Sauer-Danfoss Inc. Q1 2008 Earnings Call Transcript

Sauer-Danfoss Inc. (SHS)

Q1 2008 Earnings Call

April 29, 2008 10:00 am ET

Executives

David J. Anderson - President and Chief Executive Officer

Karl J. Schmidt - Executive Vice President and Chief Financial Officer

Analysts

Amit Daryanani - RBC Capital Markets

Joe Calvello - Cleveland Research

John Emerett - Ironworks Capital

Bill Wyatt - Delta Management

Presentation

Operator

Welcome to the Sauer-Danfoss Q1 2008 earnings result conference call. (Operator Instructions) I would now like to turn the conference over to David Anderson, President and Chief Executive Officer of Sauer-Danfoss.

David J. Anderson

Welcome to Sauer-Danfoss first quarter 2008 results conference call. Participating with me today are Karl Schmidt, Executive Vice President and Chief Financial Officer; and Ken McCuskey, Vice President and Chief Accounting Officer.

Before we get started, I would like to inform you that this conference call contains forward-looking statements that involve risks and uncertainties that could cause the actual results to differ materially from those in the forward-looking statements. The company’s reports on the file with the Securities and Exchange Commission provide a more detailed description of these risks and uncertainties.

I will begin the call today by reviewing our first quarter highlights, including the status of new orders and current backlogs, and Karl will follow on and cover the details of our overall financial results. I will then wrap up with comments on our 2008 outlook before opening the call for questions.

Regarding the first quarter results, it was an excellent start to 2008 with all time records for sales and earnings. We continued our longstanding trend in sales growth, finishing the quarter with a very strong 13% increase, excluding the effects of currency translation and divestitures. This growth is the reflection of new customer programs going into production, our broad geographic diversification, and continued gains in our existing business.

With respect to our record earnings, we are beginning to benefit from the wind down of costs associated with our past restructuring activities as well as the implementation of our common business system. In addition, we are beginning to realize operational efficiencies from our efforts in both these areas.

At the same time, we’ve got significant operational opportunities, which we continue to address related to localized capacity restraints. Our first quarter sales increase of 13%, excluding the effect of currency translation and divestitures, resulted from a 15% increase in our propel division, a 13% increase in controls, and a 9% increase in work function.

Sales in the Americas increased 8% compared to the first quarter of 2007, which is quite an achievement considering the current state of the U.S. economy. This increase comes primarily from new programs going into production, growth from customers who have strong export markets, and the strength in the ag and turf care market, which grew 10%.

Sales into the Americas constructions and road-building market grew 3%, with growth in non-residential construction offsetting continued weakness in residential housing and road building. Most of our gains in this segment are coming from new program wins based on recently introduced products in our hydrostatic transmission, open circuit piston pump, and valve families.

Sales into the material handling and specialty equipment market were relatively flat, with gains in material handling offset by reductions from the sale of our DC Electric Motor business. We also experienced a drop in sales of fan drive cooling systems into the recreational vehicle market, which is a direct result of the high fuel prices.

Finally, our North American Distribution Organization continues to do an excellent of applying our newer products and serving our mid-sized OEMs, and as a result our sales through distribution grew by 10%.

In Europe, our sales grew 14% compared to the first quarter of 2007. Overall strength in the ag equipment market in combination with new program wins are the big contributors, giving us a 21% increase for this market.

Sales in the construction and road-building market increased 8%, even though we recently phased out several underperforming products which had been developed specifically for this market.

Material handling and specialty market sales increased by 1%, with growth across the region. This sales increase was held down because the first quarter 2007 numbers include the DC Electric Motor business that we recently divested.

The Asia-Pacific region is becoming more and more significant to Sauer-Danfoss’ results. Asia-Pacific growth made up a quarter of our total overall increase this quarter with sales increasing a very strong 34% on a comparable basis. Growth in the region was led by strength in China, as well as new program wins and new customer wins.

Sales into the construction and road-building market grew 52% over last year’s first quarter largely due to China’s focus on building infrastructure. Sales into the material handling and specialty market doubled for a wide variety of reasons, including general market growth, new customer wins, and improvement in our on-time delivery performance.

