occurred during atime when domestic prices, which drive our buying costs, were on the rise.

The freight impact was not only related to costs. Shipavailability was also an issue. During the quarter, there were times whenvessels of the size used to transport scrap were not attainable at anyreasonable price. As a result, we moved five shipments of ferrous scrap intothe second quarter despite having the inventory available and customers willingto take delivery.

As I’ll discuss in a moment, we are cautiously optimisticthat these issues were the product of unusual circumstances that do not appearto be in place during the second quarter.

During the quarter, we shipped 1 million tons of ferrousfrom our processing operation and 89 million pounds of non-ferrous, with bothbeing higher on a year-over-year basis but down from the fourth quarter.

Our ferrous trading volumes were down pretty sharply bothquarter over quarter and year over year, with the flow of material out ofRussia being tighter than normal and customer demand in our primary tradingmarkets in the Mediterranean being down as well.

Overall, our customer base continued to be diversified as wetook advantage of our global reach to sell into 14 countries. Steel mills inMalaysia and Turkey were the largest customers and demand overall was strongerin Asia than it was in the Mediterranean.

There has been a fair amount of industry discussion aboutthe use of shipping containers to carry scrap to overseas destinations. Duringthe quarter, we did increase our container volumes and made investments inequipment that will improve our ability to ship product by this means. Flexibilityto meet customer demand requirements is important and we want to continue tohave it. However, we also believe that container volumes, while increasing, arenot expected to replace bulk shipments as the preferred method for deliveringscrap overseas. They are unlikely to represent a material amount of our overallexport volumes.

We should also note a couple of interesting trends regardingcontainers. First, it appears that container rates are starting to increase.While there is still a fairly sizable cost advantage for containers versus bulkshipments, the advantage is starting to narrow. Second and more importantly,the availability of containers for scrap has become limited in certain areas,partly because of increased demand as an alternative to bulk shipments forother products and partly because some of the customer container owners viewscrap as less desirable material because of the damage it can do to thecontainers.

This is an interesting trend to watch because while itprobably won’t have a big impact on our exports, it might have an impact on ourcompetitors who don’t have the ability to ship in bulk.

This summer, we completed the installation of a megashredder at our Portland export facility and we were pleased with the operationof that machine during the first quarter. As with the other three shredderswe’ve installed, it will also take a few months for the new machine to fullyramp up but everything we’ve seen so far indicates we are on schedule toachieve the expected benefits.

We continue to see improvements in back-end sortingtechnology. During the quarter, we took down the non-ferrous line at our Bostonfacility to install new equipment, which we expect to provide even greaterrecovery of non-ferrous material from the shredding stream. That installationtook about three weeks and while it had a minor delay in impact on our Zorbavolumes and revenues, those will be made up in coming quarters.

We continue to be active in pursuing acquisitions. Since theend of the year, we’ve closed on a car-crushing operation in Maine and metalsrecycling facilities in Alabama and Georgia, both of which were announced withour year-end results. These additions are consistent with our strategy ofexpanding our presence within our existing footprint and strengthening ourposition in the areas in which we operate.

The metals recycling industry remains highly fragmented andwe expect to continue to be an active participant in the ongoing industryconsolidation.

Turning to the steel manufacturing business, year-over-yearrevenues were up 14%, primarily due to a $55 increase in average net prices anda 4,000 ton increase in volumes. Sequentially, we did see softness in WestCoast demand as both volumes and prices declined, although that decline wasfrom a fourth quarter with record -- quarterly record prices.

The steel business was one of the areas where we facedchallenges -- in this case, related to the costs of raw materials used in steelmaking. The decline in operating income both year over year and quarter overquarter is primarily related to increased cost for scrap, alloys, [plexis] andelectrodes. Compared to the first quarter of last year, these costs increasedmore than the increase in net sales prices. Compared to the fourth quarter,these costs actually went up as prices came down.

As you know, the mill gets 100% of its scrap from our metalsrecycling business so the increases in scrap costs are somewhat offset on aconsolidated basis but the higher cost for the other non-scrap raw materials doimpact the bottom line. The mill was able to offset some of the increased scrapcost by improving yield loss, which has been a major focus of both our steeland metals recycling teams.

