NN, Inc. (NNBR) Q1 2016 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen, and thank you for standing by. Welcome to the NN Incorporated First Quarter 2016 Conference Call. During today's presentation, all parties will be in a listen-only mode. Following the presentation, the conference will be opened for questions. [Operator Instructions] This conference is being recorded today, May 5, 2016. I would now like to turn the conference over to Mr. Robbie Atkinson. Please go ahead, Mr. Atkinson.

Thank you, operator, and good morning, everyone, and thanks for joining us. I am Robbie Atkinson, Vice President, Corporate Treasurer and Investor Relations. On behalf of our team, I would like to welcome you to NN’s first quarter 2016 earnings conference call. Our presenters this morning are President and Chief Executive Officer, Richard Holder, and Vice President and Principal Financial Officer, Tom Burwell. If anyone needs a copy of the press release or the supplemental presentation, please call the Financial Relations Board at 212-827-3746 and they will be happy to send you a copy. Before we begin, I would ask that you take note of the cautionary language regarding forward-looking statements contained in today's press release, supplemental presentation and the risk factor section of the company's 10-K for the year ended December 31, 2015. This same language applies to the comments made on today's conference call, including the Q&A session, as well as the live webcast. Our presentation today will contain forward-looking statements regarding sales, margins, foreign exchange rates, cash flow, tax rate, acquisition synergies, future operating results, performance of our worldwide markets and other topics. These statements should be used with caution and are subject to various risks and uncertainties, many of which are outside of the company's control. The presentation also includes certain non-GAAP measures as defined by SEC rules. A reconciliation of such non-GAAP measures is contained in the tables in the final section of the press release and the supplemental presentation. First, we will give an update and overview of the quarter. And then afterward, we will open up the line for questions. With that said, Rich, I will turn the call over to you.

