NN, Inc. (NNBR) Q4 2016 Earnings Report, Transcript and Summary

Good day, and welcome to the NN Inc. Fourth Quarter and Full Year 2016 Earnings Conference Call. Today's conference is being recorded. A question-and-answer session will follow today’s presentation. [Operator Instructions] At this time, I would like to turn the conference over to Mr. Robbie Atkinson. Please go ahead sir.

Thank you, operator. Good morning, everyone and thanks for joining us. I’m Robbie Atkinson, Vice President, Corporate Treasurer and Investor Relations and on behalf of our team, I would like to welcome you to NN’s fourth quarter and full year 2016 earnings conference call. Our presenters this morning are President and Chief Executive Officer, Richard Holder, and Senior Vice President and Chief Financial Officer, Tom Burwell. If anyone needs a copy of the press release or the supplemental presentation, please call Abernathy Macgregor at 212-371-5999 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 presentations and in the risk factors section in 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, acquisitions, 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. This presentation also includes certain non-GAAP financial measures as defined by SEC rules. A reconciliation of those non-GAAP measures is contained in the tables in the final section of the press release and supplemental presentation. First, we will give an update and an overview of the year and the quarter and then afterwards, we will open up the line for questions. With that said, Rich, I'll turn the call over to you.

Thanks, Robbie. Good morning and welcome to our year-end call. We will follow our normal format. We’ll begin with a review of the year, we’ll follow that by the fourth quarter, get in the guidance and then we'll open the lines for questions. So let's get started. Sales for the year came in at $833.5 million net of divestitures, the PEP acquisition contributed $183 million. Sales in the legacy business was negatively impacted to the tune of $16.8 million, driven entirely by the weakness in the industrial market. We had organic sales of $21 million outside of the industrial end-markets that offset it. So said another way I guess the best way to think about it, relative to the business is we had about a $40 million impact to the business due to weakness in the industrial end-markets primarily beginning with July, going through the end of the year. Growth in our non-industrial sectors offset that high by better than half, and I think that bodes well for our strategy around diversification because, clearly we had an offsetting series of action. Adjusted net income increased 22% to $39.5 million. Earnings per share of $1.45, operating margins improved 220 basis points to 12%. Free cash flow generated for debt repayment for the year was $45 million. So let me take a minute to comment on cash because I don't think we deep dive anywhere else in the presentation. If you think about the fourth quarter, we had a stronger than normal December and within December a stronger than normal second half of December. Normally we go through various shutdowns and so on in the last two weeks of the December. We didn't experience that this year. We had a little bit of market bounce towards the end of the year and so that manifested itself in a cash push of about $10 million in cash, which should have been in the year was pushed into January. So when you think about cash generated throughout the year, the debt repayment just consider that $10 million and then obviously you will see a flow through continuing through the 2017 and you will see it in guidance. As we move on to Page 4, earnings per share of $1.45, net sales again of $833.5 million. Again I need to point to earnings per share, as everyone is well aware, we issued 7.6 million shares in July of 2015. So that's contained in the comparative, but simply on the pure earnings basis for the organization, the enterprises grown 22% just on a pure basis. So we feel comfortable with the path that we're on relative to growing earnings. As we move on to Page 5, gross margin of 25.5%, a 430 point basis improvement driven in part by the PEP acquisition, but also the continued operational and flex discipline of the NN Operating System. As we move to operating margin, 12%, again up 220 basis points again in part because of the PEP acquisition and the consistent operational discipline across the rest of the operating group. As we move to Page 6, EBITDA margin of 17.9% up 221 basis points. SG&A at $80.7 million, $15.5 million of that is coming in from the PEP acquisition, especially when you consider we've done some retooling of the sales force and added resources there to grow that side of the business. And about $3.5 million of what we will call a lingering merger and acquisitions cost that probably disappear here shortly. So let's talk about the businesses let's start with the Autocam. Strong CAFE growth was in the Autocam group, was something simply affected by the weakness in the industrial sector and so that netted a scenario where Autocam and sales was down about $2 million. With that said, the adjusted operating margin was up some 60 basis points. So here is the way to think about it. I will tell you that the Autocam group did an impressive job in flex performance. We grew significantly in our CAFE business particularly in Asia and we performed better than expected flex on the incremental. Where we were hit and some relatively good margin products on the industrial side in North America, the Autocam group outperformed on the decremental. So put all back together and even though they are down $2 million in sales, they are up 60 basis points in operating margin. So I think the group did a nice job managing the business. As we move to Page 8, the Precision Bearing group they suffered the brunt of the hit in the industrial – in the weakness in the industrial market down, they are down $13.3 million. But even with that, they're up two-tenths of a point to 11.1 in operating margin