In the auto parts business, year-over-year revenues were up19% and operating income was up 90%, with the improvements driven by higher carvolumes. At the end of last year’s first quarter, we implemented changes to ourpurchasing model that emphasized increasing the number of scrap vehicles beingprocessed through our facilities. As a result of the continued impact of thosechanges, year-over-year car purchases were up, leading to higher core and scrapvolumes.

In addition, core and scrap revenues per car outpaced thecost of scrap vehicles, which along with higher full service part sales alsocontributed to higher operating income.

During the quarter, we opened a new full service receivingfacility in New Jersey, which allows us to cross-utilize inventories in NewEngland with those in North Carolina and Virginia and to improve our fillrates. It also gives us an opportunity to penetrate the lucrative New York/NewJersey markets. While this new operation had limited impact in the firstquarter, we believe it will be a contributor in the quarters ahead.

I’d now like to turn the call over to Richard for moredetails on the quarter. Richard.

Richard D. Peach

Thank you, John. I thought I’d start out with more detail onfreight issues. Looking at the metals recycling business, the total cost offreight to deliver the product to our customers in the first quarter was $67million. In the fourth quarter of last year, the cost was roughly the same, $68million, despite the fact that ferrous processed volume sold were about 25%higher in that quarter.

If you look at it on a cost-per-unit basis, that equates toabout $14 per ton sequential increase in freight costs across all ferrous tonssold during the first quarter. Of course, sales to our own steel mill and otherdomestic customers are largely unaffected by the ocean-going freight market sothe impact on the 640,000 tons of processed export sales is closer to $25 perton.

As John mentioned earlier, in addition to the cost issuessurrounding freight, availability of ships caused us to delay five ships into thesecond quarter. So not only were the freight costs per ton higher, we wererequired to delay recognition of income from about 175,000 tons.

Looking at our balance sheet, our net debt was up $93million from the end of the last fiscal year, with almost two-thirds of theincrease being related to inventory balances. Inventory levels should reduceduring the second quarter as this inventory is shipped and as the steelmanufacturing business makes sales out of inventories during the plannedshutdown for maintenance.

During the quarter, we repurchased 300,000 shares of ourstock for $18 million. Since we restarted our buy-back a year ago, we haverepurchased 2.8 million shares, or about 9% of the total shares outstanding. Wenow have about 1.9 million shares remaining under the current authorizationfrom our board.

Capital expenditures in the quarter were $16 million and wespent an additional $25 million on acquisitions, so in total during thequarter, we reinvested nearly $60 million in value-enhancing opportunities togrow the business, or in returning money to our shareholders.

Depreciation during the quarter was $12 million, whichshould be a good run-rate for the remainder of the year, and the tax rate was alittle less than 36%.

Finally, SG&A costs were $45 million, which were up $2million year over year, primarily due to share-based compensation expense andheadcount from acquisitions made over the last 12 months. Sequentially,SG&A costs were down $7 million, which is more of a reflection of thetiming of a number of expenses which hit during the fourth quarter.

Let me turn the call back to John.

John D. Carter

Thanks, Richard. Let me turn to our outlook for the secondfiscal quarter; in the metals recycling business, we are seeing positive signsfor the overall market demand for scrap. We are also seeing some relief insight from the shipping issues which had such a negative impact in the firstquarter.

Based on the sales made to date, gross prices for shipmentscommitted for January and February have risen enough to offset the freightprice increases that took place in the first quarter. At the same time,pressures on the availability of ships are easing, at least in the near term.Even though shipments made in December were for the most part contracted beforesales prices rose significantly, the average net prices for the entire quarterare expected to increase over the prices in the first quarter.

As indicated by the upward trend in pricing, demand forferrous scrap remains strong. The five export cargos which were delayed fromthe first quarter have already been shipped and second quarter ferrous volumesin our processing operations are expected to increase by at least 150,000 tonsfrom the recently completed first quarter and they will exceed the volumeshipped in the second quarter of last year. Non-ferrous volumes are alsoexpected to increase, both quarter over quarter and year over year.

Turning to the steel manufacturing business, West Coastnon-residential construction demand remains soft, which is consistent with whatis being reported elsewhere in the country. Offsetting the soft demand,customer inventories are very low and imports are down so the supply/demandequation is fairly good.

West Coast prices currently appear to be higher than therest of the country and in California, Nevada, and Arizona, we are seeingcompetition for domestic producers who are shipping product from other regionsin the country. Until activity picks up enough in these regions to reduce theincentive to ship to the west, this competition is expected to put a damper onprice increases which we’d otherwise expect due to lower import volumes.

