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Sun Hydraulics Corporation (NASDAQ:SNHY)

Q3 2012 Earnings Conference Call

November 6, 2012 09:00 ET

Executives

Rich Arter - Investor Relations

Allen Carlson - President and Chief Executive Officer

Tricia Fulton - Chief Financial Officer

Analysts

Mig Dobre - Robert W. Baird

Jon Braatz - Kansas City Capital

Operator

Good morning, ladies and gentlemen, and welcome to the Sun Hydraulics Corporation 2012 Third Quarter Conference Call and Webcast. Today's call is being recorded. At this time, I’d like to turn the conference over to Mr. Rich Arter. Please go ahead.

Rich Arter - Investor Relations

Thank you, Diana. Good morning and thank you for joining us for Sun Hydraulics third quarter conference call. We are conducting the call today from the Baird Industrial Conference in Chicago, where we will presenting around midday. Allen Carlson, Sun's President and CEO and Tricia Fulton, Sun’s CFO are participating in today's call. We will take questions after we have concluded our prepared remarks.

Please be aware that any statements made in today's presentation that are not historical facts are considered forward-looking statements. For more information on forward-looking statements, please see yesterday's press release. At this time, it is my pleasure to introduce Allen Carlson.

Allen Carlson - President and Chief Executive Officer

Good morning. During the quarter, our North American business continued showing strength. However, both the European and Asia-Pacific economies continued to struggle. Our forecast indicates we will finish the year within a couple of percentage points of last year, which was a record year for Sun in terms of both sales and earnings. Our priorities are to work on product and market development. One of the bright spots in the second half of this year is the new customer base we are adding globally, which helps offset business conditions related to macroeconomic softness.

Work on our new Sarasota factory is continuing. The shell is up and we should be under roof by year end. We expect to be online when additional capacity is needed. Until then, we have adequate capacity to meet the current market demand. Our visibility of the future is based on PMI, which throughout several business cycles has been our most reliable indicator of future business conditions. PMI has yet to indicate any substantial trend movement either positive or negative. We recognize that we cannot control macroeconomic issues and that much of the capital goods demand is driven by the macro-economy. However, there are many things we can’t control like product development, increasing productivity, maintaining delivery reliability and developing new markets and customers.

I’ll now turn the call over to Tricia for a commentary on the quarter.

Tricia Fulton - Chief Financial Officer

Thanks, Al. While we saw the decline in top line run rates in the third quarter compared to Q1 and Q2 of this year, we were able to maintain our gross margins of 40%. Our agile employee base equips us with a flexibility we need to adapt to changing business condition.

Let's look now at the numbers for the third quarter. Third quarter sales were $49 million, down 8% over Q3 last year. Earnings per share were down 23% over last year to $0.34. The EPS change was influenced by a one-time gain in the prior year of $0.03 per share related to HCT and higher FDA cost in the current year. Sales continued to be impacted from currency translation as a result of a stronger U.S. dollar. Q3 sales were down approximately $1 million from currency compared to prior year. Gross profit margin remained high at 40% for the third quarter. With the lower sales volume estimated for the fourth quarter, we expect gross margin to decrease to approximately 36% to 37%.

SEA expenses increased 18% compared to the third quarter last year. The change was primarily related to variable compensation to directors and SEA cost related to HCT, which were not present in the prior year period. Please note that this is the last quarter, where HCT financial results will influence quarter-over-quarter comparison.

The provision for income taxes for Q3 was 35%, which included approximately 1.5% of pre-tax income for discrete items. We expect the Q4 tax rate to be 33% to 34%. Net cash from operations for the quarter was $16 million. Inventory turns were approximately 9 times and days sales outstanding were 34. Capital expenditures for 2012 are expected to be approximately $13 million, which includes $6 million for the new U.S. factory and $2.5 million for an update to our UK facility. The remaining expenditures consist of purchases of machinery and equipment. A quarterly dividend of $0.09 per share for the quarter was paid on October 15th to shareholders of record on September 30th.

Looking ahead to the fourth quarter, global demand is down and sales are estimated to be approximately $41 million compared to $46 million in the prior year. Earnings are estimated to be $0.22 to $0.24 per share, compared to $0.24 per share last year. Despite the global headwinds in the later half of the year 2012 will be a very successful year for Sun. Sales for the year are estimated to be $202 million compared to $204 million in 2011 and earnings are estimated to be $1.40 to $1.42 compared to $1.46 in 2011. For comparison purposes, 2011 results included a one-time $0.03 per share gain resulting from the acquisition of HCT. Given our new product development, delivery reliability and development of new markets and customers and our agile employee base, we are well conditioned for growth in 2013.