and again a solid performance around flex on the decremental of the organization. As we move on to Page 9, the PEP group, this should be the last slide that you will see that has comps that are not really usable. We've had the business through about an entire cycle, so next time around you’ll see usable comps, so I apologize for that. But nonetheless sales out of the group was $258.8 million, adjusted operating margins of 22.9%. So here's the way to think about from the end of the first quarter to now the group has improved 210 basis points in operating margins. So we continue to drive improvement into what was already a fairly well producing business. And if you recall, from the time we bought the business to the end of first quarter, we were up about 100 basis points, at that point in time. So when you think about the way we bought the business and now we're probably up somewhere around 200 maybe 300 basis points in total. So we are feeling pretty good about that. When you get to Page 10, our scorecard. Overall we – I guess we would characterize the business on the margin side, as we are about, where we hope we would be at this stage of the game. Still lots of work to be done, but a nice clear path forward, we still have a little bit of softness on the top line obviously that attained unexpectedly lasted from the industrial market. But all in all, we think we're about where we should be the Company in total is up 430 basis points in gross margin. If you see up 30% in spite of the hit you see PVC up 100 basis points and PEP that number all things that should more like 300 basis points, up from since we've owned them. Operating margin up 220 basis points, and EBITDA margin up 210 basis points so we think we are about where we should be. As we move on to Page 11, in the summary. We think the diversification strategy is proving itself. We think the thesis continues to prove itself, albeit a differential in sizing in the business that we have had sort of a bigger electrical and medical business to offset the industrial business that would have been nice but nonetheless I think the strategy is proving itself. The NN Operating System continues to drive margin expansion and discipline around flex productivity is evident in the organization. PEP integration is ahead of plan. And our cash flow expectations are in line in spite of a challenging top line. As we move over and go to the fourth quarter, in the interest of time I’ll just cover the Q4 highlights and the business as a whole. I won’t deep dive into the individual businesses but be advised if there is questions around the deep dive into the business I'm happy to field them. Sales for the quarter was $202 million, PEP contributed $11.6 million. Organic sales growth $6.5 million in the quarter, I believe it was the first quarter of the year that we had organic growth in every one of our businesses. So it was nice to see that. Earnings per share of $0.35 gross margin improvement of 520 basis points on a year-over-year basis, $34.7 million of EBITDA. Adjusted operating margins of 10.6%, which was in line with expectation. Again I'll talk a little bit more about this, but it’s a timing issue and a mix issue, we knew it was coming and we saw the industrial markets and so it’s about where we thought we would be. Cash flow generated the debt repayment in the quarter was $13.7 million. As we move to Page 14, again a repeat $0.35 earnings per share, $202 million in net sales, as we move to Page 15, you see gross margin at 24.8% and the operating margin at 10.6% Let me take you back to gross margins just for a second. Right, we don't often spend a lot of time talking about gross margin in the business, but fundamentally it's about the purest form of demonstrating the improvement, the operating improvements in the business. And so the gross margins is up some five point in the business and I think that's about as pure as you can get in terms of seeing and realizing the improvement in the business. As we move to Page 16, EBITDA margin of 17.2%, SG&A of $20.1 million, again this is an overhang from the industrial market as you all well know. Our margin profile in the industrial markets are subsequently better than some of our other end-markets. And so when we mix down in industrial it is a little bit more painful than when we mix on some of our other verticals. We move on to Page – we’ll bypass Page 17, 18 and 19 and go directly to the summary again. A little bit of a repeat but the diverse portfolio is performing as expected. The weakness in the industrial market at least through fourth quarter is continuing. Again repeat the NN Operating System is driving the discipline that we expect and command a flex in the business is working well for. A solid free cash flow in the quarter and the PEP integration is as expected. So let's move over to guidance Page 22. First quarter guide is $212 million to $217 million on a net sales basis. Operating margin between 12.1% and 12.6%, adjusted EBITDA between $38.9 million and $40.5 million and EPS between $0.40 and $0.45. So clearly you see when we move the business back into an appropriate mix scenario and we continue to manage our flex you see the positive outcome of just a little bit of top line in the business. So especially following through on the EPS line. As we go to full year guide again it's a repeat of what we said last quarter. We are maintaining our guide $850 million to $880 million. Operating margins between 12.4% and 13%, EBITDA $157 million to $164 million, EPS $1.55 to $1.75, CapEx between $40 million and $50 million and again within that CapEx the right way to think about it is about this year normally were about 50/50 maintenance cost out to growth this year. It's possible more like 40% maintenance cost take out and 60% growth as we continue to invest in growing our aerospace and medical businesses. And then we expect free cash flow in the range of $55 million to $60 million, which would allow us to do de-lever even faster. With that, I will open the lines up for questions.

