Altra Industrial Motion Corp.
Q3 2014 Earnings Call Transcript

Published: 24 Oct 2014

[Operator:]

Greetings, and welcome to the Altra Industrial Motion Third Quarter 2014 Earnings Call. [Operator Instructions] As a reminder, this conference is being recorded. I would now like to turn the conference over to your host, David Calusdian. Thank you, sir. Please go ahead.

[David C. Calusdian:]

Thank you, Brenda. Good morning, everyone, and welcome to the call. With me today are Chief Executive Officer, Carl Christenson; and Chief Financial Officer, Christian Storch. To help you follow management's discussion on this call, they'll be referencing slides that are posted to the altramotion.com website under Events & Presentations in the Investor Relations section. Please turn to Slide 1. During the call, management will be making forward-looking statements as defined in the Private Securities Litigation Reform Act of 1995. Forward-looking statements are inherently uncertain, and investors must recognize that events could differ significantly from management's expectations. Please refer to the risks, uncertainties and other factors described in the company's quarterly reports on Form 10-Q and annual report on Form 10-K and in the company's other filings with the U.S. Securities and Exchange Commission. Except as required by applicable law, Altra Industrial Motion Corp. does not intend to update or alter its forward-looking statements, whether as a result of new information, future events or otherwise. On today's call, management will refer to non-GAAP diluted earnings per share, non-GAAP income from operations, non-GAAP net income and non-GAAP free cash flow. These metrics exclude certain items discussed in our slide presentation and in our press release under the heading, Discussion of Non-GAAP Financial Measures, and any other items that management believes should be excluded when reviewing continuing operations. The reconciliations of Altra's non-GAAP measures to the comparable GAAP measures are available on the financial tables of the Q3 2014 financial results press release on Altra's website. I'll now turn the call over to Altra's CEO, Carl Christenson.

[Carl R. Christenson:]

Thank you, David. Please turn to Slide 2. Our solid third quarter performance met our expectations even as we faced headwinds from discrete, higher health care costs and the weaker than expected European economy. Revenues increased 16% from the third quarter of 2013. Net of acquisitions, net sales were $178.6 million, up 2% from Q3 2013. We grew non-GAAP earnings 13% to $12.2 million or $0.45 per share. As we discussed on our second quarter call, a significant increase in medical claims and supplier issues resulted in increased expenses. During the third quarter, we experienced a much smaller impact to expenses from the supplier issues. However, the high-cost medical claims, again, had a significant impact on our results, and we expect those medical costs to continue to impact our fourth quarter results. Now please turn to Slide 3. Most of our end markets continued to demonstrate good demand in the quarter, while a few remained soft. Let's begin with our distribution channel, which is predominantly made up of sales of aftermarket parts and original equipment parts for small OEMs. In the third quarter, distribution sales were relatively strong as a result of the general industrial economic recovery in North America. In Turf & Garden, where we are the market leader, sales were off against a difficult comparison with a very strong Q3 2013. Last year, an extended growing season caused by favorable weather conditions led consumers to make outdoor equipment purchases in Q3 that they had delayed from Q2. For the full year, we expect to have one of our best years ever in this market, and we also expect 2015 to be marginally better than 2014. The Ag market continued to slow during the third quarter as expected. The outlook for Ag has softened considerably as weakened commodity prices reduced investments in new equipment. Transportation was up modestly in the quarter, led by stronger automotive sales. In the materials handling market, we saw broad-based sales growth from the third quarter a year ago. Turning to our late cycle markets. Energy, overall, remained strong, led by oil and gas as well as alternative energy. Drilling rig counts, permitting for future drilling, fracking activity and directional drilling have all been at very good levels. However, with oil prices heading towards $80 a barrel, it remains to be seen if this activity will continue. The wind market also continues to be strong in most regions with Europe being the exception. Power generation revenue was down overall from a year ago. In the metals markets, sales were up significantly from a year ago. We said in the first quarter this year that demand had appeared to have bottomed. We have now seen 2 good quarters of growth since then. Mining, on the other hand, continues to be very weak, although we have recently seen some increase in proposal requests for projects. Aerospace and defense was also down as expected, primarily based on declines in defense-related programs. In terms of geography, excluding the impact of recent acquisitions, North America was up low mid-single digits from a year ago, while sales in Europe were up slightly, and Asia was down. The outlook for the global economy is mixed with deteriorating conditions in Europe, but relative strength in North America. With that, I'll hand the call over to Christian, and close with a discussion of our strategic initiatives.