I would now like to open the call up for questions.

Question-and-Answer Session

Operator

Thank you. (Operator Instructions) We will hear first from Mig Dobre with Robert W. Baird.

Mig Dobre – Robert W. Baird

Good morning guys. This is Mig Dobre with Baird. How are you?

Allen Carlson

Good morning Mig.

Tricia Fulton

Good morning Mig.

Mig Dobre – Robert W. Baird

My first question, I guess is kind of a high-level question and I’d realize that visibility is limited, but I guess I’m wondering what is your kind of sense are we going through inventory correction, is this maybe the beginning of something that’s a little more drastic. I know that some of your competitors and even some of the OEMs have commented that we’re really in the middle of a inventory correction really and that’s likely to sort run of its course once of the first or second quarter of 2013 are behind us. Do you have any visibility or are you hearing anything from your customers or distributors?

Allen Carlson

Well, that’s, I’ll take that question. First of all, inventory correction maybe correct for some in our industry it’s not correct for Sun. We have a very short book to ship cycle and we monitor our distributor inventory, it doesn’t change much up or down during the course of a cycle. What I think we’re seeing actually started perhaps in the late second quarter. I think that it’s just a normal business cycle and we’re seeing the end of an expansion cycle that probably started in mid-‘09, continued through ‘10, continued through ‘11, first half of ‘12 and I think May timeframe of ‘12 we saw that business cycle decline. I think we are staged for an up-tick based on PMI going forward, but it’s a little bit too early to call the election on this one yet.

Mig Dobre – Robert W. Baird

Yeah, and I guess my comment was perhaps was related to the inventory that you might in a channel, but really sort of that on the mobile side the OEMs reacting to their own inventory issues that’s kind of what….

Allen Carlson

Some of that, I don’t think it’s huge, I don’t think it’s significant. Well, keep in mind that 60% of our business is global outside the U.S.

Mig Dobre – Robert W. Baird

Right.

Allen Carlson

A correction of the U.S. mobile inventory, for example, adds our customers that would have some impact. I don’t think it’s significant I think it’s – I think what we are seeing is the U.S. economy is just kind of doing okay. And I think Asia and Europe are still sort of bouncing around the bottom, but likely to begin seeing some growth going forward that would be my – that’s how I read it. Tricia, do you want to add to that?

Tricia Fulton

I would agree I think the Asian and European economies are affecting us quite a bit. Above this going into the fourth quarter it’s really the first quarter that we’ve seen a downturn in the North American business which we’re up with extremely strong even through Q3, what we’re looking at for Q4 is down a little bit in that market as well which maybe an impact coming from the other economies around the world.

Mig Dobre – Robert W. Baird

I see. And then following up here, you mentioned in the press release in your comments some customer wins helping to offset some of the decline out there. I guess, I am wondering can you provide a little more color on that as to maybe what’s driving those wins as well as the magnitude, the impact of those wins, perhaps give us a sense for what I don’t know for lack of a better term same-store sales would have been without 8 customer wins?

Allen Carlson

Sure.

Mig Dobre – Robert W. Baird

You get a better sense for demand trends out there?

Allen Carlson

I understand the question and I can provide some color. I am not sure I can give you any specifics on like same-store sales, but I understand the concept. For example, in China, we have added multiple new stores through our channel partners that didn’t exist last year or the year before. Keep in mind prior to 2010 if it was say between 1998 and 2010, our channel to market in China was a JV. In 2010, we moved away from the JV, sold it to our JV partners, but then opened a Sun sales office in China that’s responsible for adding new stores if you would in the marketplace. I believe there is 11 that exist today that did not exist in 2010. And so while our China business might be down 25% in total, it probably would have been down 75% if we had not increased the number of stores in the marketplace. This bodes well when the Chinese economy does pickup, because we will have these stores in place promoting Sun. That’s China, for example. We have others – we have other opportunities in Asia. It’s not just China that we are proceeding with. If we take a look at Europe, we are very active in Germany, Scandinavia, Russia. Basically, there are number of activities of new channels to market, which are helping to support our business. Our year is going to end very much like our best year ever. If we had not increased the presence in the markets, we would have seen a significant haircut in those markets.

Mig Dobre – Robert W. Baird

I see. Thank you for that. That’s helpful. And my last question is on the United Kingdom where performance was frankly quite a bit better than what we expected with really nice operating margin and I guess I am wondering can you comment at all on the drivers there?

