Xerium Technologies Inc. (NYSE:XRM)
Q4 2007 Earnings Call
April 10, 2008 8:30 am ET
Stephen Light – Chief Executive Officer and President
Michael O’Donnell – Executive Vice President and Chief Financial Officer
Michael Stick – Executive Vice President and General Counsel
Ron Pearson - Bowmark Capital
Chip Dillon - Citigroup
Good day ladies and gentlemen, and welcome to the fourth quarter 2007 Xerium Technologies Incorporated earnings conference call. (Operator Instructions) I’d now like to turn the call over to Mr. Michael Stick, Executive Vice President and General Counsel.
Thank you and good morning everyone. Welcome to the Xerium Technologies fourth quarter 2007 conference call. We are pleased you could take the time to join us today. Also on this call this morning are Stephen Light, who was appointed President and Chief Executive Officer in February; and Mike O’Donnell, our Chief Financial Officer.
Stephen will start the discussion this morning with an update on our progress addressing our credit issues and his first impressions of Xerium’s operating and financial strengths and challenges.
Next Mike will provide some further details with respect to the fourth quarter and 2007. Then after Stephen provides some further remarks, the floor will be open to questions.
Xerium Technologies financial results for the quarter were announced in the press release after the market closed on Tuesday April 8, 2008. The press release is available on the company’s website.
Our 2007 Annual Report on Form 10-K was filed with the SEC on Tuesday and is also available on the company’s website. Notification of this call was broadly disclosed. This conference call is being webcast using the link on the Investor Relations home page on our website.
Comments will be made today about future expectations, plans and prospects for the company that constitute forward-looking statements for the purposes of the Safe Harbor provisions under the Private Securities Litigation Reform Act of 1995.
Our actual results may differ materially from those indicated by these forward-looking statements as a result of various important factors, including those described in Tuesday afternoon’s press release and in the 2007 Annual Report on Form 10-K filed on Tuesday.
The forward-looking statements represent views as of today, April 10, 2008 and we specifically disclaim any obligation to update these forward-looking statements.
Lastly, on this call, we plan to discuss supplementary non-GAAP financial measures such as adjusted EBITDA. Adjusted EBITDA is a key metric for our credit facility covenants and one that we use internally to assess liquidity and financial performance, and therefore we believe it will assist you in better understanding our company. A reconciliation to the comparable GAAP numbers is available in our press release.
With that I will drop off and Stephen Light and Mike O’Donnell will handle the rest of the call and a question-and-answer period.
Thank you, Michael. Good morning ladies and gentlemen. Thank you for joining today’s Xerium Investor Update call. We’ll address four topics this morning and then answer your questions.
We will discuss the present state of our senior loan, our fourth quarter and 2007 full-year results, the health of the markets we serve, and then lastly, our strategy to move the company forward.
Early in February we recognized that the company would potentially violate its total leverage covenant; that is total debt divided by adjusted EBITDA, in the first quarter of 2008.
This situation was the result of actions taken during the fourth quarter to accelerate capital spending to support growth initiatives, primarily in Vietnam and to acquire a roll cover company in China. Compounding the metric calculation, fourth quarter EBITDA came in lower than the company’s expectations.
Simultaneously, the leverage ratio became more restrictive from Q4 of 2007 to Q1 of 2008, decreasing from 4.5 to 1 to 4.25 to 1. At the same time, the value of the U.S. dollar was falling precipitously versus other foreign currencies, including the euro and Canadian dollar, in which significant portions of the company’s debt is denominated.
In fact during 2007, the U.S. dollar declined approximately 11% versus the euro and 19% versus the Canadian dollar. At year’s end, $270 million of the debt or 41% was denominated in euros and $76 million of debt or 11% was denominated in Canadian dollars.
While there is no economic impact to the company so long as we pay the principal and interest on those debt and interest components, with cash generated in local currencies, for purposes of our covenant calculations, total debt is translated back into the U.S. dollar.
Several strategies to address this potential violation were available to us, including asking for another amendment from our senior lenders to loosen the troublesome covenants; selling shares in the company to raise cash with which to pay down the senior debt to a level needed to satisfy the Q1 covenant; allowing a default or seeking the protection of the courts.
