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Matson, Inc. (NYSE:MATX)

Q2 2012 Earnings Call

August 2, 2012 4:30 pm ET

Executives

Phyllis Proffer – Investor Relations

Matthew Cox – President and Chief Executive Officer

Joel Wine – Senior Vice President and Chief Financial Officer

Analysts

Michael Webber – Wells Fargo Securities

Jack Atkins – Stephens Inc.

Ian Zaffino – Oppenheimer & Co.

Mick McGuire – Marcato Capital Management

Stephen O'Hara – Sidoti & Company

Operator

Good afternoon and will come to Matson’s Second Quarter Earnings Call. For your information, all participants will be in the listen-only mode during the company’s presentation. There will be an opportunity for you to ask questions at the end of today’s presentation. (Operator instructions)

I would now like to turn the conference over to Phyllis Proffer, Investor Relations for Matson, Inc.

Phyllis Proffer

Thank you Denise. And welcome to our first earnings conference call as Matson, Inc. Joining me today are Matt Cox, President and CEO; and Joel Wine, Senior Vice President and CFO. Slides from this presentation are available for your download at our website www.matson.com under the investor relations tab.

Before we begin, I would like to take this opportunity to remind you that during the course of this call we will make forward-looking statements within the meaning of the Federal Securities Law regarding expectations, predictions, projections or future events.

We believe that our expectations and assumptions are reasonable. We caution you to consider the risk factors that could cause actual results to differ materially from those in the forward-looking statement, in this news release and this conference call.

These risk factors are described in our news release and are more fully detailed under the caption risk factors on pages 19 to 29 in the 2011 Form 10-K filed by Alexander & Baldwin, Inc on February 28, 2012, and all of our other subsequent filings with the SEC. In addition, please note that the date of this conference call is August 2, 2012, and any forward-looking statements that we make today are based on our assumption as of this date.

We undertake no obligation to update these forward-looking statements. Now it is my pleasure to introduce Matt Cox.

Matthew Cox

Thanks and hello all from Honolulu. Today is another milestone for Matson as we report our financial results for the first time after our successful separation from Alexander & Baldwin. We now have our own headquarters in Honolulu, and recently launched our own corporate giving program called Matson Foundation, district of Hawaii, Guam and the mainland.

This confirmed our commitment to supporting the communities in which we live and work. Another highlight for the quarter was the positive reception we received in both the debt and equity markets as we put in place new debt agreements in May, and met with prospective equity investors in June.

Our common stock began trading under the stock symbol MATX on the NYSE on July 2, and perhaps most importantly, we have accomplished all this while maintaining our focus on our core operations. As shown on slide five, Matson’s operating income for the quarter increased 11.3% to $32.5 million compared with $29.2 million last year. Operating income for the first six months of the year was $38.6 million compared with $35.9 million last year, an increase of 7.5%.

Our operating income improved year-over-year despite one-time separation costs of $5.8 million in the second quarter, and $8.3 million for the first half of 2012. The improvement was primarily due to performance of our ocean transportation unit as we will show on the next slide.

On slide six, ocean transportation operating profit increased approximately 15% compared with the second quarter and first half of the year despite the $5.8 million in separation costs for the quarter and $8.3 million for the first six months of the year.

Supporting the year-over-year positive comparison was an increase in Guam volume and improved freight rates in China, partially offset by volume declines in Hawaii, and lower contribution from our SSAT joint-venture due to fewer container lifts compared with last year.

SSAT is included in the operating profit for ocean transportation and is shown as a contra expense on our consolidated income statement. I will now talk about each trade lane. On slide seven, in Hawaii service, container volume was down nearly 5% in the quarter owing primarily to three factors. Firstly, we continue to see a modest decline in the overall Hawaii market with the lack of construction activity among the most significant drivers of lower volume.

Secondly, some non-US origin cargo that was typically delivered to the US West Coast, then carried by Matson or our competitors to Hawaii has converted to foreign direct. This cargo, a portion of which is carried by Matson direct on our China service is now accounted for us as an increase in our China volumes, and thirdly, we are experiencing some competitive pressure on selected commodity types, which have also negatively impacted our Hawaii volume.

Order volume was down almost 12% primarily due to the timing of rental fleet replacement. For the second half of 2012 we now expect relatively flat to modestly lower container volume compared to last year, which is in part a result of the freight conversion I just described, and in part the lack of construction activity, which we do not expect to improve this year.

Our view of Hawaii volumes is influenced by some of the key economic indicators, which are shown on the next slide. The table on slide eight indicates the Hawaii economy GDP. That has been improving, and it is expected to continue to improve but nevertheless

Construction in the state of Hawaii has not yet rebounded which is in part suppressed our Hawaii volumes.

This chart highlights construction jobs as proxy for construction spending because we found that the jobs measures coupled with this other data to be the most correlated with our actual freight volumes. Historically we track building permits as a key indicator, but have found construction jobs to be a better indicator.

On slide nine, in Guam, we continue to benefit from the exit of a major competitor from the trade last November, which explains the significant increase in volume year-over-year. This increase in Matson volume had some moderate contraction in the overall market itself. Expansion in this trade will occur when construction related to the relocation of the 5000 marines from Okinawa to Guam occurs. However, we currently don’t see any signs of a near term start up to the buildup.

