Superior Essex Inc., 1Q 2008 Earnings Call Transcript

Superior Essex Inc., (SPSX)

Q1 2008 Earnings Call

May 2, 2008 10:00 am

Executives

Peggy Tharp – Director, Investor Relations

David S. Aldridge – Chief Financial Officer, Executive Vice President and Treasurer

Stephen M. Carter – Chief Executive Officer, President

Analysts

Warren Chiang – JP Morgan

David Woodyatt – Keeley Asset Management

Chris Bamman – Morgan Joseph & Company

Presentation

Operator

Good morning. My name is Vanessa and I will be your conference operator today. At this time I would like to welcome everyone to the Superior Essex 2008 First Quarter Conference Call. (Operator instructions.) I would now like to introduce Miss Peggy Tharp, Director of Investor Relations. Thank you. You may begin your conference.

Peggy Tharp

Thank you for joining us for our first quarter 2008 earnings call. I am Peggy Tharp, Director of Investment Relations For Superior Essex. With me this morning are Stephen Carter, our Chief Executive Officer; David Aldridge, our Chief Financial Officer; and Justin Deedy, President of our communications cable business. Joining us via phone is Dave Reed, President of our North American magnet wire and distribution business, and Pat Jack, President of our Asia Pacific magnet wire distribution business.

Hopefully you have all seen our earnings release, issued yesterday, and which is available on our web page at superioressex.com. I must remind you that during our discussion today on the call, we will make forward-looking statements as well as historical statements. All forward-looking statements are subject to risks and uncertainties, and actual results may differ materially from those suggested by the statement.

For information regarding the risks that may cause actual results to differ, please see our earnings release issued yesterday and our 2007 form 10-K. We expressly disclaim any responsibility to update forward-looking statements.

We will also use certain non-GAAP financial terms, which are supplements to the information and should not be considered as an alternative to, or more meaningful than, GAAP financial information. Our website and our earnings release provide a reconciliation of these terms and those directly comparable GAAP financial measures.

During our call today, David Aldridge will provide a financial review. He will then turn the call over to Stephen Carter, who will first provide an update on our strategy and business development activities, followed by an outlook for the second quarter. We will then continue with Q&A. I will now turn the call over to David Aldridge.

David S. Aldridge

Thank you Peggy, and good morning. For our 2008 first quarter, we continue to produce year over year growth in all key operating performance measures. Our first quarter results reflected anticipated benefits from our 2007 acquisitions along with continued cost efficiency gains, particularly in our communications segment. Additionally, we had some favorable impact from the stronger euro.

The positive quarterly operating results were achieved despite the weakness that has persisted in North American residential demand and overall European economic performance. For the 2008 first quarter, core business revenues totaled 743 million, a 12% increase on the constant copper basis over the prior year first quarter. Acquisitions contributed approximately 114 million in 2008 Q1 revenues. Excluding acquisitions and favorable currency conversion, organic revenues did decline 9% on a constant copper basis.

Adjusted EBITDA for the 2008 first quarter totaled 39 million, representing a 16% increase year over year, with EBITDA expansion in each of our business segments. Operating income before special items increased at an even greater rate of 20%, with gains in operating margins not only on a consolidated basis but also in each business segment. Adjusted EPS for the 2008 first quarter increased 50% to $.69 per share, exceeding our previous expectations communicated in our prior quarter earnings call of 10 to 15% EPS growth.

On an operating segment basis, revenues in our global magnet wire business totaled 546 million, a 23% constant copper increase. These results included gains in each geographic region, including 43% growth in Europe and 5% growth in North America. In China, we recorded 17 million in 2008 Q1 revenues, whereas in the prior year first quarter we did not have any material revenues in China.

The three 2007 acquisitions obviously had an impact on our global magnet wire revenue performance. To a lesser degree, currency conversion rates also favorably impacted revenues.

Excluding the impact of acquisitions and currency, global magnet wire revenues at cost of copper declined 8%. This rate of decline was consistent with the second half of 2007 and clearly reflects the impact of a significant depression in residential construction in North America, which affects approximately 30 to 40% of our revenues in that region.

The slowdown in overall European economic activity also negatively affected organic performance. Adjusted EBITDA for global magnet wire increased 36% at to 22.8 million. Adjusted EBITDA margins at constant copper improved about 40 basis points, despite continued input cost increases and competitive pricing pressures in our major OEM customer accounts.

Adjusted EBITDA was impacted positively by our 2007 acquisitions. Additionally, strengthening of the euro resulted in higher conversion of euro-based earnings into U.S. dollars. However on the flip side, the stronger euro had a negative commercial impact on our European business in terms of real pricing and more competitive international import and export markets.