As a result of all these factors, second quarter prices areexpected to remain at about the same level as achieved in the recentlycompleted first quarter, although on a year-over-year basis they will beconsiderably higher.

Scrap and other raw material costs are expected to increaseand we have not yet seen the ability to offset these costs, even with the higherprices. Due to the same factors that are impacting pricing, we are expectingsecond quarter volumes for finished products to be down slightly from the firstquarter as well as the second quarter.

We are planning a two- to three-week shutdown for both themelt shop and rolling mills to perform routine maintenance. While the costs ofthe shutdown is also expected to impact margins, we were able to buildinventory in the first quarter so it won’t be a factor in the sales volumes.

In the auto parts business, on a year-over-year basis weexpect to see revenue improvements from all sources due to higher volumes andhigher prices for recycled metals. On a quarter-over-quarter basis, typicalseasonal declines in the self service business will likely more than offsetnormal improvements in the full service business, resulting in -- if the fullservice business improvements result from the impact of bad driving weather onthe vehicle repair industry.

Let me conclude by recapping; we just completed a solid quarterin all of our businesses, despite facing some fairly challenging marketconditions. The positive long-term fundamentals underlying our businessesremain in place and we are seeing signs that these issues, at least with regardto the metals recycling business, may be behind us. We continue to beoptimistic about the long-term outlook for our company.

Operator, let’s go ahead and open up the call for questionsat this time.

Question-and-AnswerSession

Operator

(Operator Instructions) Our first question will come fromthe line of John Rogers of D.A. Davidson. Please proceed.

John Rogers - D.A.Davidson & Co.

Good morning. I was curious -- first of all, on the GreenLeaf,the operation you opened in New Jersey, is that your first new store that you’veopened?

John D. Carter

No, it’s actually a transfer point where we are able to takelower cost parts from our operations in the south and fill our inventorylevels, both in New England and our other operations on the East Coast. We’regiven some price advantage there and then we also are able to sell into thosemarkets around New York, New Jersey.

John Rogers - D.A.Davidson & Co.

Okay, but is it included in the 18 --

John D. Carter

Yes, it is.

John Rogers - D.A.Davidson & Co.

Okay. All right, just so I’m clear on that. And thensecondly I guess in terms of the scrap business and particularly the exportbusiness looking out later this year, are you seeing -- I mean, I assume youare now selling product out into -- close to March. Pricing is still -- I mean,you are seeing, I’ve heard some record levels for some prices being quotedrecently, some of that export market. Is that what you are seeing as well andis it both Asia and Europe?

John D. Carter

Well, as you know, we don’t give specific information onpricing but we are very positive about our pricing in the second quarter and weare seeing strong demand, both in Asia and the Middle East and other areas thatwe sell into.

There are a number of interesting things happening on thedemand side, including the fact that some recent publications in Japan haveindicated that there are predictions there about scrap being used for the basicoxygen furnace. It’s noted a lower emission commitments that they’ve made undertheir greenhouse gas emissions requirements in Japan.

And of course, there’s a lot of new construction of EAFmills in Korea, so we see a lot of not only good pricing but upward demand onsupply.

John Rogers - D.A.Davidson & Co.

Okay, and I guess just finally, John, you talked about beingactive in terms of looking at M&A opportunities. You still expect more ofit in the scrap side of the business, you’re seeing more opportunities there ordoes that include the other businesses as well?

John D. Carter

Well, we’ve been very active in both the metals recyclingbusiness and the auto parts business, so we still think in the metals recyclingbusiness, John, there are some very good opportunities and we are remainingvery active in that area.

John Rogers - D.A.Davidson & Co.

Okay. All right. Thank you very much.

Operator

Our next question will come from the line of Sal Tharani ofGoldman Sachs. Please proceed.

Sal Tharani - GoldmanSachs

John, on scrap, you mentioned that you will see highermargins. Is this higher margin on higher volume, is that correct to assume?

John D. Carter

Well, it’s both, Sal. I mean, as we indicated, there arefive shipments out of the first quarter that we’ll make up in the secondquarter and we’ve seen not only strong pricing trends in the second quarter butsome easing off on the freight costs.