With respect to new orders and backlog levels, we continue to hold a very solid position. On a comparable basis, orders have increased 13% relative to the first quarter of 2007. Orders were up 21% in the Americas, 7% in Europe, and 5% in Asia. Compared to last year at this time, our backlog is up 41%, which is an indication of strong demand well into 2008.

But as we discussed last quarter, it’s likely that part of this increase is due to customers reacting to some capacity constraints in the market and placing orders earlier than usual to ensure that the requirements are covered.

Karl will now provide some additional detail on our financial results.

Karl J. Schmidt

We posted a strong 2008 first quarter earnings at a record of $0.57 per share compared to $0.32 per share in the 2007 first quarter. And when we look closer at the earnings per share, I’d like to comment on a few items. Our operating margin improved significantly, led by the propel segment posting a very impressive 21% margin. Our work function and controls segment margins of 2.7% and 3.4% respectively both have room for further improvement.

Over the past year, we have put a new leadership structure in place, moving from a single chief operating officer to three divisional presidents as members of the executive office. This structure adds more direct focus on the performance of our divisions. With new leadership in place in the work function and controls segment we are addressing the capacity constraints and operating inefficiencies. Big improvements will not happen overnight, but we expect more acceptable margins later this year and as we move into 2009.

Over the past three years, we have invested considerable resources in our restructuring efforts. Our improved numbers for this quarter reflect some efficiency improvements from these efforts as well as a one-time gain of approximately $1.5 million or $0.02 per share from the sale of our LaSalle, Illinois plant that was closed as a result of our completed restructuring program.

And finally, our overall tax rate in the first quarter 2008 was a more normal rate of 34%, and for the full year our effective tax rate should be in the 33% to 35% range. Cash flow from operations for the 2008 first quarter was $14.3 million compared to $2.1 million in 2007.

Along with record profits from operations, the cash flow would have increased correspondingly in this quarter were it not for special cash contributions to pension of about $20 million with a resulting reduction in our pension liabilities. A portion went to the English pension plan, which was frozen in connection with a prior year sale of our business in Swindon, and a special contribution was made to the German pension plan as we initiated the transition to a pension system which is encouraging employee contribution in the future.

Capital expenditures for the first quarter were $35.1 million. That is up from $24.9 million last year. We continue to focus on the need to increase manufacturing capacity, especially in Europe, to meet the strong demand and to get ahead of the future growth we anticipate based on our positive win-loss ratio for new applications.

With that, let me turn it back to Dave now.

David J. Anderson

While we’re pleased that the first quarter set all-time records for sales and earnings, we are still not satisfied with our existing level of capacity in some specific areas or our overall operating margins. We’re on target with our global procurement project directed at leveraging our global purchasing power, and we continue to drive lean practices throughout the organization. Efforts in each of these three areas offer a significant potential for margin growth. We remain optimistic about our business going forward from both a growth and a profitability perspective.

For the remainder of 2008, we see demand continuing at a slightly more modest pace in all three major geographic regions and expect to continue to win new business and gain market share as we have done consistently in the past.

Based on the positive results and backlog in the first quarter, we revised our outlook for 2008. We now expect sales to grow 9% to 11%, earnings per share to be $1.50 to $1.65 per share, and capital expenditures to run approximately 7% to 8% of sales.

I’d now like to open the conference call for questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Amit Daryanani - RBC Capital Markets.

Amit Daryanani - RBC Capital Markets

The capacity additions that you’re doing in Europe, I believe a lot of that should be coming live in the June quarter if not the September quarter timeframe. And I’m just curious and I know this will alleviate some of the capacity issues we have, but can you just talk about how you go through a learning curve given all the new capacity and how that might play out on the margin line?

Karl J. Schmidt

Well, there are two aspects to this. I think, yes, the capacity that was put on order already last year is coming in and we expect some relief in the summer quarter out of that and once it’s phased into the line, it should result in an increased number of products. I think what we expect in terms of margin is really also a derivative of the fact that we currently really have difficulties and need to allocate some products.

That means not all of our customers get products in equal share. And as we’ve stated before some of the pitfalls of such a program is that some of the larger customers which have a lot of our products on their systems, they get the bulk of the quantities and we have to curtail the more margin bearing accounts, the smaller accounts in Europe and that has put a damper on the margin, and I hope we can get some relief once we have new capacity in place to serve all the market equally again.

