NN, Inc. (NNBR) Q2 2013 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen. Thank you for standing by. Welcome to the NN, Inc. Second Quarter 2013 Conference Call [Operator Instructions] This conference is being recorded today, August 6, 2013. I would now like to turn the conference over to Marilyn Meek. Please go ahead, ma'am.

Thank you, and good morning. Welcome to NN's conference call. 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 you to 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 Richard Holder, 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 will open up the line for questions. With that said, Rich, I will turn the call over to you.

Thank you, Marilyn. Good morning, everyone. Before we begin our remarks relative to the second quarter and first half results, I'd like to just take a minute to speak specifically about my first 2 months with NN. First, I'll tell you that my first 2 months has been jampacked with activity. I have spent quite a bit of time listening and learning, getting to know the owners of the company, the individuals that make up the company and the culture within the company. I visited most of our locations in the U.S. and Europe, and by the end of September, I will have visited all the locations around the world. As I visit these locations, I find myself becoming more and more excited about our ability to grow and our future on a regular basis. It's just really exciting to see the things that our folks are doing out in the field. It's very evident to me that NN's past is rich in history, culture and success, and I'm personally very excited to have the opportunity to work closely with the board and the leadership team in honoring this rich culture and history and more importantly, to begin to write the next chapter of NN's future which will be one of growth and incredible success. With that said, I'm going to turn it over to Jim to speak to the financials.

Thanks, Rich, and good morning, everyone. First, I'll say on behalf of the management team at NN, we want to welcome Rich to his first -- the first of what we hope will be many inspiring conference calls. We have all enjoyed getting to know Rich these last 2 months. We've learned a lot, and we're very excited about NN's prospects under Rich's very clear leadership. So just to briefly cover the numbers. Overall, revenue was up $2.5 million, or 2.7% versus Q1, which was much stronger than our normal seasonality, and most of this strength was in Europe. Revenue was down $2.5 million or 2.5% versus the second quarter of last year, which is still reflective of the low recovery in Europe. And Rich will discuss some more about the sales momentum and our strategy -- and our strategic response in a minute. The good news is that our pretax profitability from normal operations was flat with last year, despite the lower sales levels. Gross margins are up on lower revenue and our profitability was more favorable than one would expect, due to excellent cost controls and to the deliberate elimination of some lower margin business. We are excluding only $138,000 in after-tax foreign exchange gains on intercompany loans from normal operations, or about $0.01 per share. This compares with an excluded FX gain of $1.1 million or $0.06 per share last year. In comparison to the second quarter of last year, there's another significant difference from foreign exchange which is included in normal operations, but is large enough for us to discuss this quarter. Last year, we had an FX gain on the translation of European AR balances, which we do include in normal earnings, versus a loss in the Q2 of this year. The net swing was $280,000 after-tax or about $0.02 a share. So the profitability comparison to last year is even stronger if you consider this FX effect. SG&A was $8.3 million, down from $9.1 million in Q1, and in line with the guidance we gave in the Q1 call. SG&A should run at about the same rate for the remainder of the year. Interest expense is well below last year and slightly down from Q1, as we paid debt down during the quarter and short-term rates, as you know, remained very low. EBITDA totaled $12.4 million for the quarter, which is 2.9% of revenue, and this compares with $9.6 million or 10.2% of revenue in the first quarter. The improvement between the first and second quarter is primarily the leverage on higher sales, lower SG&A and more favorable nonoperating items. Pretax income from normal operations was $1.8 million or 33% higher than in the first quarter, due to higher revenue and excellent profitability leverage on the higher sales level. Every dollar of higher sales from Q1 to Q2 dropped $0.72 to the pretax line. And this is, again, due to good cost control, lower SG&A and depreciation and strong Level 3 savings at all of our operations. And that accounts for the profitability improvement. Income taxes are a negative comparison versus last year and versus the first quarter. Last year, the tax rate was around 19% as we were not accruing taxes on U.S. earnings. The tax rate this quarter was just over 36%, which was higher than the 33% rate in the first quarter, and this was due to higher income in our high tax rate areas, particularly the U.S. and Italy. Based on our forecast, for the remainder of the year, the tax rate should be around 34%. So we had EPS from normal operations of $0.27 and if you include a small adjustment, 28% -- or $0.28 in total, which was slightly higher than the consensus analyst estimates due to the higher revenue, the good -- and the good cost control, partially offset by the higher tax rate. On the balance sheet, the largest change from last quarter is that total debt is down by approximately $12 million. We had positive free cash flow of $9.5 million during the quarter, which is stronger than normal for the second quarter. Good profitability, combined with low working capital growth and low capital spending, combined to give us a good cash flow quarter. And also, I want to point out that the second quarter dividend that we declared was not paid until July, so this is not included in the Q2 cash flow. Our year-to-date capital spending is $4.9 million versus our plan of $17 million. We do expect for spending to be heavier in the second half, based on the timing of the projects we have underway. We continue to project that capital spending will total between $15 million and $17 million for the full year, and that total free cash flow will be in the $15 million range. That concludes my comments on the financials. And now, back to Rich to talk about business trends and strategic outlook.