We expect Matson’s increased volume in Guam to continue into the second half of 2012 unless a new carrier enters the trade lane. We do expect another competitor longer-term but it is difficult to predict the timings in the shorter term. On slide 10, Matson’s ship remained full in the China service and we were pleased to see that the improvement in freight rates achieved in the first and second quarters remain largely in place as a result of capacity management by carriers in this trade.

The chart on the upper right-hand corner of the slide reflects the rate increases taken in this trade during the first half of the year. It is the Shanghai containerized freight index and captures industry spot rates. Our China business is about half on the spot rate market and about half under annual contract.

Also the freight conversion from Hawaii to China service I mentioned earlier improved our volumes in the first half. We also benefited from opportunities to optimize our yields through cargo selection. For the remainder of the year in the transpacific, we expect to run our China ships at full capacity. Freight rates are expected to continue at approximately the level experienced in the second quarter through the peak season in mid October. Then we expect a modest decline in freight rates following the peak season when the industry enters its traditional slack season.

From a macro perspective there is currently a surplus of container vessel capacity in the world international container market relative to demand. Sustaining current transpacific freight rates primarily depends upon rational industry wide carrier management of vessel capacity, and secondarily on the strength of the US economy.

On slide 11, while we are encouraged to see Logistics continued sequential improvement in operating profit in the second quarter, the profits were lower than last year resulting from a decrease in highway revenue, primarily in the full truckload service segment and lower warehouse results due to our northern California operations.

Our domestic intermodal business was up in the quarter, but was offset by lower International intermodal volume due to the discontinuation of our CLX2 service last year and the loss of a major international customer. Second half 2012 performance for this segment is expected to be flat to modestly lower than last year, and will be dependent upon improved Northern California warehouse operations, and also improvement in the US mainland economy, allowing for at least a modest peak season.

The logistics management team remains focused on expansion and improvement at the warehouse facilities, organic growth in the intermodal and highway business and the roll-out of a domestic 53 foot container pilot program to improve profitability in this segment. Now let me turn the call over to Joel for a review of our financial performance and outlook.

Joel Wine

Thanks Matt. On slide 12, let me start with an update on the separation because it had a significant impact on our financial results in our year-over-year comparisons. Due to the structure of the separation, A&B's financial results are reported as discontinued operations on our consolidated financial statements, which had a negative impact on our net income results for the quarter.

Additionally, the non-recurring costs related to the separation were $5.8 million for the quarter and $8.3 million year-to-date. These costs are in line with the range we provided previously and were primarily related to outside professional fees, and registration fees. Slide 13 is a summary of our unaudited income statement for the quarter. Total consolidated revenue for the quarter was $394.2 million, a 4.5% increase over last year. Revenues increased due to our ocean transportation segment.

Operating costs and expenses increased primarily due to higher costs in our ocean transportation segment, due primarily to higher fuel costs, higher outside transportation costs and higher terminal handling costs. Income before taxes for the quarter increased on a year-over-year basis despite the added separation costs. But our effective tax rate increased significantly for the quarter to 50%, which reduced our reported income from continuing operations.

I will talk more about the tax rate in a moment. Net income for the second quarter of 2012 was $7.8 million, or $0.18 per diluted share, including the $4.8 million of after-tax costs related to the separation from A&B. And this compared with net income for the second quarter of 2011 of $18.7 million, or $0.44 per diluted share.

Net income was reduced by a 7.5 million loss from discontinued operations for the quarter, which I would like to highlight in detail on slide 14. In the table on slide 14, you can see a summary of our unaudited income and losses from discontinued operations for the second quarter and first half of 2011 and 2012.

The CLX2 operations have been fully shut down at this point, and all charted vessels have been returned to their owners. The negative effect of CLX2 for the quarter was $1.4 million, and going forward we do not expect any material losses in discontinued operations from CLX2.

Since A&B is being accounted for as discontinued operations on Matson’s financials, A&B's unadjusted GAAP reported loss for the quarter of $4.4 million flows through Matson’s income statement as a loss from discontinued operations. Going forward with the separation transaction having been completed, there will be no impact from the A&B operation in future periods for Matson, but all historical periods will show this A&B related line item under discontinued operations.

So in summary, we do not expect any material amounts in recorded discontinued operations in the future from either CLX2 or A&B. Consequently income from continuing operations as reported per GAAP on our financial statements is an important measure of the operations that comprise Matson going forward. This is highlighted on slide 15.

Our income from continuing operations for the second quarter was $15.3 million or $0.36 per diluted share, which compares to $17.7 million or $0.42 per diluted share last year. As a reminder, income from continuing operations for the second quarter of 2012 was negatively impacted by two significant items in the quarter. First the previously mentioned separation cost, which had a negative $4.8 million after-tax effect and secondly we experienced the significantly higher tax rate when compared to last year due to the separation.

This high effective tax rate is highlighted on slide 16, which was 50% in the second quarter of 2012, which caused the rate to be 50.1% for the full first half of 2012. The rate was higher than our previously estimated normal course effective tax rate of 30.8% due primarily to certain separation related transaction cost incurred for which we recorded no tax benefit, and the non-cash remeasurement of uncertain tax revisions required as part of the separation tax accounting treatment.