Thanks, Robbie. Good morning, everyone, and welcome to our first quarter 2016 conference call. As usual, I will start with the highlights of the quarter; we will move through the deck in some detail and then we will give the guidance and questions. In terms of highlights, in the quarter we had $212.2 million in sales, $56 million of which came from the acquisition of PEP. Our adjusted earnings per share was $0.27, which was slightly above the midpoint of our guidance. Our adjusted EBITDA was $35.6 million, which was at the top of our guidance range. Adjusted operating margins increased 220 basis points compared to Q1 2015, which exceed our guidance range. We will chat a little bit more about that as we go through the presentation. Our free cash flow is ahead of expectations. Let me give you a little color around free cash. As the operating system continues to take hold and pull efficiencies out of the business, we’ve used in the first quarter about $5 million in cash, round numbers, about $5 million in cash; we had expected and/or planned to use about $50 million in cash. And so fundamentally want to say we are round numbers about $10 million ahead of plan. I think it’s important to note as an indicator of how much this has changed. If you look at free cash first quarter 2015 versus first quarter 2016, we are $22 million better, round numbers, than we were. So I think it’s one of the indicators that the business continues to morph. As we move to page 5, in first quarter, financial summary, adjusted earnings per share, I talked about that, $0.27 versus $0.41 a year ago. We are all aware of the share issuance, so see the comparator there. Net sales, $212, again PEP contributing $56 million of that growth. As we move on to page 6, when you look at gross margin were 370 basis points better year-to-year, so we are at 24.7% and about where we think we should be operating relative to gross margin. On an adjusted operating margin, we are at 11.3%. If you look at that from a guidance perspective, we are about a full point better than the midpoint of our guidance and about 80 basis points better than the midpoint of our guidance. So we feel that the operating system is continuing to take hold. As we move on to page 7, adjusted EBITDA margin, about 210 basis points improvement over 2015, so coming in at 16.8% versus last year 14.7%. SG&A were at $20.7 million versus $12 million. Let me give you a little detail around that. The way to think about this is in the quarter we have the first full quarter of PEP and then we have roughly somewhere between $2.5 million to $3 million of additional investments, which we detailed for you in the integration plan mostly geared around the frontend development and market development and so you’re seeing this come out in the SG&A uptick. Moving on to page 8 and getting into the groups, the Autocam Group, sales were up $1.4 million, driven almost entirely by the increasing demand for CAFE products. The group is performing, I think, fairly well. On the adjusted margin side, the group came in at $13.2 million versus $11.5 last year. I think it’s fair to point out when you look at the margin comparable, fundamentally the top line was extensively the same, we’re talking $1.5 million. When you think about the margin, and we’ve been kind of saying this all along, the longer we have the program, the more efficient we get. So if you look at 2015, the Autocam Group proper was about 10.4% margin – adjusted operating margin in this space and the JV added 1.1%. When you look at 2016, the Autocam Group proper is 11.5% margin and the JV added 1.7% of margin. So we think as the operating system continues to take hold, continue to do our cost out activity, we are seeing the kind of uplift that we expect to see. As we get to the Bearing Group on Page 9, sales were $64.7 million, down from $73.2 million. $1.4 million of that is currently and as the year goes on that comparison will disappear, but let me take a minute to talk about some detail around this. The predominance of our exposure in the industrial market in this business occurs inside of the Bearing Components Group. I think we’ve all seen the large industrial machinery folks, the large bearing folks, they came up light in the first quarter, which manifested itself and our lightness in sales candidly, and they are forecasting to be light in the second quarter. And so we've built that in, and we will talk a little bit more about this when I get the guidance, but fundamentally the industrial markets are clearly bumping along the bottom and our customers are telling us that in the first half, they feel the second half there will be a return of the market that’s more of a relative statement than anything else, the markets will come back with some uplift because of inventories, but that $6 million it is about the exposure moment that we have in that market. So, we’ll talk a little bit more about that when we get to guidance. Adjusted operating margin 10.9%, they rebounded well. The businesses come of the bump that they had in the fourth quarter and performing as we expected, so we're feeling pretty good about that business. As me move on to Page 10 and we look at the PEP group, the comparisons are a little skewed because we are comparing PEP to what was the Plastic Group, but nonetheless the group came in at $63.5 million for the quarter, $56 million of that was the acquisition of PEP with the acquired business. Adjusted operating margins of 20.8%, which is in line with what we expected for the group. So as we move on and we get to the first quarter summary, we think largely first quarter was in line with our expectations certainly. The operating system continues to drive margin expansion and efficiencies within and across the enterprise. Our free cash flow is better than expected and we suspect that that will continue throughout the year. The Bearing Group has rebounded nicely from a tough Q4 and they are poised to have, well 2016 that is as expected. The integration of PEP is on track and going very well, especially on the financial side we feel pretty good about that. And as we move into the guidance, just as an overall statement, we are reaffirming our guidance for the year. So let's move to Page 12, well I guess Page 13 in the deck, so for the second quarter our guidance is on the top line is $215 million to $225 million, our sales continued to increase. When you think about the sales and Group PEP is going up about 9%, APC is going about 0.5, PVC is going about close to a point, so we continue to see the sales increase. What you see, the lightness that you see reflected here is all in the industrial markets and what we're hearing from our customers about the softness in the first half. We’re hearing, our customers are telling us the market will return in the second half with some uplift as well because of the restocking characteristics of that market. So, it doesn't return one for one, just like it doesn't drop one for one. So that accounts for about $6 million to $7 million and that really is the lightness. I want to be really clear about something. The balance of the business is performing as expected and better. The electrical business and the medical business are coming into their seasons if you will, we are seeing the order, we are feeling the operation going well. So the balance of the business is going well doing well and candidly there is an opportunity to close some of the gap from other places in the business. So the rest of the business is good. This is a macroeconomic, kind of a purely macroeconomic discussion where the industrial business is. From our margin perspective, you see we continue to climb, so we’re going 13.2% to 14%, EBITDA $40.2 million to $43 million, and EPS $41 million to $48 million. So let me take you back into this just a little deeper one more time. If you look at what we’ve lightened the top line on and you calculate the decremental, our decremental is coming in better than the 25% that we always said we would. If you recall we always said we got incremental 35% decremental, 25% in this particular scenario in part because of mix we’re able to get a decremental that is even better than 25%. So the business is running as we would, as we have planned and as we hope, and as we expect, net of the macroeconomic scenario in the industrial market. As we move to Page 14, as we move to Page 14, again we are reaffirming the year, I won't walk through the page point by point, but I will say again, we have, our industrial customers are signaling a much stronger second half and with some uplift in part because of the inventory characteristics of the space. So we feel pretty good that a reaffirmation of the guidance is good and we see the demand there. So, we feel pretty good about that. When you think about this whole push out from the industrial space, a good chunk of that has manifested itself in pushing out program start-ups and outsourcing delays. So the way to think about that is, that is directly related to the timing on CapEx. So, if you think about our CapEx guidance overall we’re probably right now leaning more towards the low sides and the high sides, simply because if these programs start up to three months later than intended, we will spend the money to three months later than we need to. I think that’s it. I think with that we can open the phones up for questions.