As far as other notables within the separate magnet wire geographic regions in China, we did have an approximate 1 million gain from mark to market copper derivatives. However, this gain was offset by transitional incremental supply chain costs in our North American operations related to a temporary internal disruption in enamel wire coating availability. Additionally, in China, we did incur about $1 million in continued startup costs in our Tianjin operations, which should improve progressively during the year.

Turning to communications, revenues for Q1 2008 totaled 196 million, which represented an 11% decline on a year over year constant copper basis. Two main factors affected the revenue comparisons. First was the obvious impact of residential construction, which touches about 35 to 40% of our communication end market demand.

Secondly the prior year 2007 first quarter did include some level of extraordinary volume due to the severe budget constraints that telcos experienced during the latter stages of 2006, which resulted in pent-up demand and some positive spill-over impact into the first quarter of 2007.

Despite the lower constant copper revenues in the 2008 first quarter, communications-adjusted EBITDA did increase about 4% as adjusted EBITDA margins at constant copper increased approximately 190 basis points. This year over year margin improvement represents continuation of the exemplary profit performance in margin gains that communications delivered throughout 2007 and included the benefits of significant cost efficiencies improvements year over year in copper cost recovery, and more favorable mix.

As far as other line items within the consolidated operating statement, we did have a favorable effective income tax rate for the 2008 first quarter at about 33%. Included were certain discreet tax items related to true-ups and jurisdictional tax rate changes that positively affected the effective rate by about 2%. On an ongoing basis, we do expect our normalized tax rate to be in the 34 to 36% range. This reflects a reduction in our tax rate from prior years, and is due to the proportional increase in earnings from international operations in lower tax regions.

The last item I would like to mention in the operating statement is the current quarter pre-tax special charges of 10.1 million. 9.5 million of these charges were related to our North American magnet wire and copper rod manufacturing consolidation, and included 7.5 million in non-cash and 2.1 million in cash charges. The non-cash charge of 7.5 million is comprised of accelerated depreciation and included as a component of costs of goods sold.

Now, let me quickly cover the balance sheets, debt and cash flow. In the first quarter we did experience our normal Q1 seasonal build in working capital, which was further affected by rising copper costs. The combined impact was a $44 million increase in our net working capital.

Let me emphasize that our receivable DSO levels remain consistent with prior periods, and our inventory levels on acquisition adjusted and copper-adjusted basis are significantly below equivalent levels at the end of the first quarter. All in all, we are continuing to take good care of the balance sheet, although we will likely to see increases in working capital in the second quarter if copper remains at its current elevated level.

The expansion in net working capital did result in an increase in our net debt by 40 million to 291 million at the end of the fist quarter. However, overall liquidity remained strong at almost 300 million. Our debt to capital ratio was 0.7, and our leverage remains below two times.

The major components of cash flow results for the first quarter included net income plus non-cash charges of 26 million, reduced by the use of funds for net working capital of 44 million reduced by share buybacks of 11 million and by CapEx of 14 million. And with that, I will turn the call back over to Stephen.

Stephen M. Carter

Well, good morning and thank you David. Well as our quarterly results clearly show, we have successfully managed our company through an extremely difficult economic environment over the past three quarters.

Despite this situation we have continued to produce consecutive and significant growth in revenues and adjusted EBITDA. This accomplishment has been due in no small measure to the successful integration of our 2007 acquisitions but also to the exemplary cost containment and reduction programs that have been enacted by our operating divisions.

I must also point out that the recent upgrade to our credit rating is a direct reflection of the company’s ability to navigate through the combined issues of higher commodity and energy costs in a weaker demand environment. To that point, I want to express my gratitude to our management team across all of our business segments for contributing to these extraordinary accomplishments.

So while we are very pleased with recent results, positioning ourselves for sustained long term growth is our number one priority. In this regard, one of our top goals is to leverage the strengths of the acquired operations in Canada, China and Italy, particularly with the new, expanded magnet wire product lines that feed the growing energy end market.

As you recall, last quarter we introduced you to the key end markets that we define as our magnet wire business, those being the energy, automotive, industrial, and commercial and residential sectors. In our communications cable business, we sell our outside plant and data cable products into the telecommunications market.

For this quarter I would like to zero in on energy, as there is so much going on in both the commercial and regulatory arenas. On the regulatory side, just this past March, the Federal Energy Regulatory Commission, or FERC, issued an update to encourage investment in the transmission grid. FERC also noted that the investment levels have nearly doubled in recent years. Based on recent events, this upward trend is not likely to abate.