Thanks, Jim. Let me frame our overall situation by saying that the persistent global economic slowdown continued to affect our business during the first half. Most notably, we're still operating about 10% below our historic highs but clearly, in line with what the IHS indicates are the European -- the European auto industry is off as a whole. So we're right in line with those numbers. With that said, during the second quarter, we experienced positive revenue momentum as was stated earlier. This was mainly due on the backs of the European heavy truck industry and a very positive note, it was better penetration around existing customers. We have quite a number of initiatives where we're doing some different things with our existing customers, and I think it's starting to bear a little bit of fruit. Second quarter sales of $96.3 million was an increase of $2.5 million over our first quarter, and I think that the significance of this is, as was stated a little earlier, was we shed approximately something north of $2 million in sales that was non-core, nonstrategic business. The decision to walk away from business is never easy, especially when it negatively impacts our short-term revenue. However, we firmly believe that this decision will strengthen our opportunities for profitable growth and optimal capacity utilization going forward over the course of the next 18 months. These developments, as well as discussions with many of our customers have been encouraging, and although we are bullish about the potential for upside to our business plan, the nagging uncertainties of the global economy cause us to remain cautious regarding the second half of the year. Therefore, we will hold our original estimates for the third quarter as well as the remainder of 2013. It's important to note that all of our operations have worked diligently to improve the operating performance of our cost structure. Our balance sheet is now stronger than ever and provides us with many opportunities to return value to our shareholders. We have challenged the organization to accelerate our Level 3 initiative for the balance of the year, in order to fund various infrastructure investments to ready ourselves for growth. Additionally, our continuing cost structure improvements will allow us to return improved incremental margin to the bottom line when the European economy begins to recover in full fashion. Finally, I'd like to briefly discuss the direction of our new strategy. Our new strategy will leverage the work we've completed over the last couple of years during the global recession around fixing our cost structure, and we will now focus on accelerated growth. Our plans will be to aggressively pursue both acquisitive and organic growth in our core business, as well as exploring opportunities in adjacent markets. Our goal is to have the strategic plan completed, embedded by early fourth quarter, and to be ready to share publicly by mid-fourth quarter. With that said, thank you for joining us today for our 2013 second quarter conference call. Hopefully, you can tell that we are all excited about the future of NN, and I can assure you that the board and the management team are more excited than ever to write the next chapter in NN's future. With that said, we'll now take questions.

[Operator Instructions] Our first question comes from the line of Steve Barger with KeyBanc Capital Markets.

Just, Rich, you talked about the next chapter being one of growth. Can you give us your initial impressions around the state of readiness for the plants to take on that growth after your kind of initial review?

Yes. I think, specifically, in our core business, the plants are ready. We have appropriate capacity. We have the appropriate machinery and candidly, we can add in our core business without adding a lot of direct labor or indirect labor. So it's pretty exciting, the opportunity that we have, especially since we've already somewhat fixed the cost structure. So we're ready in the core business. As we look into the adjacent markets, we're still doing some work around that, because as we move into those markets, we will utilize some of the technology we currently have, as well as acquire new technology. So we're still working through some of those pieces.

Any more color on how you're driving penetration at existing customers? How are you approaching that, and how much opportunity do you think is there?

In terms of the opportunity, it is -- I think the opportunity is significant. I don't know that I can quantify it for you. Our basic thesis is that we're at a stage in the capital cycle that folks are going to have to do a substantive amount of investing. And our customers are clearly demonstrating a posture that says they don't want to recapitalize their business in the way they did before. And so we have positioned ourselves as the theater operation of choice, if you will. So our discussion with them really is around helping them decapitalize much faster than they have, and deferring the capital investment that they'd have to make going forward. We've been fortunate to get some audiences here recently, that I guess on the strength of some changes and so on, in Europe, that's really helped us quite a bit, as well as here in the U.S. with our Ball business.