Amit Daryanani - RBC Capital Markets

Karl, you don’t see an impact maybe from incremental capacity and the fact that a factory has to go through a learning curve. Do you think that’s going to be an issue or that should be fairly muted?

David J. Anderson

I don’t think there’s a learning curve as far as installing the capacity. I think the pain that we’re feeling right now is going to diminish. We’re at the higher levels experiencing at this point. And as we put the capacity in place, we’ll be able to do two things.

One, operate more efficiently and that’s going to improve our margins, as Karl pointed out. And the second one, which Karl talked about is we’ll be able to serve a broader range customer base, where we’ve really been unable to supply product to some of our higher margin accounts, the lower margin medium-sized accounts.

Amit Daryanani - RBC Capital Markets

In terms of the capacity addition, how much of incremental sales should you be able to do once this comes live in Q2 or Q3?

Karl J. Schmidt

Well, I think if you look into the work function segment, you can see that it’s trailing the other segments in terms of overall sales growth, and I’d say there is a delta right now of the 3% to 4% of growth that we really cannot materialize there. So order of magnitude in terms of that size we would expect to come through once the capacity is in place.

Amit Daryanani - RBC Capital Markets

If I look at the margins this quarter of 9.8% it’s a good 110 basis point improvement year-over-year. I don’t know if you can do this, but how much of that was due to some of the restructuring benefits that we’re starting to see versus the fact that we did have a good 13% organic growth?

Karl J. Schmidt

I think it’s a combination of the two. There’s some improvement obviously imbedded in the propel numbers. We talked about the Illinois plant that we finally sold for some cash in, but that was part of the propel restructuring in the U.S., and you can see that the propel segment is performing at a record high margin, so that helped to some extent.

I’m not saying, it’s the overall driver of that profitability improvement, but it helped. And finally in Work Function while that segment margin is still low, we’ve seen some improvement in the product lines where we sold off the business in England last year, which was really pulling down our results and we can see now that that is helping us by avoiding some negative margins as we saw last year.

So some of these cases are really conservative and positive, and as we commented on the last quarter, an offset effect is still in the electric drive business where we purposely sold a still profitable business to make the most out of that transaction last year. And that is hurting our comparables because there as we had still positive numbers in the first two quarters last year, we will see that we are still trailing in comparison because of the more profitable baseline.

But, overall, I think in terms of plant efficiencies to those plants that are operating normal, or within the capacity boundaries, I think we have seen some improvements from these restructuring efforts.

Amit Daryanani - RBC Capital Markets

When I look at the North American trends up, I think you said materially handling was up, offset by the sale of the DC business. So on an organic basis, how much is the material handling business up in North America, do you have that number?

David J. Anderson

I do, but we don’t split it out between material handling and specialty market, but it’s roughly up mid single digits.

Amit Daryanani - RBC Capital Markets

Could you talk about the changes in the ownership structure that happened in this quarter? Can you just talk about how, if at all, it impacts the company is operated and run?

David J. Anderson

Actually, we don’t really see any impact at all in terms of how the organization is run. The Danfoss Group has been an equal shareholder with the Murmann family since inception, since 2000. They’ve alternated positions on the Board, chair seats on the Board over a four-year cycles. They’ve been joined at the hip when it comes to strategic planning and visioning, and those strategic plans, those missions and visions been exactly in line with what management has defined and developed.

Both the shareholders have had a focus on innovation and a high interest in investing in innovation as a strategic advantage. And I think when you look back over the years on our growth, a good part of that has been a result of innovation in our product portfolio. Both of the major shareholders have had a long-term perspective in growing the business as well. And so, I don’t think you will see any shift at all, either in our focus areas or our strategies or our implementation.

I think we will benefit from having the major shareholder being, if you will, completely aligned with the industrial manufacturing company, and we will be able to benefit and draw on some experiences and resources that they have as we start moving more aggressively in leaning out our organization and leveraging off our procurement opportunities.

And they have developed some business systems that have a great deal of potential for us to be able to implement as well. And these are two areas as I think you all know that we are focusing on and we need to focus on going forward. So I see positive. I don’t see any negative impacts on how the business is being run.

Operator

Your next question comes from Joe Calvello - Cleveland Research.

Joe Calvello - Cleveland Research

The revenue guidance of 9% to 11%, does that include contribution from currency?

Karl J. Schmidt

Yes. That’s the nominal increase we expect for this year.