Starting as soon as next year, the higher TSL 4 efficiency standards for mid-sized transformers will begin to be seen and felt. The TSL 4 standard will require enhanced energy efficiency while reducing the environmental impact of energy production and peak electrical demand. Also, it will require significant transformer design changes that will result in changes in the amount of magnet wire conductors used in distribution transformers by, in some cases, as much as 50%.

In addition to these high profile efforts, many other energy and green efficiency initiatives are ongoing in the U.S. and in other parts of the world. Standards put in place by the Department of Energy over the past few years include efficiency requirements for residential applications such as room air conditioners, washer-dryers and refrigerators. DOE has also targeted commercial applications like HVAC systems and heat pumps. On top of these efforts, the DOE is considering the impact of energy conservation standards for the millions of small motors used by factories, farms, and in buildings across the U.S.

The common thread for us among all of these energy efficiency standards is of course magnet wire. As you know, the increased use of magnet wire improves the energy efficiency of all of these types of motors and many more. As a result, demand for the magnet wire product that we manufacture across the energy and motor markets is going to be positively impacted by these critical regulations and trends.

From an environmental perspective, higher electrical energy efficiency through the use of magnet wire means lower energy usage, lower fossil fuel consumption and lower greenhouse gases. The economic benefits associated with more energy-efficient equipment are obvious: lower operating costs and improved reliability mean lower utility bills and fewer maintenance issues.

So while we anticipate positive long term macro demand drivers for our magnet wire products, we are also working on internal improvements and have put cost efficiency at the forefront of our corporate goals. We believe it is imperative to be strategically prepared when the economy recovers and to have the most cost efficient manufacturing network in place.

To that end, globally, we have several initiatives which we have announced that are currently in progress. In North America we are in the midst of a factory consolidation and phased closure of our Vincennes, Indiana facility. While we will see some benefits from this project in the latter part of this year, the total benefits, which we estimate at 7 to $9 million annually, should be fully realized in 2009.

And in Europe, we have initiated discussions with the appropriate French employee representative bodies for the potential closure of our manufacturing facility in Chauny, France. We expect to reach a successful resolution that will be to the satisfaction of all the parties involved.

In our communications cable business segment, we have proven our ability to manage our profitability and assets through a difficult economic cycle. This group has carefully managed inventory, decreased scrap and achieved targeted process and material improvements over the past year.

These efforts have clearly paid off, as evidenced by the significant margin growth realized over the past 12 months. In addition, communications has continued to target favorable product and customer mix, which has also contributed to growing profitability despite sluggish revenue performance.

Turning back to our near-tem results, while for the most part overall organic demand trends are weak, we did experience growth in certain key end markets. In North America we saw strong demand for high voltage power transformer products. also saw growth in the high voltage power distribution sub-segment as compared to last year. And this trend is expected to continue. Our industrial end market appears to be stable. But while our residential and commercial and automotive markets await their recovery, we will continue to refine our end market focus and mix. In Europe, while residential does not have the same impact as in the U.S., we are seeing the effects of softer end market demand.

In Asia Pacific, the story is a little different. The automotive end market segment is the fastest growing. It is every day another 1,200 cars hit the roads in Beijing alone. We are also seeing customer growth as four of our top five customers are in the midst of construction expansions. As they plan to nearly double capacity, we expect to grow with them.

Meanwhile, in our communications cable business segment, we have continued to experience a decline in copper OSD products in North America, although this quarter’s results were compared to unusually strong first quarter results of last year. As a result, the expected soft economic conditions in depressed residential construction will continue to challenge us until an economic turnaround is seen, but albeit at a slower pace than we saw this quarter.

As I previously indicated, we are not yet seeing any signs of a recovery in the residential end market which impacts both our magnet wire and our communications cable business segments. Although it is fair to say that we are also not seeing any further dramatic declines. In addition, we should be one of the first companies to participate in the upswing when that ultimately occurs.

Our unique position at the front of the supply chain means that while we were the first to feel the impact of the housing crisis, we will also be the first to experience the benefits of a return to a more normal construction environment. As a result we are focusing our current efforts on the long term. We are investing in targeted end markets with better demand characteristics. We are streamlining our operations so we can benefit from better absorption.

And we are continually striving to make our cost structure and our products better. Over the course of the year we look to our end markets being generally weak but stable with occasional bright spots. We will continue to creatively and strategically manage our cost control efforts. And we have good prospects in place and ready for when the recovery comes as we have made key investments in targeted facilities and product areas.

We expect these efforts to result in positive benefits to our company as a whole. So as we look at the second quarter, we generally see a continuation of the trends experienced in the first quarter with weak organic demand in North America and Europe. That organic slowdown will be offset by acquisition impact, although to a lesser degree than in the first quarter.