Thank you. [Operator Instructions] And we’ll take our first question from Justin Long with Stephens.

Thanks and good morning.

Good morning, Justin.

On the 2016 guidance I was just wondering if you could provide some additional color on your assumptions by segment, Rich I think you talked about the second quarter, but each of the three segments could you talk about what you're assuming from both a top line and margin perspective for the full year?

Well I mean we are holding to the plan, I think if you think about the top line, again from when you look at PEP we are assuming roughly 9% of uplift in the second quarter. If you think about APC, roughly about 0.5% uplift in the second quarter, and PVC fundamentally is flat. It is something left in the point, we think there is a little bit to be had there. From a margin perspective all in, I think we have it listed here was 13.2% to 14% on an operating margin perspective for the enterprise, clearly the PEP Group carries a higher margin profile than say the Bearing Group or even the APC Group, but they are all performing well. So, hopefully that answers your question.

That does and just to clarify those percentages you gave on the second quarter, those are sequential increases correct?

Yes, those are sequential increases.

Okay great, just wanted to clarify that. And then on the industrial macro headwinds that you mentioned in the first half, hopefully that changes as we progress into the back half of the year, but could you talk about the magnitude of the pickup that either you're expecting in your guidance and/or your customers are telling you about later this year?

I think the way we have it – we have it built-in is second half of the year the market comes back somewhere in the tune of $6 million to $8 million in each quarter, probably call it $6.5 million of that is direct market and the balance is the inventory restocking. That’s the assumption we have. That’s what we’re hearing from the customer demand, certainly is what their demand patterns are same. With that said, we’ve seen some discussion about some strength of fuel in the industrial space just here late this month, but we’re not counting our eggs before they are hatched.

Okay, that makes sense. And then maybe one last one from me, but I was wondering if you could provide an update on how your CAFE related business performed in the quarter and I think on the last call you said that your full-year guidance assumes about 4% top line growth from CAFE related products. So, I’m just curious if that assumption has changed at all?

No, it hasn’t. And I think if you go back to the Autocam numbers, you see those guys were up $1.4-ish million on $81 million, $82 million. So we haven’t come off of that. It certainly bearing out the way we suspected. And I think it’s pretty obvious that the margin is rounding into the space where we thought it would, but we continue to say it along that we have a program and we apply the operating system to those program. We can pull more and more margins out and I think we’ve proven that. Let me make one more point around that and it’s not lost in the background. The Autocam group is operating under these numbers with a continuously deteriorating Brazil, right. So this – a lot to be said about how well the group is performing. We think we’ll see a little bit of relief in Brazil late in the year, but that’s not baked in here either. So I think the plan is bearing itself out the way we thought it would.

Sounds great. I leave it at that. I appreciate the time.

We’ll take our next question from Daniel Moore with CJS Securities.

Good morning.

Good morning, Dan.

Rich, thanks for the color. Just kind of drilldown a little bit into bearings in terms of Q1 and Q2, maybe just a little bit more color as far as either end-markets and/or geographies were you’re seeing particular incremental weakness and is there any individual customers that are softer as it really just more functional sort of across the board?

Yeah, I think the weakness especially from a percentage basis is pretty much across the board right. It’s the big bearing guys, the big yellow machinery manufactures, it’s all those guys. And they are all off between 9% and 11% in this space; it’s incredibly tight how they’re all off about the same kind of numbers. And that’s at least in part would gives us confidence that it’s truly macro and it’s not share or something being pushed around.

Okay. That’s helpful. In terms of restructuring, the cost incurred in Q1 were a little lighter than at least we had modeled, I’m not sure about your internal expectations. Have some of the plans and initiatives in costs associated been pushed out at all into Q2 or the remainder of the year?