Sal Tharani - GoldmanSachs

And in the first quarter, I mean, so in the fourth quarteryou mentioned some margin squeeze because of the buying pressure you had andcompete -- competitors, especially container wise, guys who were sending incontainer shipments. Is that still there or you have seen some relief on that?

John D. Carter

Well, I think the pressure is -- first of all, it’s notreally just the container people. It’s the mills and other people who are inthe scrap market buying but we are very comfortable with where those buy pricesare, about the same in the second quarter as the first quarter. As thingdevelop, of course, if the domestic market ticks up, then we’ll see morepressure on the buy prices there.

But as I said earlier, we see margin expansion in the secondquarter.

Sal Tharani - GoldmanSachs

At the beginning of the month generally, domestic millsstart to buy for the rest of the month -- in your southern operation, have youseen any price increases already for this month?

John D. Carter

Yes, we have.

Sal Tharani - GoldmanSachs

Are you able to quantify that?

John D. Carter

No, we can’t.

Sal Tharani - GoldmanSachs

There was news that bundled auction prices have gone upsignificantly for January/February delivery. I don’t know if you guys haveheard anything.

John D. Carter

Well, we’re not -- you know, the bundle part of the businessis not a big part of our business and the public prices for us are alwaysinteresting but not necessarily reflective of where we are. But as I saidearlier, we see good upward pressure on the pricing in the second quarter.

Sal Tharani - GoldmanSachs

And another thing on scrap, you mentioned then and youactually noted in your press release that the volume out of trading businesswas very low. That has to do with the availability of scrap from Russia. Isthat something you think will continue on over the next couple of quarters?

John D. Carter

Well, we’re watching that with interest. As you know, ourtrading business is primarily, for our purposes, a reflection of our ability tolook at the overall world market and understand where trends are. It’s a lowmargin business because we don’t add any processing value to the scrap productsthat we trade. But it has been interesting in the growth of the Russian economythat a great deal more of their generated scrap has been consumed internally.If you see that economy continue to grow and if you see other countries, boththe former Soviet Union countries and China continue to buy from Russiansources, my view is that the scrap volumes coming out of the Baltic probablyare going to be less than historically, at least recent history in terms ofvolume.

On the other hand, we don’t expect our volumes to be muchdifferent than what we said they were for the year.

Sal Tharani - GoldmanSachs

And on the freight costs, which Richard mentioned $25 a tonif you just assume the export volume, is that coming down in this quarter? Haveyou seen some relief or is this just the selling price has gone up tocompensate for the increase in the freight costs?

John D. Carter

Well, the selling price has gone up but we’ve seen somerelief in the price on the freight costs as well.

Sal Tharani - GoldmanSachs

And is this something continuing? I mean, if you areordering more and more orders, you are seeing it continuously coming down?

John D. Carter

Well, it’s difficult for us to predict what the future isgoing to be in the freight market, as obviously the spikes in the first quarterindicated some people, most of us were caught a little bit by surprise by thespike in the price.

But as you know, there’s a considerable amount of tonnagethat are on the ways in the freight market area where we are active and othercommodity shippers are active, so we expect the market to be rational aboutfreight costs going forward.

Sal Tharani - GoldmanSachs

Okay, and on the mill side, is this something new you areseeing where the mills from the East Coast or Midwest are competing in the WestCoast market, or is this something which has happened in the past also?

John D. Carter

Well, I can’t really say much about how far back to go onthat but I can say at least in the recent past where the competition on theWest Coast has been primarily from imports, the imports are down considerablyand one could say that’s probably because of the dollar. On the other hand,that means that the East Coast mills, if they see demand diminishing in theirareas, that they want to sell their product and so if they can sell into theWest Coast markets profitably, they’ll do so.

Sal Tharani - GoldmanSachs

The mills in the Midwest and East Coast have implemented a$25 increase in rebar and [inaudible] prices for January. Are you saying thatyour price will be flat -- it means that -- are they selling it at belowMidwest pricing at least in the West Coast do you think?

John D. Carter

It’s difficult to say because as you know, each of theseprices is -- prices are dependent on the customer base and much of what isbeing sold on the West Coast is sold in the L.A. Basin, so what their pricesand discounts and customer desires are is pretty tough for us to measure.

If there is improvement in the pricing on the East Coast andthe Midwest, then we expect them to not want to incur the freight cost and selltheir product where they can make more money.