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

Thanks and good morning, Well, it sounds like you saw a pick-up in the business in December, late in the quarter and I wanted to ask if that improved demand environment has continued in January and February. And along those lines have you started to see Autocam margins recover year-to-date?

Okay. So let me start with the – say it from the beginning. So I think the way we're looking at the market is certainly I think we've seen a pulse to return to the industrial market. Where we're still studying the data because, as you well know in the industrial market there is the channel and then there's the end-demand. And what happens during the second half of last year was the channel really drained. And going into the year, going into December, they were in a position that if anything popped in January or in the first quarter, there just wouldn't be enough inventory in the channel to react to it. So we think at least part of what happened in the December came as a result of the channel positioning itself. I will say that, we obtained some recovery in the earlier part of this first quarter. But we're not ready to call the market yet, this just very well may be a channel repositioning, getting ready for what may come. Relative to the Autocam margins I will tell you, I guess the simple answer is yes. In part because as the channel recover whether it's channel demand or real demand as those sales go out the door the mix ratio is, goes back to an appropriate form and so yes, those margins they flow right through. Those incrementals are substantively better than even our CAFE incremental quite frankly.

Okay, great that’s helpful and then may be, one on free cash flow. You mentioned that $10 million of free cash flow that was pushed out, it sounds like that was a temporary item late in the quarter. But I'm curious why that 2017 guidance on free cash flow didn't change just thinking about that, I would – kind of expected guidance for 2017 to get pumped up by $10 million. So maybe you could just help me understand the mechanics on that?

Yes, I think, maybe the best way to put that is we're seeing the benefits of that certainly in Q1. We're just not ready to call the year this early. So we are maintaining our guide.

Fair enough. And if you look back on 2016 and some of the industrial headwinds you faced, I think you talked about it being about a $40 million, impact could you provide some more color on the sub-segments within industrial that were the key drivers to that weakness, just because industrial is such a broad category. I'd be curious, where you were most impacted and are those still the areas where you're seeing weakness today.

So I think if you want to talk about it from sort of a margin perspective, right. We would start with let’s call it big diesel engines, right. It’s a number that’s probably from a margin perspective the biggest area of impact. And then its followed by rock bit, so drilling equipment and construction equipment, zero-turn radius equipment those kinds of pieces, better margin profile and really, really high precision tough start. Again, in terms of recovery I would tell you that our initial read on the diesel engine side, it feels like its getting back to where it was first half of last year, I don’t know that we’re ready – again ready to call a recovery but its certainly better than it was in fourth quarter. On the rock bit side of the house, the zero-turn radius and the railway side of the house we are certainly seeing signs of life. Again recovery is something that we are going to reserve until the end of this quarter to call. Again because we don’t have a good feel for the positioning of the channel right now.

Okay, that’s helpful. I’ll go ahead and pass it on. I appreciate the time.

Thank you.

And we will take our next question from Rob Brown with Lake Street Capital Markets.

Good morning. I want to – I think you kind of mentioned just sort of what’s your sense on when you will have visibility in the industrial market, is that something you can get. The first part of the year, or do you really need to see it continuing into the full year here?

I think we’ll have enough quantitative data to make ourselves comfortable probably somewhere around the end of the quarter. We will have a good sense of what the channel has done, and the inventory within the channel and that will net itself out into real demand on the other side as products begin to flow and once that happens I think we have a fairly clear view of what market is doing.

Okay, good. Thank you. And then on the electrical and medical markets, could you just give the sense of kind of what you are doing there in terms of growth are you seeing development in terms of growth opportunities in those markets I guess in aerospace as well?