Yes, the Wheeling plant closure, some of the cost was moved from Q1 to Q2, but in total the cost of that restructuring is the same, which have been – difference between the two quarters due to the timing of the actual exit of the plant.

And that’s embedded in the restructuring cost guide that you gave for Q2?

Correct. We have $3 million in there for Q2.

Correct.

Okay. That’s helpful. Go ahead, I’m sorry.

I said to cover that and some additional other programs, but beyond Q2 the restructuring should be very minimal.

Got it. That’s helpful. Lastly, just SG&A, just under $21 million for the quarter, is that a reasonable quarterly run rate as we look to Q2 in the back half or is there opportunity to bring that down a little bit?

Well. We’re always looking for opportunity to lean that out, but I think that’s a reasonable run rate for the balance of the year. Again, part of that is increased resources to do some front-end development in the newly integrated businesses, which candidly we just haven’t done before. And so, I will tell you that I think we’ll run that way for the balance of this year and we can probably lighten the load a bit next year because we will have a more mature platform, but there is still a lot of work around market development and growth to be done in the integrated business. So I think that’s a good 21, little shy of $21 million is probably a good run rate.

If I were to through a last one in, you mentioned medical and electrical performing inline, just any additional color you want to get there?

I don’t know how much more I can give. I think we have a fairly robust plan. I think we have a lot more opportunities than we thought we would, the ones we thought we would land, we’re landing. Certainly, we’re excited about the fact that we have the much larger pipeline than we thought we would and we’re quite hopeful that we can convert on the pipeline faster. As you know those businesses are a little unique where you’ve get FDA approval, you’ve got - there's a number of things that you have to do that prevents you from being able to flip something overnight. With that said, we won a few programs that we are moving light speed trying to go through the approval process and see if we can pull the program into 2016, but we won’t commit to that yet because that’s a federal approval thing. So, we’d slate to their timing, but the base plan is there. It’s solid and the businesses are performing like I said, as we expected, so we are very excited about that.

Very good. Thanks for the color.

We’ll take our next question from Stanley Elliott with Stifel, Nicolaus.

Hi, guys. Good morning, thanks for taking my question.

Good morning, Stan.

Rich, can you talk about, all the new business is winning, when does that start to translate into top line numbers for you guys?

Well. It’s different obviously by segment. Some of the new business that we won and we newly won late last year and earlier this year is already in the plan and so it’s there. Some of the newer business, I will long call the program, but at least one we won earlier this month because it’s in the medical space. It could take the better part of this year to finish all the approvals and find something to the P&L late fourth quarter maybe as far as first quarter. It’s all over the math and I don’t want to bore you, but we are products in the electrical group and candidly we already have a UL approval on. If we won something associated with that, we could turn that into revenue in 60 days. Then we have products that we can win and it could take six months worth of testing to get the UL and everything else we need before we could turn it into revenue. So, it’s really very program specific when we look at these things. I’ll give you another great example. We’ve won a CR program in Brazil. We will probably be able to turn into revenue this year because it’s a product that we made a similar product to force the odd, in a different space, some - about a year and half ago. And so they’re moving the products out of one geography into another and we won the product. So we confirm that pretty quickly. We’ve got the equipment, we’ve got the knowledge. We’ve already have the certification. We’ll go through key path and we’ll turn that quickly. Other things that were brand new, we’ve got to go through the entire process again. So it’s really very program specific.

That sounds fair. I know you guys have been attending a number of new tradeshows kind of highlighted in the new portfolio, maybe can you talk about some of the discussions that kind of the new customers that you’re meeting with just kind of help us frame out kind of the bigger picture with the newest platform?

Yeah. The tradeshows have been very exciting, especially handover because sort of everyone is there and the reaction I think a large part is they didn’t know you guys did any of this, which if [indiscernible] last year we probably we didn’t. And so, we’ve garnered a lot of interest, I would say across the Board and all of our segments, especially from the handover show [ph] and we’re spending an awful lot of time now educating those guys on our capabilities. We have an enormous amount of customer visits in the next two months. Because everyone wants to see the capability, they want to understand the capability, they want to understand the underlying technology support. I think especially there’s a couple of fairly big programs that we’ve been invited to quote on the aerospace side of the house and at least in part, we’ve been able to quote that business because we have the underlying machining technology and skill and engineering inside the Autocam Group as NN that can support sort of the purest aerospace machining probably with inside of our PEMCO organization. So, again we have, we’ve quoted the business, it’s a nice size chunk of business, it’s a long running program. We’ve been invited here recently to quote on the newest of the news in program inside of aerospace and that quote will be going back here in the next couple of weeks and we have a number of customer visits around that. So, the churn and the interest is extremely high across all the platforms, but we’re pretty excited.

