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Executives

John D. Carter – President, Chief Executive Officer & Director

Richard D. Peach – Chief Financial Officer & Vice President

Analysts

John Rogers – D.A. Davidson & Co.

Eric Prouty – Cancaccord Adams

Bob Richard – Longbow Research

John Flannigan – Fundamental Equities

Schnitzer Steel Industries, Inc. (SCHN) F2Q08 Earnings Call April 3, 2008 11:30 AM ET

Operator

Good morning and welcome to the Schnitzer Steel Industries second quarter 2008 earnings conference call. My name is Lacy and I’ll be your coordinator for today. At this time all participants are in a listen only mode. (Operator Instructions) As a reminder this conference is being recorded for replay purposes. We need to remind you that the company’s presentation and discussion today contains forward-looking statements subject to the Safe Harbor provisions of the federal securities laws including estimates on future performance and views on future market trends. Actual results may differ materially from those projected in forward-looking statements. Examples of factors that could cause actual results to differ materially from expectations are listed in our earnings press release issued this morning and are described in detail under the heading factors that could affect future results and management’s discussions and analyst section of the company’s most recent quarterly report on Form 10Q and the most recent annual report on Form 10K.

I would now like to turn your presentation over to your host for today’s call John Carter, President & CEO.

John D. Carter

Thank you and good morning. Welcome to Schnitzer Steel Industries’ 2008 second quarter earnings webcast and conference call. I’m joined on the call today by Richard Peach, our CFO. After a few introductory remarks we will be available to answer your questions. We put out a press release this morning with the details of our second quarter results. On our call today we will be hitting the highlights of what occurred during the quarter and key trends in each of our businesses.

Within the quarter we had outstanding performance from all three of our businesses. Compared to the second quarter of last year the metal recycling, steel manufacturing and auto parts businesses all achieved increases in both revenues and operating income. On a consolidated basis earnings per share were a second quarter record. Our revenues and operating income increased 24% and earnings per share increased 34% when compared to the second quarter last year. Sequentially revenues were up 24% while operating income and earnings per share increased 42% and 47% respectively.

Let me spend a few minutes talking about each of our businesses. First, in the metal recycling business during the quarter the worldwide markets for ferrous scrap were very strong. The very [inaudible] long term supply and demand fundamentals which are driving the strong pricing environment remain in place. Demand for steel products overseas was robust creating pricing pressures on all the raw materials used to manufacture steel. Domestic demand remained strong as well. Consequently, the demand for raw materials continues to out step the relatively slow growth in supply especially for recycled scrap metal. This increase demand has been primarily forecast to come from the growth in usage of electric arc furnaces particularly outside China. That growth is due in part to environmental advantages of the EAFs which we have noted in the past specifically lower usage of energy, less air and water pollution and reduced greenhouse gas emissions. Additionally, we’re continuing to see [inaudible] of integrated metals, normally minimal users of scrap metal are starting to see the benefits of increase scrap usage to help lower their own carbon dioxide emissions. This is a trend which could put even further upward pressure on scrap prices going forward.

For the quarter average ferrous processing sales prices were a record $326 per ton net of freight costs, a $46 per ton increase over the first quarter. On our last call we talked about the rapid run off in export freight costs which had resulted in a squeeze in the first quarter margins. At that time we commented that in a scrap market where the demand is strong particularly overseas it is reasonable to expect that overtime those higher freight costs could be passed through to the customer. We also indicated we thought the increases in export freight costs would slow. During the quarter that expectation held true. As export freight costs moderated and gross sales prices for ferrous scrap increased to offset the increases in ocean freight that occurred early in the fiscal year. In addition, ship availability has improved.

There’s no question that we are benefitting from the strong markets for ferrous scrap but there are other elements in our business model that give us a competitive advantage. Without question none of this progress could have occurred without the expertise and dedication of all of our people. We continue to believe that our export platform scale and investments in technology position us well against the competitors in our various regions. We also continue to benefit from productivity enhancements and accumulative impact of strategic acquisitions. During the quarter we made bulk and container export shipments to customers located in 12 countries around the world. Our worldwide view provides us with the ability to sell to the region or customer group where demand is greatest at the time maximizing our revenues.

During the second quarter for example we were able to take advantage of periodic regional market differences and make shipments to Asia out of our northeastern operations, cargos which traditionally would have been headed for the Mediterranean. This flexibility continues to provide benefits to our operating margins and we were able to take advantage of the resin markets to increase those margins. Operating margin per processed ferrous ton excluding our trading business increased from $27 in the first quarter to $43 in the second quarter. The second quarter figure included five shipments originally scheduled for the first quarter which were under contract for lower margins due to the rapid run up of first quarter exported freight costs. Without those shipments our margins would have further expanded. During the quarter we shipped 1.1 million tons of ferrous from our processing operations and 96 million pounds of non-ferrous. With ferrous sales volumes approximating the second quarter of last year and the non-ferrous increasing by 7%.