Going forward, we expect the effective tax rate to be approximately 30.5% for the third and fourth quarters of 2012, which is in line with our previously stated normal course effective tax rate.

Turning to cash flow highlights on slide 17, cash flows provided by operating activities were $25.4 million for the six months ended June 30, 2012, which is relatively consistent with the same period last year. Cash from investing activities was a positive $9.7 million this year compared with a negative $10.7 million last year due mainly to a required accounting entry of contributions from A&B that are shown on the cash flow statement of our press release.

These amounts were $26.7 million in 2012 and $16.3 million in 2011, and resulted mainly from Matson being RemainCo entity for accounting purposes under GAAP. Importantly within this investing section of our cash flow statement Matson’s capital expenditures for the six months of this year were $17.5 million compared to $27.9 million last year.

Moving down the slide, cash provided from financing activities this year were roughly flat at a negative 200,000 primarily to $173.4 million in net debt borrowings, which were mostly offset by the distribution of $156.1 million to A&B upon separation.

Lastly Matson’s cash flow statements also include the historical dividends paid amount of A&B given that Matson is RemainCo for accounting purposes. These amounts are not indicative of Matson’s dividend going forward because as we previously announced Matson’s board of directors declared a third-quarter cash dividend of $0.15 per share payable on September 6 this year, which will amount to an approximate $6.4 million quarterly payment.

Turning to the next slide on 18, Capex for ocean transportation for the first two quarters of this year has been relatively consistent between $8 million and $9 million and have totaled $17.2 million here today. Our Capex plans for the remainder of the year fall in the range of approximately $22 million to $32 million, heavily weighted towards ocean transportation, which would bring our total Capex spend for the year to be in the range of approximately $40 million to $50 million, which is in line with what we have previously stated we expect our annual maintenance Capex to be.

Lastly given this quarter included a number of non-recurring cash outflow items related to separation, we also wanted to highlight for investors the total cash outflow to Matson incurred. The chart at the bottom of this slide shows that we incurred total cash outflows of $166.3 million in relation to the separation, which are comprised of three components. The capital distribution to A&B of $156.1 million, the primary purpose of which was to implement the allocation of the former parent company’s total debt, 60:40 between Matson and A&B. This contribution was made at the end of June.

Secondly, separation costs (inaudible) commented on earlier. We do not expect any material separation costs going forward. And lastly, capitalized debt issuance costs of $1.9 million related to Matson’s previously announced financing transactions completed during the quarter.

Turning to the balance sheet on slide 19, the two balance sheet periods shown on this slide are not necessarily apples to apples because the 12/31/2011 data includes the assets, liabilities and shareholders equity of A&B. For the June 30 reporting period and going forward A&B's balance sheet amounts will no longer be included. As you can see the assets and liabilities of A&B have not been included in the June 30 data. Additionally Matson’s shareholders equity account has been reduced for the removal of A&B's historical book equity, which includes the impact of the $156.1 million contribution to A&B I previously mentioned.

The other important balance sheet item that changed significantly was our debt capitalization, which is highlighted on slide 20. Here you can see Matson’s debt balance at the end of the quarter was $372.8 million as new debt was raised to fund the contribution of payment to A&B. Our debt at the end of the quarter consists of the $72 million drawn on the company’s revolving bank facility, and $300.8 million of long-term funded debt. Our key credit statistics at the end of the quarter were healthy, at a debt to EBITDA ratio of 3.2 times, and an EBITDA to interest coverage ratio over 20 times.

Now I would like to summarize our outlook for the remainder of 2012 on slide 21. Ocean transportation operating profit for the second half of the year is expected to modestly better than last year. However, our operating profit for the third quarter will be negatively impacted by the timing of ship and barge dry dockings, and other expense related items compared with last year. Both of these operating profit comments for the remainder of the year and the third quarter include the full effect of our expected $8 million to $10 million of incremental annual corporate expenses, but exclude the $7.1 million of CLX2 related expenses that were not classified as discontinued operations in the second half of 2011.

Matson Logistics operating profit for the second half of the year is expected to be flat to modestly down compared with last year. We do not anticipate any material impact from separation costs or losses from discontinued operations for the rest of the year, and going forward we expect our effective tax rate to be approximately 30.5% for the third and fourth quarters in 2012.

Now let me turn the call back over to Matt, who will provide some closing remarks before we open the call for Q&A.

Matthew Cox

Thanks Joel. On slide 22, in summary, our financial results for the quarter were mixed. For ocean transportation, our long-term goal is to return to operating margins in the 10% to 12% range on an annualized basis and we’re not there yet. For logistics, while we’re seeing some favorable growth trends in new initiatives in our business, we are not yet producing the profit levels of 2% to 4% that we expect longer term from this business.

However, having achieved our separation transaction we remain confident about our prospects as a stand-alone company. Overall the company remains financially strong and our businesses are well positioned to participate in the Hawaii and overall US economic recovery.

That concludes our prepared remarks today, and the call is now open for any questions you may have.