[Christian Storch:]

Thank you, Carl, and good morning, everyone. Please turn to Slide 4. We had a solid quarter coming in at $0.45 per share on a non-GAAP basis while 13% higher than last year. Early in the third quarter, we resolved the supplier issues we mentioned on our second quarter call. The residual effect from these issues, coupled with the higher medical cost that Carl mentioned, combined, had a negative effect on EPS of approximately $0.04 a share. Looking at the top line, foreign exchange rates had a positive impact of approximately 60 basis points while priced at about 110 basis points. Net of acquisitions, sales increased 1.8% year-over-year to $178.6 million. Geographically, excluding acquisitions, North American revenues increased 1.9% year-over-year, while European revenues increased by 3.2%. Sales to the Asia Pacific and our other geographies declined 4.4%. We took a restructuring charge of $1.6 million with the majority of the charge relating to headcount reductions in Europe. Interest expense was $3 million, up $400,000 from the prior year, through the financing cost related to the Svendborg acquisition. During the quarter, the average price of the company's common stock exceeded $27.02, which represents the current per share conversion price of the company's convertible notes. This resulted in an additional 626,000 shares being included in the diluted earnings per share calculation, causing a less than $0.01 reduction in diluted net income per share. This was largely offset by our repurchase of 301,000 shares in the quarter. We recorded a tax rate of 45.1% during the quarter compared with a tax rate of 33.1% in the third quarter of 2013. During the quarter, we took the last step in reorganizing our foreign subsidiaries' reporting ownership. As a result, we recognized a discrete tax expense of approximately $3.7 million. $1.4 million of this expense is noncash. However, we expect these activities to reduce Altra's tax rate by approximately 100 to 150 basis points in the future. Slide 5 is a reconciliation of our non-GAAP measures. Please turn to Slide 6. Our balance sheet remains strong. Book equity was $270 million, and our cash balance was $43 million. Since the inception of our share repurchase program in May, we repurchased 383,000 shares of Altra stock for a total of $12.8 million. We are actively in the market and we'll continue to repurchase Altra shares from time to time as market conditions warrant it. Additionally, we have paid dividend in 2014 totaling $8.6 million for a total return to shareholders of over $21 million so far in 2014. Slide 7 reviews our capital working performance. Our working capital improvement efforts continue to contribute to the company's good operating and free cash flow performance with a conversion rate of more than 100%. Capital investments during the quarter totaled $5.9 million, and depreciation and amortization was $8.1 million, in line with our expectations. Please turn to Slide 8 and our guidance. In the fourth quarter, we will have 3 fewer shipping days or sequentially a 5% reduction in shipping days from the third quarter. In addition, we are facing headwinds going into the fourth quarter. As a result, we expect, at the midpoint of our guidance, that fourth quarter performance will come in below our third quarter numbers. Third quarter incoming order rates in Europe were weak as the European economy is at the verge of another recession. Altra now expects for 2014 revenues to be in the range of $815 million to $825 million, which includes revenues from the recent acquisition of Guardian. We are narrowing our non-GAAP diluted EPS guidance to $1.75 to $1.80. As a result of the foreign subsidiary reorganization, the company now expects its tax rate for the full year to be approximately 30% to 32% before discrete items. We also expect capital expenditures in the range of $23 million to $25 million, and depreciation and amortization in the range of $32 million to $33 million. With that, I will turn the discussion back to Carl.