Joe Calvello - Cleveland Research

Do you break that out between foreign and contribution from currency? I’m just wondering if the currency contribution has changed from the prior 7% to 8% to this now 9% to 11%,

Karl J. Schmidt

Without breaking out all the details, I think the FX expectations are in line with the current FX rate. So we don’t make any different projections on FX impact than where we are as of today. But we do see some strength beyond our original projections both in Europe and as you’ll see from the numbers here, the U.S. is certainly holding up a little stronger than what we had originally anticipated when we gave out full year guidance. So together, I think that makes for a overall volume increase of about 2%. So we move from where we had seven to 9% to 11%.

Joe Calvello - Cleveland Research

On the SAP implementation, can you provide some color on the cost in the first quarter versus a year ago?

Karl J. Schmidt

In terms of the overall program, we are just at the very tail end of implementations. We’re just going through some of the small operations in the more remote countries like we’re still targeting Australia, and then also Brazil later this year. So really the program as such has now been completely folded into our IT budget and we don’t plan on reporting that separately because it has been immaterial for this quarter and we don’t expect materiality for the products going forward.

But in comparison, I think last year in the first quarter, we spent around $3 million on the program. It’s now down below $2 million for this first quarter. And really I think the program has been very successful in its implementation phases and we’re very happy that we now are on a single instance of a business system worldwide. And I think we’re starting to see the benefits in terms of planning ability and seeing the orders come through and helping the efficiency of the whole supply chain.

Joe Calvello - Cleveland Research

On the change in ownership structure, I know that’s a multi-step process. I’m just wondering, as far as progress, has that first step been completed?

David J. Anderson

No. Actually, it’ll be in June sometime and that’s dependent on a shareholder vote to make some changes to the bylaws, but I don’t see any reason why that won’t be completed at all.

Joe Calvello - Cleveland Research

So that’s scheduled for June.

Karl J. Schmidt

Right, it’s a part of the shareholder meeting agenda.

Operator

Your next question comes from John Emerett - Ironworks Capital.

John Emerett - Ironworks Capital

What is in the other, the $3.8 million?

David J. Anderson

John, that’s mostly currency, loss on currency.

John Emerett - Ironworks Capital

And is there any seasonality to the minority interest line? This quarter’s numbers seem to have more correlation to a year ago than it did say December’s quarter. I’m just wondering how to think about it.

Karl J. Schmidt

Yes, John. The minority interest line is a combination of joint ventures we have in Asia and in the U.S. in the turf care business. And to the extent we’re talking turf care in the U.S., that is clearly more significant in terms of revenue and resulting margins in the first two quarters of the year. So you will see that seasonal effect consistent over the past years.

Operator

Your next question comes from Bill Wyatt - Delta Management.

Bill Wyatt - Delta Management

Your results and your outlook were quite a bit more optimistic let’s say than that of just a few months ago, and you mentioned North America’s running a little stronger than you had anticipated. I’m just curious, why do you think that is? Are you picking up share faster in certain segments, or what else might explain why North America might be better than what you had anticipated?

And then, it sounds like you must be getting your arms around some of the operational issues perhaps a little faster than you thought you might of just a few months ago. So maybe talk a little more specifically about that, and your level of confidence to driving the overall business back toward a 12% EBIT margin?

David J. Anderson

First of all, an explanation for why we’re stronger in the Americas than what we would have anticipated, the big contributor there is the ag market. And it’s a combination of the major producers in the ag market just doing extremely well. All the producers in the ag market are doing extremely well. And with some expansion in our product portfolio, the content, dollar content on many of those machines, and for us, as in some cases it doubled, tripled, quadrupled. So it’s an ag market story in that regard.

There’s an awful lot of export as well taking place. And those companies in North American that have got a strong export base and have been concentrating on export markets have done extremely well also. And so we’re finding a disconnect a little bit from the overall North American economy and what our business is doing. Brazil is also a strong spot for us as well to point out and that’s included in the Americas. And the Brazil market is also an ag story. So those would be the major reasons.

We also are gaining market share not only because of dollar content in ag machines, but the turf care market, which would be viewed generally to be weak, it does get driven to a great extent by new housing starts, and is tied to the consumer market. But we’ve gained considerable market share there as well. So our turf care market is up more than we would have anticipated it was going to be this year.