On the initial conversations, is that a hard argument to make or were they receptive to the idea? Is it something they would do quickly?

No, I -- yes, I think they're very receptive and I think it is something that they'd be willing to do, I'm going to say, relatively quickly. And having been with big organizations, quickly is very much a relative term.

Right. If you look at the next quarter or 2, are you -- how are you thinking about specific opportunities to drive margin expansion? Is it leveraging the supply chain? Is it spreading best practices? What can you do internally to really set the stage?

Well, we are definitely making a move towards leveraging the supply chain. We have created a position within the organization. We bring in someone to look at the supply chain and begin to do an awful lot of work around that. We buy on the order of about $105 million or so of material input, and we really don't have a program today that allows us to leverage that in any way shape or form. So the -- when we get this individual in, it's probably going to take a couple of months for that individual to get their arms around this, but we expect to see -- begin bearing some fruit around this, probably late fourth quarter. We have -- as I said earlier, we challenged the organization to come up with some more aggressive numbers around the Level 3 program. We think that's there. We think the opportunity to take some more cost out of the business is still there, and we want to use those savings to continue to fund some basic infrastructure needs that we have to ready ourselves for growth. We've got to make some IT investments and we've got to make some system investments. So we don't put the organization under too much pressure when the growth starts to come.

Great. Just a couple more and I'll get back in line. For the product lines you dropped, should we be straight-lining that reduction of $2.5 million for -- to think about $10 million for the year? Is that the right way to think about it?

That's a really good question.

Some of those product lines that we're dropping, have started dropping out in the third and fourth quarter of last year. So it's not a straight $2 million incremental, I think. We're seeing the biggest impact in Q2 of this year. I would pare it down in Q3 and Q4 of next year, of this year in comparable.

Does that -- does reducing those product lines or eliminating them, does that free up capacity? Do you have the opportunity to put in other product lines that have much higher margins relative to whatever you freed up?

Absolutely.

Our next question comes from Keith Maher with Singular Research.

Could you -- when you look at some of the opportunities for growth, and I'm taking several avenues, you've got acquisitions, you've got what you've talked about in terms of penetrating existing customers and then also, say, going out and winning new customers. Of this 3, I mean, where do you -- I mean, could you kind of weight them in terms of where you see most of the growth coming from going forward?

Yes. I think, let me answer it this way. I think the answer is different by our business segments. I think in our Rubber and Plastics business, the opportunity there really is going into adjacent markets. We have the technology, the equipment, the engineering skills to have a larger breadth of market access. So we'll be increasing our window to market and we'll be going after some things that we hadn't gone after before. So in the Plastics business, I think that's where that comes. In the Ball and Roller business, it really is around greater penetration of our existing customers and bringing a value proposition to them, much like the value prop that created this business, quite frankly, and it's allowing them to decapitalize, and us being able to produce a product that -- at a much lower capital base and hopefully, price at that point in time for our customers. In the Precision Machining business, that is where, I think, our ability to grow will come largely in our verticals -- in adjacent verticals, as well as a greater level of acquisition into different verticals. So we're a very, very high-end Precision Machining business, we are application-specific, and so we can take that technology and that cadre of technology, if you will, across multiple verticals. And that's what we'd intend to do in that business. Again, all of this will be vetted and publicly available. We'll start talking to this in the middle of the fourth quarter. We're still working through many of these things, so we can't quantify it just yet.

Okay. Great. That was helpful. And I understand the whole review, but would this mean -- if an opportunity came along, say for an acquisition between now and then, that you still might do that, right? You wouldn't necessarily wait for it forward.

Absolutely. This -- all these things, while they sound like they're a series of events, they're not. They're all simultaneous. We are working on all fronts.

Okay. And in terms of some of these products that had been discontinued, are there additional products areas you're looking at to get out of, in order -- that they just don't set the margin profile for the business?

Yes. Well, as we begin -- as we fine-tune our strategic plan, I think it's just good business to always review the products and everything within the business, to make sure that it's not necessary -- it may be always necessary to prune the tree. So we'll always be reviewing our products to ensure they fit those strategic profile. But right now, we think we've made a fairly substantive move and the likelihood is we probably won't make a move like this again this year.

Okay. And just a question on debt reduction. I think the target for the year was $15 million in net debt reduction. And I think you've produced at about $4 million in net debt so far this year. Is that -- are we still on target to do that reduction this year?