[Carl R. Christenson:]

Thank you, Christian, and please turn to Slide 9. I'd like to discuss some of our strategic initiatives we are working on. Our lean efforts are progressing very well. In Columbia City, Indiana, for example, we have completed the consolidation of 3 locations into 1 newly leased facility. In fact, we have already begun ramping up production well ahead of plan. This facility serves as a great demonstration of the improvement we are achieving through lean activities, and we are excited by this newest development. This month, we completed the implementation of SAP at the sites targeted for the initial implementation. We are now looking forward to focusing our efforts on realizing the benefits. SAP implementation was a 3-year undertaking and one well worth the investment. It has already driven increased cash flow, and the completion of this initiative should also result in reduced expenses as the costs associated with implementation substantially subside. Our profit improvement initiatives are also on track. Pricing is contributing to margins as expected, and these targeted increases will continue to contribute to our performance going forward. At Bauer, even with an essentially flat top line in the third quarter as a result of the weakening economic conditions in Europe, gross margin expanded in excess of our target. The new Bauer facility will be completed by the end of this year, and the office building is expected to open in May 2015. With this move, we will have consolidated 4 manufacturing facilities into 1. The Svendborg integration is in line with the projections we gave at the time of the acquisition. Svendborg remains on pace to meet our initial target for earnings accretion of $0.10 to $0.15 per share for 2014. Looking at emerging geographies. We've been moving more production work to our new plant in China, which is helping improve its performance. In Brazil, we're localizing production to some Altra products in order to meet local content requirements in that country. Looking ahead, many of our markets are performing well, especially in North America, as the industrial economic recovery here continues to build. Although the global economic picture has softened substantially, particularly in Europe, we're excited about opportunities in several of our markets. Finally, I'm quite pleased with the progress we are making at Altra. From lean to strategic pricing to our tax planning efforts, we have worked to produce an incredibly strong cash machine that is setting new standards at Altra for key -- free cash flow. It is because of this tremendous undertaking that we returned over $21 million to shareholders through quarterly dividends and our stock repurchase program through the first 9 months of the year. Thank you for your continued support of Altra, and we'll now open up the call to your questions. Brenda, if you can open up the line, please?

[Operator:]

[Operator Instructions] And our first question comes from the line of John Franzreb with Sidoti.

[John Franzreb:]

Congratulations on the final completion of the SAP rollout. From what I recall, there were direct costs associated with that. Can we expect those costs now to roll off in the fourth quarter?

[Carl R. Christenson:]

Can you repeat the question, please? Sorry.

[John Franzreb:]

In SAP, from what I recall, you had costs associated with rolling that out that we -- you incurred every year. Are those costs rolling off now?

[Christian Storch:]

Those costs are rolling off now. The last consultants, implementation consultants, have left, so I think the November and December, we will no longer have implementation cost.

[John Franzreb:]

And how much are those costs in the year-to-date or third quarter, if you can give them to us?

[Christian Storch:]

We have said historically that we spend about $1 million a quarter pretax.

[John Franzreb:]

Okay. And the medical costs you've referenced in the quarter, how much was that? And do you expect those costs to roll off in 2015?

[Christian Storch:]

So medical costs in the third quarter were about $1.4 million higher than last year in the third quarter, all driven by large claims. Large claims are claims that we define as more than $50,000 per claim. It is difficult to forecast where those large claims are going to come in the fourth quarter. We've seen a slight drop in September claims, but 1 month doesn't make a trend yet. So we are very cautious to predict that they're going to be going down at this stage.

[John Franzreb:]

Okay. And Christian, you've got a number of initiatives in place. You announced the restructuring in Europe. What are your expectations of hitting your EBIT margin projections that you put forth in -- 14% to 15%? Is that still in line? Or has Europe taken a big bite of that out?

[Christian Storch:]

So if you look at our actual results for the quarter, we show in our release an operating income margin about 8.8%. But if you add back restructuring cost, if you add back the inventory adjustment and those reconciling items, you get to about 10% operating income margin. If you then take the health care hits, it's about 70 basis points. If you project the estimated benefits of the restructuring, you're probably at 11% operating income margin on an adjusted basis. So going forward, it depends how Europe is going to do, and it depends on how the mining recovery will do in 2015. That is a very profitable segment of our business. And then hopefully, if you look at the projects that we have, SAP roll-off cost rolling off, Bauer improvement, China losses, we would hope that we're going to have margin expansion going forward in line with what we have previously communicated.