Question-and-Answer Session

Operator

Thank you Mr. Cox. (Operator instructions) Our first question will come from Michael Webber of Wells Fargo. Please go ahead.

Michael Webber – Wells Fargo Securities

Hi, good morning guys. How are you?

Matthew Cox

Good morning Mike.

Michael Webber – Wells Fargo Securities

Sorry. Good afternoon. Just wanted to jump in with a couple of questions, and maybe just jump right into the segments here, within ocean France, that margin came in a bit better than we had expected, and better on a year-over-year basis, can you talk a little bit – give me a little bit more color around those margins in the second quarter and then maybe some color in terms of how they are trending so far in Q3 and Q4, whether we should see some sequential improvement in Q3, give us little bit of color there?

Matthew Cox

Sure. I can do that. I think we were pleased in the quarter by the strength in the China freight rate environment that as we have been talking, there continues to be an industry wide overhang of [muscle] capacity, but the international ocean carriers really made a determined effort to get freight rates up, and had done a good job, a little better than we expected overall in that trade and margins improved somewhat in the second quarter related to the China rate environment.

The other thing that has happened we didn’t touch on it too much, but our volumes, our ships in China were effectively full for the quarter. What is interesting and what is happening is there is an unusually strong amount of demand in the expedited segment of the market in part owing to retailers shortening their lead times, and requiring many customers to use our expedited service rather than more traditional slower ocean freight grade services.

So there was terrific demand for expedited services. In Guam, of course we continue to benefit as we expected. There was no announcement or start-up of another service and we benefited from that additional volume, and then of course Hawaii has been flattish, and we are – we talked about the reasons for that. All of that really did translate into good margins. As you know there is a strong seasonal component to Matson’s business, the second and third quarters are the best two quarters of the year, with the fourth and first being our weakest two.

So we did expect some margin improvement for the second and third quarters. Moving forward to the other part of your question, Mike, we do see as we said Joel pointed out that in the second half of the year some improvements year-over-year in our operating results in the second half, although we wanted to note a bit more cautious tone in the third quarter relative to just the timing of dry docks and there is some incidental expenses associated with our dry docking periods. But as I said, we do remain confident that second half will show some modest improvements year-over-year.

Michael Webber – Wells Fargo Securities

Got you. Okay, I guess two follow ups to that that margin question, I guess one for you Matt and one for Joel, I mean you mentioned that the significant amount for the expedited service and you know there is certainly an expectation that we are going to see rates roll over I guess after peak season, and probably not to the degree we saw in 2011, but can you talk a little bit about how elastic you think or inelastic that expedited demand might be in the back half of the year, and kind of related to that you know most of the weakness we have been seeing has been more Asia, Europe centric, Transpac rates have held in better than most, maybe a little bit of color there in terms of (inaudible) the better?

Matthew Cox

Yes, I mean, those are two good observations. I would say as it relates to the demand for expedited services, I think while there continues to be a lot of uncertainty in retailers’ minds that uncertainty translates into keeping as little inventory as they can, which we think translates into increased demand for our expedited products.

So, we’re reasonably comfortable that given our transit advantages we are going to see relatively decent demand through the balance of this seasonal cycle. As it relates to the Transpac your observation again is rather a good one where we are seeing overall industry utilization now in the Transpac at 90% in the low 90s, it is being reported. It is lower in Asia Europe. It is reportedly to be in the 80s. The carriers on the Asia Europe side have had more problems in trying to get the favorites up, and in many cases it is the same carriers.

I think part of the problem is much of these very large mega container vessels are required to be deployed into the Asia Europe market because those are the markets that have the facilities to accommodate those large vessels. And it is that overhang of additional capacity that is required to go into the Asia Europe trade that could be part of the reason why carriers have been more successful on the Transpac and Asia Europe.

Michael Webber – Wells Fargo Securities

Got you. Now that is very helpful, and not to spend too much time on the margin there, but Joel, you are still running through the numbers and making it all work, it came out after the close, but are those separation costs that you guys called out, are those embedded in that margin figure that 10.3?

Joel Wine

Yes, they are. They are embedded and allocated to the ocean transportation segment.

Michael Webber – Wells Fargo Securities

Got you. Do you have an x number there, if we took those out.

Phyllis Proffer

We have after-tax.

Matthew Cox

Yes, in the materials we commented both to the pre-tax and after-tax. So 5.8 is pre-tax and 4.8 is after-tax.

Michael Webber – Wells Fargo Securities

Right. Ex – I could follow up off-line. Just trying to get the margin kind of ex-those embedded costs.

Matthew Cox

You can just add that right to the operating profit number that we reported and use the same revenue number, and that will give you the number.

Michael Webber – Wells Fargo Securities

Yes. Okay. Matt, just one more from me and I will turn it over, you know, you mentioned the stronger volumes you guys were seeing in Guam, and you have obviously had a major competitor leave, when you think about new entrants into that trade, how do you think about it in terms of timing, and then you know that is a US flag trade. I mean, you were thinking that is going to be a pure Jones Act carrier, or are you going to see US Flag or someone else try to come in and compete in that trade.

