NN, Inc. (NNBR) Q2 2012 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen, and thank you for standing by. Welcome to the NN, Inc. Second Quarter 2012 Conference Call. [Operator Instructions] This conference is being recorded today, August 7, 2012. I'd now like to turn the conference over to Ms. Marilyn Meek. Please go ahead, ma'am.

Thank you, and good morning. Welcome to NN's conference call today. If anyone needs a copy of the press release, please call my office at (212) 837-3746, and we will be happy to send you a copy. Before we begin, we ask that you take note of the cautionary language regarding forward-looking statements contained in today's press release. The same language applies to the comments made on today's conference call and live webcast available at www.earnings.com. With us this morning is Rock Baty, Chairman and Chief Executive Officer; and members of NN's management team. First, management will give an update and an overview of the quarter and then afterwards, we'll open up the lines for your questions. With that said, Rock, I'll turn the call over to you.

Thank you, Marilyn. Good morning, everyone, and thanks for joining in on the call. With me this morning here in Johnson City, I have Jim Dorton, our Senior Vice VP and CFO; Will Kelly, our VP and Chief Administrative Officer; and Tom Burwell, our VP and Chief Accounting Officer. Today, Jim will offer an analysis and commentary on our second quarter and year-to-date results through June 30, 2012. And then I'm going to conclude the call with additional comments regarding the quarter and year-to-date results, as well as providing revised guidance on our revenue outlook for 2012. I'd like to turn the call over to Jim now.

Thanks, Rock, and good morning, everyone. The story for our second quarter is similar to the first quarter. Lower European demand offset by strong growth and profit recovery at Whirlaway, plus good global cost control. We had revenues of $98.8 million and net income from normal operations of $5.9 million or $0.35 per share. European revenue was down just over 20% versus last year due to automotive demand and destocking by our major customers. However, Whirlaway revenue was up $3 million versus last year and the profit turnaround there continues to partially offset the lower European revenue. Even though Europe revenue was down dramatically due to the restructuring we undertook during the recession and our added ability to flex marginal costs, we are still profitable at every operation in Europe. We're not able to accurately predict the timing, but we continue to believe that destocking will diminish later this year even if fundamental recovery is delayed further. And if that were to happen, we should see an improving trend in European revenue and earnings versus the first half of the year. However, our lower revenue guidance is based on continued weakness and uncertainty as to the timing of recovery and restocking. Rock will discuss more on this in a moment. So in total, we earned $7 million or $0.41 per share in the second quarter and we had an intercompany FX gain of $0.06 per share that we are excluding from normal operations. So our earnings from normal operations were, as I mentioned, $5.9 million or $0.35 per share. Cost of goods sold as a percentage of revenues dropped during the second quarter to 78.8% from 81.7% last year and 79.4% in the first quarter. The continued improvement in our margins is primarily a result of the profitability improvement at Whirlaway. And in addition, whereas the lower revenue in Europe does negatively impact gross margins at those operations, our cost and restructuring efforts over the last 2 years have allowed us to remain profitable at these sales levels. We continue to look forward to additional margin expansion when volume begins to recover in Europe. SG&A was $8.1 million, which is in line with the first quarter and our business plan. But it is high as a percentage of revenue due to the low sales level. Depreciation was $4.4 million in the quarter, and interest expense was $1.1 million. Both are consistent with the past several quarters. We did have an other income entry of $1.2 million, of which $1.1 million was the previously mentioned gain on intercompany foreign exchange, and as I mentioned, we always exclude the intercompany item from normal operations. The tax rate was 16.2% during the quarter, which was below the forecast I gave you last quarter of 20% to 25% and this is because we earned more from our income, including that foreign -- intercompany foreign exchange gain in the U.S., where we are currently still not accruing taxes. And that brings down our average overall rate. As mentioned last quarter, we are still not accruing taxes on U.S. operations so our blended rate is a mix of international rates, which is usually, for us, between 20% and 25%. I think that the rate will probably be in the low end of the 20% to 25% range again in Q3. We spent $5 million in capital during the quarter or $9.1 million year-to-date, and this is in line with our announced goal of $15 million to $20 million for the year. As I mentioned last quarter, during the year, we will significantly expand our ball plant in China, which will ultimately allow a doubling of capacity at that plant. We also continued to invest in tapered roller expansion, new Whirlaway sales programs and cost reduction in the U.S. and the Netherlands. We have $6 million of positive cash flow during the second quarter. And we are still on track and still planning for a net debt reduction of approximately $20 million this year. And that concludes my comments. Now Rock will give you some further comments on the quarter and the outlook.