The electrical business, we came pretty close to double-digit growth last year, we grew about 9%, 9.5% in that business last year and the medical businesses I think we came in at about 5% or 6% last year in part because we had a number of programs that didn’t launch. So instead of hitting that kind of eight number, we were five or six. The aerospace business, again because it’s so small I mean we’ve doubled the business, right. And we expect to continue that and improve that trajectory this year. It’s probably one of our most exciting spaces and its growing certainly faster than even the other two and so its hopeful that we have a substance of aerospace business by the exit of 2017.

Okay, great. Thank you. I’ll turn over.

Okay.

And we will take our next question from Steve Barger with Keybanc Capital Markets.

Hi, good morning, guys.

Hey, Steve.

Good morning.

I’m going to stick with the industrial theme, we’ve been hearing from some of the distributors and some of your bearing customers, that they are seeing that same better order activity in late 2016 and early 2017 if you start to get restocking orders from multiple customers. How much of a volume increase could you handle, before running into labor capacity constraints? Do you feel like you have plenty of flexibility here?

Well, we’d have to answer that by geography. But in general, we absolutely have – we have capacity for a significant uptick before we start certainly adding direct labor, there’s a long way to go before we start adding cap – leading to the start adding capital, direct labor we probably got – we probably see somewhere between 5% and 7% before we have to make a direct labor move.

Okay. And then maybe a little early on this side, but similar question on the product that ends up in equipment OEMs. If you think about say CAT or Deere selling through their own dealer networks and those dealers want to put more inventory on the ground at some time. It would be a great problem to have but it’s the guy at the end of the chain, how are you thinking about getting ready for that, in the context of maybe seeing distribution orders picking up to?

On that side, we have what we affectionately call a phantom shift scenario where we essentially add, what’s known as a fourth shift, and so we have the plans in place to execute that should we need it. Because we obviously we don't want to lose the incremental by beating over time and we don’t necessarily want to drag in a permanent shift. So we have the sort of phantom shift scenario that optimizes the hours on the machines. So that's how we're looking at it. If it goes beyond that then we're going to – great problem to have and we’d be happy to chase that one but I think we are ready for it, because from the flex basis we are incredibly sensitized about not losing our flex on the upside. Should the sales comes, we have a flex expectation that’s better than our normal incremental for the first roughly, let’s call it $20 million than you see that reflected in the guidance for Q1. So the organization is really sensitized to making sure we hit the flex.

Right. Talking to a couple of distributors recently they are saying there are some signs of inflation on the channel, it doesn’t really seem like anything’s materialized yet but they’re talking about expecting price increases. Are you seeing input cost inflation and how would you respond from a pricing standpoint?

Yes, we are not seeing it at least not yet, and candidly we are not actually even hearing any rumbling about it. But as you all know, quite a bit of our enterprise we have the path circle. So when steel increases it’s a timing scenario, it may take depending on the contract it may take anywhere from 30 to 90 days but it’s a pass through cost. So we are fairly well protected for probably 70% of the business.

All right, that’s great. Thanks, I will get back in the line.

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

Good morning, guys.

Good morning, Larry.

Good morning, Larry.

Going back to the medical business for a minute, obviously last quarter you talked about a couple of delays on the government side. Just kind of what are you seeing on some of those products and then kind of overall for the medical business this year, should we still expect that the high single-digit growth range or there are couple of products that you are still would need to get approval on in order to get that?

I think the expectation of the high single-digit growth is appropriate for the year, I’d say this is cautiously with or without some of the approvals that we need. I think if we were to receive all the approvals, then we’d probably be certainly a less challenging year. But I think we have a plan build that we will see that kind of 7%, 8% growth irrespective or in spite of some of these approval delays.

Got you. And then just, I know its little early on the bonds to be taken about the call periods still couple of months out but just curious what you’re hearing in the marketplace and just how you're thinking about another refi-transaction on both that and essentially the term loan over the course of 2017.

So just for the record, it is never ever too early to be – so they keep me up at night. Obviously what we're seeing in the marketplace is favorable. So looking at doing some work around our debt, I’ll let Robbie comment here in a moment, but I think we are if something we live, eat and breathe every day and certainly we think there’s some EPS trapped in it and we hope to release this year and so on. I’ll let Robbie comment.

Yes, Rich said it well, the debt market is something that we are watching very closely the technical turns around the market are certainly continue to be favorable. We are watching our piece of debt and looking at that macroenvironment and combination and we’ll certainly move when we think it’s appropriate that’s the best value for the shareholders. So we continue to watch it and breathe it every day.

Got you. Well, hopefully you can stop staying up less at night some point this year.