Turning to the steel manufactured business year-over-year revenues were up 45% due to an $80 a ton increase in average net prices and a 25,000 ton increase in finished goods sales volumes. The sales volumes of 202,000 tons were a quarterly record. Our team at Cascade continues to deliver strong operating results in a variety of market conditions. Sequentially revenues were up 31% as both prices and volumes increased. The higher volumes and prices were despite softening business conditions in the company’s primary west coast construction models. We are going through an unusual period where strong volume and pricing statistics seems at odds with weak customer demand. However, steel consumption particularly on the west coast is greater than can be supplied by the domestic mills and imports have historically been necessary to meet demand. Strong overseas demand for steel products, the same conditions that create the robust demand for ferrous scrap and a weak dollar have led to a significant drop in steel products imported in to the US. So while our customers aren’t as busy as in past years they have turned to the domestic manufacturers for price reasons.

During the quarter we had separate shutdowns of the melt shop and our largest rolling mill for heavy maintenance. In anticipation of the down time for this work we built inventory during the first quarter which enabled us to ship the record volumes during the second quarter. Year-over-year operating income increased 11% due primarily to the higher sales volumes. As we discussed in previous quarters higher raw material costs particularly for scrap remained the biggest challenge for the steel mill. Of course, our Cascade mill gets it scrap supply from our metals recycling business so the increases in scrap costs are offset in a consolidated basis. During the second quarter the cost of scrap rose more than selling prices and partially offset the impact of the increased sales volumes. Compared to the first quarter operating income at the mills declined 8% with one-time expenses associated with the maintenance shutdown and to a lesser extent higher scrape costs more than offsetting the higher volumes.

In the auto parts business year-over-year revenues were up 29% and operating income was up 31% with the improvements driven by a higher car volumes and higher prices for scrap and cores. This successful change in our purchasing model would not have been able to take place without the extra effort and dedication from our team at the auto parts business. We continued to see the impact on this business of our strategy to maximize throughput at our facilities. Purchases of scrap vehicles increased 22% year-over-year and was a major contributor to the increase in operating income. In addition, the revenues from foreign scrap on those cars rose faster than the purchase costs primarily due to our ability to extract more value from each and every car processed. As a result year-over-year margins also improved.

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

Richard D. Peach

Although all three of our businesses performed strongly the metals recycling business was the biggest contributor to the quarterly increase in operating income up $22 million from Q1 and $12 million from last year’s second quarter. So, I wanted to start by providing some further commentary on those improvements. As John mentioned positive market conditions resulted in sales prices for ferrous processing net of freight increasing by $46 per ton from Q1 and $89 per ton from the second quarter of last year. In the last quarter we discussed that higher freight costs impacted export sales by more than the increase in gross sales prices during that period. However, this quarter on a cost per export ton basis the freight increase was less than $5 which was more than absorbed by the markets. The overall total costs of freight to deliver the product to our customers did increase to $80 million from $67 million in first quarter. That was mainly due to the volume impact of the five shipments which were delayed from quarter one due to ship availability at that time.

Looking at our balance sheet our strong earnings led to a decline in our net debt of $72 million from the end of first quarter. The steel mill contributed to this improvement by tolling inventory built in Q1 in preparation for the planned maintenance shut down and the metals recycling business sold the tons which it had built up in Q1 due to the timing in shipments. As a result, we saw positive decline in inventory balances at Q2 of about $28 million from quarter one contributing to the lower net debt position. Consequently, the ratio of net debt to total capital fell to 16% at the end of the quarter, a strong balance sheet position.

During the quarter we repurchased a further 146,000 shares of our stock for $7 million. Since we restarted our buyback just over a year ago we’ve now repurchased 2.9 million shares or about 9% of total shares outstanding. We have about 1.7 million shares remaining under the current repurchase authorization from our board.

Capital expenditures in the quarter were $18 million and we spent a further $9 million in cash on acquisitions. Year-to-date we’ve now reinvested $94 million in value enhancing opportunities to grow the business or in returning money to our shareholders. Depreciation during the quarter was $12 million which continues to be a good run rate for the year and SG&A costs were $52 million up $9 million year-over-year primarily due to the incremental [inaudible] of our business growth during the last 12 months and higher incentive accruals in share based compensation expense. Finally, our tax rate for the first six months was 35.6% which we do not expect to exchange significantly for the balance of this fiscal year.

Now, let me turn the call back to John.