Thanks, Jim. I'd like to begin with general comments, my general comments on the second quarter and year-to-date results, in addition to Jim's. As we mentioned in the release, the sales for the second quarter year-to-date were down in local currencies 10.7% and 7.7%, respectively, from the same periods in 2011. Sales results were definitely mixed based upon regions of the world. In North America, sales improved versus 2011 for both the quarter and year-to-date and demand remained relatively good. Weakness in Europe more than offset the positive revenue results in North America for both periods, however. Net income from normal operations, as Jim mentioned, was $5.9 million for the second quarter, down slightly from the $6.1 million in the second quarter of 2011. However, year-to-date net income from normal operations of $12.6 million, or $0.74 a share, was up 8% from a year ago and represents an earnings record for us at NN for the 6 months ending June 30. The earnings record was achieved in spite of a local currency revenue reduction of $17.6 million from 2011 year-to-date June result. From a margin perspective, the improvements for the quarter and year-to-date were very good, especially considering the current economic environment and the overall volume reductions that occurred. Gross profit margins for the quarter improved from 18.3% in Q2 of '11 to 21.2% in Q2 of '12. Year-to-date, margins improved from 18.6% in the first half of '11 to 20.9% in the first half of '12. The company-wide margin improvement is a result of 3 primary factors. As Jim mentioned, first, the significant year-over-year improvements we experienced in our Whirlaway business. Second, the skill set associated with our level 3 program continued to deliver excellent efficiency and cost improvement results in each of our global businesses. And then finally, our operations in Europe and Asia have remained very profitable, given the magnitude of the sales reductions they have experienced from 1 year ago. With respect to Europe, our restructuring actions, coupled with excellent cost control, have allowed our operations there to remain solidly profitable on significantly lower sales revenues from just 1 year ago. I'd like to conclude today's call by commenting on our outlook for the remainder of 2012. At NN, like most global industrial companies, we have experienced a reduction in overall demand and a corresponding revenues reduction associated with slowing growth in Asia and the ongoing recessions within the EU countries. As we said in our press release, the uncertain economic outlook for the second half of '12, in particular in Europe and Asia, has necessitated us lowering our revenue guidance for the year from $415 million to $425 million, to $390 million to $400 million. The midpoint of that revised range, or $395 million, if achieved, would represent a reduction for the full year of approximately around 5% in local currency from the full year results of 2011. In my earlier comments, I mentioned that the company, our overall profitability and margin improvements were achieved in an environment of declining revenues. Even with a reduction in our revenue guidance that I just mentioned, a reduction that amounts to approximately $30 million in annual revenues from 2011, we still expect solid improvements in margins, net income and earnings per share for the full year of 2012 in comparison to 2011. It is important to restate that as a company, we are much better prepared to withstand revenue reduction than we were entering the previous global recession. Previous restructuring actions removed $25 million in costs, we lowered our annual revenue, net income and cash flow break even points by $70 million and our operations through level 3 initiatives continued to improve efficiency and costs moving forward. Collectively, our improving cost, margin and profitability results during the first half of '12 reflect very good operational performances from each of our business units. Finally, Whirlaway continues to represent great opportunity from both an earnings and margin leverage point of view. We have invested, as you know, heavily, to support their growth and believe the business has exciting additional future earnings, sales and earnings potential in both the near and long-term. With that, we'd like to open the call to answer any questions you may have.

[Operator Instructions] And our first question comes from the line of Steve Barger with KeyBanc Capital Market.

First question on the comment that you have confidence that destocking will diminish in the second half. How good is your visibility into customer inventory levels?

I didn't say we had confidence that it would occur, but we believe that it should occur and that's just based on the only other experience we have with significant destocking, which was during the 2008, 2009 timeframe. But we can't really call when it's going to occur. But the statistics that I gave -- we gave, 20% down in Europe, if you look at actual auto build rates in Europe, probably depending on the country and the maker, down 7% to 10%, something like that. So you can see the destocking impact that's there and we don't know when it's going to occur. But we -- based on the earlier -- based on our only other really significant experience, it would seem to be -- it should be beginning to occur in the third and fourth quarter. But we don't know.

I understand. Is it your sense that customers are running a lot leaner in terms of inventory over the last 4 or 5 months versus what you saw in 2008?