Exacerbating this situation was the short period of time between our recognition of the issue and the mandatory reporting period for our annual results. Because an at market common stock PIPE is a very rapid vehicle by which to obtain funds, we chose that path first.
However, on March 18, while in the midst of the PIPE process, we were obligated to issue an SEC Form 12b-25 notice of late filing because we had not filed our 2007 10-K on its due date.
Contributing reasons for this delayed filing were, first, we had not yet completed our annual goodwill impairment review; and second, as the newly appointed CEO, I had insufficient tenure to appropriately certify our SOX 404 compliance for the accuracy of our reported results.
As you know, when the 12b-25 was released, the stock price fell significantly and the negative impact on the stock essentially stopped the common stock PIPE process. While we did receive several offers for other investment vehicles, whose confidential details I will not describe, we implemented another strategy.
That being to obtain outside advisory assistance, in this case from the AlixPartners and to work with our lenders toward a short term waiver of our senior loans covenants to provide the company and the lenders sufficient time to amend the present loan facility.
Today I am pleased to confirm that our senior lenders have provided us with an amendment, number four, which waives through May 31 actual and potential defaults against the senior loan covenants at March 31.
During the period of the waiver, we will work collaboratively with the lenders to restructure our debt and its covenants to give the company the time it requires for our revised operating strategy to take hold. I’ll describe the framework of our revised strategy in few moments.
We appreciate the energetic assistance and perseverance of our team at Citigroup, who led the effort to demonstrate to our lenders the benefits of this temporary waiver amendment.
While there can be no assurance we will be successful in attaining a fifth amendment, under which the company can operate effectively, nor at that this time what covenants may be manifest within that amendment if we do reach an agreement with our lenders, we believe this is an appropriate path for the company.
Now before I speak about our markets and our revised operating plans, I’ll hand the call over to Mike O’Donnell, Xerium’s Chief Financial Officer, who will give you the details about Q4 and the full fiscal year, as well as the financial consequences of the defaults.
In his remarks, Mike will also provide the background and details of our 2007 goodwill impairment write-off.
Thanks, Stephen. This morning I’ll supplement our 10-K information by providing more insight into certain key areas of our financial performance. I’ll begin with two significant impacts to our 2007 fourth quarter results.
First, in the fourth quarter of 2007 based on assessments performed as of December 31, 2007, we recorded a non-cash charge for goodwill impairment of $185.3 million related to our roll cover segment. Without getting too technical, I’d like to give a bit of background and explanation of this impairment.
The company accounts for acquired goodwill and goodwill impairment in accordance with SFAS No. 142. This pronouncement requires considerable judgment and evaluation of acquired goodwill and the ongoing evaluation of goodwill impairment.
The company performs an annual test for goodwill impairment as of December 31 at the business segment level. When the company’s predecessor was acquired in 1999, more than 80% of the goodwill was assigned to the roll cover segment based on fair values at the date of acquisition.
As reported in the 2007 10-K, segment earnings were $104 million for the clothing segment and $54 million for the roll segment in 2007.
As a lot of you are aware, goodwill impairment testing is a two-step process. Step one of the process indicated that a fair value of the net assets of the roll cover segment was $69.3 million less than their carrying value as of December 31, 2007.
This was due to both lower profitability in this segment during 2007 and to the increased carrying value of the net assets of the roll cover segment, primarily attributable to currency translation effects.
Based on that step one result, the company proceeded to step two. An aggregate impairment of $185.3 million was recorded as determined in step two, based on the increase in fair value of tangible and intangible assets, excluding goodwill, over the book value of $116 million.
We also recorded a tax benefit of $18.3 million related to this goodwill impairment. There was no goodwill impairment reported for the clothing segment during the year ended December 31, 2007.
As you are also aware, the reporting of the goodwill impairment is non-cash and does not affect our debt covenant calculations. As a consequence of the $185.3 million goodwill impairment, we reported an operating loss in the fourth quarter of 2007 of $164.1 million and that compares to the operating income of $16 million that we had in the fourth quarter of 2006.