That’s my plan.

Best of luck in the quarter guys.

And we will take our next question from Daniel Moore with CJS Securities.

Good morning, I wanted to just go backwards a little bit, Q4 operating margins were a little bit later, I know Rich you mentioned mix obviously challenging on a soft industrial maybe talk about some of the other factors and a gross margin really strong but where are some of the things that maybe kept SG&A a little higher than you might have expected?

Yes, we call out, I spoke – when I talked about cash that we had a strong part of second half of December. And so those for a lack of a better phrase those costs manifested itself kind of in the year, so it took a little bit of margin, while the cash pushed into January the cost paid in December. So that you just couldn’t shed that, there was no way to really shed or flex out of that SG&A at that point in time. So that currently impacted margins to the tune of probably about two or three tenths of a point.

Got it. Very helpful.

Obviously that and mix were the two contributors.

Okay, shifting gears the JV contribution increased nicely in 2016 just remind us what is your embedded contribution assumption for 2017 and what’s your outlook for growth beyond that?

So the outlook for growth in the JV is again it’s in line with the CapEx side of the part it’s going to be somewhere around 5% to 7%, the way things are going now it maybe a little bit better, I’m not sure if you are aware of that, a number of automotives are now beginning to launch next generation product in China, which is a great look tradition – traditionally next generation product launched in either Europe, Japan or North America. For the first time, at least two of the manufacturers are launching next generation product in China which is absolutely wonderful for us. So that business is doing real well. On a contribution perspective as you all know, we think we booked the dividend from the business.

This is Tom. There is no current maintenance of contribution into the business during 2017 and we do get a dividend of about 70% of their earning every year, when its declared by the board but that’s the consistent trend, we expect that to continue.

Got it, very helpful. Lastly, Rich, just looking a little longer term, historically it had $0.04 EPS goal in 2018, is there do you expect to update at some point is there a better way to think about the expectations for margin expansion and earnings growth as we look out beyond the year 2017 guidance?

Look, I think we are going through that sort of as we speak, with the hit in the industrial market that some $40 million, $45 million hit we said at that point in time, unless that market comes back there is certainly a gap to get to the $1 billion top line number, which then leaves a gap to get to the $4 EPS number we are probably somewhere down in the $3.20 or something like that. So I’ll just say, we are doing the math and we plan to talk about that in detail at the upcoming analyst meeting. But as it stand now, I will tell you since we are not ready to call the market yet, we are probably in the 920 to 950 top line range in the $3.00 to $3.20 EPS range if the market doesn’t come back.

Appreciate the color.

Okay.

And we will take a follow-up question from Steve Barger with Keybanc Capital Markets.

Hey, Richard, just had a quick question on the electrical business, first what is the big end market drivers there outside of residential and non-res and any update on how the products that’s coming together and what you hearing from customers.

The big drivers are anything around grid optimization, micro grid those are huge drivers for us, right. We talked a lot about smart metering and I think everyone thinks about smart metering only on the residential side recognize that the non-residential smart metering business is far larger than the residential smart metering business, right. So and we participate in everything not just – we do the electrical switching in all the smart metering. So it’s water smart meters, if not electrical smart meters, its energy smart meters its combiners, it’s all those things. So those markets are fairly attractive right now. And especially when you think about the December, January being tough residential month because of the crazy weather we’ve been having and so on. So take a look there, and a big contributor there on that smart metering side of the market and good business. In terms of products coming together I think were being received by some premier customers really, really well. I think they like the material sciences formularies that would bring into the market, I think they appreciate the ability to not only bring clad metals, Bimetal, and strips to the equitable. We can bring an entire assembly. And solve an entire solution for the customer and do the engineering that's probably the most exciting thing to them because we are consistently now being pinged by customers around, can you engineer this whole piece and that is exactly the position we wanted and expected to put ourselves in. And so it feels good, its working we are doing a number of development projects in this space and shipping kind of first time full one assembly under our customers names. And I think the strategy at least right now has worked.

All right, very good. Well I appreciate that. And good luck in the coming quarter.

Thanks Steve.

It appears there are no further questions at this time. I would like to turn the conference back over to our speakers for any additional or closing remarks.

No, I don’t think, I have anything. Thank you all for participating, great questions and we are looking forward to speaking with you soon around the first quarter. With that said, I think we can close the call. Thank you.

This concludes today’s call. Thank you for your participation. And you may now disconnect.