[John Franzreb:]

Okay. And one last question about the tax rate. What should we look for in 2015 after all the adjustments are made?

[Christian Storch:]

We don't provide guidance at this stage. What I want to say in general, the goal of the European reorganization was that our tax rate will approach 30%. So I think the current guidance of 30%, 31% is probably what's going to happen next year, but we'll fine tune that, and we'll go back...

[John Franzreb:]

I just wanted to get a sense of what the base level is we're looking at.

[Operator:]

And our next question comes from the line of Matt Duncan with Stephens.

[Matt Duncan:]

So Christian, can you quantify the annual savings from the restructuring?

[Christian Storch:]

Typically, it's a 1-year payback, so the annual savings is around $1.6 million.

[Matt Duncan:]

Okay. So $1.6 million there, about $3 million will come out of SG&A as SAP goes away. And then how -- what's the aggregate sort of above-norm medical claim number in this year? If we were to sort of get it back to a normalized level next year, how much would that reduce SG&A expenses by?

[Christian Storch:]

So I think in the fourth quarter, it was about $1.4 million. In the second quarter, it was about $1.2 million incrementally. And in the first quarter, it was slightly elevated, but we'll really start to see that hit in the second quarter. See, we had those 2 numbers, you're talking $3 million.

[Matt Duncan:]

Okay. So if I add all this up, it's like $7 million of SG&A expense savings next year, all else held constant. Is that a fair number for us to use?

[Christian Storch:]

That sounds reasonable.

[Matt Duncan:]

Okay. And then looking at sales trends, can you talk a little bit about what you're sales trends have looked like maybe by geographies since Europe is weakening, and I think things are still looking pretty okay here. It's sounds like especially from distribution channel, which I would think is a pretty good sign that we're still seeing some improvement. So what are the monthly sales trends looking like geographically?

[Carl R. Christenson:]

Yes. We don't publish monthly sales trends, but I'll talk in general what we're seeing from both economic reports that we get from third parties and our kind of bookings rate that we're seeing, and Europe is a huge disappointment. So in the beginning of the year, things were getting better there. The economic reports were all trending up, and incoming order rates were improving. So we felt really good about the recovery in Europe and what was going on there. And then in the third quarter, everything turned back down again. I think that's well-publicized, so it's nothing new, but it's definitely going to have an impact on our business. So we don't know how much yet, but when you look at the last 2 or 3 months of indicators that we get from third-party economists in Europe, they're all trending down. There is some activity going on in Europe that they're trying to stem the tide, but how long that's going to take and how effective it's going to be, nobody knows yet. In Asia, I think the news has been not great, but the business level, our business level in the markets we serve, has been pretty good. So we feel good about what's going on there. We also have such a huge opportunity there that our growth in some areas is significantly better than general economic growth. Take Bauer as an example. Our growth in China for Bauer has been very, very good, north of 20%. So some very select areas in Asia where we've targeted markets and are executing well, we're doing quite well. And then in North America, we are -- the economic recovery here seems to be progressing. We had good incoming order rates and good business levels in the industrial distribution channel, which is a good, early part of the cycle, business for us. So I think I feel pretty good about what's going on in North America. With the one caveat that there are some specific end markets that are not doing well, you look at energy, and if oil dips below $80 a barrel, then that's going to cause a problem for investment in that industry. Mining still hasn't recovered. We have had some requests for proposals for some project work that we haven't had in a couple of years. And so that's encouraging, but it takes a while to go from a proposal to an order, and -- but that's a little bit encouraging. So I think the one area to watch for us probably is the energy field and what's going to happen in energy in North America. Other than that, the general industrial piece seems to be moving along pretty well. That low energy cost helps those industries, right, you got lower commodity cost. That helps those industries, but hurts our energy business.

[Matt Duncan:]

Okay. The last thing for me, just on the M&A front. What are you guys seeing out there right now? I assume you're still after acquisitions. Give us an update on how that funnel looks.