The second impact in the fourth quarter results relates to the effects on the interest rate swap contracts that we entered into during the fourth quarter of 2007. These interest rates swaps initially qualify for hedge accounting under SFAS 133.
As a result of anticipated financial covenant non-compliance for the first quarter, the company classified as current on its balance sheet as of December 31, 2007, $641.2 million of the long-term debt under its senior credit facility.
Accordingly, because the fourth amendment, a default waiver, is temporary and this debt is potentially payable prior to the expiration of the underlying interest rate swaps, hedge accounting under the applicable accounting rules no longer was applicable for this interest rates swaps, and the mark-to-market decrease and their fair value of $1.9 million was recorded as a charge to interest expense in the fourth quarter of 2007.
So with that as background, I will cover our operational performance for the fourth quarter with some remarks about the 2007 fiscal year in total. Consolidated sales of $164.2 million in the fourth quarter of 2007 increased 6.2% from the fourth quarter of 2006, reflecting a 9% increase in our clothing segment and a 1.3% increase in roll cover segment.
When adjusted for currency translation and the currency effects on pricing, sales for the fourth quarter of 2007 decreased 1% as compared with the same period in 2006, reflecting a 1.6% decrease in the clothing segment offset by a 5.8% decline in roll covers.
Clothing sales for the fourth quarter of 2007 were a $108 million compared to $99.1 million in the fourth quarter of 2006 and accounted for 66% of total company sales in the fourth quarter of 2007.
Sales in the roll covers segment for the fourth quarter of 2007 were $56.2 million and that compares to $55.5 million in the fourth quarter of 2006 and accounted for 34% of the total company’s sales in the fourth quarter of 2007.
The total effective currency on net sales for the fourth quarter of 2007 was an increase of $11.2 million, of which $14.1 million was a favorable currency translation on net sales, partially offset by the $2.9 million unfavorable effect of currency on pricing.
That is, pricing impact of currency movements between the time of pricing commitment and the sale recognition in U.S. dollars from some of our non-US operations, especially in Brazil.
In the clothing business, the effect of currency translation on sales for the fourth quarter of 2007 was an increase of $10.2 million and the effect of currency on pricing was a decrease of $2.9 million.
Excluding these currency effects, sales in our clothing business in the fourth quarter of 2007 increased 1.6% over the fourth quarter of 2006. Sales in our roll cover business increased $769,000 or 1.3% from the prior year quarter. This increase was primarily the result of currency translation and masks the downward trend we’ve seen over the last three quarters.
Sales from the roll cover business we acquired in China during the fourth quarter contributed modestly to our volume. In our roll cover business, the effect of currency translation on sales for the fourth quarter of 2007 was an increase of $3.9 million. The effect of currency on pricing was negligible.
Excluding these currency effects, sales in the roll cover business decreased by $3.2 million or 5.8% in the fourth quarter of 2007 compared to the same quarter in 2006. We experienced relative price stability in our roll cover business in the fourth quarter of 2007 as compared to the same period of 2006.
For the total company, gross margins for the fourth quarter of 2007 remained on par with the fourth quarter of 2006 at 39.7% and 39.9% respectively. In our clothing business, gross margins remained relatively constant at 39.5% for the fourth quarter of 2007, and that compares to 39.8% for the same quarter in 2006.
Clothing segment earnings in the fourth quarter of 2007 were $25.8 million, an increase of 25.8% versus the $20.5 million in the fourth quarter of 2006. The impact of currency effects on clothing segment earnings was immaterial.
In our roll cover business, gross margins in the fourth quarter of 2007 of 40% remain constant with fourth-quarter 2006 levels of 40.2%. Segment earnings of $14.4 million in the roll cover business were comparable to the $14.5 million in the fourth quarter of 2006, yet would have decreased 5.8%, excluding the total impact of currency.
Roll cover segment earnings benefited from a favorable total currency impact of $769,000, all of which was currency translation.
Restructuring and impairment charges to improve our cost structure and streamline our operations in the fourth quarter of 2007 were $1.6 million versus $3.1 million in the fourth quarter of 2006, as we continue to invest in opportunities to improve the efficiency of our operations and our cost structure.