John D. Carter

Let me know turn to our outlook. At this point all indicators are pointing to a very good third quarter. In the metal recycling business the overseas markets for scrape are robust and prices are rising. Based on the sales made to date, average selling price net of freight are expected to increase more than $100 per ton over the recently completed second quarter. Ferrous processing sales volumes are expected to approximate the volume shipped in the second quarter and be slightly ahead of the sales volumes in the third quarter of fiscal 2007. Non-ferrous volumes are also expected to increase 5 to 10% from the second quarter and approximate the volume shipped in the third quarter last year.

Net export selling prices for ferrous scrap exceeded domestic selling prices during the quarter. Based on our outlook for the domestic markets raw material costs are not expected to increase at the same rate as export selling prices. As a result, third quarter margins are expected to expand compared to the recently completed second quarter. In the steel manufacturing business we haven’t yet seen any signs that import activity will increase due to the dollar impact on pricing for finished steel projects. West coast non-residential construction demand remains soft particularly in southern California but the overall lack of supply is expected to result in continued upward pressure on prices. In addition, higher raw material costs particularly for scrap are expected to contribute to higher steel prices as those supply conditions permit steel manufacturers to pass on a portion of these higher costs.

Sales volumes are also expected to remain at fairly high levels increasing slightly on a year-over-year basis and could reach the record volume shipped in the second quarter. While we expect higher average selling prices during the third quarter we don’t believe we’ll be able to recover all the expected increases in scrap costs. Compared to the third quarter of last year and narrowing of the metal spread should result in lower margins. Compared to the recently completed second quarter higher production points and expenses that were incurred during that quarter for maintenance shut down are expected to result in a lower unit costs and more than offset the increase in scrap costs. As a result, sequential margins should improve.

In the auto parts business both on a year-over-year and sequential basis we expect to see revenue improvements from all sources due to the higher volumes and higher prices for recycled metal as well as improved full service parts sales. On a quarter-over-quarter basis we also expect to see typical seasonal increases in self service parts sale due to the impact of more favorable weather conditions.

Let me conclude by recapping. We just completed a very strong quarter in which all of our businesses performed well. Our outlook remains optimistic both for the third quarter as well as the long term. We continue to be focused on maximizing the benefits from these positive market conditions in which we operate as well as capitalizing on the competitive advantages from our export platform, investments in technology and scale.

Operator let’s go ahead and open up the call for questions at this time.

Question-and-Answer Session

Operator

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

John Rogers – D.A. Davidson & Co.

First on the scrap business how far out are you selling now into the export market?

John D. Carter

John, we do sell forward but we sell forward based on our current look at inventories and our flows have remained very strong so our adjustments on the timing on sales is really very minimal and depends on how we see the market movement. We don’t give specific guidance on that as you know but we’re very comfortable with where we are and how we see the market going upon where our inventory supplies are.

John Rogers – D.A. Davidson & Co.

Okay. Then in terms of the steel mill I was just trying to understand the reported average prices that you saw there, $616 a ton, if you take the revenue divide by the volume you get a number closer to $700, over $700 a ton, I know there’s some adjustments in there but it’s a bigger gap than what we’ve seen in the past. Was there anything else in the steel operations that contributed to the profitability or the revenue in the quarter?

John D. Carter

Well, I think other than the shut down which of course has an effect on what our costs were during the quarter there’s also a product mix that has an effect on those average prices and some of our products have a larger margin for us than others. So, if the mix goes in that direction then obviously that increases the margin it’s not just the tonnage, it’s the mix of products.

John Rogers – D.A. Davidson & Co.

Right. But, in terms of the average pricing too, it should be picked up in there.

John D. Carter

We’ll get back to you on that John but I think it’s really just product mix.

John Rogers – D.A. Davidson & Co.

Okay. Then lastly, just in terms of the share repurchases, were you buying through the quarter or given where the price is I assume it was the early part of the quarter? And, any thoughts on it? I mean, how aggressive you plan to be in terms of the 1.7?

John D. Carter

Well, as you know our repurchase program is based on what we think is appropriate at the time. It varies from quarter-to-quarter and we can’t really predict where we’re going to be with that going forward. It depends on our view of the market and we’re pleased with what we’ve done to date.

Operator

Our next question will come from the line of Eric Prouty with Canaccord Adams. Please proceed.

Eric Prouty – Cancaccord Adams

I was wondering if you could provide some color on shipping costs and ship availability within the export markets? And then more specifically if you could provide perhaps the difference in prices on average between both cargo rates and containers now say from the west coast to Asia?

John D. Carter

I think on the shipping we made some comments on that earlier as to what we saw both in the first quarter and what was basically a correct in second quarter for purchases of our business in the sense that the availability and the price stabilization and even dropping a bit in the second quarter helped us on shipping cost. We also commented on the fact that there’s additional tonnage supply that we see coming on line that’s been commented on in various quarters late this year and early next year which will have an additional positive impact on our program. We obviously do the usual thing in terms of securing availability and making certain that we have a predictable price for our product. But, I think you see, as I said earlier sometimes the spikes in the market which is not a steady, sometimes those spikes take a little time to catch up in terms of our selling prices and they did during the second quarter.