Matthew Cox

Yes. First of all it is hard to know precisely. So I will speculate a little bit. As you rightly pointed out it is a US flag trade not a Jones Act trade, and so to us it seems more likely that a US flag operator would seek to start a service than a Jones Act operator. And as you pointed out, it is the two main existing operators in the Transpac today that operate in the container business, are Maersk Line, which has a US flag subsidiary, and APL, which has a US flag subsidiary.

So it seems most likely to us that one of two of those carriers may eventually come in. It is really difficult to tell on your question on timing. Perhaps it maybe as we get closer to seeing a catalyst around the construction activity related to the relocation of the marines from Okinawa, but in some ways it is surprising that it hasn’t already occurred. So it is just really hard for us to get visibility.

As to lead time, it is relatively straightforward matter for either of those carriers to charter a non-US built vessel, and put it under the US flag and operate a feeder service over one of their US flag relay ports in Asia. So, we think the time constraints in lead times is relatively short should one of them decide to jump in.

Michael Webber – Wells Fargo Securities

Got you, all right. And I wanted to ask one more question, but in the last couple, actually today or yesterday we saw a pretty high profile Title 11 financing application get the nod, and we saw a couple or more earlier this year. As a program you guys have used successfully in the past, you know, can you maybe give some color about what would separate you all from some of the applications (inaudible) and then I guess has anything within that program changed to the point where you have got to start maybe backing that out of your term metrics when you look at starting to renew your fleet, and then kind of the benefit with that low cost long-term debt?

Matthew Cox

Yes. I will comment on this. Mike, this is Matt, and then I will turn it over to Joel if he wants to add something. But from my point of view this reinforces one of the fundamental tenants of Matson’s initial positioning, which is to remain investment grade, because what it allows us to do is to have multiple options to finance the vessel replacement program that we had talked out wanting to put in place in the next three or five years.

And so it maybe that because we’re investment-grade, our application around our vessel replacement program would-be seen more favorably than perhaps other applicants who have submitted applications. But secondly and importantly, it doesn’t require us to use Title 11 in order to finance our vessel replacement program. So – and there have been times depending on the bank markets and lending markets where in fact one of our last 4 vessels that we built in the Jones Act was actually more competitive for us to finance on the non-Title 11 side than on the Title 11 side.

So we also have reason to believe that our application would be received favorably, but you know to the extent that that program were not to be available, we are not sweating that at all given again the orientation towards investment grade credit, and I don’t know Joel if you wanted to add to that?

Joel Wine

No, I think that is exactly right Matt, and there has been no fundamental change Mike to the program that would lead us to think about things differently economically at this point. But I would also say we’re still in the early planning stage for process. We’ve talked about how that is going to be an important activity over the next 18 to 24 months. We got plenty of time to adjust our financing programs and overall financing plans depending upon how the next couple of years play out. But we will have all the flexibility that Matt mentioned.

Michael Webber – Wells Fargo Securities

Right. That is really helpful Matt. Thank you for the time.

Operator

Our next question will come from Jack Atkins of Stephens. Please go ahead.

Jack Atkins – Stephens Inc.

Right. Thank you guys and congratulations on a good quarter and being a public company now.

Matthew Cox

Thanks Jack.

Jack Atkins – Stephens Inc.

So I guess first off here just kind of touching on the margin issue on the ocean transportation business for a minute, I mean if you back out the separation cost from ocean transportation, it sounds like your margin in that business sort of minimal what 12.4% this quarter, is that right?

Matthew Cox

Adding back Jack what item?

Phyllis Proffer

(inaudible)

Jack Atkins – Stephens Inc.

Well, adding back to the separation cost, is that correct? Add it back there, or do you add it back on the corporate line?

Matthew Cox

No, add it back there. That is correct.

Jack Atkins – Stephens Inc.

Okay. So 12.4% and that is as we talked about a great margin. And typically margins ramp sequentially from the second to the third quarter around. Now you have some dry docking going on, but is there any reason to believe that we should see at least, you know, a similar type of margin in that business in the third quarter, or do you expect the dry docking to have a material negative impact there?

Matthew Cox

We don’t think it will be material and what we are saying is that it is going to be an impact though Jack. But it is not going to be a material impact. We still expect third quarter to be strong. We are not commenting on exactly where it is going to come in from a margin perspective, but what we are saying is that there is going to be some costs embedded in this third quarter that we did not experience in the same quarter last year, and that is going to have an effect when you look at year-over-year comparisons for the quarter.

Jack Atkins – Stephens Inc.

Okay. I got you. I got you and then Joel, for your comment on operating income in 3Q 11, could you just give us the figure that you are using there, just to make sure we’re all on the same page.

Joel Wine

Well, the operating profit number for the company is comparable on a year-over-year basis. The comment I made was on income from continuing operations, and that is a lower item below operating profit. So, it is going to be a number after expense and a number of other items. So, the most comparable year-over-year is operating profit, you can still go with that, but that income from continuing operations is going to be the clean number that reflects the business going forward.

Jack Atkins – Stephens Inc.

Okay. I got you. I got you. Sorry about that confusion. And then Matt I am just kind of curious on the utilization rate in the Hawaii service in the second quarter, where does that stand today just out of curiosity?