Yes, we're ahead of target to reduce that. But as I mentioned in my prepared comments, capital spending is more heavily weighted to the second half. So we -- the cash flow generation won't be as strong in the second half as it was in the first. But we should easily make our $15 million target debt repayment.

Okay. Great. And on CapEx, is that -- I don't know if you talked about this before, but kind of what spending this year is just maintenance CapEx and how much is related to capacity additions?

This year, less than 1/2 of the spending is on maintenance. The majority of it is specifically for new programs that we've won, that will begin generating revenue in late '13 and '14.

Our next question is from Ross DeMont with Midwood Capital.

Richard, welcome to the company. Jim, can you just -- sorry, I know this should be easy, but just what should the year end net debt number be based on your guidance?

Okay. 1 second. It should be approximately $35 million.

Okay. That's great. And then either Jim or Richard, I mean, there's been a little less discussion on this call about de-stocking, especially in Europe. I think, Richard, you said that your sales are down commensurate with vehicle sales in Europe, so sort of implying or suggesting that we're no longer suffering de-stocking from our largest customers. Am I interpreting your comment correctly?

Yes. We -- as we look at the numbers, it has seemed like our customers are at the level, maybe a little lower than they would like to kind of...

In terms of their inventories?

In terms of inventory. We're not getting any indication that there's going to be any more de-stocking taking place.

Okay. So I guess I'm a little confused because previous guidance assumed the continuation of the de-stocking trend. Now I'm hearing that we're not going to face de-stocking, but guidance is staying where it is. Is there sort of an upward bias here, but it's just a little early to lift it? Or I'm confused why guidance hasn't changed if we're not suffering de-stocking any longer.

Well, from my perspective, we have an awful lot of uncertainty going on. And some of the pieces of the market are not behaving, let's say, in a sensical fashion. So again, while we think there's probably some good potential, second half of the year, we're just not willing to lift the guidance just yet. We need a few more data points, I think.

[Operator Instructions] And our next question is from Steve Barger with KeyBanc Capital Markets.

Just following up on that last line. Is some of the revenue momentum that you've seen in the heavy truck market in Europe holding through July?

Yes, definitely. It looks good through the end of July, for sure.

And any kind of -- you said there's still weakness in Europe. I'm sure you're talking about light vehicle, but as you talk to your customers, as you've been making your reviews, beyond just seeing an end to de-stocking, are they optimistic that the production schedules will increases as we go in the back half?

Yes, I think -- I don't know if -- optimistic may be too strong a word. I think they certainly feel that we've bottomed out. And so with that, I think they feel that maybe there could be a slight uplift, but I don't think anyone is willing to commit to that just yet. I am heading back over there actually, later on this month, to have some more customer discussions. So it's a tough time. These are interesting variants that are taking place.

Right. Well, and just a little more clarity on the margin improvement in Europe. Was it due to the sales momentum and seeing some message from operating leverage? Or was it more on the operational side in terms of discipline and cost takeouts and that sort of thing?

Candidly, it was a little bit of both, right? The cost structure, they've done a really nice job over there of getting the cost structure in line. So when we see the incremental sales, we're getting better than a 35% leverage uplift. So it sort of proves our thesis all along. When this business comes back, we'll drop a lot more than our normal incremental to the bottom.

Right. That's great. Switching gears, you said you're working on all fronts for the various avenues of revenue growth. Can you talk your early read on the slate of opportunities? Have you actually started doing diligence on any specific targets?

Yes. Well, I'll say this. We are certainly attracted by a few targets and discussions are taking place.

Okay. Any specific markets you see as being at the forefront of your efforts?

Candidly, Steve, I'm not sure I'm comfortable.

Okay. But overall, it sounds like you are excited about the slate of opportunities that are in front of you, both in terms of the things you can do internally and the external growth initiatives that you can drive.

Absolutely, absolutely.

Thank you. There are no further questions at this time. Please continue with any closing remarks.

Wonderful. Well, thank you all for joining us today again. I hope you can see that the leadership team, and as well as the board, are very excited about our opportunities to grow and to write the next chapter in the future. So with that, we look forward to speaking with you next quarter. Thanks for joining us.

Ladies and gentlemen, this concludes the NN, Inc. Second Quarter 2013 Conference Call. This conference will be available for replay after 1:00 today, through August 13, 2013, at midnight Eastern Time. You may access the replay system at any time by dialing 1 (800) 406-7325, and entering the access code of 4630855. Thank you for your participation. You may now disconnect.