Albany International Corp. (AIN) Q4 2012 Earnings Report, Transcript and Summary

Ladies and gentlemen, thank you for standing by. Welcome to the Fourth Quarter Earnings Call of Albany International. [Operator Instructions] At the request of Albany International, this conference call on Thursday, February 7, 2013, will be webcast and recorded. I would now like to turn the conference over to Chief Financial Officer and Treasurer, John Cozzolino, for introductory comments. Please go ahead.

Thank you, operator, and good morning, everyone. As a reminder for those listening on the call, please refer to our detailed press release issued last night regarding our quarterly financial results, with particular reference to the Safe Harbor notice contained in the text of the release about our forward-looking statements and the use of certain non-GAAP financial measures and associated reconciliation of GAAP. For purposes of this conference call, those same statements also apply to our verbal remarks this morning. For a full discussion, please refer to that earnings release as well as our SEC filings, including our 10-K. Now I will turn the call over to Joe Morone, our Chief Executive Officer who will provide some opening remarks before we go to Q&A. Joe?

Thanks, John. Good morning, everyone. Let me add my welcome to John’s. As always, I will open with a few comments and what we see is key features of the yesterday’s release and then we will go to your questions. As we discussed in the release, Q4 2012 was another strong quarter for both of our businesses. Adjusted EBITDA, that is EBITDA excluding currency reevaluation and GAAP restructuring, was 27% ahead of Q4 2011 on slightly lower sales. Machine Clothing continued its outstanding performance with full year share of market holding and growing for each of our major customers in every major region of the world. AEC continued its rapid growth and continued to progress towards the LEAP brand. We reduced net debt by another $20 million, bringing total net debt down to $129 million compared to $256 million a year ago. Our outlook for 2013 should come as no surprise. Flat year-over-year adjusted EBITDA in Machine Clothing and continued rapid growth in AEC, both driven by more or less the same internal performance and external market trends that we saw in Q4. Now there are 3 particular aspects of our outlook that I would like to just take a minute to discuss in a bit more detail before turning to your questions. First, in Machine Clothing, we saw signs in Q4 that the decline in European sales may finally be moderating. While sales in Q4 ’12 was still nearly 15% lower than sales in Q4 ’11 in Europe, they were slightly higher than they had been in the preceding 2 quarters, that is in quarter 2 and quarter 3 of ’12. This is the first sequential quarter increase in sales in Europe since Q3 of 2011, so in over a year, 5 quarters. Orders followed a similar pattern. To be sure, the European paper and PMC industries still suffer from over capacity and the European economy as all of you know is far from healthy. But our recent sales and order trends suggest that the sharp declines in the past year may finally be giving way to the more gradual and predictable erosion of sales that is driven by the longer term trends in paper demand for newsprint, printing and writing grades. As we have discussed on numerous occasions, for the long haul, we look for gradual erosion in sales in Europe offset by growth in Asia and for stability in the Americas with growth in South America and in packaging and tissue offsetting declines in newsprint, and printing and writing. The second point about our outlook is for having to do with Albany Engineered Composites. Based on current schedules, which are of course subject to change for a variety of reasons, we now expect AEC sales of our components for the LEAP engine to pull forward by about a year. We had previously stated that we view total AEC sales that is including LEAP total sales, as having the potential to grow to $120 million by 2016 from the 2012 level of about $65 million, so near doubling from the end of ’12 to ’16. Well, that 2015 now seems more likely for that $120 million level of sales. Likewise, we had previously stated that we expected a steep ramp in LEAP sales and therefore total AEC sales from 2016 to 2019. That ramp now looks more likely between 2015 and 2018. So to summarize that, this apparent pull forward about a year means that we now view AEC total sales potential to hit about $120 million by 2015 and that sharp ramp to occur starting at ’15 and going through ’18. This leads to a third point about our outlook. This apparent pull forward of our schedule for production of parts for the LEAP engine will be accompanied by our pull forward of our schedule for the associated capital expenditures. We had expected peak spending to occur between 2014 and 2017, we now think the peak will occur between 2013 and 2016. Now to put that in context for you. In 2012, total capital spending for the company was $37 million, total for the company, so both AEC and Machine Clothing. We anticipate a sharp increase in spending in 2013 due to this acceleration of our investment in AEC along with the construction of the new R&D facility in Machine Clothing that I mentioned in my comments and release. We have stated on numerous occasions that we expect capital spending for the full company between 2012 and 2016 to average roughly $70 million a year. Our view on this has not changed. In sum, Q4 2012 was a strong quarter for Albany International and our outlook for 2013 is for a continuation of the trends that contributed to the Q4 results. In Machine Clothing, those trends are strong competitive performance, promising new products and technology, effective absorption of inflation and adjustment of capacity for long term market trends, and healthy markets in the Americas and Asia coupled with a stabilizing market in Europe. For AEC in 2013, the trends are for continued rapid growth, continued progress toward critical LEAP milestones and continued advances in the new product development pipeline. So with those comments let’s go to your questions. Brad, can you read the first question?