Matthew Cox

Yes Jack. We operated in the second quarter at about mid-90% utilization, about 95%.

Jack Atkins – Stephens Inc.

Okay.

Matthew Cox

For the quarter, and what that does 95%, effectively it is very difficult to get to 100% and what you find is you are spending a lot of efforts moving freight around because it isn’t always delivered in packages that are easy to accommodate. So, we are spending a little bit of money trucking it up and down the coast to be able to accommodate. But part of our operating margin improvement despite a weaker Hawaii overall environment is the fact that we are able to operate a nine-ship deployment and operate it relatively full during the quarter.

Jack Atkins – Stephens Inc.

Sure, absolutely. So when you think about that 95% utilization rate, I mean what are some of the considerations about maybe adding a tenth ship there. It doesn’t sound like Hawaii volumes are all that robust, but I mean at what point do you maybe need to put a tenth ship into the fleet?

Matthew Cox

Yes, I mean, it is a good question, one which we watch all the time Jack, and our view is absent a catalyst in the Hawaii market, which we don't see, our goal would be to stay in this nine ship deployment. We’ll obviously to the extent that as time passes if we start to see a different freight pattern emerge in Hawaii that will be the thing that you know, requires us to take a look at it.

I would say just as a small note that there will be times because of dry docking that we do break into a ten-ship during brief periods of time as we do dry dock relief, and those kinds of things, but as we think about our core deployment as I said we see ourselves in nine-ships until we see a different market, which we haven't yet seen.

Jack Atkins – Stephens Inc.

Got you, and when we think about the China service, I mean, I think most of the upside [versus] our forecast was really driven by I guess a better rate in that Transpac lane, (inaudible) like you said I think the carriers did a very good job keeping capacity rationalized. So, I mean, going forward I know the average rate from [fleet] in the second quarter was about $2400 an FEU. Is that around the number we should use for the third quarter.

Matthew Cox

Well, I think without commenting on the [rate] I think our own internal calculation is we should use about the same rate that we saw in the second quarter. So embedded in that you may note that in the TP Jack a number of carriers are looking to put another GRI or peak season surcharge in place mid-August. We will be watching that with interest but our view is that given the supply and demand fundamentals we are about at a free equilibrium at least you know, until we get to slack season. And then of course the correction is going to be will the carriers withdraw capacity in sufficient capacity to create an orderly slack season market, and all of that is too early to call at this point.

Jack Atkins – Stephens Inc.

Sure, and then when we think about the transpacific grade, which rose not only on a year-over-year basis but sequentially this quarter, and the decline we saw in bunker fuel prices could you maybe comment on the impact both of those items had sort of on your incremental margins in the quarter which, you know, we are calculating, it was like around 64%.

Matthew Cox

Well, I can touch on each. I mean if we're talking about China, we do have mechanisms in essentially all of our contracts in the China trade, which allow for our freight rates to move up and down based on published industries of bunker freight rates. And so we have seen embedded in the average rate, which we haven’t separately called out, freight rates have declined somewhat associated with declining bunker, and that's all embedded in our comments.

And then on the Hawaiian side of course, we announced as a result of falling bunker prices a reduction or several reductions in our fuel surcharge, in fact we announced on July 10 that effective July 15 we lowered our surcharges in Hawaii and Guam and Micronesia and those as I said went into effect on July 15th. So we are going to continue to monitor that and adjust as we need to changing prices, but there weren’t dramatic improvements or degradations in margin associated with fuel. There is also little bit on the margin of timing but it was not a significant driver.

Jack Atkins – Stephens Inc.

Okay, I got you, I got you. And then Matt when you think about peak season on the Transpac I know you guys are operating at essentially 100% capacity utilization there. So you know, this question may not necessarily relate to you guys as much but when we think about what you're hearing as far as industry chatter on expectations around peak, I would just be curious again to get your thoughts on how the peak shipping season may be shaping up so far this year.

Matthew Cox

Yes, it's a great question, and I don't have any special insight. We talk to our customers everyday and every week about their expectations in their transportation departments, and there continues to be a lot of uncertainty as to what this retail season will bring, and our customers are telling us there is just a lot of caution and people are expecting a modest peak season. So it is you know, just owing mostly to the macroeconomic factors but it is really tough to say that and people don't have really firm opinions. There is, you know, there continues to be at least in our customers’ minds a lot of uncertainty about how this retail season is going to end up.

Operator

Our next question will come from Ian Zaffino of Oppenheimer & Co. Please go ahead.

Ian Zaffino – Oppenheimer & Co.

Great. Thank you very much. The question will be on the utilization side you know, given that Hawaii is somewhat weaker or you're saying it's weak, is there opportunity to actually taking market share you know, particularly given the competitive environment and what's going on there, how you're reacting to that and do you think it will be able to pick up here?

Matthew Cox

There are two questions there, one around the capacity utilization. So as I mentioned we are operating our fleet relatively full. As the overall fleet market in Hawaii has contracted over the last few years we have reduced the number of fleet units in our operation to better match the supply and demand of our freight package.

Matson has historically had a relatively large market presence in Hawaii owing to our 130-year history here, and I think our view about further share gains that's not the way we think about the business. Our goals are really around, you know, operating at about the same level and growing as the overall market will recover rather than looking for share gains.