[Carl R. Christenson:]

Yes, we continue to look at books and continue to be active, and we don't have anything to report on today, and when we do, we will.

[Operator:]

Our next question comes from the line of Scott Graham with Jefferies.

[R. Scott Graham:]

The SAP completion, that was a bit of a surprise because I -- my sense was that, that was kind of drag on until year-end and what have you. Kind of what happened during the quarter that kind of got you guys to be able to finish that up as quickly as you did?

[Christian Storch:]

Initially, we had projected that we're going to be done by the second quarter, if you look back about a year ago. And we had 2 sites that we took live this year, our Boston Gear business in Charlotte and our French business, and we then experienced delays. And then I think on the last call, we actually said that we're going to be done by the end of the third quarter, and that's what happened. So we had a delay from the initial plan to be done by June. Boston Gear was probably the most complex go-live that we have had to date. And yes, both are up and running and both are up and running without any significant issues.

[R. Scott Graham:]

Good, good. I thought -- in the last conference call, I thought you said fourth quarter, my mistake. But still, you finished it up it seems like during the third quarter. I guess, my next question is, what's the plan now with this? You've got this great data. It's kind of more about more than just these costs running off. It's -- on a go-forward basis, you guys, in particular, and your direct reports, how are you going to use this data now?

[Carl R. Christenson:]

Yes. So -- Well, I was just going to say, Scott, there will be some cost in the fourth quarter because the consult cost did go through October. So you weren't wrong that what we did say that was going to roll into the fourth quarter. Once we take it live, the consultants are used for support through 1 month after go-live. So there'll be a little bit of costs there, but for November and December, it should be essentially 0. And then going forward, hopefully, you can attend our Investor Day, and that's going to be one thing that we will talk about during our Investor Day. Christian may want give you a little preview of that, but I think that's going to be something that we'll cover in our Investor Day, the benefits that we're going to see from SAP. We don't -- we haven't talked about it to date, and I'd put any numbers on it. We have talked in general about some of the categories that we think we're going to get benefits from. But Christian?

[Christian Storch:]

2 examples. We'll continue build out our shared service office in South Beloit, Illinois. We're in the process of consolidating general ledger accounting into that facility, now that we have a common platform. And another example is given that we now have one common vendor master file, we found that we have over 250 vendors supplying us with safety shoes, safety glasses, what we call MRO items, and we're in the process of consolidating that vendor base and combining our purchasing power. These are just 2 examples of the powerful tool that we have now and the power of the data that is now available to us.

[R. Scott Graham:]

How will it help your lean efforts? I was there recently with you, Christian, in the one facility. How does SAP empower lean going forward within the facilities?

[Christian Storch:]

I think it will help us in 2 ways. Number one, it will help us to standardize transactional processes. So if you think about the purchase order and how that is being processed using standard work, so they're across the company, we have standard work in place in how we process purchase orders and other transactional processes. And the second one, how it will help us is that we can now -- we can develop processes and then deploy the processes across the organization. Forecasting, demand planning, we can now think about how we're going to standardize that using lean tools and embedding lean thinking into that process. Those are 2 examples on how the SAP as a tool will support our lean.

[Carl R. Christenson:]

And a third way, Scott, anytime we work on a Kaizen event, part of the prework is to collect a lot of data. And having SAP and the tools in SAP to extract the data, analyze the data easily to get ready for where the improvement activities are going to be in a Kaizen event is a huge help. The businesses that are on SAP are already finding it much, much easier to work on events with the good data access that they have now.

[R. Scott Graham:]

Great, great. Last question is about what has been going on in the oil and gas markets. Seems to have been obviously a gap down here in the prices of WTI. I was just wondering if in your energy market, oil and gas in particular, have you seen any change in customer order patterns recently?

[Carl R. Christenson:]

I think it's a little early to tell because they are fairly long lead time items that we make for the oil and gas field, but we know that there will be a reduction. Just based on the reduction in the price of the drilling rig counts, it should go down. So we haven't necessarily seen it yet, but the expectation is that we will.