[Operator Instructions] Our first question today comes from the line of Jason Ursaner from CJS Securities.

For the MC segment, demand came in very solid basically stable ahead of the seasonal slowdown. I see the market commentary in the press release but I want to get a better understanding for how the customer inventory switch last quarter might have impacted the quarter on a sequential basis? And then also, any additional comment on the North American market, how it started off the year and how healthy you see that market now after years of consolidation?

Okay. So let’s take Q4 first. First of all, it’s always dangerous in this business to look at trends sequentially even though I did that with Europe. In general, it’s much safer to go year-over-year because of the seasonal effects. That said, with that caution aside, if you look at the sequential trends geographically, Q3 to Q4, controlling for that one time bump because of the contract change in North America that we talked last quarter, the Americas were basically flat, both North and South America. Asia was basically flat. Europe had a bounce back up a little bit. So when you actually try to account for the difference in sales sequentially, it’s mostly an improvement in Europe. On inventory, we have seen really since the recession in 2009 a continuing trend towards customers becoming tighter and managing their inventory more and more tighter, so being more and more aggressive about running down their inventory at the end of the year. We didn’t see anything particularly new in that trend in Q4 other than a reminder that everybody is managing their inventory more tightly and that does introduce an element of volatility both down and up. We did see the expected slowdown at the end of the year particularly in the Americas, but actually we saw it everywhere. As for the beginning of Q1, no real surprises, Q1 does have a strong seasonal effect, which is really the consequence of the slowdown at the end of the previous year. But we are not seeing anything that deviates from the Q4 trends that we described in the release, that North America looks solid, Asia looks like it’s starting to come out of its funk, and Europe let’s just say the slope of the decline is moderating. So I think that covered all of your questions.

Yes. Just same with Europe, the decline obviously moderating, you talked about over capacity though. How far above consumption do you still think production is -- assuming it comes out gradually, but just how much do you think actually does need to come out?

I think a good number of 15% to 20%. If you took a snapshot at the beginning of 2012, you'd say it was about a 20% gap, that gap has closed some just because UPM acquired Milakofsky and did some consolidation there and now UPM has announced more closures and Stora is announcing closures and some of the other paper makers are announcing closures as well. So the gap is closing. From our vantage, what we have seen before and I think I have mentioned this before, when you get these periods of economic turmoil, our drop in sales happens much faster and tends to approximate the amount of over capacity. So we seem to get the drop in sales at the beginning of the process even before the paper makers have announced which mills are actually going to shut down. We think that that’s what occurred. We hope and think that that’s what occurred for us in Europe this time. So we had a 15% drop year-over-year in sales. That mimics, that pretty much approximates what the amount of over capacity was.

Got it. Just last question from me. Can you talk a little bit about the priorities for cash just given that the balance sheet is in much better shape now and the amount of cash you are holding overseas, if it can’t go to funding AEC or reducing debt, what is the longer term strategy for that cash?

Go ahead, Cozzolino, you want to take that?

Yes. As we noted a lot of our cash is held overseas. And the first part we will be investing in composites in Europe over the next few years. After that we have a pretty detailed repatriation plan that we worked through each year that allows us to get certain amount of that money back a year to pay down debt, which is what our plan has been. So right now in the near future, those are basically the primary uses for that money. There is also a certain level of just operating cash that we need throughout the world that we will be maintaining in the different sites.

Clearly, our first priority for the use of cash is to position ourselves to take full advantage of the growth potential in AEC while continuing to do whatever we need to do to maintain our leadership in Machine Clothing. That’s a little different from what our priority was a year or 2 years ago where we felt strengthening the balance sheet was a priority that we were balancing with the strategic needs. We are feeling very comfortable about the balance sheet now. So the timing we think lines up very well because the opportunity on the AEC side, and as you have seen this quarter, even on the MC side are pretty compelling. So that is our unambiguous top priority is to maintain a strong balance sheet and position ourself to take every advantage of the new opportunities that come along, we think there will be more.

Next question is from the line of John Franzreb with Sidoti & Company.

My first question is actually regarding the gross margin profile in machine clothing. It has been running above your stated historic norms of 42% to 44% for a couple of quarters now. Could you talk little bit about the sustainability that gross margin profile and where the puts and takes that will make you drop back even below that now the historic range?