I'm not sure if we can say leaner, Steve. But if looking at our -- of course, talking with our customers, as well as looking at their releases, they're definitely focused big on the softness in Europe, in particular, in destocking and taking down their working capital, especially inventory. And it's hard for us to evaluate the levels of inventories that existed in 2009 versus today. But what we can say is that we've seen evidence of destocking in our business with them for the last 3 quarters. It really started in the fourth quarter of '11, and has been occurring on into the first and second quarter of '12. And that's about what we experienced -- about 9 months, 3/4, is about what we experienced in the big global recession in 2009, about 9 months and then we saw upticks associated with just ordering to overall levels of demand and production.

Right. That's good color. So just so I'm clear, is your revenue guidance reduction, a function of kind of a proactive slowdown on your part or actual visibility in production schedules for the back half? How much is it you positioning, versus pull through?

Yes, we don't have a lot of visibility in our business. And that's not unique. It's not unique to the slowdown and it's not unique to 2009. We, as you know, the lean inventory throughout the entire supply chain in most manufacturing supply chains now imply that you don't get visibility beyond 30 to 60 days. And so our revenue guidance is really based upon what we see over the next 30 to 60 days, of course. But then, it's essentially more of the same. We didn't really forecast in the revenue guidance that we're providing to you any uptick associated with what Jim was talking about with destocking.

So just -- and not to put words in your mouth, but based on your experience with the last downturn, you would assume that your guidance is relatively conservative?

We would hope it is, based upon that factor. But again, like Jim mentioned, we ultimately don't know when the ordering is going to reflect.

And sorry if I missed this, but do you have an inventory target in mind for your own balance sheet as to where -- how much working capital you can convert as you go through this?

We actually removed $25 million in inventory during 2009 and 2010, Steve. And that got us down, as a total company, down to about 42 days on hand, 42 to 45 in terms of a corporate average. And as the revenue came back in '10, '11 and on into the first quarter of '12 versus the 9 levels, we've maintained that 42 to 45 days. And so we don't see a big -- ability to lower inventories any further on the basis of really keeping our days constant in an increasing revenue environment from 2009 levels, at least.

Got it. So when you talk about the net debt reduction, it's really just based on the profitability of the business and your confidence in your ability to hold margins through this downturn?

Yes that and, of course, we're closely monitoring and managing capital expenditures as well.

Got it, okay. One other and then I'll get back in line. Do you expect that Whirlaway will have positive organic growth rates in the back half? I mean, there's no reason that wouldn't happen given the North American footprint, right?

The -- we have seasonality in Whirlaway's business that, relative to the HVAC business, which is a big part of their total revenue, and so that's a natural occurrence in their business and has been since we acquired it. And so their revenues will be down slightly second half versus first half on the basis of the HVAC seasonality. And so we can't expect a quarter-over-quarter incremental improvement from them in Q3 and 4 like we've been seeing the radical improvements even in third and fourth quarter of last year and the beginning this year just for that reason alone, but -- though remains solidly profitable, just not to the levels that they were in the first 6 months.

So is it fair to say, Whirlaway is tracking to your internal targets?

Yes. Actually, they're exceeding our internal targets for the full year. And so, yes, that's a fair statement.

And our next question comes from the line Keith Maher with Singular Research.

I was wondering if you could talk a little bit more about what you've been doing in Whirlaway. You've mentioned these sales programs, and what exactly does that entail? Can you just give a little bit more color on that?

The new sales programs you're talking about, Keith or...

Yes, sure, yes.

I think we've mentioned historically, and I know you're new to the story, but we've mentioned historically that there were 2 major new programs that Whirlaway landed in terms of organic growth and new business beginning in early 2010 and it amounted to $30 million of new revenue on a sales base of $45 million. And so we had -- we experienced significant startup costs in '10 on into '11 and then in the third and fourth quarter of '11, those 2 programs turned to profitability and the last 6 months of -- for the first 6 months of 2012, of course, we've seen tremendous efficiency, productivity and cost improvements and margin improvements on those 2 new pieces of business, those 2 new programs. And then, of course, we've said historically that we liked -- one of the reasons we like the acquisition was their ability to grow organically. Those 2 new programs were evidence of that. And we see future organic growth over the next 12 to 18 months on top of the existing $75 million or so of business moving forward in terms of additional new programs. And we've gotten our arms around getting new program -- from a program management perspective, the new management team that's been there since January of '11 have their arms solidly around program management, new program startup development and not repeating the sins of 2011 and early -- excuse me, '10 and early '11 relative to program startup.

Also on the cost of goods sold, improvement so far this year. I think you more or less alluded to the fact that Whirlaway has a lot to do with that. I understand you've got the level 3 ongoing cost improvements and you'd have the drag because of lower than expected sales. But if it is the case, that it's mainly been Whirlaway and because of seasonality, can you just address in terms of kind of the gross margin for the balance of the year? Is it going to -- I mean, should we see it kind of leveling off here? Or you think it could, in fact, track a bit?