Allen Carlson

New customers and new markets, and their performance is a lot of little new customers and new markets, because if you remember back in 2010 and ‘11, we had one major significant one-time opportunity that was driving the numbers in 2010-11. That went away in 2012. By design, we knew it was a one-time opportunity, and it was significant based in the UK, so we have replaced that and more in the UK.

Mig Dobre – Robert W. Baird

Thank you very much.

Operator

(Operator Instructions) We’ll hear next from Jon Braatz with Kansas City Capital.

Jon Braatz – Kansas City Capital

Good morning everyone.

Tricia Fulton

Good morning Jon.

Allen Carlson

Hello Jon.

Jon Braatz – Kansas City Capital

Good morning. Allen or Tricia, is there any, at this time, any P&L impact associated with the new facility that you are building, are there maybe some minor depreciation?

Tricia Fulton

No, not at this time, since it’s not completed yeah, there is no depreciation cost. So, there is really no direct P&L impact at this time. Obviously, it’s taking some time away for some people from doing other things, but no direct impact.

Jon Braatz – Kansas City Capital

Okay. And I think you said would be – the shell would be completed this quarter, is that correct?

Allen Carlson

The shell is going up as we speak. Actually, there is multiple shells of the building. There is three different pieces of this building that will come together. The main hall, if you would, the shell is the metal piece of it is up. The two side pieces that will adjoin to that are still to be put up, but I think by the end of the year, early first quarter will be closed in completely.

Jon Braatz – Kansas City Capital

Okay. Let’s say, I’ll throw out a number, let’s say, revenues were up 20% next year, would you need that capacity to meet that type of revenue growth?

Allen Carlson

No, we would have plenty of capacity to take us to the, I am going to say 225 or more range. A large piece of construction of this building goes back to, it’s just a good time to do it.

Jon Braatz – Kansas City Capital

Okay.

Allen Carlson

We are not at capacity, but we can see it especially if the economy starts coming in – the starts come in alignment economically around the world. So, we can see that at some point we are going to need it, but you never want to build a house when you are at max full speed and prices are high for materials and construction and labor shortage. So, now sort of – because the economies are taking a breather, this is just a great time. We are going to get a barging on this facility and it’s going to position us for growth going forward.

Jon Braatz – Kansas City Capital

How much more will it cost, let’s say, build it out in the sense of facility and equipment, machinery and so on?

Allen Carlson

The facility itself is going to be about a $16 million facility all-in. That is the bricks and mortar, and now as we move the equipment into it and replace other equipment, older equipment with more productive up – yeah, I think it’s going to be a gradual transmission, it’s not going to be flip a switch and we are going to spend another $16 million to equip it. I think it’s going to be gradual over time and it’s going to drive some productivity gains along the way. That’s kind of how we’ve always operated. We also don’t take a look at – a forward look at capacity planning per se. Our approach to manufacturing is period constraints kind of approach. So, when we identify constraint what we need is to have the ability to put equipment in to relay out areas that this facility will allow us to continue to work on our period constraints approach to manufacturing.

Jon Braatz – Kansas City Capital

Okay. You ended the quarter with about close to $100 million of cash and marketable securities, and business picks up, you will probably have to invest a little bit in working capital, but the cash is building. Any thoughts on what you might do with that?

Allen Carlson

We have discussions regularly about that. We continue to look at acquisitions. It’s good in these uncertain times to have the reserve. I think we are not alone in this area. I mean, most companies that I follow are also building cash and looking for opportunities going forward to make investments that will add to both the top and bottom line. So, I am comfortable with where we are at.

Jon Braatz – Kansas City Capital

Okay. And then lastly on the gross margin discussion for the fourth quarter, I assume the decline in the gross margin is simply a sort of a de-leveraging of expenses rather than any price discounting or anything like that?

Tricia Fulton

Yes, it’s all related to the absorption of the fixed cost portion of the gross margin numbers, as no changes in pricing are opting or anything like that, but at some point, those cost become a little bit more difficult to be absorbed down the low.

Jon Braatz – Kansas City Capital

Sure.

Tricia Fulton

Sales volume.

Jon Braatz – Kansas City Capital

Okay. Alright, thank you, Tricia.

Tricia Fulton

Thank you.

Operator

(Operator Instructions) It appears that there are no further questions at this time.

Allen Carlson - President and Chief Executive Officer

Thank you, Diana. And I’d like to thank everybody for joining us on the call today. And we’d like to remind everyone to make sure you exercise your right to vote today, if you haven’t already done so. Thank you.

Operator

This does conclude today’s conference. We thank you for your participation. You may now disconnect.

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