Well, I think if you -- you’re right, we had been saying that we got the margin 42% to 43% was a reasonable estimate and another 3 quarters in a row we’re up at what we used to think it is the high end the range so, we were in the 44 range. There are a couple of reasons for that what we think are sustainable. The first is that we have made a series of smaller restructuring moves over the past couple of years and that has gradually washed in. And you’ll notice, if you go back and look at our earnings releases for the past 6 or 7 quarters, it has been again a restructuring in each quarter and those were a series of smaller moves primarily involved with the integration of engineered fabrics in [indiscernible], that has led to this increase in gross margin. Secondly and ironically as Europe shrinks as a percent of the total, the gross margin because of the customer and grade and geographic mix tends to improve a little bit. And so those were the reasons for the increase. Now the second half of your question is how sustainable it is and here are the variables that 2 of which are sort of under our control and one of which is the risk factor in this business. Inflation, this is basically a flat slight growth business, inflation is always going to be growing faster than the business. So our number one management challenge along with maintaining our competitive position is to absorb inflation year over year. If we succeed, that augers well for holding the gross margin. If we fail, then we start to erode the gross margin. The second is a continuous incremental adjustment of capacity to the geographic and market trends of the sort that you’ve seen over the last few quarters to the extent that we’re able to continue to do that we’ll hold the margin. And in the third and the single biggest risk to the whole investment proposition is off course the risk of price, price erosion, that risk is as we’ve talked many times greatest in Europe and we’re relatively -- the exposure is relatively small now and we feel like we’re taking steps to try to protect against further erosions. So that is roughly the gross margin picture.

Okay, may you mention the pricing environment in Europe, it touched on the capacity take out, how much do you think -- or you attributing maybe the stabilization that you are seeing in the sales profile in Europe almost entirely to the capacity take out or does the macro picture stabilize in Europe play any part of the stabilized sales environment that you’re seeing in Europe?

Yes, we think the rumors of stabilization of the macro environment are grossly exaggerated. We don’t think we are out of the woods on that. So this is more, the dynamics we are seeing has more to do with -- we absorb a big drop in sales and we think that as I mentioned to Jason, we think that big drop in sales approximates and reflects the over-capacity in the paper industry that is still in Europe, that’ll still continue to be squeezed out over the next few quarter and years, but in some ways we’ve taken the hit in advance.

Okay, what is the biggest challenge for you operationally by the moving up into timeline on LEAP production by year?

Your question answers itself.

But you have to answer it.

I think we’ve talked about it before the LEAP engine, this engine by the joint venture between GE and Safran replaces the CFM 56 engine. And CFM the joint venture makes roughly 1,500 engines a year. The CFM 56, about 1,500 engines a year. It has taken the joint venture 30 years to gradually ramp up to the point of 1,500 engines. Now the LEAP engine which will completely replace or very nearly completely replace the CFM 56 will need to ramp not in 30 years but in 3 years from basically 0 to 1,600 engines. That never occurred, that kind of a ramp has never occurred in the aircraft engine industry. So it is a very challenging proposition to do that quickly. Now add on top of that the parts we are making are new technology. So that is the challenge, the challenge was going to be rough, starting at 2016, our starting 2015 that makes the challenge even rougher. And it is all about continuous process of trying to on the one hand mature and industrialize, if I can use that word, industrialize our manufacturing process while at the same time our customers finalizing their design. So there is a constant iteration between their efforts to optimize their design and our efforts to optimize and line up our manufacturing process. And all that needs to be done in a manner that leads to robust high yield manufacturing by 2015, 2016. One of the reasons, very logical reason is that it appears that our customer wants us to start producing sooner is precisely to try to smooth out that ramp a bit. They are still planning to start their deliveries in late 2016, 2017, 2018, 2019 but what they are trying to do is give us more time to start making parts, working our any bugs in the manufacturing process in advance from the time when they have to start delivering. So this is from our vantage it looks to us like very intelligent risk mitigation to smooth out the curve a bit.

[Operator Instructions] The next question is from the line of Mark Connelly with CLSA.

Just 2 questions. Is the new $15 million research facility going to mean that total R&D spend goes up as well. I believe that the guidance for R&D has been relatively flat in PMC. And are you going to relocate your existing R&D assets to that new facility?

The answer to both questions I think is no, that is we expect R&D in machine clothing to hold the R&D spending. We have a strong R&D group in Wisconsin, we have a plant that used to do production in Menasha and we have a plant that still does production in Kaukauna and they are about 20 miles apart. So in our minds it is essentially one core group of R&D people working together and the center of gravity for that work is shifting to the Kaukauna plant, but it is -- no there won’t be a movement of R&D assets.

Okay, just one more question. The change in the LEAP ramp up, now that, that is ramping earlier, does that raise the probability that other projects start to move earlier?