On the container side as we’ve pointed out before, in our locations the container shipping phenomena that you see in southern California has not been a significant factor in the market. We have taken steps to be sure that we’re able to ship by container and we do ship a small amount by container that is really driven by our customer preferences and demand on their timing. So, we’re very comfortable we can do it. I think there’s been a number of articles in the press about how the gap between excess container costs for freight and boat cargo costs for freight have narrowed significantly both in terms of the availability of containers and also the actual price. Again, that is not a significant part of our market at this point and I think probably is more something you see impacting the LA basin.

Eric Prouty – Cancaccord Adams

Okay. Then I just wanted to ask you about potential acquisitions. Is your focus now more on the auto parts side, making some acquisitions there? Or, is it on scrap metal recycling? Or, is it both? Are evaluations attractive or have them been moving up given the number of deals we’ve seen recently?

John D. Carter

Well, as we’ve seen and talked about earlier, we see a lot of activity for acquisition in both those business sectors. The evaluation issue of course is that it’s been a pretty good time for the business both in the auto parts side and in the scrap business so sellers tend to like to value their businesses on the basis of the short term look at their business rather than a medium to long term look and that puts more of a challenge on what exactly we think is the appropriate use of our capital. And as a result, there are some that we look at that we just don’t think are appropriately priced and others that we like. So, I don’t think that’s going to change much in the months forward here. We continue to be very active on the acquisition front but those are not always things that we think are attractive for us.

Eric Prouty – Cancaccord Adams

Okay. But you’re not – are you more interested on the auto parts side at this point?

John D. Carter

We’re more interested at where we get the best return on our capital.

Operator

Our next question will come from the line of Bob Richard with Longbow Research. Please proceed.

Bob Richard – Longbow Research

I appreciate your comment that the supply of scrap is strong or your flows are strong, it’s kind of contrary from what we’re hearing from other yards from other companies so that’s great. Do you expect that will tail off looking forward or with the increase price it may stay stable or even improve?

John D. Carter

Well, I think as we have seen over the last year in our business our supply flow has been very steady and increasing. I think that we continue to see those factors working to our advantage in our business. As you know, some of the acquisitions we’ve made have been designed not to see that supply flow migrate to competitors. So, for a whole host of reasons in our overall strategic look marketplace we’re very comfortable that our supply flow continues and will continue to be very strong.

Bob Richard – Longbow Research

That’s very encouraging. One quick follow up traditionally, looking at fiscal year 07 your revenue base was about 40% Asia, based on your comments this morning I would imagine it’s a little bit higher than that now? Or, is it still in line with that?

John D. Carter

Well, as I mentioned markets in Asia during the last quarter were very strong so again, we don’t look at our business on a quarterly basis, we look over the course of the year and there are quarterly variations but during the second quarter the percentage of material that went to Asia was probably a bit higher than that 40%. But, the two highest countries to whom we ship during the quarter were Thailand and Turkey so there’s still a significant market that is available to us in the Middle East.

Bob Richard – Longbow Research

I appreciate that. Refresh my memory, Thailand and Turkey here in this recent quarter who historically has been your largest two? Korea and Japan, right?

John D. Carter

That’s about two and a half years out of date actually. Korea and China and Taiwan were historically the north west part of the [inaudible] customer base. We have in fact obviously because of our expansion but also because of our change in velocity of sales increased our outlook on the world to the point where we sell to about 19 different countries and a variety of customers in those countries. So, we’re pretty well spread around and we take advantage of what we see in the marketplace to direct our sales to those areas where the market is best for us on a pricing standpoint.

Operator

(Operator Instructions) Our next question will come from the line of John Flannigan with Fundamental Equities. Please proceed.

John Flannigan – Fundamental Equities

John has the acquisition by [New Core], that large scrap company affected your business with them materially? And, have you seen changes in the scrap market in the east from that acquisition?

John D. Carter

No, not for us. [New Core] of course is a customer of ours in certain regions but fundamentally the areas of the country where [New Core] operates and where David Joseph operated are not in areas where it has a significant impact on our business.

John Flannigan – Fundamental Equities

Do you know John what was paid for David Joseph in terms of earnings or price to EBITDA or whatever?

John D. Carter

Well, I don’t want to really comment on that. I think the best person to answer that would be [New Core].

Operator

At this time we have no questions in queue. I would like to turn the call back over to Mr. John Carter for final remarks. Please proceed.

John D. Carter

Thank you very much for joining us this morning and we appreciate the comments and the questions. We’ll look forward to talking with you again. Thanks very much.

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Source: Schnitzer Steel Industries, Inc. F2Q08 (Quarter End 2/29/2008) Earnings Call Transcript
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