It’s great news. The China JV was a actually a little bit was significantly more profitable than I would guess. Was that a good run rate and then maybe could you kind of highlight us what’s happening within the Chinese market?

Yeah. So it is good run rate. So you can certainly role on to that and I think the way you think about it and I think we talked about it last call. When you think about China for us in that space, you think about, let’s call it the high-end multinational find - it is a function of the wholly-owned facility and sort of the bear bonds Chinese market is a function of the JV. Correct? So and then that’s true for technology and everything else. So when the stimulus is injected in China, it’s injected in the sort of the purest Chinese market and with the Chinese brand. I don’t want to call it low end, but the brands that are sort of pure internally China focused, right. And so we see those brands out of the JV, and so part of what you’re seeing is that manifesting is up.

And last, when kind of you talked about the industrial piece and kind of the push-outs, is there a risk of that some of these bearing companies that you supply to, would want to start taking things back in house because their markets are little depressed and they have excess capacity or is it the other way around that you think that its more just, it continued to be a matter of time before they start to push more and more product down to you guys? Thanks.

Yeah. I think that’s a great question. I’ll say this, the nice part about the industrial space is, the industrial space is predominantly the roller business and so if you look at - and I’ll point anyone, obviously general statement. If you look at say SKF’s roller business, it is us. They don’t actually have any internal capacity to take that back in. We bought that business from them some years ago and have been their main partner in that. Some of the others have capacity, obviously the largest role of manufacturer on the planet, out of Ohio, they have internal capacity and they do certainly have the ability if they want to pull something in to pull it in, but from our perspective if you recall we have just begun to grow with them. So the worst case scenario from that is it manifests itself as a bit of a program delay, not really revenue disappearing. So, we think that risk is minimal, but we do continue to study that every day. I think if it were on the ball side of the house that would probably be more of a discussion then on the roller side of the house, and roller is our, fundamentally the industrial market.

Perfect. Great guys, thank you and best of luck.

Thank you.

We’ll take our next question from Steve Barger with KeyBanc Capital Markets.

Hi, good morning.

Good morning, Steve.

Looking at the consolidated gross margin increase of 370 basis points, how much of that specifically was attributable to the NN operating system do you think?

That is a great question. I’ll be honest with you Steve, we haven’t broken that out that way, right. The operating system is kind of how we do business right. So, everything we do when we put together a program when we put together a line we have very specific guides around how we do it. I think it would be tough to carve that out and say this is specifically the operating system and this is specifically the technology. I will say this though. From the supply chain and the purist cost out if you will piece of the operating system, it’s probably in the quarter, it’s probably half a point.

Okay, that’s good.

From that perspective.

Yes. I'll I guess I’ll try it this way, as you think about your list, your wish list of high payback improvement projects, is there anything sizeable you see on there that can make a material impact to operating results as soon as it gets done, or is this more a function of seeing a lots of smaller projects in the plant that will in aggregate improve results over time?

I think it’s a network of a number of things that will make this happen. Unlike last year where we had, we had a big focus on the denzel line that we really pushed on hard. I don't think we have any single big project, I mean probably getting Mexico where it needs to be is probably the biggest one we have. We get that, that's probably a need to move, but beyond that most, it’s a large array of a number of things that’s going to pick up a point here, point there, so I think Mexico is there and candidly we’ve not talked a lot about it, is making sure we continue to manage Brazil. If we can get Brazil or keep Brazil to breakeven that would help us immensely, right. Again we believe in the region where we’re winning a lot down there, but part of the winning is that everyone is believing, but it turns the corner sooner than later these could be a really nice time.

Right. Well you said, even with some of the headwinds like Brazil, you were $22 million ahead on free cash flow versus last year and you said you suspect that will continue, so was there anything unusual in the quarter in terms of working capital or anything else or why do you suspect they can't continue?