Now, the question of executing the business and getting our arms around operating expenses, I think inefficiencies, Karl touched on it. About 18 months ago and over the last 18 months, we have reorganized the operations side of the business from the original concept at Sauer-Danfoss. We had a structure that set up with a singular COO position with responsibility for eight business units.

And in the last 18 months, we did shift to a divisional president structure, where we have three division presidents, the propel, work function and controls. And putting in three divisional presidents has really helped us get our arms around and slice this business more finitely and get our arms around areas where there’s operational challenges.

And the area where those challenges exist most obviously is in work function. And we are making progress there. We’ve reached record production levels. And we are putting in capacity in place. Unfortunately, it comes with significant operating inefficiencies. And those will be put to rest here over the next 12 months as we bring in more capacity and we’re able to start to lean out that operation.

We’re also making some progress in the area of procurement. And we did some work here early on with A.T. Kearney and are partnered with them at this point. I don’t want to sound like an advertisement with SAP particularly, but I have to say that when we first started out, we had more than a dozen, 14, 16 different business systems running through the company. All were burning platforms. We had to do something about it.

In the last six months, really is the first time we’ve really been able to sit down and get a grasp on the $1 billion a year that we spend in procurement on what commodities we are buying, how much per commodity, who were buying from, how much from each person, and put together a solid strategy on how to address getting leverage out of that procurement opportunity.

As a company, going back, I think we’ve done a great job of growing and getting market share because of the merger and the broad product portfolio and geographic reach. However, we didn’t have the tools in place to go after procurement. And now we’ve got those tools in place and that’s going to be area that we concentrate on heavily.

I think I can say the very same thing about lean with the growth that we’ve had historically, we’ve been asking our manufacturing people to take on that growth challenge, give us the opportunity to capture the market share while the opportunity exists. And they’ve been doing that, doing it very well. But with a 14% to 15% compound annual growth rate, we haven’t been doing it in a very efficient way.

Now we’re going through site by site and leaning out each one of our major operating sites. We’ve finished one in Hillsboro, Oregon and we figured that that one alone has brought three points of margin improvement to that particular business. Now we are working on the largest site that we have in Europe, which is in Nordborg, Denmark. There’s no reason to expect anything less than 3 points of improvement on operating income.

So we’ve got an awful lot of opportunity ahead of us as it relates to global procurement and as it relates to leaning out the operation. So, and having three divisional presidents, or, if you will, three COOs rather than one, is giving us stability to get to it much quicker, make decisions quicker, and implement them quicker. So that’s the long story to a rather short question.

Karl J. Schmidt

Bill, if I may add to that, I think, the outlook of projects that we are a little more confident that some of these tools are in effect and are showing results. On the other hand, we still remain cautious as to the timing of all these efforts. That’s the tougher part. We know they all will be effective, as to when they’ll really show effectiveness is a little tougher to predict. So that’s really why we are a little bit guarded as to how much we will see still in 2008 versus coming through in 2009. But they’re definitely in front of us and we’re going after them then.

David J. Anderson

I didn’t mention the impact of pricing, but not having this global business system, we’ve got some people who are very, very good at strategic pricing, but without the databases to be able to really understand our business position with the customers around the world and our position in specific markets, it was an independent activity spread across the globe. And today, we are able to be much more precise and strategic in how we apply our pricing strategies or activities.

Bill Wyatt - Delta Management

There are a lot of moving parts and a lot of levers that you’ve got at your disposal. You have thrown out in the past a 12% EBIT margin goal and it sounds like the possibility of approaching that in ‘09 is reasonable. Would you agree?

Karl J. Schmidt

Well, what we said is the first goal is to try to break that 10% barrier to get into the double-digit arena. And that’s something we won’t do this year, we’re sure of that, and you see that from our guidance. But we think we are much better positioned 2009 to take a crack at that. And so overall double-digit EBIT margin is still something we keep as a target. But 2009 will give us more visibility whether we can do it then or as we move 2009 to get close to that initial time.

Operator

At this time, there are no further questions.

David J. Anderson

If there are no further questions, then I’d like to thank you all for taking your time to join us on the conference call today. And if you do have any questions later on that you’d like to follow up on, please I hope you’ll feel free to call Karl, call Ken or call myself directly. We do look forward to keeping you updated on our progress. Thank you.

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