We believe the cost reduction and restructuring efforts completed in 2006 and the first nine months of 2007 eliminated about $2.9 million of cost that would otherwise have occurred during the fourth quarter of 2007, as compared with the company’s cost structure in the fourth quarter of 2006.
For the full-year 2007, these savings totaled $6.7 million compared to 2006. We expect the restructuring efforts we completed in 2007 will provide additional benefits during 2008.
The company’s net loss in the fourth quarter of 2007 was $168 million or $3.69 per diluted share, and that compares to net income of $3.5 million or $0.08 per diluted share in the fourth quarter of 2006.
Fourth quarter 2007 earnings per share is calculated using 45.5 million diluted shares, whereas the fourth-quarter of 2006 calculations used 44.0 million diluted shares. The increase in shares is primarily the result of shares that we issued under our dividend reinvestment plan.
Net cash from operating activities was $40.5 million in the fourth quarter of 2007, and that compares to the $24.6 million in the fourth-quarter of 2006, due to improvements in working capital. This performance reinforces our belief in the ability of the business to produce strong cash flow going forward.
Adjusted EBITDA remained constant at $36.6 million for the fourth quarter of 2006, compared to $36.5 million in 2007’s fourth quarter. There have been changes in the definition for adjusted EBITDA in our amended credit facility, and I encourage you to review the reconciliation we provided in our press release and in the 2007 10-K.
Capital expenditures in the fourth quarter of 2007 were $24.5 million and that compares to $8.1 million for the fourth quarter of 2006.
Approximately $12.2 million of capital expenditures in the 2007 fourth quarter were directed towards projects designed to support growth objectives; the remaining $12.3 million used to sustain the existing operations and facilities.
As Stephen mentioned, Xerium is building a clothing manufacturing facility in Vietnam of which we began construction in the fourth quarter of 2007.
In light of our current credit issues, we have decided to slow the pace of plant capital expenditures for the Vietnam facility and we now expect the plant to begin production in 2009.
Aggregate company capital expenditures are currently expected to be approximately $10 million less in 2008 than they were in 2007, and lower in 2009 than in 2008. Our cash position at year-end 2007 stood at $24.2 million; that compares to $32.5 million at the end of the third quarter and $16.8 million at the end of 2006.
During the fourth quarter of 2007, high levels of capital expenditures and the $11.8 million of cash paid to acquire two roll cover plants in China during the fourth quarter, as well as debt repayment and dividend payments totaling $11.7 million more than consumed the cash generated by operating activities.
Our total debt position, including current maturities at the end of the fourth quarter of 2007 was $666.8 million and that compared to $639.1 million at the end of 2006, a change reflecting primarily unfavorable currency translation effects, partially offset by net debt repayments of $13.7 million that we made during 2007.
Before I turn the call back to Stephen, let me make some summary comments about the underlying operating results at Xerium. If we set aside the effects of goodwill impairment and hedge accounting mark-to-market impact, Xerium’s market position, product technology and the value proposition of our customers remains strong.
The situation that exists with our credit agreement and related covenant compliance shouldn’t distract us from the fact that our continued sales and profitability performance and our very positive operating cash flow results are a testament to the strength of the company.
On basis of the recently obtained waiver, I believe that we are on a positive path to develop an agreement with our banks that will allow management and the investors to focus on that strength.
With that, I would like to turn the call back to Stephen.
Thanks Mike. While it may be difficult in these circumstances to focus on the operational aspects of the company, I think it’s valuable to spend some time on the conditions of our markets.
Internal company analysis identifies Xerium’s global served market potential to be approximately $3 billion of roll coverings and paper machine clothing, in which the company has approximately 20% aggregate global share.
While the industry’s growth is clearly fastest in Asia, the largest part of the market remains in North America and Europe.
New paper making equipment is coming online in Asia and South America while older, slower and less efficient paper machines were taken out of service in the two mature regions.
Unequivocally the industry is following the trend of much of the world’s manufacturing in its migration to lower operating cost regions and one where per capita consumption of its products is increasing above the industry’s long-term historical 3% growth rate.
However, my analysis through company sources and industry publications suggests that the clothing and rolls arms race in Asia appears to be happening faster than the Asian end-user market justifies.