Sal Tharani - GoldmanSachs

And the demand weakness, is that something that’s seasonalor do you think it is a reflection of the economy in California?

John D. Carter

Well, I think that the demand is reflective of what has beenthe commentary on the economy overall but I also think that as you know, thereare a number of positive things longer term in the West Coast infrastructure,construction, California highway program and other things that will be upwardpressure on the demand on the West Coast. And historically, West Coast pricesfor steel have been a bit higher.

Sal Tharani - GoldmanSachs

Thank you very much, guys.

Operator

(Operator Instructions) Our next question will come from theline of Eric Prouty of Canaccord Adams. Please proceed.

Eric Prouty -Canaccord Adams

Thanks a lot. Guys, maybe just a little commentary aroundyour expected shipment volumes in the upcoming quarter in ferrous. If one looksat the product which came out of this quarter just ended into the next quarter,if we back that out it looks like volumes are kind of flat to down a littlebit. Any commentary around that?

John D. Carter

If you look at our projections for shipments in the secondquarter, as we said we expect them to be up 150,000 to 200,000 tons and thereis some seasonal effect on normal winter flows because of the weather into thefacilities, so there is the -- you know, this time of year and if you look atthe second quarter last year, you’ll see that the seasonal flows are reflectedin volumes.

Eric Prouty -Canaccord Adams

Sure, but you know again, backing out the 190 or so thatslide out of this quarter, it would be down a little bit year over year. Isthat just a timing issue or is there anything impacting that?

John D. Carter

No, no, it’s just a timing issue.

Eric Prouty -Canaccord Adams

Okay, and then on the supply side, some commentary duringprevious quarters about a shortage -- well, not a shortage but tighter marketsin the U.S. for scrap, et cetera, people ramping up shredder capacity andlooking for material. Any sign of that abating or is it still a tight marketout there?

John D. Carter

Well, as you know, our markets and our locationsgeographically are a little different than other geographic markets might be.For example, in the L.A. Basin where we don’t operate, it appears that thatcompetition is still very tight.

I think it will continue to be a competitive market for rawmaterials for us but on the other hand, that’s one of the reasons that we’vebeen very active in tuck-in acquisitions and those things that allow us to feelmore confident about our supply.

Eric Prouty -Canaccord Adams

And then a final question; you had some interestingcommentary about the use of scrap in Japan. Are you seeing that in any othermarkets, in particular China, which is also interested in a near term cut inemissions? Is that possible in that market and are there are there any discussionsaround that that you’ve heard?

John D. Carter

I haven’t seen anything on that front. As you know, theChinese had primarily moved forward with the basic oxygen furnace technologybecause they felt that the magnitude of their growth needed the larger capacityoffered by that technology. And these are really things from the Japanese SteelAssociation and from other commentators that are focused on Japan, which is acountry that’s made a commitment to lowering their greenhouse gas emissions bysome 8%, and the mills have actually gone up over the last year so that themills, in order to come within that have a substantially tighter target. That’sprobably why they are doing it.

Eric Prouty -Canaccord Adams

Okay, great. Interesting commentary. Thank you.

Operator

Our next question will come from the line of Phillip Gibbsof Keybanc Capital Markets. Please proceed.

Phillip Gibbs -Keybanc Capital Markets

I was just wondering if you could provide any added outlookcommentary on -- in addition to scrap, alloy flox electrodes, these costs giventhe various dynamics -- I mean, given that nickel has been trending lowerrecently and we’re still seeing a tight global electrode market. I just wantedto hear what you had to say about --

John D. Carter

Probably can’t add much to what I said. Many of those arepurchases that are only 30 days out, so forward trends are pretty tough for usto get a broader look at and we only have the one mill.

Phillip Gibbs -Keybanc Capital Markets

What are you seeing as far as electricity costs going into’08? Can you give any color where that’s been trending in recent months?

John D. Carter

Again, that’s actually pretty unique to us because ourelectricity costs are based on our supplier and we -- our supply situation ispretty stable.

Phillip Gibbs -Keybanc Capital Markets

Okay, great. I appreciate it. Thank you.

Operator

This concludes the question-and-answer portion of today’sconference. I will turn the call back to management for any closing remarks.

John D. Carter

Thank you for joining us today and we appreciate thequestions and look forward to talking to you next time. Thanks very much.

Operator

Thank you for your participation. You may now disconnect.Have a great day.

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