[R. Scott Graham:]

So you're saying here that you're not seeing it more because the products that you make are longer in cycle nature and that will ultimately be affected in your view, but you don't really have short-cycle types of products for oil and gas, which you could make a reasonable determination on that question then?

[Carl R. Christenson:]

Correct, correct. So I think it's going to be another month before we can really have enough data to say this is what's going on.

[Operator:]

[Operator Instructions] Our next question comes from the line of Jeff Hammond with KeyBanc.

[Jeffrey D. Hammond:]

So I think you mentioned some supply chain issues in 2Q. I just -- I don't think you mentioned it this time. Are those fully behind you?

[Carl R. Christenson:]

Yes. So they got cleaned up in the third quarter, and the cost impact was significantly less than it was in the second quarter. And so those are fully behind us.

[Jeffrey D. Hammond:]

Okay. And then 4Q, I think, Christian, you mentioned a number of headwinds, and you talked about the lower shipping days in Europe. But are there other costs? Or have you built medical -- some of this medical stuff carrying over into 4Q?

[Christian Storch:]

And so 3 fewer shipping days for Altra, which is 5%, so we just take 5% off Q3 volume. You almost end up at the low end of our guidance for Q4, and then there's -- we saw some weak incoming order rates out of Europe, particularly out of Germany, in the third quarter, which will have an impact on our fourth quarter top line. Health care costs, we just assumed that the current trend care is forward into the fourth quarter.

[Jeffrey D. Hammond:]

Okay, okay. And then strategic price, I think you said it's on track, and I think your kind of multiyear bogey was $10 million. So as you look out and you look at the traction and momentum on that, how does that feel in terms of being able to capture that full bogey over a multiyear period?

[Christian Storch:]

I think as we look at the results to date, we're projecting slightly above $3.5 million impact on the top line from these initiatives, which approximates the 50 basis points that we have communicated if you exclude Svendborg from the top line number. And then looking at next year, I mean, we have the actions in place that we believe will deliver similar results in 2015. And those actions lead to additional units or business units that are rolling into the program, and then another phase will be to revisit some of the units that have gone through the initial round of the analytics, and there would be a second round of analytics for some of the early adopters within Altra.

[Jeffrey D. Hammond:]

Okay. And then I think you gave us -- but can you give us what the North American growth was in the quarter? And what's going to drive, in your mind, the inflection and distribution?

[Christian Storch:]

So geographically, if we exclude acquisitions, North American revenues increased 1.9%, Europe decreased by 3.2%, and Asia Pacific and other -- the rest of the world declined by 4.4%.

[Jeffrey D. Hammond:]

Okay. And then I think you called out distribution as an area of strength. What are you seeing there? Was that a positive outlier to the 2? And what do you think is driving that?

[Carl R. Christenson:]

It was positive, and I think it's just a general industrial. We didn't see any one particular business or one particular end market through the distribution channel that was outsized. It was just a good general across-the-board distribution improvement. So I think it's just the industrial economy, and the ISM number -- one thing that's been puzzling is how the ISM number has been so good for so long and we haven't seen it in that channel. So it's nice to finally see it start to go up. And I think you look at some of the distributors' published numbers, it looks like the first quarter was better than the prior quarter, that the second quarter was better than the first quarter and third quarter was better than the second quarter. So they've seen a little acceleration in the business based on the limited numbers that we've seen so far.

[Operator:]

This concludes our question-and-answer session. I would now like to turn the floor back to management for closing remarks.

[Carl R. Christenson:]

I think we have one correction to make in a number that Christian talked to. So I'm going to let Christian correct that number.

[Christian Storch:]

The conversion price of our stock was $26.82 and not $27 -- $26.82 and not $27.02 as I had stated in prepared remarks.

[Carl R. Christenson:]

Okay. So with that, I would like to thank everyone for joining us this morning, and we look forward to speaking with some of you at the 2014 Altra Investor Day in New York on November 12. Enjoy your weekend, and thank you very much.

[Operator:]

This concludes today's teleconference. You may disconnect your lines at this time, and thank you for your participation.