No, there wasn't anything unusual, I will say that we have put in a new program under the operating system around working capital management and I think we touched on it the last call a little bit and where we have a program that is, what's trying to drive of five day conversion cycle improvement and clearly we've had some success on that, we expect to kind of get through that probably in the first half of the year and we think it will be sustainable. So that’s why fee feel pretty comfortable around that.

Alright, sounds good. Thanks for the time.

Thank you.

We’ll take our next question from Imran Bora with Citizens Bank.

Hi, good morning.

Good morning.

I have a couple of questions on the margins. So if you – for the bearings business, so margins year-over-year declined, is that mostly because of FX?

Well, yeah, $1.4 million was FX and then there is very little lift, but it’s kind of pure volume at better than 25% decrementally.

Okay. And if you look ahead, do you expect margins to improve on a year-over-year basis?

Yeah, absolutely.

Okay. And for your – the PEP business, I know it’s new acquisition, if you have to compare organic margins year-over-year, is that an improvement or is that flat or negative?

Okay, if you carved out the PEP business on – for quarter-to-quarter, year-to-year, they are up slightly on purely organic margin. And it’s a number of reasons, one, there are something that we have been able to do inside the business to help and get a little bit better; and two, there’s some cost that we’ve ripped out of the business as part of the operating system that they no longer bear.

Okay.

So to say it in another way, we are still doing the real work, but we are getting the incremental improvements and one of the biggest ones is on the IT side, right.

Okay. And my last question on Autocam. The improvement margins, is that mostly a function of doing more CAFE business?

Well, I’d say, yes, right. So the CAFE business is climbing. We’ve done the majority of our leaning and operating system work on the CAFE sales, so they are some of our – not some of, they are our best performing sales inside the business, so we get a higher incremental rate for every dollar that – of sales that increase.

Okay. What percentage of your revenues come from CAFE currently?

For the entire business? Let’s call it somewhere between 25% and 30%.

Okay. All right, that’s helpful. Thank you.

Okay.

[Operator Instructions] We will take our next question from Larry Pfeffer with Avondale Partners.

Good morning, guys.

Good morning, Larry.

So, looking at the bearing business and getting to the second half, are you kind of expecting a flat-ish sequential move from Q2 to Q3 or when you are talking about not a one-for-one move because of the inventory cycle that you could actually be up a little bit in the second half from Q2 levels?

Yeah, no, sequentially, we are expecting to go up.

Okay.

And I mean theoretically we should get that macro loss back and then the inventory stock.

Got you. And so that’s – and that’s going to be across your book of the industrial customers, it’s not just one that you think you have kind of an inventory issue moving back and forth?

Right. Well, we – I mean we are – we know what the inventory is because we control a lot of their inventory, so we know that the levels are down. So if the demand is there, we know what they have to build back to and, yeah, it’s strikingly similar across all of them.

Got you. So you don’t think you need to see really an improvement in demand, just that if it’s stable from here, inventory levels need to normalize a little bit?

No, no, that’s not accurate. There was a loss of demand in the first half of the year that our customers and we agree will – we think we will recover in the second half of the year. In this business, when you lose demand, you have to adjust your normal demand pattern and you have to adjust the inventory, right. So you go down a little harder than you come back up. So when you come back in the second half and demand is there, you have to refill the pipeline and you have to then begin to service the direct only and so that’s why it looks a little lumpy.

Okay. That was helpful. Thank you. And then just looking at working capitals, nice job in the quarter. How are you thinking about building inventory yourselves over the course of the year? Trying to hold it relatively flat at current levels or try to maintain it below the ramp in revenue?

I think we are looking pretty well flat from here. I will probably push number around here and there depending on who’s doing, what are the given time and the different seasonality, but I think the corporation will be pretty well flat from where we are, maybe a little improvement.

Got you. Okay, thanks for the time guys.

Okay.

And with no further questions at this time, I will turn it back to management for any additional or closing remarks.

Okay. Thank you very much for spending the time with us. If you have any further questions or you need any more details, please feel free to reach out to Robbie and/or Marilynn and we will get back to you as soon as possible. So with that, thanks for joining us and we will see next quarter.

And that does conclude today’s conference. Thank you for your participation. You may now disconnect.