It is also clear that Xerium’s newest products are highly competitive with those of all other suppliers. So we don’t see a technology breakthrough threat to at least maintaining our long-term share of the market.
We do recognize that a significant change occurring in the mature market is the increasing dependency by the papermakers on their suppliers for technical support inside their mills. We believe our large and geographically dispersed service structure ideally supports this new customer expectation.
So with the $3 billion market, solid products and global reach, we’ve developed a revised strategy to use our existing strength to our long-term advantage. That strategy, simply stated, is to use Xerium’s strong cash flow from operations and any other sources we may have or identify to pay down our senior debt, which stands at approximately $650 million at year-end.
In 2007, we spent nearly $1.14 per share on debt service interest expense. Frankly, it’s hard for me to imagine an investment opportunity with a better return than reducing debt. The new loan structure we are working on will be now be titled Amendment Five.
To facilitate the development of Amendment Five, we are creating a new five-year business plan. The strategies upon which the plan is based include substantially lower investment in growth and regional realignment until such time as we have our reduced our outstanding debt to a more manageable level.
This means we will plan to redirect the debt reduction, a significant portion of the company’s free cash flow, by slowing down capital investment in our Vietnam project as Mike indicated in his remarks; canceling equipment we have on order, or have contemplated ordering for other initiatives; and by not engaging in merger and acquisition activities for the foreseeable future.
Nor do we plan to pay a dividend on our common stock through the remainder of the term of the senior note. Our strategy is to concentrate on improving our balance sheet performance by increasing inventory turns, shortening receivable days and lengthening payable days, the levels achieved by best-in-class manufacturing companies.
We’ve already established division-level targets for each of these focus areas. And we’ll soon have control metrics driven down to the region and plant level.
Meanwhile, we’ll focus our intention on improving our present plant operations and maximizing the contributions of highly skilled people we have. Unfortunately, this may mean at least temporary reductions in the number of people we employ.
Additional plant closures may take place, but on a much reduced scale than previously implemented. These measures will help boost our sales per employee, which in 2007 was approximately $165,000.
We plan to move away from the price competition the company has engaged in recently, in order to restore a more reasonable and balanced relationship between our customers and ourselves.
Our customers will continue to enjoy the benefits of our market-leading technologies, both in product and operational assistance while they pay a fair price for the products and services we provide.
During future investor calls, we’ll provide specifics about the supply chain and lean manufacturing initiatives we’re developing as well as the capacity rationalization processes we have in mind.
Meanwhile, we plan to continue investing appropriately in new products of our own development to stay ahead of our competitors. We also expect to identify and support third-party products, which complement our offerings, where we believe those products will provide a measurable return to our customers and where we believe we can make a fair return as well.
To assure the unchallenged commitment of the company’s full executive team to this new cash focused debt reduction strategy, we’re establishing free cash flow as a primary measurement in each of their annual incentive compensation plans.
With this new focus on free cash flow, I expect substantial reduction in our indebtedness over the next few years. Once we have the debt reduced to a more reasonable level, an amount which we’ve yet to determine, then I believe we will have the flexibility we would like for other, as yet to be developed, future strategic initiatives.
Ladies and gentlemen, thank you for your attention.
Dan, we’re ready for the first question, please.
Your first question comes from the line of Chip Dillon - Citigroup.
Chip Dillon - Citigroup
The main question is, you mentioned the price process and then the stock sell after the March announcement you stopped that. Do you contemplate continuing an effort to raise equity at this point, or are you going to instead focus on just debt reduction and not depend on new equities?
Chip, a lot depends on what comes out of the development of our new business plan, which we are well along with. We intend to stress test that plan sufficiently to understand how the company will react to changes in currency, changes in mix, changes in market segmentation. And on the basis of that analysis, we will determine whether we need an equity infusion or not. We have no bias one way or the other.
Chip Dillon - Citigroup
As a follow-up, I think timing is critical. And I’ll be candid: when you came out with your announcement in March and the stock’s at one and you say well, you want to raise $50 or $100 million, you’re taking the current shareholders position down by 50%, 80% and that’s why your stock went down I believe.