Due to the timing of the Canadian purchase, we will experience only one month of contribution of this acquisition in the second quarter of 2008. Based on these factors, our second quarter outlook includes core business copper adjusted revenue growth of around 10% with adjusted EPS expected to increase 15 to 25% over the prior year. And with that, I will turn the call back over to the operator for our Q&A.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from the line of Curt Woodworth from JP Morgan.

Stephen M. Carter

Good morning, Curt.

Warren Chiang – JP Morgan

Hi. Good morning. This is Warren Chiang on line for Curt.

David S. Aldridge

Hi, Warren.

Warren Chiang – JP Morgan

Hi. I was wondering, the margin improvement that you saw this quarter, could you give some color on the breakdown between how much of that was base business versus acquisition integration?

Stephen M. Carter

Well, certainly there was a – to some extent, the acquisitions brought in some higher margin product sales that influence the results. But I would say that equally, perhaps even more so, the product mix shift that we are seeing in our communications business, and indeed in our existing magnet wire business, towards some of the higher margins sectors has probably influenced the margin percentage more.

Warren Chiang – JP Morgan

Okay. And looking forward, how much more room to run UST from each with the base business and additional business accretion.

Stephen M. Carter

Well, we continue to believe – I said in the script that we have got two major projects underway in terms of looking at our factory network, assuming that both come to fruition successfully, we do expect it to be up to produce more efficiently. And every time that happens, it is helpful to the margin. The other thing that we continue to work on very hard is assessing which are the product segments where we want to make investments.

And I think in communications, we have said before, that we are seeing a steady transition there from the old OSP products into the, for us at least, the newer data cable segment and the higher product areas within that segment.

Warren Chiang – JP Morgan

Okay. I was also wondering, how do you see pricing for magnet wire holding up in the current environment for the next few months?

Stephen M. Carter

Well, I think it will be very similar to the last few months, which that is there are some segments which are in high demand where capacity is struggling to keep up with that demand. And as a result, as you would expect, pricing is very tight. And then you have got some segments where the demand is weaker, factories have got spare capacity. And thus you are seeing a weaker negotiating position for pricing.

But bear in mind that, generally speaking, magnet wire, in the main is on a contract basis. So you should not expect and shouldn’t model dramatic shifts in pricing in magnet wire outside of the distribution side where it is more of a spot pricing. Generally speaking, as you know, in Europe we are on annual contracts. And in the U.S. it is usually multi-year contracts.

So these things tend to take place over a longer period of time and are not really dependent on a one quarter experience.

Warren Chiang – JP Morgan

Do you have a distribution for the amount that is locked in versus on a spot basis?

Stephen M. Carter

Well, our distribution business in the U.S., which is where we have most of our distribution business for magnet wire, it represents about 20% of our U.S. magnet wire volume.

Warren Chiang – JP Morgan

Okay. That’s all I have. Thank you.

Operator

(Operator Instructions) Your next question comes from the line of David Woodyatt with Keeley Asset Management.

David Woodyatt – Keeley Asset Management

Yes, you attributed the very excellent earnings gain to acquisitions and cost-reduction activities. You also mentioned currency effects of the tax rate reduction which we can sort of figure out ourselves. But I was wondering if you could give us a little more detail on how the benefits of acquisitions, cost reduction activities, and currencies contributed to the 50% earnings gain.

Stephen M. Carter

Well, good morning to you. Well, clearly, I think the tax effect you can probably calculate relatively –

David Woodyatt – Keeley Asset Management

I can figure that out.

Stephen M. Carter

Yes.

David Woodyatt – Keeley Asset Management

But those other three items, I was wondering if you could give us a clarity on the relative of at least some order of magnitude feeling for how the other three items contributed to the earnings.

Stephen M. Carter

Yes. The main foreign currency change would be with regard to Europe, really.

David S. Aldridge

Actually, there are two pieces to that as well. This is David Aldridge. We had the benefit of converting the net income from our European setup at a higher rate than last year. And if you look at the rate differential that adds around $.02 to $.03 a share to the results; however, also within our – if you look at the other expense charts for the quarter of about 1.2 million, we had some foreign exchange losses in there due to the high degree of volatility of the dollar versus the euro as we hedged certain currency positions through the normal commercial aspects of our business.

And actually, there was about a 600,000 pre-tax charge related that. So I’ll attribute that to currency, too. After tax, that’s about $.02. So if you look at really the full impact of the currency, that doesn’t take into account the negative economic effect in Europe of some of the stronger euro and some of the import and export markets.

So if you truly look at the bottom line, take all of the currency factors and combine them, what – I think is the appropriate way to look at currency these days, as volatile as it is, it was really a neutral impact on the bottom line.