Ian Zaffino – Oppenheimer & Co.

Okay, so just given the competitive environment and looking at where your competitors financial situation is, if you just can kind of sit back and wait for the market just to recover on its own?

Matthew Cox

Yes, I mean, I think given our market presence the idea of going after additional share is one that you know, it doesn't make a lot of sense to us.

Ian Zaffino – Oppenheimer & Co.

Okay, great. Thanks.

Operator

The next question will come from Mick McGuire of Marcato Capital Management. Please go ahead.

Mick McGuire – Marcato Capital Management

Hi Matt, hi Joel.

Matthew Cox

Hi Mick. How are you?

Joel Wine

Hi Mick, how are you?

Mick McGuire – Marcato Capital Management

Good, good. I actually was hoping to quickly just clarify a couple of the questions that I think the first analyst was asking about kind of operating income and some of the adjustments. So just to be clear the total operating income that you show I guess on slide 5 of the presentation that $32.5 million for the quarter that includes the $5.8 million of separation costs. So we would add back the separation costs to get to kind of like a true you know, operating like, you know, adjusted operating number.

Matthew Cox

That's correct.

Mick McGuire – Marcato Capital Management

Okay, and then – and the same obviously for the first half. So when I do that you know, I'm showing kind of year-over-year growth rates and operating income that are a little over 30% as opposed to you know, 11, or 7.5 that I think –

Matthew Cox

Yes Mick, that's correct.

Mick McGuire – Marcato Capital Management

Okay, and then I think and then as we go to ocean transportation the same thing would apply when we go to the ocean transportation segment, again we should add back, add $5.8 million back to the $31.2 million of operating profit and add back the $8.3 million to the $37 million of operating profit.

Matthew Cox

That's correct.

Mick McGuire – Marcato Capital Management

Okay, okay. So one question that would have I mean, if we do that I have done some of the arithmetic here to back into kind of what the operating margin percent levels are you know, as we back off those separation costs, and I get something you know, just over $12 million of the quarter.

Matthew Cox

$12.4 million is correct.

Mick McGuire – Marcato Capital Management

Yes, and well under $8 million for the first half. When you talk about your target you know, operating income margins you know, the ocean transportation segment of 10 to 12, you know, what does that mean in terms of kind of total like percentage improvement opportunity you think you have from where you are today. You know, what's the right number to compare that to, is it the you know, 8% you know, kind of adjusted first half operating profit margin. So you have 200 to 400 basis points of margin opportunity when you get to or you think you can be or you know, what's the right – I guess what’s the right amount of additional operating margin potentially you think that business has, you know, after you back off these one-time separation charges and things like that.

Matthew Cox

Sure Mick. I’ll take a crack at that. This is Matt and then if Joel wants to add something he can. I guess our view is really if you look historically the business we think has produced and can produce operating margins in the 10% to 12% range. We think there is no reason why the businesses can’t operate in that range, and probably should, but what it will require is for a return of the growth in the Hawaii trade.

As was commented on earlier we are extremely well positioned. We are operating a fleet very effectively that we expect if history repeats itself a recovery in the Hawaiian economy, an multi-year recovery, especially as the conditions are right again for construction to resume, and we will benefit from the volume growth. In that sense pricing approach in the Hawaiian market has long been small annual increases in pricing reflecting underlying changes in cost.

So it's really changes in Hawaii volume that will need to return in order for us to get back into this 10% to 12% margin range. So you know, we’re at 6.6% operating margin year-to-date. The adjustments that are included bring that number up and you know, effectively it is an okay quarter, but we are not satisfied because we're not in the 10% to 12% range that we think this business will return to when Hawaii volumes begin to grow again. And Joel did you want to add anything?

Joel Wine

No, I think that's exactly right but Mick you alluded to you know, what to compare that with long-term trend analysis, I think was embedded in your question. If I heard you right and admittedly that's difficult because when you look at long-term trend analysis you know, fuel costs as an example are such a big element that you can compare volumes that we had you know, five years ago with what you think might happen next 2, 3, 4 years, you will have two different fuel environments too. So admittedly a long-term trend analysis on margin is hard because of fuel but in that sense you know, we will get all that and we think the business has helped 10% and 12% all of that included over time through the cycle.

Mick McGuire – Marcato Capital Management

Okay, okay. That helpful, I guess, and on the Hawaii market you know, you have the economic indicators here that show you know, a forecast of some pretty strong recovery on the construction side. Obviously the permitting is you know, is visible today. I think these construction jobs are – I think these are percentage changes maybe in the baseline level of the construction employment. If you see this if in fact over the next two years you see something like a 15% increase in construction employment, or you know, this trend plays out, do you have a sense for you know, what that might imply for container volumes. You know, if you think about the last time that you know, it looks like this would take you above, certainly above where you were coming in the 2010, and I think even back to where you might have been historic, you know, around early ’09 if you see these growth numbers in the next couple of years, is it, you know – is the correlation close enough that you are able to say you know, if those construction forecast plays out this way that we would expect container volumes in the Hawaii market to be you know, at x higher.