No, because our customers not delivering engines sooner. It looks like as we’ll be making parts for them sooner. So I think the way to think about this is between 2013 and 2015 they are going to have -- our customers are going to have to make some decisions about several new parts that we are developing with them right now and they are going to have to. So in that period there going to have to be some announcements about plan to add new contents that would lead to potentially new plants. And those announcements typically will come 3 to 5 years before the first revenue starts to flow. So the way to think about the revenue growth in this business is as we figure out a little more than $60 million in 2012, it now looks like driven by the LEAP ramp $120 million in 2015. We said the LEAP ramp at peak, LEAP by itself is about 160 at peak. That peak now looks like 2018, add in another 40 for the rest of AECs. So you can see a projection from 60 in 2012 to 120 in 2015 to 180 to 200 in 2018. We’ve also said we expect -- we think this business has the potential to be in the 300 to 500 range by 2020. That next wave above the LEAP peak are these new parts that we’re working on, the engine nozzle enhancements to LEAP, the riveters from LEAP that we’re currently working on with customers. And in the next 2 or 3 years, there are going to be some customer decision made about grow or no grow and those decisions will dictate growth beyond the 2018 peak to that next level up. That answers your question.

[Operator Instructions] We do have a question from the line of Richard D'Auteuil with Columbia Management.

Most of my question was already answered in that last response, but just for clarification, the 2 to 3 year time period for announcements on potentially further increased content, is any of that likely to come in the next 12 months or is it they really wanted to focus on the task at hand before they look at increased content?

I am not sure, Rick. I think the window 2013 to 2015, I think we should hold to that. And it is not so much concentrating on the task at hand, it is more about their plan. If you look at the history of engine programs every 2 to 3 years, there will be a technology improvement program or a next generation engine. I think it is fairly predictable to expect that if this engine enters into service in late 2016 or say 2017 it enters into service, history would suggest that by no later than 2020 this should be at a minimum of technology upgrade and then by no later 2 years after that is a new version of the engine and that is what history tells us. And so, those are fairly likely and each enhancement, each 2 or 3 year enhancement creates an opportunity for us for additional content. We are working with our customer, partially with our own funds, partially with customer funding on numerous enhancements.

You may have said this earlier, I joined a little late, but what is the current content that you publically talking about on the LEAP access?

It hasn’t changed. We are still saying 100,000 per engine and that’s the fan blade, the fan case, and some associated parts. That has not yet -- that’s LEAP one. All of this ramp so far is about LEAP one, about the fan module for LEAP one. When I talk about the R&D pipeline or the product development pipeline, those are new components that we hope the customer will decide to include in technology improvement program and then eventually LEAP 2. So the technology development is underway, they are certainly doing their planning. We have not yet negotiated a pricing agreement on those parts and they have not yet announced the technology improvement program and what’s going to be involved in it.

Okay. So just to understand, the last quarter in composites was $20 million, was that lumpy positive? And you may again, I am sorry if you have addressed this already.

When you stated lumpy, it’s positive?

So is that the new run rate or prior to the ramp in ’15 or is that -- was there some special projects in there where we shouldn’t expect that level to continue short term?

Well, I think that’s not a bad way of thinking about the run rate for the next year or so, maybe a little more than the next year. But underneath that there is a fair amount of churning going on. But the growth, I think it’s fair to say that the growth that we will see in revenue from 2012 through 2017, 2018 we will be almost entirely driven or it will be driven by LEAP. And you know the parameters of LEAP, it will go from 0 to roughly 1,600 engines, until you hear otherwise, about $100,000 per ship set. We mention in this release that LEAP represents about 45% of the Q4 run rate. So it’s basically going from 40% roughly, $35 million -- just about $30 million in Q4 to something like $160 million in 2018, something like that. And that will be the dominant source of revenue growth in AEC. Some programs will fade like the blades program, others will grow like the JSF program. But that will all get washed out by the growth in LEAP.

Okay. The $160 million relates to just LEAP?

Correct.

So there should be another $40 million on top of that for composites.

Correct. And that’s not including any new components that might get announced in that window of ’13 to ’15 or ’13 to ’16.

At this time, it does appear there are no further questions in queue. Please continue.

Okay, everyone. Thank you for participating on the call and as always we will -- I am sure we will be having conversations with many of you between now and the next call, and if not talk to you in a quarter. Those of you on the East Coast I hope you do well in the storm. Thanks, bye.

Ladies and gentlemen, a replay of this conference will be available at the Albany International website beginning at approximately noon Eastern Time today. That does conclude our conference for today. Thank you for your participation and for using the AT&T Executive TeleConference service. You may now disconnect.