I think leveling off is a good guidance to provide.

But I did say, Steve -- Keith, in my comments that when -- because we have a drag on margins in Europe, even though we're still profitable, that when we begin to get some additional volume there, whether it's through restocking or fundamental demand, we will get a pickup.

Okay. And then maybe one final question then I'll get back in line. Just to clarify your debt target. I guess you finished the year 2011 at about, I think, $78 million in debt? Is that -- should I take that to mean you're going to be -- you can get that down to about $58 million by the end of the year? And also can you talk beyond that into 2013 any kind of targets for your debt level?

Yes. When we talk about debt reduction, we're usually -- what we almost always are talking about net debt. So you would take a look at -- for some reason, we ended up with some cash in there, that would impact the net debt being down. But ideally, we would be down $20 million on the debt line as well, not just net debt. And then so going forward, we haven't announced any -- what our plans will be going forward. But if you -- the last strategic plan that we have out there on our Investor Relations presentation, you can see that we do have additional growth in that plan, both in acquisitions and in internal growth. And some of that will require funding. But unless we have an unusual amount of investment for growth in those lines, we should be -- we will be cash flow positive and we will have further debt reduction opportunities. And then we also have investment opportunities that we counter against that.

[Operator Instructions] Our next question comes from the line of Ross DeMont with Midwood Capital.

Not to beat this destocking issue to death. But help me understand, how much more sales have come off in Europe relative to production levels, because I'm assuming the difference between those 2 is basically destocking.

Yes, it's 10%.

Okay, so then maybe...

I'm sorry, the build rates in -- as Jim mentioned, in Europe are down -- depends on the OEM, of course. But call it 7% to 10% in automotive, and we're down 20%.

Okay. So there is a multiplier sort of in excess of 2?

Yes.

Okay. And so what you're saying is if -- there's 2 ways we can benefit; one, production levels can continue to comp down, but destocking can stop?

Yes.

Or production levels can flatten. So stop going down and the assumption that with flat production levels, we would actually have restocking.

Yes.

Yes, that's correct.

But your guidance contemplated something more like production levels continue to come down and we continue to face destocking?

Yes, I think production levels continue to go down and the destocking flattens out a little bit, no restocking [indiscernible] our guidance.

Okay, right. I mean it can't go on forever or they'll run out of inventory stuff.

Yes, that's right.

Okay. And then just on this -- of this year's $20 million CapEx, is it fair to characterize kind of half of that is investment and half of that is maintenance?

A little more than half is investment.

Growth associated with -- principally associated with the doubling of the China plant.

Okay. And I know you're not providing guidance on what the investment plan looks like in '13. But will the $20 million that's spent in this year, or call it the $12 million of investment CapEx, will that all be spent in this year, or will China require more in '13?

No. Maybe just a little bit more, but the majority is already committed and will be spent this year.

Okay, so absent growth -- absent deciding to spend on growth and absent acquisitions, so the baseline CapEx would be 8 to 10 next year and then its just what the plan contemplates?

That's right.

I think a more normalized CapEx number for us is close to 20 that you should definitely think about in terms of maintenance CapEx and funding some growth is in the $15 million range, not $20 million.

Okay. So you're saying maintenance plus growth in a normal year might be $15 million.

$15 million, yes.

Yes, got it. And if you really had to dial it back, you could get it down below $10 million if you needed to.

Yes.

And I'm showing there are no further questions. I would like to turn the call back to management for any closing remarks.

Okay, I'd just like to conclude today's call with summary comments regarding the full year of 2012. While the outlook remains uncertain, as we've said, at our revised levels of revenue guidance, we still anticipate solid earnings improvement from '11. Jim mentioned our goal of reducing our net debt by $20 million. We just spoke about that for 2012. This was a beginning of the year goal that is still achievable, but we believe the $20 million in net debt reduction, if achieved, will position us from a liquidity perspective beginning in 2013. So we assume the execution of our long-term strategic growth plan. Those plans support -- not only support, but fund both organic and acquisitive growth moving forward over the next several years beyond '13 and on into '14 and '15. Thank you again for joining us on today's call.

Ladies and gentlemen, this concludes the NN, Inc. Second Quarter 2012 Conference Call. If you'd like to listen to a replay of today's call, dial (303) 590-3030, or 1 (800) 406-7325 with the access code of 4556450. We thank you for your participation. You may now disconnect.