David Woodyatt – Keeley Asset Management

Okay. Well then on the tax we can figure, which is not that significant, so that leaves us with acquisitions and cost reduction activities. Normally, I would not think the mathematics of the acquisitions would have contributed that much. So that would leave most of the gain reading from cost reduction activities. Is that a fair statement?

Stephen M. Carter

But the acquisitions represented a –

David S. Aldridge

Very accretive.

Stephen M. Carter

They were all quite accretive acquisitions. And this first quarter we benefited from the fact that there were none of those acquisitions in the first quarter last year. So unlike the rest of this year where at least one of the acquisitions existed for most of the second quarter last year, this first quarter, actually, we had the benefit of almost – what is it – 400 million or so of revenue annually?

David S. Aldridge

Well, a run rate. Yes. Right.

Stephen M. Carter

Run rate annually in contributing to the bottom line. But I don’t want to dissuade you from the fact that we have worked extraordinarily hard to try and contain costs in this rather tough economic environment. And so I am very pleased with the on balance the way the results have shaped.

David Woodyatt – Keeley Asset Management

Okay. A related question I have is this situation where you shifted it looks like about $58 million of copper rod revenues. And you have used the copper internally; whereas, previously when you sold the copper rod, I gather you didn’t really make any money at that. How much of your earnings gain, roughly anyway, came from that strategic move?

Stephen M. Carter

Well, I think that it is more – I mean it is an important move from the balance sheet point of view as much as anything else. As you say quite rightly, we always regarded copper rod as just the sale of our excess copper rod. It was always a more or less a break-even figure, so in that sense we didn’t have any less margin. And we do, obviously, by supplying it to ourselves enjoy certain number of savings over and above buying it externally.

But I think as you look at that switch, probably you should look in terms of the benefit to the balance sheet and the working capital that we are saving by not having to process it, hold it as inventory, and then sell as a receivable to external customers.

David Woodyatt – Keeley Asset Management

So that did not contribute materially to the 50% earnings gain?

Stephen M. Carter

No. Not materially. That would have been a very minor thing. But it is an efficiency area where it gives us better control over a portion of our raw material input. And it – as I say, it is a working capital strategy to ensure that we are squeezing the balance sheet as hard as we can.

David S. Aldridge

Probably the biggest impact it had on the first quarter was shielding us from what would have otherwise would have been a bigger increase in working capital due to rising copper cost.

Stephen M. Carter

Yes.

David S. Aldridge

Because we have taken some copper exposure out of our networking capital by not having that – those extra copper panels in the inventory or the receivables chain.

David Woodyatt – Keeley Asset Management

Okay. One final related question. Was there anything in the – either in your inventory, the technicalities of inventory accounting, or anything else that allowed you to actually benefit from the increasing copper price during the quarter? Did anything along those lines contribute to the earnings gain?

Stephen M. Carter

Nothing unusual at all.

David S. Aldridge

I mean we did call out thein the script that we had a million dollar copper derivative gain in our China operations. Other than that, actually, the impact of copper was slightly negative in the communications cable business during the quarter, so that – there were no other major copper items that affected the results of inventory or otherwise.

David Woodyatt – Keeley Asset Management

Good. Well, congratulations on a great quarter.

Stephen M. Carter

Thank you very much.

Operator

(Operator Instructions) Your next question comes from the line of Chris Bamman with Morgan Joseph.

Chris Bamman – Morgan Joseph & Company

Yes. Good morning.

Stephen M. Carter

Hey, Chris.

Chris Bamman – Morgan Joseph & Company

Just a quick question regarding your communications segment, are you seeing anything from the non-res side that is benefiting the [inaudible 41:51] cable that there is an actual slowdown. So while volumes might be down a little bit even though your margins are still holding up. Are you seeing anything of that?

Stephen M. Carter

I don’t think we have seen anything dramatic there. I think it has been a continuation of the trend of the move to higher broadband-capable products. And with that, a move up the value chain in terms of the sort of margin you can gain from those products. But no real major shifts from last quarter in terms of the demand characteristics.

Chris Bamman – Morgan Joseph & Company

Okay. That’s pretty much all I had for right now. Thank you.

Stephen M. Carter

All right. Thank you.

Operator

(Operator Instructions) At this time there are no further questions. I will now turn the call back over to Ms. Tharp for any concluding remarks.

Peggy Tharp

We would like to thank you all for joining us. And we look forward to having you on our second quarter earnings call some time this quarter. Good day.

Operator

Thank you for participating in today’s Superior Essex first quarter earnings call. You may now disconnect.

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