Matthew Cox

You know, we don’t have the confidence to say that with precision Mick. I think what we – what our expectation is that we are in for a multi-year modest growth in container volumes. We are in the construction cycle returns. We do like to watch as we indicated the permitting although it is choppy, and we think a better indicator is this employment and you're right.

Those are percentage change terms in employment, and there is a correlation but recall that the construction as an overall part of our market you know, maybe while it maybe the thing that grows the fastest, it is just a subset of the overall market and so it's really difficult to say with precision where the – how to translate that into a market container growth. But, I think you're on the right track. It's just putting a level of precision to it is difficult.

Mick McGuire – Marcato Capital Management

Okay, fair enough. And then lastly I guess, and my only other question is on the China service, you know, rate environments are trying to add a little specificity and make sure that I am thinking about this right. You know, if you continue to see you know, the pricing and the spot market holds through the third quarter, you know, is the arithmetic right, you know, we're seeing you know, $800 or $900 a container higher year-over-year you know, and when you're looking at 15,000 containers during that period, you know, if that was all in the spot market that would translate into $12 million of additional, you know, revenue that I would think would be more or less – more of pure margin from a pricing standpoint. Obviously you have half of that in more longer-term contracts and I guess one am I thinking about that arithmetic right and two, even though you do have some of the – half of that contracted out on a longer-term basis are the contracted rates that you have set today different, you know, potentially higher than last year’s contracted rate, so you could, you know, you would still will expect to see a pretty significant year-over-year benefit from a margin standpoint. It looks like we picked up $10 million of extra margin you know, this quarter alone maybe from this dynamic and I was – the magnitude could be similar next quarter.

Matthew Cox

Sure, yes. So Mick, let me – this is Matt. Let me answer that and I’ll answer the last part first. I think you know, we did pick up margin improvement, part of the margin improvement was because of this China factor, but clearly the benefit of having the entire Guam market and that volume was a big driver also to the margin improvement. But back to your question on the China rate, Matson’s business as we point out is about half annual contract and half spot.

The annual contract cycle runs May 1 to April 30th and for us and for most participants if not all participants in the Transpacific, fleet rates in the annual contracting cycle back in May ended up renewing flat that is at the expiring freight rates. So there was no because of the competitive dynamic at the time and the market uncertainty and dynamics there was effectively no increase in freight rates on the annual contracted cycle.

Since then we've seen strong attempts by the carriers and successful attempts to try to get spot rates up further. I think in part because of their lack of success in getting rates up in the contracted cycle and you asked a question about the math. Yes, so to the extent that half our business is flat and half our business is going up we don't exactly describe our actual rates in the market, but the math and the algebra the way that you are approaching it is the right one.

Mick McGuire – Marcato Capital Management

Okay, thanks a lot. I appreciate the time and congrats on the first quarter.

Matthew Cox

Thank you Mick.

Operator

Our final question for the day will come from Steve O'Hara of Sidoti & Company. Please go ahead.

Stephen O'Hara – Sidoti & Company

Hi, good afternoon, or good morning, good afternoon.

Matthew Cox

Hi Steve.

Matthew Cox

Hi, you guys, you know, you are kind of saying that the business should do between you know, you think from the cycle 10% to 12% operating margins. You know, you're there today I mean, is it fair to say that you know, you could kind of continue at this level with Hawaii where it is as long as Guam stays at the level it is?

Matthew Cox

Steve, this is Matt. I think the first point I would make that you made I don't agree with which is we had a good quarter, but if you look at our year-to-date operating margins we are still at 6% or 6.6% even if you adjusted upward for the separation cost. We are not where we want to be, and typically because of the strong seasonal component of our business the second and third quarters typically have margins that are above it but they are way down by the first and fourth quarter.

So I think our view is that we are not where we need to be. Certainly the Guam volumes and the China rate environment is helpful but we do need to see we think a recovery of growth in the Hawaii market before we think we will return to that 10% to 12% operating margin range.

Stephen O'Hara – Sidoti & Company

Okay, thank you. And I guess the other thing in terms of you know, competitive capacity you know, what are you seeing on that front in Hawaii and anything?

Matthew Cox

There has not been any significant changes in capacity deployed in the Hawaii trade in the last – this year. Horizon continues to operate its fleet effectively. Similarly our other competitor on the self propelled guns side Patria, continues to operate its [fuel powered] truck carrier on a fortnightly basis. Patria has announced as we have indicated before that it has plans to build a second vessel, which we understand is in some stage of construction, and that will if you believe their announcements will be deployed in late ’13 or in early ’14. And that certainly could be a change when it is deployed but there have been no changes in deployment or deployed capacity in the market this year.

Stephen O'Hara – Sidoti & Company

Okay, all right. Thank you.

Matthew Cox

Goodbye Steve.

Operator

Ladies and gentlemen that will conclude our question-and-answer session. I would like to turn the conference back over to Matson’s president and CEO, Matthew Cox, for his closing remarks.

Matthew Cox

Okay, well thanks everybody for your interest. We look forward to catching everyone, catching up with everyone next quarter, aloha.

Operator

Ladies and gentlemen the conference has now concluded. Thank you for attending today's presentation. You may now disconnect.

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