Are you “that easy,” or are you going to be a little bit disciplined in how you pursue this, as far as the existing shareholders would be concerned about that? Because if you do something now that’s different than if you develop your plan, you get a little more breathing room on your balance sheet and/or your covenants and then you do something down the road, it can have a tremendous swing in terms of what share count we assume out there.
I will respond to your comment by saying we are taking a deliberate approach to developing a long-term business model, business plan that we will stress test, that we will use to evaluate the path for the company.
We are very sensitive to the issue of shareholder dilution, but we will run the company for the long term, and we’ll not react to the vagaries of stock price on a daily, weekly, monthly basis.
This is the company that has significant capabilities and strengths. This is the company that will demonstrate that, I think, has demonstrated and will demonstrate that prospectively. We are, I think, trying to demonstrate and hopefully in this call give you clear indication about a very disciplined approach to managing the business for balance sheet improvement.
I made it absolutely clear that there is no investment that I see available for the company that has a better return than debt reduction. We will do that in a disciplined and orderly manner and will not react nervously or emotionally to the stock price.
Chip Dillon - Citigroup
Go that. One quick follow-up: I know Steve, it’s early days for you. But what seems maybe serendipitous is that a lot of us have noticed in the last 6 months that with the dollar continuing to plunge, it hit $1.59 today, it seems like there is just no question that the U.S. in many grades is now clearly without doubt the low cost producer on earth and with OCC and ONP costs going through the ceiling, they are starting to question the cost position of places like China, at least in the recycle base grades.
Have you given any thought to how the dynamics of where the market is headed in the next 3 to 5 years could actually be changing from what had been expected 2, 3 years ago, although you weren’t involved back then.
The short answer is no. Not yet. My focus since arriving at the company on February 11 has been the issue that we have identified, which is making sure that we’ve got in place a long-term banking agreement that gives us operational room, but also allows us to be responsible and pay the debt down.
As I get more and more engaged in the business, the observation that you’ve made will be tested and if correct, validated and we will respond accordingly. Once again our approach is going to be to be very disciplined and deliberate and not react to today’s news or tomorrow’s news, but take a pragmatic approach to running the business.
I think it’s important too, Chip to knit together two points of disclosure that we have made in our releases this morning, that is first the slowing up the pace of the Vietnamese investment and we attributed that to the credit situation that we are in.
I would also make sure that we connect the dots to another comment that Stephen made and that is that the pace of change and the race to arms, I think was the terms that Stephen used, to address the market growth in Asia, that clearly the investment by Xerium and perhaps the investment by our industry in total is in advance of or at a faster pace than quite frankly the shifts in the markets that you are describing.
And so I would offer that as a bit of a response to whatever the next number of months will unfold as to what Xerium’s more robust response to your question might be.
Chip Dillon - Citigroup
Yes, and that makes total sense and so thanks very much and I appreciate the extreme synergy of the way you plan to proceed. Thank you. Good luck.
Your next question comes from the line of Ron Pearson - Bowmark Capital.
Ron Pearson - Bowmark Capital
I was just really following up on Chip’s question about the ability to raise equity or the intention to raise equity. I just wondered when you thought you would get clarity on that point? Clearly you got till 31 of May. Just want to know when you thought you would get clarity on that point?
Ron, it will be over the next couple of months, as we work the business model. I would not confirm or affirm that it has anything to do with the May 31 amendment.
Ron Pearson - Bowmark Capital
Okay. And just a follow-up on a slightly broader question. Do you feel that anything has fundamentally changed about the competitive position of Xerium in the marketplace?
Absolutely. We’re going to stop being the bottom-priced guy. We’re going to be responsible in our pricing and that is a fundamental change that the marketplace will see.
As I entered this industry, what I heard around the horn and also during my due diligence was that there were price wars going on and as I came to the company, I think that a lot of the blame for that lies here and that’s over.
Ron Pearson - Bowmark Capital
Okay. That sounds very promising. Thank you.
At this time, there are no further questions in the queue. I would now like to turn the call over to Mr. Stephen Light for closing remarks.
Ladies and gentlemen, we thank you for participating in our earnings call. And we look forward to speaking with you again in what will be about a month when we release our Q